The Tenth Circuit Court of Appeals upheld a district court’s ruling that a company could not carry back a loss because the statute of limitations had passed.

Taxpayers that incur net operating losses are permitted under IRC § 172 to carry them back two years and forward 20 years. A carryback of 10 years is allowed for “specified liability losses,” which include those arising from certain statutory environmental requirements of mining, oil drilling and nuclear power generation, specifically including land reclamation. Section 6511(d)(2)(A) limits the time for filing these amended returns to within three years of the due date of the return that had the net operating loss.

Gold mining company Barrick Resources had net operating losses in tax years 1997 and 1998. In 2001, the company timely filed amended returns for 1994 and 1995 carrying back the losses but without specifically explaining that they stemmed from land reclamation costs. In 2002, Barrick realized that part of the loss qualified for the 10-year carryback. It filed amended returns for 1991 and 1992 and received a refund. The following year, it filed yet another amended return for 1991 carrying back more of the reclamation costs from 1997 and 1998. The government denied this refund and demanded return of the earlier refund as paid in error. Both sides filed motions for summary judgment in federal district court in Utah.

Barrick argued that its 2002 and 2003 filings were not new claims but amendments of its 2001 amended return—like those the Supreme Court in U.S. v. Andrews (19 AFTR 1243 (1938)) and the Tenth Circuit in U.S. v. Ideal Basic Industries (22 AFTR2d 5438 (1969)) held were amendments or amplifications of pending timely refund claims and thus considered timely, even though the three-year period elapsed in the meantime. But, the district court held, and the Tenth Circuit affirmed, Barrick’s claim was distinguished by not mentioning a specified liability loss in its 2001 amendments. The courts also rejected Barrick’s contention that its designation of a “reclamation and closure” line item under “other costs” on its Schedule A of Form 1120X in that initial set of amended returns constituted sufficient notice of a specified liability loss for land reclamation.

The Tenth Circuit went on to reject the Eleventh Circuit’s decision in Mutual Assurance Inc. v. U.S. (76 AFTR2d 95-5132). In it, the Eleventh Circuit allowed an extension to amend a refund claim that had already been paid. According to the Barrick court, the extension applies only to claims that are still pending.

Barrick illustrates that taxpayers cannot necessarily expect further amendments of pending refund claims to keep the statute of limitations open, especially if the reason for those amendments deviates from the original issues. Also, to take advantage of the 10-year carryback for specified liability losses, taxpayers must clearly invoke the provision, which also covers losses arising from product liability claims and workers’ compensation payments.

Barrick Resources (USA) Inc. v. U.S., 101 AFTR2d 2008-2656

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

©2008 AICPA

A district court in Texas allowed Shell Petroleum to carry back capital losses and receive a nearly $19 million refund. The losses were generated by a restructuring transaction involving an exchange of highbasis property for new subsidiary stock followed by loss-generating dispositions of the stock.

In 1992, Shell Oil was facing serious financial difficulties. Oil prices had dropped significantly, causing serious declines in Shell’s net income and net cash flow at the same time that its debt was increasing.

In reaction, Shell and its affiliated oil companies (the Shell Group) restructured to improve cash flow while preserving assets, especially offshore leases and oil shale rights that were currently nonproducing but that Shell thought could eventually yield profitable oil discoveries. (Shell had learned its lesson decades earlier, when it had abandoned its holdings on the North Slope of Alaska and the region then became home to the biggest oil field in North America.) The Shell Group transferred the properties to a new subsidiary, Shell Frontier Oil & Gas Inc., in a section 351 transaction. In such a transaction, shareholders receive a basis in the stock of the new corporation equal to the basis of the property they transfer to acquire that stock. In this case, the basis of much of the transferred property was far greater than its value. As a result, subsequent disposal of the stock in Shell Frontier created losses exceeding $350 million for tax year 1992. The Shell Group in 2004 carried back the consolidated net capital loss to 1990, which resulted in an overpayment for that tax year of $18.9 million.

The IRS disallowed these losses on various grounds. It claimed that since many of the transferred properties were nonproducing, they had no value and thus should not be considered section 351 property. However, the district court found that even though the properties were nonproducing, they did in fact have value and thus were considered property for section 351 purposes. Noting that the provision does not define “property,” the court said Shell’s interests “fit the classical—indeed, paradigmatic—definition of ‘property’ in that they are identifiable and transferable real property interests.”

