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Covered opinion rules would be eased  
December 2012

The IRS released proposed regulations that would eliminate the complex rules in Circular 230, Section 10.35, governing covered opinions (REG-138367-06). To replace them, the proposed regulations would expand the requirements for written advice under Circular 230, Section 10.37.

The IRS notes in the preamble to the proposed regulations that “[y]ears of practical experience ... have shown that the covered opinion rules in current §10.35 have produced some unintended consequences and should be reconsidered.” For example, the IRS has observed that many practitioners attempt to exempt their advice from the covered opinion rules by making a prominent disclaimer stating that the opinion cannot be relied on for penalty protection.

Under current Circular 230, Section 10.35, covered opinions include written advice concerning:

1. A listed transaction;

2. A transaction with the principal purpose of tax avoidance or evasion; or

3. A transaction with a significant purpose of tax avoidance or evasion, if the advice is a reliance opinion, marketed opinion, subject to conditions of confidentiality, or subject to a contractual protection.

Practitioners must comply with extensive requirements when providing written advice that constitutes a written opinion, and the IRS acknowledges that they have to expend considerable effort to determine whether advice rendered in a particular circumstance is subject to the covered opinion rules.

The IRS has concluded that the rules are overbroad, are difficult to apply, and do not necessarily produce higher-quality tax advice. Proposed Section 10.37 would require practitioners to base all written advice on reasonable factual and legal assumptions, exercise reasonable reliance, and consider all relevant facts that the practitioner knows or should know.

The proposed regulations also withdraw proposed amendments to Section 10.39 governing requirements for state or local bond opinions and remove the definition of, and exclusion for, state or local bond opinions from the definition of covered opinions.

The proposed regulations broaden the scope of the procedures to ensure compliance under Section 10.36 by requiring that a practitioner with principal authority for overseeing a firm’s federal tax practice take reasonable steps to ensure the firm has adequate procedures in place for purposes of complying with all provisions of Circular 230.

The proposed regulations clarify that the prohibition on a practitioner’s endorsing or otherwise negotiating any check issued to a taxpayer in respect of a federal tax liability applies to government payments made by any means, electronic or otherwise.

The proposed regulations expand the categories of violations subject to the expedited proceedings in Section 10.82 to include failures to comply with a practitioner’s personal tax filing obligations that demonstrate a pattern of willful disreputable conduct.

Finally, the proposed regulations clarify that the IRS Office of Professional Responsibility has exclusive responsibility for matters related to practitioner discipline, including disciplinary proceedings and sanctions.

The proposed changes will take effect when they are published as final regulations.

No extended assessment period for innocent S shareholder  
By Janet A. Meade, CPA, Ph.D.
December 2012

The Office of Chief Counsel (OCC) advised in Chief Counsel Advice (CCA) 201238026 that the assessment period is not extended for the personal tax liability of a shareholder who did not take part in the fraud reflected on his S corporation’s Form 1120S, U.S. Income Tax Return for an S Corporation.

Sec. 6501(a) generally requires the IRS to assess any tax within three years after a return is filed by a taxpayer. One of several exceptions to the three-year assessment period is Sec. 6501(c)(1), which provides for an unlimited assessment period in the case of a false or fraudulent return with the intent to evade tax. Generally, the statutory requirement of an intent to evade tax looks at the intent of the taxpayer who filed a return. However, there are several exceptions, such as cases involving spouses filing joint returns (where both spouses are liable for deficiencies by virtue of the joint filing) or TEFRA unified partnership proceedings.

As explained in the CCA, shareholders A and B were equal owners of an S corporation engaged in the business of roofing, remodeling, and repairing buildings. The corporation often hired subcontractors to perform work for customers, and the subcontractors billed the corporation for their work.

In addition to working for the corporation, some subcontractors worked for shareholder B personally. Shareholder B instructed these subcontractors to record false job site addresses of the corporation’s customers on their invoices rather than his personal address, where the work had been performed. He also changed the address on other personal invoices from his own to those of the corporation’s job sites. His actions caused many personal expenses to be falsely recorded as business expenses on the corporation’s books and deducted on its tax return. This resulted in an understatement of the S corporation’s income that passed to shareholders A and B and was reported on their personal tax returns.

