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Recently, the written supervisory approval requirement of Section 6751(b) has been one of the primary issues in Tax Court litigation concerning penalties that the IRS has asserted against taxpayers. The focus of this litigation is the effect of Section 6751(b) and its interplay with the Commissioner’s burden of production as to penalties in court proceedings under Section 7491(c). In Dynamo Holdings v. Commissioner, 150 T.C. No. 10 (May 7, 2018), the Tax Court addressed these issues in a partnership-level proceeding.

Section 6751(b)(1) provides that “[n]o penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination…” (note that Section 6751(b)(2) provides certain exceptions to this general rule).

Section 7491(c) provides that the IRS “shall have the burden of production in any court proceeding with respect to the liability of any individual for any penalty, addition to tax, or additional amount imposed by this title.”

Until the Chai and Graev III opinions, there had been little litigation over the effect of Section 6751(b).

In Chai v. Commissioner, 851 F.3d 190 (2nd Cir. 2017), the taxpayer argued in his post-trial brief that compliance with the written-approval requirement in Section 6751(b)(1) is an element of the Commissioner’s claim for penalties and is therefore part of the Commissioner’s burden of production under Section 7491(c). The Second Circuit Court of Appeals agreed, holding that Section 6751(b)(1) requires written approval of the initial penalty determination no later than the date the IRS issues the notice of deficiency (or files an answer or amended answer) asserting such penalty. Chai held that Section 6751(b) is part of the Commissioner’s burden or production in a deficiency case in which a penalty is asserted.

In Graev v. Commissioner (Graev III), 149 T.C. No. 23 (Dec. 20, 2017), the Tax Court held that the Commissioner’s burden of production under Section 7491(c) includes establishing compliance with the written supervisory approval requirement of Section 6751(b). Thus, in a deficiency case in which a penalty is asserted, it is the IRS’s burden to introduce sufficient evidence establishing compliance with the supervisor approval requirement.

In Dynamo Holdings, the Tax Court addressed the interplay between the supervisor approval requirement and the IRS’s burden of production in a partnership-level proceeding. The Court held that the IRS does not bear the burden of production with respect to penalties under Section 7491(c) in a partnership-level proceeding. The Court reasoned that Section 7491(c) provides that the IRS has the burden of production “with respect to the liability of any individual for any penalty…” Because partnership-level proceedings do not determine liabilities and are not with respect to individuals, the IRS does not bear the burden of production as to penalties. In a similar vein, the IRS does not bear the burden of production with respect to penalties asserted against corporations.

The Court further held that where the IRS does not bear the burden of production as to penalties, the lack of supervisory approval of penalties may be raised as a defense to those penalties. However, taxpayers should note that they must affirmatively argue that the IRS failed to comply with the supervisory approval requirements of Section 6751. Failure to make such an argument can be costly, as the taxpayer will be deemed to have waived the defense.

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 Tax Cuts and Jobs Act, enacted in December 2017, is the most significant change to the U.S. Tax Code since 1986 and dramatically alters the tax landscape for individuals. A number of changes take effect this year, while other provisions will not take effect until 2019. Many provisions are temporary, set to expire in 2026, which creates uncertainty for tax planning.

New Income Tax Rates and Loss of Itemized Deductions

Most fundamentally, the new law significantly lowers income tax rates for individuals. The top individual rate is now 37 percent – down from 39.6 percent. Individuals can earn more before the top rate applies as well. Under the prior law, the top rate applied to any income over $470,000 for married individuals filing jointly. Now, the top rate for those individuals applies only to income over $600,000. These lower rates currently apply only to the 2018 through 2025 tax years.

The law also significantly increases the standard deduction. The standard deduction for married individuals filing jointly is now $24,000. For head-of-household filers, the standard deduction is now $18,000, and $12,000 for all other taxpayers. The law slashes a number of itemized deductions, however, such as the deductions for unreimbursed employee expenses, union dues, and tax preparation fees. As a result, more individuals should elect the standard deduction.

State and Local Deduction Limitation

Another major change is a new $10,000 limitation on the deduction for state and local tax, or SALT, which includes state and local income taxes, local real estate taxes and state sales taxes. Previously, there was no limitation on an individual’s SALT deduction. The new limitation is more unfavorable for individuals in high tax states, such as California and New York. The average SALT deduction in California was around $18,500, while the average deduction in New York was around $22,000.

