Teachers and professional educators get a tax break for 2002 and 2003 that should ease the pain of many out-of-pocket classroom expenses. The Job Creation and Worker Assistance Act of 2002, section 406, allows teachers and other education professionals to deduct up to $250 of unreimbursed classroom expenses.

The deduction is above the line (deductible even when the taxpayer does not itemize), so it is valuable and covers a lot of expenses.

Qualifying expenses. The new law allows an above-the-line deduction up to $250 each year for certain expenses, which must have been for

Books.

Supplies (other than nonathletic supplies for health or physical education courses).

Computer equipment (including related software and services).

Other equipment and supplementary materials used in the classroom.

The expense must be one the taxpayer otherwise can deduct as a trade or business expense (an ordinary and necessary expense paid or incurred during the tax year to carry on any trade or business) under IRC section 162. Educators qualified to take the deduction must have been kindergarten through 12th grade teachers, instructors, counselors or principals for a minimum of 900 hours in the course of a school year. (In the act “school” is defined to be any institution providing elementary or secondary education, as determined under state law.)

The deduction applies only to 2002 and 2003 tax returns. While the deduction appears to be very broad, CPAs should encourage clients to keep receipts in the event the IRS questions a deduction.

Observation. The new law does not specifically mention certain issues. For instance, although it defines categories of qualifying educators, it does not mention substitute teachers or whether it covers summer school expenses. The IRS likely will clarify any ambiguities in future guidance.

—Lesli S. Laffie, JD, LLM, a technical editor of The Tax Adviser.

TAX CASE

Although tax-exempt organizations are exempt from federal taxation on their principal activity, they must pay tax on any unrelated business income. Numerous court cases have considered what constitutes unrelated business income. Recently the Eighth Circuit Court of Appeals clarified the taxation of royalty income.

The Arkansas State Police Association signed an agreement with Brent-Wyatt West (BWW) to publish a magazine called the Arkansas Trooper. Labeled a royalty agreement, the document required BWW to pay the police association $25,200 per year plus between 26% and 27% of the magazine’s advertising revenue. BWW had total responsibility for marketing the magazine and paying all publication costs. The association’s vice-president of public relations spent only 15 to 20 hours a year on magazine-related activities including reviewing content for suitability and encouraging members to submit articles and photographs.

The Tax Court agreed with the IRS that the association’s receipts of about $877,000 in the years at issue were taxable unrelated business income and not nontaxable royalty income. The association appealed.

Result. For the IRS. The taxpayer argued that the proceeds were passive royalty income exempt from tax under IRC section 512(b). It equated its case to the affinity-card cases in which the courts held that the payments an exempt organization had received for the right to use its name were nontaxable royalty income. They also relied on two examples from revenue ruling 81-178, 1981-2 CB 135.

In both instances the tax-exempt entity licensed its name to a taxable organization, which used the name to sell a product. In the second situation, however, the exempt entity required its members to perform services endorsing the taxable entity’s product. The ruling concluded the payments in the first example—simple use of name—were nontaxable royalties whereas the payments in the second—name plus services—were taxable unrelated business income. According to the police association the existence of the services made the payments taxable. Since it did not perform any services for BWW, the association said, it did not have any taxable income.

The Eighth Circuit was able to distinguish the precedents the association cited. In both cases the taxable entity used the tax-exempt entity’s name to market its own product. In this case the taxable BWW, instead, was marketing the association’s product—its magazine. The court determined the appropriate precedent was National Collegiate Athletic Association, which held that the publication and sale of the Final Four basketball brochures were taxable unrelated business income since the product promoted the tax-exempt organization.

In most cases the decision on the taxability of proceeds will be determined based on whether members of the tax-exempt organization performed personal services. However, if the product being marketed is the exempt organization itself, the proceeds will be taxable even without performing personal services.

Arkansas State Police Association v. Commissioner, 282 F3d 556, 2002-1 USTC 50, 269.

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 CASE

Over the past decade, many businesses have had to downsize their workforce to stay competitive. Severance payments to workers generally are considered wages subject to withholding for

Income taxes under IRC sections 3401 and 3402.

Federal Insurance Contributions Act (FICA) under IRC section 3121.

Federal Unemployment Tax Act (FUTA) under IRC section 3306.

Railroad Retirement Tax Act (RRTA) under IRC section 3231.

