Federal Taxation - Dustin M. Covello, Jacquelyn L. Griffin, and Svetoslav S. Minkov

• Publication year: 2009

Federal Taxationby Dustin M. Covello^* Jacquelyn L. Griffin^** and Svetoslav S. Minkov^***

I. Introduction

The courts in the the Eleventh Circuit heard a number of tax-related cases in 2008.¹ In Wright v. Everson,² the United States Court of Appeals for the Eleventh Circuit affirmed the validity of regulations that deny, in certain circumstances, an unenrolled tax preparer the right to practice before the Internal Revenue Service (the Service).³ In Rose v. Commissioner,⁴ the Eleventh Circuit reversed the United States Tax Court, holding that a shareholder of an S corporation may increase his basis in the shares of the S corporation by the amount of debt of the S corporation that the shareholder satisfied by forgiving amounts previously lent by the shareholder to the S corporation's creditor.⁵ In another unpublished opinion, Estate of Greenfield v. Commissioner,⁶ the Eleventh Circuit affirmed a Tax Court decision holding that the Service timely issued a notice of deficiency and that the waiver of the limitations period on tax assessments extended not only to the underlying tax liability, but also to any interest and penalties.⁷ The Eleventh Circuit also revisited a familiar case in Ballard v. Commissioner⁸ and determined that the Tax Court judge was not appropriately deferential to the report of the Special Trial judge and that the taxpayers, in fact, did not participate in a fraudulent kickback scheme.⁹ In Regions Financial Corp. v. United States,¹⁰ the United States District Court for the Northern District of Alabama held that a taxpayer's tax accrual workpapers were protected by the work-product privilege and that the taxpayer's disclosure of tax accrual workpapers to an independent auditor did not waive the work-product privilege claim.¹¹ Finally, in United States v. Mount Sinai Medical Center of Florida, Inc.,¹² the United States District Court for the Southern District of Florida determined that the Mount Sinai teaching hospital qualified as a "school, college, or university" under section 3121(b)(10) of the Internal Revenue Code (the Code)¹³ and that its medical residents were "students" within the meaning of the same section.¹⁴ Thus, the hospital was entitled to an exemption from taxation for the salaries or stipends paid to such residents under the Federal Insurance Contributions Act (FICA).¹⁵

II. Eleventh Circuit Cases

A. Regulations Denying an Unenrolled Tax Preparer the Right to Practice Before the IRS are valid

In Wright v. Everson,¹⁶ the Eleventh Circuit affirmed the validity of regulations that deny, in certain circumstances, an unenrolled tax preparer the right to practice before the Service.¹⁷ In Wright a former revenue officer who was registered with the Service as an "unenrolled" tax return preparer sought to represent his customers before appeals officers and revenue officers of the Service. The Service often refused Wright permission for such representation, and he filed a declaratory judgment action in the United States District Court for the Middle District of Florida challenging the validity of 31 C.F.R. Sec. 10.7 (Regulation 10.7).¹⁸ Wright argued that Regulation 10.7 violated his due process rights and section 7521(c)¹⁹ of the Code.²⁰

According to 31 U.S.C. Sec. 330(a)(1),²¹ the Secretary of Treasury (Secretary) has the authority to regulate practice before the Department of Treasury.²² Regulation 10.7 implements this authority, in part, by allowing a tax preparer to represent a taxpayer before revenue agents, customer service representatives, or similar officers and employees of the Service during an examination with respect to tax returns that the preparer has prepared.²³ However, Regulation 10.7 prohibits a tax preparer from representing a taxpayer before appeals officers, revenue officers, counsel, or similar officers or employees of the Service, even if the preparer seeks to represent taxpayers concerning tax returns that the preparer has prepared.²⁴ In addition, section 7521(c) of the Code allows a representative of a taxpayer to represent the taxpayer in an interview with the Service.²⁵ When deciding the validity of a legislative regulation, courts apply the principles of Chevron deference.²⁶ Under Chevron deference, if there "is an express delegation of authority to the agency to elucidate a specific provision of the statute by regulation," a resulting legislative regulation is invalid only if it is "arbitrary, capricious, or manifestly contrary to the statute."²⁷

The district court granted the government's motion for summary judgment, finding that Congress delegated to the Department of Treasury the authority to regulate the practice of representatives to the Secretary, and therefore Regulation 10.7 was a legislative regulation.

