There currently is a split in the courts of appeal concerning the deductibility by trusts of expenses they pay for investment advice. The Fourth Circuit Court of Appeals has now joined the debate.

In 1944 John Stewart Bryan’s will established a trust for his children and grandchildren. In 1996 and 1997 the trust had assets of approximately $25 million. In those years it paid—and deducted—$107,000 and $120,000, respectively, for investment advice. The IRS rejected the deductions on the grounds they were miscellaneous itemized deductions subject to the 2% floor. The trust paid the tax and sued for a refund. The district court ruled in favor of the IRS in part on the grounds the trustees could have avoided personal liability by using the states’ “legal list” of investments and thereby avoided the expense of hiring advisers. The taxpayer appealed.

Result. For the IRS. As a general rule, trusts are entitled to the same deductions as individuals. As a consequence, miscellaneous itemized deductions are subject to the 2% floor described in IRC section 67. Subsection (e) contains an exception to the 2% floor for expenses incurred in administering a trust the taxpayer would not have had to pay if the property was not in a trust.

The first question the Fourth Circuit addressed was the extent to which it should rely on the legislative history of section 67(e). The general rule of interpretation is that a court should refer to the legislative history only if a provision is ambiguous. The appeals court found the code section clear and unambiguous and therefore did not rely on any of the legislative history the parties cited in their appeal.

According to the Fourth Circuit, the exception to the 2% floor for trusts has two requirements. First, the expenditures had to have been incurred in the administration of a trust. Both parties agreed the taxpayer fulfilled this condition. The second requirement is that the costs “would not have been incurred if the property were not held in such trust.” This requirement was where the dispute laid. The taxpayer argued the trustees had needed the investment advice to fulfill their obligation to the beneficiaries. The IRS argued the expenses were not unique to trusts.

In its decision the Fourth Circuit agreed with the Federal Circuit Court of Appeals that this provision requires the expenses to be unique to the administration of a trust. Put another way, the expense cannot be one individuals commonly incur. Since it is common for individual taxpayers with large portfolios to use outside advisers and pay for their advice, the trust did not incur a unique expense. Therefore investment advice expenditures are subject to the 2% floor.

With this decision the Fourth Circuit joins the Federal Circuit in treating these expenses as miscellaneous itemized deductions. The Sixth Circuit Court of Appeals, on the other hand, has ruled they are fully deductible on the grounds that a trustee without investment experience must hire an outside adviser to fulfill his or her fiduciary responsibility to the beneficiaries. Additional litigation on the issue is likely in the future to resolve this interpretation conflict.

J .H. Scott v. United States, CA-4, May 2003.

Prepared by E dward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

In a recent case, the court held that the owner and president of an accounting firm who signed a client’s tax return was the preparer of that return. As such he was liable for preparer penalties for failing to make a reasonable inquiry. IRC section 7701(36)(A) defines an income tax preparer as “any person who prepares for compensation, or who employs one or more persons to prepare for compensation,” a tax return.

Generally a preparer can rely on representations—explicit or implicit—a taxpayer makes to the preparer or to his or her employees. However, the preparer may not ignore the implications of information the taxpayer furnishes or of which the preparer is aware. To avoid penalties under IRC section 6694, the preparer must make reasonable inquiries if the information the taxpayer provides appears to be incorrect or incomplete.

James Schneider, a licensed CPA and attorney, was owner and president of an accounting firm, Schneider & Co. Inc. He was the firm’s “executive reviewer.” William Conour, an attorney and sole practitioner, was Schneider’s client. Brian D. Rhea, CPA, was an employee of Schneider & Co. and the accountant “in charge” of preparing Conour’s return.

Conour first hired Schneider’s firm in the late 1970s. It prepared adjusting journal entries, tax-basis compilation financial statements and tax returns for Conour’s business. The firm also provided a variety of other financial and accounting services to him.

