ANNUAL EMPLOYMENT TAX FILINGS ARE OPTIONAL
The IRS issued proposed and temporary regulations under IRC §§ 6011 and 6302 (TD 9440) that no longer mandate annual filings by eligible employers in the reporting and paying of income taxes and Federal Insurance Contribution Act (FICA) taxes withheld from wages. The annual filings, using Form 944, Employer’s ANNUAL Federal Tax Return, are now optional for eligible employers. As originally issued in January 2006 (TD 9239, REG-148568-04), the rules required eligible employers to file annually rather than quarterly, using Form 941, Employer’s QUARTERLY Federal Tax Return.

Under Temp. Treas. Reg. §§ 31.6011(a)-1T(a)(5) and 31.6011(a)-4T(a)(4), which are in effect for tax years beginning on or after Jan. 1, 2009, employers that estimate that their annual employment tax liability will be $1,000 or less can contact the IRS to request permission to file Form 944 rather than Form 941. The eligibility threshold of $1,000 may be raised through future guidance.

The rules also create a safe harbor under IRC § 6302 for quarterly filers whose quarterly withholdings exceed $2,500. Previously, a quarterly filer avoided a penalty for failure to make timely monthly or semi-weekly deposits of employment taxes if the aggregate amount of employment taxes for the quarter was less than $2,500 and the amount was paid with a timely filed Form 941. The safe harbor under Temp. Treas. Reg. § 31.6302-1T(f)(4) exempts an employer from the penalty if the employment tax due was less than $2,500 in the current quarter or the prior quarter. The safe harbor is not effective until deposit periods beginning on or after Jan. 1, 2010.

PENALTY ON RETIREES SUSPENDED IN 2009
Required minimum distributions (RMD) from retirement accounts were suspended for 2009, giving seniors a respite from a potential 50% excise tax. The Worker, Retiree and Employer Recovery Act of 2008, PL 110-458, waives the penalty for one year, giving retirees some time to recoup losses from the sharp stock market decline of 2008. Without the waiver, individuals age 70½ and older would be required to withdraw an amount, based on remaining life expectancy, from their traditional IRA, 401(k) or 403(b) accounts. Failure to withdraw the full RMD timely normally results in a 50% excise tax on the amount not withdrawn.

The Act also eases funding requirements for employer-sponsored pension plans and multiemployer plans. Without temporary relief, companies short on cash would be forced to make significantly increased contributions because of large declines in major world markets in the past year.

CROSS-CHAIN SALE RESULTS IN COMPLETE TERMINATION
The Tax Court for a second time rejected an attempt by Merrill Lynch & Co. Inc., as the parent, to use a cross-chain sale by one subsidiary of a subsidiary to a sister corporation to increase its basis in the seller’s stock and facilitate a loss on the seller’s stock when it, in turn, was sold to an unrelated buyer.

In earlier litigation on the same matter, the Second Circuit Court of Appeals (94 AFTR2d 2004-6119) upheld the Tax Court’s decision that the IRS could reclassify the reported stock redemption under IRC § 304 as a sale under IRC § 302(b)(3), which deals with a complete termination of interest (see “Tax Matters: Firm-and-Fixed-Plan Rule Reaffirmed,” JofA, Feb. 05, page 75). The Second Circuit agreed that the “firm-and-fixed-plan” test applied because Merrill Lynch had a firm-and-fixed plan for its subsidiary, Merrill Lynch Capital Resources (MLCR), to lose control of the second-tier subsidiary. The sale, therefore, was a complete termination of interest under section 302(b)(2). The Second Circuit did, however, remand the case to the Tax Court to allow Merrill’s argument, raised for the first time on appeal, that the section 302(b)(3) test for a complete termination required consideration of the parent’s ownership interest in the issuing corporations.

In the most recent phase of litigation, Merrill argued it was entitled to dividend treatment because neither the cross-chain sales nor the later sale of MLCR reduced the 100% constructive ownership interest attributed to Merrill, as the parent, in the issuing corporations. The Tax Court disagreed (131 TC no. 19 (2008)). The court said that under section 304, MLCR was the only shareholder whose interest in the issuing corporations had to be tested pursuant to section 302. Because MLCR was completely terminated, the redemption was properly treated as a distribution in exchange for stock under section 302(a).

