Tax Watch: IRS gets poor marks from oversight board

The Internal Revenue Service Oversight Board has issued a scathing review of the agency’s performance. The same report also criticizes President Bush’s 2002 IRS budget.

“The IRS is not meeting any of the goals and objectives demanded by Congress and the American taxpayers,” says the interim report, “The IRS Budget Fiscal Year 2002: Analysis and Recommendations.”

“Service to taxpayers is inadequate, and enforcement activities have dropped to a dangerous level, giving the impression that it is easy to get away with cheating. The agency’s computer systems are completely outdated, while the number of IRS employees continues to drop while the workload increases.”

The report claims that the IRS sometimes does not provide top-quality service, and when it does, it is not always through fair and uniform application of the law. And it does not provide a work environment that leads to satisfactory productivity.

The Oversight Board recommends a 2002 budget of $10.25 billion compared with the administration’s request for $9.42 billion. It says that its recommended budget, “which is 8.9% higher than the administration’s budget, fully supports [a] program of modernization and improvement.

“The administration’s 2002 budget does not adequately support the IRS strategic plan, and provides inadequate support for technology modernization.”

Secretary of the Treasury Paul O’Neill countered that Mr. Bush has requested adequate resources to make necessary improvements. “In balancing competing priorities in the budget, the president has requested a sensible but significant 7% increase in funding for the IRS, which is nearly twice the average governmentwide increase,” Mr. O’Neill said.

“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.”

Medical corporation

misnamed dividends

It’s becoming an almost daily occurrence. The U.S. Tax Court has ruled that a portion of bonuses paid to shareholders working for a personal services corporation were non-deductible disguised dividends, not compensation.

Although the case involved a medical company, such a scenario could affect any professional.

Pediatric Surgical Services employed shareholder surgeons who received monthly salaries and cash bonuses, and non-shareholder surgeons who received only monthly salaries.

Pediatric deducted payments to the shareholder surgeons as officers’ compensation. The IRS disallowed part of the deductions, reasoning that they were dividends.

Tax Court Judge James S. Halpern rejected the corporation’s argument that the IRS’ deficiency adjustments raised new matters. The court ruled that the IRS had put Pediatric on notice that its business expense deductions were at issue.

The court noted that in order for a payment to be deductible as compensation for services, it must be both reasonable and purely for services.

The court, relying on its own calculations regarding the corporation’s profits and expenses, found that the deductions Pediatric claimed for the surgeons’ salaries exceeded the reasonable allowance for services they actually rendered.

The court found that the IRS had properly characterized portions of the bonuses as disguised dividends.

The court also sustained the IRS’ accuracy-related penalty, finding a lack of good faith.

Cite: Pediatric Surgical Associates PC v. Commissioner, T.C. Memo 2001-81

A split decision for financial pro

The U.S. Tax Court recently ruled that a financial services professional could take claimed interest deductions for loans related to the acquisition and renovation of two nursing homes. That financial pro was, however, held liable for the accuracy-related penalties for claimed net operating losses that he was unable to document.

Thomas Rosser operated a sole proprietorship that provided financial services. Through a general partnership, and in conjunction with his wife, from whom he was subsequently divorced, Mr. Rosser acquired a building that housed the financial services proprietorship.

Later, he and his ex-wife purchased two nursing homes with financing from a bank, the sellers and various clients.

Mr. Rosser transferred ownership of the nursing homes to two S corporations that he owned. Despite the transfers, Mr. Rosser still retained responsibility for repaying the funds that he borrowed to acquire the homes. Mr. Rosser also borrowed other amounts that were used to repay earlier loans and renovate the nursing homes.

After the purchase, Mr. Rosser began to manage the homes. On his 1994 income tax return, Mr. Rosser claimed net operating losses but did not file appropriate documentation, nor did he make a formal election.

In January 1996, he faxed the IRS a statement that claimed the net operating losses were from carry-overs in 1993 and 1991.

