Tax Watch: New IRS program seeks to head off disputes

The Internal Revenue Service has announced an Industry Issue Resolution Pilot Program. Its objective, according to IRS Notice 2000-65, is to resolve frequently disputed tax issues that are common to a significant number of large or midsize businesses.

The effort is part of the IRS’ strategy to resolve issues in a manner other than the traditional post-filing examination, where IRS auditors usually tell a specific taxpayer that there is a problem. The large- and midsize-business division will undertake much of the operational responsibility for the program.

The resulting guidance under that program may take a variety of forms. The most likely form will be a revenue procedure that permits taxpayers to adopt a recommended treatment of the issue on future tax returns. In many cases, that may require filing a request for a change in accounting method.

Although the principal focus of the program will be to prevent issues arising in future years, resolution may also be provided for certain issues for previous years.

The IRS is inviting taxpayers — as well as industry associations and other groups representing taxpayers — to suggest issues and possible options for resolution. Parties submitting suggestions may be asked to meet with government representatives and to provide additional information.

After analysis and review, the IRS and Treasury Department intend to select issues to address in the pilot program. For more information, contact Richard Druk at the division’s pre-filing and technical guidance office at (202) 283-8387 before Feb. 28.

IRS is struggling

to track partners

* The Internal Revenue Service’s plans to electronically match partnership K-1 Forms to their respective partners’ tax returns “will be impossible to do in large taxpayer/partner returns,” according to members of the Internal Revenue Service Advisory Council reporting to IRS Commissioner Charles O. Rossotti.

Similarly, council members addressing the commissioner on small-business and self-employed issues said that there was “significant potential for problems” with the process of matching taxpayer returns with K-1 reporting forms used by S corporations, limited liability companies and trusts, among others.

The council’s chairman, N. Jerold Cohen, told Mr. Rossotti that the IRS’ planned electronic matching of K-1s is a matter of concern to the entire council.

“The members of the council who are experienced in the preparation and filing of tax returns have grave doubts about the efficacy of the matching of K-1 data and are worried that this could create serious problems for both the IRS and taxpayers,” said Mr. Cohen.

Mr. Cohen is a former chief counsel for the agency and past chairman of the American Bar Association section of taxation.

Mr. Rossotti assured council members that the IRS would move forward on the electronic K-1 document-matching front in a cautious manner.

Larry Langdon, commissioner of the IRS’ large- and midsize-business division, and Joseph Kehoe, commissioner of the IRS small-business/self-employed division, echoed those sentiments.

The supplemental staffing tax administration for balance and equity resources initiative, or Stable, requested by the IRS for fiscal 2001, includes 408 full-time-equivalent staff positions that the IRS says will be used to transcribe data from 18 million Forms K-1 on paper.

Further, the IRS has told Congress that the Stable initiative will fund 200 full-time equivalents for additional document matching within the IRS’ underreporter program.

Just last November, Mr. Kehoe was quoted as saying that the small-business division’s strategy for 2001 “is to stop the drop in compliance activity and turn it around.”

This year, the small-business division plans to process many more paper K-1s from partnerships and complete more document-matching cases.

The division also plans to increase its compliance presence in the area of pass-through entities because of the recent growth in trusts, partnerships and corporations.

Tax court rules

on side business

* It could have been any professional when the U.S. Tax Court recently decided that legal fees incurred by a physician who operated a side business were not tax-deductible as Schedule C expenses. The reason being because they were not directly related to the side business.

Odelia Braum, a doctor who worked at the University of California, San Francisco, was director of the school’s center for pre-hospital research and training.

As director, Ms. Braum researched emerging medical response training for paramedics and other emergency response professionals.

Ms. Braum later created a private-sector emergency response program known as Save-A-Life Systems.

A year later, a state audit of the university’s medicine department, including the training center, generated adverse publicity, prompting Ms. Braum to consult two lawyers because the publicity might hurt her professional reputation.

A year later, she retained a law firm that rendered legal services related to the state audit and a criminal prosecution for wrongdoing associated with the training center.

On Ms. Braum’s 1994 joint income tax return, prepared by a certified public accountant, she deducted $87,300 on Schedule C for legal and professional fees.

The IRS determined that $70,600 of the fees was deductible as a Schedule A miscellaneous itemized deduction and sought an accuracy-related penalty as well.

Tax Court Judge Joel Gerber held that the deductibility of legal fees as an ordinary and necessary business expense depends on the origin and character of the claim and whether the claim has a sufficient nexus to the business.

The court rejected Ms. Braum’s argument that the legal fees were directly related to her professional reputation and thus to her side business.

Instead, the court found that the origin of the fees stemmed from her status as a university employee and from the impending release of the damaging audit report of the training center.

Mr. Gerber wrote that the entire record showed that Ms. Braum hired lawyers in response to that audit.

Although Ms. Braum may have been concerned that the audit and its consequences could hurt her side business, the rule established by earlier court cases requires courts to look to the “origin” of the underlying claim, not to the “consequences.”

Ms. Braum’s legal fees were incurred in response to an event – the training center’s audit – which was not part of SLS’ business but rather was part of Ms. Braum’s employment.

Therefore, the court sustained the IRS’ determination that the legal fees were deductible as unreimbursed employee business expenses on Schedule A.

Finally, the court decided that Ms. Braum was liable for an accuracy-related penalty only on the portion of legal fees that she failed to substantiate.

The court held that she was not otherwise liable for a penalty because she relied on the advice of her CPA to properly characterize the deduction, and she proved her actions associated with the characterization were reasonable.

Cite: Eric Test, et. al. v. Commissioner, T.C. Memo 2000-362