PTIN Renewal Period Underway; New Continuing Education and Testing Requirements Apply to Some Preparers

The IRS is reminding the nation's federal tax return preparers that they must renew their preparer tax identification numbers (PTINs) for 2013. IR-2012-79 (10/22/12).

In a news release issued this week, the IRS reminded the nation's 730,000 federal tax return preparers that they must register with the IRS and have a PTIN, as must all Enrolled Agents.

Additionally, some return preparers have new continuing education and competency test requirements. The online PTIN renewal process (www.irs.gov/ptin) takes about 15 minutes. Renewed PTINs will be valid for calendar year 2013. According to the IRS, it has significantly upgraded the PTIN system to make it easier to use and more intuitive. Preparers who have forgotten their log-in information, password, or email address can use online tools to resolve these issues, the IRS said.

New continuing education and testing requirements also apply to approximately 340,000 preparers who previously had no such requirements. These preparers must certify when renewing their PTIN for 2013 that they have completed the 15-hour requirement for continuing education in 2012. The IRS is urging preparers who have a competency test requirement to take the time now to schedule an appointment for the exam.

OBSERVATION: Enrolled Agents, CPAs and attorneys are exempt from the new continuing education requirements because they already pass more extensive tests and take continuing education courses to satisfy their professional credentials.

The following are the requirements for the competency test requirements:

(1) Enrolled Agents: 72 hours every three years; Obtain a minimum of 16 hours per year (2 of which must be on ethics)

(2) Enrolled Retirement Plan Agents: 72 hours every three years; Obtain a minimum of 16 hours per year (2 of which must be on ethics)

(3) Registered Tax Return Preparers: 15 hours per year (beginning in calendar year 2012); 2 hours of ethics, 3 hours of federal tax law updates, 10 hours of other federal tax law

(4) Registered Tax Return Preparer candidates (provisional PTIN holders who have until 12/31/13 to become RTRPs): 15 hours per year (beginning in calendar year 2012); 2 hours of ethics, 3 hours of federal tax law updates, 10 hours of other federal tax law

Additionally, preparers with a testing requirement should schedule their tests, whether it is the Registered Tax Return Preparer (RTRP) test or the more extensive Special Enrollment Exam (SEE) for those interested in becoming Enrolled Agents. The RTRP test can be scheduled online through the PTIN system by selecting next steps and additional requirements from the PTIN account Main Menu. The SEE can be scheduled online at www.prometric.com/see.

OBSERVATION: The IRS is warning preparers who wait until next year to schedule a test that they may find it difficult to arrange the test at a convenient date, time, and location.

For a discussion of the PTIN requirements, see Parker Tax ¶275,100.

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Wages Weren't Disguised Purchase Price Payments; IRS Report on Reasonable Salary Entirely Unbelievable

In H & M, Inc. v. Comm'r, T.C. Memo. 2012-290 (10/15/12), a small corporation sold its biggest asset, a successful insurance brokerage business, to a local bank. The corporation's sole shareholder then went to work for that bank. The corporation continued and subsequently issued a note to the sole shareholder for being undercompensated in prior years. It made no payments on the note for many years and when it finally did make payments, it deducted the payments as interest.

The IRS argued that a large portion of the wages the bank paid to the sole shareholder under its employment and deferred compensation with him were actually disguised purchase-price payments to the corporation. It said that the wages were, in part, disguised payments for goodwill. It also argued that the interest payments deducted by the corporation were actually disguised dividends.

On the issue of selling goodwill, the taxpayer won. The Tax Court reminded the IRS that a corporation cannot sell something it doesn't own. The goodwill in this case was personal to the sole shareholder. However, on the issue of the interest payment being disguised dividends, the taxpayer wasn't so lucky. The court determined that the history of sporadic payments on the note and the fact that the corporation didn't pay any dividends showed that the shareholder used the promissory note as a way to get money out of the corporation whenever he wanted. This didn't have to be the case. Had the corporation made regular principal payments and made some dividend payments over the years, the taxpayer might have prevailed.

The Insurance Business

Harold Schmeets lived in Harvey, North Dakota, and began selling insurance as an employee of the National Bank of Harvey in the late 1960s. The insurance agency was housed in the same building as the bank. Eventually, Harold began to buy the bank's insurance agency a little bit at a time. By 1980, he had become the agency's sole shareholder. He changed the name of the company to Harvey Insurance Agency, Inc. In 1983, however, the bank built a new and bigger office and got back into the insurance business with a company called National Insurance. Despite the competitive market, Harold stood out among insurance agents in the area. He had experience in all insurance lines and all facets of running an insurance agency, including accounting, management, and employee training.

Despite being competitors, Harold and Gary Bergstrom, the bank's president, spoke often. In January 1992, Bergstrom and Harold began to talk about whether to merge the two agencies. Both thought that it would help them stay in business by shoring up their shrinking customer base. The bank also thought a merger would revive its own insurance business's profitability. Harold thought joining agencies would help him--he had employees who wanted benefits, and his agency was not in a position to provide them.

The bank's legal counsel prepared the two key documents: a purchase agreement and an employment agreement. Harold didn't hire his own lawyer for the negotiations, nor did he seek advice on how to structure the deal. Under the purchase agreement, Harvey Insurance agreed to sell all files, customer lists, insurance agency or brokerage contracts, the name of Harvey Insurance, and all the goodwill of Harvey Insurance to National Insurance for $20,000, payable in six equal annual installments plus interest. The purchase agreement was contingent on the parties' execution of an employment agreement with Harold. And it contained a non-compete provision, which specified that Harvey Insurance and Harold would not compete with National Insurance for 15 years.

