Reporting Requirements for ISOs and ESPPs

The IRS has released proposed Regulations to implement the recent changes in Code Sec. 6039. These Regulations require corporations to report the transfer of stock upon the exercise of incentive stock options (ISOs) and by employee stock purchase plans (ESPPs).

Pursuant to the changes in Code Sec. 6039, corporations must provide this information to the employee and, now, to the IRS by the 31st of January in the year following the transfer. The Regulations indicate that Forms 3921 and 3922 will be used for this purpose.

These Regulations may make it easier to establish the employee’s tax basis in stock acquired from ISOs and ESPPs.The option period for ISOs can be up to ten years.The option period for ESPPs can be even longer.

Prior to the recent changes in the Code, corporations were only required to provide stock transfer information to employees in the year following the transfer.On audit for the year in which the stock was eventually sold, which could be many years or decades later, employees (and the IRS) often realize that the employee has not retained these old records.

Because corporations are not able to deduct the costs of ISOs or ESPPs compensation, many corporations put little effort into providing employees with this information or retaining this information for a long period of time.This is especially true for stock options granted by under-funded start-up companies and in cases where the company has gone out of business or has been acquired by another company.

Now that this information is to be reported to the IRS, the IRS may be able to use its computer matching program to help ensure that the employee’s taxable gain on the sale of the stock is reported correctly.As a result, this may mean that ISO and ESPP-related audits may increase.This also raises questions such as will the government retain this information, how long the government will retain this information, and can the employee rely on the government to retain this information?

July 17th, 2008 | No Comments »

Discharging Tax Debts in Bankruptcy: The Three Year Look-Back Period

Often, discharging tax debts in bankruptcy is the best method of resolving unpaid tax debts. The U.S. Tax Court recently addressed one of the rules for discharging unpaid tax debts in bankruptcy in Lehman v. Commissioner, T.C. Summary Opinion 2008-83.

In Lehman, the taxpayers initially sought Chapter 13 bankruptcy relief. The taxpayers filed their tax returns as part of this process. Three and one half years after the taxpayers filed Chapter 13 bankruptcy, the bankruptcy court confirmed the taxpayers’ plan of reorganization.

The taxpayers were ordered to pay their unpaid tax liabilities over a 33 month period. Shortly thereafter the taxpayers moved to dismiss their Chapter 13 petition. The bankruptcy court eventually approved the dismissal, which resulted in the taxpayers’ tax liabilities not being discharged.

The taxpayers then filed a Chapter 7 bankruptcy petition. Three months later, which was five years after the taxpayers submitted their Chapter 13 bankruptcy petition, the bankruptcy court dismissed the taxpayers’ debts.

The IRS then issued the taxpayers a Notice of Intent to Levy for three of the older tax periods. The taxpayers appealed the Notice, believing that these tax liabilities were discharged in bankruptcy. The IRS held its ground and Tax Court litigation ensued.

As the U.S. Tax Court pointed out, the taxpayers failed to realize the impact that their Chapter 13 filing had on the discharge of their unpaid tax liabilities. Generally, unpaid tax debts may be discharged in Chapter 7 bankruptcy if the tax return was due to be filed more than three years prior to the date the Chapter 7 bankruptcy petition was filed. This three year period is often referred to as the three year look-back period.

The idea is that taxpayers should be able to discharge these older tax liabilities in bankruptcy, but not newer tax liabilities.  Thus, if the tax return was due to be filed during the three year look-back period, the unpaid tax debt for that year is not dischargeable in bankruptcy.

If the taxpayer acts to hold open the three-year look-back period, the three year look-back period will be extended for the period of time that the taxpayer holds it open. There are a number of ways that this period of time can be held open.  Filing a bankruptcy petition is one such way.  This is what the taxpayer’s Chapter 13 filing did. Because of the taxpayer’s Chapter 13 filing, the three year look-back period for the taxpayers’ Chapter 7 filing was extended to seven and one half years. Because the tax debts for the older tax years were due to be filed during this period of time, the unpaid tax debts for these years were not dischargeable in bankruptcy.

