IRS Suspends Tax Refunds and Tax Court Closes during Government Shutdown

In yet another administrative move designed to make the government’s partial shutdown as painful as possible for ordinary citizens, The Internal Revenue Service has temporarily stopped sending out tax refunds. Tax payments, however, continue to be due on a timely basis. The Tax Court has also suspended operations for the time being.

“Tax refunds will not be issued until normal government operations resume,” said the IRS. The IRS emphasized, however, that the underlying tax law remains in effect, and all taxpayers should continue to meet their tax obligations as normal.

“Individuals and businesses should keep filing their tax returns and making deposits with the IRS, as they are required to do so by law,” said the IRS. “The IRS will accept and process all tax returns with payments, but will be unable to issue refunds during this time. Taxpayers are urged to file electronically, because most of these returns will be processed automatically.”

In addition, the IRS noted that no live telephone customer service assistance will be available. However, most automated toll-free telephone applications will remain in operation. IRS walk-in taxpayer assistance centers will be closed, though.

While federal government offices are closed, people who have appointments with the IRS related to examinations and audits, as well as tax collection, appeals or Taxpayer Advocate cases should assume their meetings are canceled, the IRS noted. IRS personnel will reschedule the meetings at a later date once the government shutdown ends.

Final Rules Issued on Individual Health Care Mandate

The IRS released final   regulations last week on the Sec. 5000A shared-responsibility   payment: the penalty or tax imposed on individual taxpayers who do not obtain   minimum essential health care coverage beginning in 2014, shares the AICPA Journal of Accountancy.

Corporate/Individual Tax – S-Corp Distribution Held to be Wages

Distributions from S corporation to its president were wages, not loan repayments

Glass Blocks Unlimited, TC Memo 2013-180

The Tax Court has held that distributions from an S corporation to its president/sole shareholder were taxable wages. IRS’s determination that the president was an employee was uncontested, and the S corporation failed to show that any portion of the distributions reflected repaid loans or that recharacterizing all of the distributions as wages would result in unreasonable compensation to him.

Background. The proper characterization of transfers by shareholders to corporations, as either loans or capital contributions, is made by reference to all the evidence, and the burden of proving that a transfer is a loan falls on the taxpayer. (Dixie Dairies Corp., (1980) 74 TC 476)

Courts have established a nonexclusive list of factors to consider when evaluating the nature of transfers of funds to closely held corporations. Such factors include:

  1. The names given to the documents that would be evidence of the purported loans;
  2. The presence or absence of a fixed maturity date;
  3. The likely source of repayment;
  4. The right to enforce payments;
  5. Participation in management as a result of the advances;
  6. Subordination of the purported loans to the loans of the corporation’s creditors;
  7. The intent of the parties;
  8. The capitalization of the corporation;
  9. The ability of the corporation to obtain financing from outside sources;
  10. Thinness of capital structure in relation to debt;
  11. Use to which the funds were put;
  12. The failure of the corporation to repay; and
  13. The risk involved in making the transfers. (Calumet Indus., Inc., (1990) 95 TC 257)

That is, the inquiry before a court is “whether the transfer… constitutes risk capital entirely subject to the fortunes of the corporate venture or a strict debtor-creditor relationship.” (Dixie Dairies Corp.) Transfers to closely-held corporations by controlling shareholders are generally subject to heightened scrutiny.

Facts. Glass Blocks Unlimited (GBU) is an S corporation that, during 2007 and 2008, sold and distributed glass blocks for the real estate market in North America. During those years, Fredrick Blodgett was GBU’s president and sole shareholder.

GBU had no other full-time employees. Mr. Blodgett was responsible for all of GBU’s operational and financial decisions, and he performed nearly all of the work necessary to run the business.

GBU began to experience financial difficulties following the downturn in the real estate and construction markets, and Mr. Blodgett transferred funds to GBU in order to cover operating expenses and other costs. In 2007, he transferred $30,000. His then-fiance contributed $15,000 in 2007 and $10,000 in 2008. There was no collateral given or promissory notes issued reflecting the transfers.

