COURT REJECTS IRS'S ATTEMPT TO INDOPCO THE WORLD
Tax controversy practitioners have experienced a noticeable trend for IRS agents to capitalize expenses based on the Supreme Court's decision in INDOPCO Inc. v. Commissioner">
| Court Rejects IRS's Attempt to INDOPCO the World |
| S Distributions are Wages |
| Tax Liens Attach After Sales Rescission |
COURT REJECTS IRS'S ATTEMPT TO INDOPCO THE WORLD
Tax controversy practitioners have experienced a noticeable trend for IRS agents to capitalize expenses based on the Supreme Court's decision in INDOPCO Inc. v. Commissioner, 503 U.S. 79 (1992). In that case, you may recall, Justice Blackmun opined that current deductions are the exceptions to the norm of capitalization, thus turning on its head the historic thinking that capitalization is the exception to the norm of current deduction. We had previously thought that the default accounting and tax rule was that an expenditure should be currently expensed unless there was a clear nexus between the expense and a discernible future year benefit. We had not previously thought that all expenditures were capitalized unless there is no discernible future year benefit. In most cases, either way of stating the rule should produce the same result, but in close cases the way of stating the rule could conceptually create different results.
Since INDOPCO, the IRS has applied its spin on the holding expansively to attempt to force taxpayers to capitalize items that have not historically been capitalized. Taxpayers, of course, resist, but often are forced into a settlement because of the inherent uncertainty of INDOPCO and the costs and risks of litigating.
A recent case, PNC Bancorp, Inc., et al. v. Commissioner, ___ F.3d ___ (3d Cir. May 19, 2000), rejects one initiative in the IRS's INDOPCO juggernaut. There, in connection with its mainstream lending operations, banks incurred internal costs (such as employee salaries for time devoted to loan screening) and external costs (such as credit checks). These costs have historically been deducted by banks on the theory that they are ordinary expenses incurred in their mainstream business operations.
The IRS sought capitalization under INDOPCO. In the words of the Third Circuit Court of Appeals, the IRS was "emboldened" by INDOPCO and by Statement of Financial Accounting Standards No. 91 ("SFAS 91") which the Court described as follows:
Beginning in the late 1980s, SFAS 91 required for the first time that, for financial accounting purposes, loan fee income and the costs incurred in connection with loan origination should be deferred and recognized over the life of the loan, rather than being recognized in full in the year the loan closed.
First, the Court rejected the IRS's argument and the Tax Court's holding that the loans thus acquired were "separate and distinct assets" within the meaning of Commissioner v. Lincoln Sav. & Loan Ass'n, 403 U.S. 345, 353 (1971). You may recall that, in that case, the Court required capitalization of payments made into the FSLIC Secondary Reserve. The Court distinguished Lincoln Savings on the basis that it was not an asset acquired in the taxpayer's mainstream business operations The Court said:
The Tax Court's broad reading of Lincoln Savings essentially treats the term "separate and distinct asset" as if it extends to cover any identifiable asset. We do not subscribe to this reading of Lincoln Savings.
Apparently recognizing that this distinction was not alone compelling, the Court then denied that the required nexus between the expenditures in question and the loans existed. The Court seemed to think that the expenditures must "create" the asset – here the loans – in order to be deductible. The Court reasoned the expenditures in question did not create the assets but merely were incurred in the connection with the loans.
The Court then moved to INDOPCO which by its words seemed to shift the inquiry from Lincoln Savings' articulation of a separate and distinct asset to the future benefit test. In INDOPCO, the Supreme Court said:
Lincoln Savings stands for the simple proposition that a taxpayer's expenditure that "serves to create or enhance . . . a separate and distinct" asset should be capitalized under section 263. It by no means follows, however, that only expenditures that create or enhance separate and distinct assets are to be capitalized under section 263.
The Third Circuit rejected that test as requiring capitalization here, although the Court's reasoning is not clear. The Court seemed to acknowledge that there was some future benefit. The court seemed, however, to find controlling the "ordinariness" a la Section 162 of the expenses – in the mainstream business and what it felt was a weak conceptual link between the expenditures and the loans.
In the course of its opinion, the Court rejected the IRS's reliance on SFAS 91, correctly citing Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (1979) for the proposition that accounting standards do not control tax accounting. Of course, they do not. But the economic verities giving rise to SFAS 91 are the same as those behind this application of INDOPCO and the SFAS does establish real world acceptance of these economic verities.
From taxpayers' perspective, it is heartening that the courts will limit the IRS's INDOPCO juggernaut. The Court's analysis is not wholly satisfying as the discussion above implies. The real explanation of the result may be the key differences between the Tax Court which held for the IRS and the Court of Appeals which held for the taxpayer. The Tax Court is a specialist court, more focused upon and understanding of the big picture in the Code. The Appeals Court is a nonspecialist court, with perhaps a greater concern for the practical difficulties to taxpayers in applying the uncertain distinction between capitalized expenditures and ordinary deductions.