Had these taxpayers consulted with a tax attorney, they may have been able to time their bankruptcy filings and discharge their tax debts in bankruptcy.

July 16th, 2008 | No Comments »

Finding Tax Savings in a Lost Marriage: The Taxation of Alimony

If payments qualify as alimony pursuant to federal tax law, the payments may be tax deductible by the payor spouse and included in gross income to the payee spouse. If the payments do not qualify as alimony pursuant to federal tax law, the payments may not be tax deductible by the payor spouse and they may be excluded from gross income of the payee spouse.

It is very common for the IRS, on audit, to recharacterize alimony payments. For payee spouses, this often results in the IRS finding that the spouse failed to report their alimony income. For the payor spouses, this often results in the IRS disallowing tax deductions for the alimony payments. For example, in Przwoznik v. Commissioner, T.C. Summary Opinion 2008-50, the U.S. Tax Court found that “unallocated familiy support” was child support and not tax deductibe alimony. The U.S. Tax Court reached the opposite conclusion in Raga v. Commissioner, T.C. Summary Opinion 2008-46, finding that ”unallocated maintenance and child support” was alimony and therefore it had to be included in the payee spouse’s gross income.

These rules also present taxpayers with other problems for unwary taxpayers. For example, in Melvin v. Commissioner, T.C. Memo. 2008-115, the U.S. Tax Court concluded that transfers of property made several years in advance of the divorce that were accepted by the payee spouse in satisfaction of later alimony payments were not paid in cash and therefore did not entitle the payor spouse to a tax deduction. In Morris v. Commissioner, T.C. Memo. 2008-65, the U.S. Tax Court concluded that the payor spouse was not entitled to deduct alimony payments becuase he failed to substantiate that the payments were alimony and not child support.

With advance tax planning, these problems may have been avoided. This type of tax planning may allow the separating and divorcing spouses to recognize significant federal income tax savings. Separating and divorcing spouses should be aware of what payments do not qualify as alimony for purposes of federal tax law.  Generally, payments do not qualify as alimony for purposes of federal tax law if:

• the payments are not made pursuant to a divorce decree or separation agreement,
• the spouses are married and file a joint tax return (married copules who file a joint tax return may qualify for innocent spouse relief),
• the spouses are members of the same household at the time the payments are made,
• the divorce decree or separation agreement designates the payments as non-alimony,
• there is an obligation to continue the payments after the death of the payee spouse (either in the decree or agreement or in state law),
• the payments consist of property rather than money,
• the payments call for significantly larger payments in the first three years following separation or divorce,
• the payments are for the payee spouse’s bills (such as mortgage payments and real estate taxes), and
• the payments are child support.

Ideally, one or both of the separating or divorcing spouses will consider these rules. Also, spouses should ensure that their divorce decrees or separation agreements are written in a way that addresses these rules. As with other major financial transactions, taxpayers should consult with their tax counsel if they have any doubt about the taxation of their alimony or other payments.

July 15th, 2008 | No Comments »

IRS Recognizes Employee Tool and Equipment Plans

The IRS recently issued a Coordinated Issue Paper that sets out its view of what constitutes an acceptable Employee Tool and Equipment Plan.

An Employee Tool and Equipment Plan is an agreement between an employer and one or more of its employees to reimburse the employee for the use of the employee’s tools and equipment. The idea is that a portion of the compensation paid to the employee is for use of his tools and equipment and, therefore, that portion is not taxable wages to the employee.

In addition to saving the employee federal income taxes, the employer would not have to withhold employment taxes on that portion of the employee’s compensation. As the IRS’s Coordinated Issue Paper points out, taxpayers can achieve this tax result by structuring the Employee Tool and Equipment Plan as an “Accountable Plan” pursuant to Code Sec. 62(c).

To qualify as an Accountable Plan, the Plan must meet some very minimal requirements. Specifically, the Plan must require the employee to substantiate the expense and the Plan must provide that the employee must return any amount in excess of the amount of the expense that is substantiated.

