Articles

Section 56-Mininum Tax Adjustments

Written by Richard M. Colombik | May 4, 2022 3:15:19 PM

SECTION 56
MINIMUM TAX ADJUSTMENTS

The Service ruled in technical advice that for alternative minimum tax purposes, a cash-method farmer realized income in the year farm commodities were sold to the extent of the fair market value of a payment deferred into the next year. Taxpayers operate a potato farm that sells potatoes to various buyers under agreements deferring a portion of the purchase price until the following tax year. Under the agreement, the taxpayer might receive as much as 75% of the amount owed following delivery and inspection, and the remainder to be paid prior to January 15 of the following year. For regular tax purposes, the taxpayer reported income from the potato crop sales in the year they received the cash payments. They did not file alternative minimum tax forms. The examining agent proposed to require the taxpayer to report their entire income from a potato crop sale in the year of the sale for AMT purposes. The National Office agreed, noting that the taxpayer is precluded from reporting income from the potato crop sales under the installment method for AMT purposes under section 56(a)(6). LTR 9640003

SECTION 61
GROSS INCOME DEFINED

The Tax court held that an ex-Army Reserve officer's special separation benefit (SSB) was taxable income event though the Department of Veterans Affairs (VA) was going to recover the payment in exchange for nontaxable disability benefits. The taxpayer received the SSB after being honorably discharged during a reduction in force in 1992. He had previously applied for a disability pension, to which the VA determined he was entitled. However the VA would not pay the pension until it recovered the SSB. The taxpayer had reported the SSB on his 1992 return, which also included a $4,000 deduction for two $2,000 IRA contributions. The taxpayer filed and amended return, omitting the SSB payment from income and claiming a refund, which the IRS denied. The Tax Court rejected the taxpayers argument, that the SSB was not includable because he is required to repay it out of nontaxable disability benefits, on grounds that Congress could have made the SSB payment nontaxable to the extent of any recoupment. Absent such an express provision, the court ruled that it could not infer that the SSB was nontaxable. Ronal A Weigelt, et ux. v. Commissioner, T.C. Memo. 1996-445.

Tax Court has held that a man was taxable on 45% of the gain on a stock sale, where an agreed Judgment of Divorce had provided that 55% of an eventual stock sale proceeds would belong to the man's former wife.Eugene A. Friscone, et ux v. Commissioner. Full text citation: Doc. 96-102052 (9 pages).

Lawyer Taxable on Contingent Fees Assigned to Ex-Wife

The 9th Circuit has affirmed the Tax Court decision that a lawyer was taxable on the full amount of contingent fees received after his divorce, even though half of the fees were assigned to his ex-wife in a property settlement agreement. The Appeals Court also found that the lawyer was not liable for negligent penalties.

The court held that the attorney did not transfer any income producing property. The fee was taxable to the attorney because, even though the fee was contingent, (when it materialized), it was undisputed compensation for the attorney's personal services. Therefore, the attorney was liable for the tax on the entire contingency fee, even though his former wife received half, pursuant to the marital settlement agreement. The negligent penalty of the Tax Court was reversed by the Circuit Court because there was some ambiguous authority for contention of the attorney.Richard W. Kochansky vs. Commissioner,No. 94-70747 (9th Circuit August 13, 1996).

SECTION 71
ALIMONY

Family Support Payments are Alimony

The service has ruled that family support payments made under a marital settlement agreement are alimony payments under§71(d) that are deductible by the payer's spouse and includable in the income of the payee's spouse.

Terms of a divorce couple's marital settlement agreement requires the husband to make family support payments to the wife. The payments will terminate on the death of either party or at the expected retirement date of the husband. The payments will not terminate within six months before or after a contingency relating to their children.

The service concluded that the payments satisfied the four-prong definition of alimony under§71(b)(1) and that they will not constitute child support payments under §71(c). LTR 9625050.

SECTION 83
PROPERTY TRANSFERRED FOR SERVICES

Right to Future Payment of Fees 'structured Settlement Not Includable in Income

11th Circuit has affirmed a Tax Court decision, holding that the value of three attorneys rights to receive deferred installment payments of fees under an unsecured settlement were not includable in income in the year of the settlement.

In a personal injury case, the settlement included the purchase of annuity policies to satisfy installment payments of attorney's fees. The settlement agreement stipulated that the attorneys rights under the annuity policies were no greater than those of general creditors. The insurers were not required to set aside specific assets to fund the payments.

The Tax Court agreed with the attorneys that the rights to receive payments in the future was not includable under§83 because the promises to pay were neither funded nor secured and, thus, did not meet the definition of property under§83. The 11thCircuit affirmed in a one sentence order, incorporating the Tax Court reasons and attaching a copy of the lower Court's opinion.Richard A. Childs, et.ux. et al. v. Commissioner,No. 95-8762 (11thCir. June 11th, 1996).

SECTION 86
RETIREMENT BENEFITS, INCOME AND INCLUSION

The Tax Court has held that half a man's Social Security Disability Benefits was taxable income, rejecting his claim that the benefits were excludable.Roger G. Maki, et ux v. Commissioner. Full text citation: Doc. 96-12998 (6 pages).

§104 — Damages, Awards\Sick Pay

The Service has ruled that the disability benefits paid by a city to employees who become disabled in the performance of their duties are excludable from gross income under§104(a)(1). Full text citation: LTR 9617014; Doc. 96-12564 (4 pages).

SECTION 104
DAMAGES, AWARDS\SICK PAY

Settlement from Wrongful Discharge Action Not Excludable

The Fifth Circuit citingCommissioner v. Schleier,115 S.CT. 2159 (1995 TNT 116-8), has vacated a Tax Court decision that held nearly seventeen million in damages received by a couple in settlement of a state law wrongful discharge claim were excludable from income (for the Tax Court opinion see 102 TC 465 (1994 [TNT 60-9]. ) In this unpublished per curiamopinion, the Appeals Court held that underSchleier, the settlement received by Bill and Lana McKay was not receivable on account of injuries.L.E. McKay, Jr., et ux v. Commissioner, 94-41189 (5thCir. Apr 10, 1996). Full text citation: Doc. 96-13888 (3 pages).

Corporations Cannot Suffer Personal Injury; Settlement is Taxable

The Tax Court granting that the IRS summary judgment has held that a corporation was not entitled to exclude from income any of the proceeds it received from settlement of lawsuit. A grocery store, T & X Markets, Inc. sued numerous parties alleging breach of lease, with malicious prosecution and intentional interference with its business. T & X settled the suit for $850,000.00, and reported only a portion of the settlement proceeds as taxable. The Tax Court, citingThrelkeld v. Commissioner, 87 T.C. 1294 (1986), affd. 848 F.2d 81(6 Cir. 1988) andRoemer v. Commissioner, 716 F.2d 693, No.4 (9thCir. 1983) held that a corporation by its nature cannot suffer a personal injury.T & XMarkets, Inc. v. Commissioner, 106 T.C. No.26

(June 13th, 1996).

SECTION 117
SCHOLARSHIPS

The Service ruled in technical advice that stipends paid to paramedic training program participants are wages and that the payer of the stipends is responsible for withholding taxes and filing returns on the payments. An organization conducts a full time medical training program in which students receive training at a university. The organization pays the costs of training the participants and pays the participants a monthly stipend for general living expenses. In exchange participants agree to accept employment if it is offered, and remain with the organization for two years. The Service concluded that a participant's monthly stipends represent compensation for future services under section 117(c) and are wages that must be included in gross income in the year of receipt. Since the stipends are wages, the organization must withhold taxes and comply with reporting requirements. LTR 9640002.

SECTION 127
EDUCATIONAL ASSISTANCE REFUNDS

The Service has announced that employees and employers who participated in employer-provided educational assistance plans in 1995 and 1996 may obtain refunds for taxes paid or withheld on the benefits. Section 127, which permitted annual exclusion of up to $5,250 paid for educational assistance benefits, expired for benefits paid after December 31, 1994. This was reinstated retroactively. Employees can claim refunds by filing Form 1040X, Amended U.S. Individual Income Tax Return. The form must be filed with a Form W-2c, 'statement of Corrected Income and Tax Amounts. Employees are advised to print IRC 127″ in the top margin to expedite processing. Employees with corrected income of $26,673 or less, after the amendment, may qualify for the earned income credit. If so, they should attach Schedule EIC to the 1040X. Employees may also seek reimbursement of withheld social security and Medicare taxes from their employers. If unable to obtain reimbursement, employees may file Form 843, Claim for Refund ad Request for Abatement, with IRC 127″ written in the top margin. A statement from the employer listing the amount already reimbursed and the amount claimed must be attached to the form. Employers may reduce their federal tax deposits. Adjustments should be reported on Form 941, Employer's Quarterly Federal Tax Return, or Form 843 and must be explained on Form 941c, 'supporting statement To Correct Information. IR-96-36

SECTION 151
PERSONAL EXEMPTIONS

The Tax Court held that a couple may not claim dependency exemptions for the husband's two children from a prior marriage who lived with the husband's ex-wife. The divorce decree granted joint custody but declared that the children's primary residence would be with the ex-wife. The decree also provided that the husband would claim the children as dependents, which was further supported by a letter from the ex-wife. The Tax Court held that under 152(e)(1) and reg.section 1.152-4(b), the ex-wife was the custodial parent. The husband could claim the exemptions only if he satisfied the requirements of section 152(e)(2)-(4). The court found there was no multiple support agreement and no qualified pre-1985 instrument granting the exemptions to the husband. The ex-wife's letter did not satisfy the requirements of a written declaration, because it did not state (1) the tax periods for which the ex-wife relinquished her claim the exemptions; (2) the social security numbers of either parent; and (3) that the ex-wife would not claim the children as dependents. William C. White, et ux. v. Commissioner, T.C. Memo, 1996-438.

SECTION 162
BUSINESS EXPENSE DEDUCTION

The Tax Court held that a member of the Chicago Mercantile Exchange (Merc) was entitled to deduct the fine he paid to the Merc for violating Merc rules. The taxpayer paid the fine, thus avoiding litigation and allowing him to resume business activities. He deducted the payment on his 1989 tax return, but the Service disallowed the deduction. The Tax Court held that the payment was an ordinary and necessary expense paid for carrying on a trade or business. Payment of the fine was a response that could ordinarily be expected from one in [the taxpayer's] situation. Private wrongdoing is not extraordinary in the course of conducting a business. The Tax Court has held that an individual may deduct the cost of joining a country club that he was pressured to join by his employer. The taxpayer accepted employment which required him to relocate. The taxpayer stored his belongings in 1987, 1988, and 1989 while he looked for a new home. He bought a new home in 1989 and claimed a deduction on his 1989 return for expenses incurred in moving from an apartment to his new home, as well as for moving out of storage to the home. Also, his employer strongly suggested that he join a local country club. The employer paid his initiation fee and reported in on his 1989 W-2. He deducted the fee as well as other expenses incurred while taking workers to the club. The IRS disallowed the deductions, claiming the moving expenses were not reasonably proximate in time, and a variety of other reasons for denying the other deductions–primarily lack of substation. The Tax Court allowed deduction of the country club fees, noting that the taxpayer's testimony was credible and that he terminated his membership when he was terminated from employment. However, it disallowed all other deductions. Les B. Martin, et ux. v. Commissioner, T.C. Memo 1996-503.

