Expanded Innocent Spouse Relief

IRC section 6015 allows certain taxpayers to claim relief from joint tax liability if they qualify as an innocent spouse. There are strict qualification rules. Recently the Tax Court allowed a taxpayer to raise the issue even though she failed to meet all the qualifications.

Dorothy Clark was married to Edward Wenner. He died in 1988. Following his death, the IRS audited the couple’s joint returns for 1982 to 1984, assessing $11,500 in additional tax and $24,000 in interest. Clark paid the tax but not the interest. In 1997 she asked the IRS to abate the interest. It denied the request in 1999. She filed suit in the Tax Court claiming the IRS had abused its discretion under IRC section 6404 in not approving her abatement request and asking for relief of liability as an innocent spouse under section 6015. The IRS objected to the court considering her innocent spouse petition on the grounds it was not filed properly.

Result. For the taxpayer—in a case of first impression. Normally, to obtain innocent spouse relief, a taxpayer must comply with the requirements of section 6015, which include filing a timely election, receiving a denial of the request and then filing a timely petition with the Tax Court. Based solely on section 6015, Clark was not entitled to innocent spouse relief because she had failed to meet the requirements, including filing a timely innocent spouse petition with the Tax Court.

However, in this instance, Clark had filed a timely petition to have the interest abated. Once a taxpayer is properly before the Tax Court, it may consider all affirmative defenses. Therefore Clark had the right to have the court decide if she was entitled to innocent spouse relief. The fact that she had not met the normal requirements was irrelevant.

This decision may open the door for certain taxpayers to have a second chance at claiming innocent spouse relief. If they legally can bring a suit before the Tax Court on the years at issue, they should consider raising this affirmative defense in addition to any other issues. This will aid taxpayers who failed to meet the time requirements in section 6015 but who are now in the process of disputing the tax or interest liability for the years in question.

Estate of Edward Wenner v. Commissioner, 116 TC no. 22.

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

Valuing a Decedent’s Closely Held Stock

A contentious issue in estate taxation is the valuation of stock in a closely held corporation. The fair value of such stock at the valuation date may be difficult to determine since no market quotations are available. Treasury regulations section 20.2031-2(f) and revenue ruling 59-60 (1959-1 CB 237) lists factors CPAs can consider in determining the value for estate tax purposes. Generally, the value would be what a willing buyer would pay to receive the economic benefits attached to that amount of stock.

J.R. Simplot Co. is a family-owned corporation that processes and sells frozen food, fertilizer and cattle. The company also owns stock in Micron Technology, Inc. Simplot has two classes of common stock, A and B, which are held by family members, family trusts and an employee-stock-ownership plan. Although only class A stock has voting rights, both classes have the dividend rights (none has ever been declared), and class B stock has a slight liquidation advantage. Class A stock has a transfer restriction of 180 days during which the company may buy the stock and another 180 days in which other class A stockholders may purchase the stock before a shareholder can sell it to an outsider.

At the time of his death in 1993, Richard R. Simplot owned 23.55% of the 76.445 shares of class A stock and 2.79% of the 141,288.584 shares of class B stock. His estate hired Morgan Stanley & Co. to ascertain the stock’s value for estate tax purposes. Morgan Stanley determined a value of $2,650 per share. Because the decedent held only a minority interest in class A stock, it was assigned the same per-share value as the class B stock. The IRS determined a value of $801,994 per share of class A stock and $3,585 per share of class B stock and assessed a tax deficiency of $17,662,886 and penalties of $7,057,554. The estate petitioned the Tax Court for review.

After hearing from valuation experts for both the IRS commissioner and the estate, the Tax Court reached its own value determination, adding a premium to the class A stock equal to 3% of the equity value ($830 million) of the company. The court based its decision on the presumption that class A stock, as voting stock, had the potential to influence and control the company. The court then allocated the total premium equally to all class A shares, resulting in a per-share value of $331,595.70, subject to a 35% discount for lack of marketability. The court created several specific scenarios to support the idea that a willing buyer might pay such a premium to obtain the decedent’s 18 shares of class A stock. The Tax Court waived penalties, but assessed a deficiency of $2,162,052. The estate appealed to the Ninth Circuit Court of Appeals.

Result. For the taxpayer. According to the Ninth Circuit, the Tax Court committed three errors in reaching its decision.

The Tax Court correctly stated the property valuation law: “The standard is objective, using a purely hypothetical willing buyer and willing seller…. The hypothetical persons are not specific individuals or entities.” However, the Tax Court violated that law by creating scenarios involving particular purchasers, their likely combinations with other family members and their probable patience in waiting for a return on their investment.

After determining the class A stock should receive a premium of 3% of equity value based on the above scenarios, the Tax Court allocated that premium equally to each class A share. The court erred in valuing all class A stock as a controlling block. The asset to be valued was the 18 shares of class A stock (not a controlling interest) Simplot owned at his death. According to Treasury regulations section 20.2031-1(b), the value of each unit of property is to be determined; in the case of stock, a unit is a share of stock.

