The Bipartisan Budget Act of 2018 eases the requirements for combat-zone contractors to claim the foreign earned income exclusion.  A U.S. citizen is generally taxed on his worldwide income.  The foreign earned income exclusion, however, allows a taxpayer to exclude foreign income from his gross income for U.S. tax purposes, up to a certain dollar threshold.  For 2018, the threshold is $103,900.

But the exclusion only applies to a taxpayer whose tax home is in a foreign country.  Under prior law, a taxpayer could not have a tax home in a foreign country if his “abode,” which is generally his home or residence, was in the U.S.  See Tax Court Broadens Foreign Earned Income Exclusion.  Before the Bipartisan Budget Act of 2018, combat-zone contractors had difficulty qualifying for the foreign earned income exclusion because it was difficult to prove their abodes were not in the U.S.  The new law removes the “abode” requirement by providing that a contractor who supports the U.S. Armed Forces in a combat zone is entitled to the foreign earned income exclusion even if his “abode” is in the U.S.  The new law went into effect in 2018.  This is a significant development for contractors supporting the military overseas.

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I have recently penned a Law360 article discussing lessons learned from recent tax decisions impacting cannabis businesses.  We will continue to cover this topic on this blog.

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There is not too much to say about the Tax Court’s latest decision involving a marijuana company.  In Loughman v. Commissioner, T.C. Memo 2018-85, the operators of a Colorado marijuana dispensary argued that for a marijuana dispensary operating as an S corporation, Section 280E discriminates against S corporation shareholders by double taxing income when shareholder salary is disallowed pursuant to Section 280E as a deduction from flow-through S corporation income and also included on the shareholder’s individual tax return as W-2 wages.  The Tax Court noted that the regime was not discriminatory, but rather applied equally, because Section 280E disallows salaries not attributable to cost of goods sold whether or not the salaries are paid to the shareholder.

One of the harsh realities of operating a marijuana business is that Section 280E creates double taxation for owners who receive payments for services from marijuana companies.  It would seem the only way to avoid this is if the owner’s sole responsibility is activities related to the production of inventory. However, any officer/owner’s responsibilities are bound to include some sort of management and oversight.  While making an election to be taxed as a C corporation can minimize the cost of double taxation in this situation, it won’t eliminate it.

The Tax Court has shown little sympathy for marijuana companies when it comes to the harsh realities of Section 280E.  The court notes that the taxpayers can elect to be taxed as any type of entity and also elect to operate in any line of business.   Simply, in order to avoid double taxation caused by Section 280E, you are advised to operate a business not subject to Section 280E.

Yesterday, the Tax Court issued its opinion in Alterman v. Commissioner, T.C. Memo 2018-83.  This case involved the operation of a medical marijuana dispensary which was reported on Schedule C.  The opinion includes a long recitation of intricate accounting details that I will address on a summary basis so as to not lose readers other than accountants.  Readers interested in the details should read the opinion linked above.

The important facts are as follows:

  • The taxpayer sold marijuana and non-marijuana products.  The sales of non-marijuana products were 1.4% of gross receipts in 2010 and 3.5% of gross receipts in 2011.
  • On the tax returns, the taxpayer reduced gross receipts by cost of goods sold.  The taxpayer also deducted business expenses.  It does not appear based on the findings of fact that on the original return the taxpayer disallowed any expenses pursuant to Section 280E.
  • It appears the amount of cost of goods sold claimed on the return was, for the most part, amounts paid for purchases of inventory and did not include production costs.  At trial, the taxpayer asserted that it incurred over $100,000 of production costs each year in addition to the amounts paid for purchases of inventory.

The court found:

  • The sales of non-marijuana products were complimentary to the sales of marijuana products and therefore, were not a separate trade or business.  Even if the non-marijuana product sales were a separate trade or business, the record did not give the court any basis for determining the expenses attributable to the secondary business of sales of non-marijuana products.
  • The court applied Section 471 to determine cost of goods sold.  Section 471 allows taxpayers to include direct and indirect production costs in cost of goods sold.
  • The amount of cost of goods sold conceded by the IRS, which does not appear to include production costs, was the allowable amount of cost of goods sold because the taxpayers failed to properly account for beginning and ending inventories.
  • The taxpayer was negligent and subject to the negligence penalty because they did not keep adequate records to compute beginning and ending inventories or adequate books and records.  Further, there was no reasonable cause because the taxpayers did not seek advice regarding inventory accounting or the application of Section 280E.