SECTION 162(a)(2)
TRAVEL EXPENSES

The Service ruled in technical advice that airline tickets furnished to an employee for travel to a remote work site are taxable fringe benefits, includable in the employee's income and wages subject to withholding, FICA and FUTA. The employer provides services to a company at work sites in a remote area. The employer provides the employee with round trip transportation from his family residence to the work area, where the employer supplies meals and lodging. At the end of a work shift lasting a number of days, the employer pays for the employee's transportation back to his family residence, where the employee has no other significant place of business and does not work any significant amount of time. The employer devised this arrangement because the work areas have no suitable places with schools and medical facilities. The Service ruled that cost of flights was a nondeductible personal expense. Nothing suggests that the work assignment was of a limited or short duration, or anything other than indefinite from its inception. Therefore the temporary work exception did not apply, and the employee's tax home was the work are for purposes of the business travel deduction under section 162(a)(2). LTR 9641003

SECTION 162(m)
EXCESSIVE COMPENSATION

The Service ruled in a letter ruling that accelerated payments of deferred compensation following modifications and proposed changes to a pre-1993 written agreement will be deductible and will not be applicable employee remuneration under section 162. In 1989 a company entered into similar deferred compensation agreements with two employees. The agreements originally provided for 240 consecutive monthly fixed payments for each employee on retirement or the attainment of age 65. Both employees reached age 65 but remained on the job, agreeing to amend the deferred compensation plans by condensing the payments into four installments over four years, discounting the present value using a 7 percent discount factor. After making two of the four payments, the company proposed condensing the final two payments into one, again using the 7 percent factor. The company asked that the Service not treat the modifications as applicable employee remuneration under section 162(m)(4). The Service ruled that the modifications complied with the requirement that they reflect the time value of money, and therefore the accelerated payments will not be applicable employee remuneration. LTR 9633031

SECTION 163
INTEREST DEDUCTION

The Tax Court denied an interest deduction claimed by a cash basis partnership that paid the obligation with funds borrowed from the same lender to which the obligation was due. CPA Charles Davison and tow other individuals formed White Tail, a general partnership formed to acquire, cultivate, and sell farm properties. In 1979 and 1980, the partnership incurred losses. John Hancock Mutual Life Insurance Co. extended credit to White Tail in the amount of up to $29 million. In May 1980, John Hancock disbursed $19.6 million to White Tail, a portion of which consisted of a credit to White tail's prior loan account with John Hancock. That credit was applied $6.5 million to principal and $227,600 to accrued interest on the prior loan. The new credit arrangement called for a $1,587,000 interest payment in January 1981. White Tail's business, however, was unprofitable, and White Tail anticipated a default. Instead, John Hancock wired the exact amount to White Tails bank account, increasing White Tail's debt. White Tail wired $1,595,000 to John Hancock the next day to satisfy the $1,587,000 interest due an $8,000 of principal. White Tail claimed the $227,699 and $1,587,000 as interest deductions on its 1980 partnership return, and reported ordinary loss, and Davison claimed his distributive share on his return. The IRS disallowed the interest deductions and determined a deficiency. The Tax Court rejected Davison's position. The relevant inquiries, the court stated, are whether the transactions were simultaneous, whether the borrower had other funds with which to pay the interest, whether the funds used to pay the interest were traceable, and whether the borrower could realistically have used the borrowed funds for any other purpose. Charles H. Davison, et ux. V. Commissioner, 10-7 T.C. No. 4(Aug. 26, 1996).

The Tax Court denied a lawyer's claimed interest expense deduction, ruling that the expenses were personal, but allowed other deductions as employee business expenses even though the lawyer controlled the law firm on whose behalf the expenses were made. The taxpayer was the sole shareholder and incurred expenses, entertaining clients, which were unreimbursed because of financial difficulties. The taxpayer claimed these expenses on his 1991 return. Also, the taxpayer paid interest on the firms debt, which he had personally guaranteed. The interest was paid in the form of a note and gifts from the taxpayer's father. He claimed the interest expense on his 1991 return. The Tax Court denied the interest expense because the taxpayer did not pay the interest in cash. However, the Tax Court allowed the taxpayer to deduct the business expenses. The court rejected the Service's argument that the expenses were voluntary because the taxpayer controlled the firm. Instead, the court reasoned, because the taxpayer controlled the it could only be inferred that he was required to pay as a condition of his employment. Samuel C. Stone, et ux. v. Commissioner, T.C. Memo 1996-507

SECTION 166
BAD DEBT DEDUCTION

A district court allowed a capital loss deduction resulting from an individual's guarantee of his business's debt, finding that the business owner's primary motive for guaranteeing the loan was to protect his income, not his investment in the company. The taxpayer and his wife purchased a roofing company. They both worked for the company and earned substantial wages. The taxpayer guaranteed a loan in order to obtain sufficient credit to complete a large job. The company finished the job but did not get paid, thus making the roofing company unable to pay the loan and causing the lender to foreclose against the taxpayer's personal assets. The taxpayer claimed a $100,000 ordinary net operating loss, which he sought to carry back to 1986 resulting in a refund for that year. The government contended that because the guarantee was made only to protect the taxpayer's investment in the corporation, the loss was a capital loss that could only be carried forward. The district court found that the taxpayer's primary motive in making the guarantee was to protect his income rather than his investment. The court emphasized that the business was the taxpayer's only substantial source of income. Also, the investment was much smaller than the guarantee, so the guarantee would make no sense in terms of protection of that investment. Albert Ira Rosenberg v. United States, No. 94 C 5978(N.D. Ill. Aug. 20, 1996)

The Tax Court has held that a man's loans to a corporation were made to protect his equity investment and, therefore, the debts werenon-business debtsthat were not entitled to ordinary loss treatment when they become worthless.Paul G. Gubbini v. Commissioner. Full text citation: Doc. 96-13735 (20 pages).

SECTION 167
DEPRECIATION DEDUCTION

The Tax Court denied an individual's claimed depreciation deductions for alleged life interests in tax-exempt bonds, concluding that the taxpayer acquired the entire ownership in the bonds and then retained life estates and transferred the remaining interests to others. Attorney Julian Kornfold and his long time secretary, Patsy Permenter, as trustees of a revocable trust entered into joint purchases of tax exempt bonds in which Kornfeld held a life interest and Permenter and Kornfeld's two daughters held the remainder. After the purchases but before the closing dates, Kornfeld calculated the value of the parties respective interests based on IRS actuarial values. Kornfeld then transferred to Permenter and his daughters the amounts representing their shares of the purchase price. The recipients were not legally obligated to use those funds to acquire their interests in the bonds; however, this is in fact what they did. Kornfeld filed gift tax returns reflecting the gifts. No gift tax was paid because of the unified credit. When the bonds were redeemed, each party received proceeds based on the IRS actuarial values. Kornfeld claimed amortization deductions on his 1990 and 1991 returns with respect to his life estates in the bonds. The IRS disallowed the deductions, determining that Kornfeld in substance purchased the bonds as a whole and donated the remainder interests. The Tax Court noted that the relationship of the parties caused 'skepticism in accepting the form of the transaction. The court rejected Kornfeld's reliance on the availability of other assets from which Permenter and his daughters could have paid for their interests, and found the gift tax returns insignificant. Julian P. Kornfeld v. Commissioner, T.C. Memo 1996-472.

SECTION 170
CHARITABLE DEDUCTION

The Service ruled in technical advice that a donor may not take a charitable contribution deduction for the full fair market value of real property leased to and renovated by a charity, and later donated to the charity. The donor purchased the property for $37,500 in May 1991. On June 24, 1991, he leased the property to the charity for $1 per year for use as a licensed maternity home. The donor served as medical director of the home. The lease provided that the charity was responsible for the maintenance, repair, and upkeep of the property as well as renovation expenses and ad valorem taxes on the improvements. Over the course of a year hundreds of volunteers donated their time, appliances, and office equipment to renovate the property. The donor never used the property for his own use, and did not include the value of the renovations in his income. On March 3, 1993, the donor transferred title to the property to the charity, which had the property appraised at between $173,316 and $213,969. The donor claimed a contribution deduction of $115,586. The Service ruled that from the inception of the project the parties understood that the donor would donate the property after the renovations, and concluded that the donor did not contribute the renovations because for tax purposes he never acquired them. In order to hold property a person must acquire it. In this case the charity retained the benefits and burdens of ownership over the renovations. LTR 9639009

SECTION 212
EXPENSE OF PRODUCING INCOME

The Tax Court held that homeowners may not claim a section 212(l) deduction of legal fees incurred in challenging their insurance company's determination of the replacement value of their home. The court concluded that the legal expenses were capital expenditures, nondeductible under section 263, and an offset against the gain represented by the recovered insurance proceeds–none of which the homeowners recognized in the tax year at issue. The homeowners lived in the home since 1967, and it was destroyed by fire in 1991. It was not held for rent or sale in 1991. The homeowners disputed the insurance provider's determination of the replacement value, and prevailed after hiring a law firm and having plans drawn for a new home. The homeowner incurred more than $70,000 in legal fees before the dispute was settled. The IRS disallowed their deduction of $25,000 in legal fees, claimed on their 1991 return. The Tax Court applied the origin of the claim doctrine, arguing that But for the residence and the fire, the insurance policy would be meaningless. Thus it upheld the IRS disallowance of the deduction and assertion that the homeowners had not held their home for the production of income. The fees were incurred to recover a loss, not to produce income.

The Court has held that a woman may not deduct under§212(1) or (2) the legal fees paid in a State Court action against the executors or trustees of a mother's estate.Robert Joseph Looby, et ux v. Commissioner. Full text citation: Doc.96-13000 (11 pages).

The District Court has sustained a Chapter 13 debtor's objection to an IRS proof of claim based on incorrect original returns that the debtor had sought to correct the amended returns that the service rejected.Michael Weiss, et ux. v. United States. Full text citation: Doc. 96-13157 (10 pages).

