The Tax Court, in a case of first impression, has held that nonpetitioning or former spouses have the right to challenge innocent spouse relief petitions whenever their spouses or former spouses file them. The court directed the IRS to notify nonpetitioning and former spouses of their right to intervene in all innocent spouse relief cases. The IRS recently acquiesced to this ruling (Chief Counsel Notice N(35) 000-173, 10-17-00).

In King v. Commissioner (115 TC no. 8 (2000)), the taxpayer and her husband filed a joint tax return in 1993. Two years later, they divorced. The IRS determined that a deficiency existed for the 1993 return and issued identical notices of deficiency to the taxpayer and her former husband. The taxpayer moved for innocent spouse relief from joint liability and filed a petition before the Tax Court. When her former husband learned of the innocent spouse petition, he sought to challenge it and moved to intervene in the case.

In its decision, the Tax Court stated that the IRS Restructuring and Reform Act of 1998 expanded the innocent spouse protections. But the court also found that this case was based on a notice of deficiency, and therefore innocent spouse relief, in this situation, could be used as an affirmative defense.

The court saw similarities between this case and a more recent one, Corson v. Commissioner (114 TC 354 (2000)). Corson also was based on a notice of deficiency, but both former spouses were petitioners in the same deficiency case. In this case, the taxpayer’s former spouse did not file for relief from the IRS’s deficiency determination. However, the Tax Court found that this should not preclude the former spouse from intervening in the taxpayer’s case.

Furthermore, the Tax Court found that Congress, when it expanded the innocent spouse rules in the 1998 act, was concerned about fairness to nonpetitioning spouses. The court also noted that IRC section 6015(e)(1)(A) specifically calls on the Tax Court to establish rules for notice to be given to nonpetitioning spouses and requires that they have an opportunity to be heard.

The court stated that the reason for giving a nonpetitioning spouse the chance to be heard in these cases is to insure that innocent spouse relief is granted on the merits after all relevant evidence is brought forward. In any proceeding where a taxpayer brings forward a claim for relief from joint liability under section 6015, and the spouse or former spouse is not a party to the case, the IRS must serve notice on that taxpayer’s spouse or former spouse. The IRS must inform and advise the nonpetitioning spouse of his or her right to intervene in the case, and to challenge the relief petition.

King v. Commissioner, 115 TC no. 8. (Aug. 10, 2000)

—James Ozello, Esq., Ozello Tax and Legal Consulting, Ringwood, New Jersey.

In the October 2000 issue of the JofA, t wo tax articles discussed day traders and day trading. One, “Being a Trader in Securities”(page 118), was an excerpt from a longer Tax Adviser article, “Securities Trader Reporting Requirements,” by Thomas Rolfe Pudner. It said a “trader’s activity is not subject to self-employment tax.” The second article, “Paying the Piper: Some Tax Rules for Day Traders” (page 115), by Marc I. Lebow and P. Michael McLain, said day trading is subject to self-employment taxes. The JofA and the authors received many inquiries asking for clarification. Below is a second article by Lebow and McLain (joined by Wayne Schell, an associate professor at Newport University) that explains why they believe the tax law in this area is ambiguous and why a day trader may want to pay self-employment tax.

In the October 2000 JofA, we argued that taxpayers whose trade or business is trading marketable securities (a.k.a day traders) should report gains and losses from their business on schedule C, form 1040, so they can ignore the $3,000 capital loss limitation. However, another alternative is for the taxpayer to report business expenses on schedule C while reporting gains and losses on schedule D. In this instance, the $3,000 capital loss limitation applies. If the taxpayer elects to use schedule C for both expenses and gains, the net gains are subject to self-employment taxes.

We have received several requests for a clarification of our position. Most concerns related to the practitioners’ interpretation of IRC section 1401, which says, “The 1998 act provides that the rule treating gain or loss as ordinary by reason of the taxpayer’s election to apply mark-to-market rules does not apply for purposes of applying IRC section 1402 (rules relating to the self-employment tax).” In other words, gains or losses caused by the mark-to-market election do not affect self-employment tax expense and liability.

Tax practitioners have told us that many accountants advise clients they are not liable for any self-employment tax on their day-trading activities. This position comes from a misunderstanding of the mark-to-market concept. In its explanation of mark-to-market, the code says, “In the case of a person who is engaged in a trade or business as a trader in securities and who elects to have this paragraph (mark-to-market) apply to the trade or business:

“Such person recognizes gain or loss on any security held in connection with the trade or business at the close of any tax year as if the security were sold for its fair market value on the last business day of such taxable year, and

“Any gain or loss is taken into account for such taxable year. (IRC section 475(f)(1)(A).)”

The code then explains that gains and losses from applying the mark-to-market provision, while they may be ordinary income or loss, they are not subject to self-employment taxes (IRC section 475(f)(1)(D)). That is, the ability to avoid self-employment taxes from this section does not apply to realized gains or losses; it merely applies to the revaluation of a portfolio of securities from cost to market value occurring at the end of a tax year.

