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White House Calls for Internet Tax Harmony

The White House released on July 1 a final report on the Clinton administrations electronic commerce initiatives. A Framework for Global Electronic Commerce urges consistent international treatment of taxes and duties on Internet commerce, including uniform regulation of its standards and licensing requirements. "We seek to establish basic rules on international electronic commerce, with minimal regulation and no new discriminatory taxes," said President Clinton when he announced the publication of the report.

The president also signed a proclamation to implement an information technology agreement the terms of which were set at the World Trade Organization in Geneva in March. The agreement eliminates tariffs on a number of types of computers, semiconductors and telecommunications technologies by the year 2000. "Eliminating tariffs on these goods will amount to a $5 billion cut in tariffs on American products exported to other nations," said Clinton.

Principles of U.S. initiative
The White House report lists five principles intended to limit restrictions and facilitate the growth of Internet commerce. The first recommends that governments encourage industry self-regulation whenever appropriate and support private-sector efforts by including it in government policy-making processes.

The second principle strongly urges governments to refrain from imposing new taxes and tariffs on commercial activities that take place via the Internet. The remaining principles encourage government support of electronic commerce by enforcing a minimalist, consistent legal environment, building a harmonized global framework of regulations and tailoring government policies to Internet commerce needs.

The Clinton administration also sent a memorandum to the heads of all executive branch departments and agencies directing them to implement the strategy outlined in the reports five principles. It also instructed officers of the agencies to achieve specific objectives within the next 12 months.

A copy of the report is available on the White House Web page at http://www.whitehouse.gov .

Senate Will Examine Stock Option Bill

The Senate Committee on Finance will hold hearings on a bill that would limit the deduction for compensation in the form of stock options. The bill (S 576), introduced by Senators Carl Levin (D-Mich.) and John McCain (R-Ariz.), would require a company to record stock options as an expense in the financial statements if it claimed them as a deduction for tax purposes. "This issue deserves the critical analysis that an open committee process can provide," said Levin.

At issue in the legislation is what Levin has called a corporate loophole that allows companies to deduct from their income taxes multimillion-dollar pay expenses that never show up on the financial statements as an expense. "Every other form of compensation is shown as an expense on the company books," said Levin. He said either a stock option lowers company earnings or it doesnt.

S 576 would limit the amount of Internal Revenue Code section 41 research tax credit a company could claim based on stock option wages. It also would establish an exemption for stock option plans that benefit all full-time employees. According to Levin, a 1994 survey of 6,000 publicly traded companies found that only 1% offer stock option compensation to anyone other than management, and 97% of stock options issued were going to 15 or fewer persons per company. "Our bill would ensure that closing the stock option tax loophole does not affect the pay of average workers," said Levin.

A heated, but long-standing, issue
The American Institute of CPAs publicly opposed the Levin-McCain bill because it would inappropriately inject Congress into the accounting standard-setting process. In a letter to Finance Committee Chairman William V. Roth, Jr. (R-Del.), and Senator Daniel Patrick Moynihan (D-N.Y.), AICPA tax executive committee chairman Michael E. Mares said the tax treatment of stock options should not be governed by accounting standards and that Congress should "leave financial accounting standards to the Financial Accounting Standards Board." He said strict Securities and Exchange Commission and Internal Revenue Service regulatory standards already were in place for stock option grants and S 576 violated fundamental principles of tax policy.

In 1994, the FASB issued a proposal to require companies to recognize stock compensation as an expense in the financial statements. However, after receiving pressure from members of Congress and the SEC, the FASB decided only to encourage, but not require, companies to include stock option pay as an expense. For 1997 financial statements, a company is required to disclose in a footnote the earnings it would have reported after deducting stock options.

The Senate Finance Committee is expected to begin its hearings on the legislation in October. For a copy of the AICPAs comments to Congress, dial from a fax machine 201-938-3787 and request document no. 926.


