Reasonable Cause

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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!

Seal_of_the_United_States_Tax_Court_svgOn January 30, 2017, Judge Goeke of the United States Tax Court issued an opinion rejecting a taxpayer’s asserted reasonable cause defense for failure to file Forms 5471, which are entitled “Information Return of U.S. Persons With Respect to Certain Foreign Corporations.” See Flume v. Commissioner, T.C. Memo. 2017-21. At issue in the case was whether the taxpayer, a U.S. citizen residing in Mexico, was liable for penalties for failing to declare his ownership interests in two foreign corporations for tax years 2001 through 2009. The Court’s opinion is one of the few cases to address the meaning of “reasonable cause” in the context of Forms 5471, and by following established case law on reasonable cause in other penalty contexts, it establishes a high bar for any taxpayer seeking penalty relief in the Form 5471 context, especially if the taxpayer was less than forthcoming with their return preparer.

Form 5471 Reporting Obligations

IRC § 6038(a)(1) imposes information reporting requirements on any U.S. person who “controls” a foreign corporation. A person controls a foreign corporation if he or she owns, or constructively owns, stock that is more than 50 percent of the total combined voting power of all classes of voting stock or owns more than 50 percent of the total value of shares of all classes of stock. Id. § 6038(e)(2). A U.S. person must furnish, with respect to any foreign corporation which that person controls, information that the Secretary of the Treasury “may prescribe.” Id. § 6038(a)(1). Form 5471 is used to satisfy the § 6038 reporting requirements, and must be filed with the U.S. person’s timely-filed federal income tax return. Treas. Reg. § 1.6038-2(i).

IRC § 6046 requires information reporting by each U.S. citizen or resident who is at any time an officer or director of a foreign corporation, where more than 10 percent (by vote or value) of stock is owned by a U.S. person. Id. § 6046(a)(1)(A). The stock ownership threshold is met if a U.S. person owns 10 percent or more of the total value of the foreign corporation’s stock or 10 percent or more of the total combined voting power of all classes of stock with voting rights, id. § 6046(a)(2), and attribution rules apply to stock held by family members. Id. § 6046(c). A U.S. person who disposes of sufficient stock in the foreign corporation to reduce his or her interest to less than the stock ownership requirement is required to provide certain information with respect to the foreign corporation. Treas. Reg. § 1.6046-1(c)(1)(ii)(c). Form 5471 is used to satisfy the § 6046 reporting requirements, and must be filed with the U.S. person’s timely-filed federal income tax return. Treas. Reg. § 1.6046-1(j)(1).

When a taxpayer, who was required to do so, fails to complete and file Form 5471 on time, a fixed penalty of $10,000 per foreign corporation per annual accounting period is imposed. IRC §§ 6038(b)(1), 6679. If any failure to provide the required information continues for more than 90 days after the day on which IRS mails notice of the failure to the U.S. person, the person shall pay an additional penalty of $10,000 for each 30-day period, or fraction thereof, during which the failure continues. The “continuation” penalty may not, however, exceed $50,000. Id. § 6038(b)(2), 6046(f), 6679(a).

Form 5471 and its accompanying instructions set forth four categories of persons required to file the form. A category 2 filer is a U.S. person who is an officer or director of a foreign corporation in which a U.S. person owns at least 10 percent of the company’s shares by vote or value. See IRC § 6046(a)(1)(A). A category 3 filer is a U.S. person who acquires, or disposes of, 10 percent or more of stock in a foreign corporation. See id. § 6046(a)(1)(B). A category 4 filer is a U.S. person who “controls” a foreign corporation by owning more than 50 percent of the stock of the foreign corporation (by vote or value). See id. § 6038(a)(1), (e). A category 5 filer is a U.S. person who is a U.S. shareholder of a “controlled foreign corporation,” which is defined as a foreign corporation in which U.S. shareholders own more than 50 percent of the company’s stock (by vote or value).

To avoid penalties for failure to file Form 5471, a taxpayer must make an affirmative showing that the failure to furnish the appropriate information with his or her return was due to “reasonable cause.” IRC § 6038(c)(4)(B); 6679(a)(1).

The Court’s Analysis of “Reasonable Cause”

In Flume, the IRS assessed initial and continuation penalties against the taxpayer based upon his failure to file Forms 5471 to declare his ownership interests in a Mexican corporation and a Belizean international business company. In response, the taxpayer asserted a commonly-heard defense for non-filing of Forms 5471: his return preparer did not advise him that he was required to do so.

In evaluating the taxpayer’s assertion of “reasonable cause,” the Court began by noting that there are no regulations defining “reasonable cause” within the specific context of IRC § 6038. The Court further noted the few cases addressing this issue have followed the Supreme Court’s definition of reasonable cause as articulated in United States v. Boyle, 469 U.S. 241, 246 (1985). See Congdon v. United States, No. 4:09-CV-289, 2011 WL 3880524, at *2 (E.D. Tex. Aug. 11, 2011); In re Wyly, 552 B.R. 338, 442 (Bankr. N.D. Tex. 2016). In Boyle, the Supreme Court held to establish reasonable cause, the taxpayer must demonstrate that he exercised ordinary business care and prudence but nevertheless was unable to file within the prescribed time. Boyle, 469 U.S. at 246.

The Court next observed that similar rules apply with respect to the civil penalties imposed under IRC § 6679 for failure to file information required under IRC § 6046. Sec. 6679(a)(1); Treas. Reg. § 301.6679-1(a). If a taxpayer exercises ordinary business care and prudence and is nevertheless unable to obtain and provide the required information, a failure to file will be considered to be due to reasonable cause. Treas. Reg. § 301.6679-1(a)(3).

The taxpayer claimed that his return preparer failed to advise him that