Ethics - Extreme Balance Sheet Liability

[Snaggletooth]

This is an outgrowth of the thread below by Ringers entitled "Tough Tax Situation". I've removed this topic because that thread has multiple issues and I want to focus on only one of them.

Recreating the scenario, one corporation is accruing $15,000 more rental expense than it pays. Over an 11-year period, it shows an unpaid liability of $165,000 which we can presume the corporation has deducted over this period of time.

TXEA, obviously one of our better forum members, recommends 3 years of amended returns to reclaim $45,000 of this errant expense and pay up to the IRS. This can reduce the unpaid liability to $120,000. This entire $120,000 needs to be removed from the balance sheet. I think most of us can agree with the foregoing.

Here's where the divergence of opinion may occur. YOU are the new accountant and preparer for this corporation. For book purposes, removing the $120,000 liability unquestionably results in an accretion of income attributable to the year in which it is written off. The question is, should you:
a) Claim in the current year, an injection of $120,000 taxable income on the current years' tax return, or
b) Do not record this as taxable income, but show it on Schedule M-1 as a book-to-tax adjustment.
c) Neither of the above.

Arguments can be forged to support a) and b) above. There is no question that the corporation has deducted improperly for a long period of time and the arrangement probably was set up under fraudulent intent.

But is the taxpayer obligated beyond the 3-year statute? If there was a tax benefit beyond 3 years the IRS would disallow it. Was the 3-year statute set up to be ignored in extreme cases? (Mind you "extreme" is in the eye of the beholder). And if there is indeed fraud, it is your responsibility as preparer to ferret this out?

Some other factors as yet unmentioned - first the disclosure of a large M-1 adjustment is likely to raise eyebrows if it is looked at. Secondly the taxability of a bulk $120,000 added to an 1120 or 1120S in a single year creates an inordinate amount of tax if compared to spreading the effect over a number of years. Thirdly, does the total assets, currently and in years past, significant enough that a Balance Sheet (Sch L) is necessary?

So, is the decision as simple as choosing between representing your client's best interest or is this just helping him weasel out of proper taxation?

Respected collegue TXEA has spoken and so has the Corduroy Frog (i.e. me on another computer). What say ye?

[ChEAr$]

The debit to the 120,000 liability has to have an equal and opposite reaction (Sir Isaac Newton? grin), and that would not be a sudden income in current tax year, but since it stems from before the three years to be amended, a prior period adjustment, i.e. credit to retained earnings.

[JON]

Correction of an error - maybe material

I think that can go beyond the 3 years - if it is material change due to an error.

[TXEA]

Respectfully, I do not know how one can argue that the taxpayer gets the deduction for all prior years, and then we determine an error and it is contribution to capital in essence.

This is a liability on the corporate books. If it was a Note Payable to the bank to pay rent and the bank canceled the debt, would you consider it to be a contribution to capital or debt forgiveness?

Another possibility is to pay the liability to the creditor. I see no problem with that. From the other post, the recipient will have to include this in income since they did not do so at the time.

Finally, in tax there is no fairness. If the liability was $3,000 or if the liability is $120,000 the decision should be the same. It does not matter that the higher amount will be difficult for the taxpayer.

[Snaggletooth]

Thanks for Joining

TXEA thanks for responding. These differences of opinion on ethical questions are the very reason we have this forum. I'll respond as follows - not to be argumentative, but to present additional considerations:

Respectfully, I do not know how one can argue that the taxpayer gets the deduction for all prior years, and then we determine an error and it is contribution to capital in essence.

No one can make a case for the taxpayer being able to deduct for all prior years. My point is those prior years are no longer under the microscope. Unless other circumstances are warranted, the IRS gets a shot at this scheme for only three years. There may indeed be fraud but that burden should not be on the preparer.

This is a liability on the corporate books. If it was a Note Payable to the bank to pay rent and the bank canceled the debt, would you consider it to be a contribution to capital or debt forgiveness?

The existence of this ridiculous liability on the balance sheet is the progenitor of current income, and there is no question that it is in fact income under GAAP. However, what if this were an accrual based proprietor and there WAS no balance sheet? Would we STILL insist on recovering taxable income beyond the statute? Or perhaps even more possible is the total assets being less than the amount required to even report such a balance sheet (Sch L). A bank generates a cancellation of indebtedness and there is no doubt this is reportable. There are several differences between a loan and an accrued liability. In this context, items deducted paid with loan proceeds are always fully deductible thus a loan forgiveness is a different type of income.

Another possibility is to pay the liability to the creditor. I see no problem with that. From the other post, the recipient will have to include this in income since they did not do so at the time.

Yes, this would solve all problems. I doubt any of parties are interested in this but it IS another possibility.

Finally, in tax there is no fairness. If the liability was $3,000 or if the liability is $120,000 the decision should be the same. It does not matter that the higher amount will be difficult for the taxpayer.

Absolutely agree. My concern is with the timing and not the amount.

Thanks for the response. Would love to hear from others...

[TXEA]

Tax Benefit Rule

Snaggletooth, I think those are all well reasoned arguments. I do not necessarily disagree with any of them. However.......

Let's look at the tax benefit Rule - 3 court cases on point to some extent.

