The Fourth Circuit Court of Appeals held that a LILO (lease in, lease out) transaction by banking company BB&T Corp. was not a genuine leasehold interest but only a circular transfer of funds. In so ruling, the Fourth Circuit upheld a district court’s denial of deductions arising from the deal.

At the recommendation of a LILO promoter, BB&T in 1997 leased an interest in wood pulp manufacturing equipment from a Swedish cooperative for 36 years. The bank simultaneously leased the equipment back to the cooperative for 15.5 years. At the end of the sublease, the cooperative could repurchase the remaining lease years. Alternatively, BB&T could extend its lease for another 13.3 years or lease the equipment to another party. In effect, the cooperative continued to use the equipment and had significant incentives to reacquire all rights at the end of the sublease. The deal was partially financed by a loan secured and repaid by the rent payments, resulting in a $68 million intrabank transfer in which no money changed hands. On its 1997 tax return, BB&T reported a deduction for rent, interest and fees, net of sublease income, of $9.4 million, which the IRS disallowed. LILOs, like other tax shelter transactions, are usually evaluated under the economic substance doctrine. Since the litigation was for summary judgment, the court decided to analyze the lease and loan separately, using the form-versus-substance doctrine instead of the economic substance doctrine.

The analysis of the lease was based on the Supreme Court’s decision in Frank Lyon Co . (41 AFTR2d 78-1142) that a lease will be honored if the lessor retains significant and genuine attributes of the traditional lessor status. In the actual transaction, the court found that all rights given to BB&T were returned to the cooperative. The bottom line was that BB&T had solely an annual inspection right. An analysis of the cash flow showed that the only real transfer was $6 million from BB&T to the cooperative to participate. The cooperative continued to use the equipment without any interruption, and the deal protected BB&T from losing the other $12 million it put up. The end result bore no resemblance to a traditional lease, the court said. Therefore, the form was not respected.

Next, the court analyzed the loan interest deduction. Since the funds never actually left the bank, which treated the deal as an off-balance-sheet transaction, no money was actually loaned, the court said, and no interest deduction permitted.

The opinion quoted a riddle attributed to Abraham Lincoln: How many legs does a dog have if its tail is called a leg? The answer is four, since calling a tail a leg does not make it one. Calling a transaction a lease or a loan does not make it one if the rights and obligations do not match the title, the court said. Taxpayers should not forget that the form-versus-substance and step transaction doctrines will prevent tax abuse even if the plan is carefully structured to avoid being disallowed under the economic substance doctrine.

BB&T Corp. v. U.S. , 101 AFTR2d 2008-1933

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

Just before the Memorial Day holiday, the U.S. House and Senate passed by unanimous consent and voice vote, respectively, HR 6081, the Heroes Earnings Assistance and Relief Tax Act. The act provides benefits to military personnel, funded in part by new rules for taxing individuals who expatriate. The bill also alters the tax treatment of foreign subsidiaries of U.S. companies for employment tax purposes and increases penalties for failure to file returns. President Bush signed the bill on June 17 as Public Law no. 110-245 ( http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=110_cong_public_laws&docid=f:publ245.110 ).

The legislation imposes a mark-to-market regime for taxing unrealized gain of U.S. citizens and long-term U.S. residents (defined at IRC § 877(e)(2)) who expatriate. Most property of a covered expatriate would be treated as sold on the day before the expatriation at fair market value. Gains in excess of $600,000—adjusted for inflation after 2008—would be includible in income and taxed. Also, a gift tax is imposed on U.S. citizens or residents who receive qualifying gifts or bequests exceeding $12,000 (indexed for inflation) from a covered expatriate (or an individual who immediately before death was a covered expatriate). In addition, the act imposes a 30% withholding tax on qualifying deferred compensation payments as well as distributions from certain nongrantor trusts that are paid to a covered expatriate. The withholding tax is imposed in lieu of a mark-to-market tax on such assets.