The argument that day traders are liable for self-employment taxes follows a different path. First, we argued the day trader will want to report business transactions using schedule C to avoid the $3,000 limitation on capital losses. The courts ruled that individuals whose main business was gambling on fluctuations in the value of securities were in a trade or business and thus subject to the self-employment tax. For example, in Groetzinger v. Commissioner, (480 U.S. 23; 107 S. Ct. 980 (1987)), a person involved in a trade or business was identified as one whose activities were regular, frequent, active and substantial. The case involved a gambler who was recording his income and losses on schedule C. In a footnote, the U.S. Supreme Court cited Barrish v. Commissioner (49 TCM 115 (1984)) and Baxter v. United States (633 F.Supp 912 (1986)), and determined that there was no distinction between a gambler and an active market trader (a day trader). The Court also said “the courts have properly assumed that the term includes all means of gaining a livelihood by work, even those which would scarcely be so characterized in common speech.”

In Trent v. Commissioner (291 F.2d 669, 671 (CA2 1961)), the courts ruled that gamblers involved in trade or business are subject to self-employment taxes. An example of this relationship can also be found in the court ruling in Groetzinger :

“If a taxpayer, as Groetzinger is stipulated to have done in 1978, devotes his full-time activity to gambling, and it is his intended livelihood source, it would seem that basic concepts of fairness (if there be much of that in the income tax law) demand that his activity be regarded as a trade or business just as any other readily accepted activity, such as being a retail store proprietor, or, to come closer categorically, as being a casino operator or as being an active trader on the exchanges.”

In another case, Meredith v. Commissioner (TC Memo 1984-651), an active trader of securities was also defined as a gambler. To quote the ruling, “one may gamble in stocks while another may gamble in dogs.” Finally, citing Fuld v. Commissioner (139 F.2d 465 (1943)), 26 section 1236 USCS Interpretive Notes and Decisions says, “Taxpayers purchasing and selling securities for themselves for speculation may constitute a ‘trade or business’ for reporting taxes on profits derived from such dealings.”

A taxpayer who follows the logic of the gambling and similar cases, knows that gains and losses should be reported on schedule C, and therefore be subject to self-employment taxes and not be subject to the $3,000 loss limitation.

This is not to say the courts were unanimous in their rulings. In King v. Commissioner, (89 TC 445, 458 (1987)), for example, the Tax Court found traders “occupy an unusual position under the tax law because they engage in a trade or business [that] produces capital gains and losses.”

Using the logic of King , the gains from the sale of capital assets (marketable securities) should be treated as capital gains and not be subject to self-employment taxes. The argument here is that day trading is a unique business that generates capital gains and losses. Logically, the $3,000 loss limitation would apply. This position is strengthened if the taxpayer is not considered to be in a trade or business but is instead merely an investor.

The difficulty lies in determining whether the taxpayer is in a trade or business. In King , the court ruled that “a trader’s activities must seek profit from short-term market swings, unlike those of an investor who seeks capital appreciation and income and who is usually not concerned with short-term developments that would influence prices on the daily market.”

In Paoli v. Commissioner (TC Memo 1991-351 (1991)), the court found 326 trades during the year did not make the taxpayer a trader. If the taxpayer had other employment or other sources of income in a taxable year, he or she might not be able to report gains and losses on schedule C. It was also noted in King that not every individual who trades in securities is considered to be participating in a trade or business. In Beals v. Commissioner (TC Memo 1987-171 (1987)), the IRS initially took the position that someone who managed investments was subject to self-employment taxes but later said that its initial position was in error—that one who merely managed investments was not subject to the tax. In a response to a September 1999 taxpayer inquiry on this subject, the IRS said, “Self-employment tax does not apply since the sale of a capital asset is involved and the profit or loss is ordinary only because of the mark-to-market election.”

Whether or not a day trader is subject to self-employment tax is ambiguous. If the taxpayer is in trade or business and elects to report both expenses and gains and losses on schedule C, there is significant case law supporting that position. As a matter of consistency, the taxpayer would be subject to self-employment taxes and not subject to the $3,000 capital loss limitation. If the taxpayer follows King and similar cases, gains and losses may be reported on schedule D and self-employment taxes are not relevant. Here, the $3,000 capital loss limitation applies. An interesting solution to this problem has been proposed by several tax practitioners. The taxpayer elects to report income on Form 4797, Sales of Business Property, and expenses on schedule C. This will allow him or her to maximize both trading losses and business expenses. The appropriateness of reporting gains and losses on the sale of marketable securities on form 4797, however, is not addressed in this article.

—Marc I. Lebow, CPA, PhD, and Wayne Schell, CPA, PhD,
associate professors 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.

When I became Commissioner of Internal Revenue in 1997 I pledged to turn the IRS into an organization that would consistently deliver the highest quality service to America’s taxpayers. The IRS must measure its success or failure not only by the taxes it collects but also by its effect on the people it serves. To achieve this goal, the IRS undertook a historic reorganization, the most comprehensive since the 1950s, to improve performance in all areas.

Change has been gradual and much remains to be done. A complete modernization of the IRS, especially its technology, will take the better part of a decade. Over the next three to four years, however, we will institute a number of changes that ultimately will make a major difference in how we work to better serve taxpayers.