Attorney's Fees Spent to Obtain Ordinary Income are Deductible

The 9thCircuit has held that pre-judgment interest awarded in an inverse condemnation proceeding is taxable ordinary income, and that the recipients may deduct all attorney's fees paid to obtain the interest awarded.

The Appeals Court agreed with the Tax Court that the origin of the claim controls the question whether attorney's fees are deductible.John D. Leonard, et.ux. et al. v. Commissioner,No. 95-070046 (9thCir. July 31, 1996).

SECTION 213
MEDICAL EXPENSE DEDUCTION

Surgery to Correct Nearsightedness is a Deductible Medical Expense

The service has ruled that expenses incurred for radial keratotomy (eye surgery to correct nearsightedness) are deductible under§213 subject to normal medical expense restrictions. The service held that radial keratotomy is a surgical procedure affecting the structure or function of the body, to correct a physical defect and, thus, constitutes medical care. LTR 9625049.

SECTION 215

ALIMONY DEDUCTION

Family Support Payments Not Alimony

The Tax Court, in two consolidated cases has held that monthly family support paid by a man to his ex-wife was not deductible as alimony or includable in the recipients gross income.

A California State Court ordered Ronald Murphy to pay Diane Murphy $4,000.00 each month. Three of the Murphys four children lived with Diane at the time of the order and during the years at issue.

The Tax Court reasoned that under California law a family support order combines child and spousal support, the California law does not segregate unallocated child and spousal support payments, and that Ronald had failed to demonstrate that any portion was allocable to spousal support.Ronald J. Murphy v. Commissioner,T.C. Memo 1996-258.

SECTION 265
EXPENSE OF TAX-EXEMPT INCOME

The Fourth Circuit affirmed a holding that a physician was not entitled to deduct her payments to the government in repayment of her breached National Health Services Corps Scholarship. Any deduction was precluded by section 265 because the scholarship was tax-exempt income. However the physician was entitled to deduct a portion of the interest paid on that obligation. Nancy B. Stroud, et vir. V. United States, No. 95-3139(4th Cir. Aug. 23, 1996).

Health Insurance and Small-Business Bills

On August 20, 1996 President Clinton signed the Small Business Job Protection Act. Small business taxes will be cut by about $20 billion over 10 years. The new law increases the limit on small business expensing, makes numerous changes to simplify pension and S corporation rules, allows expanded contributions to spousal IRSs, and extends a number of expired tax provisions. The new act increases the minimum wage, creates a $5,000 tax credit for adoption expenses, increases the credit to $6,000 for adoption expenses for a special needs child, and allows the credit to be carried forward for five years. Employees may exclude up to $5,000 from income adoption expenses paid by an employer, or $6,000 for a special needs child. To offset the tax breaks the law creates nearly 20 revenue-raising measures, including repeal for five-year income averaging for lump sum pension distributions, repeal of the possessions tax credit, repeal of the 50 percent interest exclusion for financial institution loans to ESOPs, and temporary airport and airway trust fund taxes. Most provisions do not take effect until January 1, 1997.

SECTION 355
CONTROLLED FIRM STOCK

The Service ruled in a letter ruling that the split-off of a business to a family trust will be a tax-free reorganization under sections 355(a)(1) and 368(a)(1)(D). Individuals A and B are the grantors of two family trusts. A trust and B trust, which hold stock in Distributing, an S corporation that engages in two lines of business. A trust and B trust disagree over the operation of the business. They propose to have Distributing transfer the assets of once business to a Controlled corporation, and then make a non-por-rata distribution of Controlled stock to the B family trust in exchange for all of its Distributing stock. Distributing will redeem all of B's children's separate shares in Distributing. Controlled will then elect to be an S corporation. The Service ruled that the transactions will be tax-free to Distributing, Controlled, and the B family trust, and the momentary affiliation of Distributing and Controlled will not make Controlled ineligible to make an S corporation election. LTR 9635036.

The Service ruled in a letter ruling that a spin-off of a business to create an ESOP for its employees will be tax free under sections 355 and 368(a)(1)(D). Distribution is the parent corporation of an affiliated group that includes wholly owned Controlled corporation. Distribution's management believes Controlled's business must be separated to give Controlled the ability to provide equity-based compensation in order to attract key management. Distributing proposes to make capital contributions to Controlled, and then distribute Controlled stock to its shareholders pro rata. Controlled's management will create an employee stock ownership plan for the exclusive benefit of its employees. The Service ruled that Distribution's capital contribution to Controlled, and pro rata distribution of Controlled stock will be a tax free reorganization under section 368(a)(1)(D). No gain or loss will be recognized to Distributing and Controlled or their shareholders on the contribution or distribution under sections 361, 355(a)(1), or 1032(a). LTR 9635043.

SECTION 368(a)(1)(D)
ASSETS FOR CONTROL

Divorcing Shareholders Divide Family Business in Tax-Free Reorganization

The services ruled that the division of a business owned by a husband and wife, who were in the process of getting a divorce, will be a tax-free reorganization under§368(a)(1)(D).

After the reorganization, the husband owned stock in a corporation that owned one of the roller rinks, and the wife owned stock in another corporation that owned another roller rink. Prior to the reorganization, the husband and wife each owned 50% of the corporation that owned the roller rinks. LTR 9620030.

SECTION 402
TRUST BENEFICIARY's TAX

The Service ruled in a letter Ruling that an excess distribution from a retirement plan is includable in the participant's gross income for the year of distribution, but will be excluded from the participant's gross income in the year of repayment out of an IRA. An employee participated in Plan X, a qualified profit-sharing plan, and Plan Y, a qualified money-purchase pension plan. His employment ended in 1988. In 1992 he received distributions from both plans, qualifying collectively as lump sum distributions eligible for roll over. He rolled over the distributions into five separate IRAs. In 1994 the participant discovered that the distribution from Plan Y included an overpayment, and that $4,654.76 remained in his Plan X account. The participant proposed to pay the overpayment and earnings to the plan Y account from a single IRA. The Service ruled that the collective disbursement was a lump sum distribution in 1992. None of the amount distributed from Plan X in 1992 and timely rolled into the IRA was includable in the participant's gross income for 1992. The balance in the Plan X account may be rolled over into an IRA and not included in the tax year of distribution.

The excess distribution, however, did not qualify for rollover treatment and was includable in the participants income in the year of distribution. The excess amount will not be includable in the participant's income in the year of withdrawal from the IRA. The amount constituted an excess contribution to the IRA under section 4973(b), and a 6 percent tax applies. The earnings on the excess amount to be distributed from the IRA to Plan Y are includable in the gross income of the participant for the tax year in which the earnings are distributed. The distribution by the IRA of the earnings on the excess amount in the IRA will not cause those earnings to be included in the participant's income in the tax years of those earnings. Distribution by the IRA of the earnings on the excess amount in the IRA will not cause those earnings to be considered excess contributions under section 4973. Also the distribution of the excess amount is not subject to the excise tax under section 72(t)(1). The earnings, however, are subject to the tax.

SECTION 451
YEAR OF INCLUSION

The Service has ruled that a lotto jackpot winner's assignment, under a state statute, of all or part of his future lottery payments to another individual, does not result in other lottery winners realizing income before they receive their lottery payments. Lottery prizes are paid from a lottery fund that is designated by state statute. The state legislature passed a bill that permits a lottery winner to assign the right to receive future payments in whole or in part. The Service concluded that a lottery prize winner's assignment of his prize did not cause other winners, who did not assign their rights, to realize income before they received their prize payments. A lottery winner is not taxable under the doctrine of constructive receipt on the value of an annuitized prize in the year it is won. LTR 9639016.

SECTION 511
UNRELATED BUSINESS INCOME TAX

The Service ruled in technical advice that a lobbying organization's mailing list exchanges result in unrelated business taxable income. The organization was formed to educate, identify, and mobilize a grassroots constituency for promoting legislation. Contributions to the organization were not deductible. The organization rented its list to both for-profit and not-for-profit companies, and it exchanged its mailing list. In 1981, the Service ruled in technical advice that the organization's mailing list exchanges were not subject to tax. Since then, the organization has reported income from the rental of its mailing list, but not from the exchanges. The Service ruled that providing its mailing list to another organization does nothing to further the organization's exempt purposes, a nd that even when the organization accepts something of equal value, rather than a cash payment, 'there is still a quid pro quo. The exchanges are therefor offsetting rentals. LTR 9635001.

SECTION 752
PARTNERSHIP LIABILITIES

Partner must Recognize Gain on Share of Partnership Debt Discharged in Bankruptcy

In technical advice, the service has ruled that when a Bankruptcy Court discharges a partner from his share of a partnership recourse debt, the partnership's tax consequences are determined under§731 and§752 and not under§61(a)(12) and§108(a). The service found this result consistent with the Tax Court's decision inMoore v. Commissioner,T.C. Memo. 1994-446, 94 TNT 176-9. It distinguishedMarcaccio v.Commissioner,T.C. Memo. 1995-174, 95 TNT 75-9.

The taxpayer had a one-third interest in the partnership, so his share of the debt was $93,000.00 and he was able to deduct his tax basis of his partnership interest of $18,000.00 from his share of the partnership debt, resulting in a tax of $75,000.00 of either capital gain, or ordinary income, depending upon the application§751(a). Full text citation: LTR 9619002; Doc. 96-14102 (6 pages).

SECTION 985
TAXPAYER's FUNCTIONAL CURRENCY

The First Circuit ruled that a couple's adjusted cost basis in their U.K. residence must be computed using the dollar-pound exchange rate as of the date they purchased it, not the rate prevailing on the date they sold it. The taxpayers purchased a residence in the U.K. in 1986, paying in pounds sterling with a mortgage loan. They made capital improvements for which they also paid in pounds. They sold the residence in 1990 and retired the mortgage, all in pounds. They reported a capital gain on their 1990 U.S. tax return, using the exchange rate at the date they purchased the residence to calculate their adjusted basis. They later filed an amended return, claiming a refund based on use of the exchange rate at the date of sale to determine both their adjusted basis and the sale price. The IRS denied the claim and the taxpayers pursued the action in the district court. The First Circuit concluded that the taxpayers were not entitled to offset the capital gain with the loss realized on their mortgage-loan transaction–resulting from the decline in value of the dollar from the time of the mortgage loan to the date of repayment. The appeals court agreed with the government that the loan transaction was separate from the purchase and sale of the residence. Further, the taxpayer's mortgage oan could not be considered part of a hedging transaction under section 988(d)(1), because the loan was not conducted by a trade or business or entered into for profit. Next, the appeals court held that the taxpayers could not use the sale-date exchange rate to compute their adjusted basis in dollars, rejecting their claim that the pound was their functional currency. Citing section 985(b)(1), the court reasoned that the purchase and sale of the residence was not carried out by a qualified business unit. Carlos J. Quijano, et ux. v. United States, No. 96-1053(1st Cir. Aug. 21, 1996).

