Section 1341 allows a deduction when a taxpayer had an apparent right to an amount over $3,000 included in gross income in a prior year but subsequently discovers it did not have an unrestricted right to that income. Uncertainty surrounding such questions as what kinds of claims qualify and how intrinsically they must be related to the income against which they are deducted, however, often make applying this relief problematic.

From 1940 to 1987, aluminum manufacturer Alcoa Inc.’s production process created waste byproducts that required it to spend large sums in 1993 for environmental cleanup. Under the annual accounting period rules, these expenditures would have been deductible in 1993. But since the corporate tax rate in 1993 was significantly lower than in 1940–1987, Alcoa used section 1341 to deduct the costs from its income in the prior period. The government’s rejection of Alcoa’s resulting refund claim of more than $12 million was upheld in 2005 by the U.S. District Court for Western Pennsylvania. The court based its ruling on a nearly identical case decided a short time earlier that year by the U.S. District Court for Eastern Virginia against Reynolds Metal Co. (Reynolds Metal Co. et al. v. U.S. , 96 AFTR2d 2005-6003). Alcoa appealed the Pennsylvania case to the Third Circuit.

The Third Circuit said in a Nov. 28, 2007, opinion that Alcoa’s retrospective deduction for its cleanup costs failed because the costs lacked a substantial nexus of circumstances, terms and conditions with the earlier income. The cleanup obligations did not arise from the earlier failure to spend the money but from new circumstances, terms and conditions—notably a 1980 legislative mandate. Moreover, it wasn’t clear who was exercising a competing claim to the money. Earlier cases, along with the plain meaning of “restoration” and “restitution” referred to in section 1341’s legislative history, require payment to a specific individual or business and not simply an expenditure that benefits many.

It was also unclear to the court what relation the 1993 costs bore to amounts Alcoa would have incurred for cleanup during the earlier period and how the costs might have been apportioned over those 47 years. Although a “significant question,” this point was relegated to a footnote; Alcoa’s construal of the statute’s key elements, “while artful, is not convincing,” the opinion said.

In a separate case, the Federal Circuit Court of Appeals rejected a claim by Pennzoil-Quaker State Co. (the successor to Quaker State Corp.) for a $4.4 million deduction claimed under section 1341. The amount was paid in 1995 as a settlement in a price-fixing lawsuit. The Federal Circuit overturned the 2004 decision of the Court of Federal Claims (94 AFTR2d 2004-6545), which had allowed the deduction. (See “ Tax Matters: Section 1341 Clarified,"  March 05, page 86.)

Quaker State claimed the payments as “other deductions” on its 1995 and 1996 tax returns, contending the settlement resulted in an overstatement of gross income of $4.4 million for the years 1981–1995. Similarly to the Third Circuit in Alcoa , the Federal Circuit said Pennzoil-Quaker State’s “settlement payments did not arise from the same circumstances” as the oil company’s past understatement of cost of goods sold. The court also ruled the claim was barred by the “inventory” exception of section 1341(b)(2), which disallows the deduction when the item was included in gross income because of the sale of inventory.

These decisions, if followed by other courts, reject the use of section 1341 for claims lacking a clear and contemporaneous connection to income or an identifiable claimant.

Alcoa Inc. v. U.S. , 100 AFTR2d 2007-6815
Pennzoil-Quaker State Co. v. U.S. , 101 AFTR2d 2008-415

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

In a summary opinion, the Tax Court ruled that a woman who operated a trucking business by day and played casino slot machines by night was a professional gambler, allowing her to deduct $1.4 million in gambling losses as a business expense rather than as a miscellaneous itemized deduction. A key factor the court found in her favor was that although she usually gambled into the early morning hours and sometimes all night, she took no pleasure in it.

The IRS assessed the woman, Linda Myers of South St. Paul, Minn., a $5,266 deficiency and $1,055 penalty on her 2003 return. She argued that she had developed strategies for playing the slot machines that she believed would maximize her odds of winning. Although she didn’t report an overall profit from gambling in the three years preceding 2003 or the year after, she had won several large jackpots, including $50,000 twice and ones exceeding $1,200 more than 300 times in 2003. She had begun gambling in 1992 and by 2000 considered herself a professional. Myers also owned and operated a trucking business at which she worked 25 to 35 hours a week. Starting around 2 p.m. most days, she would spend the next 12 hours or more at a local casino.