Lessons and observations:

  • It is important that taxpayers subject to Section 280E use their best efforts to apply Section 280E when filing returns.
  • It is important that taxpayers subject to Section 280E properly classify costs as inventory costs when filing returns and maintain beginning and ending inventories with integrity.
  • It is important that taxpayers retain records needed to substantiate all accounting entries.
  • The substantiation issues are not unique to the marijuana industry.  However, due to high audit rates and the impact of Section 280E, the cost of the failure to substantiate is uniquely burdensome.  That being said, here, it is unclear how the failure to substantiate beginning and ending inventory also creates a restriction on the production costs that should be allowed.  Careful documentation and preparation of returns should overcome some of these burdens.

Attorneys representing cannabis businesses are often faced with questions about what happens when the cannabis business has not paid its taxes and the IRS is proceeding with collection actions.  No one thinks the IRS will seize and sell cannabis to satisfy tax liabilities, because in doing so the IRS would engage in criminal violations of the Controlled Substances Act.  However, recently, IRS Chief Counsel issued advice addressing questions posed by the field about whether an IRS sale of equipment used in a cannabis business would result in a violation of criminal laws.

In CCA 2018042616201420, Chief Counsel determined that Gas Chromatographer Mass Spectrometers (GCMS) and Liquid Chromatographer Mass Spectrometers (LCMS) used by taxpayers involved in the marijuana industry to measure the amount of cannabinoids in marijuana were not drug paraphernalia under the Drug Paraphernalia Statute, 21 U.S.C. § 863.  The conclusion was that because the equipment, which is used to measure organize material, can be used for purposes other than measuring cannabinoids, such as in fire investigations, explosive investigations, and even the identification of foreign material collected from outer space, the equipment was not drug paraphernalia.

The CCA also concluded that the existence of marijuana residue on the equipment did not prohibit the sale because, pursuant to 21 U.S.C. § 841(a), the existence of a residual amount of a controlled substance did not create the intent to distribute a controlled substance.

The CCA advised that the equipment should be subject to a “deep cleaning” prior to sale not only to avoid any possibility of a criminal violation but also to maximize the value of the equipment at auction.    The cost of this cleaning should be considered by Collections when determining collection potential of the property.

United States v. Gerard, a recent case from the Northern District of Indiana, demonstrates how a tax lien, once attached, can stay with property even after the property is conveyed to someone other than the taxpayer.  In 1990, a husband and wife named Robert and Cynthia Gerard bought a residence as tenants by the entirety.  Although the Gerards bought the residence together, Robert paid at least 90% of the purchase price.  Between 2003 and 2008, Cynthia owned a business with outstanding employment and unemployment taxes.  The Gerards and the government generally agreed that the assessments for these tax liabilities attached to Cynthia’s interest in the property.  As time went on, Robert and Cynthia decided to convey the property solely to Robert.  The deed stated that the conveyance was “by way of gift and without any consideration other than for love and affection.”

The government, however, still wished to enforce the liens.  Litigation ensued, and the government moved for summary judgment.  The key issue was whether the liens that were attached to Cynthia’s interest in the property survived the severance of the tenancy by the entirety.  Section 6323 provides that a lien is not valid against a purchaser until the IRS files proper notice.  Thus, according to the court, Robert would not be liable for Cynthia’s outstanding tax balance if Robert was a “purchaser.”  A “purchaser” is “[a] person who, for adequate and full consideration in money or monies worth, acquires an interest (other than a lien or security interest) in property which is valid under local law against a subsequent purchaser without actual notice.”  IRC § 6323(h)(6).  “Adequate and full consideration in money or money’s worth” is “a consideration in money or money’s worth having a reasonable relationship to the true value of the interest in property acquired.”  Treas. Reg. § 301.6323(h)-1(f)(3).