IRS DROPS WORKPAPERS APPEAL
The government abandoned its appeal before the Eleventh Circuit of the decision last year by the District Court for the Northern District of Alabama in Regions Financial Corp. v. U.S. that quashed a workpapers summons. In so doing, the court let stand the district court’s holding (101 AFTR2d 2008-2179) that the papers were protected by the work product privilege. See also “Line Items: Work Product Stymies IRS Again,” JofA, August 08, page 88.

AMAZON LOSES ROUND IN NY.Y. NEXUS FIGHT
A New York state trial court dismissed Amazon.com’s challenge to a law that establishes sales tax nexus through in-state “associates” whose Web sites feature links to the online retailer. Amazon and another Web seller, Overstock.com, separately sued the state’s Department of Taxation and state officials last spring after New York extended its definition of “vendor” to include a seller who enters into agreements with instate parties to solicit business on behalf of the seller by means specifically including Internet links. The law requires such sellers, whether physically present in the state or not, to collect New York state taxes on sales to New York residents. (For previous coverage, see “Tax Matters: Online Retailers Battle N.Y. Nexus,” Oct. 08, page 96.)

The Supreme Court for New York County dismissed Amazon’s complaint Jan. 12. Amazon had argued that the law violates the U.S. Constitution’s Commerce Clause because it imposes tax collection obligations on out-of-state entities that have no substantial nexus with New York. The court, however, said the law passes constitutional muster because it requires a contract between a seller and a New York contractor, referrals by the contractor to the seller, payment of a commission to the contractor and a threshold of $10,000 annually in total sales to New York customers via the arrangement. An arrangement that meets those requirements, such as Amazon’s, reflects a “conscious decision” by the seller, and the seller thereby “avails itself of the benefit of in-state contractors compensated for referrals,” the court said.

As for whether the arrangement constitutes solicitation by the associates, as opposed to Amazon’s characterization of the relationship as merely one of advertising, the court said Amazon doesn’t discourage its associates from reaching out to customers “and pressing Amazon sales.” Consequently, the court said, it didn’t matter that Amazon doesn’t expect associates to actively solicit business, or even that associates’ contracts prohibit them from offering customer discounts for purchases made after customers “clicked through” to Amazon from their Web sites.

In a case on appeal before the Sixth Circuit, household consumer goods manufacturer Procter & Gamble (P&G) and a related entity claim a refund of taxes paid on a foreign sales corporation (FSC) advance payment transaction (APT). The U.S. District Court for the Southern District of Ohio had denied the claim by P&G and P&G FSC, which is based on a claimed deduction of more than $362 million for tax year 2000.

P&G, P&G Canada, and P&G FSC are related entities but file separate tax returns. During tax year 2000, P&G Canada made a $374,790,000 advance payment to P&G FSC. P&G FSC, in turn, made a $288,588,300 advance payment and an interest-free loan of the difference—$86,201,700—to P&G. P&G FSC reported sales income of $374,790,000 attributable to the APT, while P&G reported only $288,588,300 (the transfer price) in sales income on its tax return.

The manufacturing cost of the products subject to the APT was $359,344,974. P&G and P&G FSC calculated combined taxable income (CTI) by adding P&G FSC’s gross receipts for the APT and not subtracting any of the $359,344,974, on the rationale that the costs were not incurred until tax year 2001. P&G reported these costs as cost of goods sold on its 2001 tax return. P&G also reported a net loss of $70,756,674 on its 2000 and 2001 tax returns in connection with the APT.

The essence of the transactions was to allow the taxpayers to shift the difference between the gross receipts and the transfer price to P&G FSC, which P&G FSC reported as a profit. Under the now-repealed FSC rules, the taxpayers were allowed to exempt 23% of their CTI permanently from tax under IRC §§ 921 and 923. The amount excluded equaled the profit reported by P&G FSC.