An activity may be considered a trade or business if it is conducted with continuity, regularity and with the primary purpose of earning a profit. The continuity and regularity of Myers’ gambling were not disputed, but her profit motive was. The court analyzed it by the nine nonexclusive factors of Treas. Reg. § 1.183-2(b). One factor, the taxpayer’s history of income or loss from the activity, was held to favor the government. Two more factors were neutral or didn’t apply: Myers did have substantial income ($64,000) from another source, her trucking business. In other situations, this could indicate a motive for claiming offsetting losses. But since IRC section 165(d) limits deductions for gambling losses to the extent of winnings, they would not avail her for this purpose. Likewise, an expectation that assets used in the activity may appreciate in value was held not to apply.

The remaining six factors were held to favor Myers:

1. The manner in which the taxpayer carried on the activity . She retained her bank and credit card statements and copies of casino records, including a player card account and IRS forms W-2G, Certain Gambling Winnings. Although she didn’t maintain separate books on her gambling, she kept a daily tally of how much money she took to the casino.
    
2. The expertise of the taxpayer or his or her advisers . The continuity and regularity of her play, coupled with her study of the machines and other gamblers, indicated she had gained expertise.
    
3. Success of the taxpayer in other activities . Myers had succeeded in the trucking business, the court said.
    
4. Amount of any occasional profits . The court noted her occasional large wins and frequent smaller ones.
    
5. Time and effort expended by the taxpayer on the activity . The court said her gambling regimen satisfied this factor, in light of the next one:
    
6. Whether elements of personal pleasure or recreation were involved . The court noted that casino gambling is commonly thought to be recreational. But it considered credible Myers’ testimony that she found no pleasure in gambling and considered it not just work, but stressful, tiring and time-consuming toil.

Although this ruling may not be appealed by the IRS and may not be treated as precedent, it does provide one illustration of how an activity may be conducted as a trade or business for tax purposes. For a contrasting decision, see Jose Calvao v. Commissioner , TC Memo 2007-57.

Linda M. Myers v. Commissioner , TC Summary Opinion 2007-194

Prepared by Tina Quinn, CPA, Ph.D., chair and associate professor of accounting, Arkansas State University, Jonesboro, Ark.

The Eleventh Circuit Court of Appeals vacated a Tax Court judgment and allowed a valuation discount of 100% of an estate’s built-in capital gains tax. The court based the contingent tax liability and resulting discount on an assumed immediate liquidation of the decedent’s interest in a closely held investment holding company, rather than the 16-year indexed discount allowed by the Tax Court. On an issue of first impression for this court, the Eleventh Circuit followed the Fifth Circuit’s approach in Estate of Dunn , 90 AFTR2d 2002-5527.

When Frazier Jelke III died in 1999 in Miami, he held through a revocable trust a 6.44% interest in Commercial Chemical Company (CCC), a closely held C corporation that held and managed investments for its shareholders. The other CCC shareholders were irrevocable trusts for other Jelke family members. The terms of the trusts did not prohibit the sale or transfer of CCC stock. CCC’s primary investments were marketable securities, and the portfolio was well managed by a stockholder-elected board. The investment strategy was long-term capital growth, which resulted in low asset turnover and large unrealized capital gains. There were no plans to liquidate any significant portion of CCC’s portfolio.

The federal estate tax return reported the value of Jelke’s interest in CCC as $4,588,155, which was computed by reducing CCC’s net asset value by the entire built-in capital gains tax liability, as if the securities had been sold at the date of death, then applying a 20% discount for lack of control and a 35% discount for lack of marketability. The IRS issued a notice of deficiency based on the same net asset value but discounting for the built-in capital gains tax liability by $21 million, or 41%, to reflect when it was expected to be incurred, and using lesser discounts for lack of control (5%) and lack of marketability (10%).

The Tax Court agreed with the IRS and disallowed the full reduction for built-in capital gains tax liability, on the presumption that the tax would be incurred in the future. However, the Tax Court applied a 10% lack-of-control discount and a 15% lack-of-marketability discount.

In siding with the estate, the Eleventh Circuit used Dunn’s “snap shot of valuation” approach, which takes into account only the facts known at the date of death “without present values or prophesies,” the court said.

