Internet Bill Gets White House Thumbs Up
President Clinton announced his support for a bill that would prohibit new taxes on goods sold over the Internet for six years while lawmakers and industry study the effects of online taxes. The Internet Tax Freedom Act (S 442, HR 1054), introduced by Senator Ron Wyden (D-Ore.) and Congressman Christopher Cox (R-Calif.), has strong bipartisan support in both the House and Senate.
“There should be no special breaks for the Internet, but we can’t allow unfair taxation to weigh down and stunt the growth of the most promising new economic opportunity in decades,” said Clinton at the Technology 1998 conference in San Francisco.
The bill would prohibit state and local governments from imposing taxes on Internet access charges, such as the fee users pay to Internet service providers. It also would protect against new taxes for consumers and vendors involved in commercial transactions over the Internet, including “nexus” taxes imposed on out-of-state businesses.
The bill would require the administration and Congress to study U.S. and international taxation of Internet commerce, meet with foreign government officials in an effort to keep the Internet free of tariffs and recommend to Congress how and when online taxes should be applied.
| New FICA Guide for Government Employers The IRS has published a new edition of Publication 963, Federal/State Reference Guide , as part of an extensive outreach program to help state and local government employers meet the reporting and payment requirements of the Federal Insurance Contributions Act (FICA). The guide, which covers Social Security and FICA reporting requirements, was developed by the IRS, the Social Security Administration and the National Conference of State Social Security Administrators. Copies are available from the IRS at 800-829-3676. For more information on the IRS outreach program, contact your local IRS office. |
Tax Briefs
INDIVIDUAL
Reporting the Sale of a Home
The Taxpayer Relief Act of 1997 liberalized capital gains exclusion rules for the sale of a principal residence. Taxpayers now may exclude up to $250,000 ($500,000 if married filing jointly) of gain from gross income when their homes are sold. The act also eases the rules for reporting these gains.
IRC section 6045(e) requires persons reporting real estate transactions (usually the attorney conducting the closing, the title insurer or the real estate broker) to furnish the IRS with a detailed information return for each transaction and to give a payee statement to the seller following each closing. According to new paragraph (5) of this section, the reporting person can avoid these requirements by asking the seller to provide written certification of the following:
- The seller owned and used the home as a principal residence for at least two years during a five-year period ending on the date of sale (the seller need not be using the home as a principal residence on the date of sale).
- The seller has not sold another principal residence during the previous two years (not including any sale before May 7, 1997).
- No portion of the residence was used for business or rental purposes by the seller or the seller’s spouse after May 6, 1997.
In addition, at least one of the following statements must be true:
- The entire residence has been sold for $250,000 or less.
- If the seller is married, the entire residence has been sold for $500,000 or less and the related gain has not exceeded $250,000.
- If a married seller intends to file a joint return, the seller’s spouse also must have used the home as his or her principal residence for two or more years during the last five years. he or she also must not have sold another principal residence during the previous two years (again, taking into account only sales after May 6, 1997).
If there are several sellers, a separate written certification must be obtained from each seller. These certifications must have been obtained on or before January 31 of the year following the sale and then retained for four additional years. A sample certification form is included in revenue procedure 98-20 (1998-7 IRB).
Observation: Sellers still must file Form 2119, Sale of Your Home, in addition to the certification form. CPAs should discuss with their clients the option of forgoing the annual home-office deduction (including depreciation) for periods after May 6, 1997, in order to obtain the maximum available gains exclusion when their homes are sold.
—Michael Lynch, CPA, Esq., associate professor of tax accounting at Bryant College, Smithfield, Rhode Island.
Line Items
“Don” Deductions
On The Road Again
Commuting expenses are nondeductible; however, taxpayers who have one or more regular work locations outside of their homes can deduct the costs of commuting to and from temporary work sites. In private letter ruling no. 9806007, the IRS ruled for an employee who spent approximately 75% of his time working at various client locations and the remaining 25% at his employer’s field office. The IRS said the time spent at this field office was sufficient to make it the employee’s regular place of business. Therefore, all costs of traveling to the temporary work sites are deductible.
Not-So-Original Deductions
Employees of a company arranged their business travel with an agency that used a ticketless travel procedure. Reservations were made electronically, and the agent e-mailed or faxed the itinerary back to the employer. In private letter ruling no. 9805007, the IRS ruled that Treasury regulations section 1.274-5T(c)(2)(iii) does not require documentary evidence to be original. Thus, the faxed or e-mailed copies of the itineraries were sufficient evidence to support a business deduction.
Taxing Tuition
A high school boy delivered newspapers for the Boston Globe under a program that paid him $5,000 toward his college tuition if he was accepted into an accredited college or university. Upon acceptance into Dartmouth College, the boy received a check (payable to him and the college), applied it toward his tuition and excluded it from his gross income. The Tax Court held the payment was taxable ( Daniel E. Godfrey v. Commissioner , TC Memo 1998-51).