Shareholder B was convicted of various tax crimes, including fraud and filing false individual and corporate tax returns. Shareholder A did not sign the S corporation’s tax return, nor did he participate in the preparation of the return. There was also no evidence that he was aware of shareholder B’s fraudulent activities. Consequently, the Small Business/Self-Employed Division attorney sought advice from the OCC as to whether shareholder A’s personal return could be assessed a tax deficiency, given that it had been filed approximately 10 years earlier.

Case law has established that the mere act of reporting fraudulently understated income from an S corporation on the personal return of a shareholder does not automatically make the shareholder guilty of fraud. Instead, to determine whether an unlimited assessment period is appropriate, the IRS must examine the activities of each shareholder. According to the CCA, this is similar to the way the assessment statute has been applied to spouses. Fraud by one spouse holds the assessment period open for the other spouse only when the spouses file a joint return, not when they file separate returns.

Because shareholders A and B filed separate tax returns and the fraudulent amounts reflected on shareholder A’s return did not arise from his actions, the OCC advised that the general three-year assessment period applied to his return. Any assessment of deficient tax on that return consequently was barred.

The OCC’s reasoning in the CCA does not apply to partners. Under Sec. 6229 (c)(1), partners that sign or participate in the preparation of a partnership return containing a false or fraudulent item with the intent to evade tax are subject to an unlimited assessment period. Partners who do not sign or participate in the preparation of such a return but who report their share of a partnership’s fraudulent income on their own returns are subject to a six-year assessment period. While application of these rules to shareholder A’s situation would not have altered the outcome (his return had been filed more than six years earlier), partnerships are subject to unified audit procedures that do not apply to S corporations.

The OCC’s conclusion contrasts with the position of the IRS in Allen, 128 T.C. 37 (2007), where the Tax Court agreed with the IRS and held that an income tax return preparer’s fraud extended indefinitely the assessment period of a taxpayer’s personal tax liability, even when the taxpayer did not intend to evade tax. Instead, the OCC’s reasoning is more in keeping with the IRS’s recent loss in City Wide Transit, T.C. Memo. 2011-279 (appeal docketed). In that case, the Tax Court determined that although the taxpayer’s accountant engaged in various tax crimes including filing false returns for the taxpayer, the false filings were incidental consequences of the accountant’s scheme to embezzle from the taxpayer, not willful attempts to evade taxes.

  CCA 201238026 (9/21/12)

By Janet A. Meade, CPA, Ph.D., associate professor, University of Houston.

Spousal payments are not child support  
By Charles J. Reichert, CPA
December 2012

The Tax Court held that spousal support payments received by a taxpayer from her ex-husband prior to the fourth and final support reduction were alimony payments, not child support, since the final reduction was not clearly associated with a contingency related to a child.

Generally, cash payments received by a taxpayer for spousal support are taxable alimony to the recipient unless the payments are designated as child support or continue after the death of the recipient. However, Sec. 71(c)(2) states that reductions in spousal support due to the occurrence of a contingency related to a child or at a time that can be clearly associated with a contingency will be treated as nontaxable child support. Temp. Regs. Sec. 1.71-1T provides two examples where reductions to spousal support are presumed to be “clearly associated with” a contingency related to a child. The first is where the payments are reduced not more than six months before or after the date the child attains the age of 18, 21, or the local age of majority; however, if all spousal payments end in the sixth post-separation year, the payments are alimony under a minimum-term rule. The second situation is where the payments are reduced two or more times, where each reduction occurs not more than one year before or after a different child attains a certain age between the ages of 18 and 24, inclusive.

Sharon Schilling and her ex-husband, parents of three minor children then still living with them, separated in March 2003 and divorced in October 2003. Under the separation/divorce agreement, the taxpayer, Schilling, was to receive from her ex-husband monthly spousal support for six years, starting in 2003 and ending in 2009. The payments were initially set at $2,450 per month but were reduced to $2,325 in 2003, $2,125 in 2004, and $1,925 in September 2006, as each minor child turned 18 or left for college, whichever occurred later. Schilling reported no income from the spousal payments on her 2006 federal income tax return; however, the IRS classified $23,100 (12 payments of $1,925) as taxable alimony, while conceding that the first three reductions were qualifying contingencies.