The Gerards argued that Robert was a purchaser because Cynthia used marital assets to pay her business’s expenses and then transferred her interest in the property in repayment of those debts.  The government, however, pointed out that the deed specifically stated that the transfer was made “by way of gift and without any consideration other than for love and affection,” and that any consideration would have been past consideration, which was insufficient.

The court was not concerned that the deed stated that the property was a gift.  It noted that “[i]t is a well-known fact that often a conveyance recites a nominal consideration whereas the true consideration is not nominal.  It is therefore never certain that the recited consideration is the true consideration.”  Clark v. CSX Transp., Inc., 737 N.E.2d 752, 759 (Ind. Ct. App. 2000).  The court was, however, concerned with the fact that the parties agreed that the use of marital assets to pay Cynthia’s business expenses was “past consideration.”  Under the regulations, “adequate and full consideration” includes past consideration only if, “under local law, past consideration is sufficient to support an agreement giving rise to a security interest. . .”  Treas. Reg. § 301.6323(h)-1(a)(3); (f)(3).  Accordingly, the court turned to Indiana law to determine whether past consideration could create a security interest.

The Gerards could not cite any Indiana authority indicating that past consideration gives rise to a security interest.  Also, other federal courts hold that past consideration does not make a party a “purchaser” under section 6323(a).  See, e.g., United States v. Register, 727 F. Supp. 2d 517, 526 (E.D. Va. 2010).  Thus, the court concluded that Robert was not a purchaser under section 6323(a) and that the liens attached to Cynthia’s interest in the property survived the conveyance.

The parties still disputed the extent to which the liens attached to the property.  The government argued that the liens remained attached to a one-half interest in the property.  The Gerards, however, argued that Cynthia’s actual interest was worth less than one-half of the property when it was conveyed, so the liens only attached to something less than a one-half interest.  Here again, the court found that Indiana law did not support the Gerards’ argument.  For example, in Radabaugh v. Radabaugh, the court held that the trial court erred by “conclud[ing] that appellee was the owner of less than an undivided one-half interest in the mortgage loan” for real estate owned by a husband and wife as tenant by the entirety.  35 N.E.2d 114, 115-16 (Ind. Ct. App. 1941).  Thus, the court concluded that the liens were still attached to one-half of Robert’s interest in the property, even after the conveyance.

 

The White House released a statement on February 8, 2018 that President Trump nominated Charles Rettig as the new Commissioner of Internal Revenue Code for the remainder of a five year term that began in November 2017.  Unlike other recent presidential nominees that may have ignited fierce debate among political parties, Rettig’s nomination has been universally praised across party lines and by both the public and private sector of tax practitioners.  Rettig spent over thirty-five years in private practice defending clients against the IRS, but also recently published an article discussing the pitfalls of tax collection today and encouraging greater tax enforcement.  Although Rettig’s professional experience is in the private sector, he has consistently encouraged and advocated for voluntary tax compliance and tax enforcement.  Rettig will likely bring this perspective to his new position as IRS Commissioner.

Professional Experience

Rettig spent the last thirty-five years at Hochman, Salkin, Rettig, Toscher & Perez, P.C. in Beverly Hills, California representing clients in a variety of tax matters.  His peers and other national sources have deemed Rettig as a leading practitioner in tax fraud, tax law, and tax litigation and controversy.  See Charles P. Rettig, Biography, Hochman, Salkin, Rettig, Toscher & Perez, P.C.  Throughout his career, Rettig represented thousands of individual, business, and corporate taxpayers involved in civil examinations, tax collection matters, and criminal tax investigations, often representing clients against the IRS.

Concurrent to defending clients in tax matters, Rettig was appointed by the IRS to serve as Chair of the IRS Advisory Counsel (“IRSAC”), and was an active member since 2008.  The IRSAC receives commentary from the public regarding the public’s perception of IRS activities.  The IRSAC then advises the IRS Commissioner on its findings to encourage the public’s involvement regarding tax administration policy, programs, and initiatives.  See Internal Revenue Service Advisory Council Facts, IRS.

