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Image rights create royalty payments  
By Charles J. Reichert, CPA
June 2013

The Tax Court held that fees received by foreign professional golfer Sergio Garcia under an endorsement agreement should be treated as 65% royalty compensation and 35% personal service compensation, based on the facts and circumstances of the agreement. The court also held that Garcia’s U.S. image rights payments were royalties and thus exempt from U.S. tax since the U.S.-Switzerland Income Tax Treaty exempts royalty income from U.S. taxation. All of the taxpayer’s U.S. personal service compensation was taxable to the United States, however, since the court held that he had previously conceded the issue to the IRS.

When foreign golfers receive income from endorsement agreements, the court has divided the income between personal service income and royalty income based on the facts and circumstances of the case (see Retief Goosen, 136 T.C. 547 (2011), and Tax Matters coverage, “Golfer Bogies Endorsement Income,” Sept. 2011, page 66). In addition, the United States has tax treaties with numerous countries to coordinate taxation of income. Article 12 of the U.S.-Switzerland Income Tax Treaty exempts royalty income of Swiss residents from U.S. taxation, while Article 17 of the same treaty permits the United States to tax the income of Swiss actors, radio and TV personalities, musicians, and sportsmen from their personal activities conducted in the United States.

Garcia, a well-known professional golfer and a resident of Switzerland, signed a seven-year endorsement agreement starting in 2003 with TaylorMade, a company that sells golf equipment and accessories. TaylorMade paid an annual fee to Garcia who, in turn, was required to exclusively use TaylorMade products, play in a minimum number of golf events, and make a minimum number of personal appearances. TaylorMade also received the right to use Garcia’s image to promote its products worldwide. Garcia sold his image rights to Long Drive, his 99.5%-owned Swiss corporation, in exchange for a promissory note. Long Drive then assigned the note to Even Par, a U.S. corporation owned 99.8% by Garcia. TaylorMade made all image rights payments to Even Par, which transferred the money to Long Drive, which then paid the amount to Garcia in satisfaction of his promissory note.

In 2010, the IRS issued deficiency notices for 2003 and 2004 totaling $1,719,766, arguing all of Garcia’s endorsement income was personal service income. Garcia petitioned the Tax Court for relief.

The court allocated 35% of the endorsement income to personal service income and 65% to royalty income based on the facts and circumstances of the agreement, using an analysis similar to the one it used in Goosen, while acknowledging that a perfect allocation is not possible.

Concerning the image rights payments, the IRS argued they could be taxed by the United States since Article 17 of the U.S.-Switzerland Income Tax Treaty permits the United States to tax a Swiss resident’s income derived from personal activities performed as a sportsman in the United States. Garcia maintained that the payments were royalties and that Article 12 of the same treaty specifically exempts royalties from U.S. taxation. The court agreed with the taxpayer, citing a Treasury Department technical explanation of Article 17 of the treaty. In the technical explanation, an entertainer who conducts a performance in a source country could be taxed by the source country on the income from the performance but would not be taxed on royalties from the sale of recordings of the performance. In a similar manner, the court held, the income from Garcia’s sale of the image rights was not attributable to his performance in the United States. Instead, the image rights were a separate intangible asset that produced royalties.

Since the court held that income from the image rights could not be taxed by the United States under the treaty even if Garcia had received them directly, it did not consider the IRS’s arguments that Garcia’s use of Long Drive had violated the assignment-of-income and economic substance doctrines. The court, however, rejected Garcia’s attempt to reduce the amount of his personal service income subject to U.S. tax since he had not raised the issue in a timely manner.

  Garcia, 140 T.C. No. 6 (2013)

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

Partner cannot avoid valuation penalty by conceding on other grounds  
June 2013

In a big win for the IRS, the Tax Court refused to grant partial summary judgment to a partner who had conceded his tax shelter case on grounds other than valuation in an attempt to avoid the 40% gross valuation misstatement penalty under Sec. 6662(a). This has been a common method used by taxpayers who have invested in tax shelters, in an attempt to avoid the draconian 40% penalty.

