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Practical Advice on Current Issues.


Casino May Deduct Slot Club Points in Year Accumulated

Affirming the district court, the Ninth Circuit has ruled that a casino using the accrual method of accounting may deduct the value of slot club points in the tax year in which the slot club member has accumulated the minimum number of points required to redeem a prize (Gold Coast Hotel & Casino, 10/16/98). The casino's liability to redeem accumulated slot club points is fixed once a club member acquires the minimum number of points.

The Gold Coast Decision

Gold Coast Hotel & Casino, a Nevada bruited partnership, has operated a slot club since March 1987. Slot club members receive a club card, similar to an ATM card. When the card is inserted into a slot machine, a computer tracks the accumulation of slot club points. Slot club points can be redeemed for prizes, ranging from coffee mugs to Hawaiian vacations; the minimum number of points needed to redeem a prize is 1,200. The parties stipulated that the market value of each club point is $0.0021.

On its 1989 tax return, Gold Coast deducted as an expense the difference between the total value of slot club points accumulated by club members and the total value of points redeemed by club members. In addition, Gold Coast recaptured as income the value of accumulated slot club points in accounts in which there had been no activity for over a year, and which had been deducted as an expense in the prior year.

The IRS challenged the deduction, citing General Dynamics Corp., 481 US 239 (1987) and arguing that the casino did not incur the expense of accumulated points until they were redeemed for a prize. In General Dynamics, a company had established a reserve account reflecting its estimated liability for medical care received by employees but unpaid by General Dynamics. General Dynamics sought to deduct the amount of its estimated liability as an accrued expense, but the Supreme Court ruled that the "all events" test had not been met because the last event necessary to fix the liability (the filing of a claim by the employee) had not occurred by the end of the tax year. Relying on General Dynamics, the Service argued that the "last event" for Gold Coast's accounting purposes was the actual redemption of club points.

Citing Hughes Properties, Inc., 476 US 593 (1986), Gold Coast argued that the "last event" fixing its liability occurred when the minimum number of club points necessary to earn a prize was accumulated; at that time, the liability became fixed pursuant to Nevada gaming regulations. In Hughes, the Supreme Court ruled that a casino operator could deduct the amount of money guaranteed for payment on progressive slot machines; under Nevada law, the liability was fixed at yearend even though the amount had not been won by the end of the tax year.

The Ninth Circuit, comparing Gold Coast's guaranteed prize to the guaranteed payout in Hughes, agreed that, even though not all slot club members will redeem their points, an "absolute liability" existed. The court also found the IRS's reliance on General Dynamics to be misplaced, ruling that a slot club member's demand for payment is nothing more than making a demand for payment of an uncontested liability. "Unlike in General Dynamics, there is no involvement of third parties necessitating that slot club members establish or otherwise offer proof of their right to payment."

The court, relying on the fact that the parties had stipulated to the value of each point, held that the amount of Gold Coast's liability was determinable with reasonable accuracy, thus meeting the second prong of the all-events test.

The tax years at issue in this case were prior to the effective date for the economic performance rules for payment liabilities. Regs. Sec. 1.4614(g) (4) provides that economic performance occurs with respect to a liability to pay an award, prize or jackpot when payment is made to the person to whom the liability is owed. Thus, the economic performance rules for payment liabilities would bar the deduction permitted in Gold Coast, unless an exception applies. The recurring item exception is available under Regs. Sec. 1.461-5 to allow generally a deduction in the tax year in which a recurring liability for a prize, award or jackpot was fixed and determinable, if payment is made within eight and one-half months after the end of such tax year.



Publicly Traded Stock Exception for Gifts to Private Foundations Made Permanent

Congress passed, and President Clinton signed into law, legislation extending a host of business tax breaks, including a provision to make permanent the special rule contained in Sec. 170(e)(5) on the deductibility of contributions of qualified appreciated stock to private foundations.

The general rule of Sec. 170(e)(1)(B) is that taxpayers can deduct only their basis when they donate long-term capital gain property to a private foundation. However, Sec. 170(e)(5) permitted both individual and corporate taxpayers to obtain a fair market value (FMV) deduction for contributions of appreciated publicly traded stock to a private foundation--as long as the contribution was made by June 30, 1998. The Tax and Trade Relief Extension Act permanently extended this special rule; it is effective retroactively for contributions of qualified appreciated stock to private foundations made after June 30, 1998.

One limitation on this technique under Sec. 170(e)(5)(C) is that total donations made by the donor (and members of the donor's family) to private foundations of stock in a particular corporation may not exceed 10% of that corporation's outstanding stock.

Corporations can donate treasury stock to a private foundation and obtain an FMV deduction without relying on Sec. 170(e)(5). This approach may continue to be useful for non-publicly traded corporations. The rule in Sec. 170(e)(1)(B)(ii) limiting deductions to basis actually provides that, when a charitable contribution is made to a private foundation (other than a so-called conduit foundation described in Sec. 170(b)(1)(E)), the deduction is reduced by "the amount of gain which would have been long-term capital gain if the property contributed had been sold by the taxpayer at its fair market value...." In the case of a sale or exchange by a corporation of its own stock (including treasury stock), Sec. 1032 provides that no gain or loss is recognized. Therefore, the cutback rule of Sec. 170(e)(1)(B) does not apply to donations by a corporation of its own stock to a private foundation; see Rev. Rul. 75-348.

Gifts by individuals of closely held stock or other non-publicly traded business interests (which never qualified for the now-resurrected exception under Sec. 170(e)(5)) may be made to so-called conduit foundations (described in Sec. 170(b)(1)(E)(ii)) with excess distribution carryovers to obtain FMV deductions.

For a foundation to be treated as a conduit foundation eligible to be treated as a public charity (with resulting 30% of adjusted gross income (AGI) and FMV deductibility), all contributions received during the year must be distributed within the two and one-half month period following the close of the tax year or applied against excess distribution carryovers. If anything less than all contributions received is distributed, the foundation is not a conduit. If excess distribution carryovers are to be used, an election must be made under Regs. Sec. 53.4942(a)-3(c)(2)(iv).

A limited exception applies to this conduit rule. Solely for purposes of determining the FMV deductibility of property, the foundation only has to distribute an amount equal to property contributions (not all contributions) received during the year. The contributor would continue to be subject to the 20%-of-AGI limitation.



Sec. 338 Treatment Denied for Bankruptcy Workout

In Letter Ruling (TAM) 9841006, the IRS rejected a taxpayer's claim that the stock of a corporation was acquired in a Sec. 338 qualified stock purchase. Instead, the Service's position was that the stock was acquired in a Sec. 368 reorganization.

Corporation B was the common parent of an affiliated group filing consolidated returns. B owned all the stock of corporation C, which owned all the stock of corporation E, which owned all the stock of corporation E B also owned all the stock of corporation D. D, E and F owned stock of corporation I. I owned all the stock of corporation J. C and F were holding companies, which combined to own all the stock of corporation H (which was an operating company). The B group experienced financial difficulties following several leveraged stock acquisitions. As a result, B, C, E, F, I and J filed voluntary Chapter 11 bankruptcy petitions. As part of a bankruptcy reorganization, C and F contributed their H stock to a new corporation (G) for the stock of G and then distributed the G stock to the B creditors. The B creditors included corporation X, which had received a lien on the H stock when it had lent money to B several years before. Pursuant to the bankruptcy plans of reorganization, C and E were liquidated; the plan also called for the eventual dissolution of B. In addition, F was merged with and into J, which became a new corporation, New Corp. All of the stock of F and J was canceled and shares of New Corp stock were issued to creditors. After the transaction, C and G made a Sec. 338(h)(10) election with respect to G's acquisition of the H stock.

