July 30, 2002 Wednesday

	Headlines IRS Letters Attorney-Client Privelege How To Lose A Deduction Cancelled Debt Bonds Can Be Losers
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 1

You can't avoid an assessment by the IRS by simply failing to claim your certified mail. In Thomas R. Hochschild (T.C. Memo. 2002-195) the Court found the IRS had delivered a deficiency notice when it had mailed it certified and two attempts by the post office to deliver the notice were refused by the taxpayer. The Court held that the notice was presumed delivered.    

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 2

Documents and discussions with your attorney are usually, but not always, protected by the attorney-client privilege. In Thomas E. Johnston (119 TC--, No. 3) the IRS asserted that notes between a client and his attorney were not protected on several alternative grounds:

• Waiver by the taxpayers' having placed the nature of attorney-client communications at issue through claimed reliance on counsel's advice,
  
• Waiver by the taxpayer's attorney having testified about privileged matters, during proceedings in Superior Court, prior to claiming the privilege, and
  
• The crime-fraud exception, applicable due to participation by his attorney in the taxpayer's scheme to defraud a party of his interest in certain property.

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 3

You can lose a deduction because it's not allowed under the tax law or you can lose it because you can't substantiate the expense. In Perry H. Kay, Sr. (T.C. Memo. 2002-197) the taxpayer lost on both counts. The Court agreed with the IRS and disallowed many of the expenses for his musical entertainment business because he could not substantiate the amounts. Some expenses were denied because the Court found he incurred them as part of his regular employment, not his sole proprietorship. The Court held he couldn't deduct the full amount of "repairs" related to a casualty loss. Casualty losses are generally measured by the difference between the fair market value of the property before and after the casualty. The cost of repairs may be used to calculate the loss only in certain circumstances and the taxpayer did not convince the Court that was the appropriate method here. Finally, the taxpayer was denied a Section 179 expense deduction for a van for the year at issue. The Court noted the van was actually placed in service in the prior year when he bought the vehicle and should have been taken on that year's return. 

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 4

Repayment of forgiven debt deductible . . . If a creditor agrees to settle a debt you owe for less than the full amount, that's generally discharge of indebtedness income (DOI, also known as cancellation of debt income, COD) and it's fully taxable. But what happens if you repay all or part of the debt in a later year? In recent Service Center Advice (SCA 200235030) that was the situation presented to the IRS. A taxpayer defaulted on a consumer credit obligation and the creditor sent the taxpayer a Form 1099-C. The taxpayer reported the income on his tax return for the year, but paid the debt in a later year. The Service held that the taxpayer could file a refund claim for the year in which he reported the income. If the taxpayer repaid only part of the liability, the proper amount to have reported as income would depend on the facts and circumstances. (Disputed amounts, such as extra interest may not give rise to cancellation of debt income.) Remember, there's generally a 3-year limit on filing an amended return. This is a tricky area; get good advice.

If you satisfy a debt you owe for less than the full amount of the debt, you have cancellation of debt income that is taxable income to you. There are exceptions to this rule. In George W. Earnshaw (T.C. Memo. 2002-191) the taxpayer's credit card company agreed to settle his $29,800 balance for $12,700. The card company sent him a 1099-C, discharge of indebtedness income of $19,867. (There were some additional issues that made up the difference.) The taxpayer argued that there wasn't any such income; rather, the difference represented a compromise of a doubtful and disputed claim. The Court found that the taxpayer had cancellation of debt income in the amount of $13,098. 

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 5

Bonds not riskless . . . The less than ebullient stock market and the miserly interest rates offered by savings and money market accounts and CDs has turned many individuals to invest in municipal, government and corporate bonds. While the returns are significantly higher than CDs, etc. they are not without risk. Corporate, municipal and foreign bonds carry a credit risk. There's always a risk the issuer will default and the bonds be worth only a small fraction of their face value. How much will depend on the issuer. Even bonds of major corporations are not without risk; that's clear from recent events. U.S. government bonds have no credit risk. But these issues, like all other bonds are susceptible to movements in interest rates. That is, as rates decline the market value of these bonds increase; but, as rates increase, the market value of bonds will decline. Zero coupon bonds are the most volatile with respect to movements in interest rates. Longer term bonds are more susceptible than short-term issues. Return is proportional to risk. The riskier the investment, the greater the yield. Unless you've got a lot to invest (so you can diversify) or don't want to take on any credit risk so you're limiting your investment to U.S. government bonds or highly rated municipals, you're probably best off with a fund. Look for one with low sales charges and management fees. 

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 6

Even if you're divorced and do not have custody of your child, you may still be able to claim the dependency exemption. However, in Nimia Maria Ramos (T.C. Memo. 2002-179) the Court sided with the IRS in denying the taxpayer the exemption because did not file a Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents. Since the child did not qualify for the dependency exemption, the child was not an eligible child for the child tax credit.

You may try to argue that the IRS didn't follow all the rules when completing the notices of deficiency. In Wesley W. Burnett and Patsie Burnett (T.C. Memo. 2002-181) the taxpayer contended the notices were invalid because the Service didn't execute a return as stated in Sec. 6020(b). The Court held that wasn't necessary to making sure the notice was valid. 

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 7

The IRS is always looking to reclassify a worker as an employee instead of an independent contractor. While there can be substantial penalties for misclassifying workers as independent contractors, the penalties can be significantly reduced if you can show you complied with the safe harbor provisions of Sec. 530 of the Revenue Act of 1978. Two of the most important requirements is that you filed all required information returns (i.e., 1099s) on the workers and treated them consistently. In Kentfield Medical Hospital Corp. (2002-2 USTC 50,542; U.S. District Court, No. Dist. Calif.) the taxpayer did not treat one worker (psychologists) consistently during the prior to the tax period at issue. (The consistency test requires that all workers in substantially similar positions the same.) 

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 8

You can't stop the IRS from seizing your property by simply transferring title to a relative or friend. If you do so without adequate consideration, it's called a fraudulent conveyance and the courts can void the transfer. In Patricia Labato, Denise Labato (2002-2 USTC 50,541; U.S. District Court, Mid. Dist. Fla., Orlando Div.) the taxpayer asserted that the fraudulent conveyance rule didn't apply since the transfer occurred more than a year and a half before the IRS assessed the tax. The Court found that under state law the IRS claim arose on the date on which the taxes were due and became a liability on the date the return was filed. It didn't help that the taxpayer's daughter didn't take possession of the property until some two years later. The Court also held that the taxpayer could not argue that she didn't receive a notice from the Service. The IRS showed it had sent notice to 4 different addresses, only one of which was returned. 

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 9

You can exclude up to $250,000 (%500,000 if married, filing joint) of gain on the sale of your principal residence. For the exclusion to apply, you must generally have both owned and used the property as your principal residence for at least 2 of the last 5 years. You can only apply the full exclusion once in 2 years, but you may be able to exclude a portion of the gain if the reason you can't meet the 2-year requirement is because of a change in employment, health, or, other unforeseen circumstances as provided in the regulations. In Notice 2002-60 the IRS held that taxpayers affected by the September 11, 2001 attacks may claim a reduced maximum exclusion of the gain if the sale of the residence was as a result of being affected by the attack.

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