Too Good to Be True
A New York couple relied on the advice of a tax shelter promoter to prepare their tax return. They deducted a $15,400 loss based on a $3,000 investment. The IRS sought penalties for negligence and substantial underpayment of taxes. According to the Tax Court, the couple should have known that it was too good to be true ( Michael J. Heckler, et al. v. Commissioner , TC Memo 1998-49).
A Capital Gain
A partnership sold some land and used the percentage-of-completion method to calculate its gain. The IRS issued a notice of deficiency and disallowed the use of this method. The Tax Court found the IRS was not substantially justified in its position. Therefore, the partnership was entitled to recover reasonable attorney’s fees incurred in contesting this issue ( Foothill Ranch Co. Partnership v. Commissioner , 110 TC no. 8).
Calling a Spade a Spade
A state court ordered a husband to pay his wife monthly spousal support before their divorce. The wife argued that these payments were not alimony and therefore excludable from her gross income. The Tax Court held that all the payments constituted alimony and were deductible by the husband and taxable to the wife ( Norman D. Peterson, et al. v. Commissioner , TC Memo 1998-27).
Michael Lynch, CPA, Esq., associate professor of tax accounting at Bryant College, Smithfield, Rhode Island.
Poor Divorce Planning Can Be Costly
A taxpayer who fails to provide for a prior year’s dependency exemptions in his or her divorce decree may find the omission costly. Although the tax law allows a custodial parent the dependency exemption after a divorce, it is silent on the issue of who gets the exemption before the divorce. Proper planning could have prevented the following situation.
A couple and their child lived together for the entire 1996 tax year. Both taxpayers worked outside the home, with the husband earning slightly more than the wife. In January 1997, the husband moved out of the home and quickly filed for divorce. The divorce was granted in April 1997 and the decree granted custody of the child to the wife, thus settling the dependency exemption issue for 1997 and beyond. However, the decree did not address the dependency exemption for 1996. Because the couple was married and living together that year, they had to file their 1996 returns either jointly or as married filing separately. They elected to file separately for that year, but both wanted to claim the child as a dependent.
Which parent was entitled to claim the child as a dependent for 1996? The IRS provides an abundance of guidance on dependency exemptions for divorced or separated parents but does not specifically address the issue of dependency exemptions for married taxpayers who reside in the same household. Since splitting the exemption is not allowed, the following five dependency tests must be met:
- Relationship test.
- Joint return test.
- Citizen or resident test.
- Income test.
- Support test.
All but the support test were met by both taxpayers; therefore, the claim rested solely on who would provide the child with the best financial support. The mother took the exemption because she provided over 50% of the financial support in 1996. The father chose not to challenge her claim.
Determining support can be complicated if support items are provided from joint funds. In community property states, the exemption may be lost unless the taxpayers execute a multiple support agreement.
Observation : Taxpayers who are considering divorce should consult their tax advisers to incorporate tax planning into their divorce plans. Tax advisers should advise their clients to include tax issues of prior years in the divorce decree. The divorce decree should settle the dependency exemption issue for any period before the divorce as well as for periods after the divorce. This will protect the clients and avoid further conflict.
—Tina Steward Quinn, CPA, PhD, assistant professor of accounting, and W. Terry Dancer, CPA, PhD, associate professor of accounting, Arkansas State University.
Tax Cases
Deductibility of Home Mortgage Interest
Individual taxpayers are permitted to take an itemized deduction for qualified residence interest. The interest must have been paid on a loan used to purchase or build a residence or on home equity indebtedness of up to $100,000. The debt, to qualify, must have been secured by the residence. The Tax Court recently considered whether actual ownership of the residence also was a requirement for the deduction.
Saffett Uslu and his wife, Ana, wanted to purchase a home. Because of his poor credit rating and prior bankruptcy filing, however, he was unable to obtain financing. Saffett arranged for his brother to buy a house using money the brother had borrowed on a debt secured by the home. Saffett and his family occupied the house and made the mortgage payments as well as all payments for repairs and maintenance. Saffett deducted the mortgage interest as qualified residence interest. The IRS disallowed the deduction because he did not own the property.
Result : For the taxpayer. Saffett Uslu and his wife were permitted to take a home mortgage deduction.
While it is generally accepted that interest is deductible only on obligations of the taxpayer, there have been challenges to this rule. In Golder (604 F.2d 34, 79-2 USTC P9451), the taxpayer argued that Treasury regulations section 1.163-1(b) created an exception: The regulation says interest is deductible if the taxpayer is “the legal or equitable owner” of the real estate. In rejecting Golder’s argument, the 9th Circuit Court of Appeals said the regulation permits a deduction only in cases of nonrecourse debt when the debtor will lose the property if the debt is not paid.
In two other cases, Loria (TC Memo 1995-420) and Song (TC Memo 1995-446), taxpayers again argued that the regulation created an exception. In both, a family member purchased the home and borrowed the funds while the taxpayer who occupied the home made the payments. The Tax Court, basing its decision on Golder, rejected both taxpayer’s arguments.