Sec. 338 provides that, if a purchasing corporation makes a qualified stock purchase (QSP), it can elect Sec. 338(h)(10) treatment. The selling corporation recognizes no gain or loss on the sale of the target stock; the target is treated as (1) selling all its assets at their fair market value, (2) a new corporation that purchases such assets and (3) liquidating.

Under Sec. 338(d)(3), a QSP means any transaction in which stock possessing 80% of a corporation's vote and value is acquired by another corporation by purchase during a 12-month period. Under Sec. 338(h)(3)(A)(i), "purchase" does not include an acquisition of stock if the acquiring corporation obtains a carryover basis in the stock.

The IRS held that G's acquisition of the H stock was not a QSP, because the stock was acquired with a carryover basis either in a B, C or G reorganization.

G Reorganization

The requirement of a G reorganization that C transfer substantially all its assets to G was met, because the H stock transferred to G was substantially all of C's assets. The TAM pointed out that, as a general matter, in determining whether the "substantially all" requirement is met, "the nature of the properties retained by the transferor, the purpose of retention, and the amount thereof" are considered; see Rev. Rul. 57-518. As a general rule, the percentage of transferred and retained assets are computed by reference to the assets' net value, rather than their gross value. Moreover, the "substantially all" requirement for G reorganizations is not as strict as for C reorganizations.

The taxpayer argued that the "substantially all" test was not met, because it requires a look-through of the E and H stock held by C to the underlying assets held by E and H. In response, the Service stated that, in the instant case, a look-through approach was not appropriate because, in effect, C no longer held an equity interest in E and the underlying operating assets held by E's subsidiaries; the institution of bankruptcy proceedings for E, F I and J had supplanted C as equity owner of E and indirect owner of E's subsidiaries. The E stock was worthless in C's hands. In this regard, the New Corp stock received by C in the bankruptcy reorganization was received in its capacity as a creditor and represented only a small percentage of the New Corp stock.

The Sec. 354 distribution requirement for a G reorganization was met by C's deemed distribution of G stock in exchange for B's C stock: C's transfer of the G stock to B's creditor was a constructive distribution by C of the G stock to C's shareholder B. Even though several years before, C had pledged the H stock to X for B's benefit, it is only on the transfer of stock to B's creditors in satisfaction of the pledge that B is viewed for Federal income tax purposes as receiving a distribution; see Maher, 469 F2d 225 (8th Cir. 1972).

TAM 9841006 also concluded that the transaction met the "continuity-of-interest" requirement. Under Alabama Asphaltic Limestone Co., 315 US 179 (1942), creditors of a bankrupt corporation may step into the shoes of the shareholders and receive stock of an acquiring corporation in satisfaction of the continuity-of-interest requirement. Moreover, under Rev. Rul. 84-30, it does not matter that the creditors receiving the acquiring corporation (G) stock were creditors of the target corporation's (C's) parent (13). The payment of the G stock to B's creditor, X, in satisfaction of a pledge of the H stock, satisfied the continuity-of-interest requirement.

B Reorganization

A failure of the transaction to qualify as a G reorganization would not preclude qualification under another reorganization provision. The transaction could have qualified as a B reorganization in which G acquired the H stock solely for G voting stock. However, under a settlement agreement, G and H agreed to pay J and New Corp to assume certain tax liabilities of B, C and H. The taxpayer argued that the cash paid under this provision of the settlement agreement was "boot," violating the "solely for voting stock" requirement of a B reorganization. On the other hand, the IRS examiner asserted that the cash was not paid in exchange for H stock. The IRS National Office said the question of whether there was boot allocated to G's acquisition of the H stock was a factual question that could not be resolved in technical advice.

C Reorganization

Finally, if G's acquisition of the H stock was not a G reorganization, it was a C reorganization, because the "solely for voting stock" requirement was met under the Sec. 368(a)(2)(B) boot relaxation rule. Further, consistent with the G reorganization analysis, the transaction met the continuity-of-shareholder-interest requirement, the Sec. 368(a)(2)(G) distribution requirement and the "substantially all of the assets" requirement for a C reorganization, even though the "substantially all of the assets" requirement is stricter for a C reorganization than for a G reorganization.

In sum, because G's acquisition of the H stock was either a G or a C reorganization (or possibly a B reorganization, depending on the factual resolution of the boot question), G acquired the stock of H in a carryover basis transaction. Therefore, under Sec. 338(h)(3)(A)(iii), G did not acquire the H stock in a QSP and the Sec. 338(h)(10) election of G and H was invalid.



Accelerated Pension Contribution Deduction Rejected

The Ninth Circuit has affirmed the Tax Court's decision that a participating employer in several multiemployer defined benefit plans (collectively bargained) could not deduct contributions paid to the plans after the end of the relevant plan year but before the deadline for filing the corporate tax return (Lucky Stores, Inc., 8/20/98).

This ruling is significant in the multiemployer plan context because it emphasizes that Sec. 404(a)(6) merely provides an extension of time for making deductible contributions "on account of" the preceding year and cannot be used to increase the otherwise allowable deduction based on contributions for which an obligation does not arise until the next tax year. Such a contribution approach is standard for multiemployer plans under which employers are obligated to contribute only with respect to actual hours that their covered employees work (i.e., a cents-per-hour plan). This is in contrast to a single employer defined benefit plan, under which a range of contributions is permitted under actuarially based funding standards (Sec. 412).

The Tenth Circuit is currently hearing a case on appeal from the Tax Court (American Stores Company) with very similar facts; Lucky Stores has filed a petition for rehearing and a motion to stay the ruling, pending the Tenth Circuit's decision. In addition, a taxpayer intending to adopt this acceleration strategy may be faced with whether this would be treated as an accounting method change.

Ninth Circuit Opinion

Under various collective bargaining agreements, Lucky Stores was required to make monthly contributions to the plans based on the number of hours participants had worked in the preceding month. During each tax year prior to the year in issue, Lucky Stores added the 12 monthly contributions attributable to covered hours or weeks worked during the year and claimed a deduction for the total amount. However, for the tax year ended Feb. 2, 1986, Lucky Stores claimed a deduction for the 12 contributions made during the tax year, as well as for contributions made before Oct. 15, 1986, the extended deadline for filing its tax return (a total of 19 or 20 months, depending on the plan). The IRS disallowed the deduction for contributions made during the post-year-end "grace period"

Sec. 404(a)(6) affords sponsors an extended period of time to make deductible contributions to a qualified retirement plan, by providing that payments are deemed to be made on the last day of the preceding tax year if the payments are "on account" of the preceding tax year and made by the extended due date of the income tax return for such tax year.

Rev. Rul. 76-28 provided that a payment was deemed to be made "on account" of the preceding tax year if the plan treated the payment as it would have treated payments actually received during the prior tax year.

Lucky unsuccessfully argued that, unlike defined contribution plans (which maintain individual accounts and require precise accounting as to the date and amount of contributions), the payout for defined benefit plans is based on the formula under the plan and not on the date of the sponsors' contributions. Thus, Lucky argued that it had treated the contributions in the same manner as contributions received on the last day of the preceding year, because all contributions were treated the same under defined benefit plans.

In rejecting this argument, the court noted that multiemployer trustees establish schedules and accounting procedures for plan contributions to ensure they will be able to meet their liabilities under the plans. Further, Lucky was required to make monthly contributions under the collective bargaining agreements based on the hours worked by participants in the prior month, including an interest assessment if the payments were delayed. Thus, according to the court, Lucky's contributions were being used to satisfy its liability to the plans for a particular month and the contributions made after February 1986 were not treated the same as contributions made during the year ending February 1986.


