The Tax Court has denied the deductibility of legal fees incurred to defend a wrongful death suit brought against the sole shareholder of an S Corp. Authored by Judge Holmes in inimitable style, the opinion offers a good discussion of the various instances when a corporation can, and cannot, deduct legal fees incurred on behalf of its employees.
Read the opinion here:
Cavanaugh v. Commissioner, T.C. Memo. 2012-324
Late last week, the IRS filed a petition for rehearing en banc with the 6th Circuit Court of Appeals in U.S. v. Quality Stores. As we originally reported, the three judge panel that heard the case decided in favor of the taxpayers, triggering a potential refund opportunity for many corporate taxpayers.
The government’s petition confirms the magnitude of existing refund claims. Eight refund suits are pending in the district courts with a total of over $120 million at issue and that there are administrative refund claims totaling over $127 million from taxpayers within the jurisdiction of the Sixth Circuit (Kentucky, Michigan, Ohio and Tennessee). The IRS projects that the total amount in controversy over this issue is more than $1 billion.
Read the IRS’s Petition for Rehearing here:
Quality Stores Petition for Rehearing
The Second Circuit Court of Appeals has affirmed the ruling of the U.S. District Court for the Southern District of New York that Clause 3 of the Defense of Marriage Act (DOMA) is unconstitutional.
The case originated with a refund claim for overpaid estate taxes. Edie Windsor and Thea Spyer were a married homosexual couple from New York. Upon Thea’s death, Edie paid $363,053 in federal estate taxes because she was not eligible for the unlimited marital deduction under IRC Section 2056(a) – a benefit routinely applied to married couples of different sexes. When Edie’s claim for refund of the estate taxes was denied she filed a refund action in U.S. District Court.
The trial court held that DOMA denied Ms. Windsor equal protection under the law as guaranteed by the 5th Amendment to United States Constitution. The three judge appellate panel agreed. It added that “homosexuals have suffered a history of discrimination” and thus the proper legal standard for determining Constitutional protections is intermediate scrutiny. The court held that DOMA could not meet that standard and thus Edie’s 5th Amendment right to equal protection under the law was violated when the provisions of the Internal Revenue Code applied differently to her than to other surviving spouses.
Read the opinion here:
Windsor v. U.S., No. 12-2335 (2d Cir. Oct. 12, 2012)
On September 1, the IRS unveiled the details of a new program to encourage more offshore account holders to file U.S. income tax returns and the associated Reports of Foreign Bank and Financial Accounts (FBAR). This program is a departure from the current Offshore Voluntary Disclosure Program and its predecessors in at least one significant aspect – there are no mandatory penalties.
Taxpayers must meet a number of qualifications to take advantage of the initiative and avoid penalties. The new procedure is limited to non-residents subject to U.S. filing requirements who have not been filing U.S. income tax returns. Dual citizens meeting the non-resident, non-filing requirements also may participate. Qualifying taxpayers must have lived abroad since January 1, 2009 and not filed a U.S. tax return in that time.
Eligible taxpayers also must present a low level of compliance risk. All applications will be reviewed and the IRS will determine whether the taxpayer presents a low compliance risk. The determination will be made on the basis of returns filed under the procedure and a two-page questionnaire that each applicant must complete. High risk factors include material economic activity in the United States, ongoing IRS investigation or audit, and previously assessed FBAR penalties.
Applications will be processed in a streamlined manner if no high risk factors are present and the returns show tax due of less than $1,500 per year. The low tax liability may be within reach for many non-resident taxpayers if they are eligible for the foreign earned income and foreign housing cost exclusions under IRC Section 911.
Two important notes for taxpayers who may be considering this program. First, participation in the program does not provide protection from criminal prosecution. Second, once a taxpayer files a submission with this procedure they will no longer be eligible to participate in the Offshore Voluntary Disclosure Program (OVDP). Taxpayers interested in this program should contact a well-qualified tax professional to discuss their facts and the details of this program.
This fairly nuanced Tax Court opinion defines the scope of gross receipts for calculating research tax credits under Sec. 41. The case demonstrates that a thoughtful examination of return calculations, and what is included and excluded from those calculations, can yield significant tax savings. However, since the issue raised in this case was addressed by regulations defining gross receipts for Section 41 published after the tax years involved in the case, the direct application of this holding in current years is limited.
