Tax Watch: IRS shutting down yet another tax shelter

In an effort to shut down a new tax shelter, the Internal Revenue Service is informing investors that they will not be able to use so-called common-trust funds to reduce their tax bills.

The IRS has served notice on the companies that promote these schemes, as well as those who buy them, stating that the transactions are reportable as tax shelters.

Common-trust funds represent a new twist on an old tax avoidance scheme. Banks created them to pool the customer assets they were holding so that they could invest them more efficiently. The funds themselves do not pay taxes, but any gains that they report are assigned to participating investors.

Apparently, the IRS recently became aware that the claimed tax benefits purportedly generated by these transactions are not allowable for federal income tax purposes.

The IRS said investors were establishing common-trust funds and then engaging in offsetting currency trades.

This is the latest move in the government’s continuing battle to close loopholes used by wealthy individuals and corporations to avoid paying taxes.

The IRS and the Department of the Treasury have filed lawsuits in recent months, forcing accountants and law firms to disclose the names of customers to whom they sold suspect transactions.

Fringe benefits? Forget about them

* The IRS is reminding employers and retirement plan professionals that they are no longer required to file information about fringe- benefit plans. It suspended the requirement for an annual Form 5500 and Schedule F last year for so-called pure fringe-benefit plans.

The IRS has since eliminated Schedule F and also modified Form 5500 so fringe-benefit plans could not be reported.

However, based on past experience, the IRS is concerned that some employers may try to adapt prior-year forms and schedules or add write-in information on a Form 5500 because they mistakenly think the filing requirement still exists.

In fact, pure fringe-benefit plans have no IRS filing requirement and therefore should file neither a Form 5500 nor a Schedule F.

Claim disallowed on transferred loss

* The IRS recently determined that the loss claimed by a member of a limited-liability company on the sale of assets transferred to the LLC after having been purchased with loan proceeds should be disallowed.

The IRS also noted that an accuracy-related penalty can be asserted after the loss is disallowed.

The technical advisory involved an LLC that purchased assets from another LLC in a so-called custom adjustable-rate-debt transaction.

The seller had purchased the assets with proceeds borrowed under a loan that provided for principal repayments after 30 years and annual interest payments at annually reset rates.

The buyer purchased the present value of the total loan proceeds, assumed the obligation to pay the principal amount, and assumed joint and several liability for the loan.

Both LLCs pledged collateral equal to the principal and interest on the loan, and the seller agreed to make all interest payments.

Later, the buyer sold the assets and, about a year after the loan was made, repaid the loan using the pledged collateral of the LLCs.

A member of the buyer claimed a basis equal to the entire principal amount of the loan, noting that the LLC had assumed joint and several liability. The claimed basis resulted in the transaction’s being a loss.

The IRS concluded that the loss should be disallowed because the member’s basis should equal the fair market value of the assets at the time they were conveyed, rather than the entire principal amount of the loan.

The IRS, as it had warned it would in the earlier notice, also upheld the imposition of an accuracy-related penalty.

Cite: Technical Advice Memorandum 200326034

Court doesn’t trust a taxpayer’s trust

* The U.S. Tax Court has ruled that an individual failed to report taxable income, isn’t entitled to claimed deductions and is liable for fraud penalties, accuracy-related penalties and additions to tax.

Ray Sowards practiced law from 1995-97, during which time he had a close business relationship with System Two Ltd., a financial services company, and its operator, Robert Strong.

The company issued checks on a near-weekly basis to a trust that Mr. Sowards purportedly set up in 1994.

Mr. Sowards maintained exclusive control over the trust’s bank account and used its funds to pay for the family’s living expenses. Mr. Sowards and his wife didn’t report the System Two payments on their 1995-97 joint returns.

The Sowardses also claimed deductions for Marilyn Sowards’ consulting business in 1996, although they later admitted the business didn’t exist.

The Sowardses divorced shortly thereafter.

Senior Tax Court Judge Robert P. Ruwe dismissed the Sowardses’ contention that the payments from STL were loan proceeds, and concluded that the IRS had properly determined that they were income.

The judge also upheld the IRS’ disallowance of the claimed business deductions, ruling that they were wholly unsubstantiated.

Cite: Ray W. Sowards, et ux., v. Commissioner, T.C. Memo 2003-180