The IRS also asserted that the transfer was a sham transaction intended to artificially inflate tax basis. While the Shell Oil tax department was involved in the restructuring plan, it did not discuss any of the plan’s tax benefits with management, so that the restructuring decisions would be based on economic factors. Among other things, this plan enabled the Shell Group to raise cash without jettisoning assets. The court found that the transaction therefore did have economic substance and that it was not tax-motivated and thus not a sham transaction.

Finally, the IRS asserted that it could reallocate the losses to Shell Frontier under section 482, which allows such reallocation between two or more entities owned or controlled by the same interests. The court, however, noted that the reallocation is provided “to prevent evasion of taxes,” which it said was not the case with Shell. Courts have recognized the beneficial effect of tax-deferred exchanges under section 351 in encouraging the formation of new corporations and strengthening existing ones—all the more so, considering that when Shell undertook its transfer, the provision’s allowance of a carryover of basis also enabled tax losses by both the transferee and transferor. Shortly before Shell filed its amended return, however, Congress plugged that loophole with the American Jobs Creation Act of 2004. For section 351 exchanges taking place after Oct. 24, 2004, such transfers of property with builtin losses require a reduction to fair market value of the basis of either the transferred property or the stock received for it.

Shell’s 1990 tax year was open in 2004 because its original return was still under administrative appeal and it had waived the period of assessment. Under section 6511(c)(1) such a waiver also extends the period for filing a claim. The company said in an explanation accompanying its amended return that it had previously executed a Form 870-AD, Offer to Waive Restrictions on Assessment and Collection of Tax Deficiency and to Accept Overassessment, reflecting an agreed overassessment for 1990 of nearly $128 million, not including the $18.9 million that was the subject of the claim.

Shell Petroleum Inc. v. U.S, 102 AFTR2d 2008-5085

By Karen M. Cooley, 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.

The Tax Court held that a married couple could deduct mortgage interest and property tax payments made from a corporate checking account on a home that was owned by their son. The court held that the taxpayers were equitable and beneficial owners of the property and that the checking account was in essence their personal account. Thus they were entitled to itemized deductions for the payments.

Taxpayers may deduct interest paid by them on debt related to a qualified residence. Generally, the debt must be the taxpayer’s, not someone else’s. Treas. Reg. § 1.163-1(b) permits a deduction for interest paid on a mortgage when a taxpayer is the legal or equitable owner of the property, even though the taxpayer is not directly liable for the mortgage. In Saffet and Ana Uslu v. Commissioner, TC Memo 1997-551, the Tax Court held that a married couple was the equitable owner of a home titled to the husband’s brother since, from the date of acquisition, they had occupied the home and made all payments for the mortgage, taxes, repairs, maintenance and improvements. In Bruce D. Loria v. Commissioner, TC Memo 1995-420, the same court held that the taxpayer was unable to demonstrate that he was the equitable owner of a home owned by his brother—thus denying deductions for interest and property taxes.

In the instant case, Ndile George Njenge and Ekinde Sone Nzelle Rachel resided in a home owned by their son. In 2001, their son purchased the home in his name since the taxpayers were unable to obtain financing; however, from the date of acquisition until the date of the trial, Njenge and Rachel made all of the mortgage, property tax and maintenance payments and were the sole occupants of the home. In 2003, the taxpayers paid those housing costs from a checking account of a company called Camrock General Engineering Co., an entity for which the taxpayers had established a bank account but never actually formed or started and did not intend to do so in the future. The IRS disallowed the mortgage and property tax deductions for 2003, causing the taxpayers to petition the Tax Court for relief.

The IRS argued that no deduction for interest and taxes should be allowed since Njenge and Rachel were not the legal owners of the property and were not legally obligated to make any payments. Furthermore, the IRS argued that Camrock had made the payments, not the taxpayers. The court rejected both arguments, holding Njenge and Rachel were the equitable owners of the property since, from the date of acquisition, the taxpayers were the only ones who enjoyed the benefit and bore the burden of the home. Furthermore, the court found that the Camrock checking account was in essence the taxpayers’ personal account.

This case illustrates that the economic substance rather than the legal form of a home ownership situation can dictate the tax result. In this case, it is important to note that the taxpayers prevailed because the evidence suggested that their son was owner in name only and that the “business,” whose name was on the checking account used to make the housing payments, existed in name only.

Ndile George Njenge and Ekinde Sone Nzelle Rachel v. Commissioner, TC Summary Opinion 2008-84

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

The Court of Federal Claims held that the statute of limitations applies to taxpayers who paid the telephone excise tax through carriers and were not required to file returns related to it.