Protected Benefits for SESOPs

The IRS has released temporary and proposed regulations modifying the existing Sec. 411(d)(6) regulations (which generally prohibit the elimination of an optional form of benefit in a retirement plan) to conform with the Taxpayer Relief Act of 1997 (TRA '97) changes for S corporations that maintain ESOPs (SESOPs).

As modified, the regulations provide that SESOPs will not violate Sec. 411(d)(6) by making cash distributions in lieu of in-kind distributions. In addition, the new regulations extend the period of Sec. 411(d)(6) relief for amendments necessary to reflect the TRA '97 until the end of the TRA '97 remedial amendment period (generally, the end of the 1999 plan year).

A literal reading of the new temporary and proposed regulations suggests that Sec. 411(d)(6) relief for SESOPs not making in-kind distributions may not be available for SESOPs converted from C status after the start of their 1998 tax years. However, IRS officials indicate that the intent of the new regulations is to provide relief to SESOPs converted from C status for tax years beginning after 1997. Without such relief, C corporations sponsoring ESOPs would effectively be prevented from maintaining a SESOP after converting to S status, because they would be required to make in-kind distributions of employer securities and could quickly violate the 75-shareholder requirement.


Although ESOPs must generally allow in-kind distributions of employer securities, Sec. 409(h)(2) allows certain employers, whose by-laws restrict company ownership, to distribute cash in lieu of employer securities. Section 1506 of the TRA '97 extended the Sec. 409(h)(2) exception to S corporations, effective for tax years beginning 1997.

Generally, the right to an optional form of benefit (including in-kind distributions) is a protected benefit under Sec. 411 (d)(6). Regs. Sec. 1.411 (d)-4, Q&A-2(d) (2)(ii), provided relief from the Sec. 411 (d)(6) in-kind distribution requirements for certain employers maintaining ESOPs, but this relief did not apply to SESOPs. To reflect the TRA '97 changes to Sec. 409(h)(2), the temporary regulations extend Sec. 411(d)(6) relief to SESOPs.

Under the TRA '97, any amendment necessary to reflect the provisions of the TRA '97 was excepted from the requirements of Sec. 411(d)(6), as long as it was adopted before the first day of the first plan year beginning in 1999 (later for government plans), which was the original TRA '97 remedial amendment period. The remedial amendment period for adopting amendments necessary to comply with the TRA '97 was subsequently extended until the last day of the first plan year beginning in 1999 (later for government plans). To coordinate the Sec. 411(d)(6) relief period for the TRA '97 amendments with the remedial amendment period, the temporary regulations extend the deadline to amend a plan to obtain the Sec. 411 (d)(6) relief until the end of the TRA '97 remedial amendment period. (For more information on SESOPs, see Diamond, "Post-TRA '97 S Corps. and ESOPs--An Ideal Combination," p. 46, this issue.)


Rules Disallow Gifts of Roth IRAs, Limit Reconversions

The IRS has issued proposed regulations, in question-and-answer format, offering guidance on the new Roth individual retirement account (IRA), established by the Taxpayer Relief Act of 1997 and modified by the IRS Restructuring and Reform Act of 1998.

Regular Contributions

Four examples are set forth illustrating the operation of rules governing maximum contributions to both traditional and Roth IRAs. For instance, if an individual violates the maximum regular contribution limit by contributing $2,000 to a traditional IRA and $2,000 to a Roth IRA for the same year, the $2,000 contributed to the Roth IRA would be an excess contribution, because the $2,000 aggregate IRA contribution allowance is applied first to traditional IRAs. Under Sec. 4973, a 6% excise tax applies to an excess contribution unless the excess is distributed (along with net income allocable to that contribution) before the extended due date of the taxpayer's return for the contribution year.

Employer contributions (including elective contributions) to a simplified employee pension (SEP)-IRA or savings investment match plan for employees (SIMPLE) IRA do not reduce the annual contribution allowance to traditional/Roth IRAs.

Conversions from Non-Roth IRAs to Roth IRAs

According to the proposed regulations, an amount converted from a non-Roth IRA (i.e., a traditional IRA, SIMPLE IRA or SEP-IRA) to a Roth IRA is treated as distributed from the non-Roth IRA and rolled over to the Roth IRA, regardless of the actual means by which the conversion is made. The conversion amount is generally includible in gross income for the year of the conversion, under Sec. 408(d)(1) and (2). (If the conversion occurred in 1998, the taxpayer can include the amount in income in 1998 or elect to spread it over four years, beginning in 1998.) However, such amount is not includible for purposes of determining the taxpayer's eligibility to convert (i.e., the taxpayer can only convert if his modified adjusted gross income does not exceed $100,000). For this purpose, in the case of a conversion effected by an actual distribution and rollover contribution (rather than a trustee-to-trustee transfer or a transfer between IRAs of the same financial institution), the year of the distribution from the non-Roth IRA is the year that the conversion amount is includible in gross income. Minimum required distributions (MRDs) from IRAs cannot be converted, as Sec. 408(d)(3)(E) prohibits rollovers of MRDs.

An individual can convert a traditional IRA to a Roth IRA if he is receiving substantially equal periodic payments (within the meaning of Sec. 72(t)(2)(A)(iv)) from that traditional IRA, as long as such payments are continued from the converted Roth IRA. However, for 1998 conversions to which the four-year spread applies, any distributions made from a Roth IRA within the three-year period beginning with the year of conversion may accelerate the tax due as a result of the conversion. Prop. Regs. Sec. 1.408A-6, Q&A-10, contains several examples highlighting the tax consequences of receiving "nonqualified" distributions from Roth IRAs.

Recharacterizations of IRA Contributions

The regulations interpret Sec. 408A(d)(6) to provide broad relief to taxpayers who wish to change the nature of an IRA contribution, not limiting the relief only to taxpayers who wish to correct Roth IRA conversions for which they were ineligible.

Under Prop. Regs. Sec. 1.408A-5, a taxpayer can recharacterize an IRA contribution (e.g., undo a Roth IRA conversion) by instructing the trustee of the first IRA (the Roth IRA) to transfer, in a trustee-to-trustee transfer, the contribution (plus allocable net income) to the trustee of the second IRA (the non-Roth IRA). To be effective, the taxpayer must notify both trustees of the intent to recharacterize the contribution by the due date (including extensions) of his Federal income tax return, as well as furnish the trustees with certain other information (as detailed in the proposed rules). The effect of the recharacterization is to treat the contribution as having been made to the second IRA on the date the contribution had originally been made to the first IRA (or the date of the distribution from the non-Roth IRA, if the taxpayer is recharacterizing a rollover from a non-Roth IRA to a Roth IRA).

If an "ineligible taxpayer" fails to properly recharacterize a rollover or conversion to a Roth IRA, he will be liable for (1) income tax on the (deemed or actual) distribution from the non-Roth IRA, (2) a 10% premature distribution tax on same (unless an exception applies) and (3) a 6% excise tax on the amount contributed to the Roth IRA, to the extent it exceeds the regular Roth IRA contribution allowance.

Notice 98-50

The proposed regulations do not contain rules preventing the taxpayer from engaging in multiple recharacterizations in a given year. However, the IRS issued Notice 98-50 to provide interim guidance on Roth IRA reconversions. The notice is intended to clarify and supplement the proposed regulations and may be relied on as if it were incorporated in those regulations. The notice contains several examples illustrating the rules on reconversions.

