General Tax Controversy News & Updates

We have all heard the old proverb “if it’s too good to be true, then it probably is.” In the tax world, this proverb might as well be referred to as the economic substance doctrine. Generally, taxpayers are free to structure their business transactions in a manner of their choosing. However, the economic substance doctrine permits a court to disregard a transaction for Federal income tax purposes if the transaction has no effect other than generating an income tax loss.  In the case of Smith v. Commissioner, T.C. Memo. 2017-218, the taxpayers violated this doctrine by trying to transform cash and securities into a loss through a series of transfers involving an S corporation and a limited partnership.

The Plan

In Smith v. Commissioner, Mr. Smith retired from National Coupling in 2009. Upon retirement, he received a bonus and total employee compensation of approximately $664,000. Mr. Smith’s financial adviser referred him to a tax and estate planning attorney (who was also a CPA) for tax planning services. With the intention of offsetting the compensation income Mr. Smith received from National Coupling, the attorney recommended the following tax planning structure:

  • In 2009, Mr. Smith and his wife (the “taxpayers”) would create an S corporation (wholly owned by the taxpayers) and a family limited partnership.
  • The S corporation (along with a management company) would own the family limited partnership.
  • The taxpayers would transfer cash and marketable securities to the S corporation. The S corporation, in turn, would immediately transfer the cash and marketable securities to the family limited partnership.
  • The S corporation would dissolve in 2009 (the same year it was created). Upon dissolution, the S corporation would distribute limited partnership interests in the family limited partnership to the taxpayers.
  • The fair market value of the distributed partnership interests would be discounted for lack of marketability and lack of control, generating a tax loss equal to the difference between the fair market value of the discounted partnership interests that were distributed over the cash and marketable securities the S corporation transferred to the family limited partnership.

The taxpayers agreed to the structure, and in 2009 they transferred a total of approximately $1.8 million in cash and marketable securities to a newly formed S corporation. The S corporation transferred an approximately equal amount to the newly created family limited partnership. At the end of 2009, the taxpayers and the attorney dissolved the S corporation. In the dissolution, the S corporation transferred a 49% limited partnership interest to each Mr. and Mrs. Smith. The attorney determined that the fair market value of the distributed partnership interests were approximately $1.1 million after discounting the value for lack of marketability and lack of control. The S corporation reported a loss of approximately $700,000 ($1.1 million in gross receipts (equal to the discounted value of the distributed partnership interests) less $1.8 million cost of goods sold (equal to the cash and marketable securities transferred to the family limited partnership)).

The Problem

The S corporation did not have any business activity whatsoever. It did not have a bank account, did not issue stock certificates, did not keep minutes of meetings, and did not follow corporate formalities. The S corporation existed solely to generate an artificial tax loss to offset Mr. Smith’s income. Consequently, the Court determined that the economic substance doctrine prevented the taxpayers from claiming the loss.

The Kicker

The IRS also asserted that the taxpayers were liable for a $125,000 accuracy-related penalty for a substantial understatement of tax. Taxpayers have a defense to accuracy-related penalties for reasonable reliance on the advice of a tax professional if they can prove three elements: (1) the taxpayer reasonably believed that the professional was a competent adviser with sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser’s judgment. Further, due care does not require that the taxpayer challenge his or her attorney’s advice or independently investigate its propriety. Surely, the taxpayers would be able to establish that they reasonably relied on the faulty advice of their attorney, right? The Court determined that the taxpayers proved the first two elements of the defense, but not the third. What was the taxpayers’ fatal flaw? The Court thought they lied during trial. In the Court’s own words:

“They understood, early in the process, that [the S corporation] would be organized and dissolved in 2009 but continued to represent, even at trial, that [the S corporation] had a business purpose. This is not acting in good faith. They knew from the beginning that [the S corporation] would not last past 2009, it did not have a genuine business purpose, and its sole purpose was tax avoidance. That knowledge alone negates a reliance defense.”

Consequently, the Court determined that the taxpayers were liable for the accuracy-related penalty.

We highly recommend that taxpayers understand every aspect of transactions they enter into, especially when targeted to tax planning.  If a proposal seems too complicated or if you can’t make sense of something, get a second opinion, or…RUN!

The Treasury Department and the IRS released their 2017-2018 Priority Guidance Plan, which prioritizes various tax issues that should be addressed through regulations, revenue rulings, revenue procedures, notices, and other published administrative guidance. The new plan takes into account various Executive Orders issued this year directed at administrative regulations.