Until May 2006, the IRS contended that telephone toll charges that varied only with elapsed time but not distance were subject to the 3% federal excise tax. It had been instructing carriers to collect and remit the tax. Then the IRS conceded that time-only charges were not subject to the tax under IRC § 4252(b)(1) and set up a refund mechanism; however, Notice 2006-50 stated that only taxes collected for services billed between Feb. 28, 2003, and Aug. 1, 2006, were subject to refund.

RadioShack purchased long-distance service from carriers from Jan. 1, 1996, until July 31, 2006, and paid communications excise taxes on it. Because it paid the tax directly to its carriers and those carriers then remitted the tax, RadioShack was not required to file returns for it.

In October 2006, RadioShack filed a refund claim for the taxes paid during the first quarter of 1996. The IRS denied the claim because it was not filed within the period required under section 6511(a): “Claim for credit or refund of an overpayment of any tax imposed by this title in respect of which tax the taxpayer is required to file a return” must be filed within three years of the return’s filing or two years from when the tax was paid, whichever is later. RadioShack contended the statute of limitations didn’t apply, since RadioShack was not required to file a return for the phone tax.

The Court of Claims disagreed. Holdings by three circuits including its own appellate authority suggest the provision would “effect a discriminatory exemption,” the court said, if construed as literally as RadioShack asserted and in isolation from section 7422(a), which requires a properly filed administrative claim before any suit to recover tax paid. The court also cited U.S. v. Clintwood Elkhorn Mining Co. (101 AFTR2d 2008-1612; “Tax Matters: The Code Trumps Tucker,” JofA, July 08, page 87) to note the Supreme Court recently underscored the “expansive reach” of the latter provision. In this case, the refund claim was filed approximately 10 years after RadioShack paid the taxes. Even claims for more recent tax years must be pursued within the limitations period, which means that for the estimated 94% of eligible corporate taxpayers who failed to claim a phone tax refund in tax year 2006, time is slipping away.

RadioShack v. U.S., 101 AFTR2d 2008-2350

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

An owner of a California health care company was found liable by the Tax Court for an accuracy-related penalty for a deduction he claimed in spite of his CPA’s advice against it.

Larry Wadsworth was a general partner of Gold Coast Medical Services (GCMS), which provided medical products and services to beneficiaries of the California Medical Assistance Program in 2001 and 2002. In 2003, the California Department of Health Services (CDHS) audited GCMS and found the company had engaged in “discriminatory billing.” The state agency ordered the partnership to repay $2.3 million for the two years. Wadsworth and GCMS sought to amend their federal tax returns to reflect the repayment amount as a contingent liability, even though the company’s appeal of the demand was still pending before the CDHS. Keith Borges, who the Tax Court noted is a CPA and member of the AICPA and California Society of Certified Public Accountants, had prepared the original tax returns for both the partnership and Wadsworth. After researching the request, Borges declined to amend the returns absent any supporting information or legal authority from Wadsworth. Instead of providing it, Wadsworth turned to an attorney representing GCMS in its appeal before the CDHS. The attorney then engaged a non-CPA preparer to amend the returns, resulting in more than $200,000 in tax refunds to Wadsworth for the two tax years. Meanwhile, CDHS granted GCMS’s appeal and overturned the state’s repayment demand. The IRS examined Wadsworth’s amended returns and issued deficiencies in the amount of the tax refunds, plus accuracy-related penalties totaling $40,668. Wadsworth paid the deficiencies but contested the penalties.

The Tax Court ruled that the amended Schedule K-1 attached to the amended returns was not adequate disclosure to avoid the penalty, as the taxpayer argued. The court noted that it was not accompanied by Form 8275, Disclosure Statement, or other explanation of the basis of the changes. Moreover, the position lacked a reasonable basis as required by Treas. Reg. § 1.6662-4(e)(2)(i), the Tax Court said.

The taxpayer said he had elected a “modified cash” method of accounting but presented no evidence that the amount was paid. An accrual-method taxpayer would not be able to deduct a contested liability except under the conditions of IRC § 461(f), that is, having made a transfer to provide for the satisfaction of a liability that remained contested after the transfer. Moreover, the taxpayer lacked reasonable cause and did not act in good faith, the court found. “We find that Mr. Borges’ refusal to amend the returns should have raised a red flag for petitioners, but petitioners disregarded that warning,” the court said.

