The Seventh Circuit held that an accounting and consulting firm organized as a C corporation could not deduct payments to related entities because they were dividends, not compensation for services rendered by the company’s owners.

The firm was founded in 1979 by three accountants. During the tax years at issue—2001, 2002, and 2003—the three founders served as the firm’s board of directors and sole officers. During those years, the firm made payments to three related entities, which then passed those payments on to the founders in proportion to their hours worked for the firm.

The payments to the related entities reduced the firm’s taxable income to zero or nearly zero. The firm initially characterized those payments as consulting fees, but during the trial in the Tax Court, it claimed they were compensation for the founders’ services. A corporation can deduct a “reasonable allowance for salaries or other compensation” (Sec. 162(a)(1)) but cannot deduct dividends.

The IRS disallowed the firm’s deductions for the “consulting fees,” reclassifying them as dividends, and imposed Sec. 6662 accuracy-related penalties on the firm. The Tax Court upheld the IRS’s determinations.

On appeal, the Seventh Circuit, in an opinion authored by Judge Richard Posner, applied the “independent-investor test.” The Seventh Circuit characterized the premise of this test as “an investor who is not an employee will not begrudge the owner-employee his high salary if the equity return is satisfactory; the investor will consider the salary reasonable compensation for the owner-employee’s contribution to the company’s success” (slip op. at 4). However, in this case the payments reduced the firm’s income—and thus its equity return to investors—to zero. Thus, the court held, “the firm flunks the independent-investor test” (slip op. at 8).

The Seventh Circuit rejected the firm’s argument that the consulting fees were really disguised salary. The court noted that the firm did not otherwise treat them as labor expenses: It did not withhold payroll taxes, report them on W-2s, or disclose them on the officer compensation schedule of Form 1120, U.S. Corporation Income Tax Return.

The court also rejected the firm’s argument that the payments could not have been dividends because they were distributed in proportion to the number of hours each founder worked rather than their ownership percentages. The court said this was irrelevant: “[I]f the fees were paid out of corporate income … the firm owed corporate income tax on the net income hiding in those fees. A corporation cannot avoid tax by using a cockeyed method of distributing profits to its owners” (slip op. at 9–10).

The court affirmed the Tax Court’s decision that the payments were taxable dividends and not deductible business expenses and that the firm was liable for the accuracy-related penalty.  

Mulcahy, Pauritsch, Salvador & Co., No. 11-2105 (7th Cir. 5/17/12), aff’g T.C. Memo. 2011-74

The Third Circuit Court of Appeals, reversing the Tax Court, held that a state that paid taxpayers installment interest on amounts owed pursuant to an eminent domain settlement did so under its borrowing authority, and the interest therefore was tax-exempt. According to the court, the interest was paid due to a voluntary agreement between the taxpayer and the state, not due to the operation of state law, and thus invoked the state’s borrowing power.

Sec. 103 excludes from gross income interest earned on the obligations of state and local governments. The interest must have been paid under the government’s borrowing power, which occurs when the interest results from voluntary bargaining. The interest is not excludable if it is incurred due to the operation of law, such as under a state law requiring the state to pay a fixed interest rate when there is a delay in the payment of condemnation proceeds after property has been taken under eminent domain.

Dominick and Louis DeNaples were equal partners in four realty companies in Pennsylvania. From 1993 to 1998, the Pennsylvania Department of Transportation (PennDOT) took by eminent domain property owned by the realty companies. The companies objected but reached a settlement with PennDOT in 2001 that required PennDOT to pay the entities $40.9 million—$24.6 million allocated to principal and $16.3 million to interest from the time of the taking until the settlement (settlement interest). Since the state lacked sufficient funds, the companies agreed to receive $8.1 million plus accrued interest (installment interest) in 2002 and four payments of $8.2 million each plus accrued interest in 2003, 2004, 2005, and 2006. From 2003 to 2005, each taxpayer excluded interest totaling $6,507,733 (a portion of the settlement interest and all of the installment interest) from his individual tax return.

