Qui Tam Settlements and the Tax Benefit Rule

A qui tam claim involves a lawsuit where a private citizen helps the government prosecute fraud perpetrated against the government. These claims are often filed by employees or former employees who know of wrongdoing by an employer. These are often whistleblower claims. In exchange for helping to prosecute the claim, the private individuals are entitled to a portion of the government’s recovery.

Qui tam claims - and especially agreements to settle qui tam claims - raise a number of unique tax issues. One such issue is whether a taxpayer who pays to settle a qui tam claim can take advantage of the tax benefit rule. The IRS recently released a legal memorandum that addresses this issue.

The tax benefit rule allows a taxpayer to deduct or receive a tax credit for repaying income that the taxpayer paid tax on in a prior year. The idea is that the taxpayer who paid tax on income in a prior year and then had to repay the income, should be entitled to reduce their current year tax liability to offset the taxes that they paid in error in the prior year.

To qualify for the tax benefit rule, it must appear that the taxpayer had an unrestricted right to the payment in the year in which they received the payment. The courts have created a rule that says that taxpayers are not entitled to claim of right deductions or credits if the income was received on account of fraud or wrongdoing. The idea here is that the taxpayer who commits fraud knows or should know that it does not have an unrestricted right to the income.

A question arises where the taxpayer settles the claim without admitting or being found to have committed fraud - even though the taxpayer’s fraud is readily apparent. As the legal memorandum sets out, the IRS must scrutinize the settlement agreements and the intention of the parties to determine whether the settlement was for wrongdoing and whether there is sufficient nexus between the repayment and the income that was previously reported.

July 24th, 2008 | No Comments »

IRS Details the Federal Income Tax Consequences of Gift Cards

If an accrual method taxpayer issues a gift card, does the taxpayer have to recognize taxable income at the time that the card is sold or when the card is redeemed? The IRS Office of Chief Counsel recently issued a legal memorandum that addresses this question.

According to the IRS attorneys, taxpayers who issue gift cards are to recognize income for federal tax purposes when its gift cards are purchased. The IRS attorneys also conclude that taxpayers are not able to deduct the expense until the time that the gift cards are used.

Here is an example based on the conclusion reached by the IRS attorneys. Say that an accrual method business issues ten $10 gift cards in year one. The business would recognize $100 of income at the time that the gift cards were purchased. If five of the gift cards were used at participating stores in year one, the business would be required to pay $50 to the stores. The business would be able to deduct this expense in year one. If three of the gift cards were used at participating stores and the business paid the stores $30 in year two, the business would be able to deduct the $30 expense in year two. If the two remaining gift cards are not ever used, the business will not be entitled to a deduction for the remaining amount.

In analyzing the tax consequences of gift cards, the IRS attorneys compare payment for the gift cards to situations where a taxpayer receives a non-taxable deposit. With deposits, the recipient generally does not have to recognize income at the time of the payment because the recipient is, in most cases, required to refund the monies at some future time.

The recipient may have to recognize the payment as income when the recipient becomes entitled to retain the payment. This is often referred to as the “all events test.” This test provides that all the events that fix the right to receive income generally occur when (1) the payment is earned through performance, (2) payment is due to the taxpayer, or (3) payment is received by the taxpayer, whichever happens earliest. This often occurs at a subsequent date when the recipient does something to earn the money, such as when the recipient provides a product or service to the payee.

The IRS attorneys discounted the fact that the taxpayer who issued the gift cards may have to refund the monies at any time. The IRS attorneys argue that the payor has immediate control over the payments, given the uncertainties associated with the amount and timing of when the gift cards will be redeemed. In support of this position, the IRS attorneys noted that the taxpayer had not deposited the sale proceeds into a separate account.

The IRS attorneys do note that the result may be different if the payment is actually an advance payment for the sale of the payor’s own goods. If this is the case, the payment may fit within an exception in the Regulations.

July 23rd, 2008 | No Comments »

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 »