New Independent Contractor Bill
New legislation was introduced in the House on April 23 that would clarify the difference between independent contractors and employees for federal tax purposes. The Independent Contractor Tax Simplification Act of 1998 (HR 3722), sponsored by Congressman Jon Christensen (R-Neb.), provides a simple set of criteria for determining who is not an employee.
Currently, worker classification is determined by applying common-law standards which have not changed in decades. Based on these standards, the IRS created a 20-factor common-law test that focuses on the employers control over when, where and how the work gets done. It has been argued that this test not only is ambiguous and difficult to apply but also has been rendered obsolete by modern telecommuting techniques.
HR 3722 substitutes for the 20-factors a simple three-part test that examines the service providers investment, workplace and written documentation. The service provider is not considered to be an employee and the service recipient is not considered to be an employer if the criteria are met in all three parts.
For example, the three-part test would determine whether the individual
- Has a significant investment in assets and/or training and incurs significant unreimbursed expenses.
- Has a principal place of business and does not primarily provide the service in the service recipients place of business.
- Is performing services pursuant to a written contract.
Christensen commented that the three-part test is a common-sense approach to an old problem. Clarifying the tangled federal tax provisions with respect to the distinction between full-time employee and independent contractor status has emerged as the top priority of the nations small business community, he said.
HR 3722 is very similar to an independent contractor bill that was introduced in the House in 1995. That bill became part of the House version of the Taxpayer Relief Act of 1997 but was not included in the final bill.
INDIVIDUALTaxing Employer Securities
The Taxpayer Relief Act of 1997 created two different tax rates for all long-term capital gains: a 20% rate for assets held for more than 18 months and a 28% rate for assets held for more than 12, but not more than 18 months. However, the 1997 act did not specify which rate would apply to net unrealized appreciation. This no longer is a mystery. According to IRS Notice 98-24 (1998-17 IRB), net unrealized appreciation will be taxed at the lowest capital gain rate of 20%.
A net unrealized appreciation occurs when a qualified retirement plan invests in employer securities that increase in value after they are purchased by a trust. According to IRC section 402(e)(4)(B), if the employer securities are distributed as part of a lump-sum distribution, the taxable amount does not include the net unrealized appreciation. However, the net realized appreciation is taxed as a long-term capital gain when the securities are sold. Any additional gain will be either long- or short-term depending on how long the taxpayer holds the securities from the distribution date to the date of sale.
Under the new rate, taxpayers do not have to calculate the actual holding. All such securities will be considered to be held by the trust for more than 18 months prior to any distribution. This is a tremendous taxpayer victory and it will save CPAs hours of tedious work.
Observation: The guidance in Notice 98-24 applies to sales of employer securities that occur (1) after May 6, 1997, and (2) before January 1, 2001, or the date further guidance is issued, whichever is later. Beginning 2001, the capital gains rates for traded securities that have been held for more than five years will be reduced.
Michael Lynch, CPA, Esq., associate professor of tax accounting at Bryant College, Smithfield, Rhode Island.Nullifying IRS Access to Tax Preparation Software
A U.S. magistrate judge recommended that the U.S. District Court for the Northern District of Texas quash three summonses the IRS issued to obtain access to tax software programs on the grounds that their enforcement would constitute an abuse of the courts process ( United States v. Caltex Petroleum, et al., no. 3-96-CV-2726-X, April 16, 1998).
Caltex has undergone a five-year audit of foreign tax credits claimed for 19871990. The IRS issued summonses for copies of the international and foreign modules of the Tax Management System (ITMS/FTMS), now owned by Computer Language Research Inc. (CLR), as well as the source code and related documentation used in computing foreign tax credits. Although Caltex and CLR claimed they had gone to some lengths to provide the IRS with other software and materials it could use to audit Caltexs data, the IRS insisted that they provide, in executable and readable formats, the software used in the original computations.
Magistrate Jeff Kaplan applied the legitimate purpose and relevancy tests set forth in United States v. Powell (379 U.S. 48, 1964) to determine whether to enforce or quash the summonses. Citing the Eighth Circuits decision in United States v. Norwest (116 F3d 1227, 8th Cir. 1997), the magistrate concluded that the summonses had at least one legitimate purposehelping the IRS determine Caltexs liabilityand that the summonsed information was relevant to the audit because Caltex used the ITMS/FTMS program to calculate foreign tax credits. Kaplan also concluded that the source code could be summonsed because Caltex adopted the computers computations.
Nonetheless, the magistrate recommended quashing the summonses because enforcement would constitute an abuse of process. According to Kaplan, the evidence showed that the IRS issued the summonses for an improper purposegaining unrestricted access to the source code for all tax preparation software programs. According to the magistrate, the IRS did not need the ITMS/FTMS source code to audit Caltexs returns, it ignored all other means of obtaining the information necessary to complete the audit and it refused to use its own computer program to verify Caltexs foreign tax credits.
Observation. Kaplan took the debate over IRS access to tax software to a new level by accepting the abuse of power argument put forth by Caltex and CLR. The many taxpayers who also face IRS demands for access to software should welcome this decision with caution. The magistrates recommendations face challenges before the district court and, probably, the Fifth Circuit.