Reconversion transactions generated significant publicity in late summer 1998, in light of the decline in stock values after July. A taxpayer who converted a traditional IRA to a Roth IRA, when the value of the traditional IRA was higher than it is currently, has an opportunity to lower the amount recognized as ordinary income on conversion by "undoing" the conversion in a recharacterization and reconverting the amount at the lower, current value. Because the proposed regulations were silent on whether there was a limit on the number of times a taxpayer could recharacterize and reconvert an IRA contribution, some taxpayers were engaging in a new form of "market timing" by attempting to catch the low point in the value of their IRAs. Some IRA custodians were imposing their own limits to avoid excessive administrative costs. The notice restricts an individual's ability to reconvert an unlimited number of times on and after Nov. 1, 1998.

Notice 98-50 provides that an individual who converted a traditional IRA to a Roth IRA at any time during 1998 and then transferred the converted amount back to a traditional IRA in a recharacterization (as described in Prop. Regs. Sec. 1.408A-5) could have reconverted that amount to a Roth IRA:

1. An unlimited number of times for reconversions occurring before Nov. 1, 1998 (i.e., these are grandfathered);

2. One time only for reconversions occurring on or after Nov. 1, 1998, and on or before Dec. 31, 1998; and

3. One time only for reconversions occurring in 1999.

The four-year spread treatment under Sec. 408A(d) (3) (A) applies only to conversions and reconversions occurring in 1998.

In addition, an individual who converts a traditional IRA that has not been previously converted to a Roth IRA at any time during 1999 and then transfers the converted amount back to a traditional IRA in a recharacterization may reconvert that amount to a Roth IRA one time only, on or before Dec. 31, 1999.

Any reconversions that exceed the above limits will be treated during the November 1998-December 1999 period as "excess reconversions." As such, they will not affect the determination of the taxpayer's gross income attributable to a conversion. Nor will excess reconversions be subject to penalties. In other words, excess reconversions during the period covered by the interim guidance will be "tax neutral."

Final regulations may impose additional limitations on post-1999 reconversions or prohibit them entirely. This matter is currently being studied by Treasury and the IRS.


Distributions made following the death of the Roth IRA owner are governed by the MRD rules applicable to non-Roth IRAs when the account owner dies prior to the required beginning date--April 1 following the year in which the owner reaches age 70 1/2--regardless of the age of the Roth IRA owner at death (Sec. 401(a)(9)(B)). However, any distribution from a Roth IRA made to the surviving spouse of a Roth IRA owner who has elected to treat the Roth IRA as his own is not treated as made after the Roth IRA owner's death. Thus, such distributions will not meet the Sec. 72(t)(2)(A)(ii) exception to the 10% premature distribution tax. The five-tax-year period for determining whether a distribution is a qualified distribution is not recalculated when a Roth IRA owner dies.

Aggregation and ordering rules under Sec. 408A(d)(4) are also provided. A Roth IRA is not aggregated with a non-Roth IRA, but all of a taxpayer's Roth IRAs are aggregated with each other, under these provisions. Roth IRA distributions are treated as made first from Roth IRA contributions and second from earnings. Distributions treated as made from contributions are treated as made first from regular contributions and then from conversion contributions on a first-in, first-out basis. A distribution allocable to a particular conversion is treated as consisting first of the portion of the conversion includible in gross income by reason of the conversion. For purposes of the ordering rules, different types of contributions are allocated pro rata among multiple Roth IRA beneficiaries after the Roth IRA owner's death.


Some commentators have suggested that a Roth IRA owner can make a completed gift of a Roth IRA for transfer tax purposes by establishing an "irrevocable Roth IRA trust" for the benefit of other family members--funded in whole or in part with a rollover from a non-Roth IRA--retaining no interest in (or powers over) the trust. In addition, the beneficiary designation of the Roth IRA trust would explicitly provide that the settler would not receive any distributions from the trust (MRD rules do not apply to a Roth IRA during the owner's lifetime). This technique would allow the settler to "freeze" the value of the Roth IRA for transfer tax purposes at the time of the gift, thereby creating significant transfer tax leverage, while removing the value of the Roth IRA from the settler's estate.

The proposed regulations significantly reduce the attractiveness of this technique by providing that a transfer of a Roth IRA by gift would constitute an assignment. As such, the Roth IRA's assets would be deemed to be distributed to the Roth IRA owner and, accordingly, treated as no longer held in a Roth IRA (i.e., the Roth IRA would effectively be converted to a taxable account). Thus, although a completed gift of a Roth IRA could be made for transfer tax purposes, the ability to accumulate income on a tax-free basis for the benefit of future generations would be lost at the time of the transfer.



Lease Rollover Charge Is Capital Expense

The lax Court has ruled that a $2.5 million lease rollover charge incurred by a bank when upgrading its leased computer mainframe equipment must be capitalized and amortized over the five-year term of the new lease (U.S. Bancorp, 111 TC No. 10).

One year into its original five-year lease, a bank determined that its mainframe was no longer adequate for its needs and that an upgrade would be required. The bank and the lessor executed a rollover agreement, under which the bank agreed to pay a rollover charge financed over the five-year period of the new lease. The assets leased under the new lease were not the same assets as those leased under the terminated lease. If the bank had not leased the new equipment from the same company, the termination charge would have been immediately due and payable. Relying on Rev. Rul. 69-511 and on case law that held that payments to terminate a lease are not made to produce future income but are costs incurred and damages paid to be released from an existing unprofitable arrangement, the bank argued that it was entitled to deduct the rollover charge in the year incurred as an expense of terminating the first lease.

Citing Pig & Whistle, 9 BTA 668 (1927), and Phil Gluckstern's, Inc., TC Memo 1956-9, the IRS asserted that the rollover charge was properly capitalized and amortized over the five-year lease term. Further, the Service argued that under INDOPCO, Inc., 503 US 79 (1992), because the $2.5 million was incurred not only in terminating the first lease but also in entering into the second lease, the $2.5 million obligation is a cost of obtaining significant future benefits under the second lease and, therefore, should be capitalized and recognized over the term of the second lease.

The Tax Court agreed with the IRS, ruling that the rollover charge must be capitalized as a cost of acquiring the second lease; the bank's termination of the first lease and initiation of the second lease were integrated events that should not be viewed in isolation. The Tax Court noted that the authorities cited by the bank and the Service represented two ends of a spectrum. The taxpayer cited authority for lease terminations in which no subsequent lease was entered into. In the authorities relied on by the IRS, the lessees entered into second leases covering the same property; in each case, the court ruled that, due to the continuity of rights and strong interrelationships between the two leases, the unextinguished cost of the first lease was part of the cost of the second lease. However, the Tax Court found that the facts in the present case were more similar to the modification of a lease than to a simple lease termination.

The Tax Court acknowledged that the rollover charge incurred by the bank would have been higher if the bank had not entered into a second lease with the same lessor. However, it further noted that the bank obtained an advantage by being able to finance the charge over the term of the second lease. Thus, the Tax Court concluded, "[t]here is no ground for concluding that the rollover charge is currently deductible in full or for making an allocation under which a portion of the charge would be currently deducted as attributable to the termination" of the first lease.



AMT Effect on Exclusion for QSB Stock

In 1993, Congress enacted Sec. 1202(a), allowing noncorporate taxpayers to exclude from gross income 50% of the gain realized on the sale of qualified small business (QSB) stock held for more than five years. The Taxpayer Relief Act of 1997 (TRA '97) lowered the maximum capital gains tax rate from 28% to 20%. However, Sec. 1202 gains were specifically excluded from the lower 20% rate, resulting in an effective Federal tax rate of 14% (0.28 x 0.50) for regular tax purposes. However, if the alternative minimum tax (AMT) applies, the tax rate on Sec. 1202 gain increases to 19.88%, effectively eliminating any Federal income tax benefit.

Nevertheless, holding QSB stock can still be advantageous because of Sec. 1045, which allows a rollover of gain on QSB stock into other QSB stock. Additionally, a benefit may be derived on taxable gains in certain high-tax states.


