Courts have applied the provision differently, however. In William O’Neill Jr. Irrevocable Trust v. Commissioner, 71 AFTR 2d 93-2052 (1993), the Sixth Circuit Court of Appeals allowed the exemption for investment advisory fees a trustee paid to meet fiduciary requirements under state law. More recently, however, the Fourth Circuit in Rudkin v. Commissioner , 98 AFTR 2d 2006-7368 (2006), declined to exempt similar fees, reasoning they were not of a type peculiar to trusts (see “ Tax Matters,” Jan. 06, p. 75). The Supreme Court may also address the discrepancy; it has granted certiorari in Rudkin.

Under Proposed Amendment 1.67-4, costs unique to the estate or trust are exempt from the 2% floor. Examples include fiduciary accountings and returns for income and estate tax, required judicial filings and distributions to beneficiaries. Expenses that would not be considered unique and thus are subject to the 2% floor include custody or management of property, gift tax returns, defense of claims by creditors of the decedent or grantor, and management of property not used in a trade or business.

Comments on REG-128224-06 may be made by Oct. 25 via www.regulations.gov.

The IRS Large and Mid-Size Business Division analyzed implications of FASB Interpretation no. 48, Accounting for Uncertainty in Income Taxes, in an industry directive and field examination guide. The summary and 10 questions and answers of LMSB-04-0507-045 cover some questions extensively discussed elsewhere, such as FIN 48 workpapers falling within the Service’s policy of restraint in requesting workpapers generally. Other questions treat more obscure points, such as whether a restricted consent agreement can be used to extend the statute of limitations for uncertain tax positions. (The guide says it depends on the facts and circumstances and lists five possible determining factors.) The guide also covers closing agreements, methods for expediting a taxpayer desire for resolution of uncertain items and whether a FIN 48-related public disclosure might prompt the Service to reopen a closed examination cycle.

Suggestions by AICPA members and staff on the Individual Tax Technical Resource Panel (TRP) included looking to existing guidance to deal with a potential difficulty also noted by other commenting parties: how to count nights when a child stays with neither parent. Existing guidance already covers temporary absences, but not when a child is away for longer periods, which could be addressed specifically, the TRP said. The group also suggested requiring that a written declaration to release a custodial parent’s claim to the child be made on Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents.

Members of Californians Helping to Alleviate Medical Problems Inc. paid an annual fee to receive benefits that included food, counseling, personal hygiene products and a limited amount of medical marijuana. Forty-seven percent of the members suffered from AIDS; the remainder had cancer, multiple sclerosis and other serious illnesses. On its final tax return for 2002, the taxpayer showed a $239 loss. The IRS denied all the nearly $213,000 in deductions because, it concluded, the taxpayer’s principal purpose was to traffic in marijuana.

IRC section 280E prohibits the deduction of all expenses and credits related to trafficking in controlled substances. Although the taxpayer objected to characterizing its activities as trafficking, the Tax Court applied a dictionary definition of the word and thus the restrictions of section 280E. The taxpayer also argued that its marijuana distribution was secondary to its care giving, for which deductions were not prohibited by section 280E. The Tax Court examined the scope of the care-giving activities and agreed they were a separate business from the drug trafficking, accounting for the majority of its expenses. Therefore, the taxpayer was allowed to deduct those expenses.

The Tax Court’s willingness to find two separate businesses—even though the clients of both were the same and the activities were all designed to help these individuals—may be beneficial to other taxpayers if other courts are willing to follow this conclusion. Numerous tax rules that require the existence of two or more businesses, such as partial liquidation and spinoffs, may be affected by this decision.

Californians Helping to Alleviate Medical Problems Inc. v. Commissioner , 128 TC no. 14 .

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

Under section 83, non-cash compensation, such as shares of stock, is taxable when it is transferred to the recipient, which according to Treas. Reg. § 1.83-3(a)(2) does not occur for an option until it is exercised.

Between March and July 2000, Gail K. Racine exercised options to purchase 25,257 shares of the stock of her employer, Allegiance Telecom Inc. Based on Racine’s estimated gain of over $1.9 million, Allegiance remitted $625,000 in income tax and withheld clear title for the shares until Racine reimbursed it for the taxes. Racine borrowed $684,000 on margin to cover the tax and the $58,000 exercise price. Soon thereafter, the market price of the stock declined, triggering a margin call for Racine. She sold stock in November 2000 and again in May 2001 to cover the margin, retaining 4,500 shares. However, because of the market’s decline, Racine’s real gain was now $366,070 (stock sales of $332,881 and remaining shares worth $92,000, less purchase price of $58,811), instead of her taxable gain of $1.9 million.

Racine’s remedy was to claim a $368,000 refund on her 2000 tax return, based on the assertion that the shares had not been transferred to her at the exercise date but rather when sold.

The tax refund was granted, but an audit of Racine’s tax return determined that the refund was made in error, and she was assessed $514,000 in taxes and interest. The Tax Court—affirmed by the Seventh Circuit—held that a transfer occurred when the options were exercised because Racine then acquired full legal and beneficial ownership of the shares. The Seventh Circuit acknowledged it was unfortunate for Racine that rather than selling at the exercise date (when the market price was over $78) or utilizing a hedging strategy to mitigate risk, she sold most of her shares in two transactions after the price had dropped by 74% and 80%, respectively.

The taxpayer cited Example 2 in Treas. Reg. § 1.83-3(a), which indicates that exchanging a non-recourse note for stock (buying stock with money borrowed from the broker) is not a taxable event because the taxpayer has nothing at risk and can walk away, allowing the broker to sell the collateral to cover the loan. Racine’s note contract, however, explicitly held her personally liable for the full amount, the Seventh Circuit noted. Thus, she was mistaken in characterizing the margin loan as non-recourse debt, the court held, saying the example more accurately describes a call option.

The Tax Court has consistently rejected the taxpayer’s line of reasoning. Three other circuits have held against taxpayers in similar cases.

Robert C. and Gail K. Racine v. Commissioner, 100 AFTR 2d 2007-5087.

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

States could face new limits on how they impose income taxes on nonresidents if a House proposal becomes law. Under the terms of the Mobile Workforce State Income Tax Fairness and Simplification Act of 2007 (HR 3359), introduced by Rep. Henry C. Johnson Jr., D-Ga., a state or locality could assess income taxes on an out-of-state worker’s wages only if the individual spends more than 60 days working in that state for the calendar year. Rep. Chris Cannon, R-Utah, is co-sponsoring the bill.

Some states currently tax individuals who work in the state for as little as one day. Several other states follow the 60-day rule that the federal legislation would make uniform. The full text of the bill is available at www.thomas.gov .