With Rettig’s professional backdrop in mind, an analysis of Rettig’s recent publication regarding IRS tax enforcement paints a full picture of Rettig’s viewpoints.  These viewpoints will most likely follow Rettig to his position as IRS Commissioner.

Viewpoint on the IRS and Tax Enforcement

In a fall 2017 issue of the Journal of Tax Practice and Procedure, Rettig published an article entitled A Lesson in Accountability and IRS Enforcement.  Overall, Rettig sets a tone for the need for a new era of increased tax enforcement. The article addresses three main areas: (1) facts on the IRS and current tax collection efforts; (2) the underlying causes of the problems with tax collection and enforcement; and (3) proposed solutions to increase tax collection.

Tax Facts

After providing statistics on the billions of tax dollars collected by the IRS, Rettig explains the current tax gap.  The gross tax gap is the difference between the amount of tax imposed on taxpayers in any given year and the amount that taxpayers voluntarily and timely pay.  The gross tax gap from 2008 to 2010 is about $458 billion.  The net tax gap is the portion of the gross tax gap that never gets paid.  It is the gross tax gap less the tax that the IRS will subsequently collect, either through voluntary payments or IRS enforcement.  Rettig says that it is estimated that the IRS will be able to collect $52 billion of the gross tax gap, leaving a net tax gap of $406 billion.

Problems with Closing the Tax Gap

Rettig addresses three issues that lead to the tax gap.  First, Rettig explains the direct causes of the tax gap: underreporting income, underpaying taxes owed, and not filing taxes at all.  Of those three, underreporting accounts for the greatest portion of the tax gap: $387 billion.  Underpayment accounts for $39 billion and non-filing accounts for $32 billion.  In addressing underreporting, Rettig explains that IRS research shows that people that have federal taxes withheld from income report 99% of their income.  Taxpayers that have reporting requirements under the law also tend to report almost all of their income (96%).  The problem lies with taxpayers that are not subject to withholding or information reporting, with that group only reporting only 68% of their income, and sole proprietors often reporting only 48% of their income.

Second, Rettig highlights that the IRS currently has a historically low number of enforcement agents, which is most likely attributable to the IRS budget.  Rettig cautions that the resource-challenged IRS impacts tax enforcement efforts, which in turn explains another contributing factor to the billion dollar tax gap.

Lastly, Rettig explains that the IRS relies on voluntary compliance.  Rettig states that research shows that increasing civil tax penalties do not increase voluntary compliance by taxpayers.  With IRS examination of taxpayers operating at low rate, Rettig suggests that this may only encourage tax payers to “push the compliance envelop” because it seems like there is not much risk of detection from the IRS.

Proposed Solutions to Close the Tax Gap

Rettig offers three solutions that will target this billion dollar tax gap.  First, Rettig suggests that the IRS should “hunt” for under-reporters and non-filers.  He suggests that technology can help target the taxpayers that fall in the categories of significant underreporting through electronic programs designed to identify these tax payers.  Technology can also be used to identify those tax payers that underreport foreign income, with the cooperation of foreign governments.

Second, Rettig discusses the need for tax practitioners to enhance professional responsibilities within their own fields.  Although the IRS is the governmental tax enforcement agency, Rettig suggests that tax practitioners also play an important role in the voluntary compliance aspect of our tax system.  Specifically, Rettig states that attorneys, accountants, and other tax practitioners must make sure their clients follow the law and observe the appropriate standards set within each profession.  Rettig states, “Tax returns are not to be perceived as an offer to negotiate with the government–information set forth on a tax return, signed by a paid return preparer, must be accurate with a reasonable foundation and reasonable support for the characterization of items set forth within the return.”

Lastly, Rettig suggests that the only way to increase voluntary tax compliance is to increase tax enforcement.  If tax payers know that there is a significant risk of IRS detection associated with underreporting, underpayment, or non-filing, tax payers will be more likely to voluntarily comply.  Because Rettig stated that research shows that increased civil penalties alone do not create the needed effect of increased compliance, only increased tax enforcement through civil examination, field (in-person) examination, and investigation will create the needed effect of increased voluntary compliance by taxpayers.

