Journal of Accountancy

TAX MATTERS

CFC Credit Rules Eased

By EILEEN REICHENBERG SHERR

JANUARY 2009

In response to the liquidity crisis, which has made it difficult for taxpayers to fund their operations, the IRS quickly responded on Oct. 3 with Notice 2008-91, temporarily expanding the short-term financing exception to IRC § 956. This measure will permit corporations to access cash from their controlled foreign corporations (CFCs) without having an income inclusion for U.S. tax purposes. Since the IRS stated that it did this to facilitate liquidity in the near term, the new exclusion rules apply only for the first two taxable years of a foreign corporation ending after Oct. 3, 2008, and does not apply to tax years beginning after Dec. 31, 2009. For calendar year corporations, the notice is applicable to tax years 2008 and 2009.

Generally, a loan from a CFC to its U.S. shareholder is treated as the acquisition of an obligation of a U.S. person by the CFC that is an investment in U.S. property. Such an investment may require the U.S. shareholder to recognize income under IRC § 951. Prior Notice 88-108 provided an exception for shortterm loans repaid within 30 days, as long as the CFC does not hold obligations that would be investments for more than 60 days during the year.

Notice 2008-91 extends the exception for loans held by the CFC that are repaid within 60 days from the time incurred (and allows the CFC to elect to exclude them under section 956 from the definition of “obligation”), as long as the CFC does not hold obligations that would be investments in U.S. property for 180 days or more during the tax year. The latest rules do not otherwise affect the application of Notice 88-108. A CFC may rely on either notice but not both.

Notice 2008-91

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

TAX MATTERS

VEBA's Excess Set-Aside is UBI

By Edward J. Schnee

January 2009

The Court of Federal Claims ruled that a tax-exempt voluntary employees’ beneficiary association (VEBA) recognized income subject to the unrelated business income tax (UBIT) because it exceeded the amount the VEBA could set aside to pay benefits.

The UBIT was enacted to prevent tax-exempt organizations from competing with taxable entities with an unfair advantage. Tax-exempt entities that receive business income unrelated to their exempt function must pay tax on this unrelated income. In 1984, Congress expanded the scope of UBIT to apply to certain passive income of VEBAs.

For tax year 2000, CNG, a tax-exempt VEBA, reported unrelated business taxable income (UBTI) of $2,693,592, from investments and paid UBIT of $1,065,684. In 2004, CNG filed an amended return for 2000 showing zero UBTI and requesting a refund of the $1,065,684 tax paid. The government denied the refund. The case was heard by the Court of Federal Claims under crossmotions for summary judgment.

Code § 512(a)(3)(B) provides that a VEBA may exclude from taxable income member contributions plus amounts set aside for payment of benefits and expenses. The amount that can be set aside without taxation, or the “qualified asset account,” is limited by section 419A(c)(1) to the amount of unpaid benefits at year-end plus expenses related to those benefits. CNG argued that its income did not exceed the set-aside amount as defined by IRC § 512(a)(3)(E). The government argued that the income exceeded the set-aside amount as defined in Treas. Reg. § 1.512(a)-5T, which it said is enforceable because the Code section is ambiguous.

The first issue before the court was whether section 512(a)(3)(E)(i) is ambiguous. Since the Code does not clearly describe the computation of the set-aside amount and the impact of using investment income to pay benefits, the court concluded that the section was ambiguous.

The court then turned to the amount of deference that must be given to the regulations. The court determined that the regulation was interpretative and entitled to deference under the standard announced in National Muffler Dealers Assn. (440 U.S. 472 (1979)). The regulation defines the set-aside amount as the total amount set aside for benefit payments from both member contributions and investment income. According to the court, this is a reasonable interpretation of the Code and congressional intent and therefore entitled to deference and enforcement.

The court also distinguished the instant case from the Sixth Circuit case of Sherwin-Williams (95 AFTR2d 2005-1864), which reached an opposite conclusion on similar facts. In Sherwin- Williams, the parties stipulated that the investment income was used to pay the benefits. In the current case, no such stipulation existed, the Court of Federal Claims noted. In addition, the fact that the investment income was paid out for benefits would not change the amount of the nontaxable set-aside, the court said. The Court of Federal Claims also said the Sixth Circuit incorrectly based the set-aside amount on the investment income left over after paying benefits.

The result of the current case is a conflict between the courts as to how the set-aside amount should be calculated. Future litigation will be necessary to determine the exact formula to calculate a VEBA’s UBTI. The final result likely will hinge on whether courts consider the regulations to be a reasonable interpretation of ambiguous Code provisions.