Home-Based Office Equipment Allowed as Business Expense

The taxpayer, a sales manager for a phone company, often worked out of two offices, one provided by the company at her place of work and one she set up at home. On her tax return, the taxpayer claimed a home office deduction for the room in her home and business expense deductions for a computer and printer she used at home for work.

The Internal Revenue Service denied the deductions, claiming that because the taxpayer had an office provided by the company at her place of work, she could not claim a home office deduction and questioned the deductibility of the computer and printer as business expenses.

Result: The Tax Court agreed with the IRS and held that the taxpayer did not qualify for the home office deduction under Internal Revenue Code section 280A, which requires the office to be "the principal place of business." Because most of her work was done at the company office, her home office could not qualify as the principal place of business.

However, the Tax Court did allow the deductions for the computer and printer under IRC section 179, which allows a taxpayer to expense, in the year it was placed in service, the cost of property used in the active conduct of a trade or business. However, some types of property—including personal property—cannot be claimed as a section 179 expense unless the property is placed in service for the convenience of the employer or is required as a condition of employment.

The taxpayer had a heavy caseload and managed a large number of sales representatives but was not at a management level that allowed her access to the company office building after hours. Having a computer at home was the only way she was able to keep on top of the volume of work. Under these circumstances, the Tax Court found the equipment qualified as a condition of employment and allowed the deductions.

  • Mulne v. Commissioner , T.C. memo 1996-320.

Wife Granted Innocent Spouse Relief From Husbands Disallowed Deductions

Rebecca Reser was married to Don Reser from 1974 until their divorce in 1991. Both were personal injury defense lawyers. In 1984, Don created a professional corporation, Donald Reser, P.C. (DRPC), which was involved in the sale of a large shopping center in San Antonio, Texas. DRPC obtained a line of credit from a bank, evidenced by 14 promissory notes executed jointly by Don and the corporation. When DRPC needed to draw on the line of credit, the bank would deposit funds directly into DRPCs account. Don also drew on the DRPC account for his personal use. In 1986, he signed an agreement with a friend who guaranteed payment on the bank line of credit; Don agreed to pay the friend a fee for each period the guaranty was outstanding.

In 1987 and 1988, DRPC reported losses of $257,354 and $333,581, respectively; the Resers filed joint income tax returns and claimed these losses. The IRS audited the returns, questioning the deductibility of the DRPC losses. They determined that because the bank loan was made to DRPC, Don could not increase his basis in DRPC by the amount of the loan proceeds. Therefore, he did not have enough basis in DRPC to deduct the losses. Don claimed the bank had made the loan to him personally and that he had loaned the money to DRPC. He did not provide any evidence to back his claim.

In 1991, the IRS issued a notice of deficiency, disallowing all of the DRPC deductions the Resers had claimed for 1987 and 1988. Rebecca filed for relief under the "innocent spouse" rule. Generally, married persons who file jointly are jointly and severally liable for the tax due, unless under the innocent spouse rule a spouse can show that (1) on the tax return there is a substantial understatement of tax attributable to grossly erroneous items of the other spouse, (2) in signing the return, the spouse seeking relief had not known and had had no reason to know of such substantial understatement and (3) taking into account all the facts and circumstances, it would be inequitable to hold the spouse liable for the deficiency.

The Tax Court upheld the IRS determination that the loan was made to DRPC and that Don Reser did not have enough basis to claim the deductions, assessing penalties on both Resers for negligent, substantial understatements of tax and for failure to file on time. The court denied Rebecca innocent spouse relief, because she failed to pass the "knowledge of the transaction test"—the taxpayer could not show that she did not know and had no reason to know that the stated liability on the tax returns was erroneous. Furthermore, the Tax Court found that Rebecca Reser had had a duty to inquire as to the propriety of the deductions and had failed to do so.

