Aggressive Enforcement Program says the Commissioner

New IRS Commissioner Shulman airs his philosophy to ABA audience:

The question of whether IRS will focus on services or enforcement poses a false choice, IRS Commissioner Douglas Shulman, who became the 47th Commissioner of Internal Revenue on March 24, 2008, told an American Bar Association audience on May 9.

The agency must do both of these and do them very well, he said. “Stated another way, IRS should do everything possible to make it as seamless and easy as possible for those taxpayers who are trying to pay the right amount of taxes to navigate our organization, get their questions answered, pay their taxes and get their way,” Shulman said. “But for those who understand their federal tax obligation, but fail to comply, we must have an aggressive enforcement program,” he added.

Shulman said he brought two “philosophical inclinations” to his job as Commissioner - the belief that IRS must understand the economic realities of the environment in which taxpayers operate and the belief that IRS must do everything possible to provide clear guidance to taxpayers. He also touched on “a few specific areas of focus,” including the need to continue on the path of modernizing IRS, the challenge of maintaining strong leadership and a dedicated workforce, addressing the increasing globalization of tax administration, and targeting the root causes of noncompliance.

In addition, Shulman stressed the importance of increased transparency. “When all parties are working from the same information, the opportunity for miscommunication and misunderstanding decreases dramatically,” he said. He elaborated on this subject with a cautionary note. “IRS personnel must not confuse greater transparency of information with greater authority over taxpayers,” Shulman said. “More than ever, the IRS will need consistent procedures, training, and an organizational commitment to using data in a way that is fair to taxpayers.”

On a lighter note, Shulman, who assumed his position on March 24, admitted to ignoring the sage advice of several former IRS commissioners—do not take office until after April 15.

For more information about Shulman, click here: http://www.irs.gov/irs/article/0,,id=98192,00.html

Tax Medicaid Rebates Adjustments

IRS clarifies ruling allowing drug manufacturers to subtract Medicaid rebates from gross receipts

Rev Rul 2008-26, 2008-21 IRB

In a revenue ruling that clarifies an earlier one issued in 2005 on the same subject, IRS concludes that Medicaid Rebates that a pharmaceutical manufacturer pays to State Medicaid Agencies are adjustments to the sales price in calculating gross receipts rather than ordinary and necessary business expenses that are deductible from gross income under Code Sec. 162.

Observation: In lieu of the foregoing conclusion, the earlier ruling (Rev Rul 2005-28, 2005-19 IRB 997) stated that Medicaid Rebates incurred by a pharmaceutical manufacturer are purchase price adjustments that are subtracted from gross receipts in determining gross income. Also, unlike Rev Rul 2005-28, the current ruling specifically states that its holding is limited to Medicaid Rebates that a pharmaceutical manufacturer pays pursuant to the Medicaid Rebate Program established by the Omnibus Budget Reconciliation Act of 1990.

Observation: IRS had reached the opposite conclusion in Field Service Advice 200101004 where it concluded that rebates paid by pharmaceutical manufacturers to state Medicaid agencies under the Medicaid Rebate Program couldn't be excluded from the manufacturer's gross sales as a discount or price adjustment. Had IRS not changed its view in Rev Rul 2005-28 and Rev Rul 2008-26, an issue could have arisen as to whether Code Sec. 162(c)(3) would bar any business expense deduction for the rebates. It provides that no business expense deduction is allowed for any rebate made by a provider of services, supplier, physician or other person who furnishes items or services for which payment is or may be made under the Social Security Act, or in whole or in part out of federal funds under a state plan approved under such act, if the rebate is made in connection with the furnishing of such items or services or the making or receiving of such payments.

Background on Medicaid rebates. The Omnibus Budget Reconciliation Act of 1990 (the Act) established the Medicaid Rebate Program to increase Medicaid beneficiaries' access to prescription drugs. Under the Act, pharmaceutical manufacturers must sign a Rebate Agreement with the Department of Health and Human Service (HHS) to gain access to the Medicaid-funded segment of the pharmaceutical market.

The Rebate Agreements require pharmaceutical manufacturers to pay Medicaid Rebates directly to each State Medicaid Agency. A Medicaid Rebate is a portion of the price paid by State Medicaid Agencies to retailers for covered outpatient drugs dispensed to Medicaid beneficiaries. The amount of the Medicaid Rebate is designed to ensure that the Medicaid Program is charged no more for covered outpatient drugs than any other purchaser.

Facts of ruling. M, which uses an accrual method of accounting and files returns on a calendar year basis, manufactures and sells prescription drugs. In '92, it entered into a “Rebate Agreement” with HHS. In 2005, the following events occur:

• M sells Product D, a prescription drug, to W, a wholesaler;
• W sells Product D to R, a retail pharmacy;
• R dispenses Product D to individual A, a Medicaid beneficiary, and then files a reimbursement claim with S, a State Medicaid Agency;
• S approves the claim and then reimburses R for the cost of Product D plus a dispensing fee; and
• M pays a Medicaid Rebate to S under the Rebate Agreement.

Background on tax treatment. In a manufacturing business, gross income means the total sales, less the cost of goods sold, plus any income from investments and from incidental or outside operations or sources. (Reg. § 1.61-3(a)) Ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business are deductible. (Code Sec. 162)

In Pittsburgh Milk Co, (1956) 26 TC 707, the Tax Court addressed whether allowances, discounts, or rebates paid by a milk producer to certain purchasers of its milk, in willful violation of state law, are adjustments to the purchase price of the milk resulting in a reduced sales price, or ordinary and necessary business expenses under Code Sec. 162 (in which case no deduction would be allowed under Code Sec. 162(c)). The court found that the allowances were part of the sales transaction and concluded that gross income must be computed with respect to the agreed net prices for which the milk was actually sold. Thus, under Pittsburgh Milk, where a payment is made from a seller to a purchaser, and the purpose and intent of the parties is to reach an agreed upon net selling price, the payment is properly viewed as an adjustment to the purchase price that reduces gross sales.