The employment agreement made Harold the manager of National Insurance for a six-year term beginning in March 1992. Harold promised to perform an extensive list of managerial duties. In return, National Insurance promised to pay him an annual base wage of $38,936, annual variable compensation equal to the greater of $50,000 or 45 percent of net adjusted income for the year, and deferred compensation of $74,000 at the end of the six-year term. If Harold died, National Insurance still had to pay Harold the annual base wage and deferred compensation for services already performed. The total compensation under the agreement was over $600,000 for Harold's services during the six years. Both parties thought the compensation package was fair, and they did not have anyone appraise Harold's insurance agency.

In March 1993, National Insurance and Harold changed the timing of the compensation payments that National Insurance had promised to pay Harold. The revised agreement provided that part of Harold's compensation would be deferred and earn interest, and then be paid out over a seven-year period beginning in March 1999. If Harold died before the complete payout of the deferred-compensation balance, National Insurance still had to make annual payments to Harold's estate. The total amount of deferred compensation under the agreement ended up being more than $340,000, as reflected in a Form W-2 issued to Harold in 1998.

Harold served as the manager of National Insurance for the entire six-year term of the employment agreement, and the bank reported his compensation as wages subject to withholding and Federal Insurance Contributions Act (FICA) tax. Harold rewrote existing insurance policies, took new applications, supervised and trained the agency's four employees, attended bank planning sessions, negotiated commissions with insurance companies, and did the agency's bookkeeping. The transition multiplied his responsibilities, and Harold went from a 40-hour workweek before the sale to almost double that after. At the end of the six-year term, the bank was pleased with Harold's performance and asked him to continue to manage the agency under year-to-year contracts. Harold agreed and kept working several days a week for about $30,000 per year to help train his replacement. Despite this lack of experience, the bank paid Harold's replacement an annual salary of between $55,000 and $65,000. Harold then retired.

The Promissory Note

Instead of liquidating the old Harvey Insurance Agency after its name and assets passed to the bank, the corporation's board of directors--which consisted of Harold, his wife Mona, and his son, Stuart--decided to keep the corporate entity alive to exploit some patents that Harold was working on relating to certain inventions. The corporation reissued its stock under the new name of H&M, Inc. Harold remained the sole shareholder and president, and Mona continued to serve as its secretary/treasurer. The board of directors stayed the same. In the months leading up to the sale this board agreed that Harold had been undercompensated for his services to the insurance agency in past years, though it never specified which years and what amounts. It recognized that the deal with National Insurance could free up some money to pay him, but postponed a decision on giving any of that extra cash to Harold.

At the end of March 1992 H&M issued Harold a promissory note, which Harold signed as H&M's president. Under the note, H&M promised to pay Harold $120,000 plus interest at the rate of 10 percent. The note didn't include any payment terms or a maturity date, and it was unsecured. H&M treated the $120,000 obligation as accrued officer compensation on its 1992 income tax return, but didn't actually deduct it that year. H&M never paid anything--either interest or principal--on the note until 1999, and even after that, its payments were sporadic. H&M deducted the amounts it paid as interest in tax years 2002 through 2005. The balance sheets of H&M's tax returns for those years list the $120,000 salary payable as a liability. They also indicate that H&M had more than $190,000 in cash and $240,000 in retained earnings at the beginning and end of each of those years and that H&M didn't make any distributions to Harold.

IRS Audit

The IRS audited H&M's returns for tax years 2001 through 2005. It issued a notice of deficiency based on the theory was that Harold's wages under the employment and salary-deferment agreements were actually payments to H&M for the sale of the insurance business, including goodwill. This recharacterization resulted in capital gain and interest income to H&M for each of the years at issue. An IRS expert issued a report that estimated the fair market value of Harold's services to be $22,700 in 1994 and 1995; and $38,300 in 1996, 1997, and 1998.

The IRS also disallowed H&M's deduction for interest it paid to Harold in tax years 2002 through 2005 on the promissory note, saying that neither Harold nor H&M intended to create a bona fide debt.

According to the IRS, a substance-over-form analysis showed that the value of the assets that National Insurance bought should have included not only the $20,000 purchase price paid to H&M, but also the $38,936 annual base wage and $74,000 deferred compensation under the employment agreement paid to Harold. This would leave the annual variable compensation (the greater of $50,000 or 45 percent of net adjusted income for the year) as payment for Harold's services. According to the IRS, this allocation more accurately reflected the fair market value of Harold's services to the bank's agency, as well as Harvey Insurance's value at the time of the sale, because only this allocation would account for goodwill and the corporation's other intangible assets.

The IRS pointed to several factors that it argued showed that the form of the transaction didn't match its substance: (1) Harold's estate would still receive the entire annual base wage and deferred compensation if he died; (2) there was no documentation supporting the allocation; (3) the parties did not have adverse interests in the transaction because there were tax advantages to allocating more of the overall price to compensation; and (4) the fair market value of Harold's services to the bank's agency was much less than the amount he was being paid.

According to the IRS, the parties set up the deal the way they did for the tax benefits: The bank wanted to deduct the compensation it paid to Harold, and Harold wanted to avoid being taxed twice on the proceeds of the sale--once at the corporate level when H&M received the purchase-price payments, and then again when he received dividends from H&M.

