Vince Nardone: Tax and Controversy

Will S-Corporation Distributions Become Subject to FICA Taxes Under the New Obama Administration?

Guest Author: M. Pilar Honer, Esq., Columbus, Ohio

 

During the past few years, there has been much speculation among tax practitioners as to whether Congress plans to have S-corporation distributions become subject to FICA taxes. This would eliminate what some tax professionals see as the perceived benefit of S-corporations over other types of taxable entities. As background, this issue was introduced back in October of 2007 during the 110th Congress by Charles Rangel, chairman of the ways and means committee (the committee in charge of tax legislation), in bill 3970.  This bill, however, never became actual law.  See the attached documents discussing the bill.

 

Because of recent discussions in the media and other places regarding Congress and specifically Obama’s desire to tax the distributions and subject them to FICA tax, our firm wanted to obtain an update and understanding as to whether or not this is going to occur.  Recently, our firm sat in on an update from Senator Hatch’s office in Washington DC regarding S-corporation legislation. Senator Hatch has been intimately involved in S-corporation issues over the last decade. During that update, there was no specific discussion regarding the S-corporation distribution issue.  But, they did indicate that we should anticipate some significant legislation dealing with S-corporations in 2009.

 

Our firm also contacted the Joint Committee of Taxation to gain some additional insights.  The Committee advised us that while there is no bill currently being reviewed that includes the S-corporation distribution issue, it is definitely on their radar.  Unfortunately, they could not give us a definitive answer as to whether or not it will be introduced again.  But, they did point out that after bill 3970 was introduced back in 2007, Congress became and is still aware of this issue.   They also advised us that although this issue has not been reintroduced since the 111th Congress session started in back in January 2009, it does not mean anything. It could be reintroduced at anytime.  I would also like to point that Charles Rangel, the person who initially introduced bill 3970 back in 2007, continues to be the chairman of the ways and means committee.  Further, we currently have a Democratic controlled Congress; therefore, I believe it is safe to predict that this issue will likely be introduced again.

 

The question then is how do we plan for the future?  Do we eliminate the desire to form S-corporations for now?  Or, do we hold off on any tax planning until we have a better understanding of what is going to happen?  I will leave those questions for another discussion.  I would, however, be interested if anyone has heard anything different or in addition to the above.  Thanks.

 

See the attached documents regarding the prior legislation.

Download S corporation legislative materials – distributions and taxes

 

Ninth Circuit holds that the gross valuation mistatement penalty does not apply when a deduction is completely disallowed

Guest Author: M. Pilar Honer, Esq., Columbus, Ohio

 

In Keller v. C.I.R., 556 F.3d 1056 (9th Cir. 2009), the Ninth Circuit held that Internal Revenue Code’s § 6662(h) gross valuation misstatement penalty did not apply where a taxpayer’s deduction was completely disallowed. Although the taxpayer had overvalued the item for which the deduction was taken, the court held that since the taxpayer was not entitled to the deduction at all, the taxpayer’s underpayment of tax was not attributable to the overstatement but rather to the improper tax deduction.  Therefore, at the end of the day, the taxpayer was only assessed the negligence penalty of 20 percent.

           

This case involved a taxpayer who was one of hundreds of individuals duped into participating in a sheep and cattle tax shelter scheme. The tax shelter was structured so that the taxpayer signed a 15-year promissory note to the promoter in exchange for 146 heifers that were still in the embryonic stage.  The taxpayer made no initial payments other than a $50.00 application fee, and promised to reinvest 75% of the tax benefits back into the scheme.

 

As it turned out, the whole investment was a sham.  During the criminal investigation of the promoter, the government found that although there was a severe and pervasive shortage of cows, these non-existent cows continued to be sold to investors.  Further, the promoter sold the same cows to more than one investor. Regardless of these facts and although the taxpayer allegedly did not purchase the cattle until 1995, the taxpayer’s 1994 return showed substantial losses from the cattle operation. These losses eliminated all of the taxpayer’s 1994 income tax, and income taxes from 1991, 1992, and 1993. Further and most importantly, the depreciation schedules reflected the value of the cattle to be more than 200 percent greater than their actual value.