The IRS assessed deficiencies on the basis that all of the interest was taxable. The taxpayers petitioned the Tax Court for relief; however, it agreed with the IRS (DeNaples, T.C. Memo. 2010-171). The court held that the taxpayers failed to show that any of the settlement interest exceeded the amount the state was required to pay by law and that the settlement interest appeared to be arbitrarily determined by the taxpayers and PennDOT rather than being based on any interest computation. In addition, the court held that the installment interest was taxable, since the state of Pennsylvania was required by law to pay interest on the installment payments. The taxpayers appealed the decision to the Third Circuit.

The appellate court upheld the Tax Court’s decision that the settlement interest was taxable but reversed the Tax Court regarding the installment interest. The court held that the installment agreement was the result of voluntary negotiations between Pennsylvania and the taxpayers because the parties negotiated it due to the state’s inability to pay the entire $40.9 million at the date of settlement. The agreement extinguished the eminent domain proceeding and thus was entered into outside it, the court concluded. Thus, according to the court, the state’s obligation to pay interest was the result of a freely negotiated contract that invoked the state’s borrowing authority, as opposed to the operation of state law.

DeNaples, 674 F.3d 172 (3d Cir. 2012)

By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota–Duluth.

The First Circuit Court of Appeals on May 31 declared part of the federal Defense of Marriage Act unconstitutional, upholding a Massachusetts federal district court decision. The appeals court held that the act’s denial of federal benefits to lawfully married same-sex couples violates the Equal Protection Clause of the U.S. Constitution.

At issue was Section 3 of the Defense of Marriage Act, P.L. 104-199 (DOMA), which defines “marriage” for purposes of federal law as “only a legal union between one man and one woman as husband and wife.”

The First Circuit, like the lower court, focused on two aspects of DOMA: (1) that it prevents same-sex married couples from filing joint federal tax returns, thereby preventing them from benefiting from the lower tax burden available to most married couples who file jointly, and (2) that it prevents the surviving spouse of a same-sex marriage from collecting Social Security survivor benefits.

The plaintiffs in the several cases combined in the lower court were lawfully married same-sex couples. They had filed amended joint returns and requested refunds based on their lower tax liabilities as joint filers.

The lower court found that Section 3 of DOMA was unconstitutional under the Equal Protection Clause. The court held that the government had no basis for denying benefits to same-sex married couples and that Congress had no legitimate interest in applying a uniform definition of marriage for purposes of determining federal rights, benefits, and privileges.

The district court also ordered specific remedies for the plaintiffs’ tax claims (Gill v. Office of Personnel Management, amended judgment (8/17/10)). These remedies included ordering the payment of federal tax refunds plus statutory interest under Sec. 6621, based on the tax owed on the plaintiffs’ amended joint returns. The court, however, stayed this relief pending appeal.

The Justice Department originally defended DOMA in the suit, but later it filed a revised brief arguing that the equal protection claim should be assessed under a standard of “intermediate scrutiny” used for gender discrimination cases and that DOMA failed under that standard. The First Circuit refused to extend intermediate scrutiny to this case but nevertheless affirmed the lower court’s holding.

The circuit court noted that DOMA does not prevent same-sex marriage where it is permitted by state law but penalizes same-sex married couples by limiting their tax, Social Security, and other federal benefits. It said this burden was comparable to burdens the Supreme Court had found to be substantial in earlier equal protection cases involving “historic patterns of disadvantage suffered by the group adversely affected by the statute” at issue in those cases.

The appeals court affirmed the district court’s holding but continued the stay of the relief ordered, anticipating that the Supreme Court will eventually decide the issue.

Massachusetts v. United States Dep’t of Health and Human Servs., No. 10-2204 (1st Cir. 5/31/12), aff’g Gill v. Office of Personnel Management, 699 F. Supp. 2d 374 (D. Mass. 2010).

On May 8, the House Ways and Means Oversight and Social Security Subcommittees held a hearing on tax fraud involving identity theft. The same day, the Treasury Inspector General for Tax Administration (TIGTA) released a report saying the IRS does not handle identity theft issues well (TIGTA Rep’t No. 2012-40-050). The inspector general, J. Russell George, also testified in the hearing concerning the report.

The congressional hearing examined how identity theft contributes to tax fraud and whether the IRS and the Social Security Administration are doing enough to protect Social Security numbers and to prevent and detect false tax returns filed by identity thieves.