Some states, notably New York and California, are attempting to work around the SALT limitation. The California Senate recently passed a bill that would allow taxpayers a credit against their state income tax for contributions to the newly created California Excellence Fund. The theory is that Californians could also deduct these contributions for federal tax purposes as charitable contributions. If the California bill becomes law, the IRS will likely challenge it. It is unclear whether these “contributions” would actually count as charitable contributions because there would be no real charitable intent.

New York, New Jersey and Connecticut are also preparing to sue the federal government to challenge the SALT deduction limitation.

Mortgage Interest Deduction Limitation

The law also reduces the amount of mortgage interest individuals can deduct. The previous limit was $1 million, but the new law caps mortgage interest deductions at $750,000 on acquisition indebtedness. Acquisition indebtedness is debt incurred in acquiring, constructing or substantially improving a residence. The new law also completely disallows the deduction for home equity indebtedness interest – even if the home equity loan was taken out before the new law was enacted.

Increased Charitable Contribution Deduction Limitation

The new law is more favorable to charitable contributions. It increases the limits on deductions for charitable contributions to public charities and some private foundations from 50 percent to 60 percent of an individual’s adjusted gross income. For tax purposes, however, the increased limit is helpful only for individuals whose itemized deductions are higher than the increased standard deduction.

One way to beat the higher standard deduction and take advantage of the increased limit on itemized charitable deductions is to “bunch” charitable contributions that would otherwise be made over several tax years into one year.

Other Changes to Consider

There are a number of other changes individuals should consider. The law removes the tax for failing to have health insurance, starting in 2019. This could effectively undermine the entire Affordable Care Act. It also modifies the alternative minimum tax, or AMT, by increasing the exemption amount. The higher exemption amount means that fewer taxpayers will be subject to the AMT. The law also curtails the availability of “like-kind” exchanges.

Under Section 1031, taxpayers could previously exchange all property for similar property and defer the tax. Now, however, real estate is the only property that qualifies for like-kind exchange treatment.

Finally, it is important to note the significant changes for taxpayers who hold interests in pass-through entities. The new law creates a 20 percent deduction for certain business income from pass-through entities. Importantly, however, the deduction does not apply to certain service businesses, including law and accounting firms.

In CRI-Leslie, LLC, the Eleventh Circuit confronted whether a taxpayer is entitled to capital gains treatment for a forfeited deposit on the sale of land.  CRI-Leslie, LLC, Donald W. Wallace, Tax Matters Partner v. Commissioner, 11th Cir., No. 16-17424, February 15, 2018.  It is not a stretch to describe this area as “among the most frustrating in income tax law.”  Sirbo Holdings, Inc. v. Commissioner, 509 F.2d 1220, 1223 (2d Cir. 1975).

In 2005, CRI-Leslie paid almost $14 million for a hotel and restaurant in Tampa on prime waterfront property.  It planned to eventually sell the property, but it hired a third party to run everything in the meantime.  Over a year later, CRI-Leslie agreed to sell the property for around $39 million.  As part of the deal, CRI-Leslie received a $9.7 million nonrefundable deposit to be credited to the purchase price at closing.  But in 2008, the buyer fell through and forfeited the deposit.  CRI-Leslie reported the $9.7 million deposit as long-term capital gain.  The IRS disagreed, and argued that the Code allows capital gains treatment only for finalized sales, not forfeited deposits.

The case made its way to the Eleventh Circuit, which began its analysis with section 1231.  Section 1231(a) states that “any recognized gain on the sale or exchange of property used in the trade or business” is “treated as long-term capital gains.”  (Emphasis added).  Section 1231 also provides that the “term ‘property used in the trade or business’ means property used in the trade or business, of a character which is subject to the allowance for depreciation provided in section 167, held for more than 1 year, and real property used in the trade or business, held for more than 1 year ….”  If CRI-Leslie had actually sold the property, the $9.7 million would have been taxed as long-term capital gain under section 1231.

But the deal never happened, so the tax treatment of the deposit was governed by section 1234A, not section 1231.  Section 1234 states that any gain or loss resulting from the termination of an agreement to buy property will still be treated as capital gain, if the property is a “capital asset” for the purposes of section 1234A.  Thus, the narrower issue was whether the hotel was a capital asset.