CNG Transmission Management VEBA v. U.S., 102 AFTR2d 2008-6714

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

TAX MATTERS

Stock Loan Treated as Sale

By Steven C. Thompson and Robert L. Severance

January 2009

The value of a couple’s stock securing a loan could not be deducted as a theft loss, even though the stock was sold without the borrowers’ knowledge, the U.S. District Court for the Northern District of California ruled. Other claims, including whether, as the government argued, the loan was really a sale resulting in a taxable gain, remained in litigation.

Stock loans allow shareholders to borrow as much as 90% of the value of a traded stock, using the stock as collateral. They are typically classified as nonrecourse loans because the borrower’s personal assets are not at stake. They tend to operate as a built-in hedging transaction because if the stock drops, the borrower can simply walk away. If the stock appreciates, the borrower can pay back the loan and the stock is returned. Most stock loans have no margin calls, and the money can be used for anything except purchasing more stock.

In June 2000, Carl and Nancy Schlachte entered into two 90% stock loans with Derivium, an investment company, and received loans totaling approximately $2.3 million for a term of three years. At the end of that period, the taxpayers were notified by Derivium that both their loans were maturing, so they opted to surrender their shares in full satisfaction of their loans. Derivium allegedly told more than 1,700 clients nationwide they could avoid paying income taxes on the proceeds of the loans, saying they were not sales. The government, however, called the loans a sham and in 2007 sought an injunction against Derivium’s principals for allegedly operating a tax fraud scheme. According to the complaint (U.S. v. Charles Cathcart et al.), also in the U.S. District Court for the Northern District of California, Derivium helped its clients improperly avoid paying tax on the sale of more than $1 billion in assets.

In February 2004, the California Franchise Board took the position that the Schlachtes’ stock loans were sales on the date the loans were signed. The IRS subsequently took the same position and collected $842,782 in taxes for the tax year 2000. In the couple’s continuing dispute with the California Franchise Board, the Superior Court of California ruled in the Schlachtes’ favor that the stock loans were not sales for purposes of state tax treatment. The couple submitted amended federal returns for 2000 claiming a refund and for 2003 reporting the sale in the year when the stock was forfeited.

In June 2006, the IRS processed both requests, rejecting the year 2000 refund request (declaring the transaction was a sale disguised as a loan) and accepting the taxpayers’ amended 2003 return reflecting the stock sale. Thus, tax on the stock loan at this point was to be collectible twice. For that reason, the Schlachtes petitioned the district court. Later in the proceedings, they also claimed that they qualified for a theft loss deduction for 2000 because Derivium had sold their stock without their knowledge.

According to IRC § 7422(a), no suit for the recovery of any tax can be made until a claim for refund or credit has been duly filed. Furthermore, Treas. Reg. § 301.6402-2(b)(1) also requires that a claim for refund “set forth in detail each ground” for which a claim for refund is requested. If the claim for refund on its face does not call for an investigation into a concern, the issue cannot be later raised by the taxpayer in a refund suit. Boyd v. U.S. (762 F.2d 1369, 1371-72 (9th Cir. 1985)).

While the taxpayers did file a claim for refund in 2006, they never formally disclosed the theft loss issue on their original claim that was filed with the Treasury Department. Although they did informally discuss it, as evidenced in handwritten notes taken by the reviewing IRS agent and in a nine-page letter sent to Treasury officials, the court ruled they did so after the original claim was denied. Moreover, the court noted that an informal claim raising new grounds after an initial claim is filed is not considered timely filed for purposes of a refund claim. Consequently, the IRS was not properly made aware of the theft loss claim, and such a claim could not have been reasonably investigated. Accordingly, the court dismissed the taxpayers’ theftloss claim theory.

Schlachte v. U.S., 102 AFTR2d 2008-5894

By Steven C. Thompson, CPA, Ph.D., McCoy Professor in Accounting, and Robert L. Severance, CPA, CIA, CFP, lecturer in accounting, both at Texas State University, San Marcos, Texas.

tax matters

Line Items

january 2009

CONGRESS TRUMPS SUPREME COURT
In Announcement 2008-103, the IRS provided procedures and guidelines for claiming refunds of excise tax paid by domestic coal producers and exporters on exported coal. The guidance was in response to an extension by Congress of the tax years for which refunds may be claimed, to those preceding the normal three-year statute of limitations of IRC § 6511. The provision was part (section 114) of the Energy Improvement and Extension Act, a division of the Emergency Economic Stabilization Act of 2008. Thus Congress overruled the Supreme Court’s holding in U.S. v. Clintwood Elkhorn Mining Co. (101 AFTR2d 2008-1612, “Tax Matters: The Code Trumps Tucker,” JofA, July 08, page 87) that a refund claim for the tax may be pursued only within the time frame of section 6511 and administrative strictures of section 7422. The tax was held in 1998 to violate the export clause of the Constitution in Ranger Fuel Corp. v. U.S. (83 AFTR2d 99-375).