Rev Rul 76-96, 1976-1 CB 23, concluded that an automobile manufacturer that offered rebates to retail customers who independently negotiated a purchase price with the dealer could deduct the rebates as ordinary and necessary business expenses under Code Sec. 162 .

Analysis. Rev Rul 2008-26 notes that the Medicaid Rebate is paid by M to S pursuant to the terms of the rebate agreement. Under the purpose and intent test of Pittsburgh Milk , the Medicaid Rebate is a factor used in setting the actual selling price, negotiated and agreed to before the sale to W takes place.

Observation: In Rev Rul 2005-28 the foregoing sentence read as follows: “Under the purpose and intent test of Pittsburgh Milk , the Medicaid Rebate is made with the purpose and intent of reaching an agreed upon net selling price, and is negotiated and agreed to before the sale to W takes place.”

Accordingly, as noted above, in language that varies somewhat from that in Rev Rul 2005-28, Rev Rul 2008-26 concludes that Medicaid Rebates that a pharmaceutical manufacturer pays to State Medicaid Agencies are adjustments to the sales price in calculating gross receipts rather than ordinary and necessary business expenses that are deductible from gross income under Code Sec. 162.

Effect on other rulings. Rev Rul 2008-26 clarifies and supersedes Rev Rul 2005-28. Rev Rul 2008-26 notes that Rev Rul 2005-28 suspended, in part, Rev Rul 76-96. Rev Rul 2008-26 then states that IRS is reconsidering whether a rebate of the type described in Rev Rul 76-96 is an ordinary and necessary business expense or, alternatively, is an adjustment to the sales price in calculating gross receipts. Therefore, pending IRS's reconsideration of the issue and publication of subsequent guidance, IRS will not apply, and taxpayers may not rely on, the conclusion of Rev Rul 76-96 that rebates made by the manufacturer are ordinary and necessary business expenses deductible under Code Sec. 162.

Observation: Using somewhat different language, Rev Rul 2005-28 also said that Rev Rul 76-96 could not be relied on pending its reconsideration by IRS.

Observation: Thus, while Rev Rul 2008-26 nominally involved a drug manufacturer, its scope is far broader as a result of the reconsideration of the stated conclusion in the earlier ruling.

Observation: Should IRS conclude that rebates are allowed only as an adjustment to the sales price and are not deductible as ordinary and necessary business expenses, this could actually be good for taxpayers because (1) they would not be faced with the bar on deductions under Code Sec. 162(c), and (2) they could qualify for a potentially larger research credit if the credit is reinstated and its amount is again determined with reference to a taxpayer's research expenditures as measured under a formula taking into account its gross receipts.

Benefits of Passthrough Entities

Which tax-free and tax-favored fringe benefits are passthrough owners entitled to?

Partnerships, LLCs treated as partnerships, and S corporations have distinct tax and nontax advantages. However, entrepreneurs considering these forms of business should be aware that fewer tax-free and tax-favored fringe benefits are available to owner-entrepreneurs of passthroughs than to shareholder-employees of C corporations. This Practice Alert reviews which fringe benefits can be made available on a tax-preferred basis to partners, members of LLCs taxed as partnerships, and more-than-2% S shareholder-employees. It helps practitioners advise clients who are thinking of operating a business as a passthrough, or are operating as a passthrough and are looking for ways to maximize their tax-free compensation.

Note that the statutory rules allowing or denying fringe benefits to passthrough owners are stated explicitly only in the context of partners and partnerships. However, under the default classification rules of Reg. § 301.7701-3(b)(1)(i), a domestic eligible entity with two or more members automatically is treated as a partnership unless it elects to be taxed as an association (i.e., as a corporation). And under Code Sec. 1372 , for fringe-benefit purposes, more-than-2% S corporation shareholder-employees are subject to the rules that apply to partners, and S corporations are treated as partnerships. As a result, unless otherwise noted, the tax consequences of fringes for members of LLCs taxed as partnerships and for more-than-2% S shareholder-employees are the same as they are for partners.

Working condition fringe benefits. Property or services supplied by an employer to an employee are tax-free working condition fringe benefits (WCFBs) if the employee would be entitled to a business expense deduction under Code Sec. 162 or Code Sec. 167 for the item had he paid for it himself. (Reg. § 1.132-5(a)(1)(i)) For WCFB purposes, the term “employee” includes partners who perform services for the partnership. (Reg. § 1.132-1(b)(2)(ii)) Thus, partners may receive the following WCFBs tax-free:

• Business-related use of a company auto, if properly substantiated. (Reg. § 1.132-5(a)(1)) The personal-use value of the auto must, however, be treated as compensation income. (Reg. § 1.61-21(a)(1))
• The business-use portion of company paid country club dues, even though the dues are completely nondeductible. (Reg. § 1.132-5(s))
• Job-related education expenses paid by the firm. (Reg. § 1.132-1(f))
• Job placement assistance. (Rev Rul 92-69, 1992-2 CB 51)

De minimis fringe benefits. For purposes of the tax-free de minimis fringe benefit rules, “employees” include any recipient of a fringe benefit. (Reg. § 1.132-1(b)(4)) So partners are entitled to get tax-free supper or supper money or local transportation fare if provided on an occasional basis in connection with overtime work. (Reg. § 1.132-6(d)(2)(i)) Other de minimis fringes include:

• traditional birthday or holiday gifts of property (not cash) with a low fair market value (an undefined term in the regs), occasional theater or sporting event tickets, and fruit, books, or similar property provided under special circumstances (e.g., on account of illness, outstanding performance, or family crisis) (Reg. § 1.132-6(e)); and
• traditional awards (such as a gold watch) upon retirement after lengthy service. (H Rept No. 99-426 (PL 99-514) p. 105)

