Tax Brief. Business/Industry: New pension plan self-correction programs.





BUSINESS/INDUSTRY

New Pension Plan
Self-Correction Programs


The IRS consolidated four correction programs for tax qualified plans into a single Employee Plans Compliance Resolution System (EPCRS). Self-correction programs allow employers that sponsor tax-qualified pension plans to correct failures or defects that otherwise might threaten a plan's qualification.

Revenue procedure 98-12 provides a uniform set of correction principles that clarify the use of EPCRS. It also ensures that EPCRS is consistently administered. The new procedure has a graduated sanction schedule that takes into account the nature, extent and severity of the violation. The administrative programs that were consolidated into EPCRS include

  • Administrative Policy Regarding Self-Correction (APRSC), which permits a plan sponsor with established compliance practices and procedures to correct "insignificant" operational failures without IRS approval, or a fee, and to amend "significant" failures within a two-year period with IRS approval.
  • Voluntary Compliance Resolution (VCR), which allows a plan sponsor prior to audit and with IRS approval (and for a limited fee) to rectify operational defects that do not qualify for APRSC.
  • Walk-In Closing Agreement Program (Walk-In CAP), which enables a sponsor to voluntarily disclose and correct qualification defects that do not qualify under the VCR program, with the payment of a compliance correction fee based on a new fee schedule.
  • Audit Closing Agreement Program (Audit CAP), which allows a plan sponsor to negotiate the monetary sanctions for, and the methods of correcting, plan failures discovered on examination.

Observation. The IRS has exacted hefty monetary penalties from sponsors whose plans did not comply with the extensive legislative and regulatory qualification rules. EPCRS brings needed clarity to the self-correction process and provides for more reasonable sanctions. Plan sponsors and their advisers should familiarize themselves with the programs that fall under the EPCRS umbrella.

—Tracy Hollingsworth, Esq., staff director of tax councils at Manufacturers Alliance, Arlington, Virginia.

INDIVIDUAL

Unsecured Note Makes Gain Disappear

Individuals can incorporate an ongoing business tax-free, according to IRC section 351. For example, if a sole proprietor whose assets have a fair market value of $600,000 and a basis of $200,000 wants to incorporate his business, the $400,000 gain would not be recognized. However, according to IRC section 357(c), gain must be recognized immediately if liabilities assumed by the corporation exceed the basis of the transferred assets. The taxpayer in the above example would owe taxes on the $150,000 gain if the assets were subject to a $350,000 mortgage.

In order to avoid this gain, CPAs generally advise clients to contribute additional cash of $150,000 or to pay off $150,000 of the debt prior to incorporation. Now, according to Peracchi v. Commissioner (CA-9, 4/29/98), there is an easier way to avoid recognizing gain.

In 1989, Donald Peracchi transferred two parcels of real estate with a basis of $981,400 to NAC, his wholly owned corporation. The assets were encumbered by $1.5 million in liabilities. To avoid recognition of gain on the excess of debt over basis, Peracchi issued an unsecured promissory note, agreeing to pay NAC $1,060,000 over a term of ten years at 11% interest.

The IRS determined that Peracchi realized a gain on the transfer, asserting that the note was not genuine indebtedness under IRC section 357(c)(1) because Peracchi incurred no cost in issuing the note to NAC. According to the IRS, the basis in the note was zero. However, Judge Alex Kozinski said it was more important to determine whether Peracchi had any basis in the note. If so, then he had contributed property with a basis exceeding liabilities and no gain would be recognized.

The court concluded that the note was genuine because

  • Peracchi was creditworthy and had the funds to pay the note.
  • The promissory note carried a market rate of interest for a reasonable and fixed term.
  • The note was transferable and enforceable by third parties and NAC could borrow against it.

Peracchi also put himself at economic risk by transferring the note to NAC. If NAC filed for bankruptcy, its creditors could enforce the note as an unliquidated asset of NAC. The court ruled that if the risk of bankruptcy was significant and the taxpayer was financially capable of making future payments on the note then the shareholders should get a basis in the note. The court found that NAC's risk of bankruptcy was significant and ruled in favor of Peracchi. Thus, he was not required to recognize any gain on the transfer.

Observation : If a taxpayer recognizes a gain under IRC section 357(c), the taxpayer's stock basis generally is reduced to zero. This creates a major problem for subchapter S shareholders. Under IRC section 1366(d)(1), an S shareholder can deduct corporate losses only to the extent of his or her stock or debt basis. The Peracchi decision now allows certain creditworthy S corporation shareholders to get additional basis in their S stock simply by issuing an unsecured promissory note to the corporation.