Executive Orders

Since taking office, the President has issued several Executive Orders directed at regulations, including tax regulations. Executive Order 13771 requires federal agencies to withdraw two existing regulations for every new regulation. Executive Order 13777 created regulatory review task forces at federal agencies. Executive Order 13789 instructed the Treasury Department to review the tax regulations issued in 2016.

In July, the Treasury Department identified two regulations to be withdrawn and six regulations to be revoked, modified or otherwise changed. The two regulations withdrawn by the IRS are the estate tax valuation proposed regulations and the political subdivision proposed regulations.

“Treasury is taking a serious look back at its own regulations that are already on the books” said Treasury Secretary Steven Mnuchin in October. According to Mnuchin, the IRS has identified “hundreds of rules and regulations that are outdated.”

Priority Guidance Plan

The 2017-2018 Priority Guidance Plan is divided into four parts. Part 1 focuses on the eight regulations identified for withdrawal, revocation, modification, or other action. Part 2 describes certain projects that the Treasury Department and the IRS have identified as burden reducing. Part 3 describes various projects to implement the new centralized partnership audit regime. Part 4 describes specific projects by subject area that will be the focus of the balance of the efforts of this plan year.

Items identified for near-term burden reduction include:

  • Guidance under Section 170(e)(3) regarding charitable contributions of inventory.
  • Guidance on refunds under the Combat-Injured Veterans Tax Fairness Act.
  • Guidance under Section 954(c) regarding foreign currency gains.
  • Guidance under Section 3405 regarding distributions made to payees, including military and diplomatic payees, with an address outside the United States.

Additional guidance projects include:

  • Guidance under Section 707 on disguised sales of partnership interests.
  • Guidance on the physical presence of certain individuals in Puerto Rico or the United States Virgin Islands under Section 937(a) following Hurricane Irma or Hurricane Maria.
  • Update to the whistleblower regulations.
  • Additional guidance on issues relating to lifetime income from retirement plans and IRAs.
  • Regulations updating the rules applicable to Employee Stock Ownership Plans.
  • Guidance under Section 401(a)(9) on the use of lump sum payments to replace lifetime income being received by retirees under defined benefit pension plans.
  • Regulations under Regulation Section 1.1502-36 and related provisions regarding losses on subsidiary stock.

 

The IRS is putting an increased emphasis on identity theft protections for business returns as a result of an increase in fraudulent business tax returns in recent years. The IRS will be asking tax professionals to gather more information on their business clients to assist the IRS in authenticating that the tax return being submitted is actually a legitimate return filing and not an identity theft return.

IRS Commissioner John Koskinen cautioned:

We know that cybercriminals are planning for the 2018 tax season just as we are. They are stockpiling the names and SSNs they have collected. They try to leverage that data to gather even more personal information. This coming filing season, more than ever, we all need to work diligently and together to combat this common enemy. We all have a role to play in this fight.

The IRS explained that there are some signs that may indicate identity theft, including:

  • A request for an extension is rejected because a return with the Employer Identification Number (EIN) or Social Security Number is already on file.
  • An e-filed return is rejected because a duplicate EIN/SSN is already on file with the IRS.
  • An unexpected receipt of a tax transcript or IRS notice that does not correspond to anything submitted by the filer.
  • Failure to received expected and routine correspondence from the IRS.

To help curb identity theft, tax professionals will begin gathering additional information and asking additional questions, including:

  • The name and SSN of the company individual authorized to sign the business return. Is the person signing the return authorized to do so?
  • Payment history: Were estimated tax payments made? If so, when were they made, how were they made, and how much was paid?
  • Parent company information: Is there a parent company? If so, who?
  • Additional information based on deductions claimed.
  • Filing history: Has the business filed Form(s) 940, 941 or other business-related tax forms?

The IRS is also cautioning taxpayers and tax professionals about an ongoing scam to steal Forms W-2. Identity thieves are creating fake Forms W-2 to accompany fraudulent returns. Going forward, all Forms W-2 will now include a “Verification Code” box. The code is 16 digits and will assist the IRS in authenticating the Forms W-2.

The IRS is also warning all tax professionals and entities holding personally identifiable information to be especially alert to cybercriminals impersonating clients to steal sensitive information from their files. The IRS is urging all tax professionals incorporate verification steps regarding email requests for personal information and to watch out for phishing emails.

 

On Thursday, November 2, the House Ways and Means Committee released the proposed Tax Cuts and Jobs Act, which proposes significant revisions to the Internal Revenue Code. According to Fox Rothschild tax partner Jennifer Benda, “my sense after reading the Bill is that most taxpayers’ tax liabilities will roughly remain the same.” The Tax Policy Center agrees with this general view.

