Tax Watch: Canada offers tax lures for backing risky exploration

Canada is offering potentially lucrative incentives to those who invest in Canadian mining exploration. However, according to the Montreal Gazette, those incentives apply only to the riskiest ventures.

The new benefits, announced last fall, are in the form of a 15% non-refundable credit. The incentive is intended to facilitate raising capital by junior exploration companies. Analysts warn that investors stand to lose everything if a company doesn’t find anything.

This latest incentive is in addition to the Canadian Exploration Expense, a tax write-off under which investors can claim a deduction of 100% of their costs.

The greatest potential benefits apply only to mineral exploration, which carries the highest risk. Under the new incentives, once a company has found something and enters into the development phase, the available tax write-off drops to 30% – 10% on oil and gas investments.

Delinquents get free ride from IRS

The Internal Revenue Service has virtually given up trying to go after more than a million tax delinquents – a move that effectively wrote off more than $2.5 billion in taxes owed the government last year alone, according to published reports.

Citing documents provided by an unidentified IRS executive, the reports revealed that more than one-third of the 3 million Americans who are late on tax payments have had their cases sent to an inactive file since June 1999, when the IRS decided to stop pursuing them. Last year, 668,018 cases were sent to the file, compared with 98 cases in 1998, the documents said.

Although some of those cases involved tens of thousands of dollars, they were too small to pursue given the agency’s resources, according to David A. Mader, assistant deputy commissioner.

The IRS’ own figures show that from 1992 to 2000, its staff shrank to 97,000, from 115,000, while the number of tax returns filed increased by 10%. During that period, the number of audits the agency performed fell by two-thirds, and seizures of property to pay back taxes declined by 99%.

President Bush’s budget would result in 1,300 fewer employees hired than recommended by the newly created IRS Oversight Board. According to the board, the change comes when demand is increasing for taxpayer education, traffic is growing at walk-in sites, and phone calls are on the rise.

In a written statement, Secretary of the Treasury Paul O’Neill said that Mr. Bush’s budget “requested adequate resources to fund necessary IRS improvements.” It represents a 7% increase over the year before, he added.

“I am confident that the amount in the president’s budget will allow the IRS to provide America’s taxpayers with better-quality service and help to enforce the tax law with integrity and fairness,” Mr. O’Neill said.

Running afoul of PHC tax rules

Much has been written about personal holding companies and how they can run afoul of the tax rules and become subject to the surtax on undistributed income.

The PHC rules can also apply to real estate corporations that receive 60% or more of their income from rents, interest or dividends.

Attempts to relabel income often fail, as they did in one recent case that came before the 10th U.S. Circuit Court of Appeals.

The McKelveys, who renovated, leased and sold properties through their closely held company, the Char-Lil Corp., tried to re-characterize PHC interest received by Char-Lil on installment sales as rent qualifying for the exception. They argued that Char-Lil was in the business of buying and selling commercial real estate.

Under the tax law, interest on obligations from the sale of real estate that is held for sale to customers in the ordinary course of business is considered rent for purposes of applying the PHC tests.

If that statute applied to the interest on Char-Lil’s installment sales notes, its rents would exceed 50% of adjusted ordinary gross income, the rents would be excluded from PHC income under the exception, and the PHC surtax would be avoided because Char-Lil would not have PHC income exceeding 60% of adjusted ordinary gross income.

However, the IRS argued that the interest re-characterization rule did not apply because Char-Lil held properties primarily for rental income, not for sale to customers in the ordinary course of business.

Thus, the interest could not be re-characterized as rent. Without it, Char-Lil’s rental income was not enough to qualify for the exclusion from PHC income.

The installment sale interest was also PHC income, and taking into account the interest and the rent, Char-Lil was subject to the PHC tax because total PHC income was at least 60% of adjusted ordinary gross income.

