The AICPA, in a June 7 letter from Jeffrey R. Hoops, chairman of the Tax Executive Committee, urged Treasury and the IRS to provide transitional relief to allow preparers, taxpayers and the IRS time to understand and implement the changes. Notice 2007-54, issued June 11, provided that for income tax returns, amended returns and refund claims, the IRS will apply the preparer standards during the transition period under prior law. For other returns, the IRS will apply the reasonable basis standard under the section 6662 regulations, without regard to the disclosure requirements. In general, the transition relief is provided for income tax returns due by Dec. 31, 2007, as well as 2007 estimated tax returns due by Jan. 15, 2008, and 2007 employment and excise tax returns due by Jan. 31, 2008.

For the notice, see www.irs.gov/pub/irs-drop/n-07-54.pdf . For the AICPA letter, see http://tax.aicpa.org/Resources/.

The change to IRC § 6676(a) assesses the penalty on any claim or credit for an excessive amount unless the taxpayer has a “reasonable basis” for the claim. However, section 6676(c) essentially waives the penalty on any portion of the excessive claim that also would be subject to accuracy-related or fraud penalties imposed by sections 6662, 6662A or 6663. The new penalty applies to claims filed after May 25, 2007, the date President Bush signed the legislation. Previously, no penalty applied to the excessive refund if the taxpayer was not subject to a penalty under the aforementioned accuracy-related or fraud penalty statutes.

The growing prevalence of refund fraud has been identified in numerous reports from the Treasury Inspector General for Tax Administration in the past several years. A 2006 audit report of fiscal years 2000 through 2005 said refund fraud increased 36.2% between 2003 and 2005. The audit is available at www.treas.gov/tigta/auditreports/2006reports/200610074fr.pdf. A letter to Congress, issued in June 2005 by Inspector General J. Russell George, identified prison inmates as a large source of refund fraud cases. The letter is available at www.treas.gov/tigta/congress/congress_062905.pdf.

In Davis v. Department of Revenue, 193 S.W.3d 557 (2006), the Kentucky Court of Appeals agreed with the taxpayers’ argument that Kentucky’s income tax statutes, which assess income taxes on interest earned on out-of-state municipal bonds but exempt interest on in-state municipal bonds, violate the Commerce Clause of the U.S. Constitution, Art. I, § 8, cl. 3. The state court said such discrimination is unconstitutional “economic protectionism” that is “designed to benefit in-state economic interests by burdening out-of-state competitors.”

Kentucky, in its writ of certiorari to the U.S. Supreme Court, based its argument, in part, on the decision by the Ohio Court of Appeals in Sharper v. Tracy , 647 N.E.2d 550 (1994), which said the Commerce Clause was not intended to apply to acts of one sovereign state trying to gain an advantage over another sovereign state. Tax laws in 38 states give such favorable treatment to in-state municipal bonds.

In the early 1980s, Heinz created H.J. Heinz Credit Co. (HCC), a Delaware-based wholly owned subsidiary, to finance subsidiary operations and minimize its state tax burden. In 1994 and 1995, HCC bought 3.5 million shares of Heinz common stock on the open market. It sold 3,325,000 shares back to its parent at their then-fair market value, in exchange for zero-coupon debt convertible into 3,510,000 shares of Heinz. HCC then sold its remaining Heinz shares to an unrelated third party. HCC reported a capital loss on the sale of $124 million, which the government disallowed.

HCC determined its loss based on IRC sections 302 and 318. Section 302 determines whether a stock redemption is to be treated as a sale or a dividend, depending on how much the transaction affects the seller’s ownership of the corporation redeeming the stock. Section 318 mandates that the ownership determination must include stock on which the seller holds an option to purchase. The convertible debt was treated as such an option. Thus, the redemption did not change HCC’s ownership of Heinz, and it was treated as a dividend. The regulations under section 302 permit the seller to tack the basis of the redeemed stock onto the remaining stock owned, which HCC said allowed it to claim a loss when it sold the remaining stock.

The IRS challenged the claim on several grounds. First, it argued that HCC never really owned the Heinz stock. The court rejected this argument, noting that HCC had all the benefits and burdens of true ownership, including title and dividend income, and sold the stock for an actual value different from the purchase price.

The IRS then challenged the loss as the result of a sham transaction, requiring HCC to prove that the transaction had a business purpose and economic substance. HCC argued that it acquired the stock as an investment and to add substance to its activities, to counter state challenges to its existence. On this argument, the court sided with the IRS. The record showed that Heinz negotiated the redemption price before HCC even bought the stock, negating the argument that the acquisition was an investment. The record also failed to show Heinz’s tax department ever recommended the transaction to protect HCC’s corporate existence. As often happens, the taxpayer was hurt by its own workpapers and actions, which contradicted or failed to support its claim in the courtroom.

The court could have stopped there but chose to examine whether the step transaction doctrine applied, by both the “end-result” and “interdependence” tests. It found that both tests would treat the transaction as a single step, the purchase by Heinz of its stock in the open market. There was no question that Heinz intended to redeem the stock shortly after it was purchased by HCC and that running the stock through HCC’s hands did nothing to change the outcome or effect of the transaction. Heinz could have purchased the stock directly and saved money. The court emphasized a different aspect of the interdependence test than normal. Usually, the test looks to see if each step had an independent economic effect. Since the court had already concluded that HCC was the true owner of the stock and received a dividend, the answer to this question could have been “yes.” However, the court asked whether HCC would have undertaken the purchase without knowledge of the redemption. The redemption was planned, and the sale of the remaining stock had to be at a price less than the purchase price since it was purchased on the open market and sold in a private placement. Given those facts, the court concluded HCC would not have undertaken the purchase as an independent investment. Therefore, the steps were interdependent and collapsed into a single step—a direct purchase of stock by Heinz.