With respect to the note payable, the IRS said that the note was more like equity than a debt. It pointed to H&M's sporadic payments, the fact that the note had no maturity date, and the lack of any dividend payments to Harold.

H&M's Arguments

H&M countered that recharacterizing all the compensation payments as purchase-price payments was inappropriate because the parties' allocation reflected the economic realities of the transaction. H&M took issue with the IRS's allocation of all the insurance business's goodwill to a corporation few people knew about and argued that any goodwill of the business was attributable to Harold personally. It also said that Harold's compensation under the agreement was reasonable because the bank needed Harold to keep the insurance business going, and Harold had significant responsibilities as the manager of the bank's agency after the sale. And it pointed out that instead of focusing on the tax consequences of the transaction, Harold and the bank wanted to create an employment relationship and both consistently treated the deal as if they had.

With respect to the note payable, H&M argued that it should be able to deduct the amounts it paid to Harold as interest because the note represented a valid business debt. It said the corporation's board agreed that Harold had not been adequately compensated for his services to Harvey Insurance before the sale and that it decided to issue him the note and make payments--but only to the extent possible after meeting the cash needs that the corporation would have in exploiting the patents.

Tax Court's Analysis

In light of Harold's personal relationships, his experience in running all facets of an insurance agency, and his responsibilities as manager of the bank's agency, the Tax Court found that the compensation that the bank paid him was reasonable. The employment agreement contained an extensive list of duties Harold was required to perform as the agency's manager, and Harold went from working around 40 hours a week before the sale to double that afterward. The court was satisfied that Harold and National Insurance were genuinely interested in creating an employment relationship and were not just massaging the paperwork for its tax consequences.

With respect to the IRS report, which estimated the fair market value of Harold's services to be $22,700 in 1994 and 1995 and $38,300 in 1996 - 1998, the court said the report was entirely unbelievable. According to the court, the report ignored the fact that Harold was more than an insurance salesman and that he had significant management and bookkeeping responsibilities as manager of the bank's insurance agency. It also didn't account for his level of experience in the insurance industry, the court noted, and failed to explain why the fair market value of Harold's services was only $22,700 to $38,300 despite the fact that his replacement, who was less experienced than Harold, was paid $55,000 to $65,000 per year. As a result, the court gave the report no weight.

With respect to the goodwill issue, the court noted that there is no specific rule for determining the value of goodwill. The court cited Martin Ice Cream Co. v. Comm'r, 110 T.C. 289 (1998), for the proposition that there is no salable goodwill where the business of a corporation depends on the personal relationships of a key individual, unless that individual transfers his goodwill to the corporation by entering into a covenant not to compete or other agreement so that his relationships become property of the corporation. The court noted that the insurance business in Harvey is extremely personal, and the development of Harvey Insurance's business before the sale was due to Harold's ability to form relationships with customers and keep big insurance companies interested in a small insurance market. The court specifically found that when customers came to his agency, they came to buy from him--it was his name and his reputation that brought them there. The court concluded that Harold had no agreement with H&M at the time of its sale that prevented him from taking his relationships, reputation, and skill elsewhere, which was precisely what he did when he began working for the bank's renamed insurance agency.

With respect to the promissory note, the court looked at the factors used to solve debt-versus-equity problems and said the relevant factors made it more likely than not that the note didn't represent bona fide debt. The court cited the fact that it had no maturity date, no principal payments were made in a 17-year period after the note was issued even though cash was available, the interest payments were sporadic, and no dividends were paid to Harold.

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IRS Releases Certain Inflation-Adjusted Figures for 2013; But Holds Off on Others

The uncertainty about what will happen with next year's tax rates and some prominent deductions and credits crept into the annual inflation-adjusted revenue procedure that the IRS issues each fall. The 2001 Bush-Era tax cuts that were originally scheduled to end in 2010 but were extended through 2012 have been the subject of much debate between the presidential candidates, President Obama and Governor Romney. The current expiration date for most of these tax cuts is December 31, 2012. Thus, for example, the overall limitation on itemized deductions that used to apply to high-income individuals but was phased out under the Bush-Era tax cuts is scheduled to return in 2013, as are higher tax rates in general. While President Obama has called for increasing rates on the top-income earners, he has advocated keeping the lower rates for everyone else. Governor Romney has advocated an across-the-board 20 percent tax rate cut, but has also mentioned capping deductions. As a result, in Rev. Proc. 2012-41, the IRS didn't release all the inflation-adjusted numbers that it normally would, presumably because it is waiting to see what the future holds.

The inflation-adjusted numbers for 2013 include the following:

(1) The annual exclusion for gifts is $14,000 (up from $13,000 in 2012).

(2) The first $143,000 (up from $139,000 in 2012) of gifts to a spouse who is not a citizen of the United States (other than gifts of future interests in property) are not included in the total amount of taxable gifts made during the year.

(3) The amount used to reduce the net unearned income reported on a child's tax return subject to the kiddie tax, is $1,000 (up from $950 for 2012).

(4) The foreign earned income exclusion amount is $97,600 (up from $95,100 in 2012).

(5) The exclusion from income for U.S. savings bond interest for taxpayers who pay qualified higher education expenses, begins to phase out for modified adjusted gross income above $112,050 for joint returns (up from $109,250 in 2012) and $74,700 (up from $72,850 in 2012) for other returns. The exclusion is completely phased out for modified adjusted gross income of $142,050 (up from $139,250 in 2012) for joint returns and $89,700 (up from $87,850 in 2012) for other returns.

