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The U.S. Supreme Court declined to review Textron Inc. v. U.S. (Sup. Ct. docket no. 09-750), letting stand a First Circuit Court of Appeals decision that the work product privilege did not protect the corporation’s tax accrual workpapers from an IRS summons. For the First Circuit’s decision, see U.S. v. Textron Inc., docket no. 07-2631 (1st Cir., 8/13/09) (en banc). For earlier Tax Matters coverage, see “First Circuit Denies Textron Work Product Privilege,” Nov. 2009, page 76; and “Work Product Stands Up to IRS Summons,” Nov. 2007, page 80.


While auditing the 1998–2001 tax returns of Textron Inc., the IRS issued an administrative summons for Textron’s tax accrual workpapers. Textron refused to supply the workpapers to the IRS, which petitioned the U.S. District Court for the District of Rhode Island to enforce the summons. In district court, Textron argued that its tax accrual workpapers were protected by either the attorney-client privilege, the tax practitioner privilege or the work product privilege. The district court rejected Textron’s attorney-client and tax practitioner privilege claims; however, it held that the workpapers were protected by the work product privilege (Textron Inc. v. United States, 507 F. Supp. 2d 138 (D. R.I. 2007)).


Among the questions for the court was whether the documents qualified for protection as having been “prepared in anticipation of litigation or for trial” (Fed. Rule of Civil Procedure 26(b)(3), where the work product doctrine is codified). The court noted that the First Circuit had interpreted that phrase to mean documents prepared “because of” a prospect of litigation, which was a purpose, if not the primary one, in Textron’s case.


The district court concluded that, although Textron created the workpapers to satisfy its financial audit requirements, “but for” the prospect of litigation the documents would not have been created at all, and therefore they were protected by the work product privilege.


On appeal, a three-judge panel of the First Circuit affirmed the district court. The court then granted an IRS petition to hear the case en banc. The full court reversed the district court and held that the work product privilege did not apply to Textron’s tax accrual workpapers because the documents sought were prepared not for litigation but for a statutorily required purpose of financial reporting and therefore were prepared in the ordinary course of business.


Textron petitioned for a writ of certiorari, which the Supreme Court denied May 24.




The U.S. Supreme Court agreed to review a case denying student status to medical residents for the purpose of exempting their employer from withholding and payment of FICA taxes. The case is Mayo Foundation for Medical Education and Research v. U.S. (Sup. Ct. docket no. 09-837). In it, the Eighth Circuit in June 2009 (docket no. 07-3242) approved Treasury regulations (Treas. Reg. § 31.3121(b)(10)-2(d)(3)(iii)) that categorically deny to full-time employees of a school, college or university or auxiliary nonprofit organization the exception otherwise available under IRC § 3121(b)(10) to withholding and payment of FICA taxes for students employed by a school, college or university where they are enrolled and regularly attending classes. The provision, which was added effective April 1, 2005, defines full time as 40 hours a week or less, if the employer so classifies its employees. Full-time services, the regulation states, are not incident to and for the purpose of pursuing a course of study, and therefore such employees do not qualify as students within the meaning of the statute. For earlier JofA Tax Matters coverage, see “Full-Time Medical Residents Not Exempt From FICA,” Sept. 2009, page 77.


Circuits have split on the issue. The Eleventh and Second circuits have held that medical residents may qualify as students for purposes of the FICA exemption, in, respectively, U.S. v. Mount Sinai Medical Center (486 F.3d 1248 (2007)) and U.S. v. Memorial Sloan-Kettering Cancer Center (563 F.3d 19 (2009)). Those cases, however, involved refunds sought for tax years before 2005, when the regulations at issue in Mayo took effect.




In Notice 2010-38, issued April 27, the IRS provided guidance on the tax treatment of extended medical insurance coverage of adult children under their parents’ employer-provided plans.


Among the more prominent features of the health care legislation enacted in March (the Patient Protection and Affordable Care Act, PL 111-148, and the Health Care and Education Reconciliation Act of 2010, PL 111-152) was its requirement that group health plans and health insurers that provide dependent care coverage must continue to make such coverage available to adult children until age 26. A related provision extends to children who will not attain age 27 before the end of a tax year the general exclusion from gross income for reimbursements for such care under an employer-provided accident or health plan (or retiree health account or voluntary employees’ beneficiary associations, or deduction by self-employed individuals). A Treasury Department official said the higher age for the income exclusion provisions is intended to encourage employers to continue coverage through the end of a plan year of children who turn 26 during it (Helen Morrison, Treasury deputy benefits tax counsel, quoted in BNA Daily Tax Report, May 27, 2010). The coverage mandate is effective for plan years beginning on or after Sept. 23, 2010, while the income exclusion took effect with enactment on March 30, 2010.


