W. Val Oveson, CPA, has been very busy ferreting out tax policy and administrative problems that make compliance burdensome for taxpayers. In his annual report to Congress, Oveson, who has been National Taxpayer Advocate since 1998, identified the top seven issues that impede taxpayer compliance.

The earned income tax credit (EITC) led the list of issues. The EITC is a problem, particularly for the low-income taxpayers to which it is targeted, because it is difficult to calculate. Taxpayers trying to figure the credit must contend with a long list of eligibility tests, modifications to income and unique definitions.

“The earned income tax credit is one of the primary causes of advocate casework,” Oveson said. “A great deal needs to be done to simplify it.” In the report, he made the following recommendations to improve the way the EITC is administered:

• Simplify the definition of a qualifying child.
• Permit taxpayers who reside with another eligible adult to also claim the EITC.
• Eliminate the age requirement for the EITC.
• Make the EITC exempt from offsets for federal tax debt or other liabilities (for example, delinquent child support).

Six other areas identified as particular obstacles to taxpayer compliance, along with proposals to address each, follow:

• Business deductions: Correct inequitable treatment of business deductions for taxpayers whose expenses are not reimbursed by their employers and who do not itemize.
• Interest charged by the IRS: Broaden the interest abatement requirements and limit the assessment of interest on tax balances owed.
• Penalties: Eliminate the inequities in the assertions, abatements and computation of penalties.
• Refunds: Amend statutes, notifications and other laws that prevent taxpayers from legally collecting the refunds due them.
• Alternative minimum tax: Repeal or reform the unnecessarily complex and burdensome AMT.
• Phase-out of itemized deductions and the personal exemption: Repeal the phase-outs of these items because they add to the complexity of tax calculations and are burdensome to a large number of taxpayers.

In another part of the report, Oveson revealed the results of a survey in which he asked individual and business taxpayers and tax professionals to rank their most serious tax problems. Not unexpectedly, the ones that topped the list in 1998 were still causing headaches in 1999. The top five problems were the complexity of the tax law, the clarity and tone of the IRS, the administration of the EITC, the lack of “one-stop” service and the administration of penalties.

Oveson also presented a detailed discussion of 53 legislative proposals for improvements in the Internal Revenue Code and the IRS in the annual report. The full text of the report is posted on the IRS Web site, ( www.irs.ustreas.gov/prod/ind_info/rpt99-1.html ).

Last fall, the Tax Court issued several unusual related memorandum decisions on the earned income tax credit (EITC)—a refundable credit available to taxpayers with income below a specific threshold.

The cases involved five prisoners who attempted to claim the EITC on money they had obtained from “begging.” The Florida inmates claimed that money they solicited from family and friends was earned income from begging. In each case, the prisoner’s taxable income was insufficient to result in a tax liability. Also, the inmate had not made any estimated payments or any withholdings during the years in question.

The prisoners claimed EITC refunds in amounts from $17 to $90. Two claimed the credit for two years (1996 and 1997). The others claimed it for only one year.

The court found the amounts received by the inmates were gifts and not income. In its decision, the court determined that friends and family gave the money to the prisoners out of charity with no expectation of repayment. It said the money was not earned and therefore could not be considered income. The EITCs were not allowed.

In its deliberations, however, the court ignored a provision in the Internal Revenue Code that already disallowed the credits. Any income earned for services provided by an inmate in a penal institution is not “earned income” for the purposes of the EITC, according to IRC section 32(c)(2)(B)(iv).

Observation. The Tax Court may have been trying to answer a broader question in these cases—can money begged from family and friends be considered income and therefore qualify as earned income for EITC purposes? In its rulings the court addressed the begging issue for all taxpayers—in or out of prison.

• ( Pradel Lucas v. Commissioner, TC Memo 1999-321; John Walter Wolf, 1999-320; Alfredo Dominquez, 1999-319; Floyd Daniel, Jr., 1999-318; Miguel A. Bauta, 1999-317.