For the 2007 and 2008 tax years, GBU didn’t report paying Mr. Blodgett any salary or wages, despite the fact that it distributed money to him as cash was available and when he asked for it (not less than $30,844 in 2007 and $31,644 in 2008). For 2007, GBU reported repayment of $29,132 of loans from shareholders and, on Form 1120S, Schedule L (Balance Sheet per Books), reported that it had no outstanding loans from shareholders at the beginning of the year and had a balance of $12,868 in loans from shareholders at the end of the year. For 2008, GBU reported repayment of $8,391 of loans from shareholders (a decrease in its reported loans from shareholders balance from $12,868 at the beginning of the year to $4,477 at the end of the year) and dividend distributions totaling $21,078.

Mr. Blodgett did not have any other employment during 2007 or 2008. On his 2007 return, he reported $877 of subchapter S income from GBU and $11 in taxable interest. For 2008, he reported $8,950 of subchapter S income from GBU.

IRS audited GBU’s 2007 and 2008 tax years and determined that Mr. Blodgett should be classified as an employee and the distributions should be characterized as wages for employment tax purposes. GBU didn’t object to IRS’s determination that Mr. Blodgett was an employee, but it asserted that some of the distributions represented the repayment of loans to Mr. Blodgett and shouldn’t be characterized as wages. IRS, in turn, argued that the funds were contributions to capital and the distributions were wages.

GBU also argued that if all of the distributions made to Mr. Blodgett were characterized as wages, such would constitute unreasonable compensation. In support of its argument, GBU claimed that he worked only 20 hours per work and performed only “undemanding” duties that didn’t require any training or special skills.

Transfers weren’t loans. Applying the factors outlined above, the Tax Court found that the transfers in this case were capital contributions and not bona fide loans. Notably, there were no written agreements or promissory notes, and while a portion of the transfers was reported as loans from shareholders on GBU’s Form 1120S, that factor carried little weight absent other supporting criteria. Further, not even Mr. Blodgett treated the transfer from him to GBU as a loan.

Other factors supporting the Court’s conclusion included the lack of interest, security, or a fixed repayment schedule. Mr. Blodgett withdrew funds based on GBU’s ability to pay, thus rendering repayment dependent on the success of the business rather than on an unconditional obligation.

Recharacterized wages were reasonable compensation. The Tax Court also easily concluded that recharacterizing all distributions to Mr. Blodgett as wages wouldn’t constitute unreasonable compensation to him. GBU failed to show that the salary information that it submitted was for positions comparable to Mr. Blodgett’s, Specifically, it submitted salary statistics for positions like a shipping clerk and accounts payable clerk, but Mr. Blodgett’s role was more substantial than any of the supposedly analogous positions. In effect, he performed each of those roles.

The Court also dismissed the claim that Mr. Blodgett worked only 20 hours per week. It was inconsistent with what Mr. Blodgett told the tax examiner who audited GBU, and it was further undermined by the hours posted on GBU’s website.

RIA observation: The Tax Court’s opinion doesn’t explain why GBU raised this argument. In general, unreasonable compensation is taxable to the recipient and not deductible by the payor, which is a worse result for the taxpayer. It appears as though Mr. Blodgett, who represented GBU before the Court, may have thought that only reasonable compensation would be treated as taxable wages, and the excess, if any, would be treated as loan repayments.

© 2013 Thomson
Reuters,  2395 Midway Road, Carrollton, TX  75006

Individual Tax – Rollover Triggers IRA Modification Penlty and Can’t be Undone

PLR 201323045

IRS has privately ruled that a taxpayer’s rollover of some of his IRA funds into an IRA at another financial institution was a modification of his prior election to receive a series of substantially equal periodic payments. As a result, he was hit with an early withdrawal recapture penalty that could not be corrected by rolling the funds back into the original IRA.

