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The IRS has issued revised guidance (Rev. Proc. 2004-14; IRB 2005-7) on the application of Secs. 121 and 1031 to a single exchange of property. Sec. 121 provides that a taxpayer may exclude gain realized on the sale or exchange of property if the property was owned and used as the taxpayer's principal residence for at least 2 years during the 5-year period ending on the date of the sale or exchange. Section 121(b) provides generally that the amount of the exclusion is limited to $250,000 ($500,000 for certain joint returns). Section 1031(a) provides that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment (relinquished property) if the property is exchanged solely for property of like kind (replacement property) that is to be held either for productive use in a trade or business or for investment.

When is a bankruptcy case no longer "pending" for purposes of the relief from the imposition of certain penalties provided under section 6658 of the Internal Revenue Code for the period during which a bankruptcy case is pending? That's the issue addressed in Rev. Rul. 2005-9 (IRB 2005-6). The Rev. Rul. described three fact situations involving individuals in Chapter 7 and Chapter 11 bankruptcy proceedings. The IRS held that a bankruptcy case is no longer pending for purposes of relief under section 6658 when the bankruptcy case is closed or dismissed.

Tip

Roth rules . . . Many taxpayers still don't understand Roth IRAs. The rules are actually simpler than for other IRAs. You can make a contribution for 2004 up until April 15, 2005. For 2004 the maximum contribution is $3,000; if you were at least age 50 by the end of 2004, you can add $500 to that as a "catch-up" contribution. You can make a full Roth contribution as long as your modified adjusted gross income is no more than $95,000 for a single individual and no more than $150,000 for a married couple filing jointly. If your modified adjusted gross income exceeds those amounts, your deduction is phased out. For 2005, the maximum contribution is $4,000 (add the $500 catch-up contribution if you're age 50 by the end of 2005). You can make contributions to a Roth even if you're covered by any regular pension plan. However, any contributions to a deductible or nondeductible IRA count toward the maximum Roth contribution. Thus, if you contribute $1,000 to a deductible IRA for 2004, your Roth contribution for 2004 is limited to $3,000. While you get no deduction for the contribution, qualified distributions are tax free.

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Most fraud cases involve the understatement of income. In Winston Knauss (T.C. Memo. 2005-6) the IRS asserted that the taxpayer both underreported income and overstated his basis in assets sold. The taxpayer was in the business of yacht chartering (as well as certain other businesses). He made capital improvements to the vessels, used them for a while and then sold them. The IRS argued that the taxpayer overstated his basis in the yachts by claiming capital expenditures that he could not substantiate. The Court noted that his records were inadequate with respect to his basis in the yachts and the real estate he sold, as well as his charter business. He claimed his former spouse stole his records, but his testimony concerning the theft of his records lacked credibility, and other evidence concerning his records showed that his account was implausible and inconsistent. Notably, the taxpayer failed, through the time of trial, to make any serious effort to reconstruct his records. Though he claimed his ex-wife took records, he did not subpoena her to obtain them. He generally failed to contact any vendors of the goods or services that underlay his unsubstantiated basis claims; in one instance where a contact was made, petitioner did not disclose the retrieved records to the IRS. The taxpayer claimed that his efforts to obtain records from his financial institutions were unsuccessful, whereas the IRS was able to obtain them. Instead of making a good faith attempt at reconstruction, the taxpayer merely rested on his claim that his records had been stolen. The Court believed that someone in the taxpayer's position, facing challenged basis claims exceeding $1 million in the aggregate, would have made a more serious effort to reconstruct unless he knew that such efforts would tend to disprove his claims. The records of taxpayer's financial transactions that were proffered were generally obtained through the efforts of the IRS alone and substantially rebut the taxpayer's basis claims. The repeated instances where the dates on invoices proffered as evidence had been altered is further evidence of the taxpayer's fraudulent intent. The Court also noted the fact that the taxpayer was convicted of felony forgery in 1996 for forging the signatures of persons residing near the country club he operated on that business's application for a liquor license. The Court found the taxpayer liable for the underpaid taxes and for fraud.

