Charitable Remainder Trust

Charitable remainder trust can be divided into separate trusts without adverse tax consequences

Rev Rul 2008-41, 2008-30 IRB

Mike Habib, EA

In the context of two fairly detailed factual situations, a new revenue ruling makes it clear that a charitable remainder trust (CRT) can be divided into two or more separate CRTs without adverse tax consequences. If properly effected, the separate trusts will continue to qualify as CRTs, the division won't be a sale, and no excise taxes will arise under Code Sec. 507(c), Code Sec. 4941 or Code Sec. 4945.

Background. In general, a charitable remainder trust (CRT) provides for a specified periodic distribution to one or more noncharitable beneficiaries for life or for a term of years with an irrevocable remainder interest held for the benefit of charity. A CRUT pays a unitrust amount at least annually to the beneficiaries as opposed to a charitable remainder annuity trust or CRAT, which pays a sum certain at least annually to the beneficiaries. (Code Sec. 664)

A CRT is exempt from income tax but is subject to tax on unrelated business taxable income. (Code Sec. 664(c))
Income, gift and estate tax deductions are allowed for the value of the charity's remainder interest in a CRT. (Code Sec. 170(f)(2), Code Sec. 2522(c)(2)(A), Code Sec. 2055(e)(2)(A)) To qualify as a CRT, numerous requirements must be met. They are spelled out in Code Sec. 664(d).

Situation 1 facts. A summary of the key facts in Situation 1 follows:
Trust qualifies as either a CRAT or CRUT. Under its terms, two or more individuals (recipients) are each entitled to an equal share of the annuity or unitrust amount, payable annually, during the recipient's lifetime, and upon the death of one recipient, each surviving recipient becomes entitled for life to an equal share of the deceased recipient's annuity or unitrust amount. Thus, the last surviving recipient becomes entitled to the entire annuity or unitrust amount for his or her life. Upon the death of the last surviving recipient, Trust's assets are to be distributed to one or more Code Sec. 170(c) charitable organizations (remainder beneficiaries).

The state court having jurisdiction over Trust has approved a pro rata division of Trust into as many separate and equal trusts as are necessary to provide one such separate trust for each recipient living at the time of the division, with each separate trust being intended to qualify as the same type of CRT.

The separate trusts may have different trustees. To carry out the division of Trust into separate trusts, each asset of Trust is divided equally among and transferred to the separate trusts. The recipients pay all the costs associated with the division of Trust into separate trusts.

Each of the separate trusts has the same governing provisions as Trust, except that: (i) immediately after the division of Trust, each separate trust has only one recipient, and each recipient is the annuity or unitrust recipient of only one of the separate trusts (that recipient's separate trust); (ii) each separate trust is administered and invested independently by its trustee(s); (iii) upon the death of the recipient, each asset of that recipient's separate trust is to be divided on a pro rata basis and transferred to the separate trusts of the surviving recipient(s), and the annuity amount payable to the recipient of each such separate CRAT is thereby increased by an equal share of the deceased recipient's annuity amount (the unitrust amount of each separate CRUT is similarly increased as a result of the augmentation of the CRUT's corpus, and each separate CRUT incorporates the requirements of Reg. § 1.664-3(b) with respect to the subsequent computation of the unitrust amount from that trust); and (iv) upon the death of the last surviving recipient, that recipient's separate trust (being the only separate trust remaining) terminates, and the assets are distributed to the remainder beneficiaries.

The remainder beneficiaries of Trust are the remainder beneficiaries of each of the separate trusts and are entitled to the same (total) remainder interest after the division of Trust as before.

Situation 2 facts. The facts are similar in Situation 2 except that the recipients are a married couple in the process of divorcing and on the death of the first recipient to die, the remainder of that separate trust goes to the charities. The trust assets do not first go to the survivor recipient as was the case before the division. Thus, the charity can wind up with more than under the original scenario but no increased charitable deduction is allowed.

Favorable rulings. IRS issued these favorable rulings with respect to both Situations 1 and 2:

(1) The pro rata division of a trust that qualifies as a CRT under Code Sec. 664(d) into two or more separate trusts does not cause the trust or any of the separate trusts to fail to qualify as a CRT under Code Sec. 664(d).

