TAX CASE

With the increased availability of electronic tax research services, CPA tax practitioners have easier access to potential authority to support positions their clients want to take. In addition to revenue rulings, there also are field service announcements (FSAs) and general counsel memorandums (GCMs), among others. After finding one of these items in the course of his or her research, a practitioner must decide how much to rely on it. Recently, the Court of Federal Claims had an opportunity to address this issue.

Vons Companies Inc. sued for a tax refund as the result of a denied deduction for a contribution it made to its pension plan. The company argued that revenue ruling 76-28 permitted the deduction. To bolster its claim of deductibility and to distinguish prior court decisions, the company asked the IRS to turn over certain letter rulings and other background documents. In deciding whether to force the IRS to turn over the requested documents, the court had to examine the precedential value of each class of documents.

Result. Partially for the taxpayer and partially for the IRS. The first pronouncement the court examined was a revenue ruling. The court pointed out that the value of a revenue ruling as precedent differs depending on whether the IRS or a taxpayer is seeking to enforce the ruling. If the IRS is trying to enforce it, the courts should weigh the ruling based on how long it has withstood challenges and how persuasive it is. However, if a taxpayer is trying to enforce a ruling, the court may view it differently and give it a different weight. Based on a long line of prior precedent, the court reiterated the IRS could revoke a revenue ruling retroactively even if a taxpayer relied on it to its detriment. The reason the IRS is permitted to revoke a ruling is to prevent a taxpayer from paying less tax than it owes by forcing the IRS to enforce an incorrect interpretation.

Vons also requested information about letter rulings (LTR) and technical advice memoranda (TAM). Under IRC section 6110(k)(3) these are not precedent and may not be cited by anyone other than the taxpayers to whom they are issued. There is one minor exception, based on a case involving IBM. If two taxpayers are competitors and both request letter rulings and one gets a favorable decision and the other gets an unfavorable one, the losing taxpayer can use both rulings to argue the IRS abused its discretion by attempting to apply a new standard retroactively. This is a very limited exception. The general rule, as the U.S. Supreme Court said in Hill , is that courts should eschew any reliance on LTRs or TAMs.

The last item Vons sought to obtain from the IRS was a GCM. These are similar to LTRs in that they are not precedent. However, since they are well researched and documented, the court said the taxpayer could use them as a research and planning tool.

In recent years there has been an apparent increase in reliance on LTRs, TAMs and GCMs. This case reminds taxpayers and their CPAs that these documents are not precedent. A taxpayer that treats them as such does so at his or her own risk.

Vons Companies Inc. v. United States, 2002-1 USTC p. 50, 158.

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

To avoid federal employment taxes, S corporations may be tempted to understate the wages and salaries of employee/shareholders. The IRS however, may recharacterize what S corporations classify as nontaxable distributions as wages and salaries subject to employment taxes. For an employee/shareholder who earns wages or salary of $84,900 in 2002, an employer must withhold $5,264 of FICA tax and $1,231 of Medicare tax. The employer match is $6,495; the employer also must remit $434 of federal unemployment tax, less amounts paid to state unemployment funds.

As early as 1968, the Tax Court, in Roob, 50 TC 891, ruled the criteria to determine reasonable compensation of officers and executives also applied to cases involving inadequate or no compensation. Whether IRS personnel are assessing the reasonableness or the adequacy of compensation, the guidelines they use to make these determinations are relevant. The Internal Revenue Manual Handbook says the employee/shareholder’s duties, responsibilities, background and time devoted to the business, knowledge of the business, size of the business and the amounts paid such employees by similar-size businesses are all considerations.

The case at hand involved sizeable S corporation distributions. Veterinary Surgical Consultants (VSC) paid Dr. Sadanaga—its sole employee/shareholder—no wages or compensation subject to employment taxes. He worked approximately 33 hours a week, generating all VSC’s revenues. Moreover, Sadanaga had sole signature authority over VSC’s bank account and handled all its correspondence and administrative tasks. VSC made no regular payments to the doctor; he simply withdrew money at his discretion from the corporation’s bank account. Since VSC took the position that none of the withdrawals was remuneration for services, it did not withhold or match any FICA or Medicare taxes nor did it make any federal unemployment tax contributions. VSC did not file Form 941, Employer’s Quarterly Federal Tax Return, or Form 940, Employer’s Annual Federal Unemployment Tax Return, for any quarter during the periods at issue.