For many years Conour collected original works of art for both his home and office. Sometime during the preparation of his 1992 tax return, Conour asked Schneider if he could deduct the cost of the artwork. Rhea had treated the artwork as nondeductible capital expenditures in the financial records of Conour’s law practice. A letter from the accounting firm, prepared by Rhea, dated April 26, 1993, and signed by Schneider says, “During 1992, you spent $99,530 on various works of art. We have reviewed the regulations and case law regarding the tax treatment of artwork and have determined that it should be capitalized rather than expensed or depreciated.”

Conour asked Schneider under what circumstances a taxpayer could deduct the cost of artwork. In the past Conour had purchased items to give his employees as in-kind compensation, including mink coats, diamond tennis bracelets, trips to Europe and Mercedes-Benz automobiles. Conour treated these purchases as in-kind compensation for tax purposes and deducted them as a business expense. He often bought items in pairs and treated those he did not give employees as personal expenses. Schneider told his client that when given as in-kind employee compensation, the artwork would qualify as a deductible business expense.

In October 1993 Schneider signed Conour’s 1992 tax return as preparer. The return included a deduction of $49,767 (roughly one-half the total cost of the artwork) as an office expense, not as compensation expense.

The IRS audited this return and disallowed the artwork deduction. Conour, no longer represented by Schneider & Co., agreed to the increased tax liability that resulted from the adjustment. The IRS assessed Schneider a preparer penalty under section 6694(b)(2) for intentionally disregarding rules or regulations that resulted in an understatement of tax liability. Schneider filed a protest letter and administrative appeal of the penalty, which he paid in full. After the IRS denied his appeal, Schneider filed a motion for summary judgment based on two assertions:

Because Rhea had prepared a substantial portion of the return he, not Schneider, should be considered the legal preparer even though Schneider signed it as such.

Schneider did not intentionally disregard rules or regulations. He included the deduction because he justifiably believed Conour had given the artwork as in-kind compensation, not because he thought it qualified as a depreciable asset.

Schneider claimed Conour specifically told him the artwork was in-kind compensation. In fact, Conour did not give the artwork in question as compensation and denies ever telling Schneider or anyone else to take an office expense deduction on that basis. There was no evidence to show Conour expressly told Schneider or Rhea he had given the artwork as compensation to his employees.

Result. For the IRS. The court denied Schneider’s motion for summary judgment. It ruled his arguments were without merit. Schneider was both the signer of the return and Rhea’s employer, and under the law, he was without question the return’s lawful preparer. Additionally, Treasury regulations section 1.6694-2 says a “signing preparer” is one who signs a tax return or refund claim in this capacity.

By taking the office expense deduction for the artwork on Conour’s 1992 tax return, Schneider intentionally disregarded revenue ruling 68-232, which says taxpayers may generally not expense or depreciate fine art. Regulations section 1.6694-1(e)(1) addresses whether Schneider could rely on the representations—explicit or implicit—Conour made to him or his employees with respect to the artwork. It is the preparer’s duty to make further inquiry to determine a violation under section 6694(b). At a minimum Schneider should have sought Conour’s assurance that he indeed gave the artwork as in-kind compensation and that documentation existed for the claimed $49,767 expense.

James J. Schneider, CPA v. United States (S.D. Ind.), 2003-1 USTC 50,352.

IRC section 2035(c) presumes gifts an individual makes within three years of death are tax-avoidance transactions and eliminates the advantage of such “deathbed transfers” by increasing the gross estate to include gift taxes a decedent paid in the three years immediately before death. In a recent case, the appeals court affirmed that gift taxes a surviving spouse paid in connection with the joint funding of a life insurance trust were, in substance if not in form, paid by the decedent and thus within the three-year reach of section 2035(c).

Willet Brown died in 1993, leaving behind an estate of approximately $180 million. The entire estate was his separate property. Before his death, Willet, with the aid of an estate tax attorney, developed a plan that placed his entire net estate in a marital trust at his death. The transfer under the marital deduction rules of IRC section 2056 allowed Willet to provide financial stability for his wife Betty and deferred estate taxes until after her death.

