At a House Ways and Means Committee hearing on March 7, witnesses discussed the White House proposal to increase the top income tax rate to 39.6%. Because many owners of small businesses pay tax at higher individual rates, the question centered on the impact of the higher tax rate on job creation.

Ways and Means Chair Dave Camp (R-MI) opened the discussion by noting that it is important to create a tax code that does not tilt "too much in any one direction." If the tax code for small businesses favors large corporations over limited liability companies and other flow-through entities, it will cause unfavorable results. Camp suggested that the best policy is "to create a neutral tax code in which the individual tax rates are similar to the corporate rates."

Previously, Camp and other Republicans introduced legislation that proposes a top rate of 25% for both individuals and corporations. This proposed reduction in the top rates will require elimination of many business and itemized deductions.

Camp referred to a study by the Congressional Joint Committee on Taxation. It indicated that 56% of business income and 54% of small business jobs were found in small business partnerships, subchapter S corporations and limited liability companies. These are all called "pass-through entities."

The White House has proposed increasing the individual rate to 39.6% and reducing the top corporate rate to 28%. The proposed reduction in the top corporate rate is an effort to boost employment. At present, the U.S. is the country with the highest corporate rate among first-world nations.

Camp objected to the White House plan to have a personal rate of nearly 40% and a corporate rate of 28%. He suggested that a 12 percentage point difference in the two rates "will create more harm than good."

Ranking Ways and Means Member Sander Levin (D-MI) agreed that a good tax plan should "promote economic growth and job creation." He also stated that the pass-through entities account for approximately half of business income and provide half of business jobs.

Levin explained that the basic question is "whether to continue the upper-income Bush tax cuts." In his view, only 8% of the expected increase in revenue from the higher personal tax rate would be from "small business employers."

Levin continued with the suggestion that most of the partnership income comes from very substantial partnerships. At least 64% of total partnership income is earned by partnerships with over $100 million in assets.

Finally, Levin agreed that there is a major problem with complexity of taxes for small businesses. He hopes a future major tax reform bill can resolve the issue of tax complexity.

Lottery Winnings Gift

In Tonda Lynn Dickerson v. Commissioner; T.C. Memo. 2012-60; No. 20029-08 (6 Mar 2012), the Tax Court determined that a lottery ticket given to a waitress and subsequently transferred to a family-owned Subchapter S Corporation created a taxable gift of 51% of the winnings.

Tonda Lynne Dickerson was a waitress at the Waffle House in Grand Bay, AL. A regular customer, Edward Seward, had a practice of purchasing Florida lottery tickets and making gifts of tickets to waitresses at the Waffle House. On March 7, 1999, Mr. Seward gave Dickerson an envelope containing a lottery ticket. He did not know that this ticket had been selected the previous day to receive a jackpot amount of $5,075,961.71 in cash or $10,015,000 over 30 years.

After discovering the value of the ticket, Dickerson and her family discussed their options. On March 8, they created an S Corporation called 9 Mill Inc. ("9 Mill"). All stock was allocated to Reece family members. Dickerson and her husband received 49% of the shares, her mother 17% and two siblings each owned 17%. On March 12, 1999, 9 Mill claimed the jackpot and requested the $354,000 payment per year for 30 years.

There was a competing claim that delayed payment. Four coworkers at the Waffle House filed an action against Dickerson and claimed there was an existing oral agreement among the five waitresses to share proceeds of any lottery. They claimed ownership of 80% of the proceeds or $4,060,769.20. On April 30, 1999 the Circuit Court of Mobile County determined that the oral agreement was enforceable and the other four waitresses were entitled to 80% of the jackpot. However, on February 18, 2000, the Alabama Supreme Court indicated that there was an oral agreement to share the lottery proceeds, but that it was not enforceable. Under Alabama public policy, the unenforceable agreement was "founded on gambling consideration."

In 2007, the IRS asked Dickerson to file Form 709, United States Gift Tax Return. She filed Form 709 on November 30, 2007 and indicated no taxable gift. The IRS disagreed, determined the gift to be valued at $2,412,388 and issued a deficiency for $771,570.

At trial, counsel for Dickerson argued that the Reece family contract created an agreement that the gifted lottery ticket would be jointly owned. Under Alabama law, a contract requires an agreement between two parties, consideration, a legal object and capacity to enter into the agreement.

There were multiple issues with respect to the claim that a family contract existed. There was only a general plan to share proceeds. There was no requirement to share, no pattern for sharing, no specified percentages and no determination of when a jackpot was "substantial" and therefore subject to sharing. Finally, there were no defined parties to the sharing agreement. Because the alleged Reece family agreement was "too indefinite, uncertain and incomplete for enforcement," the contract was not valid under Alabama law.

In addition, the court determined that there was not a contract under federal law. While it is possible for individuals to have a formal pooling agreement or a standard practice that could create joint ownership, the Reece family did not actively pool assets and did not follow partnership formalities.

Therefore, the primary issue was the valuation of the gift. On the March 7, 1999 date of the transfer to Dickerson, the potential existed for a claim by the other four Waffle House waitresses. At court, plaintiff's attorney Steven Nicholas testified on valuation. He indicated that the potential claim of 80% of the proceeds by the four Waffle House waitresses should be discounted by 65%-80%. In addition, the litigation costs could be between 2% and 5% of the total value of the ticket.

Based on this analysis, the court determined that the 80% value would be discounted by a total of 67%. Therefore, Dickerson owned 33% of approximately $4 million and 100% of approximately $1 million. Her gift of 51% was valued at $1,119,347.90.

Beach Club UBI Tax

In Ocean Pines Association Inc. v. Commissioner; No. 11-1029 (2 Mar 2012), the Fourth Circuit affirmed a Tax Court decision that a beach club and parking lots were private assets that created unrelated business taxable income.

Ocean Pines Association is the supervising entity for a community of 10,496 persons on 3,500 acres in Berlin, MD. The association operates multiple facilities that are open to all persons in the Berlin area. It also owns a property eight miles away in in Ocean City, MD. This beachfront property includes two parking lots and is available only for association members. In 2003 and 2004, the beach club and two parking lots produced net income of $289,602. In 2007 the IRS issued a deficiency and requested payment of unrelated business income tax on that amount.

The Tax Court case reviewed two principal questions. First, was the beach club operation "substantially related" to the Sec. 501(c)(4) status of Ocean Pines? Second, was the revenue from the parking lots exempt from tax as rent from real property? The Tax Court answered no on both questions and determined that the income was unrelated business taxable income.

Ocean Pines maintained that the operation of the private club was "substantially related" to its exempt purpose and contributed to the social welfare of the members.

However, the court noted that the ocean club and parking lots were private. In order for there to be a substantial relationship with exempt status, there must be a "causal relationship" and the social welfare goal must be public rather than private. Because the operation of the ocean beach club and associated parking lots served private interests, it did not comply with the public social welfare requirement. The determination by the Tax Court that Ocean Pines must pay an unrelated business tax was affirmed.

Applicable Federal Rate of 1.4% for March – Rev. Rul. 2012-9; 2012-11 IRB 1 (20 Feb 2012)

The IRS has announced the Applicable Federal Rate (AFR) for March of 2012. The AFR under Section 7520 for the month of March will be 1.4%. The rates for February of 1.4% or January of 1.4% also may be used. The highest AFR is beneficial for charitable deductions of remainder interests. The lowest AFR is best for lead trusts and life estate reserved agreements. With a gift annuity, if the annuitant desires greater tax-free payments the lowest AFR is preferable. During 2012, pooled income funds in existence less than three tax years must use a 1.8% deemed rate of return. Federal rates are available by clicking here.