 

Eventually the Service examined the taxpayer’s returns, disallowed the deductions, and assessed penalties.  The Service found that since none of the cattle were being used in a trade or business or to generate income, the entire value of the deductions were improper and assessed a 40 percent penalty due to the gross valuation misstatements of the cattle.  Under I.R.C. § 6662, there are a variety of accuracy related penalties that the Service may impose upon a taxpayer for an underpayment of tax, these include negligence and substantial understatement of income penalties.  Generally, the penalty is 20 percent of the portion of that underpayment.  When there is a gross valuation misstatement, however, the penalty is increased to 40 percent.

 

The taxpayer conceded to the imposition of a 20 percent negligence penalty, but petitioned to the tax court the imposition of a 40 percent gross valuation misstatement penalty.  The tax court held for the government reasoning that if the taxpayer had in fact not acquired any cattle his basis in the cattle would have been zero.  That basis of zero would have been far below the claimed basis; therefore, the 40 percent gross valuation misstatement did apply.  The taxpayer then appealed to the Ninth Circuit, which reversed the tax court’s holding.

 

The Ninth Circuit’s decision was supported by its strict construction of Internal Revenue Code § 6662(h), which states that the gross valuation misstatement penalty applies when the tax underpayment “is attributable to one or more gross valuation misstatements.”  The court held that since the taxpayer’s deficiency was not due to a misstatement of the value of the item for which the deduction was taken, but rather, due to the disallowance of the entire item of the deduction, the gross valuation misstatement penalty did not apply.  In its ruling, the court was also greatly guided and constricted by its prior decision in Gainer v. Commissioner, 893 F. 2d at 227 (9^th Cir. 1990) where it held that the gross overvaluation misstatement penalty would not apply when there is some other ground for disallowing the entire portion of the deduction.  In this case, the entire deduction was disallowed on the grounds that the cattle were not being used in a trade or business; therefore, there was already another ground for disallowing the entire portion of the deduction and the gross overvaluation misstatement penalty did not apply.  

 

The Ninth Circuit, however, did recognize that other circuits have held that when overvaluation is intertwined with a tax avoidance scheme that lacks economic substance, an overvaluation penalty can apply. See Merino v. Comm'r,  196 F.3d 147, 155 (3d Cir. 1999); Zfass v. Comm'r,  118 F.3d 184, 190–91 (4th Cir. 1997); Illes v. Comm'r,  982 F.2d 163, 166–67 (6th Cir. 1992); Gilman v. Comm'r, 933 F.2d 143, 149–52 (2d Cir. 1991); Massengill v. Comm'r,  876 F.2d 616, 619–20 (8th Cir. 1989).  Further, the court found that the other circuits’ approach seemed sensible because it allowed the imposition of a higher rather than a lower tax penalty on a party that participates in a tax shelter scheme.  Nevertheless, the court was constrained by Gainer and held that even though these deductions were in connection with a tax shelter scheme, the higher 40 percent penalty did not apply.

 

Download Keller v. C.I.R.

Internal Revenue Service – Office of Professional Responsibility

The IRS's Office of Professional Responsibility (“OPR”) recently published its Guide to Sanctions for violations of Circular 230.  It provides for progressive suspensions, up to and including disbarment, based upon an individual's mitigating or aggravating factors and the number of violations, and current fitness to practice.  According to the Service, in considering whether a corrective sanction is warranted, all relevant factors must be given careful consideration. The Guide to Sanctions provides guidance in determining the proper corrective sanction.  It is not intended to establish a rigid standard or imply that a greater or lesser corrective sanction is inappropriate.

Background

 

According to the Service, choosing a corrective sanction that is reasonable and appropriate for the circumstances involved is extremely important.  All relevant factors must be given careful consideration. The Guide to Sanctions is just that, a guide for determining the proper corrective sanction, and is not intended to establish a rigid standard or to imply that a greater or lesser corrective sanction is inappropriate.  A corrective sanction that is below the range indicated could be appropriate where there are compelling mitigating factors.  A corrective sanction that is above the range indicated could be appropriate for particularly egregious misconduct or for cases where there are significant aggravating factors.