The IRS issued a final partnership administrative adjustment (FPAA) to Alan Ginsburg, a partner other than the tax matters partner in AHG Investments LLC, that disallowed more than $10 million in losses passed through from AHG to Ginsburg, for 2001 and 2002. The FPAA contained 14 alternative grounds for the disallowance, including that the losses were due to a gross valuation misstatement. The IRS also asserted 40% accuracy-related penalties for the portions of Ginsburg’s underpayments of tax resulting from adjustments of partnership items attributable to the gross valuation misstatement. Ginsburg conceded that the adjustments were correct under two of the FPAA’s other grounds, that he was not at risk under Sec. 465, and that the transaction did not have substantial economic effect under Regs. Sec. 1.704-1(b). Ginsburg then sought partial summary judgment that the IRS could not apply the 40% penalty.

In determining whether to grant Ginsburg’s request, the court was faced with its own precedents in McCrary, 92 T.C. 827 (1989), and Todd, 89 T.C. 912 (1987) (Todd I), as well as a case from the Ninth Circuit (Gainer, 893 F.2d 225 (9th Cir. 1990)) and the Fifth Circuit’s affirmance of Todd I, 862 F.2d 540 (5th Cir. 1988) (Todd II). These cases held that the legislative history of Sec. 6662(a) supported the interpretation that, when a taxpayer conceded a case on grounds other than a valuation understatement, the 40% penalty could not apply.

In rejecting the reasoning in McCrary, Todd, and Gainer, the Tax Court noted that the majority of appeals courts have held that that interpretation of the legislative history in these cases is incorrect and that even the Fifth and Ninth Circuits have suggested the majority rule is correct, while continuing to follow the minority rule. The Tax Court also explained that stare decisis (the doctrine that court precedent generally must be followed) should not apply when there is ample evidence that its earlier decisions were wrong.

The court also found that taxpayers had abused the rule it established in these earlier cases to avoid the 40% penalty. It further concluded that one of its goals for originally adopting the rule, that it would encourage taxpayers to settle cases and not burden the courts with difficult valuation issues, would be better achieved by discouraging taxpayers from engaging in tax avoidance in the first place.

A final consideration before overruling its own earlier decisions was whether doing so would conflict with the current precedent in the Fifth and Ninth Circuits (from Todd II and Gainer, respectively). To ensure that it did not, the court had to determine in which circuit an appeal of Ginsburg’s case would lie. The court found that there was no evidence where the partnership (which might not have still been in existence when the petition to the Tax Court was filed) had its principal place of business, which would normally be the jurisdiction for FPAA appeals. According to the court, where no jurisdiction can be determined and the parties have not stipulated to where the appeal would lie, the D.C. Circuit hears the case. Therefore, changing its position would not conflict with circuit precedent in the Fifth or Ninth Circuit.

Having decided to overrule its holdings in McCrary and Todd I, the Tax Court held that Ginsburg could not avoid the penalty by conceding on alternative grounds and denied his motion for partial summary judgment.

  AHG Investments, LLC, 140 T.C. No. 7 (2013)

Courts diverge on basis in shares received in demutualization  
By Karen M. Cooley, CPA, MBA and Darlene Pulliam, CPA, Ph.D.
June 2013

Two district courts reached opposite conclusions on whether stock received by policyholders in connection with demutualization of insurance companies had a cost basis greater than zero. They agreed, however, that the “open transaction doctrine” did not apply.

The first case is Dorrance, in the District of Arizona. The second is Reuben, in the Central District of California. In each situation the plaintiffs had purchased a life insurance policy or policies from mutual companies. Along with the insurance benefits, the policies granted the plaintiffs mutual ownership rights in the companies. The companies subsequently demutualized and converted into stock-based companies. As a result, the plaintiffs lost their mutual rights, which included the right to share in company profits, the right to vote, and the right to a preferred position in the event of liquidation. The plaintiffs were compensated for the loss of their mutual rights with shares of stock in the new companies. Upon subsequent sale of these shares, the plaintiffs reported a zero cost basis in the stock and a gain equal to the amount of proceeds, consistent with the IRS’s long-standing position on basis of stock received in a demutualization.