SECTION 1001
GAIN OR LOSS

The Service ruled in technical advice that a mining contractor realized an ordinary loss when it exchanged accounts receivable and notes for restricted stock in the debtor corporation. Another corporation employed the mining contractor to conduct field work and provide administrative and management services. The contractor included accrued fees in its income, evidencing the debt by notes and accounts receivable. The parent of the debtor corporation and the contractor then entered into an agreement to settle the debts in exchange for stock in the parent corporation. The contractor then sold the stock a year later, after expiration of the trading restrictions. The Service ruled that the contractor realized an ordinary loss in the year it received the stock because it acquired the notes and accounts receivable in the ordinary course of business and they were not capital assets. The loss was the difference between the contractor's basis in the notes and accounts receivable and the fair market value of the stock. The Service further ruled that the contractor realized a capital loss on the sale of the stock because the stock did not fall within any exception to the definition of a capital asset.

In three similar letter rulings the Service concluded that partition of co-owned property into separate parcels will not trigger gain or loss to an owner to the extent to which the partitioned parcel approximately equals the previous undivided interest. Three siblings inherited the property in two separate devises. The siblings proposed to partition the property into four separate parcels: one parcel to each, on which each maintained their own residence, and a fourth undeveloped parcel. Their respective interest in the undivided parcel would be adjusted to reflect an equal one-third of the whole, depending on the value of the respective residence. Each owner would be responsible for one third of the loan used to improve the parcel. The Service ruled that even though two portions of the property were acquired at different times, the property was contiguous and properly treated as one parcel. Any subsequent transfer, except gifts to a sibling, will not affect the decision that Section 1001 does not apply to the severance. The sale of all or part of the undeveloped parcel will result in gain taxable to the extent the proceeds exceed the individual's basis in the portion sold. The Service noted that the equal division of the mortgage and repayment of one-third will not make unequal the otherwise equal division of the property. LTR 9633028, LTR 9633133, LTR 9633034.

The 5thCircuit has affirmed District Court and Bankruptcy Court decisions that transfers of real property to a corporation that resulted in gain that includedindebtedness assumed by the transferee's and that§108's insolvency exception did not apply.Lillian Harold Collum, et ux v. U.S. (in re:Collum).Full text citation: Doc. 96-13278 (2 pages).

SECTION 1034
SALE OF RESIDENCE

Sale of Residence to Wholly-Owned Corporation Defers Gain

The service has ruled that homeowners who sell their personal residence to their wholly-owned corporation may defer their gain under§1034 if a replacement residence is purchased within the required two years.

The taxpayer couple that purchased the new residence and because of a depressed real estate market were unable to sell their current residence at a reasonable sales price. In order to meet the time requirements of§1034, the couple sold their current residence to a wholly-owned corporation. The service held that there is no prohibition against a sale between related parties.

SECTION 1402
SELF-EMPLOYMENT INCOME DEFINED

The Service has ruled in technical advice that a farm corporation's rental payments for agricultural and grazing land and personal property leased with the land, and Conservation Reserve Program payments are subject to the self-employment tax. A husband and wife operated their ranch as a sole proprietorship. They later incorporated, transferring livestock and a small portion of land, including the farmstead, to the corporation. They retained ownership of the rest of the land and ranch equipment, leasing it to the corporation. They received government payments for converting some land to less intensive use. The Service said that for self-employment purposes the arrangement between the taxpayers and the corporation includes not only the lease agreements but all corporate documents and employment contracts executed at the same time. The arrangement contemplates the husband's material participation, employing him as the ranch manager, naming him to the corporate board, and designating him as president with supervision and control of the corporation. The wife, too, materially participates. The fact that the couple were paid separate amounts designated as salary under the employment contracts does not prevent characterization of the rental payments as net earnings from self employment. LTR 9637003

SECTION 2042
LIFE INSURANCE

The Service ruled in a letter ruling that a private reverse split-dollar arrangement will not result in deemed gifts of premium payment or inclusion of the proceeds in the insured's estate. The insured and his wife reside in a community property state. The insured created an irrevocable trust naming his brother as trustee. During the insured's life the trustee could pay income and principal to the insured's issue, upon his discretion. After the insured's death, payment could also be made to the insured's wife. The trust terminated upon the death of the insured's wife or upon the attainment of age 25 by the insured's youngest child, whichever came later. The trustee used trust cash to insure the insured's life, and then entered into a collateral assignment reverse split-dollar agreement with the wife wherein the trustee was designated owner of the policy and will pay the portion of the premium equal to the lesser of the P.S. 58 rate or the insured's one-year term rates. The wife will pay the balance of the premium from her separate property. If the agreement is terminated before the insured's death, his wife will receive the cash value of the policy. If the agreement terminates as a result of the insured's death, his wife or her estate will receive the greater of the policy's cash value just before the taxpayer's death or the total premiums paid. The Service ruled that the payment of premiums by the trustee and the wife will not result in a gift to the trust by the wife or a deemed gift to the trust by the insured under section 2511. The Service also concluded that the insurance proceeds payable to the trust and to the wife under the split-dollar agreement will not be includable in the insured's gross estate under section 2042 because the insured retained no incidents of ownership of the policy. LTR 9636033

SECTION 3121
SOCIAL SECURITY DEFINITIONS

The Service ruled in technical advice that a law school student hired by a law firm as a part time clerk is an employee for federal tax purposes. The clerk's employment was terminable at will. He was not engaged in an independent enterprise requiring substantial capital investment or the assumption of risk of loss. The clerks services were an integral and necessary part of the firm's business. The firm supplied computers, office equipment, secretarial services, law books, and reimbursed the clerk's expenses. The firm controlled and directed the clerk's activities to the extent necessary to assure satisfactory service to its clients. LTR 9639001.

The Service ruled in technical advice that a graphic artist, hired by an office supply company, is an employee for federal tax purposes. The company provided the artist with some instruction and training. The artist was trained in the use of the company's computer and received step-by-step instructions for each of his tasks. He worked a regular 40-hour week under the company's name and did not maintain an office, advertise, or represent himself as in business to provide the same or similar services to others. He had no financial investment in a business related to the services he performed for the company and he could not incur a profit or suffer a loss in the performance of his services. The employment was terminable at will. The artist used a time card to record his time and was paid an hourly wage. The company required him to perform his services personally. LTR 963002

The Service has ruled in technical advice that state-licensed auto sellers operating under a licensed dealer's name are not employees for federal tax purposes. The sellers operate under an oral agreement with the dealer and purchase and sell used automobiles and use the dealer's funds or draft to make purchases. The have complete discretion regarding purchases and sales, and they are not required to adhere to prices fixed by the dealer. The dealer rarely furnishes leads. The sellers are not permitted to work for another company at the same time they are operating under the dealer's name. The sellers are not required to work set hours or follow a set routine. They are not guaranteed a minimum profit. When they sell an auto, the sales price is reduced by expenses and they split any net profit or loss evenly with the dealer. LTR 9639004.

The Service has ruled that a writer is not an employee of a consulting firm for federal tax purposes. The firm provides research, writhing, and editing services. It hired an individual to assist in writing a book. The firm provided no training, did not supervise the writer, and paid the writer on the basis of chapters completed. LTR 9639060.

The Service has ruled that a newspaper carrier is an employee of a newspaper distributor for federal tax purposes. The distributor hired a carrier to provide newspaper deliver services. The distributor exercised the right to change the carrier's delivery route. Subscribers paid either the distributor or the carrier. The distributor furnished most of the carrier's supplies. The carrier paid for and provided her own transportation. The carrier worked on a part time basis and was paid based on the number of papers delivered. LTR 9639061.

The Service ruled in technical advice that owner-operators who perform delivery services for a trucking company are not employees of the trucking company for federal tax purposes. The company employed truck drivers who operated vehicles owned by the company and were treated as employees. The company also hired owner-operators under contract to use their own vehicles and treated these persons and independent contractors. The owner-operators paid all expenses related to the operation of their equipment and were paid a percentage of revenue billed by the company. The company filed timely 1099s. LTR 9645001

SECTION 3121(a)
WAGE DEFINED

The Service ruled in technical advice that contributions of an employee's vacation pay benefit to a qualified stock purchase plan with a cash or deferred arrangement are excludable from FICA wages. Under the plan, employees who did not use all of their paid vacation in excess of two weeks were able to elect to have the equivalent in pay contributed to the qualified plan. The Service noted that an employee's only options were to take the vacation time, forfeit it, or contribute its value to the plan. This choice was not a cash or deferred arrangement because the employee did not have the option to receive cash or any other taxable benefit in lieu of the contribution to the plan. Rather, the contribution was a nonelective employer contribution. Therefore it is excluded from FICA wages under Section 3121(a)(5)(A). LTR 9635002

In a letter ruling the Service ruled that settlement payments distributed by a collective bargaining agent to a company's former employees are wages for FICA, FUTA and income tax withholding purposes. A union represented a company's employees. After the company filed for bankruptcy and ended its operations, the union and the company entered into an agreement whereby the company agreed to pay the union $29.5 million and 10 percent of any recovery received by it in litigation against other parties. The union would distribute the money to the company's former employees. Group I employees were employees the union believed were entitled to a money recovery under a post-petition pay parity grievance. Group II employees were employees the union believed should have received money under a lawsuit involving the company's refusal to reinstate some striking employees to positions that were reserved for newly hired employees who were still being trained. The union conceded that distributions to Groups I and II were wages. However the settlement fund was not exhausted after distributions were made to Groups I and II. The union distributed the remainder to all employees employed on a specific date who did not qualify for distributions under the other groups. The union argued that distributions to this Group III were not based on any back pay formula and were not related to a specific lawsuit or grievance, nor made because of the group's performance of services and therefore were not wages. The union claimed the payments were a premium paid to end the dispute. The Service did not see a distinction between the payments to Group III and to Groups I and II. All amounts came from money the company paid to settle claims and that the lack of a specific back pay formula was irrelevant.