Dependent care assistance. Partners are eligible for the Code Sec. 129 dependent care assistance exclusion. (Code Sec. 129(e)(3)) The exclusion is for amounts provided under a written plan of the employer and is limited annually to $5,000 ($2,500 for a married person filing separately). However, for a plan to qualify as a dependent care assistance program, no more than 25% of the amounts paid or incurred by the employer for dependent care assistance during the year may be provided for the class of individuals who are shareholders or owners (or their spouses or dependents), each of whom (on any day of the year) owns more than 5% of the stock or of the capital or profit interest in the employer. (Code Sec. 129(d)(4))

Educational assistance programs. Under Code Sec. 127, employers can set up educational assistance programs under which employees can receive up to $5,250 per year of graduate- or undergraduate-level educational assistance tax-free, whether or not job-related. Employees for this purpose include partners who have earned income from their partnerships, which, in turn, are treated as employers of these partners. (Code Sec. 127(c)(2); Code Sec. 127(c)(3); Code Sec. 401(c)(1)) However, no more than 5% of the cost of annual benefits may be provided for the class of individuals (and their spouses and dependents) each of whom (on any day of the year) own more than 5% of the stock or of the capital or profits interest in the employer. (Code Sec. 127(b)(1))

Athletic facilities. The Code Sec. 132(j)(4) exclusion for on-premises athletic facilities (e.g., swimming pool, gym) is available to partners (and their spouses and/or children). (Reg. § 1.132-1(b)(3))

No-additional-cost services and qualified employee discounts. For purposes of these tax-free fringes, partners who perform services for a partnership are treated as employed by the partnership. (Reg. § 1.132-1(b)(1))

Transportation fringes. A partner cannot exclude qualified transportation fringes under Code Sec. 132(f) (currently, the value of qualified parking up to $200 a month, and up to $115 a month of the combined value of transit passes and transportation in a commuter highway vehicle). (Code Sec. 132(f)(5)(E); (Reg. § 1.132-9(b), Q&A 24(a)) However, under the de minimis benefit rules, tokens or fare cards provided by a partnership to a partner that enable the recipient to commute on a public transit system (not including privately-operated van pools) are excludable from income if the value of the tokens or farecards in any month doesn't exceed $21. If the full value of a pass provided in a month exceeds $21, the full value of the benefit is includible. (Reg. § 1.132-9(b), Q&A 24(b)) In addition, if a partner would be able to deduct the cost of parking as a business expense (e.g., parking cost incurred in connection with traveling from the regular office to another business office), the value of the free or reduced-cost parking is excludable as a working condition fringe benefit.

Trust & Estate Tax Resolution

Transfers to LLC were not includable in decedent's estate
Estate of Mirowski, TCMemo 2008-74

The Tax Court has held that assets the decedent transferred to a family limited liability company (LLC) shortly before she died were not includable in her gross estate under Section 2036(a).

Facts. The decedent's husband was a cardiologist who developed an implantable cardioverter defibrillator (ICD) device to prevent people who suffered from ventricular fibrillation from dying because they were not in a hospital near an external defibrillator. The husband died in 1990, and, pursuant to his will, his interest under the ICD patents license passed to the decedent. Sales of ICDs increased significantly after the husband's death, and royalties received under the ICD patents license increased dramatically from thousands of dollars a year to millions of dollars a year.

In 1992, the decedent created an irrevocable spendthrift trust for each of her three daughters and their respective issue and funded the trusts with the ICD royalties. After the funding, the decedent held a 51.09% interest in the royalties, and each trust held a 7.2616% interest in the royalties. The decedent named all three daughters as co-trustees of each of the trusts because she wanted them to have a close working relationship.

By 1998, after the royalties had increased dramatically, the decedent decided to begin to consolidate her investments in an account with Goldman Sachs. She finished the consolidation in early 2001. Prior to that, by early 2000, the decedent began to think of ways, in addition to the trusts, to provide for her daughters and grandchildren and to allow them to work together closely. She settled on an LLC to achieve her goals. On 8/31/00, the decedent's attorney sent the decedent and her daughters a draft articles of organization and operating agreement for the LLC. The family decided to wait until their next annual get-together, which was scheduled to take place in August 2001, to discuss this matter.

In the meantime, in January 2001, the decedent developed a diabetic foot ulcer and began medical treatment. Although such an ulcer requires care and treatment, a patient is expected to recover. In August 2001, the daughters and their families took their annual vacation together and held their annual meeting on 8/14/01, at which the decedent was not present. At the meeting, the daughters discussed with the decedent's lawyer:

(1) The decedent's plans to form the LLC
(2) The decedent's plans to make respective gifts of interests in the LLC to the daughters' trusts.
(3) The manner in which the LLC was to function
(4) The daughters' responsibilities with respect to the LLC.

After the meeting, the lawyer finalized the documents required for the decedent to form the LLC. Although the decedent understood that there could be tax benefits from forming the LLC, these benefits were not the most significant factor in her decision to form the LLC. Instead, the decedent had the following legitimate, nontax purposes for forming, and transferring the bulk of her assets to, the LLC:

(1) Joint management of the family's assets by her daughters and eventually her grandchildren.
(2) Maintenance of the bulk of the family assets in a single pool of assets in order to allow investment opportunities that would not be available if the decedent were to make separate gifts of a portion of her assets to each of her daughters or to their trusts.

(3) Providing for each of her daughters and then her grandchildren on an equal basis.

Additionally, the decedent wanted to provide additional protection from potential creditors for the interests in the family assets that she intended to provide her daughters and grandchildren.

At the time of the family meeting, the decedent's health was not rapidly deteriorating, and in fact, she was planning to have a cataract operation to enhance her vision and improve her quality of life. The following timeline shows the events in the weeks leading up to her death.

