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TAX MATTERS
Eighth Circuit agrees that CPA was underpaid  
By Charles J. Reichert, CPA
May 2012

The Eighth Circuit Court of Appeals held that a portion of the dividends paid by an S corporation to its CPA sole shareholder/employee was compensation. In upholding the decision by the District Court of Southern Iowa, the Eighth Circuit agreed that the salary to the sole shareholder/employee used to compute Federal Insurance Contributions Act (FICA) taxes was unrealistically low.

A corporate employer may deduct salary payments for income tax purposes, but it and the payee must pay FICA taxes on those amounts. However, unlike partners and LLC members, S corporation shareholders do not pay FICA taxes on their distributive share of the business’s income. Courts have recharacterized corporate compensation payments as a dividend for income tax purposes when the amount was determined to be unreasonably high, and they have recharacterized corporate dividend payments as compensation for FICA tax purposes when the amount was determined to be unreasonably low (see “Reasonable salary for S corporation owners,” page 60).

David Watson, a CPA, formed David E. Watson PC (DEWPC), an Iowa professional corporation electing to be taxed as an S corporation, in which he was the sole owner, shareholder, director, and employee. Under an employment agreement with DEWPC, Watson provided exclusive accounting expertise to an accounting firm in which he had formerly been a partner. In 2002 and 2003, DEWPC paid Watson a salary of $24,000 each year and distributed dividends to him of $203,651 in 2002 and $175,470 in 2003. In 2007, the IRS assessed FICA taxes, interest, and penalties against DEWPC, recharacterizing a portion of the dividends it had paid to Watson in 2002 and 2003 as compensation.

During the district court bench trial, DEWPC unsuccessfully argued that its intent to pay Watson a salary of $24,000 should control the characterization of the payments. The court held that the character of the payments should rather depend on whether they were remuneration for services performed, as determined by the economic realities of the situation. According to the court, intent was one factor to be considered; however, other factors must be considered as well, including the employee’s qualifications, the nature of his duties, and comparable compensation for similar duties by similar entities. The court accepted the $91,044 annual salary calculated by an IRS expert witness as reasonable, since Watson was an extremely qualified accountant, had about 20 years of experience, and worked 35–45 hours per week for a well-established firm as one of its primary revenue producers. The court concluded that DEWPC’s assertion it intended to pay Watson a salary of $24,000 per year was “less than credible.” DEWPC appealed the decision to the Eighth Circuit.

In its appeal, DEWPC argued that the district court decision had in essence established a minimum salary although no such statutory or regulatory requirement exists. The Eighth Circuit could find no error in the lower court’s use of the reasonable compensation standard for FICA tax purposes or in any other part of its analysis, including its reliance on the finding of the expert witness.


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


TAX MATTERS
Partnerships can issue Schedules K-1 electronically  
May 2012

The IRS issued Rev. Proc. 2012-17, which contains rules partnerships must follow to supply Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., electronically. The guidance was effective Feb. 13.

A person required to furnish Schedules K-1 to partners (furnisher) can do so in an electronic format, provided the recipient has affirmatively consented to receive it in an electronic format and demonstrated that he or she can access the document in the electronic format in which it will be furnished.

If a furnisher changes its hardware or software and the change creates a material risk that the recipient will not be able to access the Schedule K-1, the furnisher must notify the recipient before it changes the hardware or software. The furnisher must explain that a new consent is required in the new electronic format to establish that the recipient is able to access the Schedule K-1 in that format.

Furnisher’s required disclosures. Before or at the same time as the furnisher obtains the recipient’s consent, the furnisher must provide an electronic or paper disclosure with the following information:

  • That the Schedule K-1 will be provided on paper if the recipient does not consent to electronic delivery.
  • The duration of the consent—whether the consent will apply to future Schedules K-1 until the consent is withdrawn or only to the Schedule K-1 that the recipient is consenting to receive currently.
  • The procedure to be used in the future to request a paper statement, and whether the furnisher will treat such a request as a withdrawal of consent.
  • The procedures for withdrawing consent, including contact information and the furnisher’s confirmation of the withdrawal and its effective date.
  • The conditions in which the furnisher will cease providing electronic statements (such as withdrawal from the partnership).
  • The procedures for updating a recipient’s contact information and that the furnisher will notify recipients of any change in the furnisher’s contact information.
  • A description of the hardware and software needed to access, print, and retain the Schedule K-1, the date after which the schedule will be unavailable on the website, and the information that the recipient may need to attach copies to federal, state, or local income tax returns.