The new law provided only a 30-day window, until Nov. 3, 2008, to claim refunds of tax paid between Oct. 1, 1990, and Oct. 3, 2008. The tax, which continues to be levied on domestically sold coal to fund a miners’ black lung disability trust fund, has not been collected on exported coal since 2000.

ABC NOT SO SIMPLE
The U.S. District Court for the Western District of Michigan vacated its earlier order that had granted summary judgment to the taxpayer in ABC Beverage Corp. v. U.S. (102 AFTR2d 2008-5905, “Tax Matters: Lease Buyout Portion of Purchase Ruled Deductible,” JofA, Dec. 08, page 94). The court said after reviewing its earlier opinion that issues of material fact remained pending and set the case for trial. ABC had claimed a deduction for the $6.25 million portion of its $11 million purchase of a business site that it attributed to buying out an onerous lease on the property. In a motion in limine, the government sought to restrict trial evidence to when ABC paid for the property and said the remaining issue was in which tax year the deduction was properly allowed under the economic performance test.

B&D CASE SETTLED
Black & Decker Corp. settled its tax case with the government for $69.5 million including interest after the Fourth Circuit last year reversed and remanded the toolmaker’s refund suit in the U.S. District Court for Maryland (see “Tax Matters: IRS, B&D Tool Up for Trial,” JofA, May 07, page 91). The case involved a claimed capital loss on contingent health care claims B&D transferred to a subsidiary formed to manage the claims. B&D had sought a refund of more than $57 million plus interest for tax years 1995 through 2000 stemming from a carryover of the loss from 1998. The Fourth Circuit overruled the district court’s application of the economic substance doctrine, finding that the district court misapplied the test to B&D’s general business practices rather than the specifics of the transaction. The settlement amount included reduction of B&D’s tax liability by overpayments in subsequent years and left open the possibility of a further adjustment in B&D’s favor from an ongoing, unrelated dispute under the competent authority process with two foreign taxing authorities for some of the years at issue.

CRT DISPOSITION “TRANSACTION OF INTEREST”
The IRS designated as a “transaction of interest” certain dispositions of assets of a charitable remainder trust (CRT) purporting to fall under the exception for disregarding basis attributable to a term interest in determining gain or loss on sale or disposition of trust property. In Notice 2008-99, the Service said that the transaction and those substantially similar must be disclosed as provided in Treas. Reg. § 1.6011-4 if entered into on or after Nov. 2, 2006. Also, material advisers who make a tax statement involving the transaction must adhere to disclosure obligations of IRC §§ 6111 and 6112.

In the transaction, a CRT to which a grantor contributes appreciated assets (and claims a charitable deduction for the charitable remainder interest) sells them and reinvests the proceeds in new assets, recognizing as their basis their fair market value. Next, the grantor and charitable beneficiary sell their trust interests to a third party for an amount roughly equal to the fair market value of the trust’s assets. Finally the trust terminates, distributing its assets to the third party. Besides taking the charitable deduction, the grantor claims to recognize no gain in the transaction, taking the position that the sale to the third party qualifies for the exception under IRC § 1001(e)(3) to the general rule that the portion of basis attributable to a term interest is disregarded in determining gain or loss on sale of property.

Comments on how the transaction might be addressed in published guidance are due Jan. 31.

IRS OFFERS ONLINE COURSE ON NEW 990
Training and information resources on the Service’s “Stay Exempt” Web site for exempt organizations (www.stayexempt.org) now include a four-part “mini-course” on filing the revised Form 990, Return of Organization Exempt From Income Tax. The audio and slide-show presentation is more than two hours long, broken up into five sessions.

HEARING SCHEDULED FOR FIVE-MONTH EXTENSION
The Service set a public hearing in mid-January on temporary rules that reduce the automatic filing extension period for partnerships, trusts and estates from six months to five.

The provision of TD 9407 (REG-115457-08) is effective for extension requests with respect to returns due on or after Jan. 1, 2009. It affects entities with a tax year ending on or after Sept. 30, 2008, that file Form 1065, U.S. Return of Partnership Income; Form 1041, U.S. Income Tax Return for Estates and Trusts; or Form 8804, Annual Return for Partnership Withholding Tax. The shorter extension period is intended to better enable partners and beneficiaries to receive Schedules K-1 and other information from the entities in a more timely manner for inclusion in their individual returns by the usual six-month extended due date. It also brings the extended due date in line with that of S corporations, which normally file by March 15 and therefore have an extended six-month due date of Sept. 15.