The Eleventh Circuit held that the answer could not be clearer based on a plain reading of the Code.  For the purposes of section 1234A, “the term ‘capital asset’ means property held by the taxpayer (whether or not connected with his trade or business), but does not include … property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business.”  IRC § 1221(a)(2) (emphasis added).

The problem for CRI-Leslie was that it stipulated that the hotel was real property used in its trade or business.  The Eleven Circuit held that this concession by CRI-Leslie was fatal because “capital asset” does not include real property used in a trade or business under section 1221(a)(2).  That meant that the hotel was not a capital asset under section 1221, so section 1234A – the special rule that says that property from the termination of a contract for the sale of a “capital assets” is still subject to capital gains treatment – did not apply.  As a result, the Eleventh Circuit held that the $9.7 million forfeited deposit was taxable as ordinary income.

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.

The Tax Court’s recent opinion in Roth v. Commissioner, T.C. Memo. 2017-248, raises interesting issues about the need for supervisor approval when the IRS asserts penalties.  In 2007, the petitioners in Roth donated a conservation easement encumbering 40 acres of land in Colorado to a charitable organization.  The petitioners claimed a charitable contribution deduction of $970,000, but the IRS disallowed the deduction.

On examination, the IRS determined that the petitioners improperly valued the conservation easement and that the easement was actually worthless.  The examiner also determined that the petitioners were liable for a 40% gross valuation misstatement penalty under section 6662, and his determination was approved in writing by his immediate supervisor.  The examiner determined that the petitioners were alternatively liable for a 20% accuracy-related penalty.

The petitioners submitted a protest letter to IRS Appeals.  The parties did not reach an agreement, however, and Appeals ultimately issued a notice of deficiency.  In a closing memorandum, the Appeals officer informed the petitioners that “[t]he proposed penalties are fully sustained for the government.”  The closing memorandum was signed by the Appeals officer’s immediate supervisor.

The notice of deficiency omitted the 40% penalty and included only the 20% accuracy-related penalty.  The petitioners then filed a petition in Tax Court.  In its answer – which was signed by an IRS senior counsel and her immediate supervisor – the IRS asserted the 40% penalty.

The parties eventually settled the case.  They agreed that the petitioners were entitled to a charitable contribution deduction of $30,000 and that the petitioners had reasonable cause for the value of the conservation easement.  As a result, the IRS conceded that the petitioners were not liable for a 20% accuracy-related penalty.

The difference between the settlement value of $30,000 and the claimed value of $970,000, however, met the gross valuation misstatement test under section 6662(h).  Unlike for the 20% accuracy-related penalty, taxpayers cannot claim reasonable cause to avoid liability for the 40% penalty.  So the petitioners tried another escape route – they argued that the 40% penalty was inappropriate because the IRS failed to comply with the procedural requirements of section 6751(b).

Section 6751(b)(1) states that “[n]o penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.”  Complying with this requirement is part of the IRS’ burden of production under section 7491(c).  See Graev v. Commissioner, 149 T.C. __ (Dec. 20, 2017), supplementing 147 T.C. __ (Nov. 30, 2016).

The petitioners argued that “initial determination” means the issuance of the notice of deficiency.  Although written approval for the 40% penalty was obtained before the notice of deficiency was issued, the petitioners argued that the Appeals officer made the “initial determination,” not the examiner.  As a result, the petitioners argued that, because the Appeals officer did not receive approval from his immediate supervisor before issuing the notice of deficiency, the IRS did not comply with section 6751(b) and could not assess the penalty.

The court observed that this issue was controlled by its decision in Graev and Chai v. Commissioner, 851 F.3d 190 (2d Cir. 2017), vacating and remanding in part, aff’g in part, and rev’g in part T.C. Memo. 2015-42.  The court held that each time the IRS sought to assert penalties, the individual proposing the penalties received approval from his or her immediate supervisor.  The examiner who proposed the 40% penalty received written approval from his group manager.  The Appeals officer received written approval from his team manager.  The senior counsel who filed the IRS’ answer received written approval from her associate area counsel, which was demonstrated by the associate area counsel’s signature on the answer.

The Tax Court held that regardless of which of these instances was the initial determination of the 40% penalty, section 6751(b) was satisfied because each instance was approved in writing by an immediate supervisor.  Thus, the court concluded that the IRS complied with section 6751(b) and found the petitioners liable for the 40% penalty.

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.

 

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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.