A broad overview of several different parts of the Bill are discussed below.

Individuals

  • The Bill reduces the number of individual income tax brackets from seven to four. In general, rates are lowered.
  • The Bill provides for an increased standard deduction (nearly double the current deduction amount). The intent behind the increased standard deduction is to achieve simplification by reducing the number of filers who itemize deductions from approximately 33% currently to less than 10%. To accomplish this objective, the Bill repeals or reduces many deductions (such as deductions for personal exemptions, moving expenses, tax preparation expenses, medical expenses, and personal casualty losses, among others).
  • The Bill reduces the mortgage interest deduction. Under current law, taxpayers are allowed to deduct $1 million for acquisition indebtedness and $100,000 for home equity indebtedness. The Bill reduces the deduction for acquisition indebtedness from $1 million to $500,000, and interest is deductible only on the taxpayer’s principal residence (under current law, the deduction is available for interest paid on a principal residence and one other residence). Interest on home equity indebtedness will no longer be deductible.
  • The Bill modifies the exclusion of gain from the sale of a principal residence. Under current law, a taxpayer may exclude $250,000 ($500,000 if married filing jointly) on gain of the sale of a principal residence if the property was owned and used as a principal residence for two of the previous five years. The Bill modifies the exclusion to require the taxpayer to own and use the home as a principal residence for five of the previous eight years, and the exclusion if phased out one dollar for every dollar by which the taxpayer’s adjusted gross income exceeds $250,000 ($500,000 if married filing jointly).
  • The Bill narrows property that is eligible for like-kind exchange treatment. Current law allows like-kind exchange treatment for real property and personal property if certain conditions are met. The Bill allows for like-kind exchange treatment only for real property. However, the Bill provides for a transition rule to allow exchanges of personal property to be completed if the taxpayer has either disposed of the relinquished property or acquired the replacement property on or before December 31, 2017.
  • The Bill increases the Child Tax Credit from $1,000 per child to $1,600, and increases the threshold at which the credit is phased out. The Bill also provides for a new family flexibility credit, which is non-refundable and subject to a phase out.
  • The Bill consolidates the current American Opportunity Credit, Hope Scholarship Credit, and Lifetime Learning Credit into a single education credit. The Bill also repeals the deduction for student loan interest and qualified tuition and related expenses.
  • Family law attorneys will want to note that the Bill provides that alimony payments are not deductible by the payor or included in income of the payee.

Repeal of Alternative Minimum Tax

  • The Bill repeals the AMT, effective for tax years beginning after 2017. If a taxpayer has an AMT credit carryforward, the taxpayer can claim a refund of 50 percent of the remaining credits in tax years beginning in 2019, 2020, and 2021, and taxpayers can claim a refund of all remaining credits beginning in tax year 2022.

Estate Tax, Gift Tax, Generation Skipping Transfer Taxes

  • The Bill doubles the basic exclusion amount from $5 million under current law to $10 million (indexed for inflation).
  • The Bill repeals the estate and generation skipping transfer taxes beginning after 2023.
  • The Bill lowers the gift tax rate to a top rate of 35% (currently 40%) and retains an annual exclusion of $14,000 (indexed for inflation).

Pass-Through Entities

  • The Bill introduces an option for individual owners or shareholders of pass-through entities to treat a portion of pass-through entity net income distributions as “business income” that would be taxed at a maximum 25% rate. The remaining income would be taxed at the owner or shareholder’s individual income tax rates. Under current law, owners of pass-through entities are taxed on their share of business income at their respective individual income tax rates (i.e., there is currently no option to treat a portion of income as business income that would be taxed at a reduced rate).
  • The proposal offers two different ways to determine business income: (1) a set capital percentage of 30% of the net business income derived from active business activities (treated as business income subject to the 25% rate, and the remaining 70% is taxed at the owner or shareholder’s individual income tax rate), or (2) apply a formula to determine the exact capital percentage. Professional service partnerships are not eligible for the 70/30 rule. If the alternative method is chosen (option 2), the election would be binding for a five-year period. The Bill distinguishes between passive and active activities, to be determined pursuant to already-existing regulations.
  • The Bill repeals the current technical termination rule related to partnerships. Under current law, a partnership terminates if within a 12 month period there is a sale or exchange of 50% or more of the total interests in partnership capital and profits. The Bill repeals the technical termination rule, meaning the partnership would be treated as continuing and new elections that are currently required in the event of a technical termination would not be required or permitted.

