Tax Watch: Treasury issues tax treatment guidance

The Department of the Treasury has issued proposed regulations that contain detailed rules on the tax treatment of contingent-payment debt instruments denominated in a foreign currency.

Existing regulations provide guidance on the tax treatment of non-contingent debt instruments denominated in foreign currency as well as on contingent instruments not denominated in foreign currency.

The proposed regulations, according to the Treasury Department, fit into the regulatory gap between these two existing sets of rules. In general, according to the department, the proposed regulations apply the so-called non- contingent-bond method provided in regulations to the debt instrument in the currency in which it is denominated.

The resulting amounts are then translated into the taxpayer’s functional currency, and gain or loss is determined under rules similar to the existing rules for non-contingent foreign-currency-denominated debt instruments. The proposed rules generally follow the method described by the Treasury Department in 1999.

Cite: JS-685

When is the rent not really rent?

The Internal Revenue Service recently ruled that rent paid to a real estate investment trust still qualifies as rent from real property under the Section 856, real estate trust rules, when a joint-venture partnership between a taxable-REIT subsidiary and the REIT’s independent contractor provides non-customary tenant services.

In the illustration provided by the IRS, a REIT owns and operates rental apartments in several cities and later forms a corporation to provide tenant services. The REIT and the corporation elect for the corporation to be treated as a taxable subsidiary.

The subsidiary provides services to tenants that aren’t customarily provided to tenants of rental apartment properties in the cities where the properties are situated.

An independent contractor, as defined by the rules, provides various services to the REIT’s tenants that also are non-customary and are primarily for the tenants’ convenience.

The contractor and the subsidiary form a partnership for federal income tax purposes to provide the non-customary services that formerly were separately provided to the tenants either by the contractor or the subsidiary.

The IRS ruled that the REIT’s only interest in the partnership is through the subsidiary. Accordingly, the services provided by the partnership are treated as if provided by the subsidiary to the extent of the subsidiary’s interest in the partnership.

Hence, the REIT will not be treated as providing impermissible tenant services to its tenants, the IRS concluded, adding that the rent paid by the tenants to the REIT still qualifies as rent from real property under the rules.

Cite: Rev. Rul. 2003-86

Mileage for visits to IRS upheld

The U.S. Tax Court has determined that an individual can’t deduct the interest paid on his income taxes or claimed charitable contributions for expenses for his residence. He may, however, deduct the standard mileage rate for car trips to the IRS to determine his tax.

In 1998, Dieter Stussy allocated insurance expenses, utilities, home association dues, repairs and maintenance for his home and claimed a charitable deduction for a portion of that amount. He allocated the expenses to the Jan Stussy Foundation, a Los Angeles-based 501(c)(3) organization.

He didn’t receive any written acknowledgment from the foundation, and it didn’t report receipt of any contributions in 1998.

He also claimed miscellaneous itemized deductions for mileage at the standard rate. Much of the mileage was for Mr. Stussy’s meetings with the IRS for audits of his returns. Mr. Stussy also deducted interest on state and federal tax deficiencies for 1992-94 that the court had considered previously.

Tax Court Judge David Laro rejected Mr. Stussy’s argument that he was entitled to a deduction as a sole-proprietorship expense for interest that he had paid for his income taxes.

The court held that he couldn’t claim costs connected with the foundation as charitable contributions, because he had no written acknowledgment. Finally, the court concluded that the disputed mileage was an ordinary and necessary expense incurred as a miscellaneous itemized deduction.

Cite: Dieter Stussy v. Commissioner, T.C. Memo 2003-232

Taxpayer beats IRS fraud charge

The U.S. Tax Court has ruled that the IRS failed to prove that an individual committed fraud on his tax returns for the 1986-88 period. The Tax Court also said that deficiencies were barred by the statute of limitations although a fraud penalty for the year 1989 was in order.

Stephen Carter, a regional vice president of Stuart-James Co. Inc. in Denver, hired a certified public accountant, Francis Pisano, to manage his financial matters and prepare his 1986-89 returns. Mr. Carter established an account in the name of Gina Oliva and used it to trade Stuart-James stock, in violation of company policy. Mr. Carter didn’t disclose the Oliva account, or report the capital gains income.

For 1986-89, Mr. Carter deducted travel and entertainment expenses that didn’t reflect Stuart-James reimbursements. Mr. Carter filed his 1986-90 returns late. He was indicted for tax evasion for 1986-89, and the decision was affirmed.

The IRS determined deficiencies in Mr. Carter’s 1986-89 taxes, plus additions to tax for fraud.

Tax Court Judge Maurice B. Foley concluded that the IRS hadn’t established that Mr. Carter was liable for fraud. The court found that Mr. Carter had established that he hadn’t intended to evade tax but that he had been negligent about records.

The court noted that Mr. Carter had relied on Mr. Pisano to prepare his returns and believed the expense reimbursements had been taken into account.

Cite: Stephen C. Carter v. Commissioner, T.C. Memo 2003-235

IRS clarifies impact of incorporation shift

Do lawyers’ fees come off the top in damage awards or are they paid to the client, with the client forwarding legal payments to the lawyers?

The IRS recently issued several rulings that provide guidance on the tax treatment of a law firm’s contingent-fee receipts and reimbursed litigation costs.

Confusing matters, the rulings pertain to contingent fees received by a law firm during its transition from a regular C corporation to an S corporation.

A personal-injury law firm elected to convert from a C to an S corporation.

The firm, which had issued outstanding shares of common stock, compensates lawyers under different types of bonus or incentive arrangements in addition to paying their salaries.

The firm enters into contingent-fee agreements with its clients. The IRS’ rulings focus on three agreements that the firm entered into before the S corporation conversion. The first and third were settled and withdrawn in a post- conversion year or the calendar year beginning on the first day immediately after the conversion date.

The firm received its fee and recovered the litigation costs when the first agreement was settled.

The second agreement was settled before the conversion date, but the client and the firm received their respective proceeds and fees in the year after the conversion date.

The firm received neither a fee nor repayment of litigation costs for the third agreement, because the firm withdrew from the case during the post-conversion year, before any settlement or final adjudication.

The IRS ruled that:

* The firm’s legal fees received in the post-conversion year for the first agreement aren’t subject to the rules of Section 1374, “S Corporation Built-In Gains,” taxes.

* The legal fees received in the post-conversion year from the second agreement are recognized built-in gains.

* The firm’s subsequent recovery in the post-conversion year of litigation costs it incurred before the conversion date in connection with the first two agreements isn’t subject to the Section 1374 taxes.

* The unrecovered litigation costs in connection with the second agreement – from which the firm withdrew – aren’t recognized built-in losses under Section 1374.

* The bonus compensation agreement the firm used for the past 10 years doesn’t violate the one-class-of-stock limitation under Section 1374.

* The presence of an incentive shareholder agreement and/or an old redemption agreement and professional employment agreement doesn’t violate, either alone or integrated as a single set of agreements, the one-class-of-stock requirement.

The IRS declined to issue advance rulings on valuation issues related to the firm’s net unrealized built-in gain under Section 1374.

Cite: Letter Ruling 200329011