(2) The division is not a sale, exchange, or other disposition producing gain or loss, the basis under Code Sec. 1015 of each separate trust's share of each asset is the same share of the basis of that asset in the hands of the trust immediately before the division of the trust, and, under Code Sec. 1223, each separate trust's holding period for an asset transferred to it by the original trust includes the holding period of the asset as held by the original trust immediately before the division.

(3) The division does not terminate under Code Sec. 507(a)(1) the trust's status as a trust described in, and subject to, the private foundation provisions of Code Sec. 4947(a)(2) and does not result in the imposition of an excise tax under Code Sec. 507(c).

(4) The division does not constitute an act of self-dealing under Code Sec. 4941.

(5) The division does not constitute a taxable expenditure under Code Sec. 4945.

Cell Phone Deductibility

IRS discusses easing of cell phone recordkeeping requirements [Information Letter 2008-0012]:

The IRS has issued an information letter in response to a question regarding the noted difficultly that states and localities are having drafting cell phone policies that comply with IRS recordkeeping requirements.

Under IRC §162(a), individuals may take deductions for all ordinary and necessary expenses incurred in carrying on a trade or business. The expenses are considered tax-free working condition fringe benefits, not subject to FITW, FICA, and FUTA, if they are incurred by an employee on behalf of an employer. Cell phones are currently included in the definition of “listed property,” as defined in IRC §280F(d)(4).

Expenses related to listed property may not be deducted under IRC §274(d), unless the employee substantiates by adequate records, or by sufficient evidence corroborating the employee's own statement: (1) the amount of the expenses; (2) the time and place of the expenses; (3) the business purpose of the expenses; and (4) the business relationship to the employee of the persons involved in the expenses. In addition, employees must document their personal use of the property, and the employer must include such use in the employee's income.

In the information letter, the IRS acknowledges the difficulty in documenting business cell phone use. The IRS is considering various changes to the cell phone substantiation requirements. There is currently legislation in Congress that would remove cell phones from the definition of listed property and allow employers to utilize a de minimus personal use policy.

The IRS is also considering possible regulatory changes that would provide a more streamlined substantiation process for cell phones.

LP Limited Partner Deductions

Limited partner's investment interest from trader partnership deductible above-the-line

Rev Rul 2008-38, 2008-31 IRB; Ann. 2008-65, 2008-31 IRB

Mike Habib, EA

Earlier this year, IRS issued Rev Rul 2008-12, 2008-10 IRB 520 concluding that where a non-corporate limited partner doesn't materially participate in the partnership's activity, his distributive share of the interest expense on debt allocable to the entity's trade or business of trading securities is investment interest, subject to the Code Sec. 163(d)(1) deduction limitation. Because it received a number of queries as to where to report such interest, IRS has issued a new revenue ruling amplifying the earlier one and a new announcement clarifying where to report such interest.

Specifically, new Rev Rul 2008-38 provides that, in the case of an individual, interest paid or accrued on debt allocable to property held for investment described in Code Sec. 163(d)(5)(A)(ii) is (to the extent allowable after the application of the Code Sec. 163(d) limitation) a deduction described in Code Sec. 62(a)(1) and is therefore taken into account in determining the individual's adjusted gross income (AGI). New Ann. 2008-65, 2008-31 IRB clarifies that the limited partner described in Rev Rul 2008-12 properly includes the allowable amount of his distributive share of the trading partnership's interest expense in computing the limited partner's ordinary business income or loss on Schedule E of the partner's Form 1040.

Background. Deductions attributable to a trade or business carried on other than as an employee are deductible in arriving at AGI. (Code Sec. 62(a)(1))

The amount of investment interest that may be deducted in any tax year by a noncorporate taxpayer generally is limited to his net investment income for the year. (Code Sec. 163(d)(1)) Investment interest is any interest allowable as a deduction that is paid or accrued on debt properly allocable to property held for investment. (Code Sec. 163(d)(3)(A)) Property held for investment includes any interest held by a taxpayer in an activity involving the conduct of a trade or business that is not a passive activity and in which the taxpayer doesn't materially participate (as those terms are used in the Code Sec. 469 passive activity loss rules). (Code Sec. 163(d)(5)(A)(ii))

A taxpayer's activity includes an activity conducted through a partnership. (Reg. § 1.469-4(a)) An interest in an activity includes both an interest in property used in an activity and an interest in an activity held through a partnership. (Reg. § 1.469-2T(c)) Under Reg. § 1.469-1T(e)(6), an activity of trading personal property for the account of owners of interests in the activity isn't a passive activity (without regard to whether the activity is a trade or business activity).