However, in Fisher, 82 Fed. Cl. 780 (2008), aff’d without opinion, 33 Fed. Appx. 572 (2009), the Court of Federal Claims held that surrendered insurance demutualization rights could have a discernible value and compensation for them a corresponding basis. The plaintiffs in Dorrance and Reuben later filed claims for refund, contending they did not owe tax on the proceeds. The plaintiffs in both cases argued that the demutualization should be covered by the open transaction doctrine, which was applied in Fisher. The open transaction doctrine may be applied when property is split and it is impossible or impracticable to allocate the cost of that property to the resulting assets. In such case, a taxpayer does not recognize any capital gain until the entire cost basis of the original property has been recovered.

Both district courts held that the open transaction doctrine did not apply because the mutual rights were not “elements of value so speculative in character as to prohibit any reasonably based projection of worth” (both quoting Campbell, 661 F.2d 209, 215 (1981)). That is, it was not impossible to determine an equitable division and allocation of the original basis in the mutual companies. As a result, the issue remaining for the courts was to determine if there actually was a basis in the stock and, if so, an appropriate method to calculate that basis and thus determine any taxable gain on the sale of that stock.

In Dorrance, the insurance companies determined the number of shares of stock to give policyholders upon demutualization by calculating both a fixed component for the loss of voting rights and a variable component for loss of other rights, based on each policyholder’s past and projected future premium contributions to the company’s surplus (book value). Sixty percent of this variable component reflected the past contributions to surplus, and the remaining 40% was an estimate of future contributions. The insurance companies determined that the fair market value of the shares issued to the policyholders was equivalent to the value of the mutual rights they gave up. As a result, the valuation of the mutual rights was the initial public offering price of the shares of stock they received as a result of the demutualization.

The court ruled for the husband and wife plaintiffs, stating that the basis should be calculated from the fixed component plus the 60% of the variable component that related to past contributions to surplus.

In Reuben, the court ruled the opposite, determining that the plaintiff had a zero basis in the stock, based on several arguments. First, regardless of the difficulty, it is the taxpayers’ burden to establish that they have a basis in property. Plaintiff Timothy Reuben argued that some portion of the premiums paid on the life insurance policy was for membership rights, but he failed to provide any evidence in support of that position.

The IRS provided substantial evidence that none of the premiums paid were for the membership interests rather than the underlying life insurance policy. For example, at the time of demutualization, the insurance company informed its policyholders that “the cost of common shares acquired in exchange for ownership rights will be nil,” and that the tax basis in these shares would be zero. Policyholders were further informed that they would not recognize any taxable gain or loss when they received the common shares, but when the shares were subsequently disposed of, a taxable gain would be reported equal to the proceeds from that sale. Likewise, an independent actuary stated that the “demutualization benefits are a windfall to the eligible policyholders” and the administrator of the trust in which the policies were held indicated that the cost basis of the stock on the date of acquisition would be zero.

Furthermore, the value of the membership rights before demutualization was zero, and it was the process of demutualization that gave those rights a monetary value, an expert for the IRS stated. Lastly, the premiums paid for the life insurance policies did not change after the demutualization, which would indicate that all the premiums paid prior to the demutualization were for the underlying life insurance policy and not for membership rights.

In light of these arguments and the fact that the taxpayer did not provide any evidence as to what was paid for the mutual rights separately from the policy as a whole, the court found that Reuben had failed to satisfy his burden to establish that the basis was other than zero and thus ruled in favor of the IRS.