Corporations

  • The Bill provides for a flat 20% corporate tax rate (25% for personal service corporations), eliminating the current marginal tax rate structure.
  • The Bill provides for enhanced cost recovery deductions and expands section 179 expensing. Under current law, taxpayers may take additional depreciation deductions when it places qualified property in service through 2019. The additional depreciation is limited to 50% of the cost of the property, at most. The Bill allows taxpayers to fully and immediately expense 100% of the cost of qualified property acquired and placed in service after September 7, 2017 and before January 1, 2023, and expands property that is eligible.
  • The Bill modifies the accounting method rules. Under current law, corporations with average gross receipts exceeding $5 million typically must use the accrual method of accounting. The Bill allows more corporations and partnerships with corporate partners to be eligible for the cash method of accounting by increasing the $5 million threshold to $25 million.
  • The Bill also allows more taxpayers to be eligible to use the completed contract method of accounting for long-term contracts (as opposed to the percentage of completion method) by increasing the threshold amount from $5 million to $25 million. The completed contract method allows eligible taxpayers to deduct costs associated with construction when they are paid and recognize income when the contract is completed.
  • The Bill modifies or repeals several business-related deductions. The Bill provides for interest deduction limitations (although the limitations do not apply to businesses with average gross receipts of $25 million or less), which disallows a deduction for net interest expense in excess of 30 percent of the business’s adjusted taxable income. The Bill also modifies the net operating loss deduction and nonrecognition for like-kind exchanges (discussed above – limited to exchanges of real property under the Bill), among other deductions. The Bill repeals deductions for local lobbying expenses and domestic production activities (DPAD).
  • The Bill repeals a number of business credits.

Tax Controversy

  • From a tax controversy perspective, the Bill does not modify any existing procedural rules for dealing with the IRS or provide for additional penalties.

This article touches on only a few topics addressed in the Bill. The Bill also revises taxation of foreign income and foreign persons, multi-national businesses, and exempt entities. You can read the Ways and Means Committee’s section-by-section summary of the Bill here.

The White House, Washington, D.C.On October 16, 2017, the White House released the Council of Economic Advisers’ Report, entitled Corporate Tax Reform and Wages: Theory and Evidence.  The Report comes in the wake of the current administration’s push for major tax reform.  With $299 billion in corporate profits abroad in 2016, the focus of the Report is to make the U.S. corporate tax rate more competitive in a global market.  The ultimate goal is for the benefits of the competitive U.S. corporate tax rate to trickle down to an increase in wages.  The Report reaches the conclusion that decreasing the U.S. corporate tax rate from the current thirty five percent to twenty percent will increase the average household income by $4,000 up to $9,000 annually.

Theory

The Report is rooted in the economic theory that there is a correlation between corporate tax rates and labor wages.  The Report states that U.S. companies move capital abroad to take advantage of lower capital tax rates in other countries.  It offers data showing that U.S. corporate profits have soared while wage growth has stagnated.  Over the past eight years, U.S. corporate profits increased at an average rate of eleven percent, but the average household income only increased at a rate of 1.1 percent.

The Report states that lowering the U.S. corporate tax rate to a more global competitive rate would not only bring profits back to the U.S., but also create an incentive for companies to invest the extra capital domestically.  It cites to research suggesting that increased domestic capital investments increases the demand for labor.  An increased demand for labor would theoretically create jobs and raise the price for labor, or workers’ wages.  Under this theoretical basis, the Report uses empirical data gathered from various sources to calculate an estimated dollar amount of the average wage benefits to the proposed lower corporate tax.

Empirical Evidence

The Report relies on different sources that use economic models to predict how a country’s corporate tax rate affects labor.  First, the Report cites to different sources that each offer a percentage of how much workers’ wages bear the burden of corporate tax in order to support the theory that wages bear most of the burden of corporate tax.  The percentages offered in the Report range from twenty-one to ninety-one percent, depending on the specifications used in the economic model.  This means that there are sources cited in the Report that calculated that workers’ wages bear the burden of only twenty-one percent of corporate tax, while other sources cited calculated that workers’ wages bear the burden of ninety-one percent of corporate tax.  The Report concludes that the disparity among the percentages depends on how much the economic model accounted for the flow of corporate capital to other countries, expressing the notion that workers’ wages bear more corporate tax burden as more corporate capital moves abroad.

