Robert Collins and several others formed Harbor Cove Marina Partners (HCMP) to acquire and run a marina. The partnership agreement provided that, upon termination, the partnership was to sell its assets and distribute the cash; it also gave the managing partner significant authority. After numerous disagreements, Collins and the managing partner decided to liquidate the partnership. But, instead of selling the assets, HCMP transferred them to another partnership and gave Collins cash equal to the assessed fair market value of his interest. Collins sued the managing partner to force a sale of the assets as stipulated in the partnership agreement.

While the suit was pending, the managing partner filed a final partnership return and sent Collins a form K-1 based on the actual cash distribution. Collins filed his tax return taking the position the partnership had not terminated, but the IRS said he had to file his return based on the form K-1 he received. Collins filed a suit in the Tax Court arguing the partnership had not terminated and his return was filed correctly.

Result. For the taxpayer. Although the taxpayer was not the tax matters partner, he was entitled to have the Tax Court adjudicate an issue involving a partnership item.

IRC section 708 provides for the termination of a partnership upon either of two events: No part of any business is being carried on by any of the partners or more than 50% of the interests in the partnership are sold within a 12-month period. The first event was before the court. Specifically, the IRS argued that since the business had ceased, the partnership had terminated. Collins argued that the partnership could not terminate until the procedure in the partnership agreement for termination was followed.

In analyzing the code section, the Tax Court noted that termination for tax purposes is not the same as termination for state law purposes. Under IRC section 708 the determination is a facts and circumstances test. In addition to restating the section 708 requirements, regulations section 1.708 includes a clarification that a termination will not occur until all the assets are distributed to the partners.

Several cases have examined this issue. They held that a partnership was not terminated even when it ceased its primary business if a nominal amount of business still was continued. For example, holding a note from the sale of partnership assets and collecting interest on it precluded termination, and so did discontinuing a business while maintaining the partnership for investment purposes.

Based on the above cases, the Tax Court concluded that HCMP’s failure to terminate the partnership under the procedure outlined in the partnership agreement with a resulting lawsuit were sufficient to prevent a termination even if no business was being conducted by the partnership. In other words, any activity or assets at the partnership level preclude a termination for tax purposes.

In the area of corporate taxation it is generally accepted that a corporation can be deemed to have completely liquidated even though it maintains its charter and a nominal amount of assets, provided it is not engaged in an ongoing business. The partnership rule is different; in addition to ceasing business, a partnership must continue to file tax returns as a going concern until it distributes all assets to the partners pursuant to the partnership agreement.

Harbor Cove Marina Partners Partnership v. Commissioner , 123 TC no. 4.

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

The Ninth Circuit Court of Appeals recently heard a case relating to the deductibility of a paid but contested tax liability from a business’s accumulated taxable income. At the time, the rate of the penalty tax was 39.6%. Metro Leasing and Development Corp. and the East Bay Chevrolet Co. (collectively “Metro”) paid a 1995 contested tax liability in 2001 based on their calculation of the accumulated earnings tax. Metro argued that, based on IRC section 535(b)(1), the payment of the contested tax liability should be deductible from the 1995 accumulated taxable income. To support its argument, Metro noted the Fifth Circuit’s decision in J. H. Rutter Rex Mfg. Co. v. Commissioner , which held contested deficiencies that had been paid before legal resolution were deductible.

Metro’s 2001 payment, made while its case was still pending before the Tax Court, was intended to cover any deficiency it might owe for 1995. Pursuant to Tax Court rule 155, both parties submitted proposed computations of Metro’s accumulated earnings tax for 1995. Metro’s computation deducted the 2001 payment; the commissioner’s did not. Metro’s appeal required the Ninth Circuit to decide if a paid but still contested income tax deficiency could be deducted from accumulated taxable income under IRC section 535(b)(1).

Result. For the IRS. The Ninth Circuit said the question was purely one of statutory interpretation. The Ninth Circuit disagreed with the Fifth Circuit’s holding that the language of IRC section 535(b)(1) was unambiguous and permitted tax reduction for federal tax “accrued” during the year.

The Ninth Circuit determined that Metro’s 1995 tax liability, paid in 2001, did not qualify as “accrued.” In United States v. Anderson the U.S. Supreme Court held that, before an expense becomes deductible, “all events” that fix the amount and the taxpayer’s unconditional obligation to pay must have occurred. In general an accrual basis taxpayer may not deduct an expense until (1) all events have occurred that determine the fact of liability, (2) the amount of liability can be determined with reasonable accuracy and (3) economic performance or payment has occurred. When a taxpayer contests a tax liability in court, the “all events” test is not satisfied until the legal challenge is resolved because, until then, the amount of the liability and the obligation to pay it are not certain.

The Ninth Circuit held that IRC section 535(b)(1) should be interpreted in accordance with the long-standing meaning of the word “accrual.” Therefore, Metro’s 1995 paid but contested tax liability did not accrue in the taxable year assessed. Instead, it either accrued in 2001 when it was paid or will accrue when the appellate review concludes. The Tax Court did not address whether IRC section 461(f) might apply to permit a deduction in 2001, the year of payment. Therefore, the Ninth Circuit expressed no opinion as to which of these alternate views was correct.

The accumulated earnings tax rate is only 15% for tax years 2003 through 2008, so the imposition of the penalty is less onerous at this point. However, the timing of this deduction may be important for many corporations whose pre-2003 years still might be audited. Taxpayers and their tax professionals should consider these opinions when planning the payment of the penalty tax prior to a court decision. The split between the Fifth Circuit and the Ninth Circuit may require a determination by the Supreme Court.

Metro Leasing and Development Corporation , 376 F3d 1015 (CA-2).