In written comments, the American Bankers Association and National Association of Publicly Traded Partnerships have opposed the measure, with the latter suggesting instead lengthening the extension period for individual returns of persons receiving K-1s to seven months, giving them an extended due date of Nov. 15. KPMG suggested in written comments delaying the change for at least a year while pursuing legislative action to move up the original due date for partnership returns by a month. In a survey of AICPA Tax Section members, 68% supported the five-month extension now while seeking due date changes.

The hearing is scheduled for Jan. 13 at 10 a.m. at the IRS Building in Washington.

TAX MATTERS

Medical Residents Not Subject to FICA

By MELANIE J. EARLES

JANUARY 2009

Although circuits have split on the issue previously, two recent decisions concluded that medical residents are not subject to FICA, based on the student exception of IRC § 3121(b)(10). The provision states that the term “employment” “shall not include…service(s) performed in the employ of…a school, college, or university…if such service is performed by a student who is enrolled and regularly attending classes at such school, college, or university.”

In August 2008, the U.S. District Court of South Dakota examined the FICA issue for two residency programs: an internal medicine program sponsored by the University of South Dakota School of Medicine and the Sioux Falls Family Medicine Residency Program operated by the Center for Family Medicine (CFM), a nonprofit corporation. Then, on Sept. 23, 2008, the Seventh Circuit upheld an exception from FICA for medical residents at the University of Chicago Hospitals.

In both cases, the IRS said none of the three programs was a school, college or university. In the South Dakota case, the government argued that the programs did not identify themselves by those terms and did not grant degrees. The IRS also said medical residents are not students because they do not enroll or regularly attend class, their purpose is to earn a livelihood rather than an education, and the amount of medical services they provide precludes student status.

Both courts disagreed. The South Dakota court, whose decision is appealable to the Eighth Circuit, looked to the 1998 holding by that circuit in Minnesota v. Apfel (151 F.3d 742) and, more recently, in United States v. Mayo Foundation for Medical Education & Research (92 AFTR2d 2003-5774 (D. Minn.)) that student status is determined also by examining whether enrollment in the program is “incident to and for the purpose of pursuing a course of study”—and concluded it was. However, chief residents did not qualify for the exception because they elected to stay after completing their residency to help administer the residency programs.

In University of Chicago Hospitals, the Seventh Circuit agreed with the Eleventh Circuit in U.S. v. Mount Sinai Medical Center (99 AFTR2d 2007-2800) (see “Tax Matters: FICA for Medical Residents Splits Circuits,” JofA, Jan. 08, page 73) that section 3121(b)(10) does not limit the exemption by the type of services performed, and that student status is determined on a case-by-case basis by the criteria of Treas. Reg. § 31.3121(b)(10)-2. Meanwhile, the U.S. District Court of Massachusetts, noting the “recent eruption” of such cases, cited University of Chicago Hospitals in denying summary judgment to the IRS on similar facts in U.S. v. Partners Healthcare Systems Inc. (102 AFTR2d 2008-5503). While leaving open the question of whether medical residents qualify for the student exception, the court refuted Partners’ argument that the payments are not wages as defined in section 3121(a).

Center for Family Medicine v. U.S., 102 AFTR2d 2008-5623

University of Chicago Hospitals v. U.S., 102 AFTR2d 2008-6275

By Melanie J. Earles, CPA, DBA, professor of accounting, Tennessee Tech University, Cookeville, Tenn.

TAX MATTERS

No Good Deed Goes Unpunished

By CHARLES J. REICHERT

JANUARY 2009

A volunteer president of the board of directors of a nonprofit day care center was held personally liable for the day care’s payroll taxes and therefore was not entitled to a refund of the taxes he paid on behalf of the organization. The Seventh Circuit Court of Appeals rejected the taxpayer’s arguments that he was exempt from any obligation for the payroll tax because of his volunteer status with the organization and the government’s failure to warn him (and the public) of the potential tax liability.

Code § 6672(a) imposes a penalty on any “responsible person” who willfully evades or fails to collect, pay or account for payroll taxes. The amount of the penalty is the tax evaded or not collected, accounted for or paid to the government. A responsible person is someone who has enough control over the financial affairs of an organization to pay other debts instead of the organization’s payroll obligation. Exclusive control is not required, and delegation of the authority to remit the payroll taxes does not relieve someone of section 6672 liability. Willful conduct is a voluntary, conscious or intentional decision not to pay the taxes and includes a reckless disregard of a known risk that the taxes are not being paid. Volunteer directors are exempt from the penalty only if three conditions are all met: Their position is strictly honorary; they don’t participate in day-to-day or financial operations; and they have no knowledge of the failure that caused the penalty.

