Charles Trantina was an independent insurance agent employed by State Farm Insurance Co. In 1978 he incorporated his business as Trantina Insurance Agency Inc. The corporation executed a corporation agency agreement with State Farm that replaced Trantina’s individual agent agreement. In 1996 Trantina notified State Farm he was retiring and the corporation, therefore, was entitled to termination payments; in 1997 the corporation’s assets were liquidated and Trantina received the right to the termination payments. On his 1997 and 1998 tax returns, he reported the termination payments as ordinary income. Later, he filed amended returns for those two years that reclassified the income as capital gains, saying the payments were from the sale of the agency back to State Farm. The IRS refunded the amount requested.

In 2003 Trantina filed an amended return for 1999 again reclassifying the termination payments as capital gains from the sale of his agency. When the IRS rejected his refund claim, he filed suit in district court.

Result. For the IRS. The court first had to decide whether it had jurisdiction over the case. Because the case introduced new issues, the IRS argued, the court could not hear it. The court agreed: It determined the taxpayer should have notified the IRS of all the grounds for a refund on the original claim for refund. Therefore, the court would consider only the initial argument, that the payments were received for a capital asset, contained in the amended return. Thus, to ensure a court will consider all of the relevant issues, taxpayers must carefully identify all reasons for a requested refund.

The court rejected Trantina’s one remaining issue, concluding that he did not own a capital asset and, therefore, there could be no sale or exchange. Previous courts have held that an insurance agency’s books and records belong to the insurance company, not the agency.

Trantina argued that the agreement itself was the capital asset, but the district court disagreed. It said the agreement could not be a capital asset because it did not contain assets or provide rights over the assets or the actions of another party. Even if it were to consider the agreement a capital asset, the court went on, Trantina would not be entitled to a refund because his receipt of payments pursuant to a contract did not constitute a sale; therefore, he was not entitled to receive capital gains.

Taxpayers must own an identifiable asset that was disposed of in a sale or exchange if they want to report a capital gain. In addition, they must list all the reasons for filing an amended return on the refund claim if they want the opportunity for a court to consider those reasons.

Charles E. Trantina v. United States, 2005 US Dist. Lexis 12487 (DC Ariz.).

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

Patricia Kean filed for divorce in 1991. Until the divorce became final in 1997, a temporary court order granted her and her husband joint custody of their three children and also required Mr. Kean to deposit specified amounts into a joint bank account for the support of his wife and the children.

In 1993 Mrs. Kean was granted the exclusive use of the money deposited into the account, though she did not withdraw any of it from March 1993 to December 1996. She reported none of the money received from her former spouse as gross income for tax years 1992–1996; however, Mr. Kean deducted the payments as alimony during that period. The IRS determined the amounts Mrs. Kean received were taxable alimony payments and assessed her a deficiency of approximately $75,000 in unpaid income taxes.

Mrs. Kean petitioned the Tax Court for relief, arguing that the amounts deposited into the account were not alimony. The court rejected her first argument that she did not receive the payments because the money was deposited into a bank account.

She then argued that the Tax Court should follow its decision in Gonzales in which unallocated support payments a taxpayer received while a divorce was pending were not considered alimony. In Gonzales, the court determined that under a temporary court order a noncustodial payor-spouse was liable for a continuing payment because New Jersey state law could require that spouse to make family support payments if the payee-spouse died before the final decree was granted.

The Tax Court distinguished the Kean case from Gonzales , stating that if Mrs. Kean had died before the divorce was finalized, her spouse would not have been liable to make payments to a third party. Under New Jersey state law, he had joint custody rights and thus automatically would have been given custody of the children.

Mrs. Kean appealed the decision to the Third Circuit Court of Appeals, making the same arguments she had presented to the Tax Court.

Result. For the IRS. The Third Circuit held that, because Mrs. Kean had access and control of the money, she had received the funds. The court also rejected her argument that Mr. Kean had a continuing payment liability, saying that if Mrs. Kean had died her husband would not have had to make payments to her estate or on her behalf due to the separation instrument. Thus, under IRC section 71(b)(1)(A), those payments could not have been considered continuing liability payments.

