TaxProf Blog

Continuing a TaxProf Blog tradition (see The Top 10 Tax Stories of 2005, 110 Tax Notes 169 (Jan. 9, 2006)), here is a list of the The Top 10 Tax Stories of 2006, generated from a post on the TaxProf Discussion Group the last week of December 2006, discussed in detail below the fold (along with eleven honorable mentions):

1. Murphy v. Internal Revenue Service, by Gregory Germain (Syracuse)
2. The Tax Relief and Health Care Act of 2006, by James Maule (Villanova)
3. The Pension Protection Act of 2006, by Steve Johnson (UNLV)
4. Tax Aspects of Stock Option Backdating Scandal, by George Mundstock (Miami)
5. The KPMG Tax Shelter Case and the Thompson Memo, by Ira B. Shepard (Houston)
6. Flooding of the IRS Headquarters Building, by Bryan Camp (Texas Tech)
7. What Does the Democratic Takeover of Congress Mean for the Tax Law?, by James Maule
8. The Fight Over Eric Solomon’s Appointment as Assistant Secretary for Tax Policy, by Adam Chodorow (Arizona State)
9. MTIC Fraud – A Billion Dollar Assault on the E.U. VAT, by Richard T. Ainsworth (BU)
10. The Non-Repeal of the Estate Tax, by Joseph M. Dodge (Florida State) & Frank Doti (Chapman)

1.  Murphy v. Internal Revenue Service,by Gregory Germain, Assistant Professor of Law, Syracuse University College of Law:

In August 2006, a unanimous panel of the Court of Appeals for the D.C. Circuit held that Congress does not have the power under the United States Constitution to tax a compensatory emotional distress damages award that was not given to compensate for lost wages. The case concerned the validity of a 1996 statutory amendment to IRC section 104(a)(2), in which Congress limited the 80-year-old personal injury exclusion to cases involving “physical injury or physical sickness,” and provided that “emotional distress shall not be treated as a physical injury or physical sickness.”

The case arose when Marrita Murphy brought an action seeking the refund of income taxes she had paid on a $70,000 personal injury award she received from a Department of Labor administrative hearing panel. The hearing panel found that Ms. Murphy had been blacklisted by the New York Air National Guard for blowing the whistle to state employees about environmental violations at an air base.

In the tax case, The District Court ruled in the government’s favor, finding that the award was not excluded by the amended section 104(a)(2) because Ms. Murphy had not suffered a physical injury. The Court of Appeals reversed, holding that Congress lacked the power to tax Ms. Murphy’s compensatory emotional distress and reputation damages award because the award did not constitute “income” within the meaning of the 16th Amendment.

The Court of Appeal’s decision has been criticized for failing to consider whether Congress had the power to tax the award under the original grants of taxing power contained in Article I of the Constitution, for reaching the constitutional question without first considering whether the award was statutorily subject to tax as “income” under IRC section 61, and for relying entirely on post-16th Amendment materials to establish the intent of the adopters of the 16th Amendment. Many have expressed concern that the decision will embolden tax protestors who have long unsuccessfully argued that wages, prizes, gambling winnings, and revenues passed through tax shelter entities were not “income” within the meaning of the 16th Amendment.

On December 22, 2006, the three-judge panel that issued the decision surprised everyone by, sua sponte, vacating its decision and ordering a re-hearing. The panel’s action may raise jurisdictional questions because no party timely filed a motion for a panel rehearing, and the time to do so had passed long ago. See FRAP Rule 40 (45 days after entry of judgment). However, the government had timely filed a motion under Rule 35 of the Federal Rules of Appellate Procedure for an en banc review by the entire D.C. Circuit Court of Appeals. Whether the government’s request for en banc review extended the time for the panel to unilaterally vacate its decision and order a rehearing may add an additional procedural question to a case already full of interesting statutory and constitutional legal issues.