The IRS Coordinated Issue Paper is directed at the Motor Vehicle Industry. It addresses tools purchased by employees in this industry. Accountable Plans can be used by taxpayers in other industries and for expenses for items other than tools.

The IRS Coordinated Issue Paper is also directed at Employee Tool and Equipment Plans that are “marketed” to employers. The Paper explains how the IRS will view these marketed plans. Assuming that the plans meet these IRS requirements, it appears that more taxpayers should be taking advantage of this tax savings opportunity.

July 14th, 2008 | No Comments »

The Private Trust Company

The IRS recently released Notice 2008-63 in advance of a formal Revenue Ruling. This Notice provides guidance on the federal tax implications of private trust companies and similar trust arrangements.

Notice 2008-63 confirms that private trust companies generally do not result in any estate, gift, or generation skipping tax benefits that could not be realized using other traditional estate planning tools.

As described in the Notice, a private trust company may be established pursuant to state law or pursuant to terms included in a trust instrument. These laws or trust terms provide that the private trust company is to serve as the trustee of the trusts. The family members can own the trust company. The tax benefits stem from control over discretionary distributions being vested in a discretionary distribution committee. The committee can be composed of family members or non-family members, but the grantor and beneficiary cannot serve on the committee for trusts that they created and for which they are beneficiaries.

The Notice confirms that if the formalities are followed, the trust assets will not be included in the grantor’s taxable estate or the taxable estate of the family members who serve on the committee. The grantor will have made a taxable gift upon establishing the trusts, rather than the committee members making taxable gifts in making distributions. Replacing a corporate trustee with a private trust company trustee will not void a generation skipping transfer exemption.

To attain these tax benefits, the parties - especially the committee members - must keep detailed records. These records include who participated in specific meetings and possibly affirmations that there were no formal or informal agreements with regard to distributions. Given the potential tax exposure, diligent tax attorneys and financial advisors may be well advised to maintain these records on behalf of their clients who establish private trust companies.

July 13th, 2008 | No Comments »

New IRS Collection Tool: The “Disqualified Employment Tax Levy”

The IRS is generally required to give taxpayers notice of its intent to levy (or take) their property prior to it actually levying on the property.  Congress recently amended the Code to provide the IRS with a new type of tax levy.  This new levy is referred to as a “disqualified employment tax levy” and it enables the IRS to levy on property without first providing the taxpayer with any notice.

A “disqualified employment tax levy” is a levy to collect employment taxes if the taxpayer (or its predecessor) requested a Collection Due Process (”CDP”) hearing for unpaid employment taxes in the past two years.  The idea seems to be that taxpayers who have submitted a CDP hearing request within the past two years should not be entitled to a CDP hearing for subsequent employment taxes.  This raises some serious questions.  Let’s look at the language used in the Code.  New Code Sec. 6330(h) is as follows:

a disqualified employment tax levy is any levy in connection with the collection of employment taxes for any taxable period if the person subject to the levy (or any predecessor thereof) requested a hearing under this section with respect to unpaid employment taxes arising in the most recent 2-year period before the beginning of the taxable period with respect to which the levy is served. For purposes of the preceding sentence, the term ‘employment taxes’ means any taxes under chapter 21, 22, 23, or 24.’

The use of the language “person subject to the levy (or any predecessor thereof)” is curious.  Would an acquiring corporation be subject to a disqualified employment tax levy if it acquires the stock of a target corporation that had filed a CDP hearing request for an employment tax liability?  What if the company merged with another corporation that had filed such a request? 

The use of the term “requested” is also curious.  Taxpayers often submit CDP hearing requests.  The IRS can refuse to grant the taxpayer a CDP hearing - either because the hearing request was not timely, or even because the request was lost by the IRS.  The Code does not require the taxpayer actually be given a CDP hearing in order for the taxpayer to be subject to the new disqualified employment tax levy. 