Next, the Report cites to sources that used economic models to measure the direct relationship between corporate tax and workers’ wages to determine the elasticity of average wages, which is how much wages change when the corporate tax rate changes.  Each economic model cited in the Report offers a different elasticity, meaning that each economic model produced a different result as to how much a one percent change in the corporate tax rate affects workers’ wages.  This is because each model used slightly different variables.  The Report uses results from these different economic models to conclude that for every one percent increase in U.S. corporate tax, workers’ wages decrease by about 0.3 percent.  Using these figures, the Report concludes that these various economic models suggest that decreasing the current corporate tax rate by fifteen percent will raise the average household income annually by, conservatively, $4,000, and up to $9,000, using the higher range of the figures.

Lastly, the Report states that data from the Bureau of Economic Analysis shows that increasing the U.S. corporate tax rate by one percent results in 2.25 percent higher corporate profit shifting to lower tax jurisdictions.  The Report suggests that reducing the U.S. corporate tax rate by fifteen percent would reduce corporate profit shifting to lower tax jurisdictions and result in $140 billion of repatriated profit, based on the figures from 2016.

Review of Sources Cited

A review of the sources cited to in the Report highlight that the disagreement among economic theorists depends on the variables used in the economic model.  First, an economic model can be based on either a closed or open economy.  In a closed economy model, the supply of capital and labor are restricted to that country’s economy.  A closed economy model results in the owners of the capital bearing the burden of the corporate tax.  See Harberger, A.C., The Incidence of the Corporate Income Tax, Journal of Political Economy (1962).  The closed economy model is found more often in older economic literature, as the modern U.S. economy is more global.  In an open economy model, the capital is mobile, meaning that the supply of capital can move to different countries, but the labor remains immobile.  The open economy model shifts the corporate tax burden onto workers’ wages.  Although the Report ultimately uses figures from open economy models to reach its conclusion, this consistency among economic models does not necessarily decrease the variability in results.

Even among economic models that use an open economy, there is drastic variability in results.  Sophisticated economic models based on an open economy can take many forms, such as analyzing data across countries or restricting the model to data from only one country.  For example, the Report used a combination of results from economic models that analyzed data across countries and from economic models that analyzed data across states within the U.S. to calculate the figure for elasticity of wages.

Each open economy model can also account for a different rate of openness, or capital mobility.  The economic models that found that workers’ wages bear a lower percentage of the burden of corporate tax used moderate estimates of capital flow overseas.  On the other hand, economic models that found that workers’ wages bear a high percentage of the burden of corporate tax used figures to account for a free flow of capital abroad.  The differences in percentages cited in the Report show the drastic effect on results when an economic model adjusts figures for just one variable: openness.

Within these sophisticated economic models, there are assumptions and variables that are manipulated.  For example, two sources cited in the Report note the differences in outcomes when an open economic model does not assume that domestic and foreign products are perfect substitutes.  See Felix, R.A. Passing the Burden: Corporate Tax Incidence in Open Economies, LIS Working Paper Series (2007; see also Gravelle, Jane and Smetters, Kent, Does the Open Economy Assumption Really Mean that Labor Bears the Burden of Capital Income Tax?, B.E. Journal of Economic Analysis & Policy, (2006).  This variability is also seen in the conclusions drawn in the Report, as it notes that the estimated $4,000 annual increase to the average household income was calculated based on economic models that used countries and time periods that have less foreign corporate profit activity than the U.S. and less corporate profits held abroad.

Conclusion

Overall, the Report offers a conclusion that is supported by modern economic theorists and empirical data; a sophisticated economic model using an open economy can show that workers’ wages bear most of the burden of corporate tax, and a decrease in corporate tax may increase workers’ wages.  Importantly, the Report’s estimated effects of lowering the corporate tax rate in the U.S. suffer the same uncertainty as the results from any sophisticated economic model.  Adjustments to even one variable can create significantly different results.  Although sophisticated economic models offer valuable insight, it is crucial to investigate the information used in order to gain a clear picture of the basis of economic predictions, which in turn become the basis of major tax reform.

 

Today, the Tax Court issued its opinion in Feinberg v. Commissioner, a case involving an ongoing and hard fought battle between the IRS and a medical marijuana dispensary, Total Health Concepts, LLC.  The IRS examined THC’s 2009 through 2011 tax returns.  As a result of the examination, the IRS adjusted the member taxpayers’ returns to reflect a cost of goods sold allowance in excess of the amount originally claimed on the return by reclassifying expenses that were originally claimed as below-the-line expenses.  However, the IRS also disallowed expenses not reclassified as cost of goods sold.  Accordingly, the IRS computed deficiencies on the member’s individual tax returns.