Tip

Doing your own return? . . . While the tax law has gotten more complicated, the software has gotten much better. (We wouldn't consider doing a return without a tax program!) Since you've paid for the software, make full use of its capabilities. The two programs most frequently purchased by individuals have extensive worksheets to help you along. While it might take a few extra minutes to enter data in the worksheet, it'll pay dividends in the long run. Not sure if you qualify for the child tax credit? Just answer the questions in the worksheet. If you do, it's almost impossible to generate an incorrect amount. Resist the urge to race through the return by "plugging" numbers and taking shortcuts. Not only do you risk an error on the entry, you could generate incorrect entries on other sections of the return if the entry carries to other forms or schedules.

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The general rule is that amounts you receive as a return of capital or a return of your contributions are not taxable; just about any other amounts are taxable income. (There are exceptions, of course.) In Thomas G. Wright et al. (T.C. Memo. 2005-5) the taxpayer excluded 40% of his disability benefits from his income. He based this percentage on his alleged 8% contribution rate and an alleged 12% contribution rate from his employer. The exclusion was different than what the payer determined and reported on his 1099-R. The Court found that the taxpayer could not substantiate that 40% of his benefits were solely the result of his contributions. In addition, the taxpayers did not show that any amounts contributed by his employer were included in the taxpayers' income. Finally, in a contributory plan, where accident, health, and retirement benefits are all included, the accident and health benefits attributable to employee contributions are tax free. (Sec. 1.72- 15(c)(1)) Where an employee contributes to such a combined accident, health, and retirement plan, any accident and health benefits are presumed to have been made by the employer's contributions and not the employee's contributions. However, this presumption can be rebutted. Accident and health benefits will be attributed to employee contributions where the plan expressly provides: (1) That the accident or health benefits are provided in whole or in part by employee contributions; and (2) the portion of employee contributions to be used to provide the accident or health benefits. Accordingly, absent an explicit plan provision, the regulations deem that the accident and health payments are attributable to the employer contributions and, therefore, taxable to the employee.

While the IRS can foreclose on property a taxpayer owns in order to satisfy a tax debt, the taxpayer can protest the action in court. In J. Leonard Padilla (2005-1 USTC 50,134; U.S. District Court, East. Dist. Calif.) the taxpayer purchased properties with his own funds but put the properties in the name of his son. The son objected to the foreclosure. the Court noted that while it has discretion to deny a foreclosure in order to protect an innocent third party, this discretion should be exercised rigorously and sparingly, with a view towards the government's paramount interest in rpompt and certain collection of delinquent taxes. It also noted that the party opposing foreclosure has the burden of showing that equity requires denial of the government's motion. There are four factors to consider in exercising the court's discretion:

• economic prejudice to the government of a partial sale,
• the third-party's legal expectations that the property would be protected from forced sale,
• dislocation costs and potential undercompensation of the third party, and

the comparative property interests of the delinquent taxpayer and the third party.
The Court held that the son did not demonstrate that equity required denial of the government's motion.

Tip

Lost W-2? . . . What are you required to do if an employee loses his or her W-2, or it's lost in the mail, destroyed, etc.? The IRS requires you to issue another W-2, and type on it "REISSUED STATEMENT". Don't send another copy A to the Social Security Administration. Just give the employee his copies. And, while you're required to issue duplicate W-2, you're not prohibited from charging for it. Unfortunately, the law is silent on how much you can charge.

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You may be able to settle your debts with the IRS for less than the full amount if the Service accepts your offer-in-compromise. But the IRS doesn't have to accept your offer. The Service will look at a number of factors including your current income, expenses, assets, liabilities, etc. In Sal Alaniz and Ruth Alaniz (T.C. Memo. 2005-4) the IRS rejected the taxpayers' offer to settle a tax bill of some $221,000 for just $2,000. The taxpayer claimed in Tax Court that, in rejecting the offer, the IRS abused its discretion. The Court sided with the IRS. The Court noted the Appeals officer followed prescribed guidelines and considered the taxpayer's age and health. The Court found that the value of a classic car that was transferred to the taxpayers' son for $1,000 was considerably more than the amount received. The Court also noted that the taxpayers purchased two cars and additional life insurance after they made their first offer-in-compromise to the IRS.