2.  The Tax Relief and Health Care Act of 2006, by James Edward Maule, Professor of Law, Villanova University School of Law:

In mid-December, some of the nation’s taxpayers received a gift: hundreds of tax reductions filling a huge Tax Relief and Health Care Act of 2006. The legislation extends provisions that seemingly had expired at the end of 2005, though most taxpayers were left with little or no opportunity to adjust their lives to take advantage of them. Provisions set to expire in 2007 or later were extended. Hundreds of excise taxes were suspended or repealed. Trade law amendments, having nothing to do with tax relief or health care, were grafted onto the bill, demonstrating why these legislative cobblings long ago were tagged as "Christmas Tree bills." In the meantime, the IRS was required to re-do its forms and instructions, to send notices to taxpayers to whom materials already had been sent warning them that those publications had been obsoleted, to re-mail new forms and publications, and to delay the date on which it could start accepting return filings. One member of Congress stated, "A lot of members of Congress are just clueless as to what is going on." Wait, that’s not news.

3.  The Pension Protection Act of 2006, by Steve Johnson, E.L. Wiegand Professor of Law, William S. Boyd School of Law, University of Nevada at Las Vegas:

The President signed this legislation in August 2006. It has two principal thrusts: expanding incentives for charitable giving and encouraging or requiring reform of charitable entities. There are over two dozen specific changes, including rules as to qualified charitable distributions from IRAs, deduction of contributed inventory items, nondeductibility of contributed items of minimal value, consistency as to fractional interest donations, limitation of deduction of qualified conservation real property, recapture rules as to donated property not used for exempt purposes, basis adjustments after contribution of S corporation stock, regulation of donor advised funds, substantiation, reporting, disclosure, excise taxes, and penalties.

4.  Tax Aspects of Stock Option Backdating Scandal, by George Mundstock, Professor of Law, University of Miami School of Law:

The growing scandal of corporate executives backdating the day on which they exercised compensatory stock options could well be the 2006 tax story with the biggest long-term impact on the tax system. Historically, the IRS felt that public companies committed little tax fraud. SEC scrutiny and an independent audit were viewed as protecting the Treasury as well as the shareholders. The rise of corporate tax shelters showed that public companies could be aggressive, but not flat-out crooked. Enron, WorldCom, and their pals, as well as the now-in-full-bloom option grant backdating scandal, showed that public companies lie on their financial statements. But now, with grant backdating, we see corporate executives engaged in tax fraud (stealing a corporate deduction to convert ordinary income to capital gain on their personal returns). Future tax compliance initiatives will be able to make big gains in pursuing public companies.

5.  The KPMG Tax Shelter Case and the Thompson Memorandum, by Ira B. Shepard, Professor of Law, University of Houston Law Center:

In its post-Enron war against white collar crime, the Justice Department’s notion that what is fair against organized crime is also fair against white collar crime receives a [temporary?] setback. Judge Kaplan finds prosecutorial misconduct in the use of the Thompson Memorandum to prevent KPMG from continuing its customary practice of paying attorney’s fees for individuals caught up in controversy by reason of their affiliation with the firm. United States v. Stein, 435 F. Supp. 2d 330 (S.D.N.Y. 6/26/06, as amended 7/14/06). The court held that the Justice Department’s 2003 Thompson Memorandum policy [continued from the 1997 Holder Memorandum] of basing a determination of whether a firm is “cooperating” with the government on its refusal (unless compelled by law) to advance legal fees for affiliated individuals unless they in turn fully cooperated with the government, as it was applied by the prosecutors in this case, was an unconstitutional interference with defendants’ ability to use resources that –absent the government’s misconduct – would be otherwise available to them for payment of attorneys’ fees. The resources in question were funds that would have customarily been received by these defendants from KPMG to pay their attorneys. Judge Kaplan subsequently refused to eliminate from his opinion a statement that prosecutors in the case were “economical with the truth.” He also refused to eliminate from his opinion the names of the prosecutors involved.

Judge Kaplan’s decision has been appealed to the Second Circuit, which has stayed its implementation pending the appeal. The Thompson Memorandum was replaced on 12/11/06 by the McNulty Memorandum, which requires threats to prosecute entities “unless” they do something [e.g., waive attorney client privilege] or “if” they do something [e.g., advance legal fees] to emanate from a higher level of the Justice Department.