SECTION 3401
INCOME TAX WITHHOLDING

A district court held that a sole proprietor properly classified some workers as independent contractors, but misclassified other workers and that he was not entitled to relief under the safe harbor provisions of section 3401. The sole proprietor operated a sod-laying and grading business and used the services of graders, sod-layers, truck drivers and a landscaper. One truck driver worked regularly. When other drivers were needed, the sole proprietor contacted other drivers who supplied their own trucks. The landscaper and others worked only when they wanted. The proprietor provided no training or employee benefits to those workers, who could hire extra workers without the proprietor's approval. The IRS audited the proprietor and determined that all of the workers were employees. The proprietor filed for bankruptcy, and the bankruptcy court ruled that all persons except the proprietor's wife and sister, who worked as secretaries and bookkeepers, and one driver were correctly classified as independent contractors. The district court ruled that the bankruptcy court correctly placed the burden of proof on the IRS. It also upheld the bankruptcy court's determination regarding the classification of the workers, but reversed the ruling that the proprietor was entitled to relief under section 3401 for misclassification of the three employees. The proprietor had the burden of proof on the 'safe harbor issue. The proprietor failed to prove that he reasonably relied on judicial precedent, published rulings, technical advice, prior IRS audit, or industry practice. United States v. Arden R. Arndt, No. 94-0088-CIV-ORL-18(M.D. Fla. Aug. 12, 1996).

SECTION 6013(d)
JOINT RETURNS/INNOCENT SPOUSE

The Tax Court has denied a woman's request for innocent spouse relief from Schedule C income attributable to her husband's business, finding that if she had reviewed the joint tax returns she would have been alerted to omissions.Carla J. Zimmerman v. Commissioner. Full text citation: Doc. 96-14707 (11 pages).

SECTION 6013
JOINT RETURN/INNOCENT SPOUSE

A bankruptcy court granted innocent spouse relief, finding that the wife lacked knowledge of the understatement and that it would be inequitable to hold her liable for the grossly erroneous items of her husband. The wife, a high school graduate, did not work outside of the home and took part in the family finances only by receiving money from her husband for household items. The husband purchased 94 percent of the stock of Erectors Inc. Although the wife knew of the investment, she was not aware of Erectors financial affairs. Erectors Form 1120S for 1987 reflected a $550,000 loss largely pertaining to a consulting agreement with the previous owner. The husband's accountant prepared the 1987 income tax return claiming a loss, which the wife signed without review. The IRS audited the return and disallowed $500,000 of Erectors loss. The wife filed for bankruptcy in 1993 and the IRS claimed the deficiency from the 1987 return. The court then determined that the wife did not know or have reason to know that the joint 1987 return contained a substantial understatement, emphasizing her education, training, reliance on her husband and accountant for preparation of the return, and her lack of knowledge of family financial affairs. The court concluded it would be inequitable to hold her liable for the substantial understatement. It also rejected the IRS argument that a separation or divorce is a condition precedent for innocent spouse relief. In re Heidi J. Lesnick, NO. 93-61764(Bankr. N.D. Ohio Aug. 9, 1996).

SECTION 6050I
BUSINESS CASH RECEIPTS RETURNS

Attorney-Client Privilege Does Not Apply to Cash Transaction Report

A District Court has upheld a§6721 penalty assessed against a law firm that reported on IRS Form 8300 the receipt from a client of more than $10,000.00 in cash and claimed privilege from further client-identifying information.

Gerald B. Lefcourt, P.C. filed Form 8300 reporting a cash payment of legal fees exceeding $10,000.00, but omitted the exact amount received and the identity of the payor and the client. The law firm defended on the grounds that it had reasonable cause sufficient to warrant a waiver of penalty under§6724, contending that the information was privileged, pursuant to the attorney-client privilege.

The Court held that the law firm did not show reasonable and sufficient cause to waive the penalty citing the strong underlying public policy of uncovering tax evasion. The Court held that the attorneys wishing to not file Form 8300 should simply insist on payment by check.Gerald B. Lefcourt, P.C. v. U.S., No. 94 Civ. 8313 (rpp) (S.D.N.Y. May 13, 1996).

SECTION 6212(b)
LAST-KNOWN ADDRESS

The Tax Court dismissed a petition that was filed one day late, rejecting the taxpayers claims that the deficiency notice was not sent to their last known address and that IRS employees advised them of an erroneous date. On December 14, 1995 the IRS mailed a deficiency notice to the taxpayers. They received it on December 15, and their power of attorney received it on December 18. The power of attorney phoned the Service's 90 day section on the date she received the notice and was advised that the deadline for filing the petition was March 14, 1996. Subsequently, a revenue agent advised the taxpayer and the power of attorney of the same date. The taxpayers mailed their petition on that date. The Tax Court found that the notice had been mailed both to the taxpayer's last known address and to the power of attorney in time to file the petition. It dismissed the argument that the filing period began when the power of attorney received the notice, and found that the IRS was not bound by erroneous legal advice rendered by its employees. Taxpayers and their counsel are responsible for calculating the 90 day period. Sarah R. Elgart, et vir. V. Commissioner, T.C. Memo. 1996-370.

SECTION 6502

COLLECTION AFTER ASSESSMENT

Ten Year Collection Period Not Available to IRS for Recovery of Erroneous Refund

The Court of Federal Claims, joining the 5th, 1stand 7thCircuits has held that an individual's payment of a tax liability satisfied the underlying assessment to the extent of the payment and that, in the absence of a new assessment, the limitation period for recovery of an erroneous refund of payment is the limitation period in§6532(b), not the ten-year period in§6502(a).

In June of 1991, the Tax Court decision became final and, just before expiration of the assessment period, the IRS assessed a total of $515,800.00 in tax, penalties and interest.

On July 15th, before the June, 1991, assessment was entered into the service's data base, the service mistakenly refunded to Stanley $637,000.00, sending him a check indicating the refund was for the 1982 tax and interest, which was the subject of the Tax Court decision. Stanley remitted the full amount, with a letter questioning any further liability for 1982, requesting that the IRS treat the remittance as a bond to stop the running of penalties and interest, and stating his expectation that the IRS would return the remittance to him, in response to a September of 1991 demand by the IRS.

On July 6th, 1993, Stanley's counsel filed a claim for a return of the $630,000.00 bond. That claim was disallowed and Stanley then filed suit in the Court of Federal Claims.

The Court of Federal Claims granted Stanley summary judgment, concluding that although the result is a windfall for Stanley, recovery for a mistaken refund was barred by the government's failure to file the erroneous refund action within the two-year limitation's period. The Court concluded that the September, 1991, remittance was a deposit not a payment.Leroy T. Stanley v. USNo. 94-32T (Fed. Cl. May 1, 1996). Full text citation: Doc. 96-13281 (12 pages).

SECTION 6512
TAX COURT PETITION LIMITATIONS

Limitation Period Bars Refund or Credit; Remittance was Payment, not Deposit

The 6thCircuit has held that a couple's estimated tax payments, sent with filing extension requests more than two years before deficiency notice were mailed, were payments of tax and not deposits in the nature of a cash bond.

The taxpayers filed no returns and after the IRS issued deficiency notices for the years, the taxpayers counsel sent letters to the IRS requesting that the undesignated remittances accompany the extension request, plus the amounts withheld from the couple's wages be treated as deposits in the nature of a cash bond, under Rev. Proc. 85-48, 1985-2 C.B. 607. The 6thCircuit agreed with the Tax Court that the taxpayers remittances were for tax payments, not deposits. The Court distinguished the taxpayers situation in which they prepared their own extension requests and sent checks representing estimated tax liabilities from audit situations in which a taxpayer remits an amount to stop the accrual of interest and in which, under Rev. Proc. 84-58, the remittance will be treated as a deposit or payment depending upon the particular acts and circumstances.John A. Gabelman v. Commissioner, No. 95-1251 (6thCir. June 21st, 1996).

SECTION 6672
FAILURE TO PAY OVER TAX

A district court has upheld a section 6672 responsible person penalty, ruling that a state statute requiring general contractors to establish a trust fund did not encumber the funds to prevent them from being paid for employment taxes. The IRS sought to hold the taxpayer liable for unpaid employment taxes of the construction contractor for which he worked. The taxpayer argued that the Michigan Builders Trust Fund Act encumbered the funds for payment obligations superior to that of employment tax obligations and, thus, that he did not willfully fail to collect and pay the taxes. The district court concluded that while the Michigan Act encumbers funds for the benefit of laborers, materialmen, and subcontractors, it also may be interpreted to provide a trust for payment of employment taxes. Part of paying laborers includes paying the employment taxes. Therefore the funds were not encumbered for section 6672 purposes, and the taxpayer was subject to the trust fund recovery penalty. Gordon Sellars, et al. v. United States, No. 94-CV-40333-FL(E.D. Mich. Aug. 29, 1996).

A bankruptcy court overruled a debtor's objection to an IRS proof of claim, holding the debtor liable for a company's unpaid employment taxes as a responsible person. The debtor helped run the company which was owned by his wife and son. The debtor was an officer for 20 days, did none of the hiring or firing, and wrote checks only with his wife's approval. He invested his life's savings into the company, and was recognized as the executive manager who had the greatest working knowledge of the store and worked long hours. The bankruptcy court found the debtor was a responsible person, given his financial investment, status as manager, and significant authority and control over the business. His failure to pay was also willful. In re: Alfred B. Pond, No. 94-31879-BKC-SHF(S.D. Fla. Sept. 18, 1996)

SECTION 6871
TAX CLAIMS IN BANKRUPTCY

The Sixth Circuit denied refund claims based on net operating losses carried over from the taxpayers bankruptcy estate because the claims were untimely and the NOLs were not reduced by discharged debts. In 1982 the taxpayers filed for chapter 7 bankruptcy. The trustee filed the estate's 1989 tax return reporting NOLs from the taxpayers farm for the years 1981-84. After the bankruptcy case closed in 1991, the taxpayers filed amended returns for 1986-89 claiming the estate's NOLs as deductions under 11 U.S.C. section 1398(g) and (I). The IRS disallowed the claims as untimely, and the taxpayers sued in district court for a refund. The district court denied the 1986 and 1987 claims because they were not filed within three years of the time the returns were due. The court denied the 1988 and 1989 claims because no NOLs remained after reducing the NOLs by debts discharged in the bankruptcy. The Sixth Circuit agreed with respect to the 1986 and 1987 refund claims, finding that the time for filing was not tolled under 11 U.S.C. section 346(i)(2) during the pendency of the bankruptcy. It also found that the taxpayers failed to prove that the NOLs reported on the estate's tax returns were reduced by discharged debts. Jack L. Firsdon, et ux. v. United States, No 95-3097(6th Cir. Sept. 12, 1996).

The Bankruptcy Court has held that a couple's income tax liabilities for the years 1985-88 are dischargeable, rejecting the service's contention that the couple filed fraudulent returns for those years or willfully attempted to evade taxes.Buford R. Burgess, et.ux. v. U.S. et al. (in re Burgess.)

The 7thCircuit has affirmed the denial of a discharge for a couple's tax debts based on Bankruptcy Court findings that the couple willfully attempted to evade tax payment .Zuhone v. U.S.,(in re Zuhone).