TIGTA reported that as of Dec. 31, 2011, the IRS’s Identity Protection Incident Tracking Statistics Reports showed that 641,052 taxpayers were affected by identity theft in 2011.

TIGTA reviewed IRS data from 1.1 million identity theft cases, interviewed IRS employees, and reviewed IRS processes and guidelines. TIGTA discovered that the “IRS is not effectively providing assistance to victims of identity theft, and current processes are not adequate to communicate identity theft procedures to taxpayers, resulting in increased burden for victims of identity theft.”

TIGTA found several problems:

1. The IRS does not handle identity theft cases in a timely fashion and can take more than a year to resolve them.
2. Communications between the IRS and victims are limited and confusing, and victims are asked multiple times to substantiate their identity.
3. When taxpayers call the IRS to advise it that their electronic tax return was rejected because it appears another individual has already filed a tax return using their identity, the IRS instructs them to mail in a paper tax return with Form 14039, Identity Theft Affidavit, attaching supporting identity documents. However, the IRS has been processing these tax returns using standard procedures.
4. Identity theft guidelines and procedures are dispersed among 38 different Internal Revenue Manual sections. These guidelines are inconsistent and conflicting, and not all functions have guidelines on handling identity theft issues.
5. The IRS uses little of the data from the identity theft cases to identify any trends that could be used to detect or prevent future refund fraud.

TIGTA made eight recommendations, which the IRS agreed to. TIGTA recommended that the IRS:

1. Establish accountability for its Identity Theft Program;
2. Implement a process to ensure that IRS notices and correspondence are not sent to the address listed on the identity thief’s tax return;
3. Conduct an analysis of the letters sent to taxpayers regarding identity theft;
4. Ensure taxpayers are notified when the IRS has received their identifying documents;
5. Create a specialized unit in the Accounts Management function to exclusively work on identity theft cases;
6. Ensure all quality review systems used by IRS functions and offices working on identity theft cases are revised to select a representative sample of identity theft cases;
7. Revise procedures for its Correspondence Imaging System screening process; and
8. Ensure programming is adjusted so that identity theft issues can be tracked and analyzed for trends and patterns.

Also among witnesses in the congressional hearing was National Taxpayer Advocate Nina Olson, who said the Taxpayer Advocate Service (TAS) she heads has also seen a surge in identity theft cases, with a 97% increase in fiscal year 2011 over fiscal year 2010 (see graphic, “Identity Theft Now Top TAS Issue,” below). The trend appears to be continuing in 2012, she said, with a 43% increase in the first two quarters over the same period in 2011.

The Tax Court upheld a disallowance of more than $22,000 of a couple’s charitable contribution deduction solely for the lack of a contemporaneous statement from their church, the donee, that the couple received no goods or services in return.

The taxpayers, David and Veronda Durden, made the contributions by check, with most of the checks larger than $250, and claimed the amount as part of a $25,171 charitable contribution deduction on Schedule A of their joint return for 2007. The IRS disallowed the deduction, and the couple produced records of the contributions, including copies of canceled checks and a letter dated Jan. 10, 2008, from the church acknowledging $22,517 in contributions during the year. However, the IRS did not accept the acknowledgment because it lacked the required statement.

Sec. 170(f)(8) provides that, to be deductible, a money contribution of $250 or more must be substantiated by a contemporaneous written acknowledgment by the donee organization that indicates the amount and whether the organization provided any goods or services in consideration for the contribution and, if so, a good-faith estimate of their value.

The Durdens obtained a second letter from the church dated June 21, 2009, that contained the same information as before, plus the statement. However, the IRS did not accept it, either, since it was not contemporaneous, defined by Sec. 170(f)(8)(C) as obtained by the taxpayer by the return’s due date (including extensions) or, if earlier, the date the taxpayer files the return.

The Tax Court rejected several arguments by the taxpayers, including that the doctrine of substantial compliance should allow the deduction. The doctrine has been applied where, despite a lack of strict compliance, taxpayers have fulfilled the essential statutory purpose of a requirement. The essential statutory purpose of the acknowledgment requirement is to assist taxpayers in determining their deduction and to aid the IRS in processing returns, the court said. But without a statement that no goods or services were received from the donee organization, neither purpose can be fulfilled, the court said.

Durden, T.C. Memo. 2012-140