During earlier phases of this case, the taxpayer argued that the Commissioner did not have jurisdiction to administratively determine whether petitioners committed a federal crime outside of the U.S. tax code, that section 280E as applied by the Commissioner is unconstitutional as it violates petitioners rights against self-incrimination under the Fifth Amendment of the Constitution, and that section 280E exceeds the authority granted to Congress under the Sixteenth Amendment of the Constitution.  The Tax Court denied the taxpayer’s request for summary judgment and compelled them to respond to IRS discovery requests.  The taxpayer’s sought a writ of mandamus, seeking review of the Tax Court’s order compelling them to produce documents.  The Tenth Circuit determined that if the discovery request harmed them, the proper time to address that harm would be after the Tax Court case was fully resolved.  As a result, the taxpayer’s case proceeded to trial.

At trial, the taxpayer did not submit documentation to substantiate the cost of goods sold allowance or the ordinary and necessary business expenses.  Instead, an expert report was submitted to substantiate a cost of goods sold allowance in excess of what the IRS allowed during the examination.  The Tax Court ruled that the expert report was unreliable because it contained statements which failed to refer to underlying source information, failed to include underlying source information which the expert relied upon, and failed to include sufficient information and data to support the report’s conclusions.  As a result, the expert report was inadmissible.

Next, the court looked to evidence which would support a higher cost of goods sold allowance than the allowance determined in the IRS report.  Without documentation, the court concluded that the IRS determination of cost of goods sold would stand.  Further, because there was no substantiation of ordinary and necessary business expenses claimed under Section 162, the court determined that it did not need to address the application of Section 280E (the code section which disallows ordinary and necessary business deductions for businesses trafficking in controlled substances).

What is the lesson here?  This case provides no guidance on the limits that will be applied to cannabis companies in determining cost of goods sold.  Rather, this case tells us that a cannabis company should prepare for an IRS examination the same way any other taxpayer should, by maintaining documentation to support the deductions claimed on the return and by provided that documentation when the IRS requests it.  This is especially true in this case, where the court determined that “there was not enough evidence in the record to make a finding of fact that THC sold medical marijuana.”  Based on this statement, if the taxpayer would have substantiated its below-the-line expenses, they would not have been subject to Section 280E, which would have been a huge win for the taxpayer.

In Palmolive Building Investors, LLC v. Commissioner, 149 T.C. No. 18, the Tax Court denied a charitable contribution deduction of a donated façade easement because the easement deed failed to satisfy the perpetuity requirement of section 170.

Background – Perpetuity Requirement

A contribution of a qualified real property interest is deductible as a qualified conservation contribution if, among other requirements, the contribution is exclusively for conservation purposes. The “exclusivity” requirement is only satisfied if the conservation purposes are protected in perpetuity. To be protected in perpetuity, the interest in the property retained by the donor must be subject to legally enforceable restrictions that will prevent uses of the retained interest inconsistent with the conservation purposes of the donation. The Regulations provide rules for many of these legally enforceable restrictions.

When donated property is subject to a mortgage, the mortgagee must subordinate its rights in the property to the right of the easement holder to enforce the conservation purposes of the gift in perpetuity. If the mortgagee fails to actually subordinate its rights in the property, the perpetuity requirement is not satisfied. Further, if an unexpected change in conditions makes the property’s continued use for conservation purposes impossible or impractical, then the restrictions required to protect the conservation purpose may be extinguished by judicial proceedings. In the event an easement is extinguished and the donor subsequently conveys the property and receives proceeds for it, the donee organization must be guaranteed to receive a certain portion of the proceeds.

Why Deed Failed to Satisfy Perpetuity Requirement in Palmolive Building Investors

In Palmolive Building Investors, Partnership PB (“Partnership”) transferred a façade easement by executing an easement deed (“Deed”) in favor of the Landmarks Preservation Council of Illinois (“LPCI”), a qualified organization. The purpose of the deed was to preserve the exterior perimeter walls of a building’s façade. At the time of the execution of the Deed, two mortgages encumbered the building. Before executing the Deed, Partnership secured an ostensible agreement from both mortgagees to subordinate their mortgages in the property to LCPI’s rights to enforce the purposes of the easement. However, the mortgagees’ subordination was limited by a provision in the Deed that gave the mortgagees a prior claim to any insurance and condemnation proceeds until the mortgage was paid off. This limitation proved to be fatal, as certain interests of the mortgagees were not actually subordinated to the interests of LPCI.