• 8/27/01: The decedent executed the LLC's articles of organization and operating agreement.
• 8/30/01: The LLC's articles of organization were accepted by the state for filing.
• 8/31/01: The decedent was admitted to the hospital for further treatment of her foot ulcer.
• 9/1/01: The decedent transferred property to the LLC, including the ICD patents and her 51.09% interest in the royalties; in exchange, she received a 100% interest in the LLC.
• 9/5-7/01: The decedent transferred to the LLC securities and cash worth more than $62 million that she held in the Goldman Sachs account. After the transfers to the LLC, the decedent retained more than $7.6 million of assets in her own name, which was more than enough to meet her living expenses.
• 9/7/01: The decedent gave a 16% interest in the LLC to each of her daughters' trusts.
• 9/10/01: Unexpectedly, the decedent's condition deteriorated significantly. She refused to consider amputation and all additional medical treatment. She developed sepsis and died the next day.

Pursuant to the decedent's will, the daughters' trusts inherited, in equal shares, the decedent's 52% interest in the LLC. As a result, after probate, the trusts would own collectively 100% of the LLC in three equal shares. The LLC continued as a valid functioning investment operation and managed business matters related to the ICD patents and license agreement. As the decedent hoped, the daughters, in their capacities as officers of the LLC and trustees of the trusts have actively worked together to manage the LLC's assets.

In 2002, the decedent's estate paid estimated gift tax of $11,750,623 with funds that the LLC distributed to it. Thereafter, the decedent's personal representatives reported the gifts of the 16% interests in the LLC at a value of $5.7 million each. They reported gift tax for 2001 of $9,729,280, which resulted in a $2,021,343 credit to the estate. The estate return showed estate tax of $14,119,863, which the estate paid with funds distributed from the LLC.

The IRS determined that there was an estate tax deficiency of $14,243,208. The Service said that the total of the date-of-death fair market value of all the assets the decedent transferred to the LLC of $71,153,000 was includable in her gross estate under Section 2036(a), an increase of $43,385,000 from the value of the decedent's LLC interests reported.

Transfers to the LLC. The estate argued that although the decedent's transfers to the LLC were transfers of property under Section 2036(a), they fell under the exception for a “bona fide sale for an adequate and full consideration in money or money's worth.” The estate pointed out that (1) the decedent had legitimate and substantial nontax reasons for forming and transferring assets to the LLC; (2) she received an interest in the LLC proportionate to the value of the assets transferred to it; (3) her capital account was properly credited with those assets; and (4) in the event of LLC's liquidation and dissolution, she had the right to a distribution of property from her capital account.

The IRS argued that the exception did not apply to the decedent's transfers because she had no legitimate, significant nontax reason for forming and transferring assets to the LLC. The Service urged the Tax Court to disregard the testimony of the decedent's children regarding the nontax reasons the decedent decided to form and fund the LLC because of their relationship to the decedent and the estate. The court refused to do so and found that the decedent had the following legitimate nontax reasons for forming and funding the LLC:

(1) Joint management of the family assets by the daughters and eventually the grandchildren.
(2) Maintenance of the bulk of the family's assets in a single pool to provide better investment opportunities.
(3) Providing for each daughter and grandchild on an equal basis.

The court also rejected the Service's other contentions that the exception did not apply:

(1) The decedent did not fail to retain sufficient assets outside of the LLC for her anticipated financial obligations. According to the court, the decedent's only anticipated significant obligation was the substantial gift tax liability resulting from her gifts of the 16% LLC interests to the daughters' trust. The court said that there was no express or unwritten agreement to use LLC assets to pay that liability, which the decedent could have paid by using a portion of the substantial assets she retained and did not transfer to the LLC, by using the distributions she expected to receive as a 52% interest holder in the LLC from the royalty payments, or by borrowing against her personal asserts and her 52% LLC interest.

(2) The LLC was a valid functioning investment operation and was managing the business matters related to the ICD patents and patent license.

(3) The decedent did not delay forming and funding the LLC until shortly before her death and her health began to fail. The court pointed out that the decedent's death was unexpected, so she and the daughters did not anticipate the estate taxes and obligations arising as a result of her death. Although the decedent had been treated for her foot ulcer for eight months and was admitted to the hospital a week before she died, until the day before she died, expectations were that she would recover

(4) The court said that the Service's contention that the decedent sat on both sides of her transfers to the LLC ignored the fact that the decedent fully funded the LLC and that the daughters' trusts did not contribute any assets. According to the IRS, the Service's argument would mean that single member LLCs would not be able to take advantage of the bona fide sale exception under Section 2036(a).

(5) Although the LLC distributed more than $36 million to the decedent's estate to pay estate obligations, including transfer taxes, the court again pointed out that the decedent died unexpectedly, and the parties did not discuss the estate obligations that would arise as a result of the decedent's death.

(6) The Service argued that, in substance, the decedent received only a 52% interest in the LLC in exchange for transfers to the LLC of 100% of its assets because she did not contemplate forming and funding the LLC without making the gifts to the daughter's trusts. As a result, according to the IRS, the decedent did not receive an interest in the LLC in proportion to her investment, and thus the bona fide sale exception to Section 2036 did not apply. The court rejected this argument, pointing out that although related, the transfers and the gifts were separate.

Gifts to the trusts. The estate acknowledged that the gifts of the 16% interests in the LLC to the trusts were transfers of property and were not bona fide sales for adequate and full consideration. It argued, however, that there was no express or implied agreement that the decedent would retain the possession or enjoyment of, or the right to income from, the property transferred. The IRS claimed that at the time she made the gifts and at the time of her death, there was an agreement, both express and implied, that the decedent retain the possession or enjoyment, or the right to the income from, the respective 16% interests in the LLC that she gave to the trusts.