Dorrance, No. CV-09-1284-PHX-GMS (D. Ariz. 3/19/13); earlier proceedings at 877 F. Supp. 2d 827 (D. Ariz. 2012)

Reuben, No. CV-11-09448 SJO (C.D. Cal. 1/15/13)

By Karen M. Cooley, CPA, MBA, instructor of accounting, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Business, both of the College of Business, West Texas A&M University, Canyon, Texas.

CPA’s nonfiling ruled inadmissible for abusive shelter promotion penalty  
June 2013

Evidence of a CPA’s failure to file and pay his own taxes was not properly admissible in determining his penalty for promoting an abusive tax shelter, the Fourth Circuit held. The appellate court thus vacated a $2.6 million penalty and liability verdict against CPA Robert Nagy and reversed and remanded his case to a district court.

Nagy had issued an opinion on the Derivium 90% loan program, in which investors purportedly transferred securities as “collateral” in return for a loan from Derivium of 90% of the securities. His opinion stated that the transactions were bona fide loans and not sales of the securities. Derivium claimed it would use the securities it received in hedging transactions and return them when the investors repaid their loans, but the entire program was in fact a Ponzi scheme in which Derivium immediately sold the securities it received to continue perpetrating the scheme. Upon investigation, the IRS determined that the 90% loans were actually sales of the securities for tax purposes (see, e.g., Calloway, 135 T.C. 26, aff’d, 691 F.3d 1315 (11th Cir. 2012), and Shao, T.C. Memo. 2010-189, and previous Tax Matters coverage, “Stock ‘Loans’ Ruled Sales,” Nov. 2010, page 63).

As a result of Nagy’s involvement in the scheme, the IRS assessed penalties against him under Sec. 6700 for promoting a tax shelter. He paid part of the penalty and sued for a refund in district court. At trial, the district court allowed the IRS to introduce as evidence regarding his Sec. 6700 liability Nagy’s failure to file his personal income tax returns and to pay his taxes.

According to the Fourth Circuit, the rules of evidence prohibit admission of evidence of a crime, wrong, or other act to prove a person’s character to show that on a particular occasion the person acted in accordance with that character. It agreed with Nagy, who argued that this evidence was not relevant to his liability under Sec. 6700 for an unrelated transaction and served only to cast him in a bad light.

The IRS claimed that evidence of his behavior in failing to file his taxes at the same time he was issuing an opinion about the tax shelter was relevant to show an absence of mistake in his tax advice. The Fourth Circuit found that there was no relationship between the two transactions (his returns and the tax shelter) and that the evidence was so prejudicial that it must be excluded. It held that the district court had abused its discretion in admitting the evidence and therefore vacated the liability and penalty verdicts and remanded the case to the district court.

Nagy, No. 10-2072 (4th Cir. 3/29/13)

IRS extends suspension of examinations of “repair reg.” issues  
June 2013

The IRS updated its Large Business & Industry (LB&I) directive on the repair vs. capitalization issue that extends the suspension of field examinations (LB&I-04-0313-001) in keeping with its previous postponement of the effective date of the tangible property temporary regulations (T.D. 9564) (in amendments published Dec. 17, 2012) to tax years beginning on or after Jan. 1, 2014. The IRS has provided its personnel with modified examination instructions for tax years beginning on or after Jan. 1, 2012, and before Jan. 1, 2014, and restated its earlier examination instructions for tax years beginning before Jan. 1, 2012, and on or after Jan. 1, 2014.

In February, the IRS, recognizing that many taxpayers are expending resources to comply with the temporary regulations and responding to comments from taxpayers, announced in Notice 2012-73 that when the final regulations are published, certain rules will be simplified. The notice permitted taxpayers the option of applying the regulations currently or delaying the effective date until Jan. 1, 2014.

For examinations of tax years beginning before Jan. 1, 2012, examiners are instructed to discontinue current exam activity and not begin any new activity with regard to:

  • Whether costs incurred to maintain, replace, or improve tangible property must be capitalized under Sec. 263(a); and
  • Any correlative issues involving the disposition of structural components of a building or dispositions of tangible depreciable assets (other than a building or its structural components).