(6) For purposes of medical savings accounts, a "high deductible health plan" means, for self-only coverage, a health plan that has an annual deductible that is not less than $2,150 (up from $2,100 in 2012) and not more than $3,200 (up from $3,150 in 2012), and under which the annual out-of-pocket expenses required to be paid (other than for premiums) for covered benefits do not exceed $4,300 (up from $4,200 in 2012). For tax years beginning in 2013, the term "high deductible health plan" means, for family coverage, a health plan that has an annual deductible that is not less than $4,300 (up from $4,200 in 2012) and not more than $6,450 (up from $6,300 in 2012), and under which the annual out-of-pocket expenses required to be paid (other than for premiums) for covered benefits do not exceed $7,850 (up from $7,650 in 2012).

(7) The limitations for eligible long-term care premiums includible in the term "medical care" are: for individuals with an attained age of 40 or less before the close of the tax year, $360 (up from $350 in 2012); more than 40 but not more than 50, $680 (up from $660 in 2012); more than 50 but not more than 60, $1,360 (up from $1,310 in 2012); more than 60 but not more than 70, $3,640 (up from $3,500 in 2012); and more than 70, $4,550 (up from $4,370 in 2012).

(8) For the estate of a decedent dying in calendar year 2013, if the executor elects to use the special use valuation method for qualified real property, the aggregate decrease in the value of qualified real property resulting from the election to use Code Sec. 2032A for purposes of the estate tax cannot exceed $1,070,000 (up from $1,020,000 for decedents dying in 2012).

(9) The amount that would be includible in the gross income of a covered expatriate is reduced (but not below zero) by $668,000 (up from $651,000 in 2012).

(10) The value of fuel, provisions, furniture, and other household personal effects, as well as arms for personal use, livestock, and poultry exempt from levy cannot exceed $8,790 (up from $8,570 in 2012). The value of books and tools necessary for the trade, business, or profession of the taxpayer that are exempt from levy cannot exceed $4,400 (up from $4,290 from 2012).

(11) For an estate of a decedent dying in calendar year 2013, the dollar amount used to determine the "2-percent portion" (for purposes of calculating interest under Code Sec. 6601(j)) of the estate tax extended as provided in Code Sec. 6166 is $1,430,000 (up from $1,390,000 in 2012).

(12) The attorney fee award limitation is $190 per hour (up from $180 in 2012).

(13) The stated dollar amount of the per diem limitation for periodic payments received under a qualified long-term care insurance contract or periodic payments received under a life insurance contract that are treated as paid by reason of the death of a chronically ill individual, is $320 (up from $310 in 2012).

Rev. Proc. 2012-41 does not include the following items that, in the past, have been included:

(1) the tax rate tables;

(2) the adoption credit;

(3) the child tax credit;

(4) the Hope Scholarship and Lifetime Learning Credits;

(5) the earned income credit;

(6) the standard deduction;

(7) the overall limitation on itemized deductions;

(8) the qualified transportation fringe benefit;

(9) the adoption assistance exclusion;

(10) the personal exemption;

(11) the election to expense certain depreciable assets;

(12) the interest on education loans; and

(13) the unified credit against estate tax for decedent's estates.

According to the IRS, the above items will be addressed in future guidance.

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Pension COLAs Announced; 401(k) Deferrals Increase to $17,500, but Catch-up Contributions Remain Unchanged

On October 18, in IR-2012-77, the IRS announced cost-of-living adjustments affecting dollar limitations for pension plans and other retirement-related items for 2013. In general, many of the pension plan limitations will change for 2013 because the increase in the cost-of-living index met the statutory thresholds that trigger their adjustment. However, other limitations will remain unchanged because the increase in the index did not meet the statutory thresholds that trigger their adjustment. The changes include:

(1) The elective deferral (contribution) limit for employees who participate in 401(k), 403(b), most 457 plans, and the federal government's Thrift Savings Plan is increased from $17,000 to $17,500.

(2) The salary reduction contribution limit under Code Sec. 408(p)(2)(E) for SIMPLE IRAs is increased from $11,500 to $12,000.

(3) The catch-up contribution limit for employees aged 50 and over who participate in 401(k), 403(b), most 457 plans, and the federal government's Thrift Savings Plan remains unchanged at $5,500. The dollar limitation under Code Sec. 414(v)(2)(B)(ii) for catch-up contributions to a SIMPLE 401(k) plan described in Code Sec. 401(k)(11) or a SIMPLE IRA described in Code Sec. 408(p) for individuals aged 50 or over remains unchanged at $2,500.

(4) The deductible amount under Code Sec. 219(b)(5)(A) for an individual making qualified retirement contributions to a traditional IRA is increased from $5,000 to $5,500.

(5) The deduction for taxpayers making contributions to a traditional IRA is phased out for singles and heads of household who are covered by a workplace retirement plan and have modified adjusted gross incomes (AGI) between $59,000 and $69,000, up from $58,000 and $68,000 in 2012. For married couples filing jointly, in which the spouse who makes the IRA contribution is covered by a workplace retirement plan, the income phase-out range is $95,000 to $115,000, up from $92,000 to $112,000. For an IRA contributor who is not covered by a workplace retirement plan and is married to someone who is covered, the deduction is phased out if the couple's income is between $178,000 and $188,000, up from $173,000 and $183,000.