Notice that Schedule K-1 is available. If the Schedule K-1 is posted on a website, the furnisher must notify the recipient by mail, email, or in person. The notice must explain how to access and print the Schedule K-1 and contain a specified subject line heading if sent by email. If the notice is sent electronically and returned as undeliverable and the furnisher cannot obtain a corrected address, the furnisher must provide a Schedule K-1 by mail or in person within 30 calendar days after the electronic notice is returned.

An original or amended Schedule K-1 must be retained on the website until the later of 12 months after the end of the partnership’s tax year or six months after the form is issued.


TAX MATTERS
AICPA: Correspondence audits challenge taxpayers  
May 2012

The IRS’s use of correspondence audits to resolve issues with tax returns has mushroomed over the past decade—but taxpayer satisfaction with the program is fairly low. According to the Treasury Inspector General for Tax Administration (TIGTA), only 48% of those surveyed by the IRS said they were either somewhat or very satisfied with the service related to their audit.

Correspondence audits were the subject of a public hearing in February by the IRS Oversight Board.

The IRS uses correspondence audits to obtain additional information from taxpayers about a few limited issues on the taxpayer’s return. Correspondence audits are generally narrower than a traditional audit and are conducted by mail or other written communications, making them cheaper and less labor-intensive for the IRS.

Among the chief sources of taxpayer dissatisfaction are the excessive time it takes the IRS to resolve cases and difficulties reaching someone to learn the status of a case. Under the IRS’s earlier call system, 13% of callers phoned more than eight times before their issue was resolved, and 70% of the calls went to voice mail. The IRS has started to implement a system designed to provide a faster connection to someone who can answer a taxpayer’s question.

“AICPA members are very familiar with the difficulties and challenges taxpayers have faced with correspondence examinations,” said AICPA Tax Executive Committee Chair Patricia Thompson, one of four panelists at the hearing. Problems identified by members and previously communicated to the IRS are similar to those in the survey. However, she cited informal feedback from CPAs that the IRS is doing a better job at waiting to issue deficiency notices (90-day letters) until it reviews correspondence from taxpayers.

Thompson recommended that the IRS:

  • Review internally whether the correct types of returns are being selected for correspondence audits.
  • Expand e-services to alleviate delays in telephone and mail processing and expedite communications.
  • Be given adequate resources to effectively and efficiently administer tax laws and collect taxes.


Thompson also said that taxpayers are often requested to substantiate tax deductions such as miscellaneous itemized deductions, state and local income taxes, and real estate taxes. However, if taxpayers are in an alternative minimum tax position, which does not allow these deductions, disallowing them generally does not result in an additional tax liability—a waste of resources for the IRS. She suggested that the IRS screen out such cases.


TAX MATTERS
Line items  
May 2012
"Fresh Start" refreshed

The IRS expanded its “Fresh Start” initiative in March to help struggling taxpayers.

For the 2011 tax year, the IRS said, it will abate the failure-to-pay penalty (0.5% per month of tax due, up to a maximum of 25%) until Oct. 15, 2012, provided the tax, interest, and any other penalties due are paid by that date. Failure-to-file penalties are not being waived.

Qualifying taxpayers include:

  • Wage earners who were unemployed at least 30 consecutive days during 2011 or 2012 up to the April 17, 2012, filing deadline.
  • Self-employed people who in 2011 experienced a 25% or greater reduction in business income due to the economy.


They must also have had income of $200,000 or less for married taxpayers filing jointly or $100,000 for single or head-of-household filers, and owe $50,000 or less in tax.

New Form 1127-A, Application for Extension of Time for Payment of Income Tax for 2011 Due to Undue Hardship, must also be filed.

In the same announcement (IR-2012-31), the IRS said it is doubling the dollar threshold for tax balance-due amounts that qualify for the streamlined installment agreement program to $50,000. The threshold had been raised from $10,000 to $25,000 in the first Fresh Start initiative announced less than a year earlier (IR-2011-20). The maximum term for streamlined payment agreements was also raised, from five years to six years.

Portability election extended

The IRS announced in Notice 2012-21 that estates of decedents dying in the first half of 2011 may obtain an extension of 15 months from the date of death to make a “portability election” to apply the decedent’s unused estate and gift tax exclusion amount to a surviving spouse.

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312, raised the estate and gift exclusion amount to $5 million for decedents dying in 2011, indexed for inflation in subsequent years. Even estates valued at less than that amount, however, must file Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, to make the portability election. The form is normally due within nine months after the decedent’s date of death. An automatic six-month filing extension is available, normally by filing Form 4768, Application for Extension of Time to File a Return and/or Pay U.S. Estate (and Generation-Skipping Transfer) Taxes, before the due date for Form 706. Estates that timely filed Form 4768 to request a six-month extension do not qualify for the longer extension under the notice.