The IRS explained that, for tax years beginning on or after Jan. 1, 2012, and before Jan. 1, 2014, if a taxpayer has changed its method of accounting under the repair regulations, with or without filing a Form 3115, Application for Change in Accounting Method, the examiner must perform a risk assessment regarding the method change. If the taxpayer has not changed its accounting method, the “option period” (the period before the applicability dates of the forthcoming final regulations, during which a taxpayer may choose to apply the temporary regulations) is still open, and the examiner is instructed not to examine the issue.

In addition, for tax years beginning before Jan. 1, 2012, the IRS reiterated its earlier instructions, telling examiners to:

  1. Withdraw the portions of Forms 4564, Information Document Request, that relate to the development of these issues.
  2. Withdraw all Forms 5701, Notice of Proposed Adjustment, related to these issues.
  3. Issue a new Form 5701 with a Form 886-A, Explanation of Items, with language specified in the directive, essentially, that the IRS does not accept or reject the position the taxpayer took in its return on these issues; the taxpayer has a two-year period to adopt the appropriate method of accounting under Rev. Proc. 2012-19 or Rev. Proc. 2012-20 or any other revenue procedures issued in the future; and if the taxpayer does not adopt the new method within that time, the taxpayer may be subject to exam for tax years beginning on or after Jan. 1, 2014.


Automated substitutes for return drop by half  
June 2013

After increasing eightfold from fiscal 2002 to 2011, the number of returns generated by the IRS’s Automated Substitute for Return (ASFR) program fell by half in fiscal 2012, and tax assessments under the program decreased by 54% (see related graphic, “Automated Substitutes for Return Decline”).

The ASFR program uses information returns including Form W-2, Wage and Tax Statement, and the Form 1099 series, plus other internal data, to prepare a return for individuals who appear to owe a significant income tax liability for one or more tax years but did not file a return. The IRS then issues a proposed assessment (Letter 2566) informing taxpayers they must file a valid return, consent to the proposed assessment, or appeal it within 30 days. Taxpayers who do not respond receive a statutory notice of deficiency.

In her 2012 Annual Report to Congress, National Taxpayer Advocate Nina Olson noted the decline in ASFR activity, attributing it to workload issues and a new practice of limiting the number of returns assessed at one time on the same taxpayer. The IRS no longer makes an ASFR assessment on a taxpayer who has a balance due for another tax year, she said. Olson called these “prudent business decisions,” but said the IRS has not made needed changes she recommended in her 2011 report, including contacting taxpayers before making assessments and not making them where the IRS has no confirmed address for a taxpayer. Olson has also criticized the program previously for what she said is its questionable effectiveness, in that it artificially inflates assessments without determining their collectibility. 

An audit of the program in 2010 by the Treasury Inspector General for Tax Administration (TIGTA) (Rep’t No. 2010-40-033) revealed that, because of limits in staffing and other resources, the IRS in fiscal 2006 and 2007 worked only 68% of the 2.7 million cases in the program’s inventory for the two years combined. TIGTA noted some success, however, in bringing taxpayers into compliance in filing and paying. For fiscal 2005, nearly 450,000 taxpayers, representing more than 580,000 returns, voluntarily filed returns, accepted the substitute for return, agreed with proposed assessments, or were identified as not liable. Of those returns, 49% showed some type of payment or other account activity. Of those in which taxpayers agreed with the assessment or filed a return, 68% of accounts were fully paid.

Both TIGTA and Olson noted favorably the IRS’s increased use of “soft notices.” TIGTA said a 2007 pilot initiative showed some promise in reducing the ASFR caseload. Olson said a plan for an additional delinquency notice in fiscal 2013 could have the same effect, plus confirm taxpayer contact information before ASFR processing.

Line items  
June 2013

OICs Making a Comeback
After declining for five years, the aggregate amount of offers in compromise (OICs) increased from 2010 through 2012. From 2009 to 2012, the number of OICs accepted rose to 23,628, a 122% increase (see related graphic, “OICs on the Rebound”).