The court held that the taxpayer received alimony of $23,100 in 2006 because the final reduction occurring in 2009 that completely eliminated the spousal support did not satisfy either of the two situations of Temp. Regs. Sec. 1.71-1T that are presumed to be clearly associated with a contingency related to a child. According to the court, the first situation was inapplicable because the complete termination (the 2009 reduction) of the spousal payments occurred in the sixth post-separation year, which disqualified it as a contingency related to a child. The court also found that the second situation was inapplicable because each reduction must occur within a specified time relative to a different child. Since the last reduction was the fourth, the second situation could apply only if the taxpayer had four children.

  Schilling, T.C. Memo. 2012-256

By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota–Duluth.

Instructions address portability election  
December 2012

The IRS posted revised instructions to Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, with guidance for electing the portability of a deceased spouse’s unused estate and gift tax exclusion amount. The instructions also address an executor’s use of a checkbox to opt out of electing portability of the unused portion of the exclusion amount.

Under the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312, a surviving spouse can increase his or her applicable exclusion amount by the amount of the unused exclusion amount of the deceased spouse (dying after 2010). As of this writing, this provision is scheduled to expire after 2012.

According to the instructions, the election is made by the executor of the deceased spouse’s estate. Form 706 must be filed to make the election, and even estates that would not otherwise be required to file Form 706 (generally because of the size of the estate) must file to make the election. The instructions explain that if an estate intends to elect portability, timely filing (including extensions) a complete Form 706 is all that is required. The deceased spouse’s unused exclusion must be computed on the return.

Executors of estates that are not required to file Form 706 under Sec. 6018(a) who are filing to elect portability of the deceased spouse’s unused exclusion amount to the surviving spouse are not required to report the value of certain property eligible for the marital deduction or the charitable deduction. However, the value of those assets must be estimated and included in the total value of the gross estate. For such property, the executor is permitted to estimate the value in good faith and with due diligence.

Executors who intend to elect portability should complete Section B of Part 6 of the form if any of the estate’s assets are being transferred to a qualified domestic trust, and Section C to calculate the deceased spouse’s unused exclusion. Section D must be completed by a surviving spouse if his or her spouse received an unused exclusion from one or more predeceased spouses.

Because filing Form 706 by default causes the election to be made, Form 706 and the instructions provide a mechanism for estates that are required to file because the value of the gross estate exceeds the applicable exclusion amount or for another reason to opt out of the election. This opt-out is made by checking the box indicated in Section A of Part 6 of the form.

If the estate is not required to file a return, not filing the form will prevent the election from being made. Only an executor who is appointed, qualified, and acting on behalf of the decedent’s estate can either make or opt out of the election. Executors who file Form 706 and do not wish to elect portability are told to “check the box indicated” and not to complete Sections B or C of Part 6.

Online travel companies not liable for occupancy taxes  
By Karen M. Cooley, CPA, MBA and Darlene Pulliam, CPA, Ph.D.
December 2012

The Sixth Circuit affirmed a district court’s judgment in favor of defendant online travel companies (OTCs) for alleged violations of local tax laws. The district court had held that the OTCs were not liable for collecting occupancy taxes.

It is common practice for OTCs such as, Expedia, and Travelocity (which were among the lawsuit’s defendants) to provide discounted hotel room rates to customers by contracting with hotels for rooms at “wholesale” rates and then booking rooms for customers on their websites at a marked-up “retail” rate that is above the wholesale rate but below the market rate. Most states allow cities and counties to assess an occupancy tax upon the persons reserving those hotel rooms. The hotel operator is required to collect and remit the tax. Eleven localities in Ohio (including cities, townships, and a county) sued the OTCs, arguing that the companies were required to remit a guest occupancy tax on the higher retail rate the companies charged customers. OTCs have traditionally remitted tax based on the contractual wholesale room rate that the hotels charged the companies. In essence, the point at issue was whether OTCs must collect and remit occupancy tax on their profit margin.