Under Code Sec. 702(b), the character of any item of income, gain, loss, deduction, or credit included in a partner's distributive share is determined as if such item were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership.

Facts in Situation 1 of new ruling. PRS is a partnership that is engaged solely in the trade or business of trading securities for its own account and not for customers. LP, an individual, owns an interest in PRS as a limited partner. He does not materially participate in the activity in which PRS is engaged. The tax year for PRS and LP is the calendar year. PRS incurs debt in its trade or business. In Year 1, LP's distributive share of PRS' tax items includes $200,000 of interest expense incurred by PRS on its debt. LP's net investment income for Year 1 is $150,000. During Year 1, his distributive share of PRS' interest expense is the only investment interest he paid or accrued. LP' distributive share of PRS' interest expense is not subject to any limitation under Code Sec. 465.

Result in Situation 1. LP may deduct $150,000 of his $200,000 distributive share of PRS's interest expense. Under Code Sec. 163(d)(2), the $50,000 of interest expense not allowed as a deduction for Year 1 is treated as investment interest paid or accrued in Year 2. His distributive share of PRS' Year 1 interest expense that is allowed under Code Sec. 163(d)(1) is deductible in arriving at his AGI under Code Sec. 62(a)(1). The investment interest limitation does not affect the character of LP's interest expense for other purposes. Thus, except for purposes of applying the investment interest limitation, LP's distributive share of PRS' interest expense deductions are characterized under Code Sec. 702(b). Accordingly, $150,000 of LP's distributive share of the Year 1 interest expense of PRS is deductible in arriving at LP's adjusted gross income.

Situation 2 facts and result. The facts are the same as in Situation 1 except that during Year 1 LP also pays $100,000 of interest expense on debt properly allocable to stocks and bonds held by LP for investment (within the meaning of Code Sec. 163(d)(5)(A)(i)). Under Code Sec. 163(d)(1), LP is allowed to deduct only $150,000 of his $300,000 of investment interest expense in Year 1. To the extent that this amount is attributable to debt incurred in PRS' trade or business, the deduction is taken into account in arriving at LP's AGI; to the extent it is attributable to the debt allocable to the stock and bonds held for investment, the deduction is reported as an itemized deduction. When an individual, such as LP, has both investment interest expense attributable to property described in Code Sec. 163(d)(5)(A)(i) and investment interest expense attributable to property described in Code Sec. 163(d)(5)(A)(ii) and his aggregate investment interest expense is greater than his net investment income, he must allocate his net investment income to the two categories of investment interest expenses using a reasonable method of allocation. One reasonable method is to allocate the net investment income to the two categories of investment interest in the same proportion that the amount of investment interest in each category bears to the total amount of investment interest (the pro rata method). As shown in Rev Rul 2008-38 this method would allow LP to deduction $100,000 above-the-line and $50,000 below the line.

Opportunity Letter - Offshore Account

Judge: IRS can seek tax information from Swiss banking giant UBS in expanding investigation

Associated Press WorldStream via NewsEdge :

MIAMI_A federal judge agreed Tuesday to allow the IRS to serve legal papers on Swiss banking giant UBS AG in an expanding investigation into U.S. taxpayers who may have used overseas accounts to hide assets and avoid taxes.

The order from U.S. District Judge Joan Lenard came one day after the Justice Department requested authority for the IRS to issue "John Doe" summons to UBS. The summons are used in IRS tax fraud investigations when the identity of the people involved is not known.

Lenard said in a two-paragraph order that based on the government court filings, "there is a reasonable basis for believing such a group or class of persons may fail or may have failed to comply" with U.S. tax laws.

The summons will allow the IRS to obtain information about American taxpayers who have UBS accounts but did not file required forms detailing their taxable income.

"The order clears the way for the IRS to take the next steps against wealthy individuals who don't pay their taxes," said IRS Commissioner Doug Shulman in a written statement. "People with hidden foreign accounts can no long rest easy."