Tax Court Judge John O. Colvin rejected the IRS’ assertion that the interest Mr. Rosser paid in 1993 and 1994 for loans used to acquire, renovate and operate the nursing homes was not trade or business interest.

The court also dismissed the IRS’ contention that the interest deductions were the expenses of the S corporations and not of Mr. Rosser. The court did, however, agree with the IRS that interest related to the building purchased by the general partnership was not trade or business interest.

Next, the judge said that Mr. Rosser failed to prove that the amounts related to the net operating losses were carried forward from 1991 or 1993 to 1994, and he was liable for additions to tax for failure to file timely returns for 1993 and 1994, as well as for the penalty for substantial understatement of tax.

Cite: Thomas J. Rosser v. Commissioner, T.C. Memo 2001-79

Employer wins on compensation

A federal appeals court recently ruled that stock acquisitions were deductible as employee compensation expenses. In reality, the payments that a holding company made to managers to buy back previously issued stock were deductible employee-compensation expenses rather than non-deductible stock redemptions.

Riverton Investment Corp. was set up as a holding company to acquire all the stock of Riverton Corp. from the latter’s parent company, Investment Corporation of Florida. Riverton Corp. developed a management stockholders agreement to encourage managers to participate in company growth while insulating its investment from devaluation.

Managers acquired shares in Riverton Investment Corp. under the agreement. On termination, the participants sold that stock back to the holding company for 60% of book value. The participants reported as ordinary income the difference between what the holding company paid for the stock and its original purchase price. The holding company claimed that amount as deductible business expenses.

The IRS deemed the payments stock redemptions and therefore non-deductible.

The magistrate in U.S. district court ruled that the parties had a buy-sell agreement which worked as a covenant that ran with the stock. Under the tax laws, a transfer of property occurs when a person acquires a beneficial ownership interest in property, disregarding any lapsing restrictions.

The magistrate found that the transfer was subject to a lapse restriction, which rendered the company’s acquisition of stock a redemption and not tax deductible.

U.S. District Judge James H. Michael Jr., sitting in U.S. Circuit Court, found in the holding company’s favor. He found that the agreement permanently restricted ownership, so the stock acquisitions didn’t qualify as stock transfers.

The court concluded that the payments should be deductible.

Cite: Riverton Investment Corp. v. United States, No. 5: 99CV00089 (W.D. Va. March 6, 2001)

Couple win appeal in refund case

The 7th U.S. Circuit Court of Appeals, in an unpublished per curiam order, has held that a federal court improperly granted the IRS a summary judgment motion – concluding that a couple’s claim for refund survived the motion to dismiss.

The IRS assessed income tax deficiencies against Nabeel and Nuha Salah for 1983 and 1987. The IRS collected the deficiency by levying the couple’s bank account, garnishing their wages and crediting income tax overpayments for other years. Every time funds were exacted, the couple complained, but the IRS ignored them.

In 1999, the IRS notified the couple that they had overpaid their taxes and that refund checks for 1983 and 1987 were on the way. Two months later, the IRS notified the couple that the 1983 refund had been denied in its entirety as untimely, and only $4,103 of the 1987 refund was to be allowed.

When the couple filed suit April 28, 1999, the IRS moved to dismiss the case, maintaining that they failed to file a refund claim within three years of filing the relevant returns or within two years of paying the tax. The lower court granted the IRS’ motion.

The appeals court concluded that the couple submitted timely informal refund claims that extended the limitations period until the formal claim was filed in 1999.

The court then concluded that the IRS’ investigation of the formal claims implicitly waived any objection to the couple’s request.

Finally, the court noted that if the refund claim wasn’t filed until Jan. 21, 1999, as the IRS assumed, and payments for tax years 1983 and 1987 were made as late as 1998, as the IRS admitted, then the couple filed a claim within two years of paying the taxes.

Cite: Nabeel Salah, et ux., v. United States, No. 99 C 2813 (7th Circuit, March 29, 2001)