The Omnibus Budget Reconciliation Act of 1993 created Sec. 1202, adopting a 50% exclusion from gross income on gain from the sale of QSB stock. Under prior law, a noncorporate taxpayer was subject to a maximum capital gains rate of 28% on net capital gain. At the time of enactment, Sec. 1202 created a net Federal tax rate savings of 14% for regular tax purposes. After the application of the AMT rules, the taxpayer would have realized a net savings of approximately 7% (because one-half of the excluded gain was an item of tax preference under Sec. 57(a)(7)).

In general, after enactment of the TRA '97, capital gain on stock held for more than 12 months is taxed at a 20% rate. However, Sec. 1202 gains are taxed at a 28% rate. Additionally, the AMT "add back" percentage on gain from the sale of Sec. 1202 stock changed from one-half of the excluded gain to 42% of the excluded gain. (Because this item is an "exclusion preference," the AMT is not allowable as a credit against future Federal income tax (Sec. 53(d)(1)(B)(ii)(II).) The effect of this AMT preference is that most taxpayers who sell QSB stock and elect Sec. 1202(a) treatment will be subject to AMT.

Example: A taxpayer with a $10,000,000 Sec. 1202 gain will exclude $5,000,000 for regular tax purposes, but add back $2,100,000 for purposes of computing AMT. Applying a 28% AMT rate to the $7,100,000 AMT income results in a total tax of $1,988,000, as opposed to a $2,000,000 capital gains tax if Sec. 1202 treatment is not elected.

Elective Rollover of Gain

The TRA '97 added Sec. 1045, which allows certain taxpayers to elect to roll over gain from the sale of QSB stock sold after Aug. 5, 1997, and held more than six months. If the rollover is elected, gain from the sale of QSB stock is recognized only to the extent that the amount realized from the sale exceeds the cost of any QSB stock purchased within 60 days of the sale, reduced by any portion of the cost previously taken into account under Sec. 1045. The holding period of the stock purchased includes that of the stock sold. Also, for the purchased stock to qualify as replacement stock, it must meet the active business requirement referred to in Sec. 1202(c)(2) for the six-month period following the purchase.

As originally enacted, Sec. 1045 only applied to individual taxpayers. However, in 1998, Sec. 1045 was modified to allow any taxpayer other than a corporation to make the election to roll over gain from the sale of QSB stock. Although Sec. 1045(a) states that corporations are not eligible to make the election, the benefit of the rollover can flow through to shareholders of an S corporation or regulated investment company (e.g., a mutual fund). Rev. Proc. 98-48 provides guidance to taxpayers making a Sec. 1045 election.

Effect on State Taxes

Although the net Federal tax benefit from selling QSB stock may be minimal, residents of certain states may derive a significant state tax benefit. Because many states adopt Federal rules but do not tax capital gains differently from other income, the 50% exclusion from the sale of QSB stock may serve to reduce a taxpayer's state tax burden. If a state imposes a tax on income, including capital gains, adopts the Federal rules allowing a 50% exclusion from the sale of QSB stock, does not impose an AMT and does not impose a significantly lower capital gains tax rate, a state tax benefit may be derived from the Sec. 1202 election. In light of this potential state tax benefit, it is important to consider the Sec. 1202 election vis-a-vis Federal and state tax liabilities.

Sec. 1202 was enacted to encourage long-term investment in certain small businesses by giving investors a savings on capital gains from the sale of QSB stock held for more than five years. Because Sec. 1202 only applies to C stock, it is a factor in deciding between C or S status. Because the "effective" Federal capital gain exclusion available to noncorporate taxpayers holding Sec. 1202 stock is relatively insignificant, both corporations and individuals should reevaluate their situations.

Due to these recent legislative developments, the attractiveness of Sec. 1202 stock to potential investors may now be a minor consideration when forming a corporation. It may no longer be advisable for investors to avoid selling appreciated positions in Sec. 1202 stock until after the five-year period, in hopes of a more favorable tax treatment. Tax consultants should analyze the impact of the AMT rules on their clients' positions in Sec. 1202 stock and other transactions. However, owning Sec. 1202 stock may continue to be advisable in certain circumstances, such as when Sec. 1045 rollover treatment can be obtained or when state tax laws provide a sufficient benefit to warrant electing Sec. 1202 treatment. (For more information on this issue, see Cohen, "Is the Qualified Small Business Exclusion Worthwhile?," 29 The Tax Adviser 856 (December 1998).)


Denial of Losses Under Economic Substance Doctrine Generally Affirmed

The Third Circuit has generally affirmed the Tax Court's decision in ACM Partnership, 73 TC Memo 1997-115, aff'd, 10/13/98, in which the lower court held that the economic substance doctrine precluded the partnership's deduction of approximately $85 million of losses attributable to the purchase and contingent installment sale of certain notes. The decision is significant in that it elevates a Memorandum Decision to a higher level of precedent and contains some broad statements that other courts might look to in evaluating tax-motivated transactions. The Third Circuit agreed with ACM that its ownership of notes received in the contingent installment sale had economic substance (even if the contingent installment sale did not); therefore, ACM could deduct $6 million of actual economic losses arising from ownership of those notes.

Colgate Palmolive Co. recognized a $105 million capital gain in 1988 on a transaction unrelated to the one at issue in the case. To shelter the gain, Colgate (a 17.1% partner), foreign bank ABN (an 82.6% partner) and Merrill Lynch (a 0.3% partner) created the ACM partnership. ACM then purchased $205 million of Citicorp notes and sold $175 million of the notes 24 days later for $140 million in cash, plus London Interbank Offering Rate (LIBOR) notes with an expected present value of $35 million. ACM reported the sale of the Citicorp notes under the contingent payment sale provisions of Regs. Sec. 15a.453-1(c)(3). Because of the mechanical, straight-line basis allocation rule in that regulation, a $110.7 million capital gain was reported for the year of sale, most of which was allocated to the foreign partner and not subject to U.S. tax. Later, after the foreign partner's interest had been sold and redeemed, ACM sold the LIBOR notes and reported a capital loss of approximately $85 million, allocated almost entirely to Colgate. Colgate used the loss to offset its 1988 capital gain, but the loss was disallowed by the Tax Court.

Afterward, in the Rule 155 computation for the case, ACM argued that, even if the $85 million loss on the contingent installment sale was disallowed, its $6 million actual economic loss should be allowed with respect to the LIBOR notes. The Tax Court disagreed and disallowed this loss as well.

Except for the treatment of the economic losses on the LIBOR notes, the Third Circuit essentially followed the same analysis as the Tax Court, both as to the facts and the law. Thus, the appeals court held against the taxpayer primarily on the ground that its purchase and contingent installment sale of the Citicorp notes for cash and LIBOR notes was a transaction that lacked both economic substance (an objective test) and a meaningful nontax business purpose (a subjective test). The court did little to clarify the interrelationship between these two tests, stating merely that "these distinct aspects of the economic sham inquiry do not constitute discrete prongs of a `rigid two-step analysis,' but rather represent related factors both of which inform the analysis of whether the transaction had sufficient substance, apart from its tax consequences, to be respected for tax purposes."

In affirming the Tax Court's findings, the Third Circuit relied on various precedents, including the Tax Court's earlier decision in Sheldon, 94 TC 738 (1990), in which that court observed that a pre-tax profit motive would not be given tax effect if it was "infinitesimally nominal and vastly insignificant when considered in comparison with the claimed deductions." The Third Circuit used a similar formulation: "a nominal, incidental pretax profit...would not support a finding that the transaction was designed to serve a non-tax profit motive" Significantly, the Third Circuit did not expand the Sheldon analysis into a "balancing test" by suggesting that a pre-tax profit motive would be insufficient merely because it was smaller than the tax motive behind the transaction.