(6) The AGI phase-out range for taxpayers making contributions to a Roth IRA is $178,000 to $188,000 for married couples filing jointly, up from $173,000 to $183,000 in 2012. For singles and heads of household, the income phaseout range is $112,000 to $127,000, up from $110,000 to $125,000. For a married individual filing a separate return who is covered by a retirement plan at work, the phase-out range remains $0 to $10,000.

(7) The limit on the annual benefit under a defined benefit plan under Code Sec. 415(b)(1)(A) is increased from $200,000 to $205,000. For a participant who separated from service before January 1, 2013, the limitation for defined benefit plans under Code Sec. 415(b)(1)(B) is computed by multiplying the participant's compensation limitation, as adjusted through 2012, by 1.0170.

(8) The limit on annual additions for defined contribution plans under Code Sec. 415(c)(1)(A) is increased in 2013 from $50,000 to $51,000.

(9) The annual compensation limit under Code Secs. 401(a)(17), 404(l), 408(k)(3)(C), and 408(k)(6)(D)(ii) is increased from $250,000 to $255,000.

(10) The dollar limitation under Code Sec. 416(i)(1)(A)(i) concerning the definition of key employee in a top-heavy plan remains unchanged at $165,000.

(11) The limitation used in the definition of highly compensated employee under Code Sec. 414(q)(1)(B) remains unchanged at $115,000.

(12) The compensation amount under Reg. Sec. 1.61-21(f)(5)(i) concerning the definition of control employee for fringe benefit valuation purposes remains unchanged at $100,000. The compensation amount under Reg. Sec. 1.61-21(f)(5)(iii) remains unchanged at $205,000.

(13) The dollar amount under Code Sec. 409(o)(1)(C)(ii) for determining the maximum account balance in an employee stock ownership plan subject to a five-year distribution period is increased from $1,015,000 to $1,035,000, while the dollar amount used to determine the lengthening of the five-year distribution period is increased from $200,000 to $205,000.

(14) The annual compensation limitation under Code Sec. 401(a)(17) for eligible participants in certain governmental plans that, under the plan as in effect on July 1, 1993, allowed cost-of-living adjustments to the compensation limitation under the plan under Code Sec. 401(a)(17) to be taken into account, is increased from $375,000 to $380,000.

(15) The compensation amount under Code Sec. 408(k)(2)(C) regarding simplified employee pensions (SEPs) remains unchanged at $550.

(16) The AGI limitation under Code Sec. 25B(b)(1)(A) (i.e., relating to the 50 percent applicable percentage) for determining the retirement savings contribution credit for married taxpayers filing a joint return is increased to $35,500 from $34,500 in 2012; the limitation under Code Sec. 25B(b)(1)(B) (i.e., relating to the 20 percent applicable percentage) is increased to $38,500 from $37,500; and the limitation under Code Sec. 25B(b)(1)(C) (relating to the 10 percent applicable limitation) and Code Sec. 25B(b)(1)(D) (relating to the zero percent applicable limitation), is increased to $59,000 from $57,500.

(17) The AGI limitation under Code Sec. 25B(b)(1)(A) for determining the retirement savings contribution credit for taxpayers filing as head of household is increased to $26,625 from $25,875; the limitation under Code Sec. 25B(b)(1)(B) is increased to $28,875 from $28,125; and the limitation under Code Secs. 25B(b)(1)(C) and 25B(b)(1)(D) is increased to $44,250 from $43,125.

(18) The adjusted gross income limitation under Code Sec. 25B(b)(1)(A) for determining the retirement savings contribution credit for all other taxpayers is increased to $17,750 from $17,250; the limitation under Code Sec. 25B(b)(1)(B) is increased to $19,250 from $18,750; and the limitation under Code Secs. 25B(b)(1)(C) and 25B(b)(1)(D) is increased to $29,500 from $28,750.

(19) The dollar amount used to determine excess employee compensation with respect to a single-employer defined benefit pension plan for which the special election under Code Sec. 430(c)(2)(D) has been made is increased from $1,039,000 to $1,066,000.

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GAO Outlines Considerations for Reporting Tax Debts to Credit Bureaus

A recently issued report by the Government Accountability Office discusses the various factors that should be considered in any plan to report taxpayer tax debts to credit agencies. GAO Report 12-939 (Sept. 2012).

In response to requests from Congressional leaders, the Government Accountability Office (GAO) prepared a report for Congress entitled, Federal Tax Debts: Factors for Considering a Proposal to Report Tax Debts to Credit Bureaus. The report notes that at the end of fiscal 2011, individuals and businesses owed a total of about $373 billion in federal unpaid tax debt; $258 billion in individual debt, and $115 billion in business debt.

Unlike many other debts owed to the federal government, tax debts are not directly reported to credit bureaus. The IRS is not allowed to directly report tax debt information to credit bureaus because long-standing federal law protects the privacy of any personally identifiable information reported to, or developed by, the IRS. However, the IRS is allowed to file tax liens on some tax debts, and such liens are public record, which can be picked up by credit bureaus and included in the credit history information they compile.

Among the potential reasons for directly reporting tax debt information to credit bureaus, the GAO stated, are the possibility that it could increase revenue by encouraging tax debtors to pay off their debts and the possibility that it could give the users of credit bureau information a more complete picture of the indebtedness of tax debtors. A proposal could conceivably encompass all tax debts or specify types of tax debts for such reporting. However, the tradeoffs that directly reporting tax debts to credits bureaus would entail are not well understood, and the GAO was asked to provide information about such tradeoffs.