—Cheryl Metrejean, CPA, assistant professor of the
E.H. Patterson School of Accountancy at the
University of Mississippi, Oxford, Mississippi.

In the past, the IRS prevented taxpayers who maintained inventories from using the cash method of accounting for federal income tax purposes. Instead, Treasury regulations section 1.446–1(c)(2)(i) forced taxpayers to use the accrual method to account for purchases and sales.

Under section 1.471–1, the use of inventories is required “in every case in which the production, purchase, or sale of merchandise is an income-producing factor.” The determination of whether “merchandise” is an income- producing factor has long been a source of controversy between taxpayers and the IRS.

The IRS had successfully argued that it had the authority to require taxpayers to use the accrual method even when they were predominantly service providers and did not maintain inventories per se. For example, in Commissioner v. Thompson Electric, Inc. (TC Memo 1995–292), the IRS contended an electrical contractor had inventories and was, therefore, required to use the accrual method of accounting. This argument prevailed, even though Thompson Electric

• Did not offer its supplies for sale to the public.
• Did not separately itemize supplies on its invoices.
• Did not separately charge for its services.
• Did not usually permit the customers to select the materials to be used in connection with the provision of services.

Traditionally, taxpayers, such as physicians, who engaged strictly in the provision of services, were not affected by these rules because none of their revenue was attributable to merchandising activities.

In Osteopathic Medical Oncology and Hematology, PC v. Commissioner (113 TC no. 26), a divided Tax Court determined when supplies or goods would be considered “merchandise.” The case involved a professional services corporation that provided oncology services and administered chemotherapy treatment to patients (see “Cash Accounting Okay for Drugs,” JofA , Mar.00, page 77). The taxpayer used the cash method of accounting, and the IRS challenged it.

When the case went to the Tax Court, the court focused on the unique characteristics of the chemotherapy drugs and treatment. Under applicable state law, the taxpayer could not sell the drugs to a patient, the medication was administered in the taxpayer’s office under a doctor’s supervision and the medication could not be self-administered.

The court compared the facts of Osteopathic Medical to other cases. It found that, in contrast to cases such as Thompson Electric, the chemotherapy patients could not choose to obtain the drugs and services separately.

After a review of existing case law, the court concluded that there was no clear precedent in this area because of the overriding service aspect of the taxpayer’s activities: “The service provider is using the items as supplies which are essential to the provision of its services. A medical practice such as the petitioner’s is inherently a service business, and the drugs administered in the practice are subordinate to the provision of the medical services.”

Observation. While this decision is certainly good news for taxpayers, until further precedent is established along these lines, CPAs must recognize that its unique and highly specific facts will make it applicable to only a few taxpayers. The finding, however, will give CPAs and taxpayers another angle from which to argue against IRS claims that taxpayers who are essentially service providers, but who have inventories, must use the accrual method of accounting.

—Vinay S. Navani, CPA, tax manager,
Wilkin & Guttenplan, PC, East Brunswick, NJ.

It’s not uncommon for a taxpayer that has defaulted on a debt to find the property securing the debt is worth less than the amount of the liability. In the event of a sale, the tax treatment will differ depending on how the debt is structured. If the debt is “recourse,” a sale of the property results in a gain equal to the difference between the value of the property and its basis. A taxpayer would have cancellation-of-debt (COD) income equal to the difference between the recourse debt and the value of the property. If the debt is “nonrecourse,” the full amount of the debt is included in the sale proceeds, resulting in gain on the sale and no COD income. Since an insolvent taxpayer can exclude COD income, taxpayers frequently try to avoid sale treatment when disposing of property securing nonrecourse debt so they can report COD income.

A partnership, 2925 Briarpark, Ltd., borrowed approximately $25,600,000 in a nonrecourse loan secured by real property. Its basis in the property was approximately $11,100,000. The partnership was in default on the note. The creditor concluded it would get the largest recovery if the property was sold for its fair market value. The creditor agreed to allow Briarpark to sell the property and to cancel the note if Briarpark transferred the net sales proceeds to the creditor.