6.  Flooding of the IRS Headquarters Building, by Bryan Camp, Professor of Law, Texas Tech University College of Law:

The IRS headquarters in Washington is built on what is now an underground river, called Tiber Creek. In June, heavy rains caused the creek to flood many buildings along the national mall, including the IRS headquarters. This was an important story not only because it shut down the building, scattering employees hither and yon across the D.C. metroplex (although many landed in Crystal City), but the flood may also have destroyed a boatload of valuable historical documents. Across from the basement food canteen on the 500 corridor (running north/south on the east side of the building along 10th street) was a large storage room. In that storage room, at least as of the year 2000, were thousands of archived documents, including case files and advice files dating back to at least the 1960’s, if not before. I know because I visited that room several times when we needed to create space up in the office and would cart stuff down there. My little historian’s nose twitched excitedly when I saw what was down there. There was little order or sense to the room. It was basically a dumping ground. It may have been cleaned up at some point since I last saw it, I don’t know. But if not, it’s a true loss and one reason why the "Great Flood" might be one of the top 10 tax stories of 2006.

7.  What Does Democratic Takeover of Congress Mean for the Tax Law?, by James Maule:

Technically, the news is that the Democrats took over control of both the House and the Senate. The speculation about the impact of this political shift, though, is more interesting. Will the Congress reinstate the estate tax? Will it restore the estate tax in some revised form? Will it fix the AMT problem? Will it repeal some or all of the Bush tax cuts? Will it weed out some of the credits that now flood the tax code? Will it engage in some serious tax reform? Will it be more of the same? All sorts of stories for next year are taking root in this one.

8.  The Fight Over Eric Solomon’s Appointment as Assistant Secretary for Tax Policy, Adam Chodorow, Associate Professor of Law, Sandra Day O’Connor College of Law, Arizona State University:

I think that Eric Solomon ought to be in the top 10. The post has gone vacant for a long time. They finally make a smart choice, and it gets held up by politics. The entire tax community rallies around Eric, and we eventually get our happy ending.

9.  MTIC Fraud – A Billion Dollar Assault on the E.U. VAT, by Richard T. Ainsworth (Adjunct Professor, Boston University; Tax Counsel, Taxware Inc.):

In 2006 it became apparent to most observers that missing trader intra-community fraud or MTIC fraud was threatening the structure and the stability of the European value added tax (VAT). Also known as carousel fraud, MTIC fraud became so serious in 2006 that the U.K. National Accounts were restated. Both Germany and the United Kingdom have provided empirical measures of the fiscal impact. Good figures for the whole E.U. are merely extrapolations from these country-specific studies. The U.K. VAT losses are estimated between 2.98 billion and 4.47 billion euros for 2006. Extrapolated “best estimates” of the annual VAT loss in the E.U. as a whole is about 23 billion euro, or $30 billion.

MTIC fraud takes advantage of an imperfect compromise worked out among the Member States in 1991 to facilitate lowering the fiscal frontiers. The compromise was implemented on January 1, 1993, and immediately afterwards an exponential growth in MTIC fraud was observable.

In 1993 border controls among the E.U. Member States were replaced with tax accounting controls. No longer were goods inspected (and VAT adjusted) by customs agents. Instead, cross-border B2B transactions were zero-rated by the first Member State and paired with tax accounting rules that obligated the buyer to perform a “reverse charge” in the other Member State. For cross-border B2C transactions were treated differently.

MTIC fraud takes aim at the requirement that an importer record a reverse charge (and pay over to the government the tax due) on imported goods. Under current rules any importer with a valid VAT ID numbers can receive goods free of VAT from another Member State. MTIC fraud involves traders who import (without recording the reverse charge), re-selling the goods with VAT, and then disappearing with the VAT receipts.

From an American perspective the solutions proposed are very interesting. The German and Austrian solution (which does not have the Commission’s support) is to require the reverse charge on all subsequent domestic transactions – a solution that effectively turns the multi-stage VAT into a retail sales tax with a multi-stage paper trail. The U.K. solution (which does have the Commission’s support, but not that of the Council or the European Parliament) is essentially the same, but limited to the market segment where the fraud is greatest – cell phones and computer chips. A paper presented by this author at the U.K. Treasury in October demonstrated how the certified service provider (CSP) option under the Streamlined Sales Tax (SST) is adaptable to the VAT and could be employed to solve the MTIC fraud problem without resorting to a domestic reverse charge.