The provisions generally apply to individuals who expatriate on or after the date of enactment. The withholding approach included in the legislation with respect to deferred compensation and nongrantor trusts was suggested by the AICPA. Other AICPA suggestions incorporated into the legislation are a charitable and marital deduction and the prospective application of the tax on gifts and bequests received on or after the date of enactment, from expatriates whose expatriation date is on or after the date of enactment. See http://tax.aicpa.org/Resources/Trust+Estate+and+Gift/Legislation/
AICPA+Comments+on+Proposed+Expat+Legislation.htm and http://tax.aicpa.org/Resources/Trust+Estate+and+Gift/Legislation/AICPA+Offers+Technical+Analysis+of+Tax+Proposals+to+Catch+Tax-Motivated.htm .

The AICPA Tax Division’s Expat Task Force worked with the tax-writing committees’ staffs to improve and simplify the legislation’s provisions since it was first considered years ago. Changes since December 2007 include:

Only the new section 877A (not the old section 877) applies to people who expatriate on or after the date of enactment. Old section 877 remains applicable only to people who expatriate prior to the enactment date.

Deferred compensation attributable to services performed outside the U.S. while not a U.S. citizen or U.S. resident is excepted from the application of the provisions, even if the compensation is part of a plan that is otherwise subject to them.

The new tax under section 2801 covering gifts and bequests is prospective from the date of enactment. Unlike in earlier versions of this legislation, it is not retroactive. This provision applies only to gifts or bequests received on or after the date of enactment and only to transfers received from individuals who expatriated on or after the date of enactment.

By AICPA Technical Manager Eileen Reichenberg Sherr, CPA, M. Taxation

The Third Circuit Court of Appeals has reaffirmed as still valid the “common-law mailbox rule”—that a properly mailed document is presumed to reach the IRS within normal delivery time—despite holdings by other circuits that the rule was supplanted by the 1954 Tax Code provision that allows a postmark date to be treated as the filing date of a return or document. In so doing, the Third Circuit found that a trust fund had a chance to prove its refund claim was submitted in a timely fashion, even though the IRS had no record of receiving it.

The Philadelphia Marine Trade Association/International Longshoremen’s Association Vacation Fund was a multiemployer trust fund that accumulated contributions from collective bargaining agreements between the Philadelphia Marine Trade Association and the local unions of the International Longshoremen’s Association. The fund hired O’Neill Consulting Corp. to withhold and remit to the IRS income and payroll taxes from money distributed by the fund. In 2001, the IRS found the fund in violation of several regulations, including remittance of fourth-quarter 1999 and second-quarter 2000 taxes by paper coupon rather than electronically, and late remittance of fourth-quarter 2000 taxes. The IRS assessed penalties against the fund and notified O’Neill. The O’Neill employee did nothing to correct the problems, and the IRS levied on $160,386 in the fund’s money market account on June 25, 2001. The O’Neill employee resigned in February 2003 without disclosing the levy to O’Neill or the fund.

The levy was discovered by the fund’s CPA in the spring of 2003 during an audit. Immediately, the CPA and O’Neill’s president contacted the IRS revenue officer for an explanation of the levy but received no information, as the case was considered closed. Subsequently, two letters, dated May 8, 2003, and June 13, 2003, requesting a refund were sent to the revenue officer. After more communications between the IRS and the CPA, the revenue officer and an IRS “troubleshooter” met with the CPA and O’Neill’s attorney and discussed a refund. The fund formally filed for a refund in September 2003 and received a partial refund of $93,365. (The government later sued to recover this refund, saying it was paid in error.) No refund was granted for the penalty assessed on the fourth quarter of 1999 because the penalty was considered paid on June 25, 2001 (date of the levy), and under IRC § 6511(a), the refund request should have been made by June 25, 2003

O’Neill reimbursed the fund for the penalty, and the fund and O’Neill filed suit in the District Court for the Eastern District of Pennsylvania to recover the remaining penalty. The District Court agreed with the IRS that O’Neill lacked standing and could not sue for a refund; nor could the fund, since the refund request was not timely. The fund and O’Neill appealed.