Result: On appeal, the Fifth Circuit Court of Appeals upheld the Tax Court decision that Don did not have enough basis in DRPC to claim the deductions but found Rebecca was eligible for innocent spouse relief. The court outlined the conflict between several appeals courts and the Tax Court regarding the test for innocent spouse relief: The Tax Court applies the knowledge of transaction test in cases involving both erroneous deductions and omission of income. However, some appeals courts have found that the test for erroneous deductions should be whether the spouse seeking the relief knew or had reason to know the deduction would give rise to a substantial understatement ( Price v. Commissioner , 887 F.2d 959 [9th Cir. 1989]).

The Fifth Circuit found the Tax Court approach made it virtually impossible for a spouse to obtain relief in erroneous deduction cases, because deductions are conspicuously recorded on the face of a tax return; therefore, any spouse who reads the return would be put on notice that some transaction had given rise to the deduction. The court found such a result would "undermine the objective of the innocent spouse defense."

The court decided to follow Price and outlined four factors it would consider in the substantial understatement standard.


Whos Filing What

  • The average tax rate for 1994 individual income tax returns increased to 14.3% because more taxpayers reported incomes of at least $50,000. This and other interesting historical information can be found in the IRSs Spring 1997 Statistics of Income Bulletin . For example, according to the bulletin, tax-exempt charities filed 165,599 returns and reported total revenue of $566 billion. An annual subscription for the Statistics of Income Bulletin is available for $33 from the Superintendent of Documents, U.S. Government Printing Office, P.0. Box 37194, Pittsburgh, Pennsylvania 15250-7954.

    Understanding Payback Time
    On July 1 the IRS issued proposed regulations designed to provide further relief for employers amending their pension plans so they no longer have to make in-service distributions to participants turning age 70 1 / 2 . The IRS also released announcement 97-70 to provide transition relief to qualified plans that failed to make distributions to employees who became 70 1 / 2 in 1996. The announcement appeared in Internal Revenue Bulletin 1997-29 on July 21. A public hearing on the proposed regulations is scheduled for October 28 at the IRS building in Washington, D.C.

    1. The spouses level of education.
    2. The spouses involvement in the familys business and financial affairs.

    3. The presence of expenditures that appear lavish or unusual when compared with the familys past levels of income, standard of living and spending patterns.

    4. The culpable spouses evasiveness and deceit concerning details of the couples finances.

    The court said, however, that "dramatic deductions" generally would put a reasonable taxpayer on notice that further investigation was needed. A spouse who has a duty to inquire, but fails to do so, may be charged with constructive knowledge of the substantial understatement and denied innocent spouse relief.

    Applying the substantial understatement standard and four factors to Rebecca, the court found the Tax Court clearly had erred.

    1. Although Rebeccas education was advanced, it provided her with no special knowledge of complex tax issues, such as basis computation.
    2. Rebecca was not personally involved with DRPCs business and financial affairs to any significant degree; instead, she was occupied full-time in her law practice and was the familys sole financial support.

    3. The record did not show any lavish or unusual expenditures for the years in question compared with the Resers normal standard of living or spending patterns.

    4. While the Resers were married, Rebecca advanced significant amounts of her personal funds for DRPCs operating expenses and knew her husband had obtained a line of credit from the bank. She thought they had invested sufficient funds to cover the losses. However, she did not know that Don had signed a guaranty agreement until after they were divorced.

    The court also considered whether Rebecca Reser had the duty to inquire about the deductions. Although the deduction amounts were large in relation to the personal funds the Resers had invested and DRPC did not generate any income, they were not dramatic enough to alert Rebecca to inquire further. In addition, the court noted the return was prepared by a CPA who had concluded the Resers were entitled to deduct the losses, and even two of the IRSs own agents arrived at different calculations of Dons basis in DRPC. Given that determining basis is an extremely technical process, the court found Rebecca had had no duty to make further inquiries as to whether the deductions were legitimate and granted her innocent spouse relief.

    • Reser v. Commissioner , CA 5, no. 96-60393, 5/12/97.

    Edited by Maria Luzarraga Albanese, JD, LLM, editor, AICPA client newsletters .


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