Regardless of the course taken, revenue losses from MTIC fraud are so severe that a solution will needed in 2007.

10.  The Non-Repeal of the Estate Tax, suggested by Joseph M. Dodge, Stearns Weaver Miller Weissler Alhadeff & Sitterson Professor of Law, Florida State University College of Law, and Frank Doti, Professor of Law and William P. Foley II Chair in Corporate Law and Taxation, Chapman University School of Law.

Honorable Mention. A variety of other important tax stories did not make our Top 10 list but are chronicled here in alphabetical order:

• Applicability of Brand X to Tax, by Steve Johnson: In National Cable & Telecommunications Ass’n v. Brand X Internet Services, 125 S. Ct. 2688 (2005), the Supreme Court addressed whether an agency can promulgate a rule which is substantively inconsistent with a previous judicial decision. The Court held that a prior case trumps a Chevron-entitled administrative rule "only if the prior court decision holds that its construction follows from the unambiguous terms of the statute and thus leaves no room for agency discretion." Two 2006 cases involved Brand X holding in the tax context. In Swallows, supra, the Tax Court majority distinguished Brand X on questionable grounds. In Gerson, supra, the Tax Court majority concluded that three cases decided before the challenged regulation was promulgated were in conflict. It held: "Where, as here, the Secretary was confronted with what we consider conflicting judicial constructions of [the statute], we do not believe the Supreme Court’s statement in [Brand X] curtailed the Secretary’s discretion to promulgate the regulation in dispute or mandates a holding in this case that [a prior conflicting case] trumps the regulation in dispute."
• The Brouhaha over Ready Return, by James Maule:  California’s experiment with Ready Return has taken almost as many turns as a mystery novel. Initiated in 2005 and designed to let the state do state income tax returns for certain taxpayers, the Ready Return program was both hailed as the most phenomenal development in alleviating the burdens of filing taxes and criticized as a dangerous approach that creates a conflict of interest for the state and possible missed tax-savings opportunities for the very taxpayers it is designed to help. In October, the Franchise Tax Board terminated the program rather than expanding it as its supporters had asked because the legislature refused to fund it. Later in the month, the program became a factor in California’s state controller race. Then in December, defying the legislature, the Franchise Tax Board decided to reinstate the program. This story isn’t finished. Surely it will show up next year, also.
• Continued Phishing by IRS Impersonaters, by James Maule:  Why would someone try to impersonate an IRS official? It’s hardly likely to increase one’s chances for a date or a special invitation to a popular night spot. But some folks think they can trick unsuspecting taxpayers into giving them their confidential identifying information by sending emails made to appear as though they come from the IRS. This so-called phishing technique has been in use for several years, another of the many treats generated when unscrupulous humans meet internet technology, but adding the IRS to banks and credit card companies was a nefarious turn. Despite issuing numerous warnings and explaining that it does not send emails to taxpayers asking for this sort of information, the IRS has not deterred thousands of taxpayers from accommodating the wrong-doers. Sadly, this story may become so common-place that it will be no likely to make this list in future years as will the "Sun Rises in East Yesterday" headline.
• Continuing Uncertainty as to Standard Governing Challenges to General Authority Tax Regulations, by Steve Johnson: It’s pretty well established that Chevron provides the controlling standard in challenges to specific authority (aka legislative) tax regulations, as several 2006 cases confirmed. E.g., Square D Co. v. Comm’r, 438 F.3d 739 (7th Cir. 2006); Swallows Holding. Ltd. v. Comm’r, 126 T.C. 96 (Jan. 2006)(en banc), on appeal to Third Circuit. But 2006 cases compounded the unceratinty as to what standard controls challenges to general authority (aka interpretive) tax regulations. In Swallows, supra, which invalidated a general authority income tax regulation, the Tax Court majority said that the pre-Chevron line of cases typified by National Muffler Dealers controls (although the majority said it also would have reached the same result under Chevron). In Estate of Gerson v. Comm’r, 127 T.C. No. 11 (Oct. 2006) (en banc), which upheld a general authority generation-skipping transfer tax regulation, the Tax Court majority said: "it is unnecessary to attempt to discern any substantive difference between Natl. Muffler Dealers Association and Chevron U.S.A., Inc. because we conclude the result here would be the same under either standard." Concurring and dissenting opinions in Swallows and Gerson argued for different standards, including Chevron and Mead.