In earlier discussions with the IRS, the AICPA had expressed its concerns and requested the Service consider relief for situations in which the estate might not have made the portability election because it did not otherwise have to file Form 706. In the notice, the IRS acknowledged such concerns.

Mandatory FBAR e-filing postponed

Treasury’s Financial Crimes Enforcement Network (FinCEN) postponed until July 1, 2013, its requirement that Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR), be filed electronically. FinCEN notes that the delay in the e-filing requirement does not relieve anyone of the obligation to file a paper FBAR or postpone the paper-filing due date.

FinCEN announced last July that it had developed an electronic filing system for FBARs. Last September, it proposed making FBAR e-filing mandatory, starting with FBARs due June 30, 2012. The FBAR filing requirements, authorized under the Bank Secrecy Act, P.L. 91-508, have been in place since 1972. The FBAR form is used to report a financial interest in, or signature or other authority over, one or more financial accounts in foreign countries.

No report is required for a year during which the accounts’ aggregate value does not exceed $10,000 at any time.

Noted in passing

The Tax Court correctly denied a charitable deduction for a house donated to a fire department for destruction in a firefighter training exercise, the Seventh Circuit held (Rolfs, No. 11-2078 (7th Cir. 2/8/12)).

The appellate court agreed with the IRS and Tax Court (see “Tax Matters: Burnt Offering Rejected,” Feb. 2011, page 56; 135 T.C. 471 (2010)) that the before-and-after valuation method used by the taxpayers failed to account for a key condition of the donation—that the property had to be removed or destroyed—and that the taxpayers received a benefit because having the house burned by the fire department saved them from having to pay a substantial amount to have it demolished.

The IRS in Rev. Proc. 2012-23 adjusted for inflation for 2012 the depreciation limitations and lease inclusion amounts for certain automobiles under Sec. 280F. For passenger automobiles (other than trucks or vans) placed in service during calendar year 2012 to which 50% first-year bonus depreciation applies, the depreciation limit under Sec. 280F(d)(7) is $11,160 for the first tax year. For trucks and vans to which bonus depreciation applies, the first-year limit is $11,360. If bonus depreciation does not apply, the corresponding first-year amounts for 2012 are $3,160 (passenger automobiles) and $3,360 (trucks and vans).

For passenger automobiles, the limits are $5,100 for the second tax year, $3,050 for the third tax year, and $1,875 for each successive tax year. For trucks and vans, the limits are $5,300 for the second tax year; $3,150 for the third tax year; and $1,875 for each successive tax year.


TAX MATTERS
Tax Court respects stock sale, denies transferee liability  
By Laura Jean Kreissl, Ph.D., and Darlene Pulliam, CPA, Ph.D.
May 2012

In Norma L. Slone, the petitioners prevailed when the Tax Court refused to apply the substance-over-form doctrine to recast a sale of a company’s stock following an asset sale as a liquidating distribution. The court further found that the taxpayers were not liable as transferees under Sec. 6901 for taxes arising from the asset sale.

Substance over form and its related judicial doctrines are used to determine the true meaning of a transaction disguised by formalisms that exist solely to alter tax liabilities. In such instances, the substance of a transaction, rather than its form, will be given effect. Courts generally respect the form of a transaction but will apply the substance-over-form principles when warranted.

Sec. 6901(a) provides a procedure through which the IRS may collect from a transferee unpaid taxes owed by the transferor of assets if applicable state law or equity principles provide an independent basis for holding the transferee liable for the transferor’s debts.

In 2000, Slone Broadcasting Corp. (SBC), a Tucson, Ariz.-based, family-owned and -operated C corporation, sold its radio station assets to a larger competitor. Then, in 2001, Slone sold its stock to an affiliate of Fortrend International LLC, which had approached SBC with a strategy to offset taxable income from the asset sale with a loss on high-basis/low-value Treasury notes. Although advisers to SBC knew of the existence of a strategy, they were not told its details, with Fortrend saying only that they were “proprietary” and that they did not constitute any of the 16 listed transactions summarized in Notice 2001-51. As part of the sale, the affiliate assumed liability for $15 million in federal income taxes owed on the asset sale. Then Fortrend contributed the Treasury notes to the affiliate, with which SBC merged.

The IRS audited the successor corporation, Arizona Media, and determined an income tax deficiency of nearly $13.5 million and a penalty under Sec. 6662 of nearly $2.7 million. The IRS levied the amount, but Arizona Media made no payments and was administratively dissolved by the state of Arizona for failing to file an annual report.

The IRS issued transferee notices for the unpaid liability to SBC shareholders including the founding family members, James Slone and his wife. The notices stated that the stock sale was substantially similar to an “intermediary transaction” tax shelter as described in Notice 2001-16 and recharacterized the asset and stock sales as an asset sale followed by a liquidating transaction. The Slones petitioned the Tax Court.