The Third Circuit held that the District Court had correctly concluded that O’Neill lacked standing and could not sue for the refund. But on the issue of untimely filing, it said there was enough direct evidence of timely receipt of the refund request to preclude summary judgment against the fund. The plaintiffs were able to present some evidence they mailed the request, including a copy of the June 13 letter. The court went on to argue that even if the direct evidence of the mailings was insufficient, the common-law mailbox rule allowed a presumption that they were timely received.

The rule was developed by the courts to determine the timing of physical delivery and allows them to presume that a properly mailed document was delivered by the U.S. Postal Service in the usual time. The IRS contended, and the Second and Sixth circuit courts have held, that IRC § 7502, regarding timely mailing treated as timely filing and paying, pre-empts the common-law mailbox rule. In this case, the fund did not rely on section 7502, since the refund requests were filed with enough time for them to arrive before the deadline. Rather, it only asked that delivery be presumed to have occurred in the usual time after mailing. The Third Circuit, in direct opposition to the Second in Deutsch v. Commissioner (44 AFTR2d 79-5063) and the Sixth in Miller v. United States (57 AFTR2d 86-928), maintained that the common-law mailbox rule was not repealed by section 7502 and may be used to determine when delivery occurred in cases where a taxpayer does not need to rely on section 7502 and produces evidence beyond its own testimony that the mailing occurred early enough to allow receipt by the IRS before the deadline.

When finalized, Prop. Treas. Reg. § 301.7502-1(e)(1) may prevent similar results for mailings after Sept. 21, 2004. The proposed regulation states that only proof of proper use of registered or certified mail will establish prima facie evidence of delivery of a document and that no other evidence of a postmark or mailing will raise a presumption that the document was delivered. Given this proposed regulation, it appears that the precedential effect of the Third Circuit’s opinion may be extremely limited.

Philadelphia Marine Trade Association v. Commissioner , 101 AFTR2d 2008-1759

By Karyn Bybee Friske , CPA, Ph.D., Pickens Professor of Business and associate professor 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.

The Fourth Circuit recently upheld a Tax Court decision that a deficiency notice beat the three-year statute of limitations only because the taxpayer had hand-delivered his returns to the wrong office.

The IRS is generally required by IRC § 6501(a) to assess income tax deficiencies no later than three years after the filing of an income tax return. In 1997, when the facts at issue in this case occurred, section 6091(b)(1)(A) required individual taxpayers to file their returns with the director of the district office in which their legal residence or principal place of business was located. In the case of tax returns delivered by hand, Treas. Reg. § 1.6091-2(d)(1) required them to be filed with the district director or any person who is the administrative supervisor of an area, zone or office which is a permanent post of duty within that IRS district. (These provisions have since been amended to require filing within the taxpayer’s IRS district to a designated service center or a responsible person at a local IRS office serving the taxpayer’s legal residence or principal place of business. Hand delivery must be to a person with responsibility to receive hand-delivered returns at the same local office.) The term “filed” was and is not defined in the Code or regulations, but the courts have considered returns filed only when they have been delivered in the proper form to an individual and location specified in the Code or regulations.