• Economic Substance Doctrine, by Steve Johnson: The Government scored some significant wins in 2006 in tax shelter litigation. They included appellate reversals — based on the economic substance doctrine — of taxpayer wins at the trial court level in Coltec and Dow Chemical. See Coltec Inds., Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006), cert. pet. filed, 75 U.S.L.W. 3267 (Nov. 8, 2006); Dow Chemical Co. v. United States, 435 F.3d 594 (6th Cir. 2006), cert. pet. filed, 75 U.S.L.W. 3207 (Oct. 4, 2006). The Democratic takeover of both Houses of Congress has sparked considerable speculation about whether long-delayed codification of the doctrine may finally happen in 2007.
• Foreign Tax Credit, by Steve Johnson: 2006 saw considerable regulatory activity with respect to the FTC. Such activity included: final regulations as to allocation of creditable expenditures by partnerships, T.D. 9292 (Oct. 19, 2006, corrected on Dec. 7, 2006), final and temporary regulations as to separate foreign tax credit limitations, T.D. 9260 (Apr. 25, 2006, corrected on Aug. 21, 2006 & Dec. 26, 2006), and notice of proposed rulemaking as to definition of taxpayer for sec. 901and 903 purposes, 71 Fed. Reg. 44240 (Aug. 4, 2006).
• Indictment of Wesley Snipes for Tax Fraud (and Further Developments), by James Maule:  Will there ever be a year when a celebrity doesn’t run afoul of the IRS? 2006 was no different. It was Wesley Snipes’ turn. He’s been charged with failing to pay almost $12 million in federal income taxes, failing to file returns for six years, and claiming fraudulent refunds on taxes already paid for earlier years when he was filing returns. Allegedly, Snipes latched on to several tax-evasion schemes such as the "section 861 argument" and the "Bills of Exchange" ploy. The story took a strange turn when it was revealed Snipes had left the country, but then news arrived that he was in Namibia filming Gallowwalker. More bizarre turns popped up when a settlement was announced, and then denied. There was more. Snipes returned to the United States and turned himself in. He denied guilt. Put this one down as another story that has a strong chance of making the Top Ten Tax Stories of 2007 list.
• IRS Decides to Stop Collecting Telephone Excise Tax, by James Maule:  After years of unsuccessful litigation, the IRS threw in the towel and announced it would no longer collect the long-distance telephone service excise tax. Enacted to fund the Spanish-American war, the tax took on a life of its own. Shortly thereafter, the IRS announced logistics for refunding the tax that had been paid after February 28, 2003. Taxpayers have alternatives. They can select standard refunds or compute the actual tax paid. The refunds will be taken into account on 2006 income tax returns filed in 2007. For most taxpayers, though, the refunds won’t come close to covering the holiday credit card bills. Unless the taxpayer is named Scrooge and didn’t buy anything
• Proposed Regulations as to Capitalization as to Tangible Property Costs, by Steve Johnson: In 2004, Treasury and the IRS promulgated regulations addressing deduction versus capitalization of costs relating to intangible assets, an area left in confusion by the Supreme Court’s INDOPCO decision. In 2006, Treasury and the IRS proposed regulations under IRC sec. 263(a) to address deduction versus capitalization of costs relating to tangible property. 71 Fed. Reg. 48590-01 (Aug. 21, 2006), 2006 I.R.B. 532.
• Section 482, by Steve Johnson:  Treasury and the IRS promulgated final and temporary regulations giving guidance as to controlled services transactions and allocation of income from intangibles. T.D. 9278 (Aug. 4, 2006).
• Still Trying To Get Sec. 199 Right, by Steve Johnson:  Poorly drafted IRC sec. 199 (deduction for income attributable to domestic production activities) has required numerous attempts at administrative clarification. Regulations proposed in 2005 were finalized in 2006, but one should not rule out additional changes. See T.D. 9262 (temporary regulations)(June 1, 2006, corrected on June 29, 2006); T.D. 9293 (final and temporary regulations) (Oct. 19, 2006, corrected on Dec. 7, 2006).