Willet also created an insurance trust to hold insurance on Betty’s life, presumably so the heirs receiving the estate at her death could use the proceeds to pay estate taxes. Betty had little money of her own so Willet gave her a $3,100,000 gift to fund the life insurance trust. Betty promptly wrote a check from her separate checking account for that amount to fund the trust.

The $3,100,000 payment to the trust was a taxable event, incurring a gift tax liability of $1,415,732. Willet and Betty had elected to be jointly and severally liable for the gift taxes under IRC sections 2513(a) and (d).

At the time of the insurance trust transaction, Willet and his attorney realized it was better for Betty to pay the gift taxes. At age 71 she was more likely to outlive the three-year reach of section 2035(c) than was Willet, age 87. Since Betty did not have the financial resources to pay the tax from her separate property, Willet gave her the money to pay the gift taxes in the form of two checks totaling $1,415,732, which she deposited in her own account. The next day she drew two checks from her personal account, payable to the IRS for the identical amount, to satisfy the gift tax liability. Betty was, however, under no legally enforceable obligation to use the funds in that fashion.

Willet died in 1993, within three years of the gift tax payment. In 1995 the estate filed a federal estate tax return indicating zero tax liability. The zero balance reflected (1) the absence of any tax liability on the gift taxes, based on the assumption Betty paid them and (2) a marital trust made up of the remaining estate (after expected administration expenses), which passed to Betty and was therefore eligible for the marital deduction.

The IRS assessed a tax deficiency on the $1,415,732 plus interest because, in substance if not in form, Willet had paid the gift taxes, which his executors therefore had to include in his estate. Since the surviving spouse lacked the financial resources to pay the gift taxes on the transfer, the IRS collapsed the two-step transaction in which she received the funds from the decedent and paid the tax. Had Betty had adequate funds to pay the tax, section 2513 would govern her payment of the joint and several liability.

The executor filed for a rebate in 1999, raising several claims. First, the gift taxes Betty paid should not have been included in the estate. Second, the estate’s actual administration expenses of $3,592,024, which were deductible from the gross estate under section 2053(a)(2), exceeded the deduction originally claimed ($1,880,000) and the estate was entitled to increase the deduction by $1,712,024 plus the interest paid on unpaid estate taxes.

The IRS argued some of the increased expenses were paid out of funds otherwise earmarked for the marital trust, so any increase decreased the trust and therefore the marital deduction.

The district court ruled in favor of the IRS. It determined that (1) the IRS had properly ascribed the payment of the gift taxes to Willet, (2) the estate was entitled to increase the deduction for administration expenses and (3) the increase must be offset by a corresponding decrease in the marital deduction.

The estate appealed, challenging whether the IRS was entitled to apply the “step transaction” doctrine and the court’s conclusion that any administration expenses paid from the trust corpus decreased the marital deduction.

Result. For the IRS. The Ninth Circuit Court of Appeals affirmed the district court. It concluded the IRS treatment of the two-step transaction was proper. Since Betty had had Willet’s funds for exactly one day, the IRS—by disregarding her fleeting ownership and her role as intermediary—had appropriately characterized the transaction. Even though Betty was under no binding commitment to complete the prearranged plan, she was “unlikely to flout the desires of her husband because it was she, as the initial beneficiary of the estate, who stood to gain if the gift tax wager was successful.” Had Betty truly paid the gift taxes from her own funds, section 2035 would not apply to her payments.

The court also held that section 2056 requires that, when an estate deducts actual administration expenses under section 2053(a)(2) and pays them out of funds otherwise earmarked for the marital trust, the marital deduction must reflect the amount diverted. If the estate elects the administration deduction, those expenses are thereby excluded from the taxable estate. Including those amounts in the marital deduction as well would create a double deduction.

Betty R. Brown v. United States (9th Cir.), 2003-1 USTC 60,462.

Prepared by Claire Y. Nash, CPA, PhD, associate professor of accounting, Christian Brothers University, Memphis, Tennessee, and Tina Quinn, CPA, PhD, associate professor of accounting, Arkansas State University, Jonesboro.