Briarpark found a purchaser willing to pay $11,600,000 for the property if all debts and liens were cancelled. The partnership sold the property and transferred approximately $10,936,000 of net proceeds and $177,500 in cash reserves to the creditor, who cancelled the nonrecourse debt. Briarpark treated these events as two separate transactions, reporting a $61,000 loss on the sale of the property and $14,470,000 of COD income as a result of the creditor’s cancellation of the nonrecourse debt. The IRS reclassified the transaction as a single event—a sale resulting in a $14,400,000 gain ($26,000,000 amount realized minus $11,600,000 of basis plus expenses). Briarpark appealed.

Result. For the IRS. Briarpark argued that the sale was separate from the debt cancellation because it involved a separate purchaser and took place before the cancellation. The partnership believed this entitled them to treat the cancellation as having created COD income rather than gain. The Fifth Circuit Court of Appeals ruled there was only one transaction. The fact that the creditor agreed to cancel the note on receipt of the net sale proceeds and that the buyer insisted all liens be canceled indicated the transactions were the same as a foreclosure sale. The Fifth Circuit rejected the taxpayer’s reliance on Gershkowitz , a case in which the debt was forgiven independent of, and three months before, the sale of the property. In Briarpark, the sale was part of the debt cancellation transaction.

It is possible for cancellation of nonrecourse debt to create COD income. The taxpayer is responsible for showing that the cancellation was in no way related to a disposition of the property. A taxpayer who fails in this burden will have taxable gain rather than excludable COD income.

• 2925 Briarpark, Ltd. v. Comm., 163 F.3d 313, 99-1 USTC 50,209, CA-5.

Taxpayers are required to include COD amounts in income. A taxpayer that is insolvent at the time a debt is cancelled can exclude COD income from gross income. The Internal Revenue Code defines insolvency as the excess of liabilities over the fair market value of assets. A recent case examined this definition.

Dudley Merkel was a general partner in HMH Partnership. Great Western Bank forgave a $1,439,000 nonrecourse debt of the partnership. Merkel had $359,721 of COD income as a result of the forgiveness. Merkel also was a shareholder in System Leasing Corp. (SLC). He personally guaranteed a bank loan to SLC. The corporation defaulted on the loan. The bank forgave $2,000,000 of the loan on the condition that SLC pay $1,100,000 of it and that Merkel refrain from filing for bankruptcy for 400 days.

Merkel included the $2,000,000 guaranteed debt on his list of liabilities as a contingent liability. As a result, he was insolvent and entitled to exclude the $359,721 of COD income. But the IRS said the guaranteed debt was not part of Merkel’s liabilities and he was, in fact, solvent, making the COD income taxable. The Tax Court ruled in the IRS’s favor and Merkel appealed.

Result. For the IRS. In the view of the Ninth Circuit Court of Appeals, the issue was, Should a taxpayer include contingent liabilities when computing insolvency? Since the IRC definition simply says “liabilities” without further explanation, the Ninth Circuit turned to the legislative history. In evaluating that history, it accepted the Tax Court’s initial conclusion that to include all contingent liabilities would create absurd results. The Ninth Circuit said Congress intended only liabilities that would actually offset assets to be included in the computation. Therefore, a taxpayer may include only liabilities he or she more likely than not will have to pay. Since Merkel could not prove it was likely he would have to pay the guarantee (the 400 days passed without his filing for bankruptcy, and the contingency lapsed), he was not insolvent.

There was one dissent. Judge O’Scannlin preferred to follow the wording of the code, which says “liabilities,” thereby implying all liabilities. To prevent the absurd results that troubled the majority and the Tax Court, O’Scannlin said he would follow the bankruptcy law rules, which include all liabilities discounted by the probability of occurrence. This would, in his opinion, provide more reasonable results than the all-or-nothing approach the majority adopted.

In letter rulings 199932013 and 199935002, the IRS concluded that when computing insolvency, a taxpayer must include all assets he or she owns—even those exempt from creditor claims. This revokes PLR 9125010 and TAM 9130005. The increase in includible assets and the omission of contingent liabilities, unless the creditor is more likely than not to require payment, will make it more difficult for taxpayers to exclude COD income. While there is a slight chance other circuit courts will follow the dissenting approach, until then a taxpayer must include all assets and omit contingent liabilities from the insolvency computation.