The IRS argued that, as the LLC's general manager, the decedent under the LLC's operating agreement expressly retained the authority to decide the timing and amounts of distributions from the LLC. It also claimed that the operating agreement expressly gave the decedent, as the majority LLC holder (or as general manager), the authority to determine the timing and the amount of distributions when the LLC is liquidated and dissolved. The court rejected these contentions, pointing out that the operating agreement provided specific distribution methods, which had to be followed. Thus, there was no express agreement in the operating agreement (or elsewhere) that the decedent retain possession or enjoyment, or the right to income from the 16% gifts (Section 2036(a)(1)), or the right to designate persons who would possess or enjoy the 16% interests or the income from the interests (Section 2036(a)(2))

In support of its claim that there was an implied agreement that the decedent retained an interest or right described in Section 2036(a)(1) with respect to the 16% gifts, the court pointed out that the Service relied on essentially the same contentions that it used to argue that the LLC transfers were not bona fide sales. It did not fare any better here, as the court rejected the contentions for the reasons stated above.

Innocent Spouse Tax Relief

Innocent spouse relief granted despite ex-husband's objection
Bishop, TC Summary Opinion 2008-33

The Tax Court agreed with the IRS and, over the objection of the taxpayer's ex-husband, held that the taxpayer was entitled to equitable relief under Section 6015(f) from her husband's tax underpayments.

Facts. The taxpayer married in 1982, and the couple had two children. The husband was previously a revenue agent who conducted income tax audits for the IRS. However, in 1995, he pled guilty to the charge of bribing a public official and was sentenced to 28 months in prison. He was released from prison in 1997 and rejoined his family. Thereafter, he began working as an auditor for a state agency. The taxpayer was employed as a claims processor for a health insurance company. The couple separated in 2003 and were divorced in 2004.

Before and after 2000, the taxpayer and her husband began to live beyond their means, incurring substantial expenses and debts. The husband was domineering; he controlled the couple's financial matters and prepared their federal income tax returns. During the years at issue (2000-2002), he decreased his tax withholding by increasing his exemptions and advised the taxpayer to do the same. These actions resulted in underpayments of tax for the years 2000-2002 and the failure to pay unpaid tax liabilities after they were assessed.

The taxpayer did not sign the joint federal income tax returns for 2000 and 2001, and her husband did not disclose or discuss the return's contents. However, she gave her Forms W-2 to the husband for those years, and they were attached to the returns. Not until late 2002 or early 2003 did the taxpayer become aware that the husband had made no payments on the unpaid taxes for 2000 and 2001 ($2,532 and $4,685, respectively).

The taxpayer did sign the couple's joint federal tax return for 2002. The total underpayment for that year was $6,105. The taxpayer subsequently corrected her withholding and entered into an installment agreement with the IRS to pay the balance of her tax due for 2003. At the time of the trial, she was current in paying her federal income tax.

Some time after the couple divorced, the taxpayer filed a request with the IRS for relief from joint and several liability under Section 6015(f) with respect to her unpaid federal income tax liability. Although the IRS initially determined that the taxpayer was not entitled to relief, on review, it changed its mind and concluded that she was entitled to relief. The ex-husband, however, objected, asserting that the taxpayer should pay her share of the taxes, which meant that the Tax Court had to determine whether the taxpayer was entitled to relief under Section 6015(f) for the relevant years.

Court's opinion. The court pointed out that because the taxpayer was seeking relief from underpayments of tax, rather than understatements of tax, relief was not available to her under Sections 6015(b) and (c), and her only avenue for relief was Section 6015(f)'s equitable relief. Under section 4.02(1) of Rev. Proc. 2003-61, 2003-2 CB 296, however, Section 6015(f) equitable relief will ordinarily be granted if each of the following elements is satisfied:

(1) On the date of the request for relief, the requesting spouse is no longer married to, or is legally separated from, the nonrequesting spouse, or has not been a member of the same household at any time during the 12-month period ending on the date of the relief request.

(2) On the date the requesting spouse signed the joint return, he or she had no knowledge or reason to know that the nonrequesting spouse would not pay the income tax liability.

(3) The requesting spouse will suffer economic hardship if the Service does not grant relief.

The court said that the taxpayer was divorced from the husband and would suffer economic hardship if relief was not granted. Also, she may not have been aware of the tax liabilities on the 2000 and 2001 returns because she did not sign them or discuss them and did not actually know that there were unpaid taxes until late 2002. The court, however, believed that the taxpayer should have had reason to know that the tax liabilities might exist because of the couple's mounting debts and severe financial situation. The court pointed out that she knew there were unpaid taxes for 2002 because she signed the return for that year and confronted her husband about the unpaid taxes for all three years. Additionally, the taxpayer knew about the tax liabilities when she joined the husband as a party in a chapter 13 bankruptcy proceeding in February 2003. Therefore, the court concluded that the taxpayer did not satisfy the knowledge element of Rev. Proc. 2003-61, section 4.02, and did not qualify for equitable relief under that section.

Luckily for the taxpayer, this did not end the inquiry. If a spouse fails to qualify for relief under section 4.02 of Rev. Proc. 2003-61, the IRS may still grant relief under section 4.03 of that Procedure. Section 4.03 lists factors that the Service will take into account in determining whether to grant equitable relief under Section 6015(f). No single factor is determinative, all factors are to be considered and weighed appropriately, and the list of factors is not exclusive.

(1) Marital status. The taxpayer and her husband separated in 2003 and divorced in 2004. (Factor weighed in favor of granting relief.)

(2) Economic hardship. The taxpayer's monthly income barely covered her monthly expenses. She was raising two children and had not received child support from her husband since 2004. In addition, when the husband was in prison, the taxpayer incurred considerable debt in order to support the family, which she was paying off. Therefore, the taxpayer would suffer economic hardship if relief was not granted. (Factor weighed in favor of granting relief.)

(3) Knowledge or reason to know. As mentioned above, the taxpayer had reason to know that her husband was not going to pay the tax liabilities. (Factor weighed against granting relief.)