President Bush is proposing to give the IRS an extra $500 million for enforcement in 2006. That would be an 8% increase and would be used to examine more tax returns, collect past due taxes and investigate cases of tax avoidance. Coincidentally, stakeholders have been telling the IRS Oversight Board that the Service needs more money to modernize technology and increase enforcement.

Tip

Pending legislation . . . What could be coming this year in new tax legislation? There's a good chance we'll see the repeal of the estate tax. But that's only on the federal level. The tax is a big revenue raiser for many states and most are unlikely to scrap it when they're under pressure to generate income. Also look for Congress to deal with tax shelters and loopholes as well as address the issue of taxpayers who don't report all their income.

News

If you do business as a C corporation the IRS can challenge your salary and label a portion as excessive, making it a constructive dividend, taxable to the recipient but not deductible by the corporation. In an earlier case Menhard, Inc. (T.C. Memo. 2004-207) the Tax Court held that only some $7,000,000 of the taxpayer's reported compensation of some $20,000,000 was reasonable compensation. In the current case. Menhard, Inc. (T.C. Memo. 2005-3) the taxpayer asked the Tax Court to reconsider its ruling on two grounds. In one of the grounds, the taxpayer argued that Exacto Spring Corp. eliminated the multifactor test not only for testing whether the compensation was reasonable but also for testing whether the compensation was paid purely for services and that it substituted a bad faith standard for determining whether compensation was paid purely for services. The Court did not agree. It noted it could not discern any intention on the part of the Court of Appeals to incorporate a bad faith requirement into the analysis of whether compensation is paid purely for services. The Court of Appeals in Exacto Spring Corp. referenced the two-prong test under Section 162 and stated that deductible compensation under Section 162 must be both reasonable in amount and a payment purely for services. If you downloaded Publication 15-B (Employer's Tax Guide to Fringe Benefits) before February 1, the standard mileage rate for 2005 on pages 1 and 17 is incorrect. The IRS has now loaded a corrected version showing the proper cents-per-mile rate of 40.5 for 2005. Here's a quick link to the Publication 15-B www.irs.gov/pub/irs-pdf/p15b.pdf.

Tip

Direct deposit speeds refund . . . The IRS continues to advise taxpayers to have their refund directly deposited in their savings or checking accounts. That's not only good advice since you'll get your refund several weeks earlier, it's easy to do. All you need do is include your routing and account number on your tax return. If you use a preparer, he'll enter it in the computer (you can do the same if you're using a program to prepare your return) and you'll only have to deal with it again if your account number changes. Most states have similar provisions. Why is the IRS encouraging direct deposit? We suspect it's because it saves a lot of money in check processing charges.

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Section 6111, as amended by the American Jobs Creation Act of 2004, requires that each material advisor with respect to any reportable transaction make a return setting forth information identifying and describing the transaction and any potential tax benefits expected to result from the transaction no later than the date specified by the Secretary. Notice 2004-80, 2004-50 I.R.B. 963 (December 13, 2004) announced that the Service intends to issue regulations providing rules under Sec. 6111. Notice 2004-80 also provides interim rules implementing the requirements of Sec. 6111 until the IRS prescribes regulations. Because further guidance is under consideration, In Notice 2005-17 (IRB 2005-8) the IRS announced that the transitional relief provided in Notice 2004-80 for disclosure of a transaction under Sec. 6111 is extended. If a person becomes a material advisor after October 22, 2004, and on or before January 29, 2005, that material advisor must file the return before March 1, 2005.

Tip

Company officer personally responsible for sales tax . . . On more than one occasion we've discussed the fact that an officer or even an employee can be held personally responsible for withheld income and social security taxes that aren't deposited. The government considers them a "trust fund" tax. That is, the funds never belonged to the employer, the company was merely collecting them for the government. Most states take the same approach to sales taxes. In a recent New York State case the Administrative Law Judge found an officer of a clothing retailer a responsible person. The judge noted that while not directly responsible for keeping the books, he was responsible for the operation and oversight of the department. The judge also noted that the responsibility to collect and pay the tax could not be ameliorated by blaming a software error. Make sure you're aware of your responsibilities to collect and pay sales taxes. That's especially true if you do business in other states.