Tax Watch: Think tank disputes Social Security report

A Washington think tank says the interim report of President Bush’s Social Security reform commission contains “misleading statements and factual errors that invite misinterpretation and are likely to sow confusion.”

The interim report, completed for the commission’s second public meeting – on July 24 – was reviewed by the Center on Budget and Policy Priorities

One of the issues the center disputed was the commission’s assertions that the Social Security Trust Fund does not hold “real” assets. The center maintains that the trust fund holds more than $1 trillion in Treasury securities backed by the “full faith and credit” of the U.S. government.

“The bonds held by the trust fund are, if anything, more secure than other paper assets,” said the center’s report.

The Social Security Trust Fund holds Treasury securities – IOUs from the federal government – to meet future obligations. Treasury securities are, of course, fine investments.

However, when they’re held in federal trust funds, Uncle Sam has the same problem that anyone has when redeeming their own IOUs.

And to quote the Clinton administration’s fiscal 2000 budget, such trust funds “do not consist of real economic assets that can be drawn to fund benefits. Instead, they are claims on the Treasury that, when redeemed, will have to be financed by raising taxes, borrowing from the public or reducing benefits or other expenditures.”

President Bush’s commission also argues that 2016 is the crisis year for Social Security, claiming that benefit payments in that year will exceed payroll revenue.

According to the center, however, the fund’s trustees project that in 2016, the fund will have reserves of more than $5 trillion and will be earning more than $300 billion per year on those assets.

The center also notes that if the commission, as expected, recommends a shift of 2 percentage points of payroll into individual accounts, it will accelerate the crisis from 2016 to 2007.

Tax avoidance plan doesn’t add up

In a legal memorandum, the Internal Revenue Service has concluded that because a partnership was set up solely to take advantage of the partnership distribution basis rules, the transaction and subsequent basis allocation should be recast for federal tax purposes.

A partnership transferred all of its assets, including inventory, prepaid expenses, security deposits, trademarks, fixed assets, customer lists and goodwill, to a third company in exchange for the third company’s stock. Ten days later, the partnership sold a percentage of its interest in that company to a newly formed corporation.

Under Section 732 of the tax code, “Basis of Distributed Property,” the corporation allocated basis or book value equal to the amount of the third company’s basis in the inventory, prepaid expenses and security deposits, and allocated the balance to other assets in proportion to the third company’s basis in those assets.

As a result, the basis in the trademarks and fixed assets was increased.

The IRS concluded that the partnership was formed and terminated solely to take advantage of the Section 732 rules. Thus, the application of the anti-abuse rule, Regulation Section 1.701.2, is appropriate, and the transaction and subsequent basis allocation should be recast.

Cite: Legal Memorandum 200128053

There’s advantage in leaving country

The IRS has confirmed that a valid election to treat newly issued stock as current taxable income will allow the recipient to sell the shares later and escape taxes on any capital gain. In other words, that section of our tax law will shield a former U.S. resident from any tax on stock sale profits.

A legal, permanent resident of the United States and a foreign corporation formed a second foreign corporation to invest in or acquire domestic businesses.

In exchange for his services in promoting those activities, the foreign national was allowed to purchase shares in the foreign investment company with a put option to sell them to the other shareholder under a formula that would provide him with a substantial gain on the transaction.

The foreign national elected to treat the receipt of those shares as income to the extent of any bonus element in them at the time he purchased them. Since he claimed that they were worth no more than his purchase price, he paid no tax at the time, despite the election.

Later, after abandoning his green card, he exercised the put option and asserted that he owed no U.S. tax since it was a capital gain of a non-resident alien.

The IRS agreed, explaining that since the promoter was a non-resident alien at the time of the sale and was no longer in any U.S. trade or business after moving abroad, he owes no tax on any capital gain, even from sources in this country.

Cite: FSA 200128037

Telling it like it is not required of IRS

The U.S. Tax Court has ruled that the IRS wasn’t required to explicitly state that it was disallowing a company’s business expenses in its deficiency notice.

Patrick and Larry Elliott owned American Energy Services Inc. They received Forms W-2 showing wages from the company, which they reported as gross income on their tax returns.

They also received Forms 1099-MISC, Non-Employee Compensation, under the company’s employee reimbursement plan, which they included on their Forms 2106, Employee Business Expenses, with claims for those employee business expenses.

The non-employee compensation was effectively offset by their business expenses as claimed on their Forms 2106.

Thus, the offset part of the non-employee compensation wasn’t included in their gross income. The brothers treated employee expenses and non-employee compensation similarly.

The IRS determined that the Elliotts should have reported the non-employee compensation as gross income.

The IRS also disallowed the excess employee expenses over non-employee compensation claimed on Schedules A.

The IRS didn’t allow the offsetting expenses in calculating the men’s gross income, and it didn’t say so.

The Elliotts argued that the IRS’ failure to do so resulted in the employee expenses’ not being placed in issue and that the court lacked jurisdiction over the offsetting expenses.

Tax Court Judge Joel Gerber held that it would have been helpful if the IRS had included a statement that the expenses weren’t allowed.

However, the court wrote that such a statement would have had no effect on the income tax deficiencies that the IRS had determined.

The court concluded that it was the Elliotts’ failure to substantiate the expenses that resulted in their not being allowed as deductions from adjusted gross income.

Cite: Patrick S. Elliott, et ux., et al., v. Commissioner, TC Memorandum 2001-164