----Munter's Estate v. Commissioner, 63 T.C. 663, 678 (1975)

"The need to assess and collect taxes at fixed and relatively short intervals underpins the principle of taxation that transactions which may possibly be subject to further developments substantially altering their character for tax purposes should nevertheless be treated as final and closed so that their tax consequences can be determined.

On the other hand, a taxpayer should not be permitted to take advantage of this governmental exigency to establish a distorted picture of his income for tax purposes. It is this countervailing consideration which spawned the tax benefit rule. The most common, and most nearly accurate, explanation of the rule is that it recognizes the "recovery" in the current year of taxable income earned in an earlier year but offset by the item deducted."

--Roxy Custom Clothes Corp. v. United States, 171 F. Supp. 851 (Ct. Cl. 1959)

"Accrued liabilities abandoned by the creditor. After issuing and deducting checks for such business expenses as wages, supplies, and customer overcharges, taxpayers often find that some checks are returned because the addressee cannot be found or are not cashed by the payee. Unless subject to a local escheat law, these unclaimed or abandoned items cannot remain outstanding for tax purposes forever. The inclusionary aspect of the tax benefit rule requires them to be taken into income, but the date when this is mandatory is unclear."

Cancellation of taxpayer's indebtedness.

When a debt is discharged for less than its face amount, the debtor ordinarily realizes income under United States v. Kirby Lumber Co. 34 and later cases. If the discharged debt gave rise to a tax deduction when it was incurred (for example, an ac- crual basis taxpayer's liability for wages or business sup- plies), then the Kirby Lumber principle overlaps the tax benefit doctrine in certain respects.

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IRC Sec 111 in brief requires inclusion in income of recovery of prior tax deductions to the extent a tax benefit was received. In the instance at hand, relief from liability is a recovery.

Let's say the taxpayer instead of accruing rent, overpaid rent in the closed years. No accrual, just paid cash. In that event assuming no fraud, then the years are closed. In this instance, there is nothing on the books to "recapture" so to speak.

However, that debt is on the books in an open year. And, it is clearly not a contribution to capital by the shareholders. It represents a tax benefit when forgiven.

Incidentally, there is an old court rule that taxes recoveries of legitimate expenses but not illegitimate expenses (if the year of the bogus expense is closed). I am not sure if the rule is still around at this time.

[Bees Knees]

This is not complicated. If debt has been accruing on the books for tax deductions claimed under the accrual method, then the moment that debt is removed from the books due to the taxpayer no longer being liable to pay such debt constitutes taxable income under the debt forgiveness rules. ...OR...the IRS can claim this is a change in accounting method and assess the tax under IRC §481.

If you are the new preparer for this client, you can't re-write history and claim it should have never been taken as a deduction in the first place, therefore we are going to make a retained earnings adjustment, and by the way, too bad for IRS...the 3 year statute has passed. The moment you try to make that argument and adjustment on the tax return, you are now co-conspirator to the sins of the prior accountant that allowed all of this in the first place. That liability is on the most recently prepared return. That means its consequences are still subject to IRS scrutiny, regardless of when the tax deduction was taken. Maybe IRS can't go back and assess tax for a 10 year old return, but they sure can assess tax on the current year when you try to get rid of that liability.

[Snaggletooth]

Send the taxpayer packing

This is not complicated.

No it is absolutely not complicated. The argument Bees and TXEA make is that the removal of a recorded liability results in instant income during the current year. And for financial statement purposes, GAAP, and every other measurement this is correct. So either by measuring current year absolution of liability in the current year, or by invoking court cases where the IRS can extend the statute, this guy is toast.

If it becomes the preparer's responsibility to drag the taxpayer through all the ghosts in the closet, taxpayer is going down the street. In fact, by all rationale, no preparer subscribing to this thinking is going to touch his work unless the taxpayer is complicitous, and there is virtually no chance of that. It appears the advice from our colleagues would be to advise the taxpayer of the grevious errors, and not offer to do tax work unless he agrees to pay back on the deductions previously taken over the last 11 years.

It would be sweet irony if this guy ended up back with the goofball accountant who got him into this mess. Downside is the farce would probably continue into future years.

I wonder if the taxpayer had been accruing income into a receivable for 11 years, and then wanted to write off the receivable, the IRS would invoke the 3-year statute. By the same allegory, he could write off the entirety of the receivable and claim a bad debt in the current year??

Thanks guys.

[Bees Knees]

The more I think about it, correcting improper deductions on a current year return is actually a change in accounting method, with a Section 481 adjustment required. There is something similar under the improper depreciation rules (TTB page 9-20). When it is discovered that prior year depreciation claimed was wrong, the correct way to fix it is to amend an open prior year and file Form 3115, Application for Change in Accounting Method. There is then a Section 481 adjustment that recaptures the under-reported income for all prior years.

The reason this is a change in accounting method rather than debt forgiveness is because under the circumstances, there was never any actual debt being accrued. For there to be debt, there has to be someone that the debt is owed to, and if this is a case where it was simply bad accounting that should have never been allowed in the first place, then correcting the prior year errors is considered a change in accounting method rather than debt forgiveness.

The advantage to calling it a change in accounting method is that when you voluntarily report this mistake (as opposed to IRS finding it upon audit), the positive income adjustment can be taken over a four-year period rather than reporting it as income all in one year. If IRS finds the mistake, it has to all be reported in one year.