Bankruptcy Courts have Jurisdiction to Award Attorney's Fees

The 9thCircuit rejected the 11thCircuit's reasoning In Re Brickell Investment Corporation, 922 F.2d 696 (11thCir. 1991), and instead agreed with the 4thCircuit's decisionin re Grewe,4 F.3d 299 (4thCir. 1993) as a more reasonable interpretation. In§7430(c)(6),the Court reasoned that because Tax Courts and the U.S. Claims Courts, which are Article 1 Courts, may award attorney's fees against the U.S. pursuant to said section, then Bankruptcy Court may award attorney's fees against the U.S. because it is also an Article 1 Court. The Appeals Court also ruled that awarding attorney's fees is a core proceeding, because the right to fees emanates from the bankruptcy itself.U.S. v. Merritt Yochum, et.ux. (inre Yochum)No. 95-15871 (9thCir. July 16, 1996).

On July 30th, 1996, President Clinton signed H.R. 2337 causing the Taxpayer Bill of Rights to become law.

SECTION 7201
ATTEMPT TO EVADE TAX

The Second Circuit vacated two individuals sentences for tax evasion and conspiracy to defraud the IRS, ruling that the district court should have applied an enhancement for use of 'sophisticated means. The individual's accounting firm instructed them to write checks payable to fictitious business and charities. The accounting firm deposited the checks into bank accounts opened in the names of those fictitious entities, and then transferred those funds into a secured set of bank accounts. Ninety percent of those funds were then used to pay the individual's creditors, pay living expenses, and make personal investments. The accounting firm retained the remaining 10 percent. The individuals then claimed $130,000 and $294,000 respectively in deductions over six years. Both pleaded guilty to tax evasion under section 7201 and conspiracy to defraud under 18 U.S.C. section 371. The Second Circuit wrote that this scheme was more complex than the routine tax-evasion case in which a taxpayer reports false information on his 1040 form to avoid paying income taxes. . . or asserts he paid taxes that he did not pay. Also, the court found fault with the trial court's emphasis on the taxpayers lack of an attempt to conceal their identity, noting that any taxpayer claiming false deductions must identify himself on the return. Finally, it disagreed with the trial court's conclusion the accounting firm devised the scheme, thereby mitigating the use of 'sophisticated means by the individuals. The court noted that the statute does not require that the means be devised by the defendant. United v. Ephraim Lewis, No. 95-1681(2d Cir. Aug. 28, 1996); United States v. Harry Richman, No. 95-168(2nd Cir. Aug. 28, 1996).

SECTION 7203
WILLFUL FAILURE TO FILE

The Ninth Circuit affirmed an attorney's conviction for failing to pay taxes reported on his return. The attorney filed accurate returns but failed to pay more than $100,000 in taxes over 5 years. He earned more than $50,000 per year and took at least five trips to Europe. A jury convicted him, rejecting his contention that he had a good-faith belief that he could 'treat the IRS like any other general creditor. The Ninth Circuit rejected his argument that the magistrate judge did not adequately instruct the jury regarding his good-faith defense. United States v. Roger Chastain, No 95-10267(9th Cir. May 17, 1996).

A.MISCELLANEOUD INDIVIDUAL INCOME TAX UPDATES

1.New Tax Bill Provides for Adoption Credit for Qualified Adoption Expenses. Section 23 was added by the 1996 Tax Act providing for a credit against income taxes for qualified adoption expenses paid by the taxpayer. Qualified adoption expenses are reasonable and necessary adoption fees, court costs, attorney fees and other expenses which are directly related to and have the principal purpose of allowing the taxpayer to legally adopt an eligible child. The credit is a $5,000 per child or $6,000 for a child with special needs. A determination of whether a child is a child with special needs is made under state law and generally refers to the situation where there are specific factors such as ethnic background, age, etc. where the child can not be reasonably placed with adoptive parents without adoption assistance. The taxpayer can claim the credit for expenses in the year that follows the year in which the taxpayer pays for the expenses. The taxpayer can also take a credit for expenses paid during the tax year in which the adoption becomes final.

2.Taxable Income Treatment of Damage Awards for Non-Physical Injuries and Punitive Damages. Pre-1996 tax law generally provided that gross income did not include any damages received pertaining to personal injury or sickness awards. The 1996 Act clarifies this general rule by providing in Section 104(a) that the exclusion from gross income for damages received on account of personal injury or sickness only applies to damages received from physical injury or physical sickness. Non-physical injuries are thus included in gross income. Note that punitive damage awards are also subject to tax.

3.Exclusion of Interest Income on Savings Bonds Used for Qualified Higher Education Expenses. The 1996 Tax Act provides clarification, under Code Section 135(b)(2), that interest on US Savings Bonds may be excluded from gross income if the proceeds are used for qualified higher education purposes. The exclusion is phased out now for taxpayers with an adjusted gross income above $60,000. The new law makes 1989 the base year for indexing this amount.

4.Section 179 Expense Deduction Increased. Significant amendments were made to Code Section 179(b) on first-year expense deductions which provide significant benefits to small businesses. The $17,500 expense deduction is increase to $25,000 over a seven-year period starting with tax years beginning in 1997. For 1997 and 1998, the Section 179 allowable deduction amounts are $18,000 and $18,500, respectively. The amount is increased gradually to $25,000 for tax years beginning in year 2003 and thereafter.

Note, however, the new law specifically excludes the following properties from Section 179 eligibility: air conditioning and heating units, property used outside the US, property used for lodging, and property used by certain tax exempt organizations.

B.MISCELLANEOUS RULINGS AND CASES AFFECTING INDIVIDUALS.

1.Withdrawals From an Individual's Revocable Trust May Be Included in the Estate of an Individual and Subject to Taxation. In technical advice, the IRS has ruled that withdrawals from an individual's revocable trust by the holder of a power of attorney in some cases may be unauthorized and thus includable in an individual's gross estate under Section 2038. The determining factor will be how the Service construes state law and the issue as to whether an individual holding a power of attorney did, in fact, have power under either the trust instrument or the general power of attorney to make withdrawals from the trust account. (LTR. 9601002).

2.Settlement Proceeds Paid to Union Members are Taxable Wages. The IRS has ruled that amounts received in settlement of a class action suit distributed by a union to its members will constitute wages for purposes of employment taxes. A union sued a company for breach of a collective bargaining agreement. The company agreed to settle the case and provide amounts to the union members. The IRS ruled that part of the settlement proceeds was includable in each union member's gross income. The Service noted that the settlement award did not result from claims arising from personal injuries or from tort-type injuries, and therefore, the amounts were not subject to the exclusion under Section 104 pertaining to personal injuries. (LTR. 9601003).

3.The Value of Subsidized Meals May Be Included in an Employee'sIndividual Income Under Section 119. In technical advice, the IRS provided some guidance on this income inclusion issue. In this ruling, the company's office employees usually had a 45-minute meal period. All employees could leave the work place during the meal period and each of the company's places of business had numerous off-site eating establishments near by. The IRS concluded that meals were not furnished for a substantial non-compensatory business reason and thus were subject to inclusion in each individual employee's income. (LTR. 9602001).

4.Damage Awards/Sick Pay. Damages for breach of an employment contract in general will be taxable income. A Ninth Circuit memorandum decision affirmed summary judgment for the government on whether damages received in the settlement of a breach of contract suit constituted taxable income. The court indicated that the critical inquiry was the type of award and reasoned that the terms of the settlement were not based on personal injuries but were economic in nature.Sue A. Bennett-Burns v. UnitedStates, No. 94-16639 (9thCir. Jan. 24, 1996).

5.Business Expense Deductions Denied for Failure to Provide Adequate Proof. The Ninth Circuit affirmed the Tax Court's decision denying deductions claimed by a couple for home office and miscellaneous business expenses. The determining factors in the denial of the deductions were that the taxpayer failed to provide adequate documentation distinguishing business calls or personal calls, failed to provide adequate receipts for equipment purchased, and also failed to demonstrate which portion of the residence was exclusively used for business purposes.Phuoc G. Cao v. Commissioner, No. 94-70487 (9thCir. Feb. 29, 1996).

C.INDEPENDENT CONTRACTOR ISSUES

1.Clear and More Unified Standards Enacted in Section 530. The Small Business Job Protection Act of 1996 (signed into law on August 20, 1996) amends IRC Section 530(e) effective generally for periods after December 31, 1996. Important clarifications and modifications include:

(a) Prior audits can provide a reasonable basis for classifying workers. Section 530 prior to the amendments permitted a taxpayer to rely on a prior audit as long as there was no assessment attributable to the treatment of individuals holding positions similar to the position held by the individual in question. Under the new amendments, a taxpayer may not rely on an audit after 1996 unless the audit included an examination of whether the individual, or someone similarly situated, should be treated as an employee of the taxpayer.

.(b)The IRS must provide written notice of Section 530 provisions before audits.

(c)Safe harbor definitions are now provided for long-standing practice and 'significant segment. This is applicable when a taxpayer attempts to show a reasonable basis for not treating an individual as an employee based on a long-standing recognized practice of a significant industry segment in which the individual was engaged. The IRS is restricted on how it may apply the terms long-standing practice and 'significant segment. For example, the term long-standing practice may not be construed as requiring that the practice must have continue for more than ten years. Similarly, the term 'significant segment may not be construed to require reasonable showing of the practice of more than 25% of the industry without taking into account the particular facts and circumstances of the taxpayer.

2.Two Recent Cases. InSpringfield v. U.S., 88 F.3rd750 (9thCir. 1996), the court allowed relief under Section 530 to a taxpayer who was a used car dealer who treated his salespeople as independent contractors. The taxpayer was able to show that it was the general practice of other independent used car dealers in the area to treat salespeople in a similar manner. This case was also significant in that it held that the filing of a Form 1099 did not start the statue of limitations running for withholding and employment tax liability. InVizcaino, et. al. v. Microsoft Corp., 93 F.3rd1187 (9thCir. 1996), the court held that free-lance workers treated as employees for employment tax purposes by the IRS were able to successfully claim employee status for Section 401(k) and stock purchase plan purposes also.

D.TAX PROCEDURE AND ADMINISTRATION.

1.No Penalty Provision for Pre-Enactment Estimated Taxes. Code Section 6654 of the 1996 Tax Act provides a general provision that no penalty will be imposed on individuals for failure to pay estimated taxes with respect to any underpayment of any installment required to be paid before the date of enactment of the Act, that is, to the extent the underpayment was created or increased by provisions and changes under the Tax Act. The date of enactment of the 1996 legislation is August 20, 1996.

2.Section 6511 Limitation on Refunds. The Eight Circuit affirmed the dismissal of a taxpayer's claim for tax refunds and damages, holding that neither the IRS's bad advice to the taxpayer nor the taxpayer's poor health were sufficient grounds for equitable tolling of the statute of limitations.Mosche Baruch Git v. Department of Treasury, No. 95-1899 (8thCir. Jan. 4, 1996).