In a scathing dissent, Judge Ed Carnes derided Dunn’s and the instant majority’s “rule of least effort,” saying “sometimes prophesying is necessary.” The Tax Court’s calculation produced a result closer to reality than assuming an immediate liquidation, Carnes wrote.

Although this is the first time this valuation issue has come before the Eleventh Circuit, it has been addressed by several other circuits besides the Fifth. The Second Circuit in Eisenberg v. Commissioner (82 AFTR2d 98-5757) and the Sixth Circuit in Estate of Welch (85 AFTR2d 2000-1200) allowed discounts (less than 100%) for built-in capital gains taxes. The Fifth Circuit vacated the Tax Court’s judgment in Estate of Jameson (88 AFTR2d 2001-5922) and remanded the case with instructions to allow a discount for built-in capital gains. A year later, the Fifth Circuit reversed the Tax Court again, in Dunn . Increasingly since 1998, when the Tax Court in Estate of Davis (110 TC 530) began recognizing such discounts, the question has been not whether they can be taken, but by how much. We will likely see more aggressive positions taken in this area. For estate tax valuation, tax advisers may want to consider the cases in their jurisdiction.

Estate of Frazier Jelke III v. Commissioner , 100 AFTR2d 2007-6694

Prepared 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 IRS scored a major success in its war against Son of BOSS-type tax shelters in Jade Trading LLC . The Court of Federal Claims used the application of the economic substance doctrine in Coltec Industries to disallow losses involving partnerships and euro call options.

In 1999, after clearing approximately $40 million on the sale of their cable businesses in Kentucky, three brothers, Gary, Robert and Tim Ervin, each formed a limited liability corporation. The LLCs each purchased euro options from insurer and financial services company American International Group (AIG) for a premium of $15,000,020. At the same time, each LLC sold a euro option to AIG for $14,850,018 and paid AIG the difference, $150,002. Each LLC then contributed its option spread to Jade Trading LLC, an investment vehicle, and treated its basis as equal to the premium for the purchased call option. In so doing, the brothers’ LLCs ignored the premium for the sold call option by claiming that the call options assumed by Jade were contingent obligations. Shortly thereafter, each LLC redeemed its partnership interest at its fair market value—a relatively small amount equal to the difference in the options. In each case, a loss was claimed for the difference between the fair market value of the partnership interest and the claimed basis of almost $15 million. On their 1999 returns, each Ervin brother claimed close to $15 million in losses and expenses from the execution of the spread transaction and involvement in Jade. The IRS audited the returns and disallowed these losses. The Ervins appealed to the Court of Federal Claims.

The court held that the Jade transactions failed the economic substance doctrine as clarified in the Coltec decision (98 AFTR2d 2006-5249; see also “Tax Matters: Denial of Contingent Liability Loss Deduction,” JofA , Jan. 07, page 67). In Coltec, the Court of Appeals for the Federal Circuit (overturning the Court of Federal Claims) determined that the legitimacy of a transaction for tax purposes is not guaranteed merely because a technical interpretation of the Code would support the tax treatment. In Jade Trading, the Court of Federal Claims required additional scrutiny of the bona fides of the transaction, requiring that the transaction pass muster under the objective economic substance test. The court said the taxpayer has the burden of proving that the transaction giving rise to the tax benefit objectively had economic substance—as opposed to a transaction created for tax avoidance purposes.

The court said that the transaction resulted in a fictional loss, had no ability to realize a profit and resulted in a disproportionate tax advantage as compared with the amount invested and potential return. In addition, there was no nontax reason for conducting the original transactions in partnerships. The court upheld the government’s $14.7 million reduction of each partnership’s basis, plus a 40% gross valuation misstatement penalty. Because the court considered only partnership items, it lacked jurisdiction to consider the individual partners’ defenses to the penalties; these defenses could be taken up subsequently in individual partner-level proceedings.

In Notice 2000-44, 2000-36 IRB 255, the IRS warned that purported losses in arrangements similar to that of Jade are subject to challenge on a variety of grounds and that a variety of penalties may be imposed on participants, promoters, and reporters of these listed transactions. Tax shelters have become less attractive due to the IRS’s aggressive pursuit of transactions that appear to lack economic substance. Tax advantages gained are less likely to withstand IRS and judicial scrutiny.

