Tax Watch: House panel urges tax break for fund holders

In a recently released report, Congress’ Joint Economic Committee recommends changing the tax treatment of capital gains distributed to mutual fund shareholders.

Currently, when a fund sells assets, responsibility for taxes on any gain from the sale is passed on to shareholders. As a result, shareholders must pay tax on the distributed gains even if they did not sell any of their own shares, if their individual accounts lost money or if the fund reinvested the gain in other capital assets.

To pay the tax, some shareholders end up selling their mutual fund shares or diverting capital from other, more productive uses. Paying the tax also cuts returns to shareholders by 15% to 20% a year.

To correct that problem, the Joint Economic Committee recommends changing the way that those distributed gains are taxed. Rather than taxing gains at the fund level, it suggests taxing the gains solely at the shareholder level and giving shareholders the option of deferring tax on the gains.

The benefits of that arrangement, according to the committee, include increasing the return shareholders receive on their investment and increased revenue to the U.S. Treasury.

Also included are greater parity in the taxation of investments in mutual funds and stocks, simplifying shareholders’ calculations of their cost basis when they redeem their shares for cash, and reducing the instances in which shareholders pay too much tax because they fail to readjust their cost basis for reinvested capital gains.

One solution considered by the committee was HR 168, sponsored by its chairman, Rep. Jim Saxton, R-N.J. Shareholders could elect to defer tax on capital gains distributions that are reinvested in the fund, and forgo an adjustment to their cost basis.

Joint filers could defer up to $6,000 of reinvested gains, while all others could defer up to $3,000. The exclusion would be indexed for inflation and retroactive to Jan. 1, 2000.

Cite: May 1 Joint Economic Committee report on better tax treatment for mutual fund owners

Treasury amends new-markets credit

* The Community Renewal Tax Relief Act of 2000 (Public Law 106-554) has amended the Internal Revenue Code to add the”new-markets tax credit.” The credit is equal to the applicable percentage of the taxpayer’s qualified equity investment in community development.

The dates that this tax credit becomes available are the date on which the investment is initially made and on each of the six anniversary dates thereafter. The applicable percentage is 5% for the first three credit allowance dates and 6% for the rest.

Authority to issue guidance has been delegated to the director of the Department of the Treasury `s Community Development Financial Institutions Fund.

That fund has recently issued a notice of proposed rulemaking that outlines how an entity can apply to be a community development entity and how, once certified, it can apply to receive an allocation of new-markets tax credits.

The plan also establishes the competitive procedure through which the allocations will be made, and outlines the actions that will be taken to ensure that they are properly made.

The basic rules require community development entities to use substantially all of the cash within the qualified equity investment to make “qualified low-income-community investments.” Under the tax rules, such investments also include any capital or equity investment in, or loan to, any qualified business.

The Internal Revenue Service is seeking taxpayer input on how best to define a “qualified active low-income-community business” as well as many other terms that are contained in the proposed rulemaking.

Written and electronic comments must be submitted by July 2 to: CC: M&SP: RU (REG-119436-01), Room 5226, IRS, P.O. Box 7604, Ben Franklin Station, Washington, D.C. 20044 or via irs.ustreas.gov/ tax_regs/regslst.html.

Cite: REG-119436-01

Did IRS steal house? Tax court says no

* The U.S. Tax Court recently agreed with the IRS in ruling that an individual cannot take a theft-loss deduction based on the court-ordered foreclosure of his home.

A state court apparently ordered a mortgage foreclosure on Harold Johnson’s home. Mr. Johnson alleged that he had failed to timely challenge the order due to a judicial assistant’s error and that he had then sued the state court.

He alleged that a non-final order in the case had been pending on appeal, which supposedly divested the court of jurisdiction to issue the original foreclosure order.

The state court dismissed Mr. Johnson’s suit, and an appeals court affirmed. Mr. Johnson sought to convey the property from himself as “settler” to himself as “trustee,” on the grounds that the court’s foreclosure order was void.

Mr. Johnson then claimed a deduction on his amended 1995 income tax return that was based on “judicial theft of real estate.” He claimed carry-over losses related to the property on his 1996, 1997 and 1998 returns, and used the carry-overs to completely offset his income tax in those years. The IRS disallowed the carry-over from 1998 and determined a deficiency in his income tax for that year.

Tax Court Special Trial Judge Robert N. Armen Jr. noted that the record wasn’t clear on whether the IRS took any action on losses claimed from 1995 through 1997. The court rejected Mr. Johnson’s challenge to the deficiency, finding that the state courts had consistently dismissed his argument that the foreclosure order gave rise to a “due-process theft.”

The Tax Court held that even if the foreclosure order had been deemed improper, the loss of his property through foreclosure couldn’t be construed as a casualty or theft loss under the tax law’s Section 165, “Losses.”

Harold A. Johnson v. Commissioner, T.C. Memo 2001-97

Audit guidelines set for consultants

* The IRS has released another of the infamous Market Segment Specialization Program audit guides. The latest educational guide contains examination guidelines that IRS auditors are to follow when auditing business consultants.

The guide outlines practices common among business consultants large and small, and identifies issues that may arise when IRS examiners conduct audits of individuals who work as business consultants. The guide identifies personal travel, meals, entertainment and reimbursed expenses as potential audit issues.

Cite: Doc. 2001-11718

House given to son still carries a lien

* A U.S. District Court, agreeing with the IRS, recently rejected a son’s argument that his interest in assets transferred by his parents after a federal tax lien had been attached to their property was superior to that lien.

The IRS assessed deficiencies against Harold and Dolores Morrell for deductions that they had taken for tax shelter investments. After the U.S. Tax Court entered an agreed decision on the deficiency amount, the IRS demanded payment, imposing liens on the Morrells’ property in late 1990.

The Morrells transferred property to their son, Michael, in May 1991. Harold contended that he had transferred the assets so that he and his wife could qualify for government medical assistance due to his wife’s declining health. The son asserted that he had no knowledge of his parents’ tax problems.

In arguing against foreclosure because his interest was superior to the government’s liens, the son noted that he had agreed to support his parents and that he was a “purchaser” under the tax rules.

Alternatively, he argued that he was entitled to an equitable lien for the money he had spent on an annuity to support his parents in the years following the asset transfer.

The government conceded that Michael Morrell would get a pro rata share of funds that couldn’t be traced to transfers after the liens attached. It argued, however, that all the funds were traceable. The government contended that it was entitled to foreclose on the annuity’s entire value, including appreciation.

Judge Nina Gershon of U.S. District Court for the Eastern District of New York granted summary judgment, noting that no reasonable juror could find that Michael was a purchaser under the rules of Section 6323, “Priority of Liens.”

The court also rejected Michael’s contention that he was entitled to an equitable lien, finding that equity wouldn’t be served by giving Michael credit for payments to his parents that actually came from the parents.

Finally, the court held that liens follow the property and transfer afterward doesn’t affect the lien.

Cite: United States v. Harold Morrell, et. al., E.D. N.Y.