 

Even for offenses where disbarment is not listed, disbarment for a first offense is not precluded. The guide may be deviated from depending upon the individual circumstances that may be involved.  Each case will be considered individually and dealt with on its merits.  Deviations from the guidelines will be documented in the file. Mitigating factors, set forth below, must be considered when proposing and deciding disciplinary and adverse sanctions.  Multiple offenses, offenses which violate more than one section of Circular 230, and repeated offenses normally will be grounds for a more severe sanction than is warranted for a single offense.

 

Disbarment and Other Punishment

 

In general, a reprimand or censure is appropriate where that sanction is all that is necessary to correct the behavior. Where the determination of suspension is 6 months or less, reprimand or censure may be appropriate.  Suspensions up to 24 months are appropriate where a suspension is necessary to bring home to the practitioner the severity of his or her violation of Circular 230. Suspensions in excess of 24 months are appropriate where the misconduct indicates that the practitioner may be perpetrating an on-going harm to the taxpaying community or where the misconduct, for example, multiple instances of violations, indicates a current lack of fitness to practice that would not be rectified by a shorter suspension.  The suggested suspensions are for each individual violation. Disbarment will be sought for any violation where the determination of suspension is at least 5 years.

 

Mitigating Factors

 

A corrective sanction that is below the indicated range could be appropriate where there are compelling mitigating factors.  The following factors must be considered when proposing and deciding disciplinary and adverse sanctions, including:

1.      For tax non-compliance cases, correction of the violation before contact with IRS or the OPR, or within a reasonably short period after contact by OPR;

2.      Illness, incapacitation, or personal hardship of the practitioner, his family or others close to the practitioner, that directly correlate to the action or inaction violating Circular 230;

3.      Personal or professional financial distress correlating to non-payment of taxes, but not non-payment of Form 941 employment tax obligations;

4.      Extrinsic circumstances (e.g., natural disasters) directly correlating to the action or inaction violating Circular 230;

5.      Recognition of action or inaction violating Circular 230 and commitment to future compliance;

6.      For firms, commitment to establishing internal controls to prevent recurrences of the violation;

7.      Preventative measures in effect prior to the misconduct/and or measures put into place after the misconduct to prevent future violations;

8.      Age of allegations.

Aggravating Factors

A corrective sanction that is above the range indicated could be appropriate for particularly egregious misconduct or for cases where there are significant aggravating factors. These factors include:

1.      Failure to respond to OPR contact;

2.      For tax non-compliance cases, failure to correct the issue after contact from IRS or OPR;

3.      For tax non-compliance cases, multiple tax issues related to noncompliance on multiple types of forms in the same tax period, including penalties;

4.      For tax non-compliance cases, sum of money at issue;

5.      Motive, especially those indicating personal gain;

6.      Pattern of action or inaction violating Circular 230;

7.      Assertion of legal arguments previously ruled frivolous by the courts;

8.      Confrontational behavior outside the bounds of zealous defense;

9.      Previous incidents of violation of Circular 230;

10.  Number of offenses;

11.  Failure to understand or recognize that actions constituted a violation of Circular 230;

12.  Negative effect on tax administration.

Multiple offenses, offenses which violate more than one section of Circular 230, and repeated offenses normally will be grounds for a more severe sanction than is warranted for a single offense.

 

Intangibles - Some may be like-kind for Section 1031

In representing professional practices, the issue of treating goodwill and going-concern value of a practice as like-kind property for purposes of Section 1031 commonly comes up.  But, the IRS has consistently held that goodwill and going-concern value of one practice is not like-kind for purposes of another practice.  The IRS has, however, recently changed its mind when it comes to certain other intangibles, such as trade names.

In Chief counsel advice, CCA 200911006, the IRS concludes that intangibles such as trademarks, trade names, mastheads, and customer-based intangibles that can be separately described and valued apart from goodwill qualify as like-kind property under Section 1031 (assuming the other requirements of Section 1031, including the nature and character rules of Reg. 1.1031(a)-2(c)(1), are met).  Thus, an exchange of these intangible assets can qualify for deferral of gain. This determination supersedes an opposite conclusion in TAM 200602034.

See the CCA attached to this article.  Download Article - Intangibles and like-kind exchange