The court also noted that IRC section 71(c) permits the parties to distinguish child support payments from alimony in the instrument. The court said it would be inconsistent with the intent of this section for state law to dictate that a parent had a continuing payment liability. The court concluded that the entire amount of unallocated support payments represented alimony; otherwise the payor-spouse would be taxed on amounts intended to support the payee-spouse.

The Third Circuit reached the same conclusion as the Tax Court for a different reason, saying previous decisions regarding unallocated family support payments placed too much emphasis on a parent’s legal responsibility under state law and ignored the overall purpose of section 71(c). This court’s position was that a continuing payment liability or a substitute payment liability is created when an instrument requires payments to the payee-spouse’s estate or on his or her behalf and is not created by a parent’s legal responsibility to support his or her children under state law. The court noted that unallocated support payments provide flexibility to parents in the use of that money and, when designing section 71(c), Congress permitted spouses to determine which of them would bear the tax burden of any payments. If the parties agree to have the payor spouse incur the tax burden, nondeductible child support payments can be specifically identified in the instrument rather than using unallocated payments; therefore the payee-spouse should be taxed in full for unallocated support payments.

Patricia P. Kean v. Commissioner, 407 F3d 186 (3rd Cir. 2005).

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

In Anthony M. Flores and Sandra L. Flores v. Commissioner (TC Summary Opinion 2005-57), the court considered whether certain workers’ compensation benefits were taxable as if they were Social Security benefits.

Usually a taxpayer can exclude workers’ compensation from his or her gross income but may be required to include Social Security benefits, including disability benefits. A statutory formula considers several factors, including the amount of the taxpayer’s Social Security benefits, other income and filing status, to determine whether he or she must pay taxes on this amount. However, when taxpayers receive workers’ compensation rather than Social Security disability benefits and this compensation reduces the amount of Social Security they receive, the workers’ compensation is taxed at the same rate as Social Security benefits.

Mrs. Flores was seriously injured at work in October 2000 and received workers’ compensation benefits from November 2000 through 2002.

At the time of her injury, Mrs. Flores also was covered by her employer’s long-term disability policy. Under the terms of the policy, employees who are disabled for more than a year must apply for Social Security benefits; in July 2002 Mrs. Flores applied for such benefits. Beginning in October 2002, she received Social Security benefit payments of $8,820—of which $6,772 represented back payments for the year 2001.

When Mrs. Flores received her Form SAA-1099, Social Security Benefit Statement, for 2002, the benefits reported totaled $20,675. This included the $8,820 Social Security benefits and $11,855 of workers’ compensation benefits. She excluded the $11,855 of workers’ compensation as “not paid by SSA” because she believed the workers’ compensation offset was not includable in taxable income.

The IRS issued a notice of deficiency stating the Floreses should have included the workers’ compensation in their income. The IRS noted that generally workers’ compensation benefits are not taxable under IRC section 104(a)(1). However, IRC section 86(d)(3) states when these benefits are paid in place of wages lost as a result of a work-related accident or injury and reduce Social Security or Railroad Retirement benefits received, they may be taxable. In these instances, the same method used to compute the taxable portion of Social Security and Railroad Retirement benefits is used to compute the taxable portion of workers’ compensation benefits.

Mrs. Flores argued she was required to apply for Social Security disability benefits under her long-term disability policy. If she had not, she would not have had to pay federal income tax on her workers’ compensation benefits under IRC section 104(a)(1), which would have allowed her to report the amount as compensation for personal injuries or sickness.

Result. For the IRS. The court examined the rationale for IRC section 86(d)(3). A review of the legislative history revealed it was meant to equalize the federal tax treatment of Social Security benefits whether the taxpayer was or was not eligible to receive workers’ compensation benefits. Under this section the $11,855 offset identified on Mrs. Flores’s 2002 form 1099-SSA—although not paid directly to her as Social Security benefits—was taxable. Although she received more than $11,855 in workers’ compensation, IRC section 86(d)(3) treats workers’ compensation benefits as though they were Social Security benefits only to the extent of the offset amount.

CPAs with clients receiving workers’ compensation benefits should inquire whether such benefits are received in lieu of Social Security disability benefits. If so, they must compute the taxable portion of workers’ compensation benefits in the same way as the taxable portion of Social Security and Railroad Retirement benefits is computed.

Anthony M. Flores and Sandra L. Flores v. Commissioner, TC Summary Opinion 2005-57.

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