January, 1996 Hot Topics

Clinton's Counterproposal; Frequent Flier Ruling; Foreign Ownership of U.S. Real Property

Clinton's Counterproposal

Note: The December Hot Topics contained the Republicans' tax proposals. To date, there has not been a compromise reached between the Republicans and President Clinton.

The following are the highlights of the Clinton Proposal for tax reform:

• A $500 non-refundable tax credit for children under age 13.

• A deduction up to $5,000 per year for the cost of college and graduate education.

• An expansion of individual retirement accounts.

In addition, Clinton has proposed several tax increases aimed at closing corporate subsidies and loopholes:

• After January 31, 1996, corporations which receive dividends would be allowed a 50% deduction, instead of the current 70% deduction.

• Under current law, the receipt of preferred stock for common stock in a reorganization is a tax-free transaction. After December 7, 1995, there would be a change in the treatment of certain preferred stock in corporate reorganizations which would cause the receipt of such stock to be taxed as "boot." Gains, but not losses, would be recognized.

• Corporate investments in tax-free obligations would be modified so that the interest deduction would be disallowed to the extent the corporation owned tax-free investments. A similar provision is in effect for financial institutions.

• Several inventory accounting changes have been proposed as well.

As part of the bargaining process with Congress, look for retention of the child credit and possibly a deduction for post-secondary schooling expenses. IRA's will be expanded. There could be some type of capital gains cut, although much more limited than under the Republicans' proposal.

IRS Reconsiders Its Frequent Flier Ruling

The IRS, in TAM 9547001 (a technical advice memorandum issued by the IRS legal department) stated that companies which permitted its employees to use frequent flier mileage for personal use caused that company to have a nonaccountable reimbursement plan under IRC Sec. 62(c). If a plan is considered nonaccountable, employees are subject to the 2% floor for miscellaneous itemized deductions and the company must withhold taxes on the value of the reimbursement.

The IRS has stated it will reconsider TAM 9547001 in light of the public outcry over its conclusion. The IRS now says that the TAM "does not address the full range of regulations potentially applicable to employee reimbursement plans involving frequent flyer miles." One vocal opponent to the TAM was the Air Transport Association of America which has written Treasury Secretary Robert E. Rubin, urging that the TAM be withdrawn immediately.

Non-Resident Alien Denied Deductions for Real Estate Expenses

In general, non-resident aliens are taxed on their salaries, rents, interest income and dividends from U.S. sources at a flat rate of 30% (unless there is a special exemption or a lower treaty rate applies). There is an exception to this rule for real estate under IRC Sec. 871(d), provided the taxpayer makes the appropriate election and files timely tax returns under IRC Sec. 874.

In Jesus A Florez vs Cm. T.C. Memo 1995-358 (filed August 1, 1995), Mr. Florez, a non-resident alien living in Mexico, but owning real estate in Texas, received rental income from his real estate for 5 years and had capital gains in 3 years. He failed to timely file his tax returns and the IRS denied him any of the deductions associated with the real estate income otherwise allowed to him under IRC Section 874. Mr. Florez eventually filed late tax returns and claimed the deductions on those returns.

The Tax Court held that Mr. Florez had to file timely returns in order to claim the deductions. If no returns were filed, then IRC Regulation 1.874-1(a) required that he had 16 months from the due date of the return to file a tax return (provided the IRS had not yet notified him that no deductions would be allowed). The court made a curious ruling regarding tax returns that were filed over 3 years late: Although section 874 and the regulations did not contain a specific timely filing requirement, the court held it was not unreasonable for the IRS to disallow the deductions, quoting Blenheim Co. vs. Cm., 125 F2d 906 (4th Circuit, 1942) in which that court "recognized the importance of filing a timely return for the benefit of deductions."

The lesson suffered by Mr. Florez is painfully clear; if a non-resident alien invests in U.S. real property, he or she must timely file annual tax returns or the expenses that would otherwise be deductible could be forever lost.

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