IRS Practice and Procedures News Briefs for April 2017

CHARITABLE DEDUCTION REQUIREMENTS – Gaines v. Commissioner, T.C. Summ. Op. 2017-15 (2017)

Why This Case is Important: Charitable contributions and related tax deductions are important to many individuals’ tax-planning strategies. These deductions are also one of the most highly scrutinized deductions because individuals frequently fail to properly document their contributions. This case details the substantiation requirements for contributions of valuable property.

Facts: In Gaines, on the taxpayers’ 2013 federal income tax return, they reported and deducted $18,000 for noncash charitable contributions. They indicated on the return that the deduction was related to clothing donated to Goodwill. The IRS examined this return and disallowed the deduction, along with other adjustments. As a result of these adjustments, the IRS issued a notice of deficiency asserting that the taxpayers owed over $7,500 in unpaid taxes and accuracy-related penalties. The taxpayers filed a petition with the U.S. Tax Court contesting, among other adjustments, the disallowance of the charitable deduction.

Law and Analysis: Under Section 170 of the Internal Revenue Code, taxpayers who make a noncash charitable contribution are entitled to a tax deduction equal to the fair market value of the contributed property at the time of the contribution, subject to certain substantiation requirements. These requirements become stricter as the amount of the contribution and corresponding deduction increases. For a contribution of property worth more than $5,000, the taxpayer must substantiate the contribution with a contemporaneous written acknowledgment from recipient. It also must maintain reliable written records for each donated item that contain: (1) the approximate date and manner of the property’s acquisition; (2) a description of the property in reasonable detail; (3) the property’s cost; (4) the property’s value at the time of contribution; and (5) the method of determining the property’s value. Finally, the taxpayer must obtain a “qualified appraisal” of the donated items and attach an appraisal summary to his or her tax return. In this case, the taxpayers did not meet any of these requirements. That being the case, the Court found in favor of the IRS.

DISCLOSURE OF TAX RETURN INFORMATION – Mescalero Apache Tribe v. Commissioner, 148 T.C. No. 11 (2017)

Why this Case is Important: Privacy concerns, especially with respect to personal financial information, are a constant topic of conversation. At issue in this case is whether the IRS can be forced to disclose a third party’s tax return information in a Tax Court proceeding.

Facts: In Mesclaro Apache Tribe, the taxpayer was a Native American Tribe with around 5,000 employees. The IRS examined the Tribe’s employment tax returns for 2009 through 2011 and determined that the Tribe was misclassifying some of its employees as independent contractors and therefore not paying enough employment taxes. With this determination came a large tax bill. The Tribe filed a petition in Tax Court contesting the IRS’s reclassification of its employees. Under Section 3402 of the Internal Revenue Code, when an employer misclassifies its employees, its resulting liability is reduced by the taxes that were already paid by the employees. Therefore, one defense that the Tribe wanted to assert in the litigation was that the workers in question had already paid some or all of their income taxes. However, the Tribe did not have information as to whether the workers actually did pay their taxes for the years in question and was unable to get that information from many of the workers. That being the case, the Tribe filed a motion to compel the IRS to provide this information. The IRS contended that it was prohibited from disclosing the information by Section 6103 of the Internal Revenue Code.

Law and Conclusion: Section 6103 generally prohibits the IRS from disclosing a taxpayer’s tax returns and tax return information without its consent. “Return information” includes records of a taxpayer’s tax payments. However, there are exceptions to this rule. One of these exceptions states that a return or return information may be disclosed in a judicial or administrative tax proceeding, but only if the return or information “directly relates to a transactional relationship” between a party to the proceeding and the taxpayer “which directly affects the resolution of an issue in the proceeding.” Relying on case law, the Court held that an employer-employee relationship is a “transactional relationship” and that the information requested by the Tribe – its employees’ tax payment records – directly related to that relationship. It further determined that the information directly affected the resolution of the case because whether the employees paid their income taxes was indicative of whether they saw themselves as employees or independent contractors. Therefore, the Court found that the IRS was permitted (and, because of applicable discovery rules, was required) to disclose the payment records to the Tribe.

TAXATION OF S CORPORATION SHAREHOLDERS – Dalton v. Commissioner, T.C. Memo. 2017-43 (2017)

Why This Case is Important: With many taxpayers operating their businesses as S corporations, it is important that they understand how they will be taxed on S corporation income. Specifically, S corporation shareholders must realize that they will report and pay income taxes on their pro rata share of the corporate-level taxable income, regardless of whether they actually receive distributions of that income.

Facts: In Dalton, the taxpayer and his brother were both 50% shareholders of an S corporation. In 2007, the taxpayer informed his brother than he wanted to resign from the company and relinquish his stock. The brothers’ relationship began to deteriorate, as the taxpayer’s brother locked him out of the company’s offices and refused to turnover financial records. Eventually, the brothers resolved their dispute with the taxpayer transferring his stock in the company to his brother in July 2008. Thereafter, the company filed its final S corporation return through the date of that transfer, reporting $903,063 in taxable income. It issued a K-1 to the taxpayer allocating to him $451,531 of this income. The taxpayer filed a 2008 income tax return reporting this income, but included a note stating that the K-1 was incorrect and that he would file an amended return to correct it. He never did. When he did not pay the related tax liability, the IRS assessed penalties and began issuing notices threatening collection action. The taxpayer filed an offer in compromise contesting that he owed the full tax due, arguing that he did not receive any income distributions from the company in 2008. When the IRS rejected this argument, the taxpayer filed a Tax Court petition.

Law and Analysis: S corporations are not subject to federal income tax at the corporate level. Instead, an S corporation’s taxable income and losses as reported on its corporate return are allocated to its shareholders pro rata based on their ownership percentages. The taxpayers then must report their share of the income (or losses) on their personal income tax return and pay income taxes on that income. This is the case regardless of whether the allocated income was actually distributed to the shareholders. Therefore, the fact that the S corporation never distributed its income to the taxpayer was irrelevant; the Internal Revenue Code required him to pay tax on that income regardless of whether he actually received it. That being the case, the Court found in favor of the IRS.

If you would like more details about these cases, please contact me at 312-888-4113 or jnesser@lavellelaw.com