Tax Watch: High court hears arguments on state residency

The U.S. Supreme Court recently heard oral arguments to decide if a Nevada taxpayer has the right to sue the California Franchise Tax Board for investigating his residency status.

In Franchise Tax Board of California v. Gilbert P. Hyatt, et al., the respondent, a former California resident, moved to Nevada in 1991 shortly before he received $40 million in license fees for a patent he obtained while a resident of California. He didn’t pay California income taxes on the fees before establishing residency in Nevada.

The board’s investigation determined that Mr. Hyatt had not become a Nevada resident until 1992, and thus was liable for California state taxes for 1991 and 1992, as well as a penalty for civil fraud.

Mr. Hyatt filed suit in a Nevada district court for damages, claiming the California authority had acted maliciously and negligently when it audited his residency status and violated his privacy, among other torts.

The Nevada Supreme Court ruled that the defendant authority was immune from the negligence claim, but allowed the case to go forward on the taxpayer’s tort claims alleging intent. The tax board has argued that California law gives it immunity from lawsuits when acting to assess or collect taxes, and the Constitution requires Nevada to give “full faith and credit” to the laws of another state.

The high court is expected to rule on the matter shortly.

Cite: U.S. Supreme Court, Docket No. 02-42

AICPA tackles Block’s `anti’ ads

* The commercials H&R Block Inc. began airing on Super Bowl Sunday continue to draw heavy criticism.

The ads promote the Kansas City, Mo.-based tax preparation giant’s “double-check challenge,” a service that reviews past tax returns for mistakes. In the commercial – as in real life – singer Willie Nelson finds himself owing millions of dollars in back taxes because of problems with prior tax returns. The commercial ends with the message, “Don’t get bad advice. Let H&R Block check your taxes for free. We’ll find what others miss.”

Since those past tax returns were presumably prepared by tax practitioners at other firms, the ads appear to have offended more than a few of H&R Block’s competitors, notably CPAs.

Although the commercial never used the term “certified public accountant,” the American Institute of Certified Public Accountants instituted a letter-writing campaign against the commercial.

To set an example, the organization’s president, Barry Melancon, wrote a letter to H&R Block chairman Mark Ernst, challenging the intent of the commercials and asking that they be discontinued. Mr. Melancon also accused H&R Block’s copywriters of “trying to capitalize on the unfortunate situation some large accounting firms are in” and, in effect, maligning the services delivered by H&R Block employees, CPAs or not.

“Some of our members have examples of returns H&R Block has prepared, which raise questions about the quality of service you are delivering to the marketplace,” Mr. Melancon writes.

The real-life version of Willie Nelson’s tax woes dates back to the mid-1980s, when the IRS audited his returns and disallowed deductions related to his investment in a risky tax shelter.

Many accountants criticize H&R Block’s ad, noting this kind of “mistake” isn’t likely to be caught by a free double-check.

In the hole again

* The Department of the Treasury recently announced that the federal government already had racked up a cumulative $98 billion deficit for fiscal year 2003, which began Oct. 1.

This marks a significant reversal from the $8.4 billion surplus lawmakers had enjoyed during the comparable period a year earlier.

The Office of Management and Budget has already forecast record deficits of $304 billion for the current fiscal year and $307 billion for 2004 before the corner toward a balanced budget is turned.

Those projections assume, however, that congressional leaders adhere to the entire $695 billion economic growth plan President Bush maintains is critical to fiscal recovery.

Certification system for preparers urged

* The National Taxpayer Advocate has asked Congress to consider a certification system for tax preparers who aren’t CPAs, enrolled agents or attorneys. Certification would require applicants to pass a series of tests as well as obtain continuing education credits.

Penalties will follow frivolous tax appeals

* An appellate court recently held that penalties may now be imposed against so-called “tax protesters” who mount frivolous appeals of their tax cases.

Most often, the penalty is assessed against taxpayers who claim their wages aren’t income subject to taxation.

In a recent case, the 9th U.S. Circuit Court of Appeals assessed a $1,500 penalty after the taxpayer unsuccessfully appealed an underlying tax matter before the court and then brought the alleged frivolous appeal to re-litigate the prior matter.

An appeal is frivolous when the result is obvious or when the appellant’s arguments are wholly without merit, the court has held.

Cite: Floyd A.Wright, 2002-2 USTC 50,768; U.S. Court of Appeals, 9th Circuit

Gains on bonds in fund are taxable

* The 9th U.S. Circuit Court of Appeals, in an unpublished per curiam memorandum agreeing with the U.S. Tax Court, recently ruled that a taxpayer was required to report capital gains from his bond-heavy mutual fund.

The appeals court also held that the taxpayer couldn’t take a casualty or theft loss deduction from the sale of his house, which he alleged was triggered by hostility and racism on the part of police and neighbors.

Robert Torre received dividends from Fidelity Investments in 1997. He argued that he didn’t have to report his long-term capital gains distributions because the fund from which the distributions came had an asset allocation of 60% in bonds. He further maintained that Schedule B of Form 1040 instructs individuals to include gross dividends and other distributions on stocks but not on bonds.

The Tax Court agreed with the Internal Revenue Service, ruling that Mr. Torre had failed to report capital gains distributions and wasn’t entitled to claimed casualty or theft loss deductions. The court also said the tax form requires all capital gains distributions to be listed on Schedule B.

The Tax Court rejected the argument that the fund distributions were exempt from the requirement. In addition to agreeing with the lower court’s rulings, the appeals court found that Mr. Torre suffered no theft or casualty losses on his house sale, reasoning that harassment doesn’t qualify as a sudden or cataclysmic event.

Cite: Robert C. Torre v. Commissioner, T.C. Memo. 2001-218

Another tax shelter bites the dust

* The U.S. Court of Appeals for the District of Columbia Circuit has reversed a lower court decision involving an investment partnership.

The appeals court said that no legitimate, non-tax necessity existed for the formation of an investment partnership seeking to invest in private placement notes to be exchanged subsequently for London interbank offered rate notes later distributed to U.S. partners.

Accordingly, the court concluded that such partnerships aren’t recognized for tax purposes.

The appeals court hinged its decision on the so-called “business purpose doctrine,” noting that in order to satisfy this test, a non-tax business purpose need for the partnership to accomplish the goals of the partners must exist.

The court said there was no evidence of any need to enter into the partnership in order to invest in the Libor notes and concluded that the only logical explanation for the formation of the partnership was the exploitation of the tax regulations and a gain of a paper tax loss to absorb its enormous capital gains.

Accordingly, according to the court, where taxpayers use an elaborate partnership with entities created solely for the purpose of the questioned transaction, the absence of a non-tax business purpose is fatal to the recognition of the entity for tax purposes.

Cite: Boca Investerings P’ship v. U.S. No. 01-5429 (D.C. Cir. 1/10/03)

Frivolously arguing taxes

* The IRS has once again updated its website addressing false arguments about the legality of not paying taxes or filing returns.

The IRS chief counsel’s office has posted online a revised list detailing “The Truth About Frivolous Tax Arguments.”

The document provides a summary of the law and relevant legal decisions involving these false claims.

“During the filing season, taxpayers will sometimes hear about suggestions that they don’t have to pay taxes or file returns,” says Bob Wenzel, the agency’s acting commissioner.

“We want people to know the truth about these schemes: They don’t work,” he adds.

The IRS says it continues to refer such cases to the Department of Justice for criminal prosecution.