Revenue ruling 90-72 excludes certain supplemental unemployment compensation benefits (SUCBs) from the definition of wages for FICA, FUTA and RRTA purposes. However, section 3402(o) extends income tax withholding to certain payments other than wages, such as SUCBs.

CSX Corp., the parent of a consolidated group of railroad companies, was forced to downsize its workforce from 1984 to 1990 due to a decline in rail transportation and increased competition. The number of CSX’s railroad-related employees decreased to 34,000 from 54,000 during that period. The management workforce declined by 33%, the union workforce by 39%. CSX accomplished the reduction through a combination of job layoffs, reductions in the number of hours of work and rates of pay and permanent separations from employment.

Affected employees received payments as follows:

Those laid off received biweekly or monthly payments.

Those with reduced hours or pay rates received payments of at least a guaranteed minimum amount.

Those who agreed to terminate their employment with CSX received either lump-sum payments or monthly payments for an agreed-upon period of time.

In accordance with RRTA and FICA, the company paid the employer’s share of employment taxes and withheld and remitted the employees’ share of those payments. It then filed refund claims for the employment taxes, maintaining those payments were not wages or compensation but, rather, SUCBs and as such not subject to tax. The IRS disallowed the claims. CSX took the case to the U.S. Court of Federal Claims.

Result. For the taxpayer. The court concluded that some of the payments were not wages subject to FICA or RRTA. Specifically, the payments that met the definition of SUCBs under section 3402(o)—paid to an employee because of his or her involuntary separation from employment resulting from a reduction in workforce—were not considered wages subject to employment taxes. In reaching this conclusion the court interpreted the U.S. Supreme Court decision in Rowan Cos. and the subsequent “decoupling amendment” to section 3121 to mean the definition of “wages” is consistent for FICA and income tax withholding purposes unless the IRS promulgates regulations to identify differences between the two. No such regulations have been issued. The IRS argued that if Congress had intended SUCBs to be exempt from FICA, it specifically would have excluded such payments in section 3121. The court disagreed since SUCBs were not wages in the first place.

The IRS also argued that the payments did not qualify as SUCBs because they did not meet the conditions in revenue ruling 56-249 and related rulings. Revenue ruling 56-249 dealt with whether benefits from an employer-funded trust were subject to FICA and income tax withholding. The trust’s purpose was to supplement state unemployment benefits for employees laid off in a workforce reduction. Payments were based on the size of the trust, the amount of state unemployment benefits, the duration of the layoff, the time worked before layoff and other conditions. On the basis of those eligibility conditions, the revenue ruling concluded the payments were income but not wages subject to employment taxes and withholding. In the CSX case, the court declined to consider these conditions since the revenue ruling did not explain how the conditions supported the ruling’s conclusion that the benefits were not subject to FICA. In addition, the conditions were not incorporated into later amendments to section 3402.

Based on its interpretation of the issues discussed above, the court held

The biweekly or monthly payments to laid-off employees were SUCBs, not subject to FICA or RRTA.

Payments to those workers with reduced hours or pay rates were subject to FICA and RRTA because they were “underemployed” but not separated from employment.

Separation payments employees elected to receive voluntarily rather than stay in their current positions or accept reduced rates or hours were subject to FICA and RRTA.

This decision is significant for any taxpayers that have paid employment taxes on severance payments similar to the CSX workforce reduction payments. Those taxpayers should consider filing claims for refund of FICA taxes they paid as well as withheld and remitted on behalf of employees. The IRS is likely to appeal this decision to the Federal Circuit Court of Appeals.

CSX Corp. v. United States, 89 AFTR2d 2002-1935.

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

The Long Arm of the Law

In United States v. Craft (S.Ct., 4/17/2002), 89 AFTR2d 2002-2005, a taxpayer owed the government nearly $500,000 in back taxes. To protect its claim, the IRS attached a federal tax lien under IRC section 6321 to “all property and rights to property, whether real or personal, belonging to” the taxpayer.

Mr. and Mrs. Craft owned a piece of real estate in Michigan as tenants by the entirety. After the lien was filed, the taxpayer and his wife filed a quitclaim deed and transferred the property to the wife for one dollar. When the wife tried to sell the property, the lien prevented her from passing clear title. The IRS agreed to release the lien if she put half the sales proceeds into an escrow account. She then sought to recover the escrowed funds. The Sixth Circuit Court of Appeals sided with the wife and held that the government’s lien could not attach to the jointly owned property because under state law, the husband had no separate interest in the property.