A vast over-simplification of the issue at controversy is as follows: Hewlett Packard sought to exclude dividends, interest, investment and other “non-sales” income from the definition of gross receipts that it used to calculate qualifying tax credits. HP wanted to reduce the total gross receipts in the calculation because the rate at which qualifying expenses became eligible for the credit increased in direct relation to the percentage of gross receipts represented by those expenses. Said differently, HP accumulated credits at a higher percentage once the qualifying expenses passed 1%, then 1.5% and finally, 2% of the gross receipts. Qualifying expenses in excess of 2% of HP’s gross receipts generated credits at the rate of 3.75% as opposed to 2.65% if the expenses were less than 1.5% of gross receipts. Thus, a lower gross receipts base meant that HP reached percentage of expenses threshold, and the higher credit percentage, more quickly.
The government argued to the contrary – a position consistent with the later promulgated regulations mentioned above. The Tax Court agreed with the government. It ruled that HP’s dividends, interest, rent, and other income must be included in total gross receipts for purposes of the calculation. You can add it all up yourself if you care to read the opinion below.
Read the opinion here:
Hewlett Packard v. Commissioner, 139 T.C. No. 8 (2012)
In a long-awaited decision, the Sixth Circuit has held that severance payments following involuntary lay-offs were not wages for FICA reporting purposes. The decision is an opportunity for refund claims by corporate taxpayers who have made similar severance payments after shutting down a physical location or line of business. Neither a bankruptcy or complete business closure is necessary. Taxpayers should contact their tax advisors to review their facts before filing a claim.
The facts of this case are as follows. Quality Stores, Inc., the operator of Central Tractor Farm & Country, went through bankruptcy proceedings beginning in the fall of 2001. Quality Stores closed all locations and operations. As part of the closures, the company filed pre- and post-petition severance plans for its employees that included payments for job losses. FICA and Federal income taxes were withheld from the payments.
Quality Stores later filed a claim for refund of over $1 million for the employer and employee portions of the remitted FICA taxes. The claim was denied by the IRS and the taxpayer sought relief in the Bankruptcy Court. The Bankruptcy Court found that the severance payments were supplemental unemployment compensation benefits (“SUB payments”) and therefore not wages for purposes of FICA withholding. The refund was proper. The District Court affirmed. The government appealed.
The Court of Appeals was asked to determine whether the payments were SUB payments, and if they were, whether or not they were also wages for purposes of FICA withholding. IRC Section 3402(o) provides for the “[e]xtension of withholding to certain payments other than wages.” The Court’s decision turned on the question of whether or not the SUB payments were “other than wages” as suggested by Section 3402(o). If the payments were not wages for FICA purposes, then the refund should be granted.
The Court of Appeals reviewed the matter de novo and agreed with the lower courts’ determinations that the payments were SUB payments. This was an important determination because it was a point of distinction between the Sixth Circuit’s analysis and that of the Federal Circuit. In CSX Corp. v. U.S., 518 F.3d 1328 (Fed. Cir. 2008), the Federal Circuit Court of Appeals held that similar severance payments were wages subject to FICA withholding.
The Sixth Circuit held that the Quality Stores payments were SUB payments as defined by a five-part test drawn from IRC Sec. 3402(o)(2)(A). In the Sixth Circuit’s view a payment meeting the following requirements was a SUB payment:
(1) an amount paid to an employee; (2) pursuant to an employer’s plan; (3) because of an employee’s involuntary separation from employment, whether temporary or permanent; (4) resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions; and (5) included in the employee’s gross income.
It further opined that the payments need not be tied to the payment of unemployment compensation and that there was no distinction between payments made in a lump sum and those made over a period of time.
By contrast, the Federal Circuit had determined that a SUB payment must meet an eight part test that was set forth in a 1956 IRS Revenue Ruling. The Sixth Circuit rejected this approach, found that the severance payments were SUB payments, and proceeded to determine the meaning and purpose of Section 3402(o).
The Sixth Circuit held that “the necessary implication” of the phrase “shall be treated as if it were a payment of wages” in Section 3402(o)(1) is “that Congress did not consider SUB payments to be “wages,” but allowed their treatment as wages to facilitate federal income tax withholding for taxpayers.” It then recognized the possibility that the language may be ambiguous, a concession to the Federal Circuit’s contrary conclusion, and reviewed the title and intent of the statute. The Court’s review yielded the same conclusion – Congress did not intend that SUB payments be treated as wages for FICA purposes and they should not be treated as such.
