Journal of Accountancy

Tax

IRS Can’t Invalidate Return After Accepting It.

By Michael Lynch

July 2001

In 1996 after 15 years of marriage and of filing joint federal income tax returns, a husband and wife divorced. Shortly thereafter, a professional tax preparer filed a joint 1995 return on their behalf, without either the husband’s or wife’s signature. The IRS accepted and processed the return, and the husband began making payments toward the couple’s joint tax obligation.

A year later, the wife filed for bankruptcy and, on the advice of the IRS, filed and signed a 1995 return as married, filing separately. This released her from the joint and several liability of the original 1995 return. The IRS then issued a new notice of deficiency to the husband based on his changed 1995 status.

The husband objected and argued that the initial 1995 joint return was valid and that the wife’s separate return should be rejected. According to the husband, the manual signature requirement had been eliminated or had become more relaxed under IRC section 6061(o).

The Tax Court sided with the government, stating that IRC section 6061(o) applied only to electronic filings. Furthermore, it held that a return without signatures submitted on behalf of a couple was not valid, regardless of whether the intent had been to file a joint return.

The husband then turned to the Tenth Circuit Court of Appeals for relief. The court noted that the IRS’s normal practice when it received an unsigned return was to either return it to the taxpayer for signature or request the signature on a separate declaration. Instead, in the present case, the IRS repeatedly refused to allow the husband to sign the original return.

The court followed Dowell v. Commissioner 614 (F2d 1263 (10th Cir., 1980)) and stated that the IRS processed, audited and used the couple’s joint return to calculate their liability and its claim against the wife’s bankrupt estate. These actions prevented the service from later declaring the return invalid. The court then held the husband intended to and was eligible to file a joint return for 1995 ( Nathan T. Olpin v. Commissioner, no. 00-9003 (10th Cir., 1-25-01)).

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

Tax

Passive Losses and LLC Members

By Edward J. Schnee

July 2001

With the increased number of LLCs operating today, the Treasury Department and the courts frequently are called upon to determine the correct taxation of these entities when they elect partnership treatment. A district court, in a case of first impression, considered how the passive loss rules applied to an LLC.

Stephen Gregg owned and managed Ethix Corp., a managed health care company. He sold his Ethix stock on November 4, 1994, and formed Cadaja, LLC. Gregg created the new company to apply the management techniques he had developed in traditional medicine to alternative medicine clinics. For its first tax year, November through December 1994, Cadaja had a loss. The IRS reclassified the loss as passive on Gregg’s tax return, making it nondeductible under IRC section 469. The IRS assessed additional tax as a result of the loss disallowance. Gregg paid it and then sued for a refund.

Result. For the taxpayer. The first question the court considered was whether to treat the taxpayer as a limited partner or a general partner. The IRS had argued that all members of an LLC were shielded from liability and, therefore, were limited partners. The court rejected this argument, noting that a limited partnership has at least one general partner subject to liability whereas no LLC members are subject to liability. In addition, limited partners have limited rights in management whereas LLCs are designed to permit all members to be active in management. Therefore, the court concluded LLC members who are active in the business should be considered general partners for passive loss purposes.

The second question the court considered was how to compute the number of hours a taxpayer needed to work to be considered as having materially participated in the business. Under temporary regulations section 1.469-5 T (a)(1), a taxpayer is actively involved in a business if he or she works more than 500 hours in the business during the year. Since he had formed the LLC in November, Gregg attempted to prorate the 500 hours over the entity’s shortened life. The court rejected this approach. The regulations specify that a taxpayer must work for at least 500 hours to be considered active. They do not allow taxpayers to prorate this amount simply because an entity’s first tax return covers less than a full 12 months.

Gregg then argued that he met the regulations’ requirement for material participation. He aggregated his participation in Ethix and the new LLC. While the IRS had objected to adding the two separate businesses together, the court concluded the regulations permitted grouping multiple businesses to determine material participation. It said they did not require the businesses to be conducted at the same time. Therefore Gregg could add his years of active participation in Ethix with his year of active participation in the LLC.

This decision will benefit professionals who start new businesses or switch companies by allowing them to deduct losses. Otherwise, the taxpayer would have to wait three years, as provided in the material participation regulations. Gregg answered a number of questions about the application of the passive loss rules to an LLC. It is almost certain there will be additional litigation to resolve other disputes.

Stephen A. Gregg v. United States, 2001-1 USTC 50, 169 (DC, Ore.)

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

Tax

Line Items

July 2001

Shopaholic Wife, Clueless Husband

A husband and wife were married for more than 20 years. The wife paid the bills, handled the banking and controlled the family’s finances. The husband rarely wrote a check.