Some subject matter specialists the GAO spoke with said it would be important to consider a proposal to report tax debts directly to credit bureaus in light of the alternative present in IRS's current use of tax liens, which are already known to credit bureaus. Credit bureau officials noted that only the initial dollar amount of the tax debt that is the subject of the lien and the identity of the debtor are publicly reported and picked up and included in credit bureau files. Changes in tax debts over time, such as if a tax debt grows (because of penalties and interest) or is reduced (because the debtor pays IRS some of what is owed), are not included with tax liens or known to credit bureaus. For this reason, direct reporting could involve more current information than what is available from tax liens and provide an incentive to taxpayers to pay down their debts because their declining balance due would be reflected on their credit histories. On the other hand, some subject matter specialists noted that direct reporting of tax debts to credit bureaus along with lien filings would increase the risk of reporting duplicative negative information on a taxpayer's credit report.

Some specialists suggested the possibility that the threat of credit bureau reporting could increase compliance because people would seek to avoid incurring reportable debts or hurry to pay off their existing debts to improve their credit scores. The National Taxpayer Advocate, however, suggested that any proposal should be evaluated in light of the possibility that reporting tax debts to credit bureaus may result in some people choosing to not file or file inaccurately if they know they owe money to IRS. Some specialists noted that once credit bureau information is redisclosed, it is less subject to controls on its use and more open to possible misuse. They noted that this would be a very serious consideration in light of the high level of protection typically given to federal tax information and taxpayers' expectation that information about them will be protected by the IRS. However, some specialists also noted that information about many tax debts is already made public through tax liens and available in credit bureau files.

Finally, experts observed that experience with tax liens may provide a useful analogue for considering potential effects of direct tax debt reporting on voluntary compliance. Studies by the IRS and the Taxpayer Advocate have revealed desired and undesired compliance effects of liens in some cases. For example, the Taxpayer Advocate Service has conducted research that raises concerns about potential negative effects associated with liens. A 2011 study found that lien filing was associated with declines in taxpayers' compliance and reported income. In the years studied, taxpayers subject to liens were less likely to reduce their initial tax debt, file required returns, and have increased income than other similarly situated taxpayers without liens filed. However, the study also found lien filing was associated with better payment compliance behavior among these same taxpayers in subsequent years. IRS studies have also found that liens had positive compliance effects for cases studied, such as increasing the likelihood that a collection case would be resolved if a lien is filed sooner.

For a discussion of the rules relating to tax liens, see Parker Tax ¶260,530.

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Second Circuit Rules DOMA Unconstitutional; Same-Sex Spouse Allowed Marital Deduction for Estate Tax

The Second Circuit held that DOMA was unconstitutional and allowed the surviving spouse of a same-sex couple, who resided in New York, to take the estate tax marital deduction. Windsor v. U.S., 2012 PTC 279 (2d Cir. 10/18/12).

Edith Windsor married Thea Spyer in Canada in 2007. Thea died in 2009 when the couple were residents of New York. Edith was denied the benefit of the spousal deduction for federal estate taxes solely because Section 3 of the Defense of Marriage Act (DOMA) defines the words marriage and spouse in federal law in a way that bars the IRS from recognizing Edith as a spouse or the couple as married. Specifically, Section 3 states that In determining the meaning of any Act of Congress, or of any ruling, regulation, or interpretation of the various administrative bureaus and agencies of the United States, the word marriage' means only a legal union between one man and one woman as husband and wife, the word spouse' refers only to a person of the opposite sex who is a husband or a wife.

In June 2012, a district court granted summary judgment in favor of Edith. The court ruled that Section 3 of DOMA violated the equal protection clause of the Constitution because there was no rational basis to support it. The Department of Justice declined to defend DOMA. Thereafter, members of Congress took steps to support it. The Bipartisan Legal Advisory Group of the United States House of Representatives (BLAG) retained lawyers and took to defending the statute. They filed an appeal in the Windsor case. The United States remained active as a party, switching sides to advocate that the statute be ruled unconstitutional.

The Second Circuit upheld the district court and ruled that Edith had standing in the case because the court predicted that New York, which did not permit same-sex marriage to be licensed until 2011, would nevertheless have recognized Edith and Thea as married at the time of Thea's death in 2009, so that Edith was a surviving spouse under New York law. The court ruled that Section 3 of DOMA violated the equal protection clause because there was no rational basis to support it and, thus, DOMA was unconstitutional.

For a discussion of DOMA and the rules regarding same-sex couples, see Parker Tax ¶10,590.

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Tax Court Rejects Bad Debt Deduction Where Taxpayer Voluntarily Released Debtor

Where a debt was extinguished not so much on account of the debtor's ability or inability to pay, but rather pursuant to an arrangement that allowed a taxpayer to avoid potential liabilities in connection with certain credit card accounts, no bad debt deduction was allowed. Arguello v. Comm'r, T.C. Summary 2012-99 (10/10/12).

Guillermo Arguello worked for Guggenheim Investments and related companies. In 2005, Guillermo, Mr. Guggenheim, the owner of Guggenheim Investments, and Marcin Ladowski met to discuss a business arrangement involving Ladowski's company, Netrostar. Guggenheim and Guillermo agreed to provide financing, share customer lists, and contribute management services to Netrostar. In return, Guggenheim and Guillermo each were to receive a one-third ownership interest in Netrostar, although neither was issued any shares of Netrostar's stock. The agreement was not reduced to writing. Guillermo characterized the agreement as a gentleman's agreement, evidenced only by a handshake. The agreement was intended to be symbiotic -- Netrostar would receive needed financing, business referrals, and management assistance, and the Guggenheim companies could take advantage of the website design services Netrostar offered.

