Anti-Dividend-Stripping Rules

  Anti-Dividend-Stripping Rules

W hen a corporation receives a dividend from another corporation, the recipient is entitled to a deduction (known as the dividends-received deduction or DRD) equal to 70% of the amount of the dividend. The DRDs purpose is to mitigate the double taxation of corporate income —the income is taxed only once until it is finally distributed to the recipients noncorporate shareholders. The DRD, therefore, allows a corporations dividend income to be taxed at an effective rate of only 10.5% (30% of a dividend is taxed at a 35% rate; .30 3 .35 = 10.5%).

The existence of the DRD led to the practice of "dividend stripping," whereby a corporation would (1) purchase stock in another corporation, (2) receive a dividend and claim a DRD and (3) promptly sell the stock and sustain a capital loss on the sale, measured by the amount of the dividend (assuming there were no other price fluctuations). This capital loss could be used to offset other capital gains. The corporation also would have converted capital gains (taxed at a 35% rate) into 10.5% dividend income.

To combat dividend stripping, Congress made the DRD unavailable unless the stock (on which the dividend was paid) had been held for more than 45 days. Moreover, "credit" toward the 45-day holding period requirement could not be earned for days on which the corporation had diminished its risk of loss (from holding the stock) through the use of options, short sales and other hedging tactics.

Until the Taxpayer Relief Act of 1997 was passed, a corporation that had satisfied the 45-day standard was entitled to a DRD for all subsequent dividends even if it then held the stock on a fully hedged basis. However, the 1997 act changed this favorable rule. The new law requires the 45-day rule to be applied on a dividend-by-dividend basis. It accomplishes this by stating that no DRD will be allowed for dividends on stock not held for more than 45 days during the 90-day period beginning on a date that is 45 days before the ex-dividend date (the line of demarcation for dividend entitlement). Accordingly, to earn a DRD with respect to a dividend, a corporate investor must be at the risk of the market throughout the period the underlying stock is owned.

Observation: This more stringent 45-day rule will make corporate treasurers somewhat less likely to invest surplus cash in the stock of other corporations. — Robert Willens, CPA, managing director at Lehman Brothers, New York City.


Year 2000 Expenditures

A s the clock ticks past midnight on December 31, 1999, many software-driven systems may respond as though the year 1900 followed 1999, potentially wreaking havoc with normal operations in virtually every sector of the economy. Computers, manufacturing systems, elevators, vending machines — almost anything that depends on time and date — will be affected.(For additional discussion on the Year 2000 issue, see "The Millennium Muddle" , "Can Your Software Make It Into Year 2000?" , "Spreadsheets Face the Millennium" .)

Companies will have to spend a lot of money to avoid the problems that could occur if a system interprets 00 as 1900. The IRS has been looking at how companies treat such expenditures for tax purposes and soon may issue some guidance.

Under current law, most taxpayers deduct software development costs on a current basis in a manner consistent with revenue procedure 69-21 (1969-2 C.B. 303). The IRS is not expected to change that treatment. However, Year 2000 "fixes" will not be limited to software development. There will be other costs, such as hardware, labor and consulting, that may be more difficult to classify.

Companies may be able to deduct some costs as incidental repairs and maintenance — for example, the replacement of a chip. However, other costs will have to be capitalized and amortized. For example, Year 2000 costs must be capitalized if a company elects to replace its systems on a wholesale basis or if the IRS views an expense as having been incurred as part of an overall plan of renovation. The IRS also may scrutinize consultants fees to determine whether they should be capitalized. Further, the IRS may be concerned that taxpayers will claim some Year 2000 costs as creditable research costs.

Observation: Companies should look carefully at the full panoply of related expenditures to ensure they are properly characterized. Equally important, taxpayers will need to make certain that these characterizations are properly documented. — Tracy Hollingsworth, Esq., staff director of tax councils at Manufacturers Alliance, Arlington, Virginia.