In his opinion, Judge Francis Allegra turned the tables on Heinz’s ketchup advertising slogan “It’s Red Magic time,” writing, “No amount of magic, red or otherwise, can hide the meat of the transactions in question, the connective tissues and gristle of which have been revealed by the multi-tined substance-over-form doctrine.” The case highlights the scrutiny that will be used on all related-party transactions and how important it is that all the documentation support the taxpayer’s motives and arguments.

H. J. Heinz Co. v. U.S., 99 AFTR2d, 2007-2940.

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

In 2000, a court order outlined future payments by Daniel Webb of Reno, Nev., to his ex-wife, Jeanette Webb, but explicitly stated that he had no legal duty to make them. It required him to provide his ex-wife an annual statement of payments and required her to include them as taxable alimony on her tax return. In 2002, Webb paid and deducted from his income $24,000, which the IRS disallowed.

The IRS conceded the payments satisfied the requirements of section 71 but said they could not be considered alimony because Webb had no legally enforceable duty to make them. The court disagreed, noting the tax code contains no such requirement. One did exist formerly, but the Deficit Reduction Act of 1984 removed it. Furthermore, Temp. Reg. § 1.71-1T, issued as a result of the 1984 act, specifically states that no legal obligation is necessary for payments to qualify as alimony.

Daniel Wayne Webb v. Commissioner, TC Summary Opinion 2007-91.

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

The government won summary judgment in an action to foreclose on Meisner’s residence to collect a portion of more than $374,000 in unpaid income taxes from 1991, 1992 and 1994–1996. Meisner failed to pay income taxes on an average of $150,000 annual royalty income after her divorce from Randall Meisner, a member of the rock group the Eagles. The district court previously granted the government’s motion for partial summary judgment on the outstanding balance of the taxes (See U.S. v. Meisner , 99 AFTR2d 2007-725) and in May ruled the IRS could foreclose upon the home.

Meisner first argued that IRM 5.17.4.7(2) required the IRS to prove that “all administrative remedies available have been exhausted” before proceeding with a foreclosure. The court disagreed, saying the IRM “is not binding on the IRS in litigation with taxpayers” and “only governs the internal affairs” of the IRS.

Meisner next argued that the principle of section 6331(j)(2), regarding levies, should apply to a foreclosure suit under section 7403. The court disagreed, saying that if Congress had intended for the exhaustion-of-remedies requirement to apply to section 7403, it would have amended the statute to reflect it. The ruling noted that Congress likely added several safeguards to levies under section 6331 because they are a purely administrative action, whereas section 7403 lien foreclosures are performed under court supervision.

Lastly, the court ruled that the equities did not weigh in Meisner’s favor to prevent the foreclosure. Her correspondence with counsel showed she was coherent and intelligent. She was the sole owner of the home, which was large and had no mortgages attached to it; she apparently did not intend to move to a smaller and more affordable home; nor did she intend to mortgage the current one to pay her tax debt. The court also found the property was uninsurable and falling into disrepair—findings backed up by Meisner’s own affidavit. This favored an expeditious foreclosure to ensure the “prompt and certain collection of delinquent taxes.”

Earlier, the court ruled inadmissible an affidavit by Meisner’s attorney. To the extent that the affidavit included conclusions and opinions based on the attorney’s review of historical financial information and not representation of his client, it contained expert witness testimony, the court held. But the attorney could not be both counsel and expert witness, it said.

CPAs are often called upon to provide information for court cases or to testify as expert witnesses. Practically and legally, these functions are different. Each CPA should carefully define and act as either a source of factual information or as an expert witness.

U.S. v. Meisner, 99 AFTR2d 2007-2627.

Prepared by Darlene Pulliam , CPA, Ph.D., McCray Professor of Business and professor of accounting, the College of Business, West Texas A&M University, Canyon, Texas.

In Hon Pui Yip v. Commissioner, TC Memo 2007-139, the court upheld the disallowance of $276,362 of claimed Schedule C expenses. The court found the taxpayer’s testimony about the expenses “sincere” but rejected the claim because the taxpayer did not produce any books or records documenting the charges. The taxpayer’s bare testimony was not the “credible evidence” necessary to shift the burden of proof to the IRS under IRC § 7491(a)(1).

The second case, Calpo Hom & Dong Architects Inc. v. Commissioner, TC Memo 2007-140, upheld a determination that the taxpayer was a qualified personal services corporation under section 448(d)(2) and subject to the flat 35% tax rate of section 11(b)(2). The court applied the principle of the Welch case and found the architect-owner’s testimony, combined with spotty documentary evidence, insufficient to meet the burden of proof that less than 95% of the corporation’s activities were related to architectural services.

In January, the AICPA submitted written comments to Baucus and Grassley on securities basis reporting and other tax measures. The letter signed by Jeffrey Hoops, chairman of the AICPA’s Tax Executive Committee, said the AICPA supports the concept, but it urged holding off implementation until the IRS is able to clear technical hurdles of processing and utilizing the information. Without the ability by the IRS to match the data to income tax returns, reporting could impose a burden on taxpayers outweighing its enforcement benefit, Hoops wrote.