UBS has said it is cooperating with Swiss and U.S. investigations and will disclose records involving U.S. clients who might have broken tax laws.

U.S. taxpayers are required to report all foreign financial accounts if their total value exceeds $10,000 at any point during a given year, prosecutors said. Failure to report the accounts can result in a penalty of up to 50 percent of the amount in the accounts.

The Justice Department requested the summons after former UBS private banker Bradley Birkenfeld, 43, pleaded guilty in a Florida federal court to defrauding the IRS. Birkenfeld, who is cooperating with investigators, said in court that UBS has about $20 billion in assets in undeclared accounts for U.S. taxpayers.

Prosecutors said Birkenfeld and others helped California billionaire Igor Olenicoff hide $200 million in assets overseas. Olenicoff, who controls a real estate empire, pleaded guilty last year to tax charges and agreed to pay the IRS more than $52 million.

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Rules for claiming a dependent child

Final regs on dependent child of divorced or separated parents or parents who live apart T.D. 9408, 07/01/2008; Reg. § 1.152-4

Mike Habib, EA

IRS has issued final regs on the rules for claiming a child as a dependent by parents who are divorced, legally separated under a decree of separate maintenance or a written separation agreement, or who live apart at all times during the last 6 months of the calendar year. They are effective for tax years beginning after July 2, 2008, and reflect amendments under the Working Families Tax Relief Act of 2004 (WFTRA) and the Gulf Opportunity Zone Act of 2005 (GOZA).

Background. A taxpayer may deduct an exemption amount for a dependent, defined generally as a qualifying child or a qualifying relative. Code Sec. 152(e), as amended by § 404 of GOZA, carries rules for parents who (1) are divorced or legally separated under a decree of divorce or separate maintenance, (2) are separated under a written separation agreement, or (3) live apart at all times during the last 6 months of the calendar year. A child of parents described in (1), (2), or (3), is treated as the qualifying child or qualifying relative of the noncustodial parent if the child receives over one-half of his support during the calendar year from the child's parents, the child is in the custody of one or both of the child's parents for more than half of the calendar year, and:

• the custodial parent signs a written declaration that the custodial parent will not claim a child as a dependent for a tax year and the noncustodial parent attaches the declaration to the noncustodial parent's tax return (Code Sec. 152(e)(2); or
• a qualified pre-'85 instrument allocates the dependency exemption to the noncustodial parent and the noncustodial parent provides at least $600 for the support of the child during the calendar year. (Code Sec. 152(e)(3))

A custodial parent is the parent having custody for the greater portion of the calendar year and the noncustodial parent is the parent who is not the custodial parent. (Code Sec. 152(e)(4)) If a child is treated as the qualifying child or qualifying relative of the noncustodial parent under Code Sec. 152(e), then that parent may claim the child for purposes of the dependency deduction under Code Sec. 151 and the child tax credit under Code Sec. 24, if the other requirements of those provisions are met.

In May of 2007, IRS issued proposed regs on the rules for a dependent child of divorced or separated parents or parents who live apart. IRS has now adopted the proposed regs as final regs, with some modifications.

Final regs. The final regs update the prior final regs, deleting obsolete provisions, revising language to improve clarity, and incorporating provisions in Reg. § 1.152-4T, which is removed. They also provide guidance on issues that have arisen in the administration of Code Sec. 152(e).

Custodial parent. Like the proposed regs, the final regs define the custodial parent as the parent with whom the child resides for the greater number of nights during the calendar year (the counting nights rule). In response to commentators' concern that this rule doesn't address how the child's residence for a night is determined (e.g., by the child's physical location at a given time such as midnight, or by where the child sleeps) and for which year the night of Dec. 31 to Jan. 1 is counted, the final regs clarify that, for purposes of Code Sec. 152(e), a child resides for a night with a parent if the child sleeps (1) at the parent's residence (whether or not the parent is present); or (2) in the company of the parent when the child does not sleep at a parent's residence (for example, if the parent and child are on vacation). The time that a child goes to sleep is irrelevant. A night that extends over two tax years is allocated to the tax year when the night begins: for example, the night that begins on Dec. 31, 2008, is counted for tax year 2008. (Reg. § 1.152-4(d))

