In a recent private letter ruling, the IRS clarified how employer reimbursement of employee expenses for tools, equipment, training or certification required as a condition of employment may qualify as an accountable plan under IRC § 62.

Reimbursements under an accountable plan are excluded from gross income of employees and are exempt from withholding and payroll taxes. Generally, an accountable plan is one that requires reimbursed expenses to have a business connection and for employees to substantiate reimbursed expenses and return to the employer any amount they receive in excess of the substantiated amount (IRC § 62(c) and Treas. Reg. § 1.62-2(c)(1)).

Tool reimbursements became such an important issue that in July 2000 the IRS developed a coordinated issue paper on them. Relying on Shotgun Delivery Inc. v. U.S. (85 F. Supp. 2d 962 (N.D. Calif. 2000)), the IRS concluded that tool reimbursement plans typically operated at that time did not qualify as accountable plans. However, the Service said, a plan could qualify if, along with meeting other requirements, reimbursements were not made in lieu of other compensation. In a decision issued after the coordinated issue paper was released, the Ninth Circuit affirmed this aspect of the district court’s decision (Shotgun Delivery Inc. v. U.S., 269 F.3d 969 (9th Cir. 2001)). In 2008, the IRS in an updated version of the earlier coordinated issue paper (LMSB-04-0608-037, revised July 2, 2008) again stated that tool reimbursement plans, as the Service had seen them, did not meet the accountable plan requirements.

The plan for which the recent ruling was sought, however, could be distinguished in these ways:

Business connection. Under Treas. Reg. § 1.62-2(d), the expense must be an item that would be allowed as a business expense deduction. The IRS ruled that the plan would satisfy this requirement by these features:

• Employees would have to certify that the tools and equipment are necessary to perform services for the employer.
• Only expenses deductible under section 162 (trade or business expenses) or section 179 (election to expense certain depreciable business property) could qualify for reimbursement.
• Tools and equipment must be kept on-site.
• The technician’s manager would be required to verify that the tools and equipment are necessary to perform services for the employer.
• The reimbursements would not be in lieu of any other compensation.
• Only expenses incurred after becoming an employee would be reimbursed. For tools and equipment that are deductible under section 179, the employee would be required to certify:
• The costs could otherwise be deductible by the employee under section 179.
• The employee would reduce the limits imposed by section 179 by the amount of the reimbursement.

Substantiation. The IRS ruled the plan would meet the requirements of Treas. Reg. § 1.62-2(e) because each of the following would be documented with a claim form and receipt or other written proof of purchase submitted within 30 days for each expense:

• The date, amount and type of expense.
• Documentation that the expense is incurred in connection with providing services to the employer.

Return of excess reimbursement. Treas. Reg. § 1.62-2(f) requires that employees return any excess reimbursements. The plan would satisfy this requirement by not permitting any cash advances. Thus, no excess reimbursement should occur, and any amounts reimbursed in error would be required to be returned to the employer. The plan also would require workers who leave employment to repay all reimbursements made during the last six months of employment.

  Private Letter Ruling 200930029 (April 13, 2009)

By W. Joey Styron, CPA, Ph.D., director of the Knox School of Accountancy at Augusta State University, Augusta, Ga.

The Fostering Connections to Success and Increasing Adoptions Act of 2008, PL110-351, made several changes to the qualifying child (QC) definitions effective for tax years beginning after Dec. 31, 2008.

Section 501(a) of the act amended the age requirement (IRC § 152(c)(3)) to also require the QC to be younger than the individual claiming a QC exemption for the child. Other QC age requirements under prior law remain in place (the QC must be under 19 at the close of the calendar year in which the tax year begins, or under 24 if a student). Also remaining is the exception for QCs who are permanently and totally disabled at any time during the calendar year.

Example. For tax years beginning prior to 2009, a taxpayer could claim a QC dependency exemption for an older sibling. This option is not available for tax years beginning in 2009 and later unless the older sibling is permanently and totally disabled.

A second change (section 501(b) of the act) codifies (at IRC § 152(c)(1)(E)) the long-standing position of the IRS that a married dependent cannot be a QC if he or she files a joint return with his or her spouse, unless the return is filed merely as a claim for a refund. Congress did so to clarify that the restriction also applies to other child-related tax benefits, such as the child tax credit, that reference the subsection.