Subsequently, Ladowski was unable to keep Netrostar in business on his own. He needed financial help, and Guillermo assisted with keeping the company afloat by purchasing and selling to Ladowski an Alfa Romero and charging various expenses to his credit cards. In 2007, Ladowski signed a promissory note obligating Ladowski or Netrostar to pay Guillermo $24,000 in installments of $1,000 on the first day of each month for 24 months. In addition, Guillermo was also liable as a cosigner on a Visa credit card with a balance of $33,000 at the end of 2007. The credit card account was used to pay Netrostar expenses. In December 2007, Guillermo agreed to relieve Netrostar of its obligations for the balance due on the note, which at the time was $21,000, in exchange for (1) an additional $2,000 payment to be made before the end of the year; and (2) Guggenheim's agreement to assume Guillermo's obligations incurred as a cosigner on the credit card accounts. Guillermo then took a bad debt deduction on his 2007 tax return for $19,000. The IRS disallowed the deduction.

The Tax Court agreed with the IRS and disallowed the deduction. The court said that the Alfa purchase and the resultant note created a bona fide debt owed to Guillermo by Netrostar. However, the court said it could not find that, as of the close of 2007, Netrostar's financial condition, although shaky, prompted Guillermo to relinquish his rights to collect the balance on the note. The evidence showed and the court found, that the debt was extinguished not so much on account of Netrostar's ability or inability to pay, but rather pursuant to an arrangement that allowed Guillermo to avoid potential liabilities in connection with the credit card accounts. The court cited Brubaker v. Comm'r, 28 T.C. 1281 (1957), for the proposition that a debt is not worthless where the creditor, for considerations satisfactory to himself, voluntarily releases a solvent debtor from liability. According to the Tax Court, that is what happened in this case. Accordingly, the court held that Guillermo failed to establish that the debt to which the deduction in dispute related was, as of the close of 2007, wholly or partially worthless within the meaning of Code Sec. 166.

For a discussion of the worthless debt requirement for taking a bad debt deduction, see Parker Tax ¶98,410.

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Disbarred Lawyer Wasn't an Independent Contractor; Schedule C Expenses Disallowed

A disbarred lawyer that did temp work as a contract attorney was an employee and not an independent contractor; thus most of his Schedule C expenses were disallowed. Rodriguez v. Comm'r, T.C. Memo. 2012-286 (10/9/12).

Since 1987, Isidoro Rodriguez has operated, as a sole proprietorship, a law office in the Republic of Columbia. He married in 2000, and his wife subsequently became an attorney also. In 2000, they moved to Virginia but continued to operate their law offices in Colombia. In 2006, they established a home law office in Annandale, Virginia, to represent clients. The officet occupied a 3,060-square-foot space within their 9,180-square-foot home. The lease on that home began on May 13, 2006, and ran through May 31, 2007.

In 2006, Mrs. Rodriguez worked as a full-time paralegal with a Maryland law firm. From 2000 to 2006, Isidoro intermittently provided temporary legal services to law firms. In 2006, Isidoro's license to practice law in Virginia was revoked. He was hired in 2006 by LegalSource Corp. and Update Legal, both temporary staffing agencies, as a temporary contract attorney to work on short-term projects. Both agencies consider their temporary contract attorneys to be at-will employees, dischargeable at the agencies' discretion.

In 2006, LegalSource assigned Isidoro to perform temporary legal services for one of its clients, the law firm of Howrey LLP, in Howrey's Virginia office. This assignment lasted from about January 2 to October 27, 2006 (i.e., shortly before Isidoro's disbarment in Virginia). Isidoro worked on temporary litigation projects at Howrey, such as electronic discovery document review. LegalSource considered Isidoro to be its employee and, in 2006, it issued him a Form W-2, Wage and Tax Statement, identifying itself as Employer and Isidoro as Employee. The Form W-2 showed wages of $59,220 and amounts withheld for federal and state income taxes, employment taxes, and Medicare taxes. Box 13, Statutory employee, was left blank on the Form W-2.

In 2006, Update assigned Isidoro to perform temporary legal services for one of its clients, the law firm of Winston & Strawn LLP (Winston & Strawn), in Washington, D.C. This assignment lasted from about November 20 to December 15, 2006. Isidoro worked at least 40 hours a week at Winston & Strawn and was compensated on an hourly basis. Update determined his rate of pay. He received overtime pay for work over 40 hours per week. Neither Update nor Winston & Strawn paid Isidoro any bonus, vacation pay, or compensation for personal leave time. Nor did they reimburse or pay Isidoro for his expenses of bar admission, legal education, cell phones, law office books or equipment, or any other items. Update considered Isidoro to be its employee.

On their joint return, the Rodriguezes attached a Schedule C, Profit or Loss From Business (Sole Proprietorship), labeling the activity the Law Offices of Isidoro Rodriguez with an address in Barranquilla, Colombia. On the Schedule C, they reported gross receipts of $72,848 and total expenses of $66,016. The IRS disallowed all of the Rodriguezes' Schedule C expense deductions, noting that only statutory employee income can be offset by expenses reported on Schedule C or Schedule C-EZ. Since neither employer indicated on Form W-2 that Isidoro was a statutory employee, he could not deduct the Schedule C expenses. According to the IRS, Isidoro was the common law employee of the agencies, and his unreimbursed employee expenses were thus properly reportable on Schedule A.

