Taxpayers - 11, IRS - 0

When taxpayers win in court, itís usually based on the interpretation of facts. When they win based on an interpretation of law, it makes headlines. Taxpayer court case successes revealed.

February 28, 2008
by Mary Bernard, CPA/MST

Tax Accrual Workpapers Protected by Work Product Privilege

In Textron, Inc. (DC RI, 2007-2 USTC), the IRS was denied access to the taxpayer’s tax accrual workpapers. The Court determined that the workpapers were to be protected under the work product doctrine, which protects materials prepared or assembled by an attorney in anticipation of potential litigation. Internal Revenue Code section 7525 also protects the workpapers under tax practitioner-client privilege. The Court concluded that the documents in question contained attorney and tax practitioner advice and opinions regarding the chance of prevailing in any future litigation with the IRS.

Because the workpapers included determinations of adequate reserves for any potential disputes, the documents were correctly protected by the work product privilege. The Court further determined that the disclosure of documents to an independent auditor did not jeopardize the work product privilege because there was very little chance that the workpapers would be disclosed by them to a potential adversary, such as the IRS. The Court deemed the workpapers to have little bearing on the determination of the taxpayer’s tax liability. The determination of the tax had to be based on factual information, which was not contained in the workpapers and was available to the IRS through other means. With plans to appeal this finding, the IRS will maintain its policy of requesting tax accrual workpapers during audits.

Innocent Spouse Relief

In J.M. Wilson, M.E.Cumings, L.J. Smith, L.D. Farmer and D. Van Arsdalen, it was determined that the IRS abused its discretion in denying the taxpayer relief from joint and several liability. In determining the granting of relief, there are specific criteria examined as detailed in Revenue Procedure 2003-61. In many of the cases denied by the IRS, there existed a preponderance of factors in favor of relief including the fact that the income generating the tax liability was not attributable to, or known by, the requesting spouse. The Tax Court considered facts of spousal abuse and economic hardship in overturning the position taken by the IRS. Several other favorable factors existed in these cases, including that the taxpayers had remained compliant with the tax laws in subsequent years, received no benefit from the unpaid liabilities and had no control over the subject income. After this many challenges on the subject, it is unknown whether the IRS will continue to deny spousal claims for relief with many favorable factors.

Overstated Basis Does Not Extend Statute

In Bakersfield Energy Partners LP (128 TC No. 17, Dec. 56,966 (2007)), the IRS contended that overstating basis is an omission of gross income for purposes of extending the statute of limitations. A substantial omission consists of omitting from gross income an amount in excess of 25 percent of the gross income reported on the return. The general assessment period of three years is extended to six years if a substantial understatement of income occurs. The Tax Court held in Bakersfield that the extended limitations period is limited to specific receipts of income excluded from a tax return. When an understatement of income results from the overstatement of basis with all gross receipts properly reported, the statute of limitations would not be extended. As long as all gross receipts are fully reported, basis understatement will not enable the IRS to extend the statute of limitations on the assessment of income. The Tax Court is using a narrow definition of omission of gross income, for purposes of extending the statute.

Deductibility of Start-up Expenses

In J.A. Toth (128 TC 1, No. 1, Dec. 56,801 (2007)), the IRS argued that the taxpayer’s expenditures were nondeductible, capitalizable start-up expenses under section 195 because they were incurred in anticipation of a section 212 activity (for the production of income) becoming a trade or business. Start-up costs are generally those incurred in investigating or creating an active trade or business before the business begins. The Tax Court has held that start-up expenses, for section 195 purposes, are limited to those that are capital in nature rather than ordinary. In Toth, the Court refused to interpret section 195 as overriding the deductibility of ordinary and necessary expenses incurred in an ongoing activity for the production of income. Once the activity began, a deduction of ordinary and necessary expenses incurred in that activity was not precluded by section 195, regardless of whether that activity was later transformed into a trade or business.

Other favorable taxpayer cases included: the determination that medical students may qualify for the student exemption from Federal Insurance Contributions Act (FICA) tax (Mount Sinai Medical Center of Florida, Inc. (CA-11, 2007-1 USTC 50,525)); the attorneys’ fees of all parties to a will contest were proper estate expenses (J. Kessler (DC Cal., 2007-2 USTC 60,544)); and the Court allowed a refund of remittance requested past the statute for refund claims based on the principle that an undesignated remittance made before any liability is imposed is treated as a deposit (J. Huskins (FedCL 2007-1 USTC 60,538)).

As 2008 is a presidential election year with unresolved tax issues, another busy litigation year can be expected.

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Mary F. Bernard, CPA/MST is a Tax Principal and Director of State and Local Tax Services at Kahn, Litwin, Renza & Co., Ltd. in Providence, RI. She has over 20 years of experience with national and local accounting firms working with a variety of individual, partnership and corporate clients, with particular focus on corporate multi-state tax issues. She has also provided advisory and compliance services to extensive nonprofit clients. Bernard is a member of the AICPA, the Massachusetts Society of CPAs and serves as President-elect of the board of directors for the Rhode Island Society of CPAs.