A third change (act section 501(c)(1)) requires that a QC for whom a taxpayer claims the child tax credit must be one for whom the taxpayer claims a dependency exemption. Although the child credit provisions of section 24 under prior law defined a QC as one qualified under chapter 152(c), it didn’t also require that the child in fact be claimed as a dependent.

Finally, under the “tie-breaker” rules of IRC § 152(c)(4) for determining which of two or more taxpayers who claim the same qualifying child may do so, prior law gives first priority to a parent over a nonparent. New subparagraph (C) further specifies that if any parent could claim a child as a QC but doesn’t do so, another otherwise eligible individual may do so only if he or she has a higher adjusted gross income than any parent eligible to claim the child as a QC for the taxable year.

Example. For years prior to 2009, parents with high AGI subject to phaseout of exemptions and reduction or complete loss of child tax credits could forgo taking QC exemptions and allow one child to take QC exemptions and a child tax credit for other siblings (assuming the claiming child met all other QC tests with respect to the siblings, including support). This option is now unavailable for 2009 and later years, unless the child claiming the child credit and/or exemptions for the siblings has a higher AGI than his or her parents.

  Title V, Fostering Connections to Success and Increasing Adoptions Act of 2008, PL 110-351

By James M. Hopkins, CPA, professor of accounting, Morningside College, Sioux City, Iowa.

The Tax Court, whose denial of a six-year statute of limitations in Bakersfield Energy Partners had been recently upheld by the Ninth Circuit, held in two more cases that an overstatement of basis did not allow the extended assessment period for a substantial omission of gross income under IRC § 6501(e). In one, two S corporations did not reduce their basis in Treasury notes by the amount of their liability to close a short sale of the securities. The other involved stepped-up basis on a sale of business assets by a limited liability company.

Generally, the IRS must assess additional tax within three years of the later of the due date of the return or the date of filing. IRC § 6501(e)(1)(A) extends the assessment period to six years when there is a substantial omission of gross income, defined as exceeding 25% of reported gross income. For a trade or business, section 6501(e)(1)(A)(i) states that gross income is the amount received from the sale of goods or services before any reduction for the cost of those goods or services. Under the safe harbor of section 6501(e)(1)(A)(ii), omitted income does not include any amount adequately disclosed on the tax return or on an attached statement. In Colony Inc v. Commissioner (357 U.S. 28), the Supreme Court differentiated an omission from an understatement when it held that a land development company had not omitted income when it overstated the basis and understated the gain from its sale of real estate.

In 1999, Kenneth Beard sold shares in two S corporations in which he was a majority owner and reported total gain of $1,406,336 from the sales on his and his wife’s 1999 joint tax return filed on April 11, 2000. Earlier in 1999, the Beards purchased Treasury notes for $12,160,000 and transferred them to the S corporations, along with an obligation of $12,160,000 to cover their short position related to the notes. They did not reduce their stock basis by the short position obligation assumed by the corporation, which the IRS did after examining their return. The Service sent a deficiency notice dated April 13, 2006. The taxpayers argued before the Tax Court that the statute of limitations for tax year 1999 had expired.

In 2007, the Tax Court, in Bakersfield Energy Partners LP (128 TC 207, aff’d,9^th Cir. , June 2009), held that the principles of Colony applied and no omission of gross income had occurred when a partnership understated its gain from the sale of oil and gas property due to the overstatement of the property’s basis. In the current case, the IRS stated Bakersfield Energy Partners had not been decided correctly and advanced the same arguments rejected by the Ninth Circuit in its holding on appeal of Bakersfield. It argued the Colony decision was not binding because Colony was based on section 275(c) of the 1934 Revenue Act, and that its successor, the current section 6501(e)(1)(A), is materially different. The Tax Court, citing the Ninth Circuit in Bakersfield, rejected that argument, stating that Congress used the identical language in the current section 6501(e)(1)(A) as in its predecessor.

Three weeks after its holding in Beard, the Tax Court again cited Bakersfield in denying the IRS a six-year limitations period in Intermountain Insurance Service of Vail v. Commissioner. Intermountain realized $1.9 million on a sale of business assets, which it reported in a September 2000 return filing as a loss of $87,680, stemming from a stepped-up basis of more than $2 million. The IRS issued a notice of partnership administration adjustment nearly six years later, claiming Intermountain overstated its capital contributions and outside partnership basis.