The IRS filed a motion for partial summary judgment, arguing that the easement deed did not satisfy the perpetuity requirement because it gave the mortgagees prior claims to extinguishment proceeds in preference to LPCI. The Tax Court agreed, holding that the easement deed failed to satisfy the perpetuity requirement for two reasons: (1) the mortgages on the building were not fully subordinated to the easement, and (2) LPCI was not guaranteed to receive its requisite share of proceeds in the event that the easement was extinguished and the donor subsequently conveyed the property and received proceeds for it.

It is worth noting that the Tax Court continued to strictly construe the requirement that the donee must be guaranteed to receive a certain portion of proceeds upon extinguishment, as it did in Kaufman v. Commissioner, 134 T.C. 182 (2010) – if a donee is not absolutely entitled to its requisite share of extinguishment proceeds, then the contribution’s conservation purpose is not protected in perpetuity. The First Circuit Court of Appeals has previously expressed its disagreement with this restrictive interpretation. In Kaufman v. Shulman, 687 F.3d 21 (1st Cir. 2012), the First Circuit explained that if any owner donates a facade easement and thereafter fails to pay taxes, a lien on the property arises in favor of the Government, and such lien would not be subordinated to the easement donee’s interest. Because this is always a possibility, a donee will never have an absolute entitlement to proceeds, so the perpetuity requirement will never be satisfied. The Tax Court refused to follow the First Circuit’s interpretation, explaining that it analyzes “conservation restrictions on the basis of property rights and interests that exist when the easement is granted, rather than conducting an analysis based on speculations of property interests that might arise in the future…”

This case illustrates the importance of ensuring that all requirements of section 170 are satisfied when a conservation easement is granted, as the Tax Court also held that the defects in the easement deed were not cured by a provision that sought to retroactively amend the deed to comply with section 170, because the requirements set forth in section 170 must be satisfied at the time of the gift.

You can read the full opinion here, and you can find more discussion on charitable contribution deductions for conservation easements here and here.

TIGTA recently released a report discusses their audit of the IRS’s estate and gift tax examination procedures.  TIGTA made eight recommendations of changes to the estate and gift tax examination process.  The bulk of TIGTA’s recommendations address the informal processes, lack of consistency, and unknown effectiveness of the estate and gift tax examination procedures.

One of the more significant findings of the report is that while the examination division proposed over $577 million of estate and gift tax deficiencies for FY 2016, only $98 million of those deficiencies were sustained after cases were considered by IRS Appeals.  The Examination division attributed this statistic to the fact that the Examination division proposes alternative deficiencies in order to prevent being whipsawed.  However, the Examination division could not separately identify the amount of deficiencies that were attributable to these alternative positions.  TIGTA highlighted that the Government could be subject to suits for attorneys’ fees pursuant to Section 7430 if the positions set forth in the notices of deficiency were not substantially justified.  TIGTA recommended that Examination division develop written guidance “on the circumstances in which it is advisable to propose and issue notices of deficiency in estate and gift tax examinations that contain alternative positions.”

Other highlights from the report include:

  • there is one gatekeeper who decides whether or not to route a case for examination and how to prioritize cases;
  • there is no quality review process;
  • unlike the process for selecting income tax returns for examination, the process of selecting estate and gift tax examinations for examination is based minimal written guidance and involves almost no objective procedures, but instead relies on human involvement and judgment; and
  • procedures for documenting case selection, examination documentation and managerial review either did not exist or if they did exist were not followed as closely as they should be.

TIGTA’s report can be accessed here.

On September 11, 2017, the Treasury Inspector General for Tax Administration (TIGTA) issued its final report discussing IRS compliance activities through fiscal year 2016 (the federal government’s fiscal year begins on October 1 and ends on September 30). TIGTA compiles statistical information reported by the IRS and issues the report annually in response to continuing stakeholder interest in the analysis and trends in IRS Collection and Examination function activities. Here are the highlights:

  • IRS Budget Increased, but Staffing Declined. Although the IRS budget increased in 2016, IRS staffing continued to decline. The budget increase was intended to improve customer service, prevent fraud and identity theft, and enhance cybersecurity to safeguard taxpayer data.
  • The Number of Tax Returns Examined Declined. The number of tax returns examined in 2016 decreased approximately nine percent compared to 2015. The number of examinations conducted in 2016 is approximately 32 percent lower than the number conducted during 2012. The report attributes the significant reduction in the number of examinations over that time period to a continued decline in examination staffing, which reached a 20-year low in 2016.