Taxpayers generally can exclude up to $250,000 ($500,000 on a joint return) of gain on the sale of their principal residence. To qualify, a taxpayer must have used the property as his or her principal residence for at least two years during the five-year period preceding the sale. When a taxpayer uses more than one dwelling in a year, Treasury regulations section 1.121-1(b)(2) requires an examination of all facts and circumstances to determine a taxpayer’s principal residence. The regulation says the property a taxpayer used the majority of time during a year will ordinarily be considered his or her principal residence. In addition to usage, other factors include the (1) taxpayer’s place of employment, (2) location of family members, (3) address listed on tax returns, voter registration, driver’s license and vehicle registration, (4) taxpayer’s mailing address, (5) location of the taxpayer’s banks and (6) location of religious organizations and recreation groups.

On September 15, 1998, James and Jean Guinan, a retired couple, sold a residence located in Wisconsin they had purchased in March 1993. The couple also had owned a home in Georgia they sold in 1996. Upon the sale of the Georgia home, the couple bought a home in Arizona. From March 1993 to September 15, 1998, the Guinans occupied the Wisconsin residence for 847 days, the Georgia one for 565 days and the Arizona one for 375 days. The taxpayers originally had reported the gain on the sale of the Wisconsin residence on their 1998 federal income tax return but later filed an amended tax return requesting a refund of $45,009 based on excluding the gain. The IRS denied the request. The taxpayers filed an action with the U.S. district court in Arizona asking for a refund.

Result. For the IRS. The court examined the factors listed in regulations section 1.121-1(b)(2) to determine the taxpayer’s principal residence. It held that from 1993 to 1998, even though the Guinans had used the Wisconsin home for more days than either of their other two homes, they used it for the majority of only one year—1993 to 1994. The court noted it must consider the other factors in the regulations together with the time the couple spent at the residences to determine the Guinans’ principal residence, although usage probably was the most important factor. In examining these factors the court grouped them as (1) indicating the Wisconsin home was the couple’s principal residence, (2) indicating Wisconsin was not their principal residence or (3) factors with no impact on this question.

During the years in question, the Guinans received mail and had bank accounts at each residence. They kept a vehicle and two boats at the Wisconsin home, but also kept two vehicles at their other residences. The couple’s children did not live in any of the states where the Guinans had a residence. The couple enjoyed recreational activities at all locations. Thus the court held that these factors did not support or contradict the taxpayers’ position that the Wisconsin home was their principal residence. However, during the five-year period, the couple filed either a Georgia or Arizona state income tax return, were registered to vote in one of those states and had either Georgia or Arizona driver’s licenses. The court found these factors indicated the Wisconsin home was not their principal residence.

The one factor that supported the taxpayers’ contention the Wisconsin home was their principal residence was its size. The court held, however, that this was not enough to overcome the factors supporting the IRS position that it was not the principal residence. If the taxpayers, however, had used the Wisconsin residence 10 days more in either of two years, they would have used it for the majority of two of the five years in question. It’s unclear whether this usage, which the court acknowledged to be the most important factor, would have outweighed the other factors.

Clients who live in northern states frequently buy homes in southern states to spend the winter months in a warmer climate. Many of these taxpayers register their vehicles and change their voting registration to the southern states to be considered residents of those states. This typically enables them to pay lower state income taxes or no state tax at all. When taxpayers are contemplating selling a home in a northern state whose value has substantially appreciated, CPAs need to help them examine the factors necessary for that home to be considered their principal residence for at least two years. This may require reestablishing residency in the northern state. CPAs should weigh the higher state income taxes paid prior to the sale against the federal income taxes the taxpayer saves by having the northern home qualify as his or her principal residence.

J ames M. and Jean M. Guinan v. United States, 2003-1 USTC 50,475.

Prepared by Charles J. Reichert, CPA, CIA, professor of accounting at the University of Wisconsin, Superior.