Because the court found Regulation 10.7 to be legislative, the court reviewed the regulation under Chevron deference. Under this deferential review, the district court found that the Secretary's implementation of his congressionally delegated authority was not arbitrary, capricious, or manifestly contrary to the delegating statute.²⁸

The Eleventh Circuit affirmed the district court's grant of summary judgment in favor of the government.²⁹ The Eleventh Circuit reasoned that Congress expressly delegated to the Secretary broad power to regulate who may practice before the Service by enacting 31 U.S.C. Sec. 330.³⁰ Accordingly, the Secretary's regulation was entitled to Chevron deference.³¹ Using Chevron deference, the Eleventh Circuit held that Regulation 10.7 was not arbitrary, capricious, or manifestly contrary to the statute because the Secretary had valid reasons to limit who could practice before the Service.³² The Eleventh Circuit noted that Regulation 10.7 balanced a taxpayer's right to "choose his representative with the need for competent representation that protects the taxpayer, the IRS, and the general public."³³ The court also noted that Wright was not prevented from fully representing clients under Regulation 10.7 if he demonstrated his knowledge to the Service and became enrolled under 31 C.F.R. Sec. 10.4(a).³⁴

The Eleventh Circuit's decision in Wright appears reasonable in light of the Regulation 10.7's statutory background and also ensures that taxpayers and the Service may expect a fundamental level of competence during the tax examination process.

B. Shareholder of an S Corporation May Increase his Basis in S Corporation Shares by an Amount of Debt Forgiven by the Shareholder that the Shareholder Lent to the Corporation's Predecessor C Corporation

In Rose v. Commissioner,³⁵ the Eleventh Circuit reversed the Tax Court and held, among other things,³⁶ that a shareholder of an S corporation may increase his basis in the shares of the S corporation by the amount of debt of the S corporation that the shareholder satisfied by forgiving amounts previously lent by the shareholder to the S corporation's creditor.³⁷

In 1992 and 1993, Rose, a majority shareholder of P.K. Ventures, Inc. (PKV), lent an aggregate of $3,853,500 to PKV. At the beginning of 1994, PKV reorganized its corporate structure, resulting in two surviving Subchapter S corporations, St. Louis Pipline Co. (SLPC) and Tampa Pipline Co. (TPC). PKV merged itself into TPC, and TPC assumed PKV's debt to Rose. After the merger, Rose owned all the stock of SLPC and a portion of the stock of TPC, but SLPC still owed TPC approximately $1.7 million. During 1994 and 1995, Rose paid a portion of SLPC's obligations to TPC by forgiving $1.15 million of the debt that TPC assumed from PKV.³⁸ In 1994 SLPC incurred major losses, and Rose deducted $455,151 of the SLPC losses on his 1994 individual tax return and $322,973 of the SLPC losses on his 1995 individual income tax return. Rose claimed that his basis in SLPC stock had been increased as a result of the payment of $1.15 million of SLPC's liability to TPC; therefore, he could deduct all of SLPC's losses in 1994 and 1995.³⁹

In December 1999 the Internal Revenue Service (Service) issued a notice of deficiency to PKV and in March 1999 the Service issued a notice of deficiency to Rose.⁴⁰ The Tax Court upheld most of the deficiencies alleged by the Service. Under section 1366(d)(1) of the Code,⁴¹ a shareholder of an S corporation may deduct his pro rata share of the S corporation's net operating losses to the extent of the sharehold- er's basis in S corporation stock and debt.⁴² To increase his basis in S corporation stock, however, the shareholder must make an actual "'economic outlay'" that leaves the shareholder "'poorer in a material sense.'"⁴³ The Service argued, and the Tax Court agreed, that Rose did not make an actual economic outlay that left him poorer in a material sense because the 1994 and 1995 transactions cancelled debt owed to TPC rather than debt owed to Rose.⁴⁴

The Tax Court analogized Rose's case to other similar cases, such as Underwood v. Commissioner,⁴⁵ in which a controlling shareholder and two controlled corporations exchanged loans to increase the shareholder's basis in stock of a controlled S corporation.⁴⁶ In Underwood the shareholder controlled a profitable C corporation and an unprofitable S corporation. To increase his basis in the S corporation's stock, the shareholder caused the C corporation to substitute the shareholder's personal note for a note owed by the S corporation to the C corporation. At the same time, the S corporation issued a demand note to the taxpayer, which the taxpayer claimed caused his basis in the S corporation stock to increase.⁴⁷ The United States Court of Appeals for the Fifth Circuit held that the shareholder was not entitled to increase his S corporation stock basis.⁴⁸ As in Underwood, the Tax Court denied Rose's claimed increase ofhis basis in SLPC stock and the corresponding losses he deducted on his 1994 and 1995 individual tax returns.⁴⁹

The Eleventh Circuit reversed the decision of the Tax Court and held for Rose.⁵⁰ The Eleventh Circuit noted that the Tax Court's analysis ignored...