The Tax Court applied common law rules and determined that Isidoro was an employee. The court noted that, whether a common law employer-employee relationship exists in a particular situation is a question of fact. The court examined the following factors in determining if Isidoro was a common law employee or an independent contractor: (1) the degree of control the principal exercised over the details of the work; (2) which party invested in work facilities used by the individual; (3) the opportunity of the individual for profit or loss; (4) whether the principal could discharge the individual; (5) whether the work is part of the principal's regular business; (6) the permanency of the relationship; (7) the relationship the parties believed they were creating; and (8) whether the principal provided employee benefits. No one factor is determinative, the court stated, and all the facts and circumstances of the relationship must be considered and weighed according to their significance in the particular case. In this case, the court concluded that the majority of the factors weighed in favor of Isidoro being an employee.

For a discussion of the factors in determining whether an individual is an employee or independent contractor, see Parker Tax ¶210,110.

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IRS Must Divulge Additional Info to Company Defending Employment Tax Treatment of Drywallers

In a case involving the possible misclassification of drywallers, the IRS was ordered to produce those documents or parts of documents, previously withheld, that contain relevant factual information that can be disclosed without revealing the IRS's administrative analysis, impressions and conclusions. Desert Valley Painting & Drywall, Inc. v. U.S., 2012 PTC 278 (D. Nev. 10/9/12).

In 2003 to 2006, Desert Valley Painting & Drywall, Inc. hired drywall workers and treated them as independent contractors. The IRS audited Desert Valley and said that the drywall workers were employees and Desert Valley was therefore required to withhold employee taxes from the workers' pay. Desert Valley contended that it contracted with Centennial Drywall Systems, Inc. to provide drywall workers for construction projects in Southern Nevada. Desert Valley alleged that Centennial represented that the IRS approved its treatment of the workers as independent contractors pursuant to a 1989 worker classification letter it received from the IRS. Desert Valley stated that it relied on Centennial's representations regarding the IRS's approval of the worker's independent contractor classification and that it was the industry standard in Southern Nevada to treat drywall workers as independent contractors. The IRS first attempted to collect employment taxes from Centennial and when that effort was unsuccessful, pursued efforts to collect employee taxes from Desert Valley and other drywall contractors who used Centennial's services.

The IRS filed a motion for protective order in September 2011 in regard to Desert Valley's witness disclosures that indicated that Desert Valley intended to elicit testimony from IRS employees regarding their analysis, impressions, and conclusions during the administrative process relating to Desert Valley's alleged tax liability. The IRS also sought a protective order regarding Desert Valley's requests for production of documents to the extent they seek such information.

In 2011, a district court agreed with the IRS's argument and granted the protective order. However, the court limited the scope of the protective order. The court noted that Section 530(a)(2) of the Revenue Act of 1978 provides that a taxpayer has a reasonable basis for not treating an individual as an employee if the treatment was based in reasonable reliance on (1) judicial precedent, published rulings, technical advice with respect to the taxpayer, or a letter ruling to the taxpayer; (2) a past IRS audit of the taxpayer in which there was no assessment attributable to the treatment of individuals holding substantially similar positions to that held by the subject individual(s); or (3) long-standing recognized practice of a significant segment of the industry in which such individual was engaged. In addition to these listed circumstances, a taxpayer may demonstrate any other reasonable basis for not treating an individual as an employee for tax purposes. Because Desert Valley's defense was based on representations allegedly made to Centennial by the IRS, and by Centennial to Desert Valley and other drywall contractors, the court held that Desert Valley was entitled to conduct discovery regarding communications between the IRS and Centennial, as well as IRS audits of Centennial, which allegedly did not result in a conclusion that the drywall workers were employees of Centennial.

Subsequently, Desert Valley argued that the IRS might be improperly withholding relevant documents and information based on an overly broad interpretation of the protective order. Desert Valley argued that it was unable to make this determination, however, because the IRS had not provided any affidavits or privilege logs that adequately described the information or documents that were withheld based on lack of relevancy. Desert Valley therefore sought to compel the IRS to further supplement its discovery responses or to provide more specific descriptions of the information and documents that have been withheld.

The district court held that the identities of IRS employees, agents, or representatives who might have knowledge of facts relevant to the issues in the case, or who might have engaged in communications with Centennial and/or Desert Valley regarding the employment status of the drywall workers, were relevant and discoverable. It ordered the IRS to answer certain questions to this extent. However, the court also stated that neither the IRS nor its past or present employees, agents, or representatives, were required to disclose their internal administrative analysis, impressions, and conclusions regarding the employment status of the drywall workers.

The court also required the IRS to produce those documents or parts of documents, previously withheld, that contain relevant factual information that can be disclosed without revealing the IRS's administrative analysis, impressions, and conclusions. The IRS was ordered to provide a privilege log or index that adequately explained the grounds for withholding each document, or portions thereof, based on the protective order. The log or index, the court said, must include a certification that the withheld document, or portion thereof, did not contain relevant factual information, or that the relevant factual information could not be segregated and produced without disclosing the IRS employees' analysis, impressions and conclusions.

For a discussion of reliance on Section 530(a)(2) of the Revenue Act of 1978 as a reasonable basis for not treating an individual as an employee, see Parker Tax ¶210,115.

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