Recently, the IRS has met with more failures than successes in a string of taxpayer challenges on this issue (see “Tax Matters: Ninth, Federal Circuits: Basis Overstatement Not Income Omission,” JofA, Sept. 09, page 78).

  Kenneth and Susan Beard v. Commissioner, TC Memo 2009-184

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

A district court held that a partnership’s reported capital loss stemming from nonperforming loans lacked economic substance and denied the claimed tax benefits. D. Andrew Beal owned a bank that was in the business of acquiring nonproducing loans (NPLs) at extreme discounts. With an associate and China Cinda Asset Management Co., a Chinese “bad bank,” Beal formed Southgate Master Fund LLC (Southgate) to invest in Chinese NPLs. Beal claimed a $1.1 billion tax loss in the years 2002 through 2004 arising out of the LLC’s NPL investments, which the government denied following an audit.

Cinda contributed a portfolio of low-grade NPLs to Southgate and took a 99% interest in the LLC. The NPLs that Cinda contributed to Southgate had a basis of more than $1.3 billion but a fair market value of only $19.4 million. Beal then purchased 90% of Southgate from Cinda. Southgate then sold some of the NPLs, which generated a loss of $295 million, $293 million of which was built-in loss. Since Beal had purchased most of Cinda’s interest, the majority of the built-in loss was allocated to him under IRC § 704(c). At the time the loss was recognized, the majority of Beal’s loss was nondeductible under section 704(d) because of insufficient basis.

To generate basis to permit deduction of the loss, Beal contributed securities of the U.S. government-owned mortgage guarantor Ginnie Mae with a $300 million face value and $181 million fair market value to Martel, a single-member LLC he owned. Martel sold some of the Ginnie Mae securities to Swiss bank UBS for $162 million. The sale contract required Martel to repurchase the securities on UBS’ demand, essentially making the transaction a loan of $162 million to Martel with the Ginnie Mae securities as collateral. A subsequent agreement between Beal and UBS required Beal to agree to the repurchase and provided him with complete control and benefit from all Martel activities. Martel distributed the cash to Beal, and Beal personally guaranteed to pay the liability to UBS if it demanded repurchase. Beal then contributed his interest in Martel to Southgate. Because he had personally guaranteed to pay Martel’s liability if UBS demanded that Martel repurchase the securities, he was able to increase his outside and at-risk basis in Southgate by the amount of the liability, creating basis to deduct the losses from the NPLs. The government denied the loss, alternately arguing that the basis of the NPLs was inflated or that the transactions lacked economic substance. The case went before the District Court for the Northern District of Texas.

The court rejected the government’s arguments that the transactions’ basis was artificially inflated. It did, however, agree that the transactions lacked economic substance; that is, they claimed a tax benefit not intended by Congress and served no economic purpose except to generate a tax saving. The Fifth Circuit Court of Appeals, to which this case would go, applies a two-part test for economic substance: The transaction must have a realistic possibility of profit, and it must be motivated by a legitimate nontax business purpose.

In making its determination, the district court separated the formation and operations of Southgate from the Martel restructure (the Ginnie Mae sale/repurchase agreement and the contribution of Martel to Southgate). It concluded that Southgate was a genuine business venture and had a reasonable possibility of profit. Therefore, the economic substance doctrine did not apply to its formation or operations. It reached the opposite conclusion for the Martel restructure. The court noted that only Beal could benefit from profits earned by Martel. Therefore, the contribution by Martel to Southgate lacked a reasonable chance for profit by the owners of Southgate other than Beal. The court also held that the contribution transaction was motivated solely to raise Beal’s basis and not for any nontax reasons. Failing either test would have permitted the court to deny the benefit under the doctrine. Southgate failed both tests, the court said.

The government also argued for 20% penalties under several provisions. However, the court held that Southgate had substantial authority for its position and had acted in good faith and with reasonable cause and denied the penalties. It noted that Southgate had obtained opinions from a law firm and an accounting firm that had both stated that the transaction was more likely than not to be sustained on its merits. These firms were not part of the group creating the transactions and had been used previously by the taxpayer.