The Tax Court’s third error was attributing any premium to the class A stock. Stock should not be valued at a premium for estate tax purposes unless the commissioner can prove a purchaser would be able to use the stock to obtain an economic benefit sufficient to justify such a premium.

The Ninth Circuit concluded that a minority interest in class A stock was worth the same as class B stock. Justice Fletcher wrote a lengthy dissent stating that the Tax Court was correct in its application of the law and the resulting decision.

This case reaffirms the idea that fair value should be based on the amount a buyer is willing to pay for the economic benefits attached to the property as of the valuation date. In this decision, the Ninth Circuit brought the Tax Court back to reality.

Estate of Richard R. Simplot, 87 AFTR2d 2001-2165, 5/14/01.

Prepared by Karyn Bybee Friske, CPA, PhD, assistant professor of accounting and Darlene Pulliam Smith, CPA, PhD, professor of accounting, both of the T. Boone Pickens College of Business, West Texas A&M University, Canyon.

Sham Transactions

What constitutes a “sham transaction” for tax purposes? U.S. case law has evolved to incorporate business purpose and economic substance as critical elements in determining what constitutes a sham. Under the subjective business purpose test, the court attempts to measure the taxpayer’s intent. Traditionally, it has done this by examining the extent to which a taxpayer has investigated the transaction and its consequences. Under the objective economic substance test, the court tries to measure a transaction’s profit potential apart from tax benefits.
IES Industries, an electric utility, purchased American Depository Receipts (ADRs) at market price plus 85% of the expected gross dividend (net of the 15% foreign withholding tax). For example, if the purchase price for a stock was $500 and there was to be a $100 dividend, IES would buy the stock for $585. After the dividend was paid, IES would sell the stock at a “loss” for its $500 market value. While IES was generating capital losses on each ADR purchase and sale (losses it carried back to offset capital gains in 1989 and 1990), overall the company made a profit because the dividends it received exceeded its capital losses.

The IRS denied IES’s foreign tax credits for the withholding tax, as well as the capital losses, arguing the transaction was a sham. It said IES had purchased only the rights to the net dividends. When characterized in this manner, the dividends would not exceed the capital losses. The Iowa district court where this case originated viewed the ADR transactions as tax motivated and concluded the only change in IES’s economic position as a result of the ADR transactions was the transfer of the foreign tax credit to IES. The district court granted the IRS summary judgment, and IES appealed.

Result. For the taxpayer. The Eighth Circuit Court of Appeals reversed the district court and held that the economic substance of the ADR transaction should be measured based on the gross amount of the dividend. Additionally, the court measured the business purpose test—the taxpayer’s subjective intent—in light of its right to “decrease the amount of what otherwise would be [its] taxes, or altogether avoid them, by means which the law permits … “( Gregory v. Helvering, 293 US 465, 55 S.Ct. 266 (1935)). This line of reasoning suggests the courts may respect such a tax-motivated transaction if it has economic substance even if the tax considerations are more important.

Contrary to this decision, in Compaq Computer Corp. v. Commissioner, 113 TC 214 no. 17 (1999), the Tax Court held that similar ADR trades did not have business purpose or economic substance and were sham transactions. The IES decision, however, is different from Compaq (now before the Fifth Circuit Court of Appeals) in two respects. First, in IES, under the objective economic substance test, the Eighth Circuit defined the amount of income that should be considered when measuring economic substance as the gross dividend. In Compaq , the Tax Court considered the economic benefit to be the dividend, net of withholding taxes. Second, under the business purpose test, the Eighth Circuit distinguished IES’s ADR transactions from Compaq , noting that IES met twice about the transactions and consulted outside accountants and securities counsel for reassurance on the legality of the transactions and their tax consequences. In Compaq , the Tax Court concluded the expected tax benefits of the ADR transaction, rather than the non-tax-related benefits, motivated the company.

The IES case contradicts IRS notice 98-5 (1988-1CB 334), which characterizes such scenarios as a type of “abusive tax-motivated transaction,” and notice 2000-15 (2000-12 IRB 2/29/2001), which classifies such scenarios as per-se corporate tax shelters that taxpayers must disclose and tax promoters must list under the corporate tax shelter regulations.

Pending further developments, such as the Compaq appeal, taxpayers should continue to treat notice 98-5 as in full force and effect. If the Fifth Circuit reverses Compaq, the Bush administration must decide whether to

Renew the Clinton administration’s push to enact the principles of notice 98-5 by legislation.

Move forward with the notice 98-5 regulations project without new legislation based on implicit interpretive authority under the existing foreign tax credit provisions.

