Tax research assignment

Tax Research Assignment 2

Acct 6140 Students Only

Fall 2013

Your assignment is to write a professional tax research memorandum that addresses the issue shown below.

Mike is a salesperson who represents several companies. On January 2, 2014, he receives by mail a commission check from Produce Packaging Distributors, Inc. in the amount of $13,500 and dated December 30, 2013. Mike is concerned about the year in which the $13,500 is taxable. Although the check is dated 2013, he contends that it would have been unreasonable for him to drive the 55 miles to the Produce Packaging offices on a holiday to collect the check. Further, Mike maintains that even if he had made the trip to collect the check, by the time he returned home, his bank would have closed and he could not have received credit for the check until after the first of the year.

In addition, Mike attended classes provided by his church in 2013. He made payments to the church that were required to attend classes. He plans to deduct the payments as charitable contributions to his church on his 2013 tax return.

a. Mike would like you to determine whether he should include the $13,500 commission income on his 2013 or 2014 tax return.

b. Mike would also like to know if he can deduct the payments to his church as charitable contributions in 2013.

Tax Research Memo Format:

· Title your memo either generally, e.g., “Research Memorandum” or more specifically, e.g., “name of the client and the specific tax situation at hand”

· Address your memo to the client file [include the standard Date, To, From, and Re headings]

· Organize the body of your memo using the following subheadings:

· Facts

· Issue(s)

· Conclusion(s)

· Analysis/Discussion

· The Facts section should clearly and concisely summarize all relevant facts that may affect the tax outcomes. In particular, include dollar amounts, dates, and names of all parties to transactions.

· The Issues section should include numbered issues if there is more than one. Write each issue as a question. Include enough of the facts to give context to the question. For example, “How much, if any, of the $3,000 John Doe paid for attending a Real Estate conference cruise from Miami to Galveston can he deduct as a business education expense?” is better than “What are the tax consequences of these facts?”

· The Conclusion(s) should be numbered to correspond to the Issue(s). State a definite conclusion, if possible, for each Issue. If a definite conclusion is not possible, for example, because you are researching alternative ways to plan a transaction, then state the conclusion that will be appropriate IF each alternative is taken.

· The Analysis/Discussion section should be organized to correspond to each issue if there is more than one. Each numbered subsection in the Analysis section should be organized as follows:

· Summarize the relevant Code section. For example, if you are analyzing a deductibility of a business expense, begin by summarizing the rule in §162(a). Paraphrase, do not copy and paste either from the Code or from commentary.

· Summarize any other relevant law sources such as regulations, Revenue Rulings, and judicial opinions, if any. The summary of the law—Code and other sources—can usually be done in a single paragraph unless the issues are very complicated or there is a large volume of sources to consider.

· Include a second paragraph in which you Apply the law to the client’s facts or planned transactions. This application should bridge between the law and your conclusion regarding the issue.

· Citations: use correct citation format. Always cite the smallest subdivision of the Code or regulation that contains the language you are referring to, e.g., §1031(c)(1)(B) instead of §1031. DO NOT CITE COMMENTARY—commentary, such as the prose contents of RIA’s Federal Income Tax Reporter, is not a primary source of the tax law and thus is not authoritative. Read and use commentary to aid your understanding of the law and as a prelude to investigating primary sources such as the Code, regs, rulings, and cases.

· Ask questions as needed!

· See the Sample Research Memorandum below

Sample Research Memorandum

Date: September 20, 20X2

To: J. Kenneth Alexander client file

From: Jane Smith

Facts: In 20X1, Mr. Alexander entered into an employment agreement with, W.F. Young, Inc., in which Alexander would remain Executive Vice President, Treasurer, and Chief Executive Officer until he reached the age of seventy (70), on December 13, 20X11. On October 15, 20X5, when Alexander was sixty-four (64) years old, Young terminated Alexander's employment.

On February 10, 20X6, Alexander filed a civil lawsuit against Young, in which Alexander alleged breach contract, breach of an implied pension benefits contract, and age discrimination.

On May 1, 20X7, Alexander and Young executed a written settlement agreement, under which Young was to pay Mr. Alexander $350,000, of which $100,000 was allocated to the age discrimination claim, and $250,000 to breach of contract. On May 5, 20X7, per the Settlement Agreement, Young issued two checks payable to "J. Kenneth Alexander and Ryan & White, Attorneys for J. Kenneth Alexander," one in the amount of $100,000 (for the age discrimination claim), and the other in the amount of $225,395.20 (for the breach of contracts claims, less taxes withheld).

On his 20X7 Federal income tax return, Alexander deducted $245,100 from the settlement proceeds attributable to the breach of contracts claims. This deduction was explained in an attached statement, which stated that Alexander paid Ryan & White $258,000 in legal fees. It also stated that according to Ryan & White's time allocations, 5% of the Legal Fee was attributable to settlement of the age discrimination claim, and 95% to settlement of the breach of contracts claims.