While the facts of ACM as found by the Tax Court and affirmed by the Third Circuit are undoubtedly worse than those of many well-planned and properly executed tax-oriented transactions found in the current marketplace, the appeals court opinion raises a number of points worth considering in structuring and evaluating such transactions. For example, in holding that the taxpayer lacked a meaningful nontax business purpose, the court observed that the return on ACM's 24-day investment in Citicorp notes was only a few basis points higher than Colgate could have obtained by simply leaving the funds on deposit with ABN. Significantly, the Third Circuit did not raise this point as part of its analysis of the objective economic substance of the transaction, but rather as part of the subjective business purpose test. (Previous authorities made it amply clear that an investment is acceptable for tax purposes even if its pre-tax return is lower than the taxpayer could have obtained on a similar investment without the tax benefits.) Thus, while an investment may have economic substance if it generates a positive rate of return, that investment may not support a nontax business purpose argument in the context of a larger transaction if that rate of return is lower than an alternative that is not tax-favored.

Further, the court emphasized that, even if Colgate had an opportunity to earn a pre-tax profit on the LIBOR notes from an increase in interest rates, it did not matter, because Colgate never acted as if it cared about earning such a profit. In fact, the record showed that Colgate expected interest rates to fall, so that it expected (and in fact realized) a pre-tax loss on the transaction. Thus, in planning a transaction, it apparently is not enough that the taxpayer have an opportunity for profit (objective test). It must also have a genuine motive to earn that profit (subjective test). Of course, actually earning a profit would be enormously helpful in supporting the position that the taxpayer had a profit motive.

The Third Circuit opinion, like that of the Tax Court, shows a willingness to focus exclusively on the tax-motivated element of the transaction and determine whether that element had a business purpose and economic substance. To identify the tax-motivated element, the court observed that the purchase and sale of the Citicorp notes was not necessary to the taxpayer's stated business objectives; if ACM had wanted to invest in LIBOR notes, it could have done so simply by purchasing them for $35 million. The court discounted the taxpayer's argument that it earned a pre-tax profit on the investment of the cash proceeds from the sale of the Citicorp notes, stating: "Any profits arising from ACM's investment of $140 million in cash into Colgate debt issues did not result from the contingent installment exchange whose economic substance is in issue." Thus (at least in the Third Circuit), it is not enough that the taxpayer have an opportunity for profit on the transaction as a whole and that it have a genuine motivation to earn that profit. The taxpayer must have a pretax profit motive on the specific aspect of the transaction that generates the tax benefits likely to be in dispute.

Significantly, the ACM case involved the generation of an artificial tax gain and a corresponding artificial loss as part of a single transaction. The court distinguished Cottage Savings, 499 US 544 (1991), in which the Supreme Court allowed the recognition of losses on exchanges of pools of mortgage loans that were purely tax-motivated, on the ground that "the disposition in Cottage Savings precipitated the realization of actual economic losses arising from a long-term, economically significant investment, while the disposition in this case was without economic effect." Thus, the rule remains that a taxpayer need not have any business purpose for a transaction that triggers a true economic loss (or, presumably, a true economic gain).

The dissent asserted that the majority had erred by injecting the business purpose/economic substance doctrine into situations in which the underlying Code section (which the dissent took to be Sec. 1001) does not have a business purpose requirement. Curiously, the dissent did not discuss whether the applicable Code section might be Sec. 165 (losses) and whether the majority had improperly extended Sec. 165(c) (which requires a profit motive or business purpose for an individual to claim a loss other than a casualty loss) to losses of corporations.


Nonrecognition of Gain on Compensatory Transfer of Stock to Employees

The IRS has released proposed regulations under Sec. 1032, clarifying when a corporation may acquire the stock of another and dispose of the stock without recognizing gain on the transaction. The new proposed regulations also apply to certain compensatory transfers of stock from a corporate shareholder to an individual providing services to the corporation (whether an employee or an independent contractor) as described in Regs. Sec. 1.83-6(d). Regs. Sec. 1.83-6(d) provides that if a shareholder of a corporation transfers stock to a service provider of the corporation, the transaction is a contribution of the stock to the capital of such corporation (the acquiring corporation) by the shareholder, followed by a transfer of such stock by the corporation to the service provider. In Rev. Rul. 80-76, which involved the use of a parent (P) corporation's stock to compensate an employee (B) of a subsidiary corporation (S), the Service ruled that, "because section 83 applies to the transfer of P stock to B, S does not recognize gain or loss on the transfer of the P stock." No other rationale was provided for the subsidiary's nonrecognition of gain.

The proposed regulations provide the rationale missing from Rev. Rul. 80-76. The acquiring corporation is deemed to have paid the issuing corporation the fair market value of the stock with money furnished by the shareholder, thus allowing the acquiring corporation to take a stepped-up basis in the stock and avoid recognition of gain on the immediate transfer to the service provider.

The proposed regulations apply only when (1) the acquiring corporation obtains issuing corporation stock to acquire money, property or services; (2) the acquiring corporation would otherwise obtain a carryover basis in the issuing corporation stock under. Sec. 362(a); (3) the acquiring corporation immediately transfers the stock to obtain money, property or services; and (4) the party that receives the stock does not get a substituted basis in it under Sec. 7701 (a)(42).

Although the proposed regulations do not provide specific guidance on what constitutes an "immediate transfer," Example 5 seems to indicate that an immediate transfer does not take place when nonvested issuing corporation stock is transferred to an employee of the acquiring corporation and the acquiring corporation (rather than the issuing corporation) retains a reversionary interest in the stock if the employee forfeits the right to the stock.



Substantial Understatement Penalty Analysis Requires Consideration of Factual Evidence

Applying the substantial understatement penalty under Sec. 6662 requires the consideration of factual evidence as well as legal authorities, according to the Sixth Circuit in Est. of Robert G. Kluener, 154 F3d 630 (1998). The opinion noted that the Sixth Circuit had not yet addressed the standard for reviewing substantial understatement penalties. While the court found language in the regulations that could be read as suggesting that only legal authorities should be reviewed, it interpreted this provision as excluding "only certain types of legal sources." The opinion held that two provisions in the regulations required a review of factual evidence and that there was no explicit prohibition on such a review. Moreover, policy concerns favor reviewing factual evidence as a form of "authority."

The case concerns the tax consequences of a horse sale. In the late 1980s, Kluener transferred 41 horses to his closely held corporation, APECO, sold the horses and transferred tax-free the proceeds back to himself. The IRS determined that Kluener himself sold the horses. Thus, it issued a notice of deficiency for taxes owed and imposed the substantial understatement penalty. The Tax Court held in favor of the Service on both issues. The Sixth Circuit affirmed the deficiency judgment but reversed the decision on the penalty.

No Valid Nontax Business Purpose Found

The main issue was whether Kluener had a valid nontax business purpose for transferring the horses to APECO. The Tax Court held that no such purpose existed, citing several factors: APECO never used any of the horse proceeds; Kluener alone ultimately benefited from the transfer; Kluener distributed the proceeds to himself less than a year after first transferring the horses; Kluener actively hid the horses and the proceeds from APECO's officers and directors; Kluener normally funded APECO through loans, and the property transfer in which he transferred the horses broke with his usual business practices; and after the transfer, Kluener continued to pay his administrative assistant for horse operations out of his personal funds, even though the assistant had nominally become an APECO employee.

The Sixth Circuit reviewed the Tax Court's factual findings, and found that the arguments presented by the taxpayer failed to overcome the deference afforded the trial court. However, it offered a de novo review to the Tax Court's holding on the substantial understatement penalty. It considered the issues to be the precise meaning of the term "substantial" and whether the term "authority" includes factual evidence as well as legal sources.