(4) Nonrequesting spouse's legal obligation. The divorce decree did not contain a provision as to which spouse had a legal obligation to pay the outstanding tax liabilities. (Factor was neutral.)

(5) Significant benefit. The taxpayer did not receive significant benefit beyond normal support from the unpaid tax liabilities. (Factor was neutral.)

(6) Compliance with income tax laws. Tax compliance is a factor considered only against granting relief. The IRS did not contend that the taxpayer did not make a good faith effort to comply with her federal income tax obligations in years subsequent to 2002. (Factor did not apply.)

(7) Abuse. While the taxpayer was not physically abused by the husband, she suffered mental and emotional abuse at his hands. He yelled and threatened her, he accessed her bank account to pay pornography sites, and he had an affair, which led to the divorce. The taxpayer also feared he would retaliate against their children. (Factor weighed in favor of granting relief.)

The court found three factors in favor of relief, one against, and the rest neutral. Accordingly, it concluded that it would be inequitable to hold the taxpayer liable for the underpayments of tax, and she was entitled to relief under Section 6015(f).

Foreign earned income exclusion

IRS fact sheet explains foreign earned income exclusion
IRS Fact Sheet May 2008

Mike Habib, EA

IRS has issued a fact sheet that explains the foreign earned income exclusion rules.

Observation: Although the fact sheet is a valuable summary of the complex foreign earned income rules that apply starting with the 2006 tax year, it does not contain references to Code sections or IRS guidance. We have added them for the reader's convenience.

Background. As noted in the fact sheet, U.S. citizens and resident aliens are taxed on their worldwide income, whether the person lives inside or outside of the U.S. However, qualifying U.S. citizens and resident aliens who live and work abroad may be able to exclude from their income all or part of their foreign salary or wages, or amounts received as compensation for their personal services. In addition, they may also qualify to exclude or deduct certain foreign housing costs. (Code Sec. 911)

General rule. To qualify for the foreign earned income exclusion, a U.S. citizen or resident alien must:

• have foreign earned income (income received for working in a foreign country);
• have a tax home in a foreign country; and
• meet either the bona fide residence test or the physical presence test. (Code Sec. 911)

Exclusion amounts and limits. The foreign earned income exclusion amount is adjusted annually for inflation. For 2008, the maximum foreign earned income exclusion is up to $87,600 per qualifying person. If taxpayers are married and both spouses (1) work abroad and (2) meet either the bona fide residence test or the physical presence test, each one can choose the foreign earned income exclusion. Together, they can exclude as much as $175,200 for the 2008 tax year. (Code Sec. 911(b)(2)(D), Rev Proc 2007-66, 2007-45 IRB 970, Sec. 3.30)

In addition to the foreign earned income exclusion, qualifying individuals may also choose to exclude or deduct from their foreign earned income a foreign housing amount. The amount of qualified housing expenses eligible for the housing exclusion and housing deduction is limited, generally, to 30% of the maximum foreign earned income exclusion. For 2008, the housing amount limitation is $26,280 for the tax year. However, the limit will vary depending on where the qualifying individual's foreign tax home is located and the number of qualifying days in the tax year. (Code Sec. 911(c)(2)) The foreign earned income exclusion is limited to the actual foreign earned income minus the foreign housing exclusion. Therefore, to exclude a foreign housing amount, the qualifying individual must first figure the foreign housing exclusion before determining the amount for the foreign earned income exclusion. (Code Sec. 911(d)(7))

How to claim the exclusion. Since the foreign earned income exclusion is voluntary, qualifying individuals must choose to claim it. The foreign earned income exclusion and the foreign housing cost amount exclusion are claimed and figured using Form 2555, which must be attached to Form 1040. However, if only the foreign earned income exclusion is claimed, a shorter Form 2555-EZ may be used instead. Once the choice is made to exclude foreign earned income, that choice remains in effect for the year the election is made and all later years, unless revoked. (Code Sec. 911(e))

What isn't foreign earned income. Foreign earned income does not include the following amounts:

• Pay received as a military or civilian employee of the U.S. Government or any of its agencies.
• Pay for services conducted in international waters (not a foreign country).
• Pay in specific combat zones, as designated by a Presidential Executive Order, that is excludable from income.
• Payments received after the end of the tax year following the year in which the services that earned the income were performed.
• The value of meals and lodging that are excluded from income because it was furnished for the convenience of the employer.
• Pension or annuity payments, including social security benefits. (Code Sec. 911(b)(1)(B))

Self-employment income. A qualifying individual may claim the foreign earned income exclusion on foreign earned self-employment income. The excluded amount will reduce his regular income tax, but will not reduce his self-employment tax. Also, the foreign housing deduction - instead of a foreign housing exclusion - may be claimed.

Figuring the tax. A qualifying individual claiming the foreign earned income exclusion, the housing exclusion, or both, must figure the tax on the remaining non-excluded income using the tax rates that would have applied had the individual not claimed the exclusions. (Code Sec. 911(f))

Foreign tax credit or deduction. Once the foreign earned income exclusion is chosen, a foreign tax credit, or deduction for taxes, cannot be claimed on the income that can be excluded. (Code Sec. 911(d)(6)) If a foreign tax credit or tax deduction is claimed for any of the foreign taxes on the excluded income, the foreign earned income exclusion may be considered revoked.