To remedy any ambiguity caused by the proposed regs' failure to define custody, the final regs provide that a child is in the custody of one or both parents for more than one-half of the calendar year if one or both parents have the right under state law to physical custody of the child for more than one-half of the calendar year. But, a child isn't in the custody of either parent for purposes of Code Sec. 152(e) when the child reaches the age of majority under state law. (Reg. § 1.152-4(c))

Release of the right to claim a child. Under Code Sec. 152(e)(2), a custodial parent may release a claim to an exemption for a child by signing a written declaration that he will not claim the child as a dependent. The final regs retain the rule in the proposed regs that a written declaration not on Form 8332, Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent, (or successor form) must conform to the substance of Form 8332. The final regs further provide that a release not on a Form 8332 must be a document executed for the sole purpose of releasing the claim. A court order or decree or a separation agreement cannot serve as the written declaration. If a release of a claim to a child is for more than one year, the noncustodial parent must attach a copy of the written declaration (rather than the original, as required in the proposed regs) to the parent's return for the first tax year for which the release is effective. Copies must also be attached to returns for later years. (Reg. § 1.152-4(e))

Revocation of release of claim. Under both the final and proposed regs, a custodial parent who released the right to claim a child could revoke the release for future tax years by providing written notice of the revocation to the other parent. The final regs require that the parent revoking the release notify, or make reasonable attempts to notify, in writing, the other parent of the revocation. What is a reasonable attempt is determined under the facts and circumstances, but mailing a copy of the written revocation to the noncustodial parent at the last known address or at an address reasonably calculated to ensure receipt satisfies this requirement. A revocation can be made on Form 8332, or successor form designated by IRS. A revocation not on the designated form must conform to the substance of the form and be in a document executed for the sole purpose of revoking a release. A taxpayer revoking a release may attach a copy rather than an original to the taxpayer's return for the first tax year the revocation is effective, as well as for later years. (T.D. 9408, 07/01/2008, Reg. § 1.152-4(e)(3))

The final regs also clarify that a multiple year written declaration executed in a tax year beginning on or before July 2, 2008, that satisfies the requirements for the form of a written declaration in effect at the time the written declaration was executed is treated as satisfying the requirements for the form of a release under the final regs. However, the rules for revoking a release of a claim to an exemption apply without regard to whether a custodial parent executed the release in a tax year beginning on or before July 2, 2008; such a release executed may be revoked. (Reg. § 1.152-4(e)(5))

Property Seizure Compliance

TIGTA results of 2008 review IRS compliance with legal guidelines when conducting property seizures [Audit Report No. 2008-30-126]:

IRS has usually followed the numerous legal and internal guidelines that apply to seizures of taxpayers' property, the Treasury Inspector General for Tax Administration (TIGTA) said in a recent audit. TIGTA based its opinion on a review of a random sample of 50 of the 683 seizures conducted from July 1, 2006, through June 30, 2007.

Auditors identified 25 instances in which IRS did not comply with a particular Code requirement but, according to TIGTA, this represented an error rate of only about 1%. The problems identified in the audit included the following—10 instances in which expenses and proceeds resulting from the seizure weren't properly applied to the taxpayers' accounts; five instances in which the sales of seized properties weren't properly advertised; five instances in which the correct amounts of the liabilities for which the seizures were made weren't provided on the notices of seizures sent to the taxpayers; and five instances that were redacted from the publicly released version of the audit.

The audit is located at http://treas.gov/tigta/auditreports/2008reports/200830126fr.pdf .

Unemployment Benefits Extended

New bill extends unemployment benefits for 13 weeks

The President has signed into law H.R. 2642, “The Supplemental Appropriations Act of 2008.”

Title IV of the bill authorizes an extension of unemployment insurance (UI) benefits. Individuals may be eligible for 13 weeks of extended benefits if they: (1) are fully or partially unemployed after July 5, 2008, (2) have exhausted their benefits in their regular UI claim, and (3) are ineligible to file a new claim.

The extension will be available to workers in all states, and can be used on top of the 26 weeks of benefits that typically are available. The maximum benefit is equal to the lesser of: (a) 50% of the maximum benefit that individuals received on their regular UI claim, or (b) 13 times the weekly benefit amount on their regular claim.