During its audit, the IRS determined that the transfer price was based on a CTI calculation that did not include total costs, thereby violating the FSC administrative pricing rules and resulting in an understatement of P&G income of $86,201,700.

The IRS assessed P&G for the understatement. P&G paid the assessment and sought a refund of the taxes at the administrative level. When the claim was denied, the taxpayers sought judicial review under IRC § 7422.

In a 2007 opinion, the district court found that because of the huge disparity between the arm’s-length price of $374,790,000 and the transfer price of $288,588,300, as a matter of law, the prices could not be viewed as an approximation of each other. The court concluded that the transfer price ran counter to legislative intent, which was to limit the FSC exemption to an approximation of an arm’s-length price in compliance with the General Agreement on Tariffs and Trade. The court ruled that the taxpayers’ calculation of CTI violated the FSC administrative pricing rules. The taxpayers filed a motion to clarify and modify the court’s 2007 opinion.

In its 2008 opinion, the court addressed only whether the taxes should have been calculated under the gross receipts method of determining CTI, as proposed by P&G, or under the arm’s-length pricing method, as used by the government in its calculation. According to P&G’s calculation, under the gross receipts method, its deduction would have been $362,066,663 for tax year 2000. However, the court found that because P&G failed to submit these calculations under the gross receipts method when it initially filed its administrative refund claim, it was barred under the variance doctrine from asserting this claim at the judicial level. The court rejected P&G’s argument that the government waived the variance doctrine defense when it first advanced at the judicial level its argument that P&G miscalculated CTI in violation of the administrative pricing rules. The court reasoned that even though the government did not expressly assert this miscalculation at the administrative level, P&G should have anticipated that the government would challenge its failure to take total costs into account when calculating CTI.

IRS' calculation of CTI:

In the waning days of the Bush administration, the government ended its long-running effort to retroactively revoke the tax-exempt status of a Democratic Party-affiliated organization that it claimed had improperly promoted the party’s candidates.

In 1985, prominent members of the Democratic Party including then-Gov. Bill Clinton formed the Democratic Leadership Council (DLC) to promote social welfare and to bring about “civil betterments and social improvements.” The DLC applied for taxexempt status as a social welfare organization, explaining that it was organized by individuals concerned about national policy and the direction of policy debate within the Democratic Party. The DLC intended to create task forces, contract for studies and host fundraising events. It would also hold town meetings, issue forums and policy meetings. It said it would not intervene in campaigns or seek to influence voter perceptions. The IRS granted the DLC tax-exempt status under IRC § 501(c)(4). Courts have allowed 501(c)(4) organizations to engage in political activities if they operate primarily to bring about social improvements.

During 1997, 1998 and 1999, the DLC hosted prominent Democratic elected officials at conferences and held events attended exclusively by Democrats. The president of the DLC stated that its activities were efforts to shift the Democratic Party’s policies closer to its own policies, which could help Democrats at the polls.

In 2002, the IRS issued a proposed adverse action letter revoking the DLC’s taxexempt status for 1997 and 1998 because, it said, the DLC was primarily benefiting a private group—newly elected Democrat officials and the Democratic Party—rather than the community. In 2003, the IRS proposed to revoke the DLC’s exempt status for 1999. The DLC paid approximately $20,000 in taxes under protest and filed suit for a refund of the amount in the District Court for the District of Columbia, which ruled in its favor in April 2008. The government appealed to the D.C. Circuit but agreed to a dismissal on Dec. 16, 2008.

The DLC argued that it qualified as a 501(c)(4) organization during the years at issue and that the IRS improperly revoked the exempt status retroactively in violation of Treas. Reg. § 601.201(n)(6). Although the IRS may prospectively revoke an organization’s tax-exempt status if the organization no longer qualifies for an exempt purpose, the IRS is subject to restrictions when it attempts to revoke tax-exempt status retroactively. The IRS may retroactively revoke an organization’s exempt status only if the organization omits or misstates a material fact or operates in a manner materially different from that originally presented.