Conclusion

In sum, Rettig offers both sides of the coin: extensive experience in advocating from the taxpayer’s point of view against the IRS and extensive experience with the inner workings of the IRS and the contributing factors to the billion dollar tax gap.  With this two-sided experience, taxpayers can expect a new frontier of the IRS focusing its resources on targeting the greatest causes of the tax gap, increasing examination of these taxpayers, and hopefully adding millions, if not billions, of uncollected tax revenue to the federal treasury.

In United States v. Stein, the Eleventh Circuit recently decided a novel – but critical – issue for taxpayers.  It held that an affidavit that satisfies Rule 56 of the Federal Rules of Civil Procedure (the summary judgment rule) may create an issue of material fact precluding summary judgment, even if it is self-serving and uncorroborated.  The case centered around an IRS assessment.  IRS assessments are entitled to a presumption of correctness, which can be a difficult burden for taxpayers to overcome.

In 2015, the government sued Estelle Stein for outstanding tax assessments, late penalties, and interest for the 1996 and 1999-2002 tax years.  The government moved for summary judgment and tried to show that Ms. Stein had outstanding tax assessments by submitting her federal tax returns, account transcripts, and an affidavit from an IRS officer.  Ms. Stein responded with her own affidavit, stating that, “to the best of [her] recollection,” she had paid the taxes and penalties at issue.  Her affidavit also explained that she used an accounting firm to file the tax returns, that she remembered paying the taxes and penalties due, but that she did not have bank statements showing these payments.

The district court granted summary judgment for the government because, it explained, Ms. Stein did not produce any evidence documenting payments.  An Eleventh Circuit panel affirmed based on Mays v. United States, 763 F.2d 1295 (11th Cir. 1985).  In Mays, the court affirmed summary judgment for the government, holding that a taxpayer in a refund suit must not only show the government’s assessment is wrong, but also establish the “correct amount of the refund due.”  Mays further held that the taxpayer’s claim “must be substantiated by something other than tax returns, uncorroborated oral testimony, or self-serving statements.”

The Eleventh Circuit sitting en banc in Stein, however, disagreed and overruled Mays “to the extent it holds or suggests that self-serving and uncorroborated statements in a taxpayer’s affidavit cannot create an issue of material fact with respect to the correctness of the government’s assessment.”  Under Rule 56(a), summary judgment may be granted only when “there is no genuine dispute as to any material fact” and the moving party is “entitled to judgment as a matter of law.”  The Eleventh Circuit further held that nothing in the Federal Rules of Civil Procedure prohibit an affidavit from being self-serving.

Stein is a significant win for taxpayers, and it may make it easier for taxpayers to overcome the presumption of correctness that IRS assessments have enjoyed.

The Internal Revenue Code requires employers to withhold certain taxes in “a special fund in trust for the United States” (sec. 7501(a)). IRS regulations require employers to pay these trust fund taxes to the IRS quarterly. Employers who fail to pay withheld taxes to the government are personally liable for the taxes under section 6672 of the Code. In general, the government can recover unpaid taxes if (1) the employer is responsible for collecting and paying withholding taxes, and (2) the individual willfully failed to collect and pay the withholding taxes. What is key is that the IRS can recover from any responsible person, not necessarily the most responsible person.

The trust fund recovery penalty is often a trap for the unwary, including for partners and shareholders of law firms, as illustrated by Spizz v. United States, 120 A.F.T.R. 2d 2017-6719 (S.D.N.Y. Dec. 4, 2017). Spizz and Todtman were shareholders of the law firm Todtman, Nachamie, Spizz & Johns, P.C., from 2009 through September 2012. The court in Spizz held that the government could hold Spizz and Todtman personally liable for the trust fund taxes the firm failed to pay between 2009 and 2012. Despite the fact that the firm was going through serious financial difficulty, the court held that both shareholders were personally liable for the trust fund taxes.

Responsible Persons

The court first turned to whether Todtman and Spizz were “responsible persons” for the firm’s payment of trust fund taxes. The court stated that the payment issue depended on whether, given the individual’s authority over the company’s financial operations, the individual could have prevented the tax delinquency.