Prepared by Ronald R. Hiner, EdD, professor of accounting and Darlene Pulliam, CPA, PhD, professor of accounting, both of the T. Boone Pickens College of Business, West Texas A&M University, Canyon.

A temporary work location outside the metropolitan area where the taxpayer lives and normally works.

A temporary work location, regardless of distance, if the taxpayer has one or more work locations away from his or her residence.

Another work location if the taxpayer’s residence is his or her principal place of business under the home office rules in IRC section 280A(c)(1)(A).

Unfortunately, revenue ruling 1999-7 does not define “metropolitan area.”

The question was considered for the first time by the Tax Court in Wheir v. Commissioner . Corey L. Wheir was a union boilermaker living and working in Wisconsin Rapids, Wisconsin. The union office assigned him jobs all over the state ranging from one day to several months, though most did not warrant overnight travel. He received the assignments by phone and did not report to locations other than the job sites. Under union rules the taxpayer was not allowed to decline any assignments.

On his tax return Wheir deducted costs related to local travel for jobs farther than 35 miles from his residence. The IRS disallowed all claimed travel expenses on the basis that since Wisconsin Rapids was not a metropolitan area as defined by the U.S. Census Bureau, the entire state of Wisconsin should be considered the taxpayer’s normal work area for purposes of applying revenue ruling 1999-7.

Result. For the taxpayer. The court disagreed with this interpretation as revenue ruling 1999-7 neither defines “metropolitan area” nor references another official standard. If the court were to follow the IRS’s interpretation of “metropolitan area,” taxpayers in rural areas would be at a disadvantage to those in more populated areas. As a result, the taxpayer’s original position was sustained.

CPAs should be aware that, as a Tax Court summary opinion, Wheir cannot be cited as precedent. However, it does provide some practical guidance with respect to local transportation deductions when the metropolitan area of the taxpayer is unclear.

Corey L. Wheir , TC Summary Opinion 2004-117.

Prepared by Vinay S. Navani, CPA, principal of Wilkin & Guttenplan PC, East Brunswick, New Jersey.

One such situation arose in Ohio. DaimlerChrysler agreed to expand its Jeep assembly plant in Toledo, a project worth approximately $1.2 billion. In exchange, the company would have been entitled to an investment tax credit against its Ohio franchise tax liability in the amount of 13.5% of the cost of newly installed manufacturing machinery and equipment. DaimlerChrysler also would have received a 10-year, 100% property tax abatement based on its commitment to create and preserve existing jobs. The total value of the incentive package was estimated at $280 million.

A group of residents and small businesses who said they would be subsidizing the company’s expansion sued the city, the state and DaimlerChrysler. They argued that the tax incentives were invalid under the commerce clause of the U.S. Constitution and the equal protection clauses of both the U.S. and Ohio constitutions. The district court upheld both the investment tax credit and the property tax abatement, and the plaintiffs appealed to the Sixth Circuit Court of Appeals.

Result. Partially for the plaintiffs. On September 2, 2004, the Sixth Circuit held that Ohio’s investment tax credit violated the commerce clause and reversed the portion of the district court’s opinion that upheld it. However, the appeals court affirmed the lower court’s decision that the property tax abatement was proper.

In Complete Auto Transit, Inc. v. Brady , the Supreme Court announced the four-pronged test against which all subsequent Commerce Clause cases have been analyzed. A state statute satisfies the clause if (1) the activity taxed has substantial nexus with the taxing state; (2) the tax is fairly apportioned to reflect the degree of activity within the state; (3) the tax does not discriminate against interstate commerce; and (4) the tax is fairly related to benefits provided by the state. There was no dispute that the Ohio investment tax credit and property tax abatement satisfied the first, second and fourth prongs. However, the plaintiffs claimed the incentives discriminated against interstate commerce.

The Supreme Court has not directly addressed the constitutionality of subsidies such as these. It has made clear, however, that state statutes that provide a commercial advantage to local businesses by burdening out-of-state businesses discriminate against interstate commerce. The plaintiffs argued the Ohio investment tax credit was unconstitutional because it induced businesses subject to the Ohio franchise tax to invest in Ohio rather than in another state. Businesses that expanded locally enjoyed a reduction in their Ohio taxes by virtue of the credit while those that expanded outside of Ohio did not. It was the plaintiff’s contention that this disincentive to invest outside of Ohio hindered economic development in other states and, therefore, discriminated against interstate commerce.

The defendants took the position that state economic incentives favoring the local economy were constitutional as long as they did not penalize activities that took place out of state. While the Ohio investment tax credit did benefit local interests, it placed no burden on out-of-state activities and therefore, defendants argued, was constitutionally sound. The Sixth Circuit rejected this narrow view. Noting that “economically speaking, the effect of a tax benefit or burden is the same,” the court agreed with the plaintiffs and held the investment tax credit discriminated against interstate commerce.

No such discrimination was found, however, with regard to the property tax abatement. The court said a business that located in Ohio and received an abatement of property tax was in no better position than a business that chose to locate outside of Ohio; neither would owe property tax in Ohio. The abatement did not favor local investment at the expense of out-of-state investment, as the investment tax credit did. That a business investing outside of Ohio may owe property taxes in another state did not invalidate the Ohio statute. Finally, the plaintiffs’ arguments that the incentives were invalid on equal protection grounds were unsuccessful.

This case serves as a warning to other states. Unless the Supreme Court grants certiorari and says otherwise, investment tax credits based on the location of an investment are constitutionally impermissible.

Cuno v. DaimlerChrysler, Inc. , 2004 US App. LEXIS 18550, CA-6.

Prepared by Laura Lee Mannino, CPA, LLM, assistant professor of accounting and taxation, St. John’s University, Jamaica, New York.