The district court held that the OTCs had no obligation to collect the guest taxes because they were not among the three types of entities designated by the localities’ tax ordinances as responsible for doing so: operators (proprietors of the hotel, whether in the capacity of owner, lessee, licensee, or any other capacity, and managing agents of hotels); vendors (persons who own or operate a hotel and who furnish lodging); or hotels (establishments kept, used, maintained, advertised, or held out to the public to be a place where sleeping accommodations are offered to guests). The court found that the tax ordinances were specifically concerned with the amount paid to the hotel for lodging and did not apply to the amount paid for service or booking fees, nor for the cost of using the online services. The Sixth Circuit affirmed the district court’s judgment.

On a related issue, the district court held that the OTCs were required to remit any amounts that they did collect as a tax. Thus, a portion of the amounts collected from customers under the description “taxes and service fees” should be remitted. However, the court determined (and the Sixth Circuit affirmed) that there was not sufficient evidence to suggest that OTCs collected money for taxes that they had not remitted as a tax.

While the courts held for the OTCs in this situation, OTC litigation continues in courts nationwide with mixed results. This is due to slight differences in statutory language and interpretation, creating different judicial conclusions (see, e.g., District of Columbia v. Expedia Inc., No. 2011 CA 2117 (D.C. Super. Ct. 9/24/12), holding some of the same OTCs liable for sales taxes because the D.C. statute does not require a hotel room seller to be the party furnishing the room). States and cities more than likely will amend their statutes to include OTCs. As a result, OTCs are seeking a federal exemption from collection of state and local occupancy tax on profit margin.

  City of Columbus, Ohio v., L.P., No. 10-4531/4545 (6th Cir. 9/10/12), aff’g No. 3:05-CV-7443 (N.D. Ohio 11/18/10)

By Karen M. Cooley, CPA, MBA, instructor of accounting, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Business, both of the College of Business, West Texas A&M University, Canyon, Texas.

Per diem rates updated  
December 2012

The IRS issued the annual update of special per diem rates for use in substantiating certain business expenses taxpayers incur when traveling away from home (Notice 2012-63). The notice provides the transportation industry meal and incidental expenses rates, the rate for the incidental- expenses-only deduction, and the rates and list of high-cost localities for purposes of the high-low substantiation method.

Last year, in Rev. Proc. 2011-47, the IRS provided general rules regarding use of a federal per diem rate to substantiate the amount of ordinary and necessary expenses for lodging, meals, and incidental costs paid or incurred for business-related travel away from home. Taxpayers using the rates and list of localities in Notice 2012-63 must comply with the rules in Rev. Proc. 2011-47.

The IRS no longer provides annual updates to the general per diem rates for substantiating deductible expenses or employer-paid allowances for lodging, meals, and incidental expenses incurred in business-related travel away from home, except for the special transportation industry rate, the incidental-expenses- only rate, and the list of high-cost localities. The general per diem rates for the continental United States are available at the General Services Administration’s website,

The rates in the notice and the GSA’s general rates are effective for per diem allowances paid to any employee on or after Oct. 1, 2012, for travel away from home on or after that date.

Incidental expenses. The substantiation rules in Rev. Proc. 2011-47 look to the definition of “incidental expenses” in the federal travel regulations. In Notice 2012-63, the IRS notes that that definition has changed: Transportation between places of lodging or business and places where meals are taken and the mailing cost of filing travel vouchers and paying employer-sponsored charge-card billings are no longer included in incidental expenses. Therefore, incidental expenses now include only fees and tips given to porters, baggage carriers, hotel staff, and staff on ships.

The per diem rate for the incidental-expenses-only deduction is $5 per day for any locality of travel.

Transportation industry. The special meals and incidental expenses rates for taxpayers in the transportation industry are $59 for any locality of travel in the continental United States and $65 for any locality of travel outside the continental United States.

High-low substantiation method. For purposes of the high-low substantiation method, the per diem rates are $242 for travel to any high-cost locality and $163 for travel to any other locality within the continental United States.