While it amended the income exclusion for reimbursements for medical care under IRC § 105(b), the health care legislation did not also amend IRC § 106, which provides an income exclusion for the cost of coverage under the employer-provided plan. The IRS said in the notice that it would amend the regulations under section 106 to mirror the new provisions under section 105, reasoning there was no indication that Congress intended a broader exclusion under the latter section than in the former. With respect to covered children, the residency, support and other tests of dependency in section 152(c), like the age limit, do not apply for purposes of extended medical care.


The notice also provides five examples, including one (Example 4) in which coverage and reimbursements are excluded from the income of an employee with respect to a child who is married and otherwise eligible for coverage (the Senate version of the legislation had restricted coverage to unmarried children, but that phrase was stricken from the final version). Although in this example the employer also provides health care coverage to the adult child’s spouse, the fair market value of the coverage for that person is includible in the employee’s gross income for the tax year.


The notice also stated the IRS plans to amend regulations concerning qualified benefits under cafeteria plans, flexible spending arrangements and health reimbursement arrangements to allow the extended coverage and to allow employees (retroactively to March 30, 2010) to elect to add children who have newly become eligible or to extend coverage past the date on which their eligibility otherwise would have expired.


In addition, under a transition rule, the IRS said that, although such changes normally require a prospective plan amendment, employers may permit employees to make pretax salary reduction contributions for accident or health benefits under a cafeteria plan for qualifying adult children effective March 30, 2010. However, plans must be formally amended by Dec. 31, 2010, to retroactively cover such children during the period.




The Second Circuit Court of Appeals affirmed (docket no. 09-1955-ag, 6/2/2010) the Tax Court’s holding in Nathel v. Commissioner that shareholders of S corporations who made additional capital contributions could not thereby increase their basis in loans to the entities, offsetting ordinary income to them from repayment of the loans. For earlier JofA Tax Matters coverage, see “Capital Contributions Increase Stock, Not Loan Basis,” April 2009, page 69.


The taxpayers, brothers Ira and Sheldon Nathel, owned interests in three S corporations, to which they had made capital contributions and loans. Losses by the corporations reduced the brothers’ stock and loan bases. In a reorganization, they received loan repayments and made new capital contributions. On their tax returns, they increased their loan bases by the amount of their capital contributions, claiming the latter were an item of income within the meaning of IRC § 1366(a)(1)(A), which provides for pass-through of income items to shareholders. The Second Circuit called the taxpayers’ argument “novel,” given a longstanding distinction between capital contributions and income and the explicit language of IRC § 118(a) that gross income does not include a taxpayer’s contributions to capital.


The court also rejected the taxpayers’ alternative argument that the capital contributions should be deductible as losses incurred in a transaction entered into for profit under section 165(c)(2). The court found that the taxpayers could not show that their primary motivation for making the capital contributions was to obtain the loan guarantee releases.




The Sixth Circuit Court of Appeals allowed Procter & Gamble Co. (P&G) to recalculate its refund claim under the now-repealed foreign sales corporation (FSC) program, reversing a district court ruling last year (Proctor [sic] & Gamble Co. v. U.S., docket no. 08-4078 (6th Cir., 4/28/10)).


The District Court for the Southern District of Ohio had found for the IRS on disputed deductions of $359.3 million under the FSC’s rules for calculating “combined taxable income” (CTI). (For previous Tax Matters coverage, see “P&G Appeals Deduction Denial,” April 2009, page 68.) P&G then requested that it be allowed to recalculate its tax liability under an alternate method—the gross-receipts method. This method allowed the parent company and FSC to set a transfer price that limited taxable income to the FSC to 1.83% of the “foreign trading gross receipts derived from the sale.” The district court denied the motion, saying that P&G was prevented from doing so by the variance doctrine, which bars taxpayers from raising at the judicial level claims they did not submit in administrative proceedings. P&G appealed.


The Sixth Circuit held that the company should be allowed to recalculate its tax liability using the gross-receipts method. The court also found that P&G was not barred by the variance doctrine from doing so because it did raise such a claim in arguing against an IRS alternative calculation under the CTI method.


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