Larry J. and Sherilyn Wadsworth v. Commissioner, TC Memo 2008-171

By JofA Senior Editor Paul Bonner.

Online retailers Amazon.com and Overstock. com sued the New York State Department of Taxation and state officials over the state’s new definition of Web sellers required to collect sales and use tax. New York changed the definition of vendors subject to the tax to include those who pay a commission or other consideration to a state resident who directly or indirectly refers in-state customers to the seller, including via Web link. The new law was enacted April 9 and applies to sellers doing more than $10,000 in business a year in the state. Sixteen days later, Amazon sued, followed by Overstock on May 30.

Amazon, the seller of books and other merchandise, allows “associates” who post a link to Amazon’s Web site on their own Web sites to receive a percentage of purchases resulting from those “click-throughs.” Discount goods seller Overstock, along with other online retailers such as Netflix and physical stores with online channels such as Wal-Mart and Office Depot, maintains a similar arrangement through an independent third party, LinkShare. Both Amazon and Overstock argued in pleadings for declaratory relief in the state supreme court that the new law violates the U.S. Constitution’s Commerce Clause and the 14th Amendment and is overly broad and vague.

Both said their associates or affiliates are advertisers, not representatives performing solicitations. Despite New York mailing addresses for some associates, the companies said they have no way of knowing whether those associates reside in the state. Also, Amazon said, because the Web is unmoored from geography, “an advertisement on a New York ‘resident’s’ website is no more likely to reach New York consumers than any other state’s consumers.”

Amazon.com LLC v. New York State Department of Taxation and Finance, docket no. 601247/08, N.Y. Supreme Court

Overstock.com Inc. v. New York State Department of Taxation and Finance, docket no. 107581/08, N.Y. Supreme Court

By JofA Senior Editor Paul Bonner.

A revenue-raising provision of the Housing and Economic Recovery Act of 2008 enacted in late July (PL 110- 289) disallows exclusion of gain from the sale of a principal residence under IRC § 121 attributable to periods the dwelling is used as a vacation or rental home or other nonqualified use. Nonqualified use is any use other than as a principal residence by the taxpayer, spouse or former spouse.

Section 121 allows exclusion of up to $500,000 in gain by joint filers ($250,000 for singles) on the sale or exchange of property that has been owned and used as the taxpayer’s principal residence for at least two years out of the previous five. An exception to the new provision is allowed for periods after the home is no longer used as a principal residence by the taxpayer or taxpayer’s spouse occurring within the otherwise qualifying five-year period preceding the sale. Exceptions also are provided for certain temporary absences of up to two years and those during extended military or other specified government service. The new provision, which would curtail or contraindicate some strategies described in previous JofA articles “ Home Sweet Home,” April 06, page 77, and “Home Free,” Jan. 07, page 40, is effective for sales and periods of nonqualified use occurring after 2008.

Tax benefits introduced by the act include a temporary standard deduction for non-itemizers who pay real property taxes. Just for tax year 2008, the deduction is equal to the amount of real property tax paid, up to $1,000 for joint filers and $500 for singles. Also, a temporary first-time homebuyer credit is worth 10% of the home’s purchase price, up to $7,500 for joint filers. Although the credit is refundable, it must be repaid over 15 years, making it in essence an interest-free loan. The credit begins to phase out at adjusted gross incomes over $150,000 for joint filers and is available only for homes purchased between April 9, 2008, and June 30, 2009.

Although payroll tax debts are one of the IRS’s top collection priorities, the Service hasn’t made optimal use of its enforcement tools against the 1.6 million businesses owing $58 billion for employees’ income, Social Security and Medicare taxes, the Government Accountability Office said. Earlier GAO audits found that payroll taxes were a major component of tax debts owed by federal contractors (see “ Tax Matters: Bills Target Contractor Scofflaws,” July 07, page 84). In this follow-up study, the GAO found that although they are required to remit payroll taxes quarterly, some businesses allow them to accumulate for years, sometimes with little consequence. Seventy percent of unpaid payroll taxes were owed by businesses with more than a year’s worth of unpaid payroll taxes, one-fourth by businesses that hadn’t remitted them for more than three years.