The U.S. Supreme Court reversed the Sixth Circuit and held that the husband did have property rights under Michigan law. According to the Court, the husband had the right to use the property and prevent others from using it, the right to sell or borrow against the property with his wife’s consent, the right of survivorship and the right to become an equal tenant in common upon divorce. The Court said that if federal liens could not attach to tenancies by the entirety, such properties would belong to no one because the wife’s interest could be shielded in the same manner. The result would remove too much property from the government’s reach, especially community property, and would be an abuse of the federal tax system.

Shareholder Discounts as Dividends

A corporation was formed to own, manage and operate a country club. The club consisted of a golf course, golf shop, swimming pool and restaurant. It was available to nearby homeowners and shareholders of the corporation who paid dues to belong. The shareholders received a discount on membership dues, cart rentals and restaurant purchases.

The IRS has privately ruled these shareholder discounts are constructive dividends under IRC section 301. According to letter ruling 200215036, any economic benefits a corporation gives its shareholders, in whatever form, even if not formally declared, constitute a dividend.

One Less Form to File

According to information release 2002-48 (4/10/2002), beginning with the 2002 tax year small corporations with less than $250,000 in gross receipts and less than $250,000 in assets no longer will have to complete form 1120, schedule L ( Balance Sheet per Books ), schedule M-1 ( Reconciliation of Income (Loss) per Books with Income per Return ) and schedule M-2 ( Analysis of Unappropriated Retained Earnings per Books ). Similar schedules on form 1120-A and form 1120S also can be omitted.

This change will allow small businesses to keep their records “based on their checkbook or cash receipts and disbursements journal instead of additional accounting methods for tax reporting,” resulting in significant savings. The IRS estimates 2.6 million small businesses will qualify for this relief.

Put the Rubber to the Road

In the past, several rulings and cases said truck, trailer and tractor tires were not part of the cost of a vehicle for depreciation purposes. Instead, they were treated as separate assets and expensed if they had a useful life of one year or less or were capitalized and depreciated over their respective lives. Previously, most tires were deducted in the year they were placed in service.

However, due to new technology, tires now generally have a life in excess of one year. So, to minimize disputes concerning the expense vs. capitalization dilemma, the IRS has provided a safe-harbor method of accounting (the original tire capitalization method) for the cost of original and replacement tires for vehicles used in business activities.

Under this method a taxpayer must (1) capitalize the cost of the original tires and depreciate them under IRC section 168 using the same depreciation method, recovery period and convention that would apply to the vehicle on which the tires are first installed, (2) treat the original tires as disposed of at the same time the taxpayer disposes of the vehicle and (3) deduct the cost of replacement tires as an expense in the tax year the replacement tires are installed.

Revenue procedure 2002-27 (2002-17 IRB), also explains how a taxpayer can obtain automatic consent to change to the new safe-harbor method. It provides an optional procedure for a taxpayer to settle open tax years using the new method if its treatment of tire expenditures is an issue currently under examination, before appeals or in front of a court.

Gift of Present Interest

Individuals can give away $11,000 per donee in a calendar year without paying a gift tax. However, IRC section 2503(b) limits this exclusion to gifts of a present interest. Under Treasury regulations section 25.2503-3, a present interest in property is an unrestricted right to the immediate use, possession or enjoyment of the property or its income.

In Christine M. Hackl v. Commissioner, 118 TC no. 14, a couple gave their children and grandchildren membership units in a limited liability company (LLC). The husband was the manager of the company and under the LLC’s operating agreement, he had the power to distribute any available cash to members. Also, no members could withdraw any property from the LLC or sell their units to the LLC without his permission. The IRS said the gifts did not qualify for the annual exclusion because they were not gifts of a present interest.

The taxpayer argued there were no restrictions on the transfers and that the donees acquired all the rights in the gifted units the donors had. Therefore, there was no postponement of any rights that would cause the gifts to be future interests.