—Michael Lynch, CPA, Esq., associate professor of tax accounting at Bryant College, Smithfield, Rhode Island.

Line Items
Residence Payment
  • The United States and Canada have signed a treaty to tax Social Security benefits in the country where the taxpayer resides. Formerly, taxes for these benefits were paid directly to the country that provided them. U.S. residents receiving Canadian Social Security payments (or vice versa) are advised to read the new rules in IRS Advance Notice 98-23 (1998-18 IRB). For 1996 and 1997, taxpayers can remain subject to the old rules or follow the new ones. The notice includes the rules for amending a tax return and obtaining a refund.

    Sorry, You Have to Pay the Interest

  • The Ninth Circuit Court held that interest on a tax deficiency associated with an unincorporated business is not a deductible business expense, reversing a Tax Court decision. The court ruled that nondeductible personal interest included interest on tax deficiencies regardless of the source of income generating the tax liability ( Redlark v. Commissioner , CA 9, 4/10/98).

    Testing Tours

  • Exempt organizations must pay federal income taxes if they engage in activities unrelated to the organization's exempt function. In recent years, many exempt organizations have generated additional income by conducting tours and travel packages. The IRS has published several examples of "acceptable" tours. According to proposed regulation 1.513-7, the organization, to remain exempt, must ensure that the tour be "educational" and possess "some academic rigor." For example, a tour should include professional instruction and exams or provide academic credit.

    Profitable Refund

  • Because of a series of IRS blunders, a taxpayer received an erroneous refund of over $600,000. According to the Court of Appeals for the Federal Circuit, the IRS neither demanded the money back nor acted in a manner prescribed by law to recover the refund. Therefore, the court allowed the taxpayer to keep the money ( Stanley v. Commissioner , CA-FC, 4/2/98).

    —Michael Lynch, CPA, Esq., associate professor of tax accounting at Bryant College, Smithfield, Rhode Island.

  • Casualty-and-Theft Loss Carrybacks

    The Internal Revenue Code (IRC) helps taxpayers who suffer net operating losses (NOLs) by allowing the carryback and carryforward of such losses to offset other years' taxable income. The Taxpayer Relief Act of 1997 amended IRC Section 172(b) governing the carryback/carryforward provision for NOLs. It shortened the carryback to 2 years from 3 and increased the carryforward period to 20 years from 15. However, the three-year carryback period was not changed for NOLs attributed to individual casualty or theft losses or presidentially declared disaster area losses of small businesses or farming operations.

    Although guidance exists for the three-year carryback of a NOL entirely the result of a casualty-and-theft loss for tax years beginning after August 5, 1997, there is no guidance on the amount of carryback to the third year if only a portion of the NOL is from a casualty-and-theft loss. For example, a taxpayer with a business loss of $60,000, a casualty-and-theft loss of $40,000 and a salary of $20,000 would have a NOL of $80,000. It is not clear how much of the NOL or the casualty-and-theft loss ($40,000) could be carried back three years. A proration could be made by comparing the casualty-and-theft loss amount to the total loss amount ($40,000/$100,000), resulting in only 40% of the NOL ($32,000) being carried back to the third year.

    Observation : More guidance is needed on the amount of carryback to the third year when only a portion of the NOL is from a casualty-and-theft loss. The past practice of providing relief as soon as possible to taxpayers suffering casualty-and-theft losses would seem to warrant allowing the entire casualty-and-theft loss to be carried back to the third year. Prorating the carryback is less desirable because relief would be slow in coming and it would further complicate an already complex NOL process.

    —Keith W. Smith, CPA, PhD, associate professor of accountancy , and Tina Steward Quinn, CPA, PhD, assistant professor of accountancy, Arkansas State University.

    1998 Luxury Auto Depreciation Limits

    The IRS released the inflation-adjusted limitations on the depreciation of 1998 luxury and electric cars. Revenue procedure 98-30 also includes the income inclusion amounts for business cars first leased in 1998 and the maximum value of employer-provided autos for which the vehicle cents-per-mile valuation rule applies.

    The inclusion amounts for leased autos are essentially the same as for 1997. The inflation-adjusted figure for computing the cents-per-mile valuation is $15,600, down $100 from 1997.

    Observation. This is the first time the inflation-adjusted limits for luxury autos have declined. The limits on luxury autos for the first, second, fourth and succeeding years are identical to the 1997 limits; however, the limit for the third year is $100 less. The limits for electric autos for each of the first three years are $100 less than the 1997 limits, with the fourth and succeeding years' limits identical to the 1997 limits.