The Sixth Circuit’s ruling, like the CSX opinion, considered the Supreme Court’s holding in Rowan Cos. v. United States, 452 U.S. 247 (1981)(holding the definition of wages is the same for FICA and income tax purposes). It also distinguished government arguments based on the Supreme Court’s decisions in Environmental Defense v. Duke Energy Corp., 549 U.S. 561 (2007), and Mayo Found. for Med. Educ. & Research v. United States, 562 U.S. ___, 131 S. Ct. 704 (2011), and its own decision in Appoloni v. United States, 450 F.3d 185 (6th Cir. 2006). It also rejected the IRS administrative guidance that played a more significant role in the CSX decision.
This opinion has set up a clear split in the circuits and it is likely that the government will pursue further review of this case. A petition for rehearing is due on October 22. A petition for certiorari to the United States Supreme Court would be due on December 6.
Read the opinion here:
U.S. v. Quality Stores, Inc., No. 10-1563 (6th Cir. Sept. 7, 2012)
The Third Circuit Court of Appeals has reversed the Tax Court on the transfer of historic rehabilitation tax credits from the New Jersey Sports and Exposition Authority (“NJSEA”) to Pitney Bowes through the purchase of a partnership interest that held the credits.
NJSEA formed a partnership, Historic Boardwalk Hall (“HBH”), in order to sell federal historic rehabilitation tax credits (section 47) earned when it redeveloped an Atlantic City property known as East Hall. A number of investors purchased interests in the partnership. The partnership interest allowed the investors to claim ownership of the rehab tax credits for the purposes of offsetting other federal taxable income. Pitney Bowes purchased a partnership interest and used the credits to offset its taxable income.
The IRS challenged the validity of the partnerships and the two sides found themselves in the U.S. Tax Court. The Tax Court found in favor of the taxpayers in Historic Boardwalk Hall v. Commissioner, 136 T.C. No. 1 (2011). The IRS appealed.
The appellate court focused on the government’s argument that Pitney Bowes “should not be treated as a bona fide partner in HBH because [it] did not have a meaningful stake in the success or failure of the partnership.” The Third Circuit viewed the transactions through the lens of the Second Circuit’s opinion in TIFD III-E v. United States, 459 F.3d 220 (2d Cir. 2006) (better known as “Castle Harbour“) and the Fourth Circuit’s holding in Virginia Historic Tax Credit Fund LLC 2001 v. Commissioner, 639 F.3d 129 (4th Cir. 2011). Applying that perspective, the Third Circuit determined that Pitney Bowes was not a bona fide partner in the HBH partnership. It follows that Pitney Bowes therefore was not entitled to use the historical rehabilitation tax credits held in the partnership.
The taxpayer argued in favor of the substance of the partnership, but was rebuked by the Court of Appeals with this strong language, “[r]ecruiting teams of lawyers, accountants, and tax consultants does not mean that a partnership, with all its tax credit gold, can be conjured from a zero-risk investment of the sort [Pitney Bowes] made here.” As suggested by the amici in this case, this opinion may have a chilling effect on future historic redevelopment projects by limiting the transfer of the valuable historic rehabilitation tax credits generated by those projects.
Read the opinion here.
Historic Boardwalk Hall v. Commissioner, No. 11-1832 (3d Cir. August 27, 2012)
Delhaize v. Lay has been a closely followed case on the North Carolina “forced combination” question. Interest waned a bit when the North Carolina Court of Appeals decided against Wal-Mart on the same issue in Wal-Mart v. Hinton, 197 NC App, 30, 676 S.E.2d 634 (NC App. 2009). In Wal-Mart, the court found that the Department of Revenue could force combined reporting to reflect the “true earnings” of the enterprise regardless of whether or not it made a finding of “non-arm’s length pricing” between the company’s related entities. The big box retailer petitioned the North Carolina Supreme Court for review but was denied a hearing.Now comes Delhaize, the parent company of the grocery chain, Food Lion, who had the unfortunate luck to have to follow in Wal-Mart’s wake.