Extended benefits will be available through the week that begins June 29, 2009. The provision was included as part of an emergency war spending bill.

House passes AMT relief

House passes AMT relief with bipartisan majority - President threatens veto

On June 25, the House by a vote of 233 to 189 approved H.R.6275, the “Alternative Minimum Tax Relief Act of 2008.” The bill will be sent to the Senate for consideration.

The bill would patch the alternative minimum tax (AMT) problem for 2008 by extending for one year AMT relief for nonrefundable personal credits and increasing AMT exemption amounts to $69,950 for joint filers and $46,200 for individuals. The one-year AMT patch would be fully offset with a variety of revenue raising measures, including taxing certain carried interests as ordinary income, barring large integrated oil companies from claiming the Code Sec. 199 domestic production activity deduction, freezing the Code Sec. 199 deduction at the 6% level for other producers of oil and natural gas, and requiring information returns for merchant payment card reimbursements.

On June 24, in a Statement of Administration Policy, President Bush indicated that he would veto the bill because of his strong opposition to provisions raising taxes on certain partners in partnerships and taxes on payments by U.S. subsidiaries to foreign affiliates and limiting the availability of the domestic production deduction for certain oil companies.

Shareholder Constructive Distribution

Loan repayment to shareholder's spouse wasn't constructive distribution Beckley, 130 TC No. 18 (2008)

Mike Habib, EA

The Tax Court has ruled that payments made by a corporation to the wife of one of its shareholders represented repayment of money she advanced to a predecessor corporation. Despite the absence of a written loan agreement, the repayment wasn't a constructive distribution to the shareholder.

Facts in brief. In '88, Alan Beckley and Robert Ebert incorporated CT Inc., a software development company and each owned 50% of the company. CT often ran short of funds and in '88 through '99, it borrowed at least $106,834 from Alan's wife, Virginia. The corporation used the borrowed funds to develop a working model of Web-based video conferencing software. CT had financial problems and was dissolved in '98. In 2000, VDN, Inc., was incorporated to succeed to CT's business and to continued to develop business products. Alan was a shareholder in VDN. The working model of the video conferencing software developed by CT was transferred to VDN in 2000, but the latter did not execute a written loan assumption agreement with regard to CT's loan repayment obligation to Virginia. She did not make a claim against CT for repayment of the funds she lent to it, did not treat her loan to CT as a worthless loan, and did not claim an ownership interest in the working model.

In 2001, VDN paid Virginia $95,434. It treated $58,600 of that amount as interest which it reported on Form 1099–INT and the balance as repayment of principal. Virginia reported the interest portion of the payment on her return as interest. In 2002, VDN paid Virginia $70,000. Virginia treated the $70,000 as repayment of principal. On its returns for 2001 and 2002, VDN deducted the payments to Virginia as nonemployee compensation.

In 2003 Alan Beckley and Robert Ebert were terminated by VDN, and it made no further payments to Virginia.
When it audited the Beckleys' returns for 2001 and 2002, IRS didn't challenge their characterization of the amounts received from VDN, but asserted that one half of the amounts received by Virginia also were corporate distributions taxable as capital gain to Alan. IRS's theory was that VDN's payments to Virginia on her loan to CT were made without any legal obligation to do so and only on the basis of a personal moral obligation of Alan and Ebert to repay Virginia. Thus, it argued that VDN's payments represented constructive corporation distributions.

Amounts represented loan repayment. The Tax Court ruled that the facts didn't support IRS's theory that VDN's payments to Virginia were made to satisfy only personal moral obligations of Alan and of Ebert. Although VDN did not execute a written loan assumption agreement, it effectively purchased the working model from CT, assumed at least part of CT's obligation to repay Virginia's loan to CT, and thus, its payments to Virginia related to that original loan. Although there was no written agreement reflecting VDN's obligation to repay Virginia, its conduct in actually making payments to Virginia, which related to her loan to CT and to CT's transfer of the working model to VDN, established the loan repayment character of the payments. In addition, the Form 1099-INT that VDN mailed to Virginia and to IRS for 2001 reflected that $58,600 represented interest on a loan.