    —Tina Steward Quinn, CPA, PhD, assistant professor of accountancy, Arkansas State University and Tonya K. Flesher, CPA, PhD, Arthur Andersen Lecturer and professor of accountancy, University of Mississippi.

    Tax Cases

    Sale of Residence by Bankruptcy Estate

    The Tax Reform Act of 1997 significantly changed the taxation of the sale of a personal residence. Under the new law, taxpayers can exclude up to $250,000 ($500,000 on a joint return) of the gain on the sale of a home they have used as a principal residence for two out of the last five years. Since the law refers to use by a "taxpayer," a question arises: Can an entity take advantage of this exclusion?

    Luciano Popa filed a petition under chapter 7 of the U.S. Bankruptcy Code. Later, he petitioned the Bankruptcy Court asking that the bankruptcy estate be given permission to "abandon" Popa's residence on the grounds that he had no equity in the property. Although the value of the house exceeded the outstanding mortgage, Popa asserted the value would be zero if the gain resulting from a sale were taxable. The bankruptcy trustees argued the gain from the sale was nontaxable under the newly enacted IRC section 121 and, therefore, the estate should not release the residence.

    Result : The bankruptcy estate is entitled to use section 121. The availability of the old section 121, which excluded the gain on the sale of a residence by a taxpayer over age 55 to a bankruptcy estate, was previously considered in In re Mehr and In re Barden . In both cases, the Bankruptcy Court concluded the estate could not take advantage of section 121. In Popa, however, the court refused to follow the prior cases for two reasons.

    1. The law had changed significantly. The old rule required the taxpayer to be over age 55. The estate could not meet this requirement. Because the new law has no age requirement, the issue is not relevant.
    2. The court interpreted the Bankruptcy Code differently. The act provides that a bankruptcy estate can tack on the holding period and character of tax items from the debtor. As a result, the court concluded the estate would meet the use test because the debtor himself met the test. The act also provides that the estate be taxed as if it were an individual. Therefore, the estate is a qualifying taxpayer.

    Given the change in the law from a tax deferral provision to an exclusion provision, it is uncertain whether the courts will follow the prior liberal interpretation of the old law under the new law. In this early decision, the answer appears to be yes. If other courts follow, taxpayers have been given major tax relief on the sale of their residence.

    • In re Luciano Popa , 1998 Bankr. Lexis 245, 98-1 USTC 50,276.

    Valuing Closely Held Stock

    Valuing stock in a closely held corporation is always difficult for CPAs. If the owner sells the stock shortly after the valuation date, questions frequently arise as to the impact that sale has on the stock's value.

    Eric Saltzman transferred closely held stock he owned to an irrevocable trust. Saltzman served as co-trustee of the trust and was also a director of the company whose stock he transferred. After the transfer, the corporation recapitalized and exchanged the trust's common stock for preferred stock. The IRS argued that the preferred stock was worth less than the common stock, resulting in a gift. The IRS valued the gift based on a sale that occurred 7 months after the recapitalization. Saltzman claimed no gift had occurred and that, if one had taken place, the IRS valued the stock incorrectly by referring to the subsequent sale.

    Result : For the taxpayer. The Second Circuit Court of Appeals decided the Tax Court erred in finding a gift because, under New York law, the trustee could claim the proceeds. The court also ruled that, even if there was a gift, the valuation was wrong. The general rule is that property is to be valued at the time of the gift or transfer, without reference to subsequent events. An exception allows reference to subsequent events only if nothing occurs between the valuation date and the subsequent event to affect the value. For this exception to apply, the subsequent event must be reasonably foreseeable at the time the stock is valued. If the event is not foreseeable, it cannot be considered. The fact that the event makes the prior valuation inaccurate is immaterial. The Second Circuit said the sale was not foreseeable and thus the Tax Court should not have considered it.

    Although the stock was sold to an unrelated corporation, the court concluded the transaction was not at arm's length because the purchaser was compelled to buy. As a result, the price was inflated and did not represent true fair market value. Normally, sales to unrelated parties are considered to be at arm's length. The court did not explain its reason for concluding that a compulsion existed, and relevant documents are sealed.

    This case serves as a reminder to CPAs that they must base all valuations on the price that would be obtained in an arm's length transaction between a willing buyer and a willing seller with neither party forced to participate. The mere fact that the parties are unrelated does not guarantee an arm's length transaction.

    • Eric F. Saltzman v. Comm. , 131 F3d 87; 98-1 USTC 50,164; 80 AFTR 2d 8365.

    Prepared by Edward Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa .

    Inflation—Adjusted Limits


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