Earned income credit. Once the foreign earned income exclusion is claimed, the earned income credit cannot be claimed for that year. (Code Sec. 32(c)(1)(C))

Timing of election. Generally, a qualifying individual's initial choice of the foreign earned income exclusion must be made with one of the following income tax returns:

• a return filed by the due date (including any extensions);
• a return amending a timely-filed return;
• amended returns generally must be filed by the later of 3 years after the filing date of the original return or 2 years after the tax is paid; or
• a return filed within 1 year from the original due date of the return (determined without regard to any extensions). (Reg. § 1.911-7(a)(2)(i)(D))

Revoking the exclusion. A qualifying individual can revoke an election to claim the foreign earned income exclusion for any year. This is done by attaching a statement to the tax return revoking one or more previously made choices. The statement must specify which choice(s) are being revoked, as the election to exclude foreign earned income and the election to exclude foreign housing amounts must be revoked separately. If an election is revoked, and within 5 years the qualifying individual wishes to again choose the same exclusion, he must apply for approval by requesting a ruling from IRS. (Code Sec. 911(e)(2))

If you are having tax problems either collection notices or audit and examination, contact our office today for a free consultation on how to resolve your tax matter.

Payroll Tax Audit? Now What Are Your Options?

IRS or State Payroll Tax Audit & Employment Tax Audit

The word audit can strike a very real sense of fear into the hearts of even the most courageous of men. When you own a business, there is even more at stake than a few minor penalties or fees; you can lose everything you’ve worked so hard to create. If you are facing a payroll tax audit you need to make every effort to cooperate with your auditor. The best way to prepare for a payroll tax audit, and therefore survive the audit, is to keep excellent records for several years past on hand and have them stored completely and according to year in case you are faced with an audit many years after the fact.

The first thing you need to do in order to keep everything straight when it comes to surviving a payroll tax audit is to keep your accounting practices current. Many businesses do this by either outsourcing their payroll responsibilities to firms that deal exclusively with payroll matters, including payroll taxes, or hiring an in-house bookkeeper to handle their payroll. The benefits of either of these is great because laws regarding payroll taxes and withholdings change regularly and are so complex in general.

You should also insure that you have the proper resources in place when it comes to avoiding a payroll tax audit or at the very least coming away from one without owing any back taxes, fines, or penalties is one of the biggest responsibilities a business owner faces. If you aren’t willing to pay for outsourcing this responsibility to someone that is qualified as an outsider you very well may want to consider hiring a fulltime staff member who has the expertise and qualifications to devote to insuring accurate payroll deductions are made. As a licensed tax professional specializing tax problems resolution, I can represent you in your payroll tax audit to advocate your position and make sure your options and your rights are taken care of.

You should also take the time each year to review your records and check for mistakes. While it won’t help you avoid a payroll tax audit this little effort made each year can save you a great deal of time and many headaches should one arise. In addition you will find out during the course of the ‘internal audit’ whether or not any information is missing, incomplete, or inaccurate and handle it immediately rather than finding out two or three years after the fact.

If you find, during the course of your internal audit or review, that you are going to have problems with your payroll tax audit it would be wise to secure the services of our firm in order to help you deal with the outcome of your payroll audit and assist you when negotiating payment options and reducing penalties. The IRS is a formidable foe and you do not want to face them unprepared or alone if it can be avoided. It could cost considerably more than it has to. There are options available, even if you owe a considerable amount of money.

As a licensed tax professional specializing tax problems resolution, I may be able to negotiate some amazing things on your behalf when it comes to your payroll tax audit and a potentially negative or outright negative outcome. Honest mistakes are made every day when it comes to handling payroll taxes don’t allow your mistakes, when discovered through a payroll tax audit be the end of your business — especially when a well qualified and experienced tax professional like Mike Habib, EA can make all the difference in the world.

Sales Tax Audit? Now What Are Your Options?

State Sales Tax & Use Tax Audits and Examination - why you need a tax professional on your side

Mike Habib, EA
myIRSTaxRelief.com

Among the most frightening words a business owner can hear are the words: sales tax audit. There are many reasons why this is a phrase that should be feared, not the least of which is that the negative outcome of a sales tax audit may cost you your business, your accounts receivable, your current business & personal assets, and can leave you starting over with nothing. There are options available to you though, keep reading to learn how you can survive this trying time.

Begin with the best possible defense - an exemplary system of record keeping when it comes to sales tax paid, received, and possible exemptions. Document everything and review your documents with an internal sales tax audit yearly. This gives you a great opportunity to catch mistakes that may have been made and correct them before an actual audit takes place. You will also want to review your documentation immediately prior to your audit.

When faced with a sales tax audit, or a use tax audit, you need to go to the tax resolution experts. Chances are that you either have a bookkeeper on staff or you use an outside bookkeeping firm in order to file sales and tax state reports. You may consider the valuable services of our firm for assistance with the your sales tax audit as well as dealing with the potential outcome and any consequences that may apply.

Many businesses find that the sting of owed sales tax is not nearly as lethal as the time and attention that must be dedicated to the process of a sales tax audit. This takes hours of work finding the documentation, defending the receipts for tax-exempt items, and time is money in the business world. Unfortunately, this is a necessary evil. The penalty for not complying with the taxing authorities in this matter are simply too devastating to consider.

When experiencing a sales tax audit you need to provide the auditor with a nice quiet place in which to work, all the documentation he or she needs and/or requests, and a basic overview of how your business operates. Be prepared to provide follow up documentation if necessary and to defend certain transactions along the way. The purpose of the sales tax audit in all honesty is to generate more money for the state so cooperate but don’t roll over.

Our firm is well-qualified and can assist you from the very beginning of your sales tax audit by speaking the language of your sales tax auditor. Many auditors are much more approachable when dealing with a licensed tax representative rather than dealing with individual taxpayers and business owners. Let our firm work for you and the tax savings are likely to pay for the service and so much more.

Having a tax expert on your team such as Mike Habib, EA often helps when enduring a sales tax audit. He knows the tax code and will be able to identify potential pitfalls prior to the audit in addition to being able to help you defend certain transactions that may fall within gray areas of the tax code or negotiate with your auditor if necessary. The most important thing you can do to prepare for a sales tax audit however is to avoid panic and let the tax experts do their job while you try going about your own as seamlessly as possible while waiting on the verdict.

For sales tax and use tax audit representation CLICK HERE.