Before trial, the IRS conceded that the stock sale was separate from the asset sale but argued it was still a liquidating distribution under the substance-over-form doctrine. However, the taxpayers successfully showed that the sales were distinct, that no tax strategies to offset potential gains were discussed, and due diligence was employed to investigate and negotiate the stock sale. There are legitimate tax planning strategies to defer or avoid paying taxes, so it was not unreasonable for the taxpayers to believe that Fortrend had a legitimate method of doing so. When SBC’s advisers were told that Fortrend’s methods were proprietary, they did not have a duty to inquire further and were not responsible for any tax strategies used after the closing of the stock sale, the court said. Consequently, the Tax Court refused to apply the substance-over-form doctrine and held for the petitioners.


By Laura Jean Kreissl, Ph.D., assistant professor of accounting, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.


TAX MATTERS
FTC "splitter" rules issued  
May 2012

The IRS issued final regulations on determining who has the legal liability to pay the foreign tax for foreign tax credit (FTC) purposes (T.D. 9576) and temporary regulations on the application of the “anti-splitter” rules of Sec. 909 (T.D. 9577). The rules are related because the legal liability to pay foreign tax affects the determination of whether foreign income has been inappropriately split off from the tax under Sec. 909.

The issues are so intertwined that the IRS withdrew the part of the proposed regulations governing who the taxpayer is for purposes of a reverse hybrid arrangement (an entity treated as a corporation for U.S. tax purposes and as a branch or fiscally transparent entity for foreign purposes) (Prop. Regs. Sec. 1.901-2(f)(2)(iii)).

Who is the taxpayer? T.D. 9576 explains that, if foreign tax is imposed on the combined income of two or more persons (e.g., a husband and wife or a corporation and its subsidiary), the tax is considered to be apportioned pro rata based on each person’s portion of the combined income, regardless of who is obligated to pay the tax under foreign law. Foreign tax is imposed on combined income if the persons compute their taxable income on a combined basis under foreign law and foreign tax would otherwise be imposed on each such person on its separate taxable income (Regs. Sec. 1.901-2(f)(3)).

For partnerships that are taxed at the entity level under foreign law, the partnership is considered to be legally liable and thus is considered to pay the tax for federal income tax purposes. For disregarded entities that are taxed under foreign law at the entity level, the person who is treated for federal tax purposes as owning the entity’s assets is treated as having legal liability for the foreign tax. Again, these rules apply regardless of who is obligated to pay the tax under foreign law (Regs. Sec. 1.901-2(f)(4)).

The rules under T.D. 9576 apply to foreign taxes paid or accrued in tax years beginning after Feb. 14, 2012, but taxpayers may choose to apply Regs. Sec. 1.901-2(f)(3) to foreign taxes paid or accrued in tax years beginning after Dec. 31, 2010, and on or before Feb. 14, 2012. There are also special rules for applying the earlier version of Regs. Sec. 1.901-2(f)(4) retroactively (Regs. Sec. 1.901-2(h)(4)).

Prohibiting foreign income tax splitting. Sec. 909 was enacted to prevent foreign income taxes from being separated from the related income. The rules prohibit taking the foreign tax into account for federal FTC purposes before the tax year in which the related income is taken into account by the taxpayer (T.D. 9577). One example of such a situation is a “hybrid instrument splitter arrangement,” which involves a U.S. hybrid equity instrument that is treated as equity under U.S. law but as debt for foreign purposes, which permits a deduction for foreign purposes for interest expense but not a corresponding taxable interest payment in the United States.

Another splitter arrangement is a “reverse hybrid splitter arrangement,” in which an entity that is a corporation for U.S. purposes is treated as a fiscally transparent entity or a branch under the laws of the foreign country imposing the tax. T.D. 9577 defines these arrangements and provides an exclusive list of them in Temp. Regs. Sec. 1.909-2T(b). The rules defining splitter arrange ments apply to foreign taxes paid or accrued in tax years beginning after Dec. 31, 2011.

Sec. 909 applies to foreign income taxes paid or accrued in tax years beginning after Dec. 31, 2010. Notice 2010-92 contains the rules to apply to pre-2011 splitter arrangements, which are supplemented in Temp. Regs. Sec. 1.909-6T. Those rules are necessary to prevent Sec. 909 from applying in computing taxes before the first day of an entity’s post-2010 tax year. Temp. Regs. Sec. 1.909-5T contains transitional rules that apply to foreign taxes paid or accrued in tax years beginning in 2011 and on or before Feb. 14, 2012.


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