The notice also lists high-cost localities that have a federal per diem rate of $202 or more.

Line items  
December 2012

FICA Exemption for SUB Payments Affirmed

The Sixth Circuit affirmed a bankruptcy and district courts' determinations that severance payments by a bankrupt company to its former employees were supplemental unemployment benefit (SUB) payments not subject to FICA tax (In re Quality Stores, Inc., No. 10-1563 (6th Cir. 9/7/12); see previous Tax Matters coverage, “SUB Payments Are Not FICA Wages,” June 2010, page 79).

The bankruptcy and district courts had held that Sec. 3402(o), which specifies that SUB payments are subject to income tax withholding, and the statute’s legislative history indicate that SUBs are not wages under the statute’s definition or the nearly identical definition in Sec. 3121(a) of wages subject to FICA. The Sixth Circuit agreed, also rejecting the IRS’s arguments that Rowan Cos., 452 U.S. 247 (1981), which held that the two wage definitions are the same, was eroded by subsequent enactments and cases. The latter include last year’s Mayo Foundation for Medical Ed. & Research, 131 S. Ct. 704 (2011), which concerned FICA assessments on stipends paid to hospital medical residents. The Sixth Circuit stated that Mayo did not address the definition of “wages”; thus, the case added “nothing of significance to our legal analysis.”

The Sixth Circuit also acknowledged its split on the issue from the holding of the Federal Circuit in CSX Corp., 518 F.3d 1328 (Fed. Cir. 2008). In that case, the Federal Circuit relied on a definition of SUBs in a line of IRS revenue rulings distinguishing them from FICA-taxable “dismissal pay,” one the Sixth Circuit said was not supported by the “express statutory definition” provided in Sec. 3402(o).

R&D Credit Limited to Research Supplies

The Second Circuit affirmed the Tax Court’s decision restricting Union Carbide’s Sec. 41 research and development credit to the cost of supplies used in research and not those also used in the production of products resulting from the research (Union Carbide Corp., No. 11-2552 (2d Cir. 9/7/12), aff’g T.C. Memo. 2009-50). The ruling concerned three projects. In two, costs of materials Union Carbide claimed were paid or incurred in the conduct of qualified research under Sec. 41(b)(2)(A)(ii) the Tax Court found were for raw materials used to make finished goods that would have been purchased regardless of whether Union Carbide had been engaged in qualified research. The third project, the Tax Court concluded, did not meet the “process of experimentation” test under Sec. 41(d)(1)(C). In regards to the first two projects, the Second Circuit agreed with the Tax Court that the disallowed expenses were, at best, indirect research costs excluded from the definition of qualified research expenses under Regs. Sec. 1.41-2(b)(2).

Drought Counties Listed for Livestock Replacement Extension

In Notice 2012-62, the IRS published a list of more than 1,800 counties and other localities in 38 states where it is extending the like-kind replacement period for involuntary conversions of livestock under Sec. 1033(e)(2)(B) for an additional year due to drought.

Sec. 1033(e) provides a four-year extended replacement period without recognition of gain for sale or exchange of livestock (not including poultry) solely due to drought, flood, or other weather-related conditions. The livestock must be held for draft, breeding, or dairy purposes and not include those the taxpayer would sell in the ordinary course of business. Under Sec. 1033(e)(2)(B), the four-year period may be extended further for weather-related conditions continuing for more than three years.

Notice 2006-82 provides that this additional extension will last through the first tax year ending after the first drought-free year (measured from Sept. 1 to Aug. 31) for the taxpayer’s applicable region. The first drought-free year for the applicable region is the first 12-month period that (1) ends Aug. 31; (2) ends in or after the last year of the taxpayer’s four-year replacement period; and (3) does not include any weekly period for which the National Drought Mitigation Center reports that any location in the applicable region is in severe, extreme, or exceptional drought. The applicable region includes the county that experienced the drought conditions that necessitated the sale of the livestock plus all contiguous counties. The drought counties are shown on maps archived at the center’s website, Rather than research those archives and compile the data manually, taxpayers may rely on the listing in Notice 2012-62 for the year ending Aug. 31, 2012.

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