The IRS claimed the DLC’s later operations did substantially differ from its originally stated purposes. The application did not state that the DLC would attempt to reclaim centrist national policies from Republicans or to help elect a Democrat president, both of which its leaders subsequently stated as goals, the IRS claimed. Also, the government said, there was no evidence that the DLC held town meetings or issue forums or contracted for policy studies.

The court recognized the IRS’ primary argument that the elected officials were dominant in the creation, control and policies of the DLC but concluded that the IRS did not provide evidence of material changes in the DLC’s operations. Regardless of whether the DLC held town meetings and other intended activities, there was no evidence that it operated in a materially different manner than it had proposed, the court said. The court noted that an IRS agent who investigated the DLC’s operations testified that it was operating within the terms of its exempt ruling.

The court said the DLC may have been unworthy of exempt status under 501(c)(4), but the revocation was a clear abuse of discretion, and the DLC was entitled to a refund.

 Democratic Leadership Council v. U.S., 101 AFTR2d 2008-1597, appeal dismissed docket no. 08-5193 (D.C. Cir. 2008)

The Tax Court held that the Uniform Standards of Professional Appraisal Practice (USPAP) are not the sole measure of an expert witness’s reliability. The witness had been called upon to provide a value of a conservation easement restricting the use of real property, or “servitude.” Based on that testimony, the court upheld the Service’s denial of the full claimed value of the servitude as a deduction for a charitable contribution.

Whitehouse Hotel, a limited partnership, purchased Maison Blanche, a historic building near the French Quarter of New Orleans, and adjoining property Whitehouse developed the parcel into a hotel operated by Ritz-Carlton. It also transferred to the Preservation Alliance of New Orleans a conservation servitude guaranteeing to maintain the historic appearance of the building’s facade in good condition. Whitehouse claimed on its 1997 federal income tax return a charitable contribution deduction for $7.44 million, the amount an appraiser determined as reflecting the property’s reduction in value by the servitude. The IRS determined that the allowable deduction should have been $1.15 million.

Both Whitehouse and the IRS used expert witnesses at trial. Whitehouse argued that the government’s expert was disqualified because (1) he was not experienced with this type of transfer and (2) his report did not conform with USPAP, since he used only the sales approach, rejecting the cost and income approaches.

In answer to the taxpayer’s first objection, the court held that the government’s expert, while having limited experience with this type of transfer, did have experience valuing property encumbered with a restriction. Furthermore, Whitehouse failed to distinguish between various types of property restrictions, the court said. On the second objection, the court held that while compliance with USPAP is an indicator of reliability, trial judges bear the responsibility of determining the reliability of an expert witness’s testimony. Whitehouse argued that USPAP should be the sole indicator of reliability. The court held that an expert’s opinion that does not fully comport with USPAP may still be admissible, even if it might not prove helpful.

The court found the report by the government’s expert to be the more reliable and held for the IRS. Furthermore, the court imposed the 40% penalty for gross valuation misstatement (greater than 400% difference) and held that Whitehouse did not qualify for the reasonable-cause exception. The taxpayer appealed the decision to the Fifth Circuit on Jan. 27.

 Whitehouse Limited Partnership v. Commissioner, 131 TC no. 10

By Michael H. Brown, associate professor of accounting, Millikin University, Decatur, Ill.

The IRS said in a coordinated issue paper that a location tax incentive paid or credited to a business by a unit of state or local government is not included in the business’s gross income but rather reduces its tax expense. A location tax incentive is a tax reduction by abatement, credit, deduction, rate reduction or exemption given to a taxpayer as an incentive to locate in, remain in or expand its operations in a particular area. These incentives are not considered purchases from the taxpayer because they do not require the taxpayer to provide any services or property to the taxing jurisdiction. They benefit the taxpayer but are provided primarily for the economic benefit of the community at large. The taxpayer also does not realize an accession to wealth resulting in gross income.

Some corporate taxpayers have argued that such rebates should be treated as an exclusion from taxable income as a nonshareholder contribution to capital under IRC § 118, while they also include them in the full amount of tax expense deductible under section 164, the IRS said. These taxpayers would then reduce their basis of property under section 362(c) by the amount of the purported nonshareholder capital contribution. IRC § 118(a) does allow the money or value of property given to the corporation by the government or a civic group to be excluded from gross income (IRC § 61) as a nonshareholder contribution to capital. However, since a tax rebate is more like a discount on a liability than new incoming money or property, it is not a nonshareholder contribution to capital, the IRS said.