Jade Trading LLC v. U.S. , 100 AFTR2d 2007-5591

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

The Third Circuit Court of Appeals recently held that payments to tenured faculty and administrators at the University of Pittsburgh who relinquished tenure rights under an early-retirement plan were subject to FICA taxes. The ruling was contrary to an Eighth Circuit case with similar facts ( North Dakota State University v. U.S. , 87 AFTR2d 2001-2522).

The Third Circuit, in a split decision that overturned a district court ruling, held that tenure, although awarded on a limited and discretionary basis, was based on past service to the university and was a form of compensation for that service. Therefore, and because the employees’ relinquishment of tenure rights was not the primary consideration given by them, the payments represented wages for purposes of FICA, the court said.

Any cash or noncash remuneration received for employment, unless exempted by law or regulation, is considered wages subject to Federal Insurance Contribution Act taxes, which support Social Security and Medicare. The Eighth Circuit in North Dakota State University based its decision on the holding of Revenue Ruling 58-301, 1958-1 C.B. 23, that a lump-sum payment to cancel an employee’s contract rights was not FICA wages. The IRS in 2002 declined to acquiesce to North Dakota State University, stating its belief that the payments arose out of the employer-employee relationship and were made as a consequence of past services performed by the professors that resulted in their tenure. Furthermore, in 2004 the IRS issued Revenue Ruling 2004-110, 2004-2 C.B. 960, which held that payments after Jan. 11, 2005, to cancel an employment contract and relinquish contract rights are subject to FICA.

Between 1982 and 1999, the University of Pittsburgh offered early-retirement plans to tenured professors and administrators. The plans had a minimum age requirement and required a minimum number of years of service to the university. Plan participants would receive monthly payments if they relinquished their tenure rights. Between 1996 and 2001, the university paid more than $2 million in FICA taxes on the payments. Later, the university attempted to recover the taxes in a district court action. The district court held, based on Revenue Ruling 58-301, that the payments were made in exchange for contractual rights and thus were not wages subject to FICA taxes.

In its appeal to the Third Circuit, the IRS argued for following the holding of the Sixth Circuit in Donald F. Appoloni et al. v. U.S., 97 AFTR2d 2006-2828. That opinion concluded that payments to public school teachers who gave up their tenure rights under an early-retirement plan were wages for FICA. After examining the terms of the Pitt retirement plans, the Third Circuit agreed. The plans linked eligibility to past service and had a stated purpose of maintaining a competitive compensation package by offering early-retirement incentives. The court also likened the payments to severance payments, which previously have been held to be FICA wages.

In a dissenting opinion, Chief Judge Anthony Joseph Scirica agreed with the university that the payments were given in exchange for property rights (tenure). Tenure at Pittsburgh is not automatically granted after a certain number of years of worthy service but is also based on other factors, such as personnel needs, financial resource constraints and curricular needs, he noted. In addition, the granting of tenure marks the beginning of a new contractual relationship, not a continuation of the old, distinguishing it from severance payments, Scirica wrote.

The decision further muddies the water on this issue. It remains unclear what impact Revenue Ruling 2004-110 might have on similar situations, since it applies to payments made after those of this case.

University of Pittsburgh v. U.S. , 100 AFTR2d 2007-6504

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

The IRS said it will revise regulations before the end of 2008 to incorporate provisions of the Small Business and Work Opportunity Tax Act of 2007 concerning preparer penalties under section 6694 and related sections.

In the meantime, interim guidance issued in the final hours of 2007 offered some clarification and relief. Most notably, the interim guidance provides a method for signing tax return preparers to reconcile section 6694’s more-likely-than-not certainty threshold for nondisclosed items with the section 6662 “substantial authority” standard for taxpayers. In Notice 2008-13, the Service said that if a position meets section 6662’s requirements for nondisclosure, the signing preparer will be deemed to have met the section 6694 requirements if he or she explains to the taxpayer the difference between the two standards and contemporaneously documents that the advice was provided.

Other provisions of Notice 2008-13 provide that the preparer of an information return listed in Exhibit 2 of the notice (or other document, such as a depreciation schedule or cost, expense or income allocation study) will be considered a preparer of a tax return if entries in the information return or other document constitute a substantial portion of that tax return. For example, the preparer of a Form 1065, U.S. Return of Partnership Income, may be considered a preparer of a partner’s individual income tax return if the entry or entries on the partnership return constitute a substantial portion of the partner’s return.