New organization and management

One reason we reorganized the IRS is that its traditional structure did not adequately support taxpayer demands. We created a modernized organization geared to understanding and solving problems from the taxpayers’ point of view. It is led by management teams with the broad range of experience needed to direct current operations while modernizing business practices and technology to achieve the IRS’s mission and strategic goals.

As CPAs are aware, the current IRS structure consists of

Four operating divisions: Wage and Investment; Small Business and Self-Employed; Large and Mid-Size Businesses; and Tax Exempt and Government Entities (see “Modernization Update: New IRS Up and Running,” JofA, Mar.00, page 72 ). This new centralized focus is helping to ensure uniform and consistent practices nationwide.

Two service organizations: Information Systems and Agency-Wide Shared Services.

Separate specialized independent channels for taxpayers: Appeals and the Taxpayer Advocate Service.

Criminal Investigation, a line unit with sole responsibility for investigation of criminal violations of the tax law.

The Office of the Chief Counsel, which provides tax advice, guidance and legislative services to all sections of the agency.

A smaller national headquarters, which sets broad policy, reviews operating unit plans and goals and develops major improvement initiatives.

The shift to e-filing

Encouraging electronic filing is a key initiative at the IRS. The IRS Restructuring and Reform Act of 1998 mandated electronic filing of at least 80% of returns by 2007. The electronic tax administration (ETA) system provides many benefits for both taxpayers and practitioners and also within the IRS, including speedier refunds to taxpayers, positive acknowledgment of returns and a reduction of the number of errors. A strong ETA will reduce the amount of time taxpayers spend dealing with the IRS.

The first and most visible ETA initiative was to allow taxpayers to file 1040 returns electronically. In the 2000 filing season, 35 million individual taxpayers took advantage of this option, and the IRS plans to expand that number. We also aim to convert from paper-based to electronic methods of doing business. The Internet, in particular, offers exciting new opportunities, particularly through the IRS Web site (the Digital Daily), which as of fall 2000 already had received 1.3 billion hits. Our business systems modernization program will provide the foundation for transforming the way the IRS does business.

Taxpayers, industry and practitioners have told us we must make electronic filing more attractive and remove barriers. To address these concerns

We are expanding the number of forms that can be filed electronically. For the 2001 filing season, we are adding 23 additional forms to the 1040 e-file program. These include form 2106-EZ for unreimbursed employee business expenses; form 2688, application for additional extension of time to file a return; and form 8379 for injured spouse claims.

We plan to include the remaining 40 forms and schedules for the 2002 filing season. This means we will expand e-file eligibility to 99.1% of all taxpayers, potentially adding 3.8 million new e-filers to the growing rolls. Equally important, those who prepare tax returns essentially will be able to go 100% electronic for all of their clients by 2002.

We plan to eliminate the requirement for a separate paper document with the e-file return. Our tests of the use of a personal identification number as the taxpayer’s signature were very successful. (See “The ETA Needs You,” JofA, Oct.99, page 97.)

We added electronic payment options. We now accept debit payments through TeleFile, and we take credit cards for form 1040ES, estimated tax payments, and form 4868, extension of time to file. As of early September 2000, more than 200,000 payments averaging $2,935 each were made via credit card and another 237,281 averaging $1,614 were made by Automated Clearing House Direct Debit, which allows taxpayers to authorize debits from either their checking or savings accounts.

Our prototype “secure messaging system” will provide participating practitioners with a Web-based means for resolving account-related issues. This pilot will involve a limited number of practitioners and focus on the resolution of notices, account problems, transcript requests and installment agreements. A major priority of our business systems modernization program is to build a secure infrastructure that will permit authorized practitioners to exchange information with the IRS through the Internet.

Information technology

The IRS depends entirely on its computer systems to administer the tax system and to collect and properly account for about $1.7 trillion of net tax revenue each year, yet our systems are fundamentally deficient and must be replaced. Reorganizing the agency’s outdated structure and replacing its archaic technology will take years to accomplish, but it is necessary if we are to reach a higher performance level. For any information-intensive, service-oriented enterprise, an efficient information technology system is essential for satisfying ever-increasing customer service demands.

While technology modernization is essential to carrying out the provisions of the 1998 act, it poses many challenges. The IRS is revamping business practices and establishing an overall architecture for a set of new business systems that will accommodate all essential tax administration functions. During the next few years, taxpayer accounts will be moved over gradually to a new system, until all taxpayers, both individuals and businesses, can benefit from improved service.

An ongoing process

Although the IRS has been changing its organizational structure, taxpayers and practitioners will continue to work with their current contacts. District liaison and similar groups will be improved. We will continue to implement the new IRS structure over the next several years by realigning our personnel resources and revising our business practices and strategies; institute enhanced information technology; and putting into place a balanced performance measurement system.

I believe we are making real progress on the short- and long-term goals and mandates of the 1998 restructuring and reform act. As we continue our modernization, we will be able to produce the tangible and visible changes in service, compliance and productivity that America’s taxpayers expect and deserve.