Even if such incentives were otherwise deemed to be gross income, they still generally would not be eligible for IRC § 118 treatment, which requires taxpayers to meet five factors, the IRS said, citing U.S. v. Chicago, Burlington & Quincy R.R. Co. (412 U.S. 401, 413 (1973)): (1) The contribution must become a permanent part of the transferee’s working capital structure; (2) the contribution must not be compensation for specific, quantifiable services provided by the transferee to the transferor; (3) the contribution must be bargained for; (4) the asset transferred must result in a benefit to the transferee commensurate with its value; and (5) the asset transferred ordinarily, if not always, will be used to produce additional income. (For treatment of a state location incentive grant analyzed by these factors and deemed to qualify as a contribution to capital, see Private Letter Ruling 200901018 issued Jan. 2.)

Under the Chicago, Burlington & Quincy R.R. rules, a tax incentive is a planned recovery of operating expenses, not a new contribution to the taxpayer’s working capital. A factual inquiry would have to be done to determine whether the contribution was made for specific, quantifiable services, in which case the transaction would be (taxable) sales revenue. Usually, tax incentives are not bargained for but are instead the result of state or local statutory tax provisions. A company would also have to show factually that the benefit enhanced the company by more than the amount of the payment deemed as income. If the benefit is used for operating expenses, it is not a longterm investment consistent with owners’ equity accounts, and it will not be considered to produce additional income for the company.

Also, since location tax incentives are not ordinarily used to purchase property but instead simply to reduce state and local tax liability, they are not capital expenditures. Instead, they lower the periodic expense of paying state and local taxes. As such, the basis of corporate assets would not be reduced as a nonshareholder capital contribution under IRC § 362(c)(1) or (2), the Service said.

The incentive is also not deductible under IRC § 164 for local, state or foreign taxes paid or accrued during the tax year. The “all-events test” under IRC § 461 allows for a deduction in the tax year in which all the events occurred that determine the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred. See Treas. Reg. §§ 1.461-1(a)(2) and 1.461-4(a)(1). Consequently, since location tax incentives are a reduction of state and local tax expense, only the tax liability net of the rebate is deductible for federal tax purposes.

Coordinated Issue Paper LMSB-04-0408-023, State and Local Location Tax Incentives (effective May 23, 2008)

The Tax Court upheld the validity of temporary regulations requiring a partner to raise partner-level defenses to penalties in separate litigation after resolution of unified partnership proceedings.

Andrew Filipowski created New Millennium Trading LLC in 1999 to generate a deductible loss through the use of foreign currency options. In 2005, the IRS determined that the partnership and the transactions were shams. It denied the deductions and assessed penalties under section 6662. Filipowski raised partner-level defenses against the penalties during the partnership-level litigation, and the IRS objected to their consideration.

Treas. Reg. § 301.6221-1T, in subsections (c) and (d), states that partner-level defenses may be raised only in separate litigation for refund following payment by the partner of the tax and penalty due. The taxpayer argued that these regulations were invalid because they denied the Tax Court the authority to hear penalty cases and because they were an invalid and unreasonable interpretation of section 6221. However, the Tax Court found that Congress amended the law in 1997 to provide that a partner, in the court’s words, “may raise partner-level defenses only in a refund action filed after the close of partnership-level proceedings.” Therefore, the regulations did not deny the Tax Court any authority granted to it by Congress, the court said.

To analyze the taxpayer’s argument against the validity of the regulations, the Tax Court had to determine which standard for review to apply. Since any appeal would be to the Court of Appeals for the District of Columbia Circuit, the court applied the Chevron standard adopted by that circuit. Under Chevron, regulations are upheld unless they directly conflict with the Code or are an unreasonable interpretation of an ambiguous Code provision. Since Code §§ 6221 and 6230, taken together, are unambiguous that partner-level defenses are to be raised by refund suits and the regulation is consistent with this rule, the regulation is valid, the court said. Following the partnership litigation, the partner must pay the tax and penalty and then sue for a refund to raise partner-level defenses. The Court of Federal Claims has decided the issue similarly in two cases, Stobie Creek and Jade Trading (respectively, 101 AFTR2d 2008-1151 and 100 AFTR2d 2007-7123; see also “Tax Matters: Levels of Certainty,” JofA, July 08, page 86).