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Employment / Payroll Tax Adjustments

Final regs include new process for reporting employment tax adjustments and refund claims
T.D. 9405, 06/30/2008, Reg. § 31.6011(a)-1, Reg. § 31.6011(a)-4, Reg. § 31.6011(a)-5, Reg. § 31.6205-1, Reg. § 31.6302-1, Reg. § 31.6402(a)-1, Reg. § 31.6413(a)-1, Reg. § 31.6403(a)-2

Mike Habib, EA

IRS has issued final regs on employment tax adjustments and refund claims, effective Jan. 1, 2009. The final regs modify the process for making interest-free adjustments for both underpayments and overpayments of Federal Insurance Contributions Act (FICA) and Railroad Retirement Tax Act (RRTA) taxes and Federal income tax withholding (ITW).

Background on interest-free adjustments and refunds. While generally interest must be paid to IRS on any tax underpayment and to a taxpayer on any tax overpayment, an exception applies to employment taxes. Where an incorrect amount of tax under Code Sec. 3101 (employee FICA tax), Code Sec. 3111 (employer FICA tax), Code Sec. 3201 (employee RRTA tax), Code Sec. 3221 (employer RRTA tax), or Code Sec. 3402 (ITW) is reported to IRS for any payment of wages or compensation, Code Sec. 6205(a) and Code Sec. 6413(a) allow employers to make interest-free adjustments for underpayments and overpayments, respectively.

Under the prior Code Sec. 6205(a) regs, if a return is filed and less than the correct amount of employee or employer portions of FICA or RRTA tax is reported and paid, the employer adjusts the underpayment (a) by reporting the additional amount due as an adjustment on a current return, or (b) by reporting such additional amount on a supplemental return. For overpayments of employment taxes, Code Sec. 6413(b) allows a refund claim to be filed when an interest-free adjustment cannot be made. Under the prior Code Sec. 6413 regs, IRS allows taxpayers to choose between filing a claim for refund and making an interest-free adjustment to correct an overpayment of employment taxes.

Late in 2007, IRS issued proposed regs on employment tax adjustments and refund claims (see Federal Taxes Weekly Alert 01/03/2008). The proposed regs have now been adopted with only minor changes.

Revised adjusted return process. The final regs are issued in connection with IRS's development of new forms to report adjustments to employment taxes which will replace the existing process of reporting adjustments on regularly filed employment tax returns. The regs are part of IRS's effort to reduce taxpayer burdens by allowing employers to make employment tax adjustments on a separately filed form as soon as an error is ascertained, rather than as a line adjustment on the regularly filed employment tax return. The new adjusted return will not affect the liability reported on the current return. Under the regs, the forms used to accept an assessment of employment taxes after an examination (Form 2504, Agreement and Collection of Additional Tax and Acceptance of Overassessment (Excise or Employment Tax), and Form 2504-WC, Agreement to Assessment and Collection of Additional Tax and Acceptance of Overassessment in Worker Classification Cases (Employment Tax)) constitute adjusted returns. (Reg. § 31.6205-1)

Interest-free adjustments. The final Code Sec. 6205 regs set out the procedures for making interest-free adjustments for underpayments of employment taxes. If a return is filed and less than the correct amount of employee or employer FICA or RRTA tax is reported, and the employer discovers the error after filing the return, the employer adjusts the resulting underpayment of tax by reporting the additional amount due on an adjusted return for the return period in which the wages or compensation was paid. The adjustment must be made by the due date of the return for the return period in which the error is ascertained, and the amount of the underpayment must be paid by the time the adjustment is made, or interest will begin to accrue from that date. An underpayment adjustment can only be made within the period of limitations for assessment. For underpayments of ITW where the incorrect amount was withheld, subject to limited exceptions, an adjustment can only be made for errors ascertained during the calendar year in which the wages were paid. (Reg. § 31.6205-1(b)(2))

The final regs also provide for interest-free adjustments of underpayments of FICA tax, RRTA tax, and ITW under certain circumstances where the underpayment arises because the employer failed to file an original return or failed to report and pay the correct type of tax. (Reg. § 31.6205-1(b)(3), Reg. § 31.6205-1(c)(3))