Abandon the regulations project and rely on subsequently enacted IRC section 901(k) to limit dividend arbitrage transactions. Section 901(k) establishes a 15-day holding period out of the 30 days bracketing a dividend period as a condition for claiming a foreign tax credit for dividend withholding taxes.

IES Industries, Inc. v. United States, 253 F3d 350 (8th Cir. 2001).

Prepared by Lawrence Witner, JD, an associate at PricewaterhouseCoopers LLP in Atlanta.

Under IRC section 761(c), partners are allowed to amend their agreements as long as such changes are made by the time the partnership information return is due (not including extensions). Furthermore, under section 704(b), allocations of items such as income, gain, loss, deduction or credit provided for in a partnership agreement will be respected if they have “substantial economic effect.” If they do not, the code says, they will be reallocated according to the partners’ interests in the partnership. In revenue ruling 99-43, the IRS found a partnership’s allocation of debt discharge income lacked substantiality.

Facts. A and B, both individuals, formed a 50/50 partnership contributing $1,000 each of capital. Their agreement provided for all partnership items to be allocated 50/50 and all partnership property to be revalued if either of them contributed additional capital.

The partnership used the $2,000 capital contributions and borrowed an additional $8,000 on a nonrecourse basis to purchase nondepreciable property for $10,000. After one year, the fair market value of the property declined to $6,000. A and B were forced to work out an agreement with the bank in which it forgave $2,000 of the loan principal. The partnership paid the deductible costs, $500, associated with the bank agreement with a cash capital contribution by A. A’s capital account was debited and credited with the agreement costs and the capital contribution. At the time of the “workout”agreement, B was insolvent and made no additional contribution. As a result, the partners agreed that A would have a 60% partnership interest and B would have the remaining 40%.

The decline in property value and the workout agreement produced two items that had to be allocated between A and B—the $2,000 of cancellation-of-indebtedness (COD) income and the $4,000 loss from the decline in property value. The $2,000 item was taxable income. The $4,000 revaluation loss was not deductible and was treated as an adjustment to the partners’ capital accounts.

The original partnership would have allocated these amounts 50% each to A and B. However, they had amended the partnership agreement to allocate these two items after the workout agreement with the bank. The entire $2,000 of income from the cancellation of debt was allocated to B, the insolvent partner. The $4,000 revaluation loss was allocated $1,000 to A and $3,000 to B.

Observation. Do the allocations in the amended partnership agreement have substantial economic effect under section 704(b)? To qualify, there must be a reasonable possibility the allocations will substantially affect the dollar amounts each partner receives regardless of the tax consequences. In this case, after the agreement with the bank, the capital account balances of A and B were zero under the allocations in both the original and amended partnership agreements. Because of this, the special allocation in the amended agreement fails the substantial economic effect test: it does not have an impact on the amounts due to the partners—as represented by the capital accounts—when the partnership is liquidated

Furthermore, the IRS will not consider an allocation to have substantial effect if it results in shifting tax consequences—that is, the total tax liability of the partners would be less than without the allocations. If the amounts in this case were allocated according to the original partnership agreement, A and B each would have $1,000 of COD income. B would not have to report this amount as taxable because he was insolvent at the time of the cancellation, and A would be taxed on the $1,000 of income. However, the result of the special allocation was to allocate all the COD income to B. Again, B would not have to report this income because of insolvency, and A would escape taxation on $1,000 of income. The result would be that none of the $2,000 of income would be taxed. The special allocations A and B made shift tax consequences by reducing the partners’ total tax liability; therefore, the allocation does not have substantial economic effect.

The IRS noted that the allocations also could fail the test if they are found to be transitory allocations—that is, original allocations offset by other allocations in different taxable years that reduce the total tax liability of the partners.

Result. The special allocations in the amended partnership agreement lack substantiality. If they had been made prior to the property’s decline in value and the workout agreement, then their effect might have been deemed substantial. However, the ruling points out that if the decline had been foreseeable, then the allocations still would be subject to close scrutiny by the IRS.

—Cheryl Metrejean, CPA, PhD,
Assistant Professor of Accountancy,
E.H. Patterson School of Accountancy,
University of Mississippi, Oxford.

Small Businesses to Give Input on Audits

The IRS has launched the Small Business/Self-Employed (SB/SE) Exam Reengineering Project to improve the audit process for small-business owners and self-employed individuals by reducing audit times, ensuring fairness in the process and encouraging tax compliance.

IRS project teams will interview other IRS employees and members of small-business and tax practitioner groups to get feedback and suggestions about the agency’s audit process. The IRS hopes that by using the diversity and expertise found in the private sector it can significantly improve the audit selection process and begin implementing changes in fiscal year 2002.

The SB/SE division serves 45 million taxpayers including small-business owners and self-employed individuals. These two groups contribute $915 billion in taxes annually and consist of 7 million small businesses, corporations and partnerships and 33 million self-employed and supplemental income earners. More information can be found at www.irs.gov . (IR-2001-68)