The IRS Restructuring Act of 1998 (H.R. 2678) would impose limits on the IRSs ability to issue summonses for software source codes and would safeguard source codes provided under summons.Time Is Short for Spin-offs
Although few U.S. corporations have spun off foreign subsidiaries (Fortune Brands spin-off of Gallaher is a notable exception), realigning multinational corporate structures has many benefits. However, a proposed regulationinitially published in 1991 but never finalizedmay put a conclusive end to such spin-offs.
Historically, when a domestic corporation sought to spin off a foreign subsidiary, Internal Revenue Code section 1248(f) provided the principal impediment. It says the distributing parent company must include in income (as a dividend) the amount by which the value of the distributed stock exceeds its basis (in the parents hands) but only to the extent of the earnings and profits accumulated in years when the distributed entity was a controlled foreign corporation. In many cases, this extra income did not translate into a substantial incremental tax liability, because the dividend was accompanied by deemed paid foreign tax credits that offset the U.S. tax.
The proposed regulation, however, dramatically ups the ante. Proposed Treasury regulations section 1.367(b)-5 provides that, in a distribution otherwise described in section 355, if the distributing corporation is domestic and the distributed entity is foreign, the distributing corporation will recognize gain if the distributee shareholder is an individual and not a U.S. corporation. In light of the ownership profile of most U.S. corporations, this proposed rule, if implemented, would cause the bulk of the appreciation inherent in the stock of a distributed foreign entity to be crystallized at the time of the distribution. The rule would defeat the tax purpose of a spin-offthat is, to allow the distributor to dispose of the spin-off entity tax-free. To the extent the rule applies, it would turn the spin-off into the functional equivalent of a taxable sale of the subsidiarys stock, differing only in the sense that the sale transaction does not generate any cash to defray the resulting tax liability.
Notwithstanding the compelling corporate business objectives of Fortune Brands spin-off of Gallaher, the transaction probably would not have been undertaken had the proposed regulation been finalized before the deal was concluded. It is likely that most other distributing corporations would reach the same conclusion. These regulations, if finalized in their present form, are slated to become effective for distributions occurring 30 days after they are published in the Federal Register .
Robert Willens, CPA, managing director at Lehman Brothers, New York City .
Deductibility of Deficiency Interest
The deductibility of interest paid by individuals on tax deficiencies has been in dispute ever since the Tax Reform Act of 1986 banned deductions of consumer interest such as that charged on credit cards or auto loans. Recently, the U.S. District Court for the Eastern District of North Carolina addressed the issue.
Robert Allen, a real estate developer, contributed real property to his closely held corporation to persuade a bank to lend it the working capital it needed. The corporation then sold the contributed property and reported the gain on its tax return. On audit, the IRS held that the gains should have been reported by Allen, not the corporation. In settlement, Allen paid a tax deficiency plus interest. He then deducted the interest as a business expense on his tax return. The IRS denied the deduction, claiming the interest Allen paid was personal interest.
Result: For the taxpayer. Temporary regulations section 1.163-9T(b)(2)(i)(A) provides that interest paid by individuals on tax deficiencies is nondeductible. The district court, citing prior decisions, held the regulation to be invalid. Therefore, Allen can deduct the deficiency interest to the extent it is an ordinary and necessary business expense.
To obtain such a deduction, the interest must be related to the business. This is generally determined under the interest allocation rules of temporary regulations section 1.163-8T(c)(3)(ii). To the extent the tax deficiency arises from a business transaction, the interest should be allocated to the business.
A taxpayer must also show that the interest is ordinary and necessary. As the court pointed out, if the adjustment that gave rise to the interest is expected or unavoidable, it is almost certainly ordinary and necessary. On the other hand, if there is no nexus between the deficiency and the taxpayers business or if the deficiency is the result of bad faith on the taxpayers part, the interest is not ordinary. The circumstances in between are subject to debate.
The court viewed the underlying transaction in this casea sale of real estate by a real estate dealeras ordinary and necessary. It rejected the IRS argument that the deficiency that generated the interest was caused by the transfer of property to the corporation, not by the sale. By phrasing the issue in this manner, the court may have increased the number of business transactions that qualify for interest deductions. As long as the direct cause of the tax is a business transaction, the interest is ordinary and necessary. Taxpayers attempting to deduct deficiency interest should identify an ordinary and necessary business transaction that gave rise to the tax. If they are able to do so, the interest paid may be deductible.
After the district court decision was rendered, the Ninth Circuit Court of Appeals reversed the Tax Court decision in Redlark , which also had held the regulation invalid. To date, the Eighth and Ninth Circuit Courts have held the regulation valid while the lower courts have ruled for the taxpayer. Since this current case is appealable to the Fourth Circuit, taxpayers may have a third opportunity to convince an appellate court that deficiency interest may be deductible if it is allocable to a trade or business.
Richard R. Allen, Sr. v. U.S., 1998-1 USTC P50, 196; 1997 U.S. Dist. Lexis 20252; United States District Court for the Eastern District of North Carolina.
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Prepared by Edward Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA Program, Culverhouse School of Accountancy, University of Alabama.