Both the U.S. Tax Court and the 10th U.S. Circuit Court of Appeals agreed. The fact that the average holding period was eight years and that most of the properties were never placed with real estate agents or advertised for sale indicate that the properties were not held primarily for sale to customers.

What’s more, Char-Lil claimed depreciation deductions for the property and used the installment method to report sales, but neither depreciation nor the installment method are allowed for dealer property held for sale to customers.

Cite: Char-Lil Corp., 10th Circuit, 10/25/00, affirming Tax Court Memo 1998-457

IRS chief warns of fake tax deals

Operating under a variety of “guises,” individuals and groups are misleading and enticing taxpayers “into believing that there is a way out of paying taxes,” IRS Commissioner Charles Rossotti recently told the Senate Finance Committee. He described organized tax evasion as an “important threat” to the administration of the tax system.

The schemes, according to Mr. Rossotti, range from complex prepared-documentation packages involving trusts and offshore bank accounts to promoting the idea that businesses do not need to pay employment and withholding taxes.

In terms of practical impact, the most important of the various tax schemes are those in which packages are sold to upper-income taxpayers “that claim to permit income taxes to be reduced or eliminated,” Mr. Rossotti testified.

“Basically, these packages use a flurry of paperwork involving domestic and offshore trusts, and foreign bank accounts to appear to move income into tax-free countries or legal vehicles, while taxpayers still maintain effective control over their funds,” he said.

Mr. Rossotti said those who usually buy into those schemes are taxpayers with six-figure incomes. The promoters range from bankers to convicted con men to “crooked” return preparers to Americans living abroad.

Mr. Rossotti described a new IRS initiative, known as K-1 Matching, that is to be launched next year. The IRS “will change its processing procedures and begin processing and matching K-1s reporting almost $700 million of income and also, importantly, reported losses on trusts and pass-throughs,” he said.

“This will help us to find potential problem cases and to follow up with audits when necessary.”

The IRS criminal investigation division has secured 117 convictions of individuals for illegal trust schemes, and has 135 open investigations. Mr. Rossotti stressed that the civil and criminal penalties “are stiff.”

Hire your wife, but employ her

By hiring one’s spouse, a self-employed individual may be able to get a 100% business deduction for family medical expenses.

Under a medical plan set up for employees, the hired spouse is covered as an employee, and their family coverage can include the self-employed business owner (as the employee’s spouse) plus dependents.

The employer spouse claims a business expense deduction on Schedule C for the cost of the family’s medical coverage, including reimbursed medical expenses.

But for a deduction, the spouse must be a bona fide employee. Paying a spouse a nominal amount on an informal basis for insubstantial services does not suffice, as many taxpayers have discovered.

Richard Haeder, a self-employed lawyer who worked out of a home office, set up a medical reimbursement plan for his employees, their spouses and dependents. His only “employee,” however, was his wife, who had no set work schedule or duties and was not paid a regular salary.

Generally, toward the end of each year, Mr. Haeder would transfer $2,000 from his brokerage account into an IRA in his wife’s name.

From 1989 through 1993, Mr. Haeder claimed Schedule C deductions of $29,725 for medical plan payments made for himself, his wife and their two children.

Holding that his wife was not a bona fide employee, the IRS disallowed the deductions claimed for the medical expenses and for the wife’s pay, as well as the IRA contribution deduction based on her “salary.”

The U.S. Tax Court agreed. There was no evidence, other than Mr. Haeder’s generalized testimony, that his wife worked in the home office answering the phone, greeting clients, typing and filing, and maintaining his business records.

The fact that Mr. Haeder did not pay her regular wages and gave her a Form W-2 for only one year of a six-year period further indicated that she was not a true employee.

The purported employer-employee relationship between Mr. Haeder and his wife, the court found, was merely an attempt to enable the couple to deduct personal medical and dental expenses as business costs and to provide an IRA for Mrs. Haeder. It didn’t work.

Cite: Richard Haeder, et ux., v. Commissioner, Tax Court Memo 2001-7