It all started in 1998, when Delhaize, with the assistance of Coopers & Lybrand (now PwC), entered into a state tax planning strategy designed to exploit states that employ the separate reporting method of calculating state income tax. The strategy involved isolating trademarks, trade names, and other assets in a new legal entity in a single state. The new entity would then charge the parent entity royalties and fees for the intellectual property and services housed in the new entity, usually at a pre-determined arm’s length rate. The parent entity would deduct these business expenses even though the fees collected by the new entity later would be returned to the parent company as inter-company dividends. On a consolidated tax return the fee expense and the inter-company dividend would be eliminated against one another having no real effect on reportable income. However, in a separate reporting state only the expense items hit the tax return. The result was a reduction in taxable income in the separate reporting state for the expense of payments that never left the corporate family.
Most separate reporting states had statutory provisions in place to prevent this kind of manipulation by forcing the two related entities to file a combined tax return thus bringing the dividend income back into the picture and triggering the tax neutral inter-company elimination. The arm’s length standard was often employed to justify a forced combination. If the inter-company transactions were not arm’s length, and supported by credible documentation to that effect, then the state could force the combination of the returns. This is exactly what happened under audit for Delhaize. Delhaize maintained that the transactions were arm’s length and therefore the state could not force the combination.
As we mentioned before, it was Wal-Mart who tripped up Delhaize. Wal-Mart made the arm’s length argument and lost at both the North Carolina Business Court and the Court of Appeals. When the North Carolina Supreme Court denied review of their case, the cards had been dealt. Delhaize also lost at the North Carolina Business Court on the substantive tax issues. However, they were vindicated on penalties. The Business Court found that the penalties were an unfair violation of 14th Amendment due process, a violation of the power of taxation under the North Carolina constitution, and that the state had abused its discretion in applying the penalty.
Feeling their oats after the Business Court’s strong language dismissing the penalties, Delhaize decided to try a similar approach to reverse the substantive tax issue at the Court of Appeals. Delhaize argued on appeal that North Carolina had violated their 5th Amendment Due Process rights when it changed the “guidelines” for applying its forced combination authority and adopted a “new approach” without properly notifying taxpayers. The Court of Appeals roundly rejected the argument. The other three arguments put forth by Delhaize were all rejected as governed by the binding authority of the Wal-Mart decision.
By putting the substantive tax arguments into play with the appeal, Delhaize also gave the state an opportunity to challenge the Business Court’s determination on the penalties. The state did exactly that and the Court of Appeals agreed with them. It rejected the lower court’s decision on the penalties and reversed the order to refund $1.8 million in penalties to Delhaize.
Read the entire opinion here:
Delhaize v. Lay, No. 11-868-1 (NC App. Aug. 21, 2012)
On Friday, the Large Business and International (“LB&I”) division of the IRS abandoned the Tiered Issue Process according to an announcement to the field by Division Commissioner, Heather Maloy. The IRS will replace the Tiered Issue Process with two “knowledge management groups”: Issue Practice Groups (“IPGs”) for domestic issues and International Practice Networks (“IPNs”) for international issues. Agents and managers at all levels are encouraged to contact these resource groups for guidance on unfamiliar or complex technical issues.
The Tiered Issue Process was established primarily to ensure consistent treatment of certain high-profile issues. Foreign Tax Credit Generators, Research Tax Credit Claims, and Backdated Stock Options are all examples of Tiered Issues. The IRS has replaced the Tiered Issue Process in an effort to “[balance] the need for consistency with the recognition that there is no “one size fits all” approach to examining and resolving issues.”
The L&BI withdrawal from the Tiered Issue approach is comprehensive. All Tier I, II, and III issues are no longer tiered. All guidance for these issues should no longer be consulted or followed, including Industry Director Directives (“IDDs”). References to Tiered Issues in the Internal Revenue Manual, Coordinated Issue Papers, or Industry Guides, are no longer valid.
Taxpayers currently defending a Tiered Issue at any stage of controversy should reference this guidance.
Read the release here:
LB&I-4-0812-010
The Second Circuit Court of Appeals has affirmed the decision of the Tax Court holding that Exxon Mobil is entitled to net interest for periods of overlapping underpayments and overpayments even where the statute of limitations for one “leg” of the overlapping periods has expired.
Congratulations to the taxpayer’s lead counsel and fellow blogger, Alan Horowitz, and our friend on the brief, Kevin Kenworthy.
Read the entire opinion here:
Exxon Mobil v. Commissioner, No. 11-2814 (2d Cir. August 8, 2012)