This particular matter has been resolved in the Third Circuit. However, until and unless other courts embrace the decision for banks and for taxpayers in other businesses, we don't know how much comfort taxpayers can take from the opinion (except, of course, banks in the Third Circuit). It is much better than a victory for the IRS, for now it offers some negotiation room to get a better settlement with respect to mainstream costs.Addendum: After the foregoing article was prepared, the Tax Court released another INDOPCO decision requiring capitalization of fees incurred to defend antitrust litigation arising out of an acquisition. American Stores Co. v. Commissioner, 114 T.C. No. 27 (5/26/2000). The Tax Court judge involved was the same judge (Judge Ruwe) deciding the PNC case in the Tax Court. The Court reasoned that the fees must be capitalized because incurred in connection with the acquisition, echoing the reasoning rejected by the Court of Appeals in PNC. The Tax Court does not cite PNC which had just been decided one week earlier. (The logistics for clearing and publishing a full T.C. opinion would make it unlikely to be able to address such a recent opinion ; in any event, the Tax Court might well have seen no reason to respond since the differences between the two have already been fleshed out in the Tax Court and Appeals Court decisions in PNC.)
The proximity in these decisions does reaffirm a conclusion we have all sensed, if only anecdotally, from our practices -- the IRS is out to INDOPCO the world.
The Sixth Circuit has held that the Tax Court properly determined that amounts that were reflected as loans on an S corporation's books to its shareholder president, but that were neither documented nor reported as such to the IRS, were wages. The Court disregarded a purported agreement that characterized the funds as a distribution of profits or as loans. Joly v. Commissioner, 2000-1 USTC ¶50,315 (6th Cir, Mar. 20, 2000).
The officer of the S corporation that built custom homes was properly determined to be a corporate employee who was liable for social security taxes on his compensation from the corporation. Although he claimed that he was primarily involved with noncorporate activities during the tax years at issue, he was largely responsible for attracting the corporation's customers, he was solely responsible for managing and operating the business during one year, and he negotiated financing, developed home plans, and reviewed construction sites during the other two years. Thus, he was not a non-employee who provided only minor assistance to the corporation.
The shareholder entered into an agreement with the corporation, acting on behalf of the corporation in his capacity as its president. The agreement stated that the sole compensation for his services would be his share of the corporation's profits. Under the agreement, the shareholder was permitted to withdraw monetary advances of anticipated profits. The advances were to be treated as loan on the corporation's books to the extent they exceeded the corporation's profits. The IRS contended that agreement should be disregarded and that portions of the amounts paid to or on behalf of the shareholder should be treated as employee wages earned with respect to personal services rendered to the corporation. The IRS further contended that the shareholder used the agreement to avoid paying employment taxes under the Federal Insurance Contributions Act..
The Tax Court found that the shareholder's argument that the services provided to the corporation were insubstantial was not valid.
The Court further found that the shareholder was an employee of the corporation by virtue of having been an officer of the corporation, and having provided more than minor services to it.
Practitioners need to be careful in advising taxpayers concerning distributions from S corporations. Advice like that received by the taxpayer in the case discussed above resulted in the taxpayer not only owing additional taxes and interest, but also penalties.
In most cases, being an officer of a corporation will make the officer an employee of the corporation.
TAX LIEN ATTACHES TO PROPERTY AFTER SALE RESCISSION
In a legal memorandum issued by the IRS (ILM 200017006 (January 4, 2000)), the IRS has determined that a federal tax lien filed pursuant to Section 6321 continues to attach to real property purchased by a taxpayer even after a judgment against the taxpayer rescinded the contract of sale and returned the property to the seller. Thus, the seller got the property back, but the tax lien filed against the buyer remained on the property. This does not seem to be the proper result.
The taxpayer and a third party entered into a contract to purchase real property from the sellers. As part of the contract, the taxpayer agreed to either assume the existing trust deed that had an outstanding balance or refinance the property. After a down payment, the sellers conveyed legal title to the taxpayer and a third party as joint tenants. The IRS filed a Notice of Federal Tax Lien against the taxpayer in the county where the real property was located. The taxpayer never did assume the existing loan nor did he refinance the property. The sellers sued the taxpayer for breach of contract and rescission. The sellers obtained a default judgment, the taxpayer was declared in breach, and the Court ordered the contract rescinded. The taxpayer refused to cooperate; therefore, the Court appointed an someone who executed a deed and conveyed the property back to the sellers.
The sellers were attempting to sell the property and questioned the demands by the IRS for an amount equal to the taxes, interest, and penalties owed by the taxpayer.
Section 6321 provides that a lien for unpaid taxes attaches to "all property and rights to property" of the taxpayer. A federal tax lien was recorded while the taxpayer was the owner of the property. The federal tax lien continues until satisfied or unenforceable due to lapse of time. Section 6322 of the Code. Treas. Reg. section 6331-1(a)(1) authorizes the IRS to seize property "subject to a federal tax lien which has been sold or otherwise transferred by the taxpayer." The IRS found that the lien therefore attached to the property and continued to attach regardless of any conveyance to a third party or a reconveyance back to the original seller. The federal tax lien is not limited to the value of the property at the time of the sale to a third party but may share in any appreciation of the property. Han v. United States, 944 F.2d 526 (9th Cir. 1991).
Here, the property subject to the federal tax lien was transferred back to the sellers after a judgment in which the Court held that the contract of sale was rescinded. The federal tax lien remained attached to the property at the time it was transferred back to the sellers and had priority over the sellers' interest. The IRS determined that it had the right to seize the property, sell it, and compensate the sellers for the value of their interest. United States v. Big Value Supermarkets, Inc., 898 F.2d 493 (6th Cir. 1990).
The sellers could have defeated the federal tax lien filed at least thirty days prior to the sale if they had notified the IRS at least 25 days prior to the sale pursuant to Section 7425(b). Otherwise the sale is made "subject to and without disturbing such lien."
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