Background. Distributions from IRAs before age 59 1/2 generally are hit with a 10% penalty tax under Code Sec. 72(t)(1). There are a number of exceptions to the penalty including one for distributions that are part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the IRA owner or the joint lives (or joint life expectancies) of the IRA owner and his designated beneficiary. (Code Sec. 72(t)(2)(A)(iv))

However, a taxpayer may have to pay an early distribution recapture tax if, before he reaches age 59 1/2, the distribution method under the equal periodic payment exception changes (for reasons other than his death or disability). The tax applies if the method changes from the method requiring equal payments to a method that would not have qualified for the exception to the tax. The recapture tax applies to the first tax year to which the change applies. The amount of tax is the amount that would have been imposed had the exception not applied, plus interest for the deferral period. The taxpayer may have to pay the recapture tax if he does not receive the payments for at least five years under a method that qualifies for the exception. He may have to pay it even if he modifies his method of distribution after he reaches age 59 1/2. In that case, the tax applies only to payments distributed before he reached age 59 1/2. (Code Sec. 72(t)(4)(A))

Rev Rul 2002-62, 2002-2 CB 710, provides three methods for determining substantially equal periodic payments: a fixed annuitization method; a fixed amortization method; and the required minimum distribution method.

Rev Rul 2002-62, also permits an individual who uses the annuitization or amortization method to compute substantially equal payments to make a one-time switch to the required minimum distribution method without triggering the penalty.

Rev Rul 2002-62, Sec. 2.02(e), provides that, under all three methods, substantially equal periodic payments are calculated with respect to an account balance as of the first valuation date selected. Thus, a modification to the series of payments will occur if, after such date, there is (i) any addition to the account balance other than gains or losses, (ii) any nontaxable transfer of a portion of the account balance to another retirement plan, or (iii) a rollover by the taxpayer of the amount received resulting in such amount not being taxable.

Facts. A taxpayer we’ll call Adam, age 58, maintained IRA B with Company C. In 2001, he began receiving substantially equal period payments of Amount 1 from this IRA calculated using one of the approved calculation methods. In late 2008, Adam’s financial advisor stopped doing business with Company C and began doing business with Company D. Adam wanted to keep his IRA invested with this financial advisor and on Date 1 attempted to transfer all of his IRA B. However, he only succeeded in transferring the majority of IRA B, totaling Amount 3, to IRA E with Company D. Adam did not learn until after Date 1 that Company D would not accept the part of IRA B invested in Real Estate Investment Trust (REIT) funds and, as a result, Amount 4 was not transferred to Company D and remained invested in IRA B.

Beginning in February 20 after Amount 3 was transferred to IRA E, monthly distributions were reestablished with Company D. However, rather than continue with the same gross monthly distribution of Amount 1, Company D mistakenly changed the gross monthly distribution to an amount equal to the net monthly distribution amount which Adam had been receiving under IRA B. As a result, the total yearly IRA distribution was less than what had been taken out under the original distribution plan. On Date 2, corrective distributions were made from IRA E to Adam to match the total yearly distributions he had been receiving under IRA B. During this time no distributions were made from IRA B.

Unfavorable rulings. When Adam transferred Amount 3 via trustee-to-trustee transfer from IRA B to IRA E, the transfer occurred prior to the end of the Code Sec. 72(t)(4) period and was a nontaxable transfer of a portion of the account balance in IRA B. Thus, IRS said that under Rev Rul 2002-62, Sec. 2.02(e), the Date 1 transfer of Amount 3 from IRA B to IRA E was a modification to the series of substantially equal payments which Adam began to receive from IRA B in 2001. As a result, IRS ruled that the Date 1 transfer of Amount 3 from IRA B to IRA E was a modification to a series of substantially equal periodic payments as described in Code Sec. 72(t)(4).

IRS further concluded that this error could not be corrected by transferring Amount 3 back to IRA B. Thus, the missed distributions from IRA B (and subsequent corrective distributions) were subject to the Code Sec. 72(t) early distribution tax since a modification to the series of equal periodic payments occurred upon the transfer of Amount 3 from IRA B.

IRS said the fact that any portion of IRA B was transferred to another IRA resulted in a modification to the series of substantial equal periodic payments and triggered the imposition of the 10% premature distribution tax under Code Sec. 72(t), beginning with the first payment in 2001 and increased by the amount of tax that would have been paid but for the substantially equal periodic payment exception.

© 2013 Thomson Reuters,  2395 Midway Road, Carrollton, TX  75006