From the early 1980s until 2001, Charles E. Jefferson, an Illinois state representative, was the volunteer president of the board of directors of New Zion Day Care Center, a nonprofit organization in Rockford, Ill. As board president, Jefferson was not in charge of day-to-day operations but had the authority to obtain loans, determine financial policy and direct payment of the day care’s bills and payroll taxes. In 1998, the executive director of the United Way informed Jefferson and other board members that the day care could lose its United Way funding due to unpaid payroll taxes. Later in 1998, after losing the United Way funding, Jefferson secured a bank loan to pay those taxes. New Zion continued to have financial problems resulting in additional unpaid payroll taxes for April 2000 to June 2001. Jefferson and other board members were made aware of these problems through reports from New Zion’s director that they approved. After paying payroll taxes of $41,432 to the IRS, Jefferson filed suit for their recovery in district court, received an adverse decision and appealed to the Seventh Circuit.

The court held that Jefferson had sufficient financial control to be a responsible person, since he had negotiated loans, reviewed financial reports, hired an accounting firm to examine the day care’s financial situation, reviewed reports prepared by that firm and had directed payment of payroll taxes in the past. The court also found his conduct willful, since he knew of the organization’s past payroll tax delinquencies and had access to financial reports indicating an increasing tax liability but took no steps to ensure payment of those taxes. The court also determined Jefferson’s board position was not honorary, due to his power and responsibilities as board president.

Jefferson also argued he should be relieved of any liability since the IRS had not prepared materials, as required by P.L. 104-168, that explain situations where board members of tax-exempt organizations can be liable for unpaid payroll taxes. The court agreed the IRS had not prepared the materials but said Jefferson still needed to show he would have paid the taxes if he had had the materials. The court found no evidence of this; therefore, the absence of the materials did not automatically invalidate the penalty.

Charles E. Jefferson v. U.S., 102 AFTR2d 2008-6572

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

TAX MATTERS

Nine Lives for Ohio's CAT?

By PAUL BONNER

JANUARY 2009

The Ohio Supreme Court has been asked to rule on Ohio’s commercial activity tax (CAT) as applied to certain food sales, after the tax was found by a state appeals court to violate the state constitution in that regard.

A gross receipts business tax, the CAT was enacted in 2005 and challenged the following year by the Ohio Grocers Association. It levies $150 on the first $1 million in taxable gross receipts (after exempting the first $150,000) and 0.26% on receipts above that. The grocers pointed to the state constitution’s prohibition of sales or other excise taxes on sales or purchases of wholesale food and food ingredients and on retail sales of packaged food and nonalcoholic beverages. A trial court ruled for the state, and the Grocers Association appealed. The Court of Appeals of Ohio, Tenth Appellate District, on Sept. 2, 2008, overruled the trial court. The state argued, and the statute states, that the CAT is a franchise tax, imposed for the privilege of doing business in Ohio and therefore is not a sales tax subject to the food tax prohibition. The state appeals court found, however, that because it is applied to gross receipts, the CAT is in effect a sales or excise tax.

In its appeal memorandum to the Supreme Court of Ohio, the state argued that the CAT is necessary to Ohio’s fiscal well-being, since it was part of tax reforms forecast to cut state income taxes by 21% by 2010. Moreover, the decision “has called into question whether Ohio must now utilize the more stringent constitutional nexus standard for transactional taxes—physical presence—rather than the current CAT standard—economic presence—in determining whether the State can impose the CAT on all out-of-state taxpayers doing business in Ohio,” the state said in the memo.

Elsewhere, economic, as opposed to physical-presence, nexus is alive and well, at least for some financial services. On Oct. 20, 2008, the Indiana Tax Court ruled that Delaware-based credit card company MBNA America Bank was subject to that state’s financial institutions tax (FIT) despite its lack of any employees or place of business in Indiana. The court cited the decision on similar facts against MBNA by the Supreme Court of West Virginia in 2006, quoting the West Virginia court’s observation that “electronic commerce now makes it possible for an entity to have a significant economic presence in a state absent any physical presence there.”

Ohio Grocers Association v. Wilkins, docket no. 2008-2018, Supreme Court of Ohio

MBNA America Bank v. Indiana Department of State Revenue, docket no. 49T10-0506-TA-53, Indiana Tax Court

By JofA Senior Editor Paul Bonner.

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