3.Failure to File Before the IRS Issues a Deficiency Notice and the Two Year Look-Back Rule. The Supreme Court has held that the Tax Court lacks jurisdiction to refund individual income taxes paid more than two years before the date the IRS issues a deficiency notice. The operative question is whether a claim filed on the date of mailing of the notice of deficiency would be filed within three of the time the return was filed. In the case of a taxpayer who did not file a return before the notice of deficiency was mailed, the claim could not be filed within three years from the time the return was filed. Therefore, the applicable look back period is instead the two-year period described in Section 6511(b)(2)(B) which is measured from the date of the mailing of the notice of deficiency.Commissioner v. Robert F. Lundy, No. 94-1785 (U.S. Supreme Court Jan. 17, 1996).

4.Expanded Electronic Filing Procedures. IRS Notice (IR-96-4) allows for more opportunities for taxpayers to file returns electronically from their homes. The IRS has authorized five transmission companies as well as nine different tax preparation software packages as eligible for electronic filing from home personal computers. The IRS will also require the taxpayer to mail to the designated transmitter Form 8453-OL US Individual Income Tax Declaration for On-Line Services Electronic Filing. A list of on-line filing program companies can be obtained from the IRS Website at http://www.irs.ustreas.gov.

5.IRS Matching Procedures. The Internal Revenue Service continues the practice of declining to pay refunds until social security numbers had been verified with the Social Security Administration. The Service discontinued its use of the direct deposit indicator which speeded electronic refunds, but put the IRS in the position of advancing funds to filers. The IRS increased use of procedures for social number matching was apparently the primary factor behind a decline estimated at approximately two million in the number of dependency exemptions claimed by taxpayers in the 1994 tax compliance season.

E.RECENT TAX LAW CHANGES AFFECTING SUBCHAPTER S CORPORATIONS AND THEIR SHAREHOLDERS.

1.Increase in Shareholders. The 1996 Small Business Job Protection Act provides for an increase in the maximum number of eligible shareholders of an S corporation from 35 to 75. This is applicable for tax years beginning after December 31, 1996. Code Section 1361(b)(1)(A). This provision makes is easier for some corporations to qualify as Scorporations. In the past, when more than 35 investors used the S corporation structure, the investors would often incorporate two S corporations, and would then form a partnership. It is assumed that the new law will allow for similar structures to be maintained with more than 75 investors.

2.Trusts as Shareholders. Under Section 1361(c)(2), electing small business trusts may now be an eligible shareholder of an S corporation. This will allow for trusts to be funded with S corporation stock. All the beneficiaries of the trust must be individuals or estates eligible to be S corporation shareholders. Note that each current beneficiary will be counted as a shareholder for the 75 shareholder limitation. Beneficiaries of the trust may be non-resident aliens.

3.Post-Death Trusts. Under Code Section 1361(c)(2)(A), the post-death holding period of S corporation stock for a grantor trust or a trust getting stock under a will is expanded to two years. Under prior law, the period was from 60 days beginning on the day of the grantor's death.

4.Exempt Organizations as S Corporation Shareholders. Certain qualified retirement plan trusts and charitable organizations are now eligible as S corporation shareholders. Section 1361(b)(1)(B) is effective for tax years beginning after December 31, 1997. A significant aspect of this provision is that the qualified retirement plan trust will be counted as one shareholder. Thus, the 75-shareholder limit is not violated where a trust with more than 75 employee beneficiaries holds an interest in an S corporation.

5.S Corporations Allowed to Hold Subsidiaries. Under the tax law prior to the enactment of the Small Business Job Protection Act of 1996, an S corporation could not have a C corporation as an 80% or more subsidiary. Similarly, an S corporation could not have another S corporation as a subsidiary, because an S corporation could not have a corporation as a shareholder. Revisions to Code Section 1361(b) effective for tax years beginning after December 31, 1996, allow for an S corporation to have 80% or more owned C corporation subsidiaries as well as certain wholly-owned S corporation subsidiaries.

An S corporation may own 80% or more of the stock of a C corporation, but can still not file a consolidated return with that affiliate. Also, under Code Section 1362(d), dividends received are not passive investment income to the extent attributable to the subsidiary C corporation's earnings and profits from the active conduct of a trade or business.

The general rule that a S corporation cannot have a corporate shareholder remains unchanged. However, an S corporation parent can have a qualified subchapter S subsidiary. (QSSS). A QSSS includes 1) a domestic corporation that qualifies as an S corporation that is 2) 100% owned by an S corporation parent and 3) the parent elects to treat it as a QSSS. All assets, liabilities, income, deduction and credits of the QSSS are tax attributes of the parent.

6.Inadvertent Termination/Late Elections. Under Code Section 1362(f), the IRS may now waive an inadvertent termination caused by inadvertent failure to qualify as a small business corporation or to obtain the required shareholders. In order for S corporation status to be reinstated, it must be established that within a reasonable period after discovering the circumstances resulting in the invalidation, steps are taken by the corporation to qualify as a small business corporation or to secure the requisite shareholder consents. Furthermore, the corporation and each person who was a shareholder during the period subject to invalidation are to agree to certain IRS prescribed adjustments consistent with the treatment of the corporation as an S corporation during the relevant period.

Similarly, where an S corporation election terminates because of a failure to qualify as an S corporation, the corporation may be treated as an S corporation during the period specified by the IRS if the same conditions referred to above are met. Code Section 1362(f)(2).

The IRS now has retroactive authority to treat late or non-existent S corporation elections as timely. Under Code Section 1362(b)(5), the IRS may treat a late election made for a tax year or a non-existent election for the tax year as timely made for that tax year if the IRS determines that there was reasonable cause for failure to file the election on time. This provision provides that the election will be treated as timely for the first effective tax year for which it is made rather than the following tax year.

7.Election by Effective Shareholders Terminates S Corporation Tax Year. In general, if a shareholder terminates his interest in an S corporation, the S corporation may elect to terminate the S corporation tax year. The effect of this election is that the tax year of the corporation will be treated as if it is made up of two years, with the first tax year ending on the date in which the shareholder's interest was terminated. Under prior law, this election would be allowed if all persons who were shareholders during the tax year agreed to the election.

Under the new law, the election to terminate the S corporation's tax year on termination of a shareholder's interest and to treat the tax year as consisting of two years requires the consent of the S corporation entity and only the affected shareholders. Code Section 1377(a)(2). The closing of the books for the split in tax years applies only to an affected shareholder who is defined as any shareholder whose interest is terminated and any shareholder to whom the terminating shareholder transferred shares during the year. If the shares are transferred to the corporation, all persons who were shareholders during the year are affected shareholders.

8.Modification to Five-Year Re-Election Period Rule. Under prior law, if an election to be treated as an S corporation was terminated or revoked, the corporation could not make an S corporation election before the fifth tax year after the first tax year for which the termination or revocation was effective unless consent was given by the IRS. For tax years beginning after December 31, 1996, Internal Revenue Code Section 1362(g) provides that the five-year waiting period is eliminated for corporations whose S election was terminated or revoked in tax years beginning before January 1, 1997. Thus, the new law allows corporations that have terminated their S corporation status within the last five years to re-elect. Note that this re-election will be allowed regardless of whether or not the prior termination or revocation was voluntary.

9.Treatment of S Corporations as Shareholders in C Corporations. The rules of Subchapter C generally govern the liquidation of a C corporation into an S corporation. Under Code Section 1371(a), the general rule that an S corporation in its capacity as a shareholder of another corporation is treated as an individual for purposes of Subchapter C has been eliminated. As noted above, S corporations are allowed to have 80% or more owned C corporation subsidiaries. The modification under Section 1371(a) allows an S corporation to liquidate its 80% or more owned C corporation subsidiaries on a tax-free basis. Note that this modification does not change the general rule that an S corporation's taxable income is computed under rules that apply to individuals. Thus, an S corporation or its shareholders are not entitled to claim a dividend received deduction with respect to S corporation dividends.

10.Capital Gain Treatment on Sales of Subdivided Real Property. Code Section 1237 provides that a lot held by a non-corporate taxpayer is generally not treated as ordinary income property solely by reason of the land being subdivided if the lot or parcel had not previously been held as ordinary income property, and in the year of sale the taxpayer did not hold any other real property, no substantial improvements were made to the property and the property was held by the taxpayer for five years. Under new law, S corporations, unlike C corporations, are eligible to use Section 1237 and obtain capital gain treatment on sales of subdivided real property.

11.Effective Audit Terminations. The period after which a corporation's S election terminates is referred to under Section 1377(b)(1) as the post-termination transition period. Losses or deduction that could not be taken by the S corporation or shareholder because of insufficient basis in the last tax year of the S corporation are treated as incurred by the shareholder on the last day of such period. These amendments under the new law also define the post-termination transition period as including the 120-day period starting on the date of any determination with respect to an audit of the taxpayer that follows the termination of the corporation's election and results in a adjustment to income or deduction items of the S corporation. The term determination includes a final court decision, final disposition by the IRS of a refund claim, a closing agreement, or any agreement between the IRS and the S corporation pertaining to failure of the S corporation qualify for S corporation treatment. Code Section 1377(b)(2).

12.Unified Audit Rules. Code Section 6233(b), applicable to tax years beginning after December 31, 1996, has repealed Code Sections 6241 through 6245. The repealed provisions were referred to as the unified audit and review procedures for S corporations. In general, items of income, loss, deduction and credits were determined and reviewed at the corporate level and not in separate audit proceedings with S corporation shareholders. The new law in effect provides that S corporations will now be audited on a shareholder by shareholder basis.

13.New Consistency Rules Applicable to S Corporation Shareholders. In addition to the repeal of unified audit review procedures for S corporations, new, modified consistency rules are set forth under Section 6037(c). In general, shareholders from an S corporation are required to treat any Subchapter S tax items in a manner that is consistent with the treatment of those items on the S corporation corporate return. An exception is allowed if the S corporation shareholder identifies the inconsistency in a statement to the IRS. The IRS is now providing on Form 8082 the means for which individual S corporation shareholders can set forth inconsistent treatment of any Subchapter S items. Note that the new disclosure is applicable where an item either is or may be inconsistent with the corporation's treatment of the item as well as those situations where the corporation did not file a return.

F.TAX UPDATES ON EMPLOYEE BENEFITS AND RETIREMENT.

Provisions affecting retirement plan distributions, life and health insurance coverage, and other employee benefits are encompassed by the Small Business Job Protection Act of 1996 (H.R. 3448 P.L. 104-188) and the Health Insurance Portability and Accountability Act (H.R. 3103 P.L. 104-191).