Employee vs. Independent Contractor Tax Problems

New bill seeks to reduce worker misclassifications

H.R. 5804, 4/15/08 [Taxpayer Responsibility, Accountability, and Consistency Act of 2008]

Rep. James McDermott (D-Wash) has introduced legislation that would revise employee vs. independent contractor rules and increase information reporting penalties The legislation is called the “Taxpayer Responsibility, Accountability, and Consistency Act of 2008,” and it primarily focuses on Section 530 of the Revenue Act of 1978. Under Section 530, employers that meet the following three requirements are protected from potentially large employment tax assessments, even though they incorrectly categorized a worker as an independent contractor: (1) reasonable basis, (2) substantive consistency, and (3) reporting consistency. An employer can meet the “reasonable basis” requirement if judicial precedent, IRS rulings, a past IRS audit, or industry practice supports the classification of a worker as an independent contractor. An employer meets the substantive consistency requirement if it (and any predecessor business) consistently treated the workers in question as independent contractors. The reporting consistency requirement is met if the employer has not classified the workers as employees on any required federal tax returns, including information returns.

New Rules. The new legislation would repeal Section 530 and replace it with a new Code section, IRC §3511, that would make it more difficult for employers to avoid employment tax liability if they misclassified a worker as an independent contractor. IRC §3511 would generally require employers to have a “reasonable basis” for classifying a worker as an independent contractor. The “reasonable basis” standard is met only if:

(1) The employer classified the worker as an independent contractor based on: (i) a written determination (as defined in IRC §6110(b)(1)) that it received addressing the employment status of either the worker in question, or another individual holding a substantially similar position with the employer; or (ii) an employment tax examination of the worker, or another individual holding a substantially similar position with the employer, that did not conclude that the worker should be treated as an employee; and

(2) The employer (or a predecessor) has not treated any other individual holding a substantially similar position as an employee for employment tax purposes for any period beginning after Dec. 31, 1977.

The new legislation would not allow an employer to rely on an examination commenced, or a written determination issued, more than seven years before the beginning of the period in question. For purposes of IRC §3511, the determination as to whether an individual holds a position substantially similar to a position held by another individual would be made in accordance with the Fair Labor Standards Act.

The IRS would issue its determination of worker status no later than 90 days after the filing of a petition with respect to employment status in any industry where employment is transient, casual, or seasonal (e.g., construction). The new statute would apply to services rendered more than one year after the date that the legislation is enacted. Section 530 would not apply to services rendered more than one year after the date that the legislation is enacted.

Increase in Information Reporting Penalties. Under current law, a taxpayer that doesn't file a correct information return may be subject to the following penalties:

• a $15 per return penalty if corrected within 30 days after the due date, up to a maximum total penalty of $75,000 a year ($25,000 for small businesses);
• a $30 per return penalty if corrected later than 30 days after the due date but before August 1, up to a maximum penalty of $150,000 a year ($50,000 for small businesses);
• a $50 per return penalty if not corrected by August 1 (or if a return is not filed at all), up to a maximum penalty of $250,000 a year ($100,000 for small businesses).

A “small business” is defined as a concern whose average annual gross receipts for the three most recent tax years ending before the calendar year in which the returns are due (or for the entire period of its existence, if less than three years) are $5 million or less.

Increase in penalties. Under the new law, a taxpayer that doesn't file a correct information return would be subject to the following penalties:

• a $50 per return penalty if corrected within 30 days after the due date, up to a maximum total penalty of $500,000 a year ($175,000 for small businesses);
• a $100 per return penalty if corrected later than 30 days after the due date but before August 1, up to a maximum penalty of $1,500,000 a year ($500,000 for small businesses);
• a $250 per return penalty if not corrected by August 1 (or if a return is not filed at all), up to a maximum penalty of $3,000,000 a year ($1,000,000 for small businesses).

The new law would also increase the penalties for failure to furnish a correct payee statement, intentional disregard of the rules, and failure to comply with other information reporting requirements (see IRC §6723).

To resolve your payroll tax problem contact us today.

1600% Increase in IRS Tax Levies since 2000

TIGTA report "Trends in Compliance Year Activities Through Fiscal Year 2007" [Audit Report No. 2008-30-095]:

Fiscal year 2007 marked another period of improvement in IRS's compliance activities, continuing an eight-year period of upward trends in such endeavors, the Treasury Inspector General for Tax Administration (TIGTA) said in a new audit.

Many enforcement activities continued to increase despite a slight reduction in the staffing of the Collection and Examination functions, the audit said, adding that both functions plan to hire enforcement personnel during FY 2008. The Collection and Examination Enforcement budget was flat for FY 2006 through FY 2008, but President Bush's budget proposal for FY 2009 calls for an 8% increase, the audit noted. The amount of enforcement revenue collected increased by almost 74% in the last five years.

The number of Collection Field function (CFf) revenue officer personnel working assigned delinquent cases decreased by 4% to 3,724 by the end of FY 2007. “Although revenue officer staffing is down, many compliance activities continued to increase and results improved during FY 2007,” TIGTA said. Some of the improvements may be attributable to an FY 2005 organizational change in the Small Business/Self-Employed Division and efforts to improve business processes, the audit said. Activities showing positive results for the Collection function during FY 2007 included the following—dollars collected on Taxpayer Delinquent Accounts (TDAs) by Automated Collection System and CFf employees increased by 3% over FY 2006; the average amount collected per CFf staff year on TDAs increased by 2% over the preceding year; and the number of TDAs closed and the number closed by full payment increased by 7% and 6% respectively.

In FY 2007, the number of liens issued was 683,659, while levies totaled 3,757,190 and seizures totaled 676. All of these were upward movements. In comparison, in FY 2000, there were 287,517 liens issued, the number of levies was 219,778 and seizures amounted to 74.

The audit is available at http://treas.gov/tigta/auditreports/2008reports/200830095fr.pdf.