PENALTY REFRESHER

As surely as April 15 comes every year, there will be taxpayers who do not file their income tax returns on time or who do not pay their income taxes on time. Here's a quick refresher on penalties relating to income tax filings, courtesy of the IRS:

FILING LATE: If you do not file your return by the due date (including extensions), you may have to pay a failure-to-file penalty. The penalty is usually 5 percent for each month or part of a month that a return is late, but not more than 25 percent. The penalty is based on the tax not paid by the due date (without regard to extensions). If you file your return more than 60 days after the due date, the minimum penalty is $100 or, if less, 100 percent of the tax on your return. For any month both the penalty for filing late and the penalty for paying late apply, the penalty for filing late is reduced by the penalty for paying late for that month, unless the minimum penalty for filing late is charged.

PAYING TAX LATE: You will have to pay a failure-to-pay penalty of ½ of 1 percent (0.5 percent) of your unpaid taxes for each month, or part of a month, after the due date that the tax is not paid. This penalty does not apply during the automatic six-month extension of time to file period if you paid at least 90 percent of your actual tax liability on or before the original due date of your return and pay the balance when you file the return.

The failure-to-pay penalty rate increases to a full 1 percent per month for any tax that remains unpaid the day after a demand for immediate payment is issued, or 10 days after notice of intent to levy certain assets is issued.

For taxpayers who filed on time, the failure-to-pay penalty rate is reduced to ¼ of 1 percent (0.25 percent) per month during any month in which the taxpayer has a valid installment agreement in force.

BOUNCED CHECKS: If you write a check to pay your taxes and the check bounces, the IRS may impose a penalty. The penalty is either 2 percent of the amount of the check - unless the check is under $1,250, in which case the penalty is the amount of the check or $25, whichever is less.

Do not fall into the trap of not filing your tax return on time just because you can't pay the tax on time.

Note that the above are only penalties - interest on late payments of tax will likely also apply.

FS-2008-19, March 2008

CREDIT CARD HOLDER COULD NOT ESCAPE DISCHARGE OF INDEBTNESS INCOME ON WRITE-OFF OF DEBT

As the economy moves closer to (or deeper into, depending on who you believe) recession, the number of credit card holders who will obtain reductions in their credit card debt from the issuer is likely to increase. Those debtors will eventually learn that the discharge of debt is taxable to them.

Section 108 of the Internal Revenue Code provides that such income will not arise in certain specified situations, including a discharge in a Title 11 bankruptcy, when the debtor is insolvent, when the debt is qualified farm indebtedness, when the debt is qualified real property business indebtedness, or when the debt is qualified principal residence indebtedness.

A recent Tax Court case highlights the creative arguments raised by taxpayers to come within Section 108 when the taxpayer doesn't fit within any of the above exceptions. In shooting down 2 taxpayer theories, it is evident that taxpayers should not expect any leniency from the IRS or the Tax Court on these issues.

The taxpayer first tried to use Code Section 108(e)(5). That provisions avoids debt discharge income where the buyer of property negotiates with the seller/creditor for a discharge of all or part of the purchase money indebtedness. The resulting discharge of indebtedness is characterized not as taxable income but in effect as a retroactive reduction of the purchase price. However, in this case the credit card company was found not be a seller of property, so the provision was held not to apply.

The taxpayer then tried to claim that the case of Earnshaw v. Comm., T.C. Memo 2002-191 stands for the proposition that the discharge of interest on debt is not income to the debtor. The Tax Court disagreed, finding that the case only applied to reductions in debt due to a bona fide dispute about the amount of the debt involved. While not discussed in the case, if the interest payment would have been deductible to the debtor, then Code Section 108(e)(2) would then have avoided debt discharge income to that extent. This provision avoids debt discharge income on debt that would be deductible if actually paid by the debtor. Presumably, the taxpayer in the Tax Court case could not use that provision because the expenses were personal, nondeductible expenses so that interest relating to their purchase would not be deductible.

Ancil N. Payne, Jr., et ux. v. Commissioner, TC Memo 2008-66

ESTATE TAX LIEN NOT DIVESTED BY SALE

When an individual dies, his or her assets are subject to a 10 year estate tax lien in favor of the IRS for any unpaid estate taxes. Many would think that the lien would be divested as to any third party purchaser of estate assets for fair value, since the purchaser would not have any involvement in the computation or payment of estate taxes. However, they would be wrong, as several title companies found out in a recent tax case.

In that case, a decedent died owning 3 houses. The 3 houses were deeded out to the appropriate heir and her spouse, and then they sold the houses to 3 purchasers. Ultimately, the IRS challenged the value of another estate asset, and assessed additional estate tax. Since it was unable to collect the unpaid tax from the estate, it came after the 3 purchases pursuant to its 10 year estate tax lien. Note that the purchasers didn't even buy the properties from the estate, but from a successor in interest to the estate (the heir and her husband).

Ultimately, the purchasers were held liable for the unpaid estate taxes (actually, the title insurers ended up paying the taxes pursuant to title insurance policies purchased by the purchasers). The case demonstrates that real property purchasers ignore the 10 year estate tax lien at their own peril, and that the IRS will come after unrelated third party purchasers when it cannot collect estate taxes from the estate. As an aside, the third party purchasers were not able to challenge the additional tax assessment that they ended up paying, because they were not the taxpayer.

Of course, knowledgeable purchasers are not without protection against estate tax liens. When a title search shows that property was owned by a decedent within the past 10 years, a purchaser can insist on the seller obtaining a release of lien from the IRS. The purchaser can also wait for a closing letter to be issued that demonstrates that estate tax has been satisfied. Further, if the executor had applied for and obtained a discharge of personal liability from Code Section 2204, the lien would have been released as to any purchasers.

FIRST AMERICAN TITLE INSURANCE COMPANY v. U.S., 101 AFTR 2d 2008-XXXX, (CA9), 03/27/2008