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

FIRST CIRCUIT DENIES TEXTRON WORK PRODUCT PRIVILEGE

In a 3-2 decision, the First Circuit Court of Appeals overturned its earlier three-judge ruling and a district court to hold that the work product doctrine did not protect from IRS summons the tax accrual workpapers of aviation and industrial conglomerate Textron Inc.

Judge Michael Boudin, writing for the majority, said that because the documents sought were prepared not for litigation but for financial reporting, the work product privilege did not prevent their discovery by the IRS, even though they contemplated the possibility of litigation. The work product doctrine is intended to curb “the extent to which a party may inquire into oral and written statements of witnesses, or other information, secured by an adverse party’s counsel in the course of preparation for possible litigation after a claim has arisen,” the court said, quoting the 1947 U.S. Supreme Court case of Hickman v. Taylor (329 U.S. 495). Federal Rule of Civil Procedure 26(b)(3) applies it to items “prepared in anticipation of litigation or for trial.”

Textron acknowledged that the documents’ primary purpose was to support its reserve amounts for contingent tax liabilities but argued that they also analyzed the prospects for litigation over individual tax positions. The District Court for the District of Rhode Island sided with the company, although it denied attorney-client or tax practitioner privilege, saying Textron waived them by showing the documents to its outside accountants. The IRS appealed. In January 2009, a divided First Circuit panel upheld the district court, and the IRS obtained a hearing en banc.

The privilege does not extend to documents “prepared in the ordinary course of business or that would have been created in essentially similar form irrespective of the litigation,” the full court said, quoting, indirectly, U.S. v. Adlman (134 F.3d 1194 (2nd Cir. 1998)). It is “well established in case law” that litigation need not be a document’s sole purpose, but it must be more than a hypothetical purpose, the court said.

  U.S. v. Textron, No. 07-2631 (1^st Cir., Aug. 13, 2009).

WANTED: MORE FEEDBACK ON PARTNERSHIP MERGER REGS

The IRS requested public comment on proposed regulations issued earlier on allocation of gain or loss in partnership mergers.

In Notice 2009-70, the IRS asked for general observations and posed particular questions to guide further study the Service and Treasury Department will undertake before finalizing regulations proposed in 2007 (REG-143397-05). The rules would address implications for partnership mergers under IRC § 704(c), which was enacted in the 1980s to prevent artificial shifting among partners of tax consequences arising from built-in gain or loss of contributed property upon the property’s disposition.

Section 704(c)(1)(A) requires income, gain, loss and deductions arising from property contributed to a partnership by a partner to be shared among the partners in a way that takes into account the difference between the property’s basis to the partnership and its fair market value at the time of the contribution. Subparagraph (B) provides that for such property distributed by the partnership within seven years of its contribution and then sold, the contributing partner is treated as recognizing gain or loss in an amount that would have been allocated to that partner under subparagraph (A) if the property had been sold for its fair market value at the time of distribution.

The proposed regulations raised further questions, however, of the treatment of layers of forward and reverse section 704(c) gain and loss, especially within tiered partnerships. Consequently, the Service in the notice posed 19 questions concerning the regulations’ application to single partnerships and layered tiers of partnerships, as well as divisions, further implications of mergers and international issues. It also invited comments on any other aspects of the issues not included in the questions.

Comments may be submitted by Feb. 22, 2010, by mail to Internal Revenue Service, P.O. Box 7604, Washington, DC 20044, Attn: CC:PA:LPD:PR (Notice 2009-70), Room 5203 or by e-mail to notice.comments@irscounsel.treas.gov with “Notice 2009-70” in the subject line.

C corporations that elect S status are often subject to the built-in gains (BIG) tax under IRC § 1374. One of the aspects of the BIG tax that can be a trap for the unwary is the treatment of accounts receivable for cash-basis corporations. The fair market value of accounts receivable is usually the face value of the receivables. The basis in those receivables is usually zero, since the corporation is on a cash basis of accounting and has not recognized any income associated with the creation of those receivables. The collection of the receivables in the first S corporation year can create a BIG tax liability, as that gain on collection relates to a C corporation year and therefore falls within the scope of section 1374. The potential for being subject to BIG tax exists for the recognition period, which starts on the first day of the first tax year the corporation is an S corporation and continues for 10 years (section 1374(d)(7)(A)).

