TAX WATCH: Annuity owners can offset now, pay later

The Internal Revenue Service recently ruled that the owners of single-premium annuity contracts could offset their annuity income with a portion of the basis but that they must recognize any payments of excess interest as income when received.

A life insurance company wants to issue single-premium immediate-annuity policies under which payments begin within one month of the purchase for a defined term. Although the policies would have no cash value, they would have a “commuted value” at least equal to the present value of the guaranteed monthly annuity payments.

The insurer plans to credit excess investment interest to the commuted value. Under a variety of options, policy owners could elect to receive the commuted value at the end of the defined term or have it distributed during the annuity period.

The IRS concluded that the policies qualified as immediate-annuity contracts under Section 72 (Annuities), and thus the owners were entitled to apply the Section 72 exclusion ratio to the guaranteed monthly payments. The IRS also concluded that excess interest is part of income when actually received by the annuitant, not when credited to the commuted value of the policy.

Cite: LTR 200036021

Options and stocks do not straddle

In a recent technical advisory, the Internal Revenue Service ruled that an insurer’s stock portfolio and options contracts are not a straddle.

The insurer, a large mutual property and casualty company, owned a diversified portfolio. To hedge against market drops, it bought listed put options on Standard & Poor’s 500 stock index futures contracts as well as call options on individual stocks. On its tax returns, the insurer deducted the losses from the option sales, taking the position that the options were not subject to the Section 1092 straddle rules.

An IRS revenue agent disagreed, finding that some or all of the portfolio stock and some or all of the options created straddles. The insurer argued that put options were not “substantially similar or related property” under the substantial overlap test and that the call options were qualified options under the straddle rules unless they were part of a larger straddle. Further, the company argued that the determination of the existence of a larger straddle must be tested on a stock-by-stock basis.

Disagreeing with its revenue agent, the IRS determined that the legislative history of this area of the tax law indicated that the “`substantially similar’ standard would not be met by a taxpayer with a diversified stock portfolio who acquired a regulated futures contract or an option on a stock index to hedge against general market risk.” The IRS noted that it would view diminution of market risk where “clearly appropriate to do so.”

According to the IRS, the purpose of the insurer’s transactions was to protect its portfolio from general market risk. Thus, the portfolio did not meet the “substantial overlap” test, nor was there any relation between the put options and call options.

Cite: TAM 200033004

Which per diem? Take your pick

The Internal Revenue Service has announced that employers may choose between two sets of per diem rates for employee travel the remainder of this calendar year. Of course, the new rates haven’t been released yet.

Previously, per diem rate changes were effective at the beginning of the calendar year. Now, however, per diem changes are effective Oct. 1. The new rates will be announced soon and will appear on the General Services Administration’s website at www.policyworks.gov/perdiem.

Cite: Notice 2000-48

Salary prepayment judged a sham

A federal court has ruled that a transaction between a corporation and its owner lacked economic substance; the prepayment scheme plus loan repayments allowed the corporation to pay a monthly “wage” in 1994 and 1995 to avoid FICA and FUTA taxes.

Jeffrey Fleck Co., a professional corporation, and its eponymous sole owner entered into an employment agreement Jan. 1, 1993, for two years ending Dec. 31, 1994. Mr. Fleck was to receive a base salary of $110,000 per year, and salaries for both years were to be paid in December 1993.

The corporation acknowledges that the objective of this scheme was to avoid 1994 FICA and FUTA taxes. Mr. Fleck lent the corporation $120,000 in December 1993, and that amount was repaid in 1994 and 1995.

The corporation filed unemployment and quarterly employer tax returns for both 1993 and 1994. However, the entire salary was reported in 1993, and no wages were reported in 1994, resulting in a tax savings of $10,000.

On audit, the IRS determined that the allocation of the entire $215,600 salary amount to 1993 was improper and adjusted the returns, allocating wages to 1994. That generated FICA and FUTA tax liabilities in 1994 that the corporation paid on Dec. 31, 1996. The corporation filed a refund claim in June 1997 that was denied on Aug. 1, 1997.

Judge Peter C. Economous of the U.S. District Court for the Northern District of Ohio, agreeing with the IRS, determined that the wage prepayment and loan were a sham transaction to improperly avoid FICA and FUTA taxes and granted the IRS’ motion for summary judgment.

Cite: Jeffrey B. Fleck Co. v. United States, N.D. Ohio

Woman loses suit in spouse’s suicide

A U.S. District Court, in a memorandum opinion, has dismissed a widow’s complaint alleging that the government conducted unauthorized tax collections that resulted in her husband’s wrongful death.

Darlene and Ernest Kugler were unable to pay their individual income taxes for 1981, 1982, 1984 and 1986-95. In addition, Mr. Kugler incurred sole proprietorship liabilities stemming from his business. The couple filed for Chapter 13 bankruptcy for the years 1990 and 1993.

In 1993, the couple agreed to make monthly payments over five years to satisfy their tax liability. In 1995, however, Mr. Kugler suffered injuries that made him unable to work, and the couple defaulted.

The IRS placed liens on the Kuglers’ home and settlement proceeds from a personal-injury action. The Kuglers expressed interest in obtaining a mortgage to partially satisfy tax liabilities.

IRS revenue officer John Marker refused to recommend the issuance of a certificate of subordination that the lending institution would require, citing the deficiency of the mortgage proceeds.

By March 1997, the Kuglers’ tax liability was $157,000, mostly accrued interest and penalties. The IRS directed the Kuglers to sell their home by April 1997. They filed for bankruptcy on April 3, 1997.

In May 1997, Mrs. Kugler attended a meeting with the IRS concerning the bankruptcy. Some time later, Mr. Kugler committed suicide.

His widow subsequently filed a complaint alleging that Mr. Marker had disregarded the tax law and that this had led to an unauthorized collection action.

Judge William L. Standish of the U.S. District Court for the Western District of Pennsylvania ruled that Mr. Marker did not act in a reckless manner or intentionally disregard any provision of the tax code or any IRS regulations, and dismissed the complaint.

Cite: Darlene Kugler v. United States, W.D. Pa.