In contrast, the preparer of an information return listed in Exhibit 3 of the notice (such as Form W-2, Wage and Tax Statement) will not be considered a preparer of a tax return even if the entries in the information return constitute a substantial portion of that tax return, unless the information return was prepared willfully to understate tax liability “or in reckless or intentional disregard of rules or regulations.”

Additional guidance regarding the effective dates for the revisions to section 6694 is provided in Notice 2008-11. Guidance regarding return preparer signature requirements is provided in Notice 2008-12.

Comments on Notice 2008-13 are requested by March 24 and may be submitted by e-mail to Notice.Comments@irscounsel.treas.gov or by other means described in the notice.

In the first year it was established, along with enhanced rewards for tips on large tax underpayments, the IRS Whistleblower Office received about 80 claims, the IRS said in a news release. About half the claims came in the last two-and-a-half months of 2007. They include a claim of $2 billion in December 2007, according to the Washington, D.C., law firm that filed it. The firm, the Ferraro Law Firm, said the claim broke the previous record of $1 billion, which it also submitted two months earlier.

Also in December, the Whistleblower Office’s first anniversary, the IRS provided interim guidance on claims and their filing in Notice 2008-4. Effective Dec. 20, 2006, the Tax Relief and Health Care Act of 2006 set rewards at between 15% and 30% (the previous maximum was 15%) of the proceeds collected (now including interest) in an action to which the tipster’s information substantially contributed. The amount of tax in dispute must exceed $2 million, and if the taxpayer is an individual, that person’s gross income for any taxable year in question must exceed $200,000.

Smaller exempt organizations received transition relief as the IRS released its revamped Form 990, Return of Organization Exempt From Income Tax, for tax years 2008 and following. Organizations with gross receipts under $1 million or total assets under $2.5 million will be allowed to use Form 990-EZ for tax year 2008. The short form is four pages, as opposed to 11 pages plus applicable schedules for the long form. The limit falls in stages to $200,000 in gross receipts and $500,000 in total assets for tax years beginning with 2010. Still, that’s double the cutoff for the 2007 tax year. Also for 2010, still-smaller organizations will double their limit from the 2007 amount for eligibility to file by e-postcard (Form 990-N), to $50,000 in gross receipts.

Among the revenue offsetting provisions of HR 3648, the Mortgage Forgiveness Debt Relief Act of 2007, were increases in penalties on partnerships and S corporations for failure to timely file returns. The monthly penalty for failure to file required partnership returns on time (absent any extension) was increased from $50 per partner to $85 per partner. The maximum number of months the penalty may be assessed was increased from five to 12. Likewise, for S corporations, the act added new IRC § 6699, which imposes a penalty of $85 per month per shareholder for failure to timely file. The penalties are effective for returns required to be filed after the law’s enactment in December 2007.

Relief provisions of the act included most prominently the exclusion of discharge-of-indebtedness income of up to $2 million received on or after Jan. 1, 2007, from forgiveness of a mortgage on a taxpayer’s qualified principal residence.

The Supreme Court ruled in a unanimous opinion that administrative expenses of nongrantor trusts or estates generally are subject to the 2% of adjusted gross income floor as miscellaneous itemized expenses, resolving a split among circuit courts on the issue. The case, Knight v. Commissioner (101 AFTR2d 2008-380), was styled as Rudkin Testamentary Trust v. Commissioner in lower court proceedings. At issue was the exemption under IRC § 67(e) from the floor for expenses that “would not have been incurred if the property were not held in such trust or estate.” While agreeing with the Second Circuit’s result (98 AFTR2d 2006-7368), the Supreme Court criticized its analysis. Rather than asking, as the Second Circuit held, whether a trust expense could have been incurred by an individual, the statute requires asking whether it would customarily be incurred by an individual, the Supreme Court said. To determine that, the court said, the trustee must predict what would happen if the property were held in the hands of an individual. Moreover, if the trustee can show that he incurred some extra, incremental cost that an ordinary individual investor would not have incurred, it would be fully deductible. The opinion addressed only investment adviser fees and did not discuss trustee fees, tax preparation fees or other costs.

On similar facts and arguments, the Sixth Circuit in 1993 allowed exemption from the floor for investment advisory fees a trustee paid to meet fiduciary requirements under state law (William O’Neill Jr. Irrevocable Trust v. Commissioner, 71 AFTR2d 93-2052).