Percentage Change in the Number of Field Examiners and Examinations Since FY 2012

Source: IRS Data Book and Table 37 Examination Program Monitoring

 

  • IRS Issued Fewer Liens and Levies. The number of liens and levies issued continued to decline in 2016. The IRS issued its fewest amount of liens and levies since 2002.
  • Payment Alternatives – Increase in Direct Debit Installment Agreements. The number of direct debit installment agreements (a payment option available to certain taxpayers who cannot fully pay their tax obligations on time) has increased by 128 percent since 2012. The increased use of this payment option is likely attributable to reductions in enforcement personnel and the need to efficiently and effectively collect outstanding tax liabilities.
  • Legislative Initiatives. In December 2015, Congress enacted the Fixing America’s Surface Transportation Act. The law contains two measures designed to assist the IRS in collecting delinquent taxes: (1) authorizing the use of private debt collectors for the collection of outstanding inactive tax receivables, and (2) authorizing the State Department to revoke, or deny, passports to taxpayers with seriously delinquent tax debt. The IRS began assigning cases to private debt collection agencies in April 2017. The IRS also worked to coordinate with the State Department to implement the passport revocation program. You can read more about the passport revocation program here and here.

You can read the full report here.

Statutory Background

When a foreign corporation receives dividends from U.S. sources, the income is generally subject to tax at 30%. To avoid double taxation and encourage cross-border investments, the U.S. has entered into bilateral tax treaties with numerous countries. The bilateral tax treaty between the U.S. and Switzerland entitles Swiss-resident entities to a reduction in the tax rate applied to dividends received from U.S. sources provided it meets the criteria enumerated in the treaty. If none of the requirements listed in treaty are satisfied, the U.S. Competent Authority (“CA”) may authorize a lower rate if it determines the Swiss entity was not established for the principal purpose of obtaining treaty benefits (the CA is the official within the Treasury Department who is authorized to interpret provisions of bilateral tax treaties). The principal purpose test is designed to prevent business from establishing tax residency in a country primarily to obtain treaty benefits (i.e. treaty shopping).

Starr’s Request for Treaty Benefits

Starr International Company Inc. (“Starr”), a Swiss resident company, was once the largest shareholder of the insurance giant AIG. In 2007, Starr, which did not meet any of the criteria for the reduced dividend tax rate in the U.S.-Swiss tax treaty, petitioned the IRS for a discretionary reduction in the tax rate applicable to approximately $191 million in dividends Starr received from AIG in 2007. The CA denied Starr’s request for treaty benefits because it concluded that obtaining Swiss treaty benefits was a principal purpose of Starr’s recent relocation to Switzerland. The CA pointed to Starr’s history in low-tax jurisdictions as suggesting that it sought to avoid U.S. tax: it initially incorporated in Panama, it was first managed and controlled from Bermuda, it briefly relocated to Ireland and finally settled in Switzerland.

Starr challenged the decision, but the U.S. District Court for the District of Columbia upheld the CA’s denial of treaty benefits (see Starr International Company Inc. v. U.S. (120 AFTR 2d 2017-5488 (DC Dist Col, 8/14/2017)). Starr argued that it was not treaty shopping because Starr was a resident of Switzerland and treaty shopping always involves a resident of a country not party to the relevant tax treaty. However, the District Court rejected Starr’s definition of treaty shopping as narrow because Starr did not differentiate between “on paper” residency and bona fide residency required by the treaty. “On paper” residency is based on objective factors like domicile, nationality and place of management whereas bona fide residency is based on a substance-over-form determination that a taxpayer has a genuine connection to its “on paper” residence. Starr conceded that it was not a bona fide resident of Switzerland before it made its decision to establish residency in Switzerland and, according to the Court, in applying the principal purpose test, the CA properly looked beyond the objective factors of residency and properly concluded that Starr’s motivation for establishing bona fide residency was primarily motivated by obtaining the benefits of the U.S.-Swiss tax treaty.

Starr also argued that even if the CA applied the correct residency standard, it did not benefit from choosing Switzerland over Ireland or over its other finalists. However, the Court explained that the analysis is not limited to whether a company’s current jurisdiction is more favorable than its previous one, but rather why a company chose to establish itself in Switzerland over any other jurisdiction (a totality of the circumstances inquiry). In addition, the Court concluded that tax considerations were obviously important because Starr acknowledged that U.S. tax was one of four key criteria that the company analyzed in its decision to establish tax residency in Switzerland.