Although Uslu appears similar to Loria and Song, there are certain differences distinguishing it. In the prior cases, the taxpayers were unable to prove they were the “beneficial” owners of the homes. In Uslu, the fact the taxpayer had made all the mortgage payments and all parties considered the home to belong to him and his wife created an implied debt between Saffett and his brother. The interest paid to the bank, therefore, was interest on that intrafamily loan. This is why Saffett Uslu was permitted to take the deduction.
A taxpayer attempting to deduct interest on a home owned by a relative must be able to show that the ownership is an accommodation necessary to obtain financing and that all parties expect the taxpayer ultimately to be responsible for the debt. Written documentation of this understanding always is helpful. But it is imperative that only the taxpayer claim the related deductions, not the family member who facilitated the sale. The family should consider transferring ownership of the home to the occupying taxpayer at the first convenient opportunity. It will be interesting to see whether, in the future, taxpayers who are the beneficial owners of nonresidential property are also permitted interest expense deductions.
- Saffett and Ana Uslu, TC Memo 1997-551.
Prepared by Edward Schnee, CPA, PhD, Joe Lane Professor of Accounting and director of the MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.
Nonresidents Entitled to Deduct Alimony Payments
In a decision with implications for those states that treat nonresidents differently from residents in a wide variety of tax matters, the U.S. Supreme Court ruled that state tax laws denying a nonresident a deduction for alimony payments made outside the state were unconstitutional under the privileges and immunities clause of the U.S. Constitution. The Court said the clause demanded a “rule of substantial equality” in treating nonresident taxpayers.
Christopher H. Lunding, a Connecticut resident, earned substantial income from his law practice in New York. He challenged a New York State law that denied nonresidents a deduction for alimony payments made outside New York, on the grounds the law violated the Constitution.
New York State’s nonresident income tax computation involves several steps. Starting with federal adjusted gross income (the U.S. tax code allows a deduction for alimony), nonresident taxpayers must compute their tax liability “as if” they resided in New York. They then determine their tax using the rates applicable to residents. After the tax is computed, nonresidents derive an “apportionment percentage” to be applied based on the ratio of New York source income to federal adjusted gross income. The denominator of the ratio-federal AGI-includes a deduction for alimony paid. The numerator-New York source income-includes net income from property, employment or business operations in New York but specifically disallows any alimony deduction.
Nonresidents multiply the “as if” resident tax by the apportionment percentage to compute their actual New York tax liability. Because there is no upper limit on the percentage, when a nonresident’s New York source income, which does not include an alimony deduction, exceeds federal AGI, the taxpayer is liable for more than 100% of the “as if” resident tax. In other words, the nonresident may end up with a greater tax liability than a resident because an alimony deduction is denied.
In ruling against Lunding’s challenge, the New York State Court of Appeals said the privileges and immunities clause did not mandate absolute equality and the clause was not violated when “there is a substantial reason for the difference in treatment, and the discrimination practiced against nonresidents bears a substantial relationship to the state’s objective.” (Lunding v. New York, 89 NY 2d, at 289.) The court reasoned that because New York residents were subject to the burden of taxation on all their income, regardless of source, they should be entitled to a deduction for all expenses, including alimony. But the court concluded that Lunding’s alimony deductions were “wholly linked to personal activities outside the state” and thus more appropriately allocated to his state of residence. The New York court was satisfied there was a substantial reason for the difference in tax treatment.
Result : For the taxpayer. On appeal, the U.S. Supreme Court said the privileges and immunities clause provided that “the citizens of each state shall be entitled to all privileges and immunities of citizens in the several states.” One right the clause protects is that of a citizen of any state to “remove to and carry on business in another without being subjected in property or person to taxes more onerous than citizens in the latter state are subjected to.” (Shaffer v. Carter, 252 US 37). The Court said the clause demanded “a rule of substantial equality of treatment for resident and nonresident taxpayers.” (Austin v. New Hampshire, 420 US 656). The Court was not persuaded that New York had presented a substantial reason for the difference in treatment of alimony deductions for nonresidents and was troubled that New York required nonresidents to compute their tax as if they were residents while forbidding them a deduction available to residents.
The Court also rejected the New York State Court of Appeals characterization of alimony as linked to activities wholly outside the state. According to the Court, alimony is an obligation of some duration that is determined mostly by a person’s income, wherever earned. The alimony obligation “may be of a personal nature, but it cannot be viewed as geographically fixed in the manner that other expenses, such as business losses, mortgage interest payments, or real estate taxes might be.” In reversing the New York decision, the Supreme Court said that requiring nonresidents to pay more tax than similarly situated residents, solely on the basis of their liability for alimony payments, violated the rule of substantial equality of treatment.
- Lunding v. New York, no. 96-1462 (1/21/98).
Prepared by Roy Whitehead, Jr., JD, LLM, associate professor of business law, and Donna Smith, CPA, assistant professor of accounting, both of the University of Central Arkansas, Conway.