Early in their marriage, the wife was convicted of a felony after embezzling from her employer. However, she subsequently obtained employment in a small Oregon town as a clerk, and, over the years, worked her way up to financial director for the town.

The wife was known as a compulsive shopper who often spent up to $1,000 on clothes for her daughters during a shopping spree. She also made improvements to their home and bought herself and her daughters new cars.

The wife again was convicted of embezzlement. This time, she had taken $225,000 from the town. Moreover, the money had not been included on the couple’s joint federal income tax return.

After their divorce became final, the husband filed for innocent spouse relief under IRC section 6015(c). However, such relief is not available to a spouse who had actual knowledge of the item giving rise to the deficiency. The IRS argued that the husband was not innocent because he failed to prove lack of knowledge. According to the IRS, he should have been aware of the embezzlement because of the home improvements, the amount of money in the joint family checking accounts and the shopping sprees.

The Tax Court, however, sided with the husband. According to the court, the IRS had to prove the husband had actual subjective knowledge of the embezzlement income and satisfy this burden of proof by a preponderance of evidence. Merely showing what a reasonably prudent person would be expected to know did not meet this burden ( Culver v. Commissioner, 116 TC no. 15).

It’s All in the Family

Several family members owned a corporation, but none of them had a controlling interest. The corporation made several interest-free loans to various partnerships. All the partners were family members, but some partners were not shareholders of the corporation.

The IRS said that under IRC section 7872, the corporation should have reported the forgone interest as taxable income on its federal return and the same amount should have been reported as dividend income by the shareholder-partners.

The corporation argued that IRC section 7872 only applied to sole or controlling shareholders, and that, even if the imputed interest rules did apply, they should apply only to the extent the shareholder-partners benefited from the loan. In other words, since the shareholders owned only part of the partnerships, then they should be taxed only on a portion of the imputed income.

The Tenth Circuit Court of Appeals affirmed the Tax Court and held that IRC section 7872 applied to any below-market interest loan, direct or indirect, between a corporation and any of its shareholders. According to the Tenth Circuit, the imputed interest rules apply when a corporation makes loans to entities owned partially by its shareholders and partially by their family members who aren’t shareholders. This holds true even if none of the corporate shareholders has a controlling interest in the entity. The court reasoned that if nonfamily members had owned significant interests in the borrowing entities, the corporation probably wouldn’t have made the loans. Therefore, the corporation and its shareholders had to report as income the forgone interest on the entire amount of the loan ( Roundtree Cotton Co. v. Commissioner, 87 AFTR2d 2001-718 (CA 10, 3-29-01)).

Too Bad Golf School Wasn’t Just About Golf

A taxpayer was a self-employed golf instructor. He enrolled himself at the Golf Academy of the South, an accredited two-year business school that offered some golf-related courses. Graduates could transfer their credits to other institutions and earn a bachelor’s degree in another two years. On his federal income tax return, the taxpayer listed his trade or business as “golf instructor” and deducted his tuition as a business expense on schedule C.

Under Treasury regulations section 1.162-5, tuition paid for courses that maintain or improve a taxpayer’s skills in his or her current trade or profession is a deductible business expense. But if the courses also qualify a taxpayer for a new trade or business, the tuition is not deductible. In this case, the taxpayer argued that the coursework maintained or improved his skills as a golf instructor. The IRS denied the deduction because the courses qualified the taxpayer for a new trade or business.

The Tax Court sided with the government and held that because the courses could be used toward an undergraduate degree and would qualify the taxpayer for a variety of new trades and businesses, the tuition was not deductible ( Fields v. Commissioner, TC Summary Opinion 2001-35).

Just the Real Tip Income, Please

Tips are subject to FICA taxes just as if they had been wages paid by the employer. Each month, employees are required to report their tips on form 3070. The employer then reports to the IRS gross sales, charged tips and employee-reported tips on form 8027.

A restaurant employed waiters, bartenders, busboys and others whose earnings partially comprised tips. The IRS assessed the restaurant for additional FICA taxes on unreported tip income. To arrive at the amount owed, the service computed an average tip percentage based upon credit card sales and multiplied this percentage by the gross receipts.

The district court held that the government had exceeded its authority by estimating the tip income. The Ninth Circuit Court of Appeals affirmed the district court, holding that the IRS should not have calculated and assessed unreported FICA tips by estimating the amount of the tips. According to the court, Congress authorized the IRS to use estimates in assessing income taxes but no such authority existed with respect to FICA taxes. Instead, there should have been an employee-by-employee determination of taxable tips. The court’s opinion made it clear that the IRS could not use an aggregate approach to estimate an employer’s FICA liability ( Fior D’Italia v. United States, no. 99-16021 (9th Cir., 3-7-01)).

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

View Comments |