The opinion reviewed the holding in Osteen, 62 F3d 356 (11th Cir. 1995), which was brought under Sec. 6661. It observed that "under Osteen, `authority' encompasses factual evidence, particularly in a case that turns on intent; 'substantial' authority exists if the taxpayers present sufficient facts to support a judgment in their favor under the clearly erroneous standard of review, looking at the case as if they had won on the deficiency." Osteen's analysis applied under Sec. 6662: "A court must examine the facts to evaluate a legal source's relevance. In this sense, a legal source can constitute substantial authority only if its facts resemble those in [this case]."

Considerable or Ample Authority Required

The Sixth Circuit took issue with Osteen's analysis of the term "substantial" however, finding that the requirement for substantial authority requires a taxpayer to present "considerable or ample authority," rather than "only some evidence." The court found that considerable factual evidence supported Kluener's tax treatment of the horse proceeds, including his reference notes (indicating that he decided to withdraw the proceeds only after meeting with bank officials); the lack of prior research regarding a tax avoidance plan; his lack of tax expertise; and APECO's genuine need for funds. Two strong contrary facts, that APECO never used the proceeds and that Kluener actively hid information regarding the proceeds from the APECO officers and directors, did not overcome the weight of the facts supporting Kluener's position. The court noted that, as APECO's sole shareholder and CEO, Kluener could have controlled the proceeds without deceiving anyone.


Financial Hardship May Be Reasonable Cause for Failure to File and Pay Tax

In Fran Corp., 998 F Supp 296 (DC N.Y. 1998), the court held that financial hardship may in some cases be reasonable cause for a failure to file returns, pay taxes and make tax deposits. In this case, however, the taxpayer's poor business judgment manifested "casual disregard for its obligations to the government" and, therefore, did not constitute reasonable cause.

During 1993 and 1994, the Fran Corp. experienced severe financial hardship. As a result, the taxpayer failed to timely pay over the Federal income and employment taxes withheld from the wages of its employees for the period between April 1, 1993 and June 30,1994; the taxpayer likewise failed to file returns for the same periods. During that time, however, Fran did pay other creditors, including its employees and primary suppliers. The IRS assessed Sec. 6651 failure to file and pay penalties and the Sec. 6656(a) failure to deposit taxes penalty, which Fran paid and then sought to have refunded.

Fran asserted that the failures were attributable to the financial hardship it was undergoing and that, therefore, there was reasonable cause for the failures. The taxpayer maintained that, by not paying the taxes when due, it avoided defaulting on two contracts and was able to finish projects that ultimately allowed it to pay its taxes. In support of this argument, the taxpayer cited the regulations under Sec. 6651, which provide that a failure to pay may be due to reasonable cause if undue hardship would result if the tax was paid.

The Service, although conceding the taxpayer's financial difficulties, argued that Brewery, 33 F3d 589 (6th Cir. 1994), established that financial difficulties, regardless of their cause and severity, can never justify recovery of penalties under Secs. 6651 and 6656. The Brewery case, which involved the failure of a restaurant to pay its withholding taxes because of operating losses and negative cashflow resulting from a decision to remodel, held that financial difficulties can never be the basis of reasonable cause to excuse the penalties for nonpayment of withholding taxes by an employer.

The court recognized that, because of its financial condition, the taxpayer had a business choice to make as to who would get paid (i.e., the government or others), and focused on whether Fran's decision not to file its returns and pay its taxes in light of such circumstances represented reasonable cause. In its analysis, the court rejected the per se rule articulated in Brewery, stating that such a rule would render the terms "reasonable cause" and "willful neglect" as found in the regulations meaningless. Under Regs. Sec. 301.6651-1, "a failure to pay will be considered to be due to reasonable cause to the extent that the taxpayer has made a satisfactory showing that he exercised ordinary business care and prudence in providing for payment of his tax liability and was nevertheless either unable to pay the tax or would suffer an undue hardship (as described in section 1.6161-1(b)) if he paid on the due date."

The court also cited the Supreme Court decision in Boyle, 469 US 241 (1985), as establishing that the proper inquiry under Secs. 6651 and 6656 is as to the reasonableness of the taxpayer's actions. As stated in Boyle, "Congress obviously intended to make absence of fault a prerequisite to avoidance of the late filing penalty.... A taxpayer seeking a refund must ... prove that his failure to file ... was the result of neither carelessness, reckless indifference, nor intentional failure."

The court found that Fran failed to prove it had reasonable cause for the failure to file its returns and pay and deposit taxes. The court pointed to business decisions, including continued rental payments made to the company's president while he had an outstanding substantial personal loan from the firm. Also, the court found evidence that Fran incurred "lavish and extravagant" expenses during the time of its financial difficulties, for things such as hockey tickets, golf outings and repairs to a Porsche that the court said did not contribute to the firm's bottom line.

The court acknowledged that Fran's severe financial difficulties were "the proximate cause of its failure to pay its taxes." However, the circumstances that precipitated those difficulties, as well as the taxpayer's allocation of scarce resources during its lean period, demonstrated that Fran "failed to exercise ordinary business care and prudence in providing for payment of its tax liability." Payment of the withheld taxes in this situation would not have resulted in the kind of "substantial financial loss" that the regulations require as the undue hardship necessary for a showing of reasonable cause. Therefore, the taxpayer's failure was the result of "either carelessness, reckless indifference, [or] intentional failure"

Establishing reasonable cause for a taxpayer's failure to file, pay and/or deposit taxes due to financial hardship can be a very tricky exercise. This is especially true if withheld employment taxes are involved. As the court stated, "it is difficult to conceive of a precise set of circumstances, where as a matter of law, financial difficulties standing alone would justify a finding of reasonable cause, absent some unforeseeable intervening factor...." However, the IRS may be precluded from imposing penalties if strong arguments are made in sympathetic cases.


Limitations Periods under New Interest-Netting Rules

Congressional tax aides are considering a technical correction to global interest-netting rules that would clarify that a taxpayer needs to have at least one open period for netting to apply. As currently drafted, however, the technical correction may be interpreted by the Service in a much more restrictive way.

In addition, there still is an issue as to how a taxpayer should account for certain periods when interest is suspended or not applicable in making the correct mathematical determination of the interest rate applicable during overlapping periods of mutual indebtedness.

Technical Correction Needs Refinement

Under Sec. 6621(d), enacted as part of the IRS Restructuring and Reform Act of 1998, a net interest rate of zero would be established when interest is payable and allowable on equivalent amounts of overpayment and underpayment of any taxes imposed by the Code that exist for any period. The provision applies to interest for periods beginning before July 22, 1998 if (1) the statute of limitations (SOL) has not expired on either the underpayment or overpayment; (2) the taxpayer identifies the periods of underpayment and overpayment for which the zero rate applies; and (3) before 2000, the taxpayer asks the Service to apply the zero rate.

A technical correction to those rules was included in legislation considered by Congress in 1998, and may be considered again in 1999. This correction clarifies that the applicability of the zero net interest rate, for periods on or before July 22, 1998, "is subject to any applicable statute of limitations not having expired with regard to either a tax underpayment or overpayment."

While this clarification appropriately establishes that for a taxpayer to equalize interest rates during overlapping periods of overpayment and underpayment, at least one of those periods must be open (i.e., the SOL has not expired), the language of the proposed technical correction may create interpretive ambiguity.

The language may lead to a more restrictive interpretation of the new netting rules that the SOL must be running on both the overpayment and the underpayment periods for netting to apply. Congressional aides indicate that this was not intended, and that the clarification is needed only to ensure that taxpayers do not request global interest-netting when both years are dosed.