Procedures designed to expedite enforcement of payroll taxes had the opposite effect when it came to liens, the GAO said. Such cases bypass the Service’s Automated Collection System to go directly to a revenue agent in the field. But because of staffing constraints, those cases languish for “extended periods” while awaiting assignment, with no lien filed in 80% of cases examined. Even after the cases are assigned to an agent, liens are underutilized, the GAO said, citing previous internal studies by the IRS. Another potentially powerful enforcement mechanism is making business owners and officers personally liable for the debt with a trust fund recovery penalty (IRC § 6672). But on average, the IRS took two years after assessing a tax debt to impose the penalty. Meanwhile, business owners in some cases continued to accumulate payroll tax debt, often along with other tax-abusive and even apparently criminal activities (besides the federal felony of willful failure to remit payroll taxes), the GAO said.

Besides potentially leaving employees holding the bag for nonwithheld income taxes, nonpayment of FICA for assessments issued as of Nov. 1, 2007, required the government to transfer $44 billion from general funds to the Social Security and Hospital Insurance trust funds, the GAO said.

Police officers and firefighters who are permitted to drive their official vehicles home are exempt from the arrangement’s being considered a fringe benefit includable in income or subject to substantiation requirements of IRC § 274(d)(4), since the vehicles are considered unlikely to be used for personal purposes more than a minimal amount. In June, the IRS issued proposed and temporary regulations widening the provision to encompass vehicles used by “public safety officers,” which include law enforcement officers, rescue squad workers, ambulance crew members and chaplains who serve a governmental unit or agency in an official capacity. A public safety officer may be paid or unpaid, but vehicles must be clearly marked by insignia or words. See REG-106897- 08.

The Service adopted final regulations governing inclusion in estates of trust property of grantor retained trusts, charitable retained trusts and similar trusts. The final regs (TD 9414) are effective for estates of decedents dying after July 13, 2008, and modify and clarify a number of features of their proposed version issued the previous summer. Provisions relating to the application of IRC § 2036, Transfers With Retained Life Estate, on grantor retained annuity trusts and grantor retained unitrusts have been clarified. Revenue rulings 76-273 and 82-105 have been superseded.

Taxpayers may elect under IRC § 195 to deduct in the first year of operation up to $5,000 of startup expenses (reduced by the excess of total startup costs over $50,000) of an active trade or business and generally must amortize the remainder over 15 years. In July, the IRS issued final, temporary and proposed regulations allowing the election to be deemed rather than made formally. Since 2004, enterprises were required to file a separate election statement such as Form 4562, Depreciation and Amortization. But effective Sept. 6, 2008, they are considered to have made the election unless they clearly elect to capitalize the costs. See TD 9411.

The IRS has provided guidance on a variety of issues pertaining to health savings accounts (HSAs). The 42 questions and answers of Notice 2008- 59 address such issues as eligibility for individuals with “limited purpose” coverage by a health flexible spending account (FSA) or health reimbursement arrangement (HRA). The guidance also covers eligibility for an HSA when an accompanying high-deductible health plan features both a family, or “umbrella,” deductible and an embedded individual deductible. If a limited-purpose FSA or HRA covers post-deductible expenses above the individual, but below the umbrella, deductible, an individual can still remain eligible for an HSA.

A Web seminar, “Nonqualified Deferred Compensation Under Section 409A: Implementation Roundtable,” will be held Oct. 2 from 2 to 4:30 p.m. ET. Tax, PFP and PCPS section members may participate free or may pay a discounted price of $74 and receive 21/2 hours of CPE credit (non-section members pay $99). Register for the free program at http://tinyurl.com/5u5jwb, or for CPE, log on to www.cpa2biz.com, go to “Web Events,” and the section discount will automatically be applied at checkout.

Eddie Adkins, from Grant Thornton, and Helen Morrison, acting deputy benefits tax counsel at the Treasury Department, will use a case study and practical examples to provide an overview of the NQDC rules and actions required by the end of 2008. In addition, Karen Field, from KPMG, and Deborah Walker, from Deloitte & Touche, will help answer questions, which may be posted throughout the session.

Then, on Oct. 27 from 2 to 3:30 p.m. ET, the Tax and PFP sections of the AICPA will present “AMT: Strategies to Escape Its Reach.” Joseph W. Walloch of the Walloch Accountancy Corp. of Redlands, Calif., and Norman Solomon of La Jolla, Calif., will moderate the session. Walloch also chairs the Tax Section’s Individual Income Tax Technical Resource Panel. This webcast will cover planning strategies, recent court cases, guidance and legislation, with a focus on planning for investment expenses, income and property taxes, legal expenses, capitalization and miscellaneous itemized deductions. Go to http://pfp.aicpa.org and click on “Web Seminar Series” to register.