The Tax Court sided with the IRS and said the gifts failed to confer a substantial present economic benefit of the use, possession or enjoyment of the property or its income. The court rejected the taxpayer’s argument that when a gift takes the form of an outright transfer of an equity interest in property, no further analysis is needed or justified. It held that to follow that logic was to sanction exclusions for gifts based solely on “conveyancing form,” without inquiring into whether the donees received rights different from those that would have come from a traditional trust arrangement. The court found the LLC operating agreement essentially prevented the donees from currently enjoying any of the economic or financial benefits that accrue from owning the membership units.

Parts Dealers Can Use Replacement Cost

In Mountain State Ford v. Commissioner, 12 TC no. 58 (1999), the IRS prevented an automobile dealer from pricing its yearend parts inventory by reference to replacement cost. Now, in revenue procedure 2002-17, the IRS has done an about-face and created a safe harbor that allows dealers to use the replacement cost method. For this purpose, a dealer is defined as a taxpayer engaged in the trade or business of selling vehicle parts at retail that is authorized, under an agreement with one or more vehicle manufacturers or distributors, to sell new automobiles or light, medium or heavy-duty trucks.

According to the government the use of replacement cost accounting is an industry standard that closely approximates actual cost. Forcing dealers to modify their recordkeeping systems to account for actual cost would be expensive and burdensome.

Installment Method Not Available

IRC section 453(b)(2) says that, in general, a dealer in property may not use the installment sales method of accounting. However, IRC section 453(1)(2)(A) says this prohibition does not apply to the sale of property used or produced in the trade or business of farming.

In Thom v. United States (CA 8, 3/19/2002; 89 AFTR2d 2002-1384), a corporation manufactured and sold irrigation systems to farmers, but it did not engage in any actual farming. The corporation used the installment method to account for these sales. The IRS disallowed the practice because the corporation itself did not “use” the property in farming.

The corporation argued the word “used” should be read to mean any property that has been, or will be, used for farming. The IRS argued that only farmers who actually used the property for farming could use the installment method and not dealers who sold the property to them.

In a case of first impression, the Eighth Circuit Court of Appeals agreed with the IRS. It said the taxpayer was trying to insert the words “to be” before “used.” The Eighth Circuit said it could not do this because Congress chose not to do it. Such an interpretation would cause the IRS to bear an unreasonable burden of determining whether a purchaser subsequently used the equipment for farming.

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

The IRS is performing better than it did in 1999, according to an independent review George Washington University and the magazine Government Executive conducted ( www.irs.gov/pub/irs-news/ir-02-62.pdf ). Contributing significantly to the service’s overall grade of B minus (up from C) was its information technology division, which improved its rating to C (from D) for its development and maintenance of the IRS’s Web site and of e-file, a service that enables taxpayers to submit their returns electronically. Of all areas rated, the agency’s management strategies drew the highest mark (B) for its clear mission statement, well-defined goals, bimonthly performance reviews and new performance measures.

Taxpayers have until October 31 to decide whether to use the five-year carryback period the Job Creation and Worker Assistance Act of 2002 introduced in March for net operating losses. Since those who filed returns before the law took effect could not benefit from the new provision, Congress is drafting corrective legislation. IRS revenue procedure 2002-40 ( www.irs.gov/pub/irs- drop/rp-02-40.pdf ) explains related aspects of the new law.

The IRS adds to its Web site a section on fraudulent trusts and other tax-evasion schemes ( www.ustreas.gov/irs/ci/tax_fraud/index.htm ). To help taxpayers identify and avoid such activities, the Web page also describes recent Justice Department and IRS civil and criminal actions against scam promoters and participants.

For the first time many taxpayers due money from the IRS can use the Internet to find out if their tax returns have been processed and to check the status of their refunds, as well as to resolve any related problems. The new service is available on the IRS Web site ( www.irs.gov ) to those who submitted forms 1040, 1040-A or 1040-EZ during the 2002 filing season.

The IRS says interest rates for the calendar quarter beginning July 1, 2002, remain the same as for the previous quarter ( www.irs.gov/pub/irs-news/ir-02-73.pdf ). For overpayments, the rate is 6%, except for corporations, for which it is 5%. And for that portion of corporate overpayments exceeding $10,000, it is 3.5%. The underpayment rate is 6%, except for large corporate underpayments (defined under IRC section 6621(c) and section 301.6621-3 of IRS regulations on procedure and administration), for which the rate is 8%. The IRS computed these rates from the federal short-term rate, based on daily compounding determined during April 2002.