The IRS sent a notice of deficiency disallowing Mr. Alexander's direct deduction of the Legal Fee from the settlement proceeds. The IRS determined that the $250,000 received from Young in settlement of the breach of contracts claims was gross income to Alexander, and that the Legal Fee associated with those claims were miscellaneous itemized deductions. Accordingly, the IRS reduced the $245,100 deduction reported on the 2007 return to $240,198, due to the increase in Mr. Alexander's adjusted gross income and the two percent (2-percent) adjusted gross income limitation for miscellaneous deductions. In addition, the IRS determined that, due to these adjustments, Alexander was liable for the Alternative Minimum Tax ("AMT"), which resulted in a deficiency of $57,441.

Issues:

(1) Whether Mr. Alexander properly deducted the Legal Fee from the settlement proceeds under Section 1001?

(2) If not, then whether the legal fee is an "above the line" trade or business deduction under Section 162 of the Code, or is a miscellaneous itemized deduction "below the line?"

Conclusions:

(1) No, the legal fee should not have been deducted from the settlement proceeds in determining Mr. Alexander’s income.

(2) The legal fee is a miscellaneous itemized deduction, not a trade or business deduction.

Discussion:

(1) Characterization of the Legal Fee

Section 61(a), defines gross income as "all income from whatever source derived." It includes, "[c]ompensation for services, including fees, commissions, fringe benefits, and similar items." In addition, 145

numerous courts have ruled that the classification of amounts received from litigation, and in settlement of litigation, is to be determined by the nature and basis of the action settled. This is referred to as “the nature of the claim” test. Raytheon Production Corp. v. IRS, 144 F.2d 110, 32 AFTR 1155 (1st Cir.), cert. denied, 323 U.S. 779 (1944); see Getty v. IRS, 913 F.2d 1486, 66 AFTR 2d 90-5517 (9th Cir. 1990) (applying Raytheon test in characterizing settlement payment for tax purposes).

An amount received in lieu of compensation under an employment contract constitutes gross income to the recipient in the year in which it was received. See Furrer v. IRS, 566 F.2d at 1117 (holding lump sum payment for termination of an agency relationship is ordinary income); Heyn v. IRS, 39 T.C. 719 (1963) (holding amount received in consideration of an employment contract is ordinary income); cf. Rev. Rul. 80-364, 1980-2 C.B. 294 (illustrating by way of three hypothetical examples the income and employment tax consequences of interest and attorney's fees awarded in connection with claims for back wages). See Henry v. IRS, 62 T.C. 605 (1974) (holding that amounts received in settlement of breach of employment contract must be held impressed with the same compensatory, taxable character).

What is relevant is that Mr. Alexander in substance was suing for damages suffered by the loss of his employment with Young -- his loss of compensation in terms of salary and retirement benefits. The claim giving rise to the legal fee is inexorably rooted in Mr. Alexander's employment with Young -- indeed, in his status as Young's "employee." Because the damages Mr. Alexander received are essentially a substitute for the salary and benefits he would have received under the employment contract, they are fully included as ordinary income in Mr. Alexander's gross income under Section 61.

(2) Deductibility of the Legal Fee

All increases in wealth must be included in gross income, unless the taxpayer can demonstrate that the amount received falls within a specific statutory exclusion. IRS v. Glenshaw Glass, 348 U.S. 426, 431, 47 AFTR 162, reh'g denied, 349 U.S. 925 (1955). Section 162(a) provides that there "shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." Section 62(a)(1) adds that expenses falling within Section 162(a) are deducted from gross income to arrive at "adjusted gross income," explicitly excluding expenses incurred by a taxpayer engaged in the trade or business of the performance of services as an employee.

Expenses excluded under the Section 62(a)(1) limitation are treated as "itemized deductions" under Section 63, such that they are subtracted from adjusted gross income in computing taxable income. I.R.C. section 63(d). In turn, under Section 67(b) "miscellaneous itemized deductions" are subject to a 2-percent floor, such that they are allowable "only to the extent that the aggregate of such deductions exceeds 2 percent of adjusted gross income."

A court would likely look to the plain language of Section 62(a)(1), which makes no distinction between present and former employees if the expenses originated in the trade or business of being an employee. Thus, the fact that Mr. Alexander's lawsuit resulted from his employment at Young determines Alexander’s status as Young's "employee" for purposes of falling within the Section 62(a)(1) limitation.

Because trade or business expenses subject to Section 62(a)(1), such as Mr. Alexander's legal fee, are not among the deductions listed in Section 67(b), statutory construction leads to the conclusion that they are miscellaneous itemized deductions subject to the 2-percent floor. See McKay, 102 T.C. at 493; cf. In Re Black, 131 B.R. 106, 71A AFTR 2d 93-4510 (E.D. Ark. 1991) (discussing the deductibility of non-reimbursed employee business expenses).

Thus, I conclude that the legal fee is properly deducted "below the line."

[Note: based on Alexander v. IRS, 77 AFTR2d 96-301 (CA1 1995)]

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