Tax Watch: No business activity, no tax-free treatment

The Internal Revenue Service recently issued guidance (Revenue Ruling 2002-49, 2002-32 I.R.B.) on transactions that qualify for tax-free treatment, using actual situations as a discussion point.

Two cases were presented to the IRS. In the first, a limited-liability company classified as a partnership owned several commercial office buildings and performed upkeep and maintenance services for them. In year one, two corporations each held a 20% interest in the LLC and provided substantial managerial services. In year three, one of the two corporations purchased all other interests in the LLC, and the LLC became “disregarded” as an entity separate from the corporation.

The corporation continued to provide the managerial services to the LLC. In year six, the LLC distributed 40% of its real estate assets to the corporation, which the latter then transferred to a new, wholly owned subsidiary.

The corporation then distributed the subsidiary’s stock to its own shareholders pro rata in accordance with the tax regulations.

In the second situation, the corporation didn’t own an interest in the LLC in year one but acquired it in year two by contributing appreciated securities in a Section 721, “Contributions to a Partnership,” transaction.

For a transaction to qualify for tax-free treatment, the IRS says, the controlled corporation must be involved in the active conduct of a trade or business throughout the five-year period ending on the distribution date.

The IRS ruled that the five-year active trade or business requirement would be met in the first situation because the corporation’s purchase of the remaining interests in the LLC didn’t result in the acquisition of a new or different business.

In the second situation, the IRS explains, the corporation would be treated as having acquired a new trade or business in a transaction in which gain or loss would be recognized in violation of the rules.

Advance tax refund praised, with caveat

The General Accounting Office recently concluded that implementation of the IRS’ controversial advance tax-refund program, though a “major accomplishment,” wasn’t without its problems. The GAO released those comments and other findings after completing a study.

In one of the first major problems, 523,000 taxpayers received notices that indicated larger refunds than they were entitled to, due to a computer glitch. That was corrected before the refund checks were mailed. Another error, according to the report, was the return of 548,000 advance-refund checks valued at about $174 million, due to incorrect addresses.

James R. White, the GAO’s tax issues director, says the IRS and the Department of the Treasury did a good job implementing the program in a relatively short time frame.

Get payee ID right to avoid Uncle Sam

Go figure. Since early this year, the Social Security Administration has sent letters to more than 800,000 businesses – almost one in eight U.S. employers – asking them to clear up cases in which their workers’ names or Social Security numbers don’t match the agency’s files. The letters cover about 7 million employees.

The crackdown has highlighted an open secret: A huge number of illegal immigrants provide stolen or made-up Social Security numbers to employers and have U.S. taxes deducted from their paychecks in order to work “on the books.”

Now, with Social Security confronting those employers, many in turn are confronting their workers, insisting that they clear up that problem. Workers who can’t are in many cases fired; otherwise they tend to leave quietly.

That isn’t the only number the IRS is paying attention to, either. The agency recently issued clarification rules for anyone making payments to a business or individual. The rules state that it is the payers’ responsibility to ensure the taxpayer identification numbers used are correct.

Any time the Secretary of the Treasury notifies a payer that an ID number furnished by the payee is incorrect, Section 3406 requires “backup withholding” of taxes. Backup withholding is, in essence, withholding a percentage – currently 27.5% – of interest, dividends and other reportable payments.

The IRS has clarified that if a payer receives two or more penalty notices during a three-year period regarding the same account, the payer must backup withhold until he or she receives verification of the correct ID number.

Current regulations haven’t been clear on whether two or more notices of incorrect ID numbers relating to the same payee and the same tax year, but received in different calendar years, count as one notice.

So the IRS proposes that when a payer receives two or more notices of incorrect ID number with respect to the same payee’s account for the same year, the payer is treated as receiving one notice, regardless of the calendar year in which the notices are received. The payee must respond to the second notice by obtaining – from the IRS or the Social Security Administration – verification of its ID number.

The proposed regulations (REG-116644-01, 67 Fed. Reg. 44579) also provide that filers who receive a Section 3406, “Backup Withholding,” notice in one year, and the following year receive a penalty notice for the same payee and the same tax year, aren’t required to make an annual solicitation for the payee’s ID number – provided, of course, that the filer has sent the required notice.

Playing with the IRS under new rules

The Treasury and the IRS have released final regulations (T.D. 9011, 67 Fed. Reg. 48760 July 26, 2002) governing the practice of attorneys, certified public accountants, enrolled agents, enrolled actuaries and others authorized to represent a taxpayer before the IRS or the U.S. Tax Court.

Included in the newly modified regulations are such matters as: assisting or receiving assistance from disbarred or suspended persons, practicing with former government employees, contingent fee arrangements, confidentiality, conflicts of interest, return of a client’s records even if a fee dispute exists, restrictions on negotiation of a taxpayer’s check, solicitations, responses to document requests even if the documents aren’t controlled by the practitioner or his or her client, and sanctions.

The IRS has indicated that the pre-existing standards governing tax-shelter opinions weren’t amended and continue to apply. It reportedly intends to issue another notice of proposed rulemaking concentrating on tax-shelter opinions.

Stock-option rule for cost sharing

The IRS has proposed regulations that would, when finalized, treat all stock options as operating expenses for purposes of cost-sharing arrangements.

It is part of the government’s effort to stanch the flow of intangible assets and income abroad through cost-sharing arrangements between a U.S. corporation’s domestic and foreign-controlled entities.

The tax law (Code Section 482, “Transfer Pricing”) states that when intangible property is transferred or licensed between controlled entities, the IRS is entitled to allocate income, deductions, credits or allowances between the entities to prevent tax evasion or to more clearly reflect income.

In a 2000 field service advisory (FSA 200003010), the IRS states that the value of compensatory stock options must be included in the costs shared with or charged out to foreign affiliates.

In litigating that position against a corporate taxpayer, the IRS successfully fought off a summary judgment motion, but then conceded the issue in a settlement. Nevertheless, the IRS publicly has maintained that, despite its concession of the litigated-options issue, it hasn’t changed its policy concerning inclusion of option costs in cost-sharing agreements.

Under the proposed regulation (REG-106359-02), stock-based compensation would be considered in determining a controlled participant’s operating expenses. Stock-based compensation would include restricted stock, non-statutory stock options, statutory stock options (incentive stock options and employee stock-option purchase plans), stock appreciation rights and even phantom stock.

The determination of whether stock-based compensation is related to the development of intangibles covered by the qualified cost-sharing arrangement would be made as of the date the stock-based compensation is granted.

Convertibles qualify as non-contingents

The IRS has ruled that the non-contingent-bond method outlined in Section 1275, “Original Issue Discount Definitions,” applies to a debt instrument convertible into issuer stock, and also provides for contingent cash payments.

A corporation can issue a debt instrument without stated interest, which may be converted at any time into the corporation’s common stock. At the time it is issued, the stock is worth less than the issue price of the debt.

The instrument also provides contingent interest after three years if over a six-month period its average market price is greater than 120% of the accreted value, or greater than the issue price plus the economic accrual-to-date of the difference between the issue price and stated principal at maturity.