 New Millennium Trading LLC v. Commissioner, 131 TC no. 18

Two brothers’ additional capital contributions to S corporations of which they were shareholders could not offset their ordinary income from payments for loans they made to the corporations, the Tax Court held. The court rejected their argument that their capital contributions restored the previously reduced basis of their shareholder loans. Instead, the court held, the contributions increased the taxpayers’ stock basis.

Shareholders in an S corporation have an initial stock basis equal to the amount of their capital contributions to the corporation. If shareholders loan money to the S corporation, their loan basis equals the loan amount. Subsequently, under section 1367, the shareholders’ stock basis is increased for their share of the S corporation’s items of income, including tax-exempt income, and is decreased (but not to less than zero) for their share of any loss items. If the stock basis has been reduced to zero, any additional loss items will decrease (but not to less than zero) the shareholders’ basis of loans made to the S corporation. Later, if items of income exceed loss items, the net increase first increases and restores the basis of the shareholder loans. Distributions to shareholders exceeding the basis of their stock will result in the recognition of capital gain, but loan repayments to the shareholders exceeding their loan basis will result in ordinary income.

Two brothers, Ira and Sheldon Nathel, each owned 25% of the stock of three S corporations, G&D Farms Inc. (G&D), Wishnatzki & Nathel Inc. (W&N) and Wishnatzki & Nathel of California Inc. (W&N CAL). The brothers also made loans to G&D and W&N CAL. As of Jan. 1, 2001, losses had reduced each brother’s stock basis and loan basis in the S corporations to $0 and $116,150, respectively. During 2001, each brother received loan repayments of $649,775 from G&D and $161,250 from W&N CAL. The payment from W&N CAL was made as part of a reorganization of the three corporations that resulted in each brother’s becoming a 50% owner of W&N, the liquidation of W&N CAL and the termination of the brothers’ interests in G&D. Also as part of this process, the brothers each made capital contributions of $537,228 to G&D and $181,396 to W&N CAL. When filing their 2001 federal income tax returns, each brother increased his loan basis by $718,624 (the amount of their 2001 capital contributions) on the theory the capital contributions were an item of income under section 1367—in other words, tax-exempt income. The IRS stated no such increase is permitted and assessed deficiencies against both taxpayers.

After petitioning the Tax Court for relief, the brothers argued the loan basis increase was proper since the capital contributions were an S corporation tax-exempt item of income. They based their argument on the 2001 holding in Gitlitz v. Commissioner, 531 U.S. 206. In it, the Supreme Court held that income from the discharge of an insolvent S corporation’s debt under IRC § 108(a) results in a positive stock basis adjustment. The Supreme Court further stated that “§§ 101 through 136 employ the same construction [as § 108] to exclude various items from gross income.” Since capital contributions are excluded from income under section 118, the brothers argued that their capital contributions were an item of income that should increase the basis of their loans.

The Tax Court disagreed, stating such an interpretation would contradict three longstanding tax principles: (1) capital contributions of shareholders increase stock basis, (2) capital contributions are not income of the corporation and (3) debt and equity are two different things treated differently by the Tax Code and courts. Furthermore, Treas. Reg. § 1.118-1 states that capital contributions are not income to the recipient corporation. Since loan proceeds and capital contributions are not items of income, they cannot increase an S corporation shareholder’s loan basis, the Tax Court said.

Note: In the Job Creation and Worker Assistance Act of 2002, Congress amended section 108(d)(7)(A) and thus overturned the Supreme Court’s decision in Gitlitz.

 Ira and Tracy Nathel v. Commissioner, Sheldon and Ann Nathel v. Commissioner, 131 TC no. 17

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