One of the overall limitations to a corporation’s BIG liability is its net unrealized built-in gain (section 1374(c)(2)). This amount is the excess of the fair market value of all the corporation’s assets over the aggregate basis of such assets as of the S effective date (section 1374(d)(1)). Amounts that are deducted during the recognition period but relate to periods prior to the first S corporation year are considered recognized built-in losses and reduce the amount potentially subject to the BIG tax (sections 1374(d)(4) and 1374(d)(5)).

In Private Letter Ruling 200925005, a cash-basis C corporation was contemplating electing S status. The taxpayer, a personal service corporation, billed its clients for services performed. As those client receivables were collected, the taxpayer paid salaries to both shareholder and nonshareholder employees. Presumably, the taxpayer’s net income was driven by its markup of the salaries of its professional shareholder and nonshareholder employees. The taxpayer sought confirmation from the IRS that the salary expenses that related to the outstanding receivables as of the S election date would be considered a built-in loss item under section 1374 and therefore reduce the taxpayer’s potential BIG tax liability.

Treas. Reg. § 1.1374-4(b)(2) holds that an item is treated as a built-in loss item if the item would have been properly accrued as a deduction by an accrual-method taxpayer in the period before the first S corporation year. Treas. Reg. § 1.1374-4(c) limits this rule for payments to related parties and payments for compensation. Amounts paid to related parties within the meaning of section 267(a)(2) (in this case, the shareholder employees) must be paid within the first 2½ months of the recognition period. Furthermore, prior to the S election date, all events establishing the fact of the liability must have occurred and the exact amount of the liability must be determined. For amounts paid to nonrelated parties, the fact of the liability must be established and the exact amount of the liability must be determined prior to the S election date, but the amount of the liability does not have to be paid within the first 2½ months of the recognition period.

The IRS allowed to be treated as a built-in loss item compensation owed to shareholder employees that was attributable to receivables as of the first day of the first S corporation year and was paid within the first 2½ months after such date. Compensation to nonshareholder employees and other accounts payable items related to the production of the accounts receivable outstanding on the first day of the first S year were also allowed as a built-in loss item if paid during the recognition period.

Advisers representing cash-basis corporations converting from C to S status need to be aware of the impact of BIG tax with respect to outstanding receivables on the effective date of the S election and the use of the compensation attributable to such receivables as a way to minimize this liability.

By Vinay S. Navani, CPA, shareholder, Wilkin & Guttenplan PC, East Brunswick, N.J.

The Fifth Circuit held that IRC § 6229(a) sets no deadline by which the IRS must issue an FPAA (final partnership administrative adjustment). Its interpretation of the relationship between the limitations period in sections 6501(a) and 6229(a) mirrors that of the Tax Court, the D.C. Circuit and the Federal Circuit (see Rhone-Poulenc Surfactants & Specialties LP v. Commissioner, 114 TC 533; Andantech LLC v. Commissioner, 331 F.3d 972 (D.C. Cir. 2003); and AD Global Fund LLC ex rel. N. Hills Holding Inc. v. U.S., 481 F.3d 1351 (Fed. Cir. 2007)).

Curr-Spec Partners filed its 1999 Form 1065 on Oct. 11, 2000. More than four years later, on Oct. 13, 2004, the IRS issued an FPAA claiming the partnership was a sham, disallowing all income, deductions, gains and losses; treating partnership transactions as individual partner transactions; and assigning no basis for partnership interests. Curr-Spec argued section 6229(a) sets an independent three-year statute of limitations for assessing tax attributable to partnership items. The IRS argued that at least three partners claimed NOL carryforwards of 1999 partnership items on their individual 2000 and 2001 returns, and thus the statute of limitations for individual returns under section 6501(a) remained open.

The court noted section 6229(a) states the statute of limitations period “shall not expire before” three years from the date the partnership return was filed or, if later, when it was due. The Fifth Circuit said the phrase “shall not expire before” is unambiguous; that is, it can extend but never shorten the section 6501(a) period for assessing individual tax liabilities attributable to partnership items. After the FPAA becomes final, the IRS may assess tax on the individual partners whose tax returns remain open under section 6501(a).

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