Tax Watch: ‘Bermuda Triangle’ loophole for state taxes

As Congress rushes to close the-infamous “Bermuda Triangle” federal tax loophole that indirectly encourages U.S. corporations to seek tax havens abroad, the House Judiciary Committee is expected to vote on a provision of HR 2526 that would create a state-level equivalent. The new tax loophole is projected to threaten $9 billion annually in state tax revenue, even as states struggle with crippling budget deficits.

HR 2526 would pre-empt states’ efforts to crack down on shelter schemes that are the grass-roots equivalent of Bermuda-related tax avoidance. To avoid state taxes, corporations reportedly are setting up shell corporations either offshore or within the United States in order to take advantage of global or domestic tax havens.

The Multistate Tax Commission warned that HR 2526 would cost state governments billions of dollars in the first two or three years after passage, and considerably more in future years as corporations reorganize themselves in order to exploit fully tax haven jurisdictions.

Phased retirement comments sought

Phased retirement in recent years has been a popular means of encouraging older workers to stay in the work force. Employees who are nearing eligibility for retirement are offered a reduced schedule or workload to ease the transition from full-time employment to retirement. The arrangements permit the employer to retain the services of an experienced employee and provide the employee with the opportunity to continue active employment at a level that allows greater flexibility.

Now the Internal Revenue Service and the Department of the Treasury are seeking comments on how phased retirements should be treated under existing tax laws, and whether new legislation is necessary to ensure fair and equitable taxation for both employers and employees. Written comments should be submitted by Jan. 1 and should reference Notice 2002-43. The e-mail address is [email protected].

Rules on reporting attorney payments

The Taxpayer Relief Act of 1997 requires that payments to attorneys be reported. The regulation affects attorneys who receive payments of gross proceeds on behalf of their clients, as well as certain payers who, in the course of their trade or businesses, make payments to attorneys.

The IRS now is proposing specific rules for reporting those payments.

The provision generally requires Form 1099 informational reporting for payments of gross proceeds made in the course of a trade or business to attorneys in connection with legal services. Although on the surface that might sound as if the reporting is mandated only for payments to your own lawyer, there need not be a lawyer-client relationship for it to be necessary. Third-party payers – for example, companies settling a lawsuit – also are required to report payments.

Although the IRS has solicited and considered comments related to those proposed regulations, it currently is seeking further comments on its revised proposed regulations before they are adopted as final regulations.

A public hearing has been scheduled for Sept. 30.

Proving profit motive is a taxing exercise

The IRS and the courts generally look at nine factors when trying to determine whether an activity with losses is a business or merely a hobby.

In Andris Zarins, Zigrida A. Zarins (2002-1 USTC 50,471, 6th U.S. Circuit Court of Appeals), the court upheld a Tax Court finding that the taxpayers’ tree-farming operation was a hobby. Five of the factors favored the IRS, while four were neutral. The taxpayers lost even though they had purchased more than $10,000 worth of equipment and worked 15 to 20 hours per week at the activity.

Another, more complex situation yielded the same results. The Tax Court, sustaining the IRS’ determination, recently held that an individual’s S corporations weren’t profit-motivated trades or businesses and thus weren’t entitled to various expense deductions.

Bond trader Lucian Baldwin bought a 5,000-acre property (Granot Loma) and created Loma Farms Inc., Baldwin Aircraft Corp. and Baldwin Commodities Corp. Loma Farms was formed for property and hotel management. Mr. Baldwin invited guests and, without their knowledge, charged their stays to other corporations he owned.

He insured Granot Loma as his second residence and investigated business uses of the property. Mr. Baldwin later maintained that Granot Loma was the site of a working Christmas tree farm, a timbering operation, a maple syrup operation and a rental activity based on the guest visits.

All of that came to light when disputes arose over Baldwin Aircraft Corp.’s S corporation election and Baldwin Commodities Corp.’s deductions for transportation and airplane-depreciation expenses.

After auditing Mr. Baldwin and his enterprises, the IRS determined that neither Loma Farms nor the aircraft corporation was a profit-motivated trade or business. The IRS disallowed their claimed expenses and concluded that Mr. Baldwin had to include in his income the aircraft corporation’s corrected S corporation income. The IRS also disallowed Baldwin Commodities Corp.’s lodging and travel deductions.

Tax Court Judge L. Paige Marvel sustained the IRS’ decision and concluded that despite Mr. Baldwin’s stated intention to develop Granot Loma as a commercial property, his primary objective was to use it as a vacation home for his family. The court ruled that Mr. Baldwin’s occasional entertainment of business acquaintances did not render Granot Loma a for-profit enterprise. Thus, Loma Farms wasn’t entitled to take expense deductions related to Granot Loma.

The court did, however, order the IRS to make adjustments reflecting the offset of Loma Farms’ income with some of its expenses for 1989-1992.

The court rejected Mr. Baldwin’s assertion that he wasn’t entitled to pass-through losses for his aircraft company, because it didn’t have a valid S corporation election. The court held that the duty-of-consistency doctrine precluded him from making that claim. In other words, he might not be permitted to deduct losses from those disqualified entities, but was responsible for the income formerly attributed to them.

The court also held that Mr. Baldwin didn’t engage in Baldwin Aircraft Corp. for profit, as it was structured and operated primarily for his personal use and benefit. The court sustained the IRS’ disallowance of Baldwin Commodities Corp.’s lodging- and travel-expense deductions as uncontested. Finally, the court held that Mr. Baldwin was liable for an addition to tax for negligence as well as for an accuracy-related penalty.

Cite: Lucian T. Baldwin III, et al., v. Commissioner, T.C. Memo 2002-162

IRS takes a hit in reporting case

The government’s campaign to bring all businesses into compliance with its cash-transaction-reporting requirements suffered a hit from a U.S. District Court. The court upheld a jury verdict in favor of a business accused of intentionally disregarding the information-reporting requirements for cash transactions of more than $10,000.

Kruse Inc. auctioned automobiles and failed to file informational returns (Form 8300) for each transaction of more than $10,000. Chief executive Dean Kruse, relying on his accountant’s advice, believed that, based on the nature of his business, such filing was unnecessary.

In a conversation with an undercover IRS agent, Kruse vice president Michael Butler reportedly suggested that payments for the cars be made in increments of less than $10,000, and that the business had reviewed the reporting requirements for cash transactions.

The government alleged that Mr. Kruse, through Mr. Butler, was aware of the cash-transaction-reporting requirements, yet in 52 instances intentionally failed to file Form 8300. A jury returned a verdict in Mr. Kruse’s favor. Notwithstanding the verdict, the government moved for judgment or for a new trial.

Chief U.S. District Judge William C. Lee denied the government’s motion. The court held that the jury had sufficient evidence to find that Mr. Kruse didn’t disregard intentionally the filing requirements, as he firmly believed that Form 8300 didn’t apply to the auction business.

The court also noted that a reasonable jury could have found that Mr. Butler had no authority to bind the corporation by his statements to the IRS agent since he had no accounting or tax responsibilities at Kruse.

The court pointed to the government’s lack of evidence to support a finding of intentional disregard. The court also rejected the government’s motion for a new trial, which was based on its assertion that the jury had heard prejudicial testimony on the non-compliance rates for filing Form 8300. The court held that evidence of non-compliance was relevant to show that mass confusion existed over the application of the law.

Cite: Kruse Inc. v. United States, N.D. Ind.