The court found that both Todtman and Spizz were responsible persons. Todtman founded the firm, served as its president while holding one-third ownership during the relevant periods and exercised authority over the firm’s finances. Although Spizz did not make financial decisions to the same extent as Todtman, the court stated that the “inquiry focuses on whether an individual could have exerted influence” to avoid tax delinquency. The court found that Spizz was also a responsible person because he held one-third of the firm’s shares and was its vice president.

Willfulness

The second element of tax payment liability under section 6672 is willfulness. A person willfully fails to pay withholding taxes if payment is made to other creditors while knowing that withholding taxes are due. The court found that Todtman was aware of the firm’s responsibility to pay trust fund taxes, and that the firm was paying other creditors before the IRS. While the trust fund taxes were still due, Todtman signed checks on behalf of the firm to disburse funds for payroll and payments to creditors.

The court also held that Spizz willfully failed to remit trust fund taxes. Although he did not learn of the firm’s tax liability until June 2010, he failed to apply the firm’s unencumbered assets to the firm’s tax liability when he found out about it. The court held that this was sufficient to establish willfulness for the pre-June 2010 period. After June 2010, when Spizz became aware of the firm’s tax liability, the court held that he could no longer maintain a reasonable belief that other members of the firm would timely pay its trust fund taxes. Thus, Spizz could not claim that he did not willfully withhold trust fund taxes.

In Mission Funding Alpha, the Pennsylvania Supreme Court recently held that the statute of limitations for a corporation to file a refund claim in Pennsylvania begins to run when the corporate tax return is due, not when the return is actually filed.

Background

The issue before the Pennsylvania Supreme Court was whether the three-year statute of limitations for a corporate taxpayer to file a refund claim begins when the tax is paid or when the annual return is filed.  Corporations like Mission Funding Alpha that are subject to franchise taxes must pay estimated taxes at the end of every quarter.  Any remaining franchise tax liability must be paid when the corporation files its annual return.  If the corporation overpays its estimated taxes, it may file a refund claim.  The refund claim, however, must be made within three years of “the actual payment of the tax.”

Mission Funding Alpha filed its Pennsylvania franchise tax return on September 19, 2008 – after the due date.  It overpaid its estimated franchise taxes, however, so on September 16, 2011, Mission Funding Alpha filed a claim for refund with the Pennsylvania Board of Appeals.  The Board of Appeals, however, dismissed the claim as untimely because it was filed more than three years after April 15, 2008, the due date for the return.  Mission Funding Alpha appealed, arguing that the statute of limitations is three years from the date the return is filed.

Commonwealth Court Decision

The Commonwealth Court agreed with Mission Funding Alpha.  The court held that whether a refund claim is timely depends on the meaning of “the actual payment of tax.”  It explained that “the common and approved usage of the phrase ‘actual payment’ means the delivering of money in the acceptance and performance of an obligation.”  The court noted that corporations must pay estimated taxes and make final payments of taxes due with their annual corporate returns.  According to the court, a corporate taxpayer makes its “final” tax payment only when it files its annual return.  Thus, the court reasoned that a corporation’s franchise tax liability is not established until it files its annual return and “the actual payment of the tax” does not happen until the annual return is filed.

Supreme Court Decision

The Pennsylvania Supreme Court disagreed and reversed the Commonwealth Court.  The Court explained that “the actual payment of the tax” happened on April 15, 2008, the date the tax was due and payable, and when the Pennsylvania Department of Revenue accepted Mission Funding Alpha’s estimated payments and credits for its 2007 liability.  Importantly, the Court also held that, when a return is filed late, the triggering event for determining when the statute of limitations begins to run for a refund claim is not when the return is filed.  Thus, the Court concluded that Mission Funding Alpha’s refund claim was not timely because the three-year refund period ended before the claim was filed on September 16, 2011.

Consequences

As a result of the Pennsylvania Supreme Court’s decision, the statute of limitations for refund claims in Pennsylvania is significantly different than many other states.