The final Code Sec. 6413(a) regs set out the procedures for making interest-free adjustments for overpayments of employment taxes. If an employer ascertains an overpayment error within the applicable period of limitations on credit or refund, it's required to repay or reimburse its employees the amount of overcollected employee FICA or RRTA tax before the expiration of that period. However, the requirement to repay or reimburse doesn't apply to the extent that taxes weren't withheld from the employee or if, after reasonable efforts, the employer cannot locate the employee. In such a case, the employer can make an adjustment for only the employer share of FICA or RRTA tax. An interest-free adjustment for an overpayment cannot be made once a claim for refund has been filed. (Reg. § 31.6413(a)-1)

Once an employer repays or reimburses an employee to the extent required, the employer may report both the employee and employer portions of FICA or RRTA tax as an overpayment on an adjusted return. The employer must certify on the adjusted return that it has repaid or reimbursed its employees to the extent required.

Under the final regs, the reporting of the overpayment constitutes an interest-free adjustment if the overpayment is reported on an adjusted return filed before the 90th day prior to expiration of the period of limitations on credit or refund. Similar rules apply for making interest-free adjustments for ITW overpayments, except that an interest-free adjustment can only be made if the employer ascertains the error and repays or reimburses its employees within the same calendar year that the wages were paid and reports the adjustment on an adjusted return. (Reg. § 31.6413(a)-2)

No repayment or reimbursement for interest-free adjustments of overpayments. Unlike in the proposed reg, in the final regs the employer isn't required to repay or reimburse the employee or to adjust the overpayment by the due date of the return for the return period following the return period in which the error is ascertained. (Reg. § 31.6402-2(a)(1)) After reconsideration, IRS determined there was insufficient reason to impose a timing restriction other than the period of limitations on credit or refund of taxes. (T.D. 9405, 06/30/2008)

Deposits, payments, and credits. An employer making an interest-free adjustment must pay the amount of the adjustment by the time it files an adjusted return. The timely payment satisfies the employer's deposit obligations for the adjustment. (Reg. § 31.6302-1(c)(7)) In determining the amount of accumulated taxes in an agricultural employer's lookback period (which determines the employer's deposit schedule), adjustments to tax liability made under the filing of adjusted returns or refund claims aren't taken into account; new agricultural employers are treated as having employment tax liabilities of zero for any lookback period before the date the employer started or acquired its business. (Reg. § 31.6302-1(g)(4))

If the underpayment amount isn't paid when the adjusted return is filed, interest begins to accrue as of the date the adjusted return is filed. (Reg. § 31.6205-1(b)(2))

The adjusted overpayment amount will be applied as a credit toward payment of the employer's liability for the calendar quarter (or calendar year for annual returns being adjusted) in which the adjusted return is filed, unless IRS notifies the employer that the credit will be applied to a different return period or that the employer isn't entitled to the adjustment under applicable laws or procedures. (Reg. § 31.6413(a)-2(b)(2))

Refunds for overpayments. As in the prior regs, instead of making an interest-free adjustment for an overpayment, employers can file a claim for refund for the amount of the overpayment. Furthermore, if an employer can't make an interest-free adjustment for an overpayment because the period of limitations for claiming a credit or refund for the overpayment will expire within 90 days or because IRS has otherwise notified the employer that it's not entitled to the adjustment, the employer can recover the overpayment only by filing a claim for refund. (Reg. § 31.6413(a)-2(d))

An employer can file a claim for refund of an overpayment of FICA or RRTA tax, but must certify that it has repaid or reimbursed the employee's share of FICA or RRTA tax to the employee or has secured the employee's written consent to allowance of the refund or credit. However, the employer isn't required to repay or reimburse the employee or obtain the written consent of the employee to the extent that the overpayment doesn't include taxes withheld from the employee or, after reasonable efforts, the employer cannot locate the employee or the employee, once contacted, will not provide the requested consent. (Reg. § 31.6402(a)-2(a)) The final regs under Code Sec. 6414 set out similar procedures for filing a claim for refund of overpaid ITW, except that an employer can't file a claim for refund of an overpayment of ITW for an amount the employer deducted or withheld from an employee. (Reg. § 31.6414-1(a))

IRS intends to issue guidance to provide examples of how the final regs apply in different factual scenarios. (T.D. 9405, 06/30/2008)