• Dudley B. Merkel v. Commissioner, 1999 U.S. App. Lexis 22449, 99-2 USTC 50,848 (CA-9).

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

Taxpayers must often rely on professionals to advise them on tax matters. Estate taxation can be particularly complicated for a layman. The personal representative of an estate, responsible for administering a decedent’s financial affairs, often has no knowledge of tax issues. Fiduciaries who disregard claims of the United States (including income tax liabilities) are held personally responsible for any unpaid amounts. Frequently, these individuals need professional advice about disbursements of funds to creditors, beneficiaries and the taxing authorities.

Jerry J. Calton died intestate in 1989. His friend, William D. Little, was asked to act as personal representative. Little had no experience as a fiduciary and sought guidance about the estate’s administration. Soon after Little was appointed personal representative, the estate hired an attorney. Little promptly forwarded tax forms and tax notices he received regarding the decedent to the attorney. Notwithstanding several W-2s and 1099s the estate received on the decedent’s behalf, the attorney advised Little the estate owed no taxes due to its small size.

Based on advice from the attorney that there was no tax liability, Little disbursed most of the estate’s assets to creditors and beneficiaries. Soon after, the estate received a notice of deficiency from the IRS proposing a tax liability based on the decedent’s earnings before his death and on the estate’s income. Little forwarded the notice to the attorney, who again told him no federal taxes were due.

The attorney hired a CPA to review the administration of the estate prior to its closing. The CPA discovered the tax documents and assessments and filed the required returns. Although there was a balance due, the estate sent no money with the returns. (The estate, however, stopped disbursing funds once it became aware of a potential tax liability.) Little subsequently sent an offer in compromise to the IRS, submitting the estate’s remaining funds ($17,586.07) as full payment of the tax liability. The IRS did not accept the offer and returned the check without explanation. The attorney and the CPA met with the IRS and came away with the erroneous belief that the IRS was canceling the tax liability as a result of the meeting. They advised Little to pay out the remaining funds and close the estate.

The IRS continued to press its claim. Little received a notice from the IRS that he was personally liable for unpaid income taxes and penalties amounting to $63,734.53 plus interest. Asserting that he had no knowledge of the tax liability when he distributed the estate’s assets, Little petitioned the Tax Court for relief.

Result. For the petitioner. The IRS based its case on a federal law which says representatives of a person or an estate are liable for government claims. Courts have held a fiduciary liable if he or she has actual knowledge of the claim or is “chargeable with knowledge of the debt.” In ruling in his favor, the Tax Court determined Little was unaware of the decedent’s income tax liability when he closed the estate.

The IRS said that Little knowingly disregarded the tax liability when he closed the estate because he was aware of the debt when he received the W-2s and 1099s. However, the Tax Court found that Little sought advice before making disbursements and acted in a “prudent and reasonable manner.” He was repeatedly informed that there were no taxes due. He disbursed all funds and closed the estate on the advice of both an attorney and a CPA.

The Tax Court determined that because he “fulfilled his duty of inquiry and was reasonable and acted in good faith in following the attorney’s advice” no tax was due from the estate.” The U.S. Supreme Court, in United States v. Boyle , (469 US 241, 151 (1985)) observed that a taxpayer who relies on the advice of a professional should not be expected to seek a second opinion. The law requires fiduciaries to pay debts due to the United States before disbursing funds to creditors and beneficiaries. Those who do not have personal knowledge of the law generally seek professional advice. When a fiduciary follows such advice, even if it is incorrect, he or she is considered to have acted reasonably and in good faith and should not be held responsible for any unpaid taxes.

• William D. Little v. Commissioner , 113 TC no. 13.

Prepared by Cynthia Bolt Lee, CPA,
assistant professor of business administration,
the Citadel, Charleston, South Carolina.