Home Office Deduction Change

T he Taxpayer Relief Act of 1997 relaxed the home office deduction rules. Before the act, taxpayers who used their home offices only for administrative and managerial tasks were denied this deduction because of the U.S. Supreme Courts controversial decision in the 1993 Soliman case (Commissioner v. Soliman, 506 U.S. 168).

In Soliman, a self-employed anesthesiologist worked in several local hospitals but was denied office space in all of the buildings. Therefore, he did all of his bookkeeping, correspondence and professional reading in his home office. The Court decided the hospitals (not his home) were his principal place of business because the "essence" of his work was performed in the hospitals. His home office deduction was denied.

The Soliman decision has prevented thousands of consultants and self-employed individuals who work out of their homes from deducting any home-related expenses such as depreciation, repairs, maintenance and utilities. In order to encourage such individuals to work out of their homes and spend more time with their families, Congress amended Internal Revenue Code section 280A(c)(1).

A home office now qualifies as a taxpayers principal place of business if (1) the taxpayer uses the office for the administrative or management activities of his or her trade or business and (2) there is no other fixed location of the trade or business where the taxpayer conducts substantial administrative or management activities. The home office still must be used exclusively and on a regular basis by the taxpayer, and, in the case of an employee, the work must be done at home for the convenience of the employer.

The 1997 act allows taxpayers to deduct certain expenses for nonsubstantial administrative or management activities at sites that are not fixed locations of the trade or business, such as in cars or in hotel rooms. It even allows the home office deduction if some administrative or management activities (billing) are performed by others at other locations. And finally, the deduction also is allowed if the taxpayer conducts substantial nonadministrative or nonmanagement business activities at a fixed location outside of the home (such as providing services or meeting with customers, patients or clients at various other locations).

Observation: Because this new rule does not take effect until 1999, CPAs must advise their clients that this deduction cannot be taken on their 1997 or 1998 returns. Also, CPAs should warn their clients that although gains on the sale of a principal residence after May 6, 1997 probably will be tax-free, any gain relating to the business use of the home (home office or rental portions) is still taxable. — Michael Lynch, CPA, Esq., associate professor of accounting at Bryant College, Smithfield, Rhode Island.

    Clocking Paperwork
  • According to the Internal Revenue Service, the 1997 form 1040 will be longer than last years but will take, on average, one hour less to prepare. However, the IRS said it will take taxpayers one hour more than last year to file Schedule D, Capital Gains and Losses.

    Marking for the Market

  • Revenue ruling 97-39 (1997-39 IRB) provides questions and answers to 20 issues under the mark-to-market requirements of Internal Revenue Code section 475 for securities dealers.

    Withdrawing for Education

  • In notice 97-53, the IRS provides guidance to taxpayers who want to withdraw funds from their individual retirement accounts to pay for qualified higher education expenses for themselves, their spouses, children or grandchildren. Penalty-free withdrawals must begin after December 31, 1997, for expenses incurred for academic periods beginning in 1998. The funds cannot be used to pay for expenses incurred during the 1997 fall semester.

    Result of a Losing Streak

  • A taxpayer had gambled on credit at a major casino in Las Vegas and accumulated $355,000 in debt. The casino attempted to collect the debt in full but finally agreed to accept $142,000 as full payment. According to Edward B. Rood v. Commissioner (no. 96-3149, 11th Cir. 97), the amount written off by the casino was taxed to the gambler as discharge-of-indebtedness income.

    Rating Yourself

  • Qualified personal service corporations are taxed at a flat rate of 35%. However, according to Internal Revenue Bulletin announcement 97-88, many such corporations inadvertently have been taking advantage of the lower rates available for regular corporations. The IRS is encouraging affected taxpayers to file amended returns. In the meantime, the service will continue to identify such taxpayers and bring them into compliance.

    Deadline Blues

  • In Commissioner v. Crawford (80 AFTR 2d 97-6171), an IRS agent contacted a taxpayer concerning his tax liability for a prior year. The same day, but before his meeting with the agent, the taxpayer had met with his accountant and filed a delinquent return for the year at issue. Even though he had filed, the taxpayer still was found criminally liable under section 7203 for willfully failing to file a required tax return.

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


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