How Should Special Rules Apply?

The new law refers to interest "payable under subchapter A and allowable under subchapter B." This has raised the question about how--if at all--the special rules involving interest-free periods and interest suspensions contained in those subchapters will be factored into global interest-netting calculations.

For instance, interest would not apply (and would be abated) during the time that an examination of a taxpayer's return was delayed because of an IRS ministerial or managerial decision. The law is silent on how that time would be accounted for if that event occurred during overlapping periods of mutual indebtedness. Because these special rules can inure to the benefit of either the government or the taxpayer, a strong argument can be made that such periods should not be taken into account. To make the mathematical determination and properly net the interest rate pursuant to this approach, one should look to overlapping periods of mutual indebtedness and then equalize the interest rate for those periods, notwithstanding the special rules. At the present time, it is unclear how the IRS will resolve this issue.



Treatment of Nexus Issues May Require U.S. Supreme Court Review

A much-anticipated opinion in the case of JCPenney National Bank v. Johnson, 10/18/98, was recently issued by the Tennessee Chancery Court. The court held that JCPenney National Bank (JCPNB) had nexus for franchise and excise (income) tax purposes, based on both the activities of other parties performed on behalf of JCPNB to establish and maintain its market in Tennessee and the presence of JCPNB'S credit cards in Tennessee. Tennessee is one of the five states that have adopted the initial draft version of the Multi-state Tax Commission's apportionment regulations for financial institutions, containing minimum nexus provisions based on regular and systematic exploitation of the marketplace. It is anticipated that this case may find its way to the U.S. Supreme Court to clarify certain substantial nexus issues under the Commerce Clause, such as the necessity for physical presence and agency nexus concepts.

JCPNB, a federally chartered bank engaged in consumer banking, was a Delaware corporation with its principal place of business in Delaware. During the years at issue, JCPNB had between 11,535 and 17,725 credit card accounts with Tennessee customers, averaging approximately $11 million in balances and producing approximately $2 million in finance charges annually. JCPNB contracted with various related and unrelated parties for services relating to JCPNB's Tennessee customers. JCPNB had never paid any franchise or excise taxes to Tennessee and had never filed a return. In 1995, the Tennessee Department of Revenue audited JCPNB and issued a $178,314 assessment for tax years 1990 through 1994.

The court addressed whether JCPNB had "substantial nexus" with Tennessee for Commerce Clause purposes, as articulated by the U.S. Supreme Court in Complete Auto Transit, 430 US 274 (1977). The court initially addressed whether the activities of other parties on behalf of JCPNB created nexus, noting that the Supreme Court, in Tyler Pipe Industries, 483 US 232 (1987), "determined that a critical factor for consideration is whether the activities performed in the state on behalf of the taxpayer are significantly associated with the taxpayer's ability to establish and maintain a market for its in-state sales."

The court decided that it was unnecessary to determine whether JCPNB exercised control over parties performing activities on its behalf such that a formal agency relationship existed; to do so would conflict with Tyler and Scripto Inc. v. Carson, 362 US 207 (1960). Instead, the court focused on the types of activities performed on JCPNB's behalf. In particular, the court noted services performed by two affiliates located outside of Tennessee that included soliciting prescreened accounts obtained from JCPenney's Tennessee retail stores, maintaining a toll-free number, contacting delinquent Tennessee customers to refer them to a nonaffliated credit counseling service located in Tennessee, and assigning accounts to a collection agency. The court concluded that these services significantly contributed to the establishment and maintenance of JCPNB's Tennessee credit card business. The court held that "the activities of the affiliates and third parties working on JCPNB's behalf satisfy the first prong [the substantial nexus requirement] of Complete Auto."

The court also addressed whether JCPNB had nexus based on physical presence in Tennessee. It is apparent that the court did not fully understand the nexus concept of "physical presence," because it provided that substantial nexus "would be satisfied by not only physical presence, but also tangible and/or intangible property located within the state" The court declined to accept JCPNB's position that physical presence was necessary for substantial nexus pursuant to Quill Corporation, 504 US 298 (1992), and provided that it "does not interpret Quill as a Supreme Court implication that the physical presence requirement should be extended to other state tax assessments"

Although the court agreed that the situs of JCPNB's intangible property was Delaware, it determined that JCPNB owned tangible property in Tennessee because its Tennessee customers held JCPNB's credit cards. The court noted that JCPNB and its customers agreed that the credit cards were the property of JCPNB. The court provided that "the issuing and use of over 17,000 JCPNB credit cards within Tennessee are considerably more than the few diskettes at issue in Quill and do not constitute a `slight presence.'" The court dismissed JCPNB's argument that the credit cards were not tangible property; "in determining whether the credit cards themselves are tangible personal property, this Court finds it significant that the JCPNB credit card is contractually agreed upon by both JCPNB and the customer prior to its issuance to be the personal property of JCPNB.... Thus the JCPNB credit cards within the state are tangible personal property that create a sufficient nexus with Tennessee."

The JCPenney decision does not establish precedent outside of Tennessee. However, it is anticipated that JCPNB will appeal and that the case may eventually make its way to the U.S. Supreme Court. An opinion rendered by the Supreme Court addressing the substantial nexus issues raised by this case could significantly affect companies in the financial services industry.



Internet Tax Freedom Act Enacted

Congress included me Internet Tax Freedom Act (ITFA) in the omnibus fiscal 1999 spendings bill that President Clinton signed into law on Oct. 21, 1998. The enactment of the ITFA closes a nearly two-year effort to prohibit multiple and conflicting taxation of the Internet, while allowing states and the business community to craft a more uniform taxation policy.

Major Provisions

Moratorium. The ITFA imposes a three-year moratorium on taxes on Internet access (unless such tax was generally imposed and actually enforced prior to Oct. 1, 1998) and multiple or discriminatory taxes on electronic commerce.

Exception to moratorium. The moratorium does not apply to any person or entity that knowingly and with knowledge of the character of the material, in interstate or foreign commerce, by means of the World Wide Web, makes any communication for commercial purposes that is available to any minor and that includes any material harmful to minors, unless such person has restricted access by minors by:

* Requiring use of a credit card, debit account, adult access code or adult personal identification number;

* Accepting a digital certificate that verifies age; or

* Any other reasonable measures feasible under available technology.

Advisory Commission on Electronic Commerce. The ITFA creates a 19-member Advisory Commission on Electronic Commerce. Its membership will include the Secretaries of Commerce and Treasury, the U.S. Trade Representative, eight representatives from state and local governments and eight representatives from the electronic commerce industry. The Commission is to conduct a thorough study of Federal, state, local and international taxation and tariff treatment of transactions using the Internet and Internet access and other comparable intrastate, interstate or international sales activities. The Commission is to report its findings, including legislative recommendations, to Congress not later than 18 months after the date of enactment. Any recommendation shall be tax-neutral and technologically neutral and apply to all forms of remote commerce.

Passage of the ITFA was generally welcomed by both state and local organizations and business organizations. The National Governors' Association had sought to ensure that the final legislation provided a grandfather clause for existing taxes, preserved existing tax debts for companies that owe tax on Internet access and included a "Main Street" business representative on the electronic commerce advisory commission. Other state groups were successful in inserting a provision that added all remote commerce (such as direct and catalog mail-order sales) to the list of items to be studied by the Commission.

Similarly, the Direct Marketing Association said it was pleased with the final bill, although it raised the concern that the inclusion of all remote commerce in the Commission's mandate could lead to eventual increases in taxation of all remote sales.

COPYRIGHT 1999 American Institute of CPA's
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Author:Brooke, Beth
Publication:The Tax Adviser
Date:Jan 1, 1999
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