By 2009, the number of OICs accepted by the IRS had fallen to only 37% of the approximately 29,000 accepted in 2002. The total amount of accepted offers had fallen as well, from more than $300 million in 2002 to less than $130 million in 2010, a 57% decrease.

An OIC is an agreement by which taxpayers can settle their tax liabilities with the IRS for less than the full amount owed if they cannot pay the full amount in a lump sum or payment agreement.

The total amount compromised rose from 2010 to 2012 by a smaller percentage, 51%, than the number of OICs accepted, suggesting much of the growth may have come from smaller amounts compromised on average.

In her 2012 Annual Report to Congress, National Taxpayer Advocate Nina Olson attributed the increase to the IRS’s Fresh Start initiative, which expanded and streamlined OICs as part of the IRS’s effort to help financially struggling taxpayers in the wake of the recession of 2008–2009. As part of Fresh Start, in February 2011 (IR-2011-20), the IRS announced it was raising its OIC income eligibility ceiling to $100,000 and doubled the maximum tax liability eligible for compromise to $50,000. In May 2012, the IRS announced (IR-2012-53) more flexible terms for OICs. These included simplifying the calculation of taxpayers’ reasonable collection potential (RCP) and guidance on including payments on delinquent state and local taxes and student loans in living expenses allowed in calculating RCP. The IRS also expanded items allowable under miscellaneous living expenses to include credit card payments and bank fees and charges.

Despite the increase, Olson said in her report, OICs remain underutilized and represent “a very small percentage of the delinquent taxpayer population.” 

IRS Identity Theft Enforcement Liaison Goes Nationwide
The IRS in late March expanded its pilot Law Enforcement Assistance Program on identity theft to all 50 states and the District of Columbia (IR-2013-34). Under the program, state and local law enforcement officials with evidence of identity theft involving fraudulently filed tax returns can obtain tax return information of identity theft victims from the IRS to aid in their enforcement efforts.

As under the pilot program, state and local law enforcement officials with evidence of identity theft involving fraudulently filed federal tax returns will receive permission from the identity theft victim by having him or her complete a special IRS disclosure form so the IRS can provide law enforcement with the fraudulently filed tax return. Law enforcement representatives can then submit this consent to the IRS Criminal Investigation Division, along with a copy of the police report. The IRS will assist law enforcement in locating identity theft victims and obtaining their consent on the special IRS disclosure form.

The program was rolled out in April 2012 in Florida, the state with the highest per capita rate of reported identity theft complaints (see Treasury Inspector General for Tax Administration Rep’t No. 2012-40-050). It was expanded to eight more states last October (Alabama, California, Georgia, New Jersey, New York, Oklahoma, Pennsylvania, and Texas).

AIG Denied Summary Judgment on Economic Substance
The District Court for the Southern District of New York ruled that the economic substance doctrine applies to transactions by American International Group Inc. (AIG) involving foreign tax credits (American International Group, Inc., No. 09-CIV-1871, (S.D.N.Y. 3/29/13)). In denying AIG’s motion for summary judgment, the court held that AIG must show its lending transactions with foreign banks had a business purpose or economic effect other than creating tax benefits.

In 2008, the IRS disallowed foreign tax credits claimed by AIG on its 1997 return stemming from transactions between 1993 and 1997 with six foreign banks, claiming the transactions were so-called foreign tax credit generators. AIG paid the assessment, penalties, and interest and argued in a refund suit that the transactions’ purpose and effect were to generate a $168.8 million pretax profit for itself. The court, however, held that the figure did not exclude tax benefits of tax-exempt dividends that the parties considered in setting lending rates and without which, a government expert testified, the profit would not have occurred.

In Notice 2004-19 the IRS reiterated its long-standing position that foreign tax credit generators, which involve cross-border arbitrage where any reasonably expected economic profit is insubstantial compared with foreign tax credits generated, are abusive transactions.

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