There is an interesting timing issue that this new type of levy raises.  Imagine that a taxpayer submits a CDP hearing request in response to a notice of intent to levy.  Imagine further that the IRS does not process the CDP hearing request until a year after the taxpayer submitted the CDP hearing request.  If the taxpayer then has an employment tax liability that arises in a subsequent tax period, it appears that the taxpayer may be subject to the new disqualified employment tax levy. 

This would result in the taxpayer eventually getting a CDP hearing prior to a levy for the first tax period and a CDP hearing after the levy for the second tax period - even though the underlying issue may be the same.  Given that the IRS will not consider collection alternatives (such as payment agreements or offers in compromise) without considering all tax periods where there is an unpaid tax debt, IRS employees may need to manually flag the second tax year in its computer system to prevent this type of levy. 

The question then is what do the taxpayer and the IRS employee to do if, unbeknownst to the taxpayer and the IRS employee, another IRS function (such as the Automated Collection System) processes this type of new levy while the IRS employee is working the case.  Does the IRS employee then have to recalculate the taxpayer’s reasonable collection potential, interest, penalties, etc. before it can work out an alternative to collections?  Does the taxpayer have the right to appeal the IRS decision if it turns out that the levy occurs while the IRS is working the case and IRS fails to recalculate these figures?  This type of procedural timing issue may be very difficult for the IRS to avoid. 

As a policy matter, the IRS already has the ability to impose a frivolous submission penalty on taxpayers who use the CDP hearing process to unreasonably delay the tax administration process and the IRS can use its jepoardy powers to levy on property if necessary to collect the tax.  If the CDP hearing request is not frivolous and collection of the tax is not in jeopardy, it is difficult to see why the government would need to have an expedited levy process.  I have yet to encounter any of these types of levies in practice.  It will be interesting to see how the IRS uses this new collection tool and how the IRS integrates this new tool into their tax collection system. 

July 9th, 2008 | No Comments »

Interesting Interest Abatement Case: Getting Interest Abated Can be Challenging

The IRS has the authority to abate or remove interest on tax liabilities; however, the process for getting the IRS to exercise this discretion can be challenging. The U.S. Tax Court describes this process in Select Steel, Inc. v. Commissioner, T.C. Summary Opinion 2008-79.

In Select Steel, the taxpayer was required to change its method of tax accounting due to a change in the law. This change resulted in a tax deficiency. Select Steel ended up conceding the accounting period change on audit. The IRS closed the audit two years after Select Steel conceded the only remaining issue in the audit. The taxpayer then submitted an Offer in Compromise to request that the IRS abate the interest. Eight months later the IRS responded by informing the taxpayer that it had lost all but the first page of the taxpayer’s Offer in Compromise (the rest of the offer was located nearly four months later). The IRS then filed notice of a federal tax lien for the interest, which resulted in the taxpayer requesting a Collection Due Process hearing. The IRS Appeals office sustained the lien.

The U.S. Tax Court made the following observations about the IRS audit and interest abatement process:

• Computational errors by the examining agent were common throughout the examination of petitioner’s return, and such errors resulted in multiple recalculations that were the primary cause of the lengthiness of the examination process.
• [T]he IRS assigned to petitioner’s examination four different audit managers, each of whom gave petitioner different advice and information at different times in the audit process.
• The Appeals officers considered almost exclusively the letters and documents petitioner submitted when requesting abatement of interest and challenging the tax lien because the IRS could not find its own case file regarding petitioner’s examination.
• [T]he available evidence is scant primarily because of [the IRS’s] destruction or loss of petitioner’s case file. The few documents in evidence have been supplied by petitioner, whose access to the information and documents most pertinent to resolution of this case is severely limited.
• The Appeals officer did not, however, inform petitioner that its case file was missing until after petitioner had petitioned the Court challenging the determinations.

The court ended up finding that the IRS abused its discretion in not abating a portion of the taxpayer’s interest. Taxpayers who incur interest on tax debts should contact a tax attorney to discuss whether all or a portion of the interest may be abated.

July 8th, 2008 | No Comments »