Tax Watch: Exchange profits by trading places

The Chicago Mercantile Exchange has completed its transformation from a non-profit organization owned by members to a for-profit, shareholder-owned corporation.

In a statement on its web page (cme.org), the Merc said that it is the first U.S. financial exchange to demutualize by converting its membership interests into shares of common stock that can be traded separately from exchange-trading privileges.

The conversion took place following a favorable ruling from the Internal Revenue Service on Nov. 7 confirming “that conversion of CME memberships into shares of a for-profit corporation qualifies for tax-free treatment.”

“This favorable IRS ruling allows us to carry out the mandate of the CME’s members, who voted overwhelmingly to transform our exchange into a for-profit enterprise,” Chairman Scott Gordon said.

During the past year, the Merc began transforming its governance, management structure and decision-making processes into those of a for-profit company, according to Jim McNulty, president and CEO.

The exchange first filed a registration statement with the Securities and Exchange Commission on Jan. 28, and on June 6, exchange members overwhelmingly voted for a shareholder-owned corporation.

IRS is considering compliance survey

The IRS appears to be making plans to “survey” a sample of taxpayers to provide data that would be similar to the data from those dreaded taxpayer-compliance-measurement-program audits of the past.

In the past, the IRS has used TCMP data to update its discriminant function (Dif) scoring methodology.

Dif is used to grade tax returns for audit potential. TCMP data was also used to estimate the size of the tax compliance gap. The IRS may take up to three years to complete the survey, which is based on past performance.

The answers to a number of important questions remain up in the air. What is to be the size of the sample? Will taxpayers subjected to those audits be reimbursed? What degree of proof will be required for each item on the return?

The IRS has not carried out its TCMP since 1989. It canceled plans for a TCMP using 1991 and 1994 tax returns. The reason for the 1994 cancellation was opposition from Congress.

Presumably, the IRS will brief relevant lawmakers about its plans and obtain their agreement before moving forward with the survey.

New rules due on dual payees

The IRS has proposed regulations that would clarify who the payee is for purposes of reporting information if a check or other instrument is payable to joint payees.

The new rules would also provide guidelines for reporting information for escrow agents and other persons making payments on behalf of another person and clarify that the amount reported as paid is the gross amount of the payment.

The regulations, withdrawing proposed regulations published on May 29, 1984 (I.R.-62-84), would clarify the definition of fixed and determinable income when a payment is made payable to joint payees.

According to the proposal, a payment made jointly may be fixed and determinable income to one payee even though the payment is not fixed and determinable income to the other payee.

The proposed rules would also require that a person who makes a payment on behalf of another person and performs a management or oversight function in connection with, or has a significant economic interest in, the payment must report it under regulation Section 6041.

A significant economic interest is defined as an interest that would be compromised if the payment were not made.

Under the proposed rules, real estate agents who manage rental property and make payments to landlords would continue to be subject to regulation Section 6041 as “payors.”

Those same rules would remove the section that provides an exception to the information-reporting requirements for amounts that a bank or similar institution collects on behalf of, and pays over or credits to the account of the actual owner of the funds – but only if it doesn’t collect the items on a regular and continuing basis.

What’s more, the proposed regulations would remove investment advisers from the list of exempt recipients.

An investment adviser who initiates a sale on behalf of a customer is required to make a return of information only if the sale relates to an investment account in the investment adviser’s name.

A public hearing on the proposed regulations is scheduled for Feb. 7 at the IRS’ main facility in Washington.

Cite: Doc. 2000-26602

Trust income called invalid diversion

The U.S. Tax Court has ruled that a realty agent’s attempted diversion of personal services income into a trust was an invalid assignment of income.

The agent, Kevin Johnston, agreed to work for World Wide Mortgage Corp. provided the company would make its payments for his services directly to a trust – Universal Trust – that Mr. Johnston created with Julia Ghavami.

Mr. Johnston, who had lived with Ms. Ghavami at one time, did not file an income tax return for 1993 or pay estimated taxes that year.

The IRS sent Mr. Johnston a statutory notice in 1998, stating that he had failed to include $104,786 of business gross receipts in his income. Mr. Johnston argued that the money was not his income because he did not personally receive it.

Instead, he asserted that the payments made by the recipients of his services should be treated as Universal’s income.

A year before the IRS sent Mr. Johnston’s statutory notice, it sent one to Universal, stating that Universal’s 1993 gross receipts were $104,786.

Of that amount, the parties stipulated that $103,420 was paid for by third parties for work done by Mr. Johnston and $1,341 was paid for work done by Ms. Ghavami. Most of the $103,420 amount came from World Wide.

The government alleged that Mr. Johnston’s attempt to divert to Universal the income from his personal services was an invalid assignment of income.

Alternatively, the government argued that Universal is a sham, not a separate taxable entity, and that even if Universal is recognized for tax purposes, it is a grantor trust whose income is taxable to Mr. Johnston under other sections of the tax law.

Tax Court Judge Renato Beghe, ruling in the government’s favor, first dispensed with Mr. Johnston’s procedural arguments.

Turning to the merits of the case, Judge Beghe agreed with the government that Mr. Johnston’s attempt to transfer his “knowledge, talent, ability and labor” to Universal was a classic example of an invalid assignment of income as established by case law dating to 1930.

Income must be taxed to the one who earns it. Mr. Beghe wrote that contractual agreements used to deflect income away from its true earner to another are not recognized as dispositive for federal income tax purposes, notwithstanding their validity under state law.

In determining whether Mr. Johnston or Universal was the “true earner” of the income, the court looked to the person or entity that directed and controlled the earning of the income, not to the person or entity that received it.

Here, Mr. Johnston directed and controlled the earning of the income. He alone did the work for which World Wide paid Universal. Universal was not involved in any business decision related to the production of the income.

In fact, the parties stipulated that Universal was not legally entitled to hold a real estate license or to conduct a mortgage business.

Because the court deemed Mr. Johnston the true earner under the assignment-of-income rules, it did not consider the government’s alternative sham and grantor trust arguments.

Finally, the court found that Mr. Johnston was entitled to limited business deductions based primarily on checks submitted into evidence.

However, the court imposed additions to tax for Mr. Johnston’s failure to file a 1993 tax return and failure to pay any estimated taxes in 1993.

The court denied the government’s motion of discovery sanctions and for Section 6673 penalties against Mr. Johnston for needlessly delaying the proceedings.

Cite: Kevin R. Johnston v. Commissioner, T.C. Memo 2000-315