TAX NEWS

In a recent interview with the JofA, Deborah M. Nolan, CPA, IRS Deputy Commissioner of the Large and Mid-Size Business (LMSB) division, spoke of the service’s strategic goals that would make filing returns easier and increase fairness of compliance enforcement.

When asked specifically how she planned to improve matters for the average business taxpayer, Nolan said that the IRS “used to approach compliance from an enforcement mode”—that is, three to five years after the returns were filed, it would have audit teams examining returns.

“Now the approach is proactive. It is based on a higher degree of trust and partnership with the practitioner community, and we now deal with tax administration in a proactive way. Suppose, for example, there is an area of tax law that is controversial: We examine the problem promptly to see if compliance could be effected, then engage the practitioners and the taxpayers in a dialogue. We suggest alternatives like prefiling, providing either case-specific or generic guidance to try to get an agreement with the taxpayer before the actual filing of the return.”

Nolan added that, to achieve the goal of fairness in compliance enforcement, the IRS has three objectives: to service all taxpayers, increase productivity through quality and ensure integrity of the process. “When we talk of ‘fairness in compliance,’ we wish to assure all taxpayers that they will be treated fairly, consistent with others similarly situated.”

Nolan said the LMSB division has been conducting seminars both for practitioners and for its own employees with the objective of reinforcing IRS goals. In a recent seminar, Commissioner Larry Langdon emphasized early resolution of pending cases. James Dougherty, a director in Deloitte & Touche LLP’s tax controversy services division and a member of the AICPA tax practice and procedures committee, who was a panelist at that seminar, said the constant refrain was “Resolve cases expeditiously.” He added that some participants at the seminar called for audits that were issue oriented, not time oriented. The consensus at the meeting was that the IRS should quickly define the elements of the case and resolve specific issues so taxpayers would not have to wait two years to close a case.

Earlier this year, the IRS had reorganized into four operating divisions—Small Business/Self-Employed, Wage and Investment, and Tax Exempt/Government Entities, as well as the LMSB. (For more about the LMSB division, see Tax News, JofA, Aug.00, page 81).

TAX NEWS

In late July the AICPA tax executive committee approved as final eight Statements on Standards for Tax Services (SSTSs), which superseded and replaced Statements on Responsibilities in Tax Practice. (See “Standards for Tax Services Proposed,” JofA, June00, page 77.) Although the substance of the rules contained in each statement, as well as the title and the number, remain the same, the language has been edited to clarify and reflect the enforceable nature of these standards. (The AICPA council designated the tax executive committee as a standard-setting body in October 1999.)

Members are expected to comply with the new standards, and violations could subject members to an ethics investigation. The text of the eight SSTSs—as well as an interpretation of SSTS no. 1, Tax Return Positions, which was also approved by the committee in July—is reprinted in full in this issue (see Official Releases, page 139).

TAX BRIEF

INDIVIDUAL

One of the new vocations of the Internet age is day trading; it is characterized by traders’ rapidly buying and selling securities to take advantage of small movements in their value and liquidating the portfolios by the end of the trading day. Coverage in the news media has generally focused on the lack of regulations governing the industry, the large losses that have prompted some day traders to act irrationally and the few successful traders who have earned large profits. But the news media has barely discussed the tax rules covering these trading transactions.

The Taxpayer Relief Act of 1997 contained several provisions that both help and hurt day traders in their computation of income taxes. First, the act permits the day trader to use mark to market accounting for his or her security portfolio. This allows him or her to recognize gains or losses in the value of a security portfolio before a gain is realized by the sale of a security. Since day trading is characterized by rapid turnover of securities and the day trader does not want to hold securities overnight, the effects of this provision are hard to determine.

Second, a day trader can classify his or her activities as a business to be reported under schedule C of form 1040. This is significantly better for the trader than the provisions that applied before the act went into effect. Previously, a day trader was limited to annual capital losses of $3,000, regardless of whether he or she had short- or long-term losses. But if he or she files as a business, there is no limitation to the total losses that can be taken. Since many day traders have experienced large losses, this is a significant tax benefit.

Third, the trader has greater latitude in deducting costs. As an individual, the day trader would have to deduct business costs on schedule A of form 1040 where 2% of adjusted gross income is first subtracted from the deduction. But if that trader classifies his or her activities as a business, such expenses—which include computer equipment, software, communication expenses, margin interest and related items—are fully deductible, and the 2% rule does not apply.