For 1994, 1995 and 1996, VSC reported total income of $418,509.24 on its forms 1120S. According to VSC, the entire amount went to Sadanaga as his share of the S corporation’s income. On schedule M-2 the company classified these amounts as “other-than-dividend distributions” paid from accumulated earnings and profits.

In partial defense for nonpayment of employment taxes, VSC pointed out Sadanaga also was a full-time employee of Bristol Myers Squibb for each of the three years in question. Since Bristol Myers withheld and paid the maximum amount of employment taxes due for Sadanaga, VSC argued the IRS was attempting to assess additional taxes the doctor did not owe.

Result. For the IRS. The Tax Court held the IRS had properly characterized VSC’s distributions as wages subject to federal employment taxes. In making its ruling, the court cited IRC section 3121(d), which defines an employee, in part, as any officer of a corporation who performs more than minor services. It also cited sections 3121(a) and 3306(b), which define wages as all remuneration for employment. The court ruled that an officer like Sadanaga who performs substantial services for a corporation, and receives compensation in any form for those services, is an employee. Therefore, VSC could not escape employment taxes by characterizing Sadanaga’s withdrawals from VSC’s bank account as distributions of corporate income.

The court was not impressed by VSC’s argument that Bristol Myers already had paid maximum FICA and Medicare taxes on Sadanaga’s behalf. It pointed out that in the case of multiple employers the taxable wage base applies separately to each one. Therefore, VSC should have disregarded the doctor’s earnings at Bristol Myers in determining its liability to withhold, match and remit employment taxes. Employees (but not their employers) are eligible for a credit or refund of FICA tax applicable to wages in excess of the wage base.

In ruling against VSC, the court also discussed section 530(a)(1) of the Revenue Act of 1978. It provides relief from federal employment taxes when the taxpayer has both

Not treated the individual as an employee for any period.

A reasonable basis for not treating the individual as an employee.

VSC satisfied the first requirement since it had not treated Sadanaga as an employee in any period. But it failed to satisfy the second requirement. Simply stated, VSC had no reasonable basis for not treating Sadanaga as an employee. Accordingly, section 530(a)(1) did not apply.

CPAs should emphasize to clients and employers that IRS examiners are on the lookout for attempts to disguise S corporation employee/shareholder wages and salaries as nontaxable distributions. The IRS is fully empowered in abusive and not-so-abusive situations to recharacterize such distributions as wages or salaries and enforce collection of the corresponding federal employment taxes. CPAs should alert clients and employers to this issue as well as to the applicable IRS audit procedures.

Veterinary Surgical Consultants, PC, vs. Commissioner 117 TC no. 14.

Prepared by R. Dan Fesler, CPA, DBA, professor of accounting and Norberto Gacho, an MBA student, at Tennessee Technological University in Cookeville.

The IRS issues final regulations governing the determination of the basis of a partner’s interest under IRC section 705. The purpose of the regulations is to prevent inappropriate increases or decreases in the adjusted basis of a corporate partner’s interest in a partnership that result from that partnership’s disposition of the partner’s stock. The rules apply to stock sales or exchanges after December 6, 1999, and their effective date is March 29.

IRS revenue ruling 2002-19 explains how expenses for weight-loss programs may qualify as a medical deduction if they are incurred to treat diseases such as obesity or hypertension. The ruling stipulates, however, that the cost of weight-loss programs to improve general health or personal appearance, as well as the cost of diet foods, remains nondeductible.

Taxpayers now can use their Visa cards to pay federal taxes, bringing to four the total number of credit cards the IRS accepts for such payments ( www.irs.gov/pub/irs-news/ir-02-36.pdf ). The other three IRS-approved card issuers are American Express, Discover and MasterCard. The IRS also expands the credit card program to include installment agreement payments for tax years 1998 or later. As of mid-March, the IRS had received more than 20,000 credit card payments, up 13% from nearly 18,000 during the same period last year.

An IRS publication, Charitable Contributions—Substantiation and Disclosure Requirements (www.irs.gov/pub/irs-utl/pub1771.pdf), explains new guidelines allowing taxpayers to document their charitable contributions with electronic receipts.

The IRS publishes its Data Book for fiscal year 2001, which includes statistics on the collection of tax revenue, the enforcement of tax laws, taxpayer assistance and the management of the tax system.