Excavation business owner and tax protester Fred W. Allnutt Sr. of Ellicott City, Md., waged a decades-long legal battle with the IRS that included criminal charges against him of tax evasion and conspiracy, of which he was acquitted in a jury trial in 1997. He then submitted returns he had refused to file for 15 previous years—1981 through 1995. On the advice of his attorney, Allnutt signed the returns and handdelivered them, along with a transmittal letter, on Feb. 21, 1997, to what he later acknowledged was the wrong place: the Baltimore District Counsel Office of the IRS. Less than a half-hour later, as what he thought was just a courtesy, he took photocopies of those returns, which he signed over his photocopied signature, to the Baltimore District Office of the IRS, where the original returns should have been hand-delivered. He addressed the envelope containing the copies to the district director and asked directions to his office, but wound up instead giving it to an unidentified person without receiving any receipt or record indicating the time and date. These copies ended up at the Philadelphia Service Center of the IRS with a postmark of May 9, 1997, while the original returns were received at the Special Procedures Office of the District Director on March 10, 1997. With neither set of returns did he pay the full amount of tax the IRS would later contend he owed: nearly $2 million, including penalties.

More than three years after Allnutt dropped off the returns, the IRS mailed him a notice of deficiency. However, the date of the notice, March 6, 2000, was four days before the third anniversary of Allnutt’s original returns being stamped as received and well before that of the copies reaching Philadelphia, where they had been processed as his returns. The notice assessed taxes for 1987 through 1990 and 1992 through 1995.

Allnutt petitioned the Tax Court for relief, stating the assessment was not timely. The Tax Court held the assessment was timely since Allnutt never intended to file the photocopied returns, and his originals weren’t properly filed until they reached the correct office. Allnutt appealed the decision to the Fourth Circuit.

The Fourth Circuit chose not to consider which of the two sets of returns Allnutt intended to file. It instead found that Allnutt had not “meticulously complied” with the Code and regulations, since he did not deliver the returns to the district director, that person’s assistant, the director’s office or even to the Taxpayer Services walk-in area in the building. The IRS could have handled Allnutt’s returns more efficiently, but statutes of limitations must be strictly construed in the government’s favor, the Fourth Circuit said.

This case illustrates how proper observance of the statute of limitations requires strict compliance with procedural rules for filing returns.

Allnutt v. Commissioner , 101 AFTR2d 2008-1836

By Charles J. Reichert , CPA, professor of accounting, University of Wisconsin –Superior.

The Tax Court reversed its prior decision in a “retail tax shelter” case, granting further relief from assessments to approximately 400 taxpayers. It did so because the IRS secretly—and fraudulently—entered into more favorable settlements with some test case litigants before the test cases were decided. The action marked a reversal of the court’s 2005 ruling in Lewis v. Commissioner (TC Memo 2005-205), which had denied relief.

The ruling in Hartman v. Commissioner (TC Memo 2008-124) said the stipulations the 400 taxpayers entered into were less favorable than settlements the IRS gave to other similarly situated taxpayers. The court said the IRS’s secret settlements with test case taxpayers constituted a fraud on the court, and the relief to the taxpayers was an appropriate punishment against the tax collector. The court ordered that all taxpayers whose cases were bound to the test cases should receive the benefit of the more favorable pretrial settlement by having their accounts adjusted within nine months after the ruling.

The cases go back to the 1980s, when hundreds of taxpayers took advantage of a shelter offered by Henry Kersting. The IRS set up test cases to litigate the schemes, and all similarly situated taxpayers who so agreed were supposed to be bound by the outcomes of those cases. Before the test cases were resolved, however, the IRS secretly settled with two of the test case taxpayers on terms more favorable than those generally offered to other taxpayers. In the 1989 trial of the test cases, moreover, an IRS attorney interjected questions to divert a party to the secret settlement from testifying about it and allowed another witness to give misleading testimony that concealed the government’s forgiveness of tax deficiencies in exchange for his testimony and other assistance.

The Tax Court said the separate settlements violated the Service’s duty of good faith and fair dealing toward the taxpayers whose cases were bound to the Kersting test cases. Allowing this action to stand also would violate the principle “that the tax system is administered fairly and impartially.” Furthermore, the failure to disclose all material facts regarding the separate settlements meant the Service was not released from facing the taxpayers’ later claims of misconduct.

Hartman v. Commissioner , TC Memo 2008-124

By JofA staff member Jeffrey Gilman , J.D.