However, there are several negative tax rules associated with day trading. First, any gains are subject to both income and self-employment taxes. The trader would have to pay employment taxes as a self-employed individual for the net business gains over the tax period.

In addition, the act placed certain accounting burdens on the day trader. He or she must segregate investments into trading securities and investment securities. This means that the gains and losses from the investment securities are recorded on schedule D and the trading gains and losses are recorded on schedule C. There is no specific regulation to use as a guide in differentiating the securities into trading and investment portfolios.

Finally, the IRS has issued no formal guidelines as to who qualifies as a day trader. Some factors that might be relevant would include (1) the number of trades an individual makes, (2) the intent of the individual, (3) how long an individual holds securities and the amount of time devoted to trading activities, (4) sources of income other than day trading and (5) the nature of the investment account and the relationship the individual maintains with the investment bank.

—Marc I. Lebow, CPA, PhD, associate professor of
accounting at Christopher Newport University in
Newport News, Virginia, and
P. Michael McLain, CPA, DBA, assistant professor of
accounting at Hampton University, Hampton, Virginia.

TAX CASE

In today’s economy, many business owners—both large and small—are considering buying other companies or selling the one they own. A recent case addresses some of the issues that may arise when the acquisition is structured to take advantage of opportunities in the financial market.

Jordan Co. negotiated the purchase of the stock of Custom Chrome from its owner, Tyrone Cruze. Jordan structured the acquisition as a leveraged buyout with a covenant not to compete. To obtain the loan, Jordan gave the lenders warrants to purchase stock at $500 per share, the current market price. Jordan paid $650,000 in legal and professional fees related to the acquisition. The Tax Court decided the covenant not to compete was valid and amortizable over its three-year life; however, the expenses associated with the acquisition were nondeductible and the warrants had a zero fair market value, creating no original issue discount (OID). The taxpayer appealed the last two decisions.

Result. In part for the IRS and in part for the taxpayer. The Ninth Circuit Court of Appeals upheld the Tax Court decision denying a deduction for the acquisition-related expenses. Although the transaction was a purchase of stock, it was structured as a leveraged buyout. Specifically, the acquiring corporation formed a subsidiary that, in turn, created a second-tier subsidiary, which borrowed the purchase price. The first-tier subsidiary bought the stock with the borrowed funds and then merged the second-tier subsidiary into the acquired company. At the end of the transaction, the shareholder had cash from a loan that was housed in his former corporation (a second-tier subsidiary of the acquiring corporation).

The Tax Court classified the end result as a stock redemption by the acquired corporation using the step transaction doctrine. The court treated the transaction as if the target company borrowed the funds and used them to purchase (redeem) the shareholder’s stock. Since the substance of the transaction was a stock redemption, all related expenses are governed by IRC section 162(k,) which denies a deduction for all redemption expenses except those directly related to any loans. The result was that the $650,000 of legal and professional fees was nondeductible.

When warrants or options are part of a loan package, part of the proceeds is allocated to the warrants, creating OID, which is amortizable over the life of the loan. The amount allocated to the warrants is the value of those warrants at the time of issue, not at exercise, as the taxpayer tried to argue.

The Tax Court assigned a zero value to the warrants primarily because they were “at the money” when issued—the exercise price of the warrants was equal to the current market price of the underlying security. Secondarily, the lender booked the warrants at a nominal value of $1,000 and the taxpayer did not amortize any OID on the tax returns originally filed.

The Ninth Circuit rejected the Tax Court’s basic reasoning that at-the-money warrants have no value. The court said that while the warrants have no intrinsic value (the bargain element in a stock purchase) they still can have a time value—a measure of the expected increase in value caused by increases in the stock’s value during the time the warrants can be exercised. The appeals court quickly dismissed the Tax Court’s consideration of how the lenders booked the warrants and the taxpayer’s failure to amortize the amount as immaterial. This part of the case was remanded to the Tax Court to determine the value of the warrants based on valuation techniques that might include the Black-Scholes formula, comparable warrants or the present value of earnings that may be acquired through exercise of the warrant.

Although the value of the warrants is still to be determined, this case addresses several issues that can surround a corporate acquisition that, on paper, seems to be a simple stock purchase.

Custom Chrome, Inc. vs. Commissioner, 86 AFTR.2d 2000-5039 (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.