Line Items

BY MICHAEL LYNCH

The Long Arm of the Law

In United States v. Craft (S.Ct., 4/17/2002), 89 AFTR2d 2002-2005, a taxpayer owed the government nearly $500,000 in back taxes. To protect its claim, the IRS attached a federal tax lien under IRC section 6321 to “all property and rights to property, whether real or personal, belonging to” the taxpayer.

Mr. and Mrs. Craft owned a piece of real estate in Michigan as tenants by the entirety. After the lien was filed, the taxpayer and his wife filed a quitclaim deed and transferred the property to the wife for one dollar. When the wife tried to sell the property, the lien prevented her from passing clear title. The IRS agreed to release the lien if she put half the sales proceeds into an escrow account. She then sought to recover the escrowed funds. The Sixth Circuit Court of Appeals sided with the wife and held that the government’s lien could not attach to the jointly owned property because under state law, the husband had no separate interest in the property.

The U.S. Supreme Court reversed the Sixth Circuit and held that the husband did have property rights under Michigan law. According to the Court, the husband had the right to use the property and prevent others from using it, the right to sell or borrow against the property with his wife’s consent, the right of survivorship and the right to become an equal tenant in common upon divorce. The Court said that if federal liens could not attach to tenancies by the entirety, such properties would belong to no one because the wife’s interest could be shielded in the same manner. The result would remove too much property from the government’s reach, especially community property, and would be an abuse of the federal tax system.

Shareholder Discounts as Dividends

A corporation was formed to own, manage and operate a country club. The club consisted of a golf course, golf shop, swimming pool and restaurant. It was available to nearby homeowners and shareholders of the corporation who paid dues to belong. The shareholders received a discount on membership dues, cart rentals and restaurant purchases.

The IRS has privately ruled these shareholder discounts are constructive dividends under IRC section 301. According to letter ruling 200215036, any economic benefits a corporation gives its shareholders, in whatever form, even if not formally declared, constitute a dividend.

One Less Form to File

According to information release 2002-48 (4/10/2002), beginning with the 2002 tax year small corporations with less than $250,000 in gross receipts and less than $250,000 in assets no longer will have to complete form 1120, schedule L ( Balance Sheet per Books ), schedule M-1 ( Reconciliation of Income (Loss) per Books with Income per Return ) and schedule M-2 ( Analysis of Unappropriated Retained Earnings per Books ). Similar schedules on form 1120-A and form 1120S also can be omitted.

This change will allow small businesses to keep their records “based on their checkbook or cash receipts and disbursements journal instead of additional accounting methods for tax reporting,” resulting in significant savings. The IRS estimates 2.6 million small businesses will qualify for this relief.

Put the Rubber to the Road

In the past, several rulings and cases said truck, trailer and tractor tires were not part of the cost of a vehicle for depreciation purposes. Instead, they were treated as separate assets and expensed if they had a useful life of one year or less or were capitalized and depreciated over their respective lives. Previously, most tires were deducted in the year they were placed in service.

However, due to new technology, tires now generally have a life in excess of one year. So, to minimize disputes concerning the expense vs. capitalization dilemma, the IRS has provided a safe-harbor method of accounting (the original tire capitalization method) for the cost of original and replacement tires for vehicles used in business activities.

Under this method a taxpayer must (1) capitalize the cost of the original tires and depreciate them under IRC section 168 using the same depreciation method, recovery period and convention that would apply to the vehicle on which the tires are first installed, (2) treat the original tires as disposed of at the same time the taxpayer disposes of the vehicle and (3) deduct the cost of replacement tires as an expense in the tax year the replacement tires are installed.

Revenue procedure 2002-27 (2002-17 IRB), also explains how a taxpayer can obtain automatic consent to change to the new safe-harbor method. It provides an optional procedure for a taxpayer to settle open tax years using the new method if its treatment of tire expenditures is an issue currently under examination, before appeals or in front of a court.

Gift of Present Interest

Individuals can give away $11,000 per donee in a calendar year without paying a gift tax. However, IRC section 2503(b) limits this exclusion to gifts of a present interest. Under Treasury regulations section 25.2503-3, a present interest in property is an unrestricted right to the immediate use, possession or enjoyment of the property or its income.

In Christine M. Hackl v. Commissioner, 118 TC no. 14, a couple gave their children and grandchildren membership units in a limited liability company (LLC). The husband was the manager of the company and under the LLC’s operating agreement, he had the power to distribute any available cash to members. Also, no members could withdraw any property from the LLC or sell their units to the LLC without his permission. The IRS said the gifts did not qualify for the annual exclusion because they were not gifts of a present interest.

The taxpayer argued there were no restrictions on the transfers and that the donees acquired all the rights in the gifted units the donors had. Therefore, there was no postponement of any rights that would cause the gifts to be future interests.

The Tax Court sided with the IRS and said the gifts failed to confer a substantial present economic benefit of the use, possession or enjoyment of the property or its income. The court rejected the taxpayer’s argument that when a gift takes the form of an outright transfer of an equity interest in property, no further analysis is needed or justified. It held that to follow that logic was to sanction exclusions for gifts based solely on “conveyancing form,” without inquiring into whether the donees received rights different from those that would have come from a traditional trust arrangement. The court found the LLC operating agreement essentially prevented the donees from currently enjoying any of the economic or financial benefits that accrue from owning the membership units.

Parts Dealers Can Use Replacement Cost

In Mountain State Ford v. Commissioner, 12 TC no. 58 (1999), the IRS prevented an automobile dealer from pricing its yearend parts inventory by reference to replacement cost. Now, in revenue procedure 2002-17, the IRS has done an about-face and created a safe harbor that allows dealers to use the replacement cost method. For this purpose, a dealer is defined as a taxpayer engaged in the trade or business of selling vehicle parts at retail that is authorized, under an agreement with one or more vehicle manufacturers or distributors, to sell new automobiles or light, medium or heavy-duty trucks.

According to the government the use of replacement cost accounting is an industry standard that closely approximates actual cost. Forcing dealers to modify their recordkeeping systems to account for actual cost would be expensive and burdensome.

Installment Method Not Available

IRC section 453(b)(2) says that, in general, a dealer in property may not use the installment sales method of accounting. However, IRC section 453(1)(2)(A) says this prohibition does not apply to the sale of property used or produced in the trade or business of farming.

In Thom v. United States (CA 8, 3/19/2002; 89 AFTR2d 2002-1384), a corporation manufactured and sold irrigation systems to farmers, but it did not engage in any actual farming. The corporation used the installment method to account for these sales. The IRS disallowed the practice because the corporation itself did not “use” the property in farming.

The corporation argued the word “used” should be read to mean any property that has been, or will be, used for farming. The IRS argued that only farmers who actually used the property for farming could use the installment method and not dealers who sold the property to them.

In a case of first impression, the Eighth Circuit Court of Appeals agreed with the IRS. It said the taxpayer was trying to insert the words “to be” before “used.” The Eighth Circuit said it could not do this because Congress chose not to do it. Such an interpretation would cause the IRS to bear an unreasonable burden of determining whether a purchaser subsequently used the equipment for farming.

Michael Lynch, CPA, JD, professor of tax accounting at Bryant College, Smithfield, Rhode Island.

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