1.Retirement Plans and Distribution Concerns.

(a).The Appeal of Five-Year Averaging Rule.

Prior to the 1996 tax legislation, lump sum distributions from qualified plans were eligible for special five-year averaging. This tax break allowed the recipient of a qualified plan distribution to pay a separate tax on the lump sum distribution that approximated the tax that would otherwise be due if the distributions were received in five equal installments. Internal Revenue Code Section 402(d) was amended by the Small Business Job Protection Act of 1996 effective for tax years beginning after December 31, 1999. In essence, the five-year averaging provision is no longer applicable. However, employees who were age 50 or over on January 1, 1986, and were therefore grandfathered under the Tax Reform Act of 1986 can still elect 10-year averaging under the Tax Reform Act of 1986 rules. Also, any taxpayer eligible for this transition rule may still elect to have a portion of the distribution applicable to pre-1974 participation in any such plan treated as a long-term capital gain, thus taxed at a rate of 20%.

(b).Excess Distribution Excise Tax Suspended.

Section 4980(A)(g) generally provides for a 15% excise tax on excess distribution from qualified retirement plans, IRAs and tax shelter annuities. Excess distributions pertain to the aggregated amount of retirement distributions that an individual receives during any calendar year which exceed a specified threshold amount that is adjusted for inflation. The excise tax on the excess distributions will not apply to distributions during calendar years 1997, 1998 and 1999. The 1997 adjusted thresholds are $160,000 for annual installments or annuities, and $800,000 for a single lump sum. The excess distribution tax is merely suspended and is not repealed. The suspension will expire for distributions beginning on or after January 1, 2000. Also, the 15% additional estate tax on excess accumulations under Code Section 49080A(d) is not affected by this legislation.

(c).Simplification of Basis Recovery Rules.

Under pre-1986 legislation, amounts received from qualified plans as an annuity or Section 403 annuity plans or contracts were generally taxable in the year received except to the extent the amounts represented the recipient's investment in the contract. An example of a recipient's investment in the contract or basis would be those amounts the participant contributed on an after-tax basis.

Under 1996 amendments to Code Section 72(d), where a participant is receiving an annuity from a qualified annuity plan or annuity contract, basis recovery of the investment in the contract is determined from a statutory table that sets forth a fixed number of anticipated payments for five age brackets. The five age brackets are 1) up to age 55; 2) 55 to 60; 3) 60 to 65; 4) 65 to 70 and 5) over 70. In essence, this is a legislative enactment of the simplified alternative method which was previously authorized by the IRS. These simplified basis recovery rules will become mandatory for any annuity starting date more than 90-days after the enactment of the amendments to Section 72(d) (Nov. 18, 1996).

(d)Elimination of Mandatory Distribution Requirements for ActiveEmployees.

Under pre-1996 Act law, participants in qualified plans or the owner of an IRA was required to take distributions by April 1 of the calendar year following the year in which the participant or owner reached age 70 ½. This mandatory distribution rule was triggered whether or not the individual had actually retired. Code Section 401(a)(9)(C) was amended by the 1996 Act to provide flexibility with respect to receiving distributions for those individuals after age 70 ½ who decide to continue being active employees. This amendment applies only to qualified plan benefit distributions and not to IRA distributions.

(e)Small Employer/ 'sIMPLE Retirement Plans.

The 1996 legislation provides a significant opportunity for small employers to provide benefits that were not previously available under prior law. An employer with 100 or fewer employees (who earn $5,000 or more) and which has no other qualified plan, is now allowed to establish a 'sIMPLE plan in a procedure or format similar to a 401(k) plan or an IRA. Section 408(p) allows employees to elect to defer up to $6,000 to the plan arrangement. Employer must either 1) match this at 100% up to 3% of pay or 2) make a 2% pay contribution on behalf of every eligible employee. Employer contributions are 100% invested. These arrangements are not encumbered with non-discrimination rules, and the top-heavy rules are waived for IRA-type plans. Code Section 408(k)(6)(H) also allows for pre-existing salary reduction simplified employee plans (SARSEPs) to continue but new SARSEPs are prohibited after 1996.

(f)Tax Exempt Organizations Allowed 401(k) Plans.

All tax exempt organizations accept state and local governments and their agencies or instrumentalities may establish a Section 401(k) elective deferral plan effective for years beginning after December 31, 1996. Tax exempt organizations encompassed by these provisions include trade associations and unions in addition to charitable organizations. Section 401(k)(4)(B).

(g)IRA Withdrawals For Medical Expenses are Penalty Free.

If a taxpayer takes an early withdrawal from a individual retirement account or a qualified plan, the taxpayer's income tax for the year is generally increased by an amount equal to 10% of the gross distribution amount in addition to regular tax on the distribution. Code Section 72(t)(3)(A) was amended by the Health Reform Act of 1996 to provide an exception to the 10% penalty for withdrawals from IRAs to cover medical expenses in excess of 7 ½% of adjusted gross income. The rule previously applied only to qualified plan distributions and is now extended to individual retirement accounts.

(h)IRS Distributions for Medical Insurance Premiums.

Health Reform Act of 1996 also provides that individuals who are unemployed can make penalty-free withdrawals from an IRA to pay premiums for medical insurance coverage. Section 72(t)(2)(D). Note that to avoid the 10% penalty, the individual must have received unemployment compensation under state law for 12 consecutive weeks. The provisions is effective for tax years beginning after December 31, 1996.

(i)Deductible IRA Contributions For Spouse.

Prior to the 1996 legislation, the maximum deductible contribution that could be made to an IRA generally was the lesser of the $2,000 or 100% of an individual's compensation. In the case of a married individual whose spouse had no compensation, the limit on IRA contributions was $2,250, hence, a spouse IRA of $250. Amendments to Section 219(c) for tax years beginning after December 31, 1996, have raised the limit on individual IRA contributions for a non-working spouse to $2,000. Note that this change in the law does not effect the phase-out of deductible contributions if either spouse participates in a qualified employer-provided plan.

(j)Employee Benefit Plans for S Corporation and S Corporation Employee Shareholders.

Amendments to Section 404(a)(9) allow S corporations to create ESOPs (Employee Stock Ownership Plan) for their employees and shareholder employees. However, certain benefits relating to ESOPs do not apply to S corporation stock held by the ESOP. An S corporation is not allowed a deduction for contributions to an ESOP. Also, an S corporation shareholder cannot obtain tax free rollover treatment for sales or transfers of S corporation stock to the ESOP.

2. Health Insurance Modifications.

(a)Medical Savings Accounts.

The Health Reform Act of 1996 added Internal Revenue Code Section 220 providing for the establishment of medical savings accounts (MSAs). Beginning in 1997, self-employed individuals or eligible small employers with less than 50 employees may create tax free medical savings accounts for their employees. In general, distributions from a MSA that are used to pay the qualified medical expenses of the individual, the individual's spouse, or dependents are excludable from gross income under Section 220(f)(1). Section 220(d)(2) defines qualified medical expenses as any medical expenses that are allowed under the provisions relating to itemized deductions for medical expenses, but only if the expenses are not reimbursed by insurance or otherwise. Contributions to the plans are limited to 65% for individuals or 75% for families of certain prescribed deductible amounts. Note that this is a pilot program established under the law, and it will be in existence until the year 2000 or the year when 750 MSAs exist, whichever is earlier.

(b)Long-Term Care Insurance.

Prior to the Health Reform Act of 1996, the rules pertaining to the treatment of the cost of long-term care and long-term care insurance premiums was not clear. The Health Reform Act of 1996, under Sections 213(d) and 7702(B), generally provides that beginning in 1997, long-term care coverage will be treated for tax purposes very much like general health coverage. The cost of qualified long-term care services and eligible long-term care insurance premiums will be included in the definition of deductible medical care. Eligible long-term care insurance premiums are defined as amounts paid during the tax year for any qualified long-term care insurance contract up to specified dollar limits. For example, in the case of an individual with an attained age before the close of the tax year of more than 70, the annual limitation on deductible premiums will be $2,500. Code Section 213(d)(1)(D). Note that the limits on deductible long-term care insurance premiums are per individual and not per return. Thus, in the case of married taxpayers over the age of 70, the limitation will be $2,500 each. Of course, the cost of long-term care services and premiums are still subject to the overall floor on the deduction of medical expenses, i.e. 7 ½ % of adjusted gross income.

(c)Health Insurance Deductions for Self-Employed Individuals.

Amendments to Code Section 162(l)(1) provide for an increase of the current deduction of 30% for a self-employed person's health insurance premiums (40% for 1997, 45% for 1998 and up to 80% by the year 2006).

3.Other Employee Benefit Provisions.

(a)Employer Provided Educational Assistance.

Section 127(d) was amended by the Small Business Job Protection Act of 1996 to extend the exclusion of educational assistance program benefits from income through taxable years beginning before June 1, 1997. Under pre-1996 act law, an employer was required to included in an employee's wages amounts provided by the employer for the employee's education assistance. However, there was an exclusion for employer-provided amounts if the amounts were paid or incurred under an education assistance program that met certain requirements. This exclusion was limited to $5,250 per year. Although the extension is provided for tax years beginning before June 1, 1997, it only applies for courses beginning before July 1, 1997. Note that in the absence of this limited exclusion, educational assistance is excluded from an individual's income only if it is related to the employee's current job.

(b)$5,000 Death Benefit Exclusion Repealed.

Prior to the 1996 legislation Code Section 101(b)(1) provided that amounts up to $5,000 paid by or on behalf of an employer to beneficiaries or the estate of a deceased employee were excludable from the recipient's gross income. The 1996 Act repeals this provision with respect to decedents dying after the date of the enactment of the 1986 Act.

(c)State Taxation of Retirement Benefits.

President Clinton signed into law in January of 1996 H.R. 394 which limits a state from taxing retirement benefits of former residents of the state. In addition to prohibiting a state from taxing earnings from qualified plans maintained by employers for all their retirees, the bill prohibits states from taxing non-residents on payouts after 1995 from the following types of retirement plans:

  • Section 401(k) Plans;
  • workforcewide pension plans and other funded retirement plans;
  • simplified employee pensions defined in Section 408(k);
  • an annuity plan or annuity contracts;
  • Individual retirement accounts;
  • eligible deferred compensation plans defined in Section 457;
  • any federal government retirement program;
  • a trust described in Section 501(c)(18) – trusts created before June 25, 1959 that are part of a pension plan meeting specified requirements and funded by employee contributions only;
  • executive retirement plans providing benefits greater the amounts payable under the above-described types of plans and any plan, program or arrangement as described in Section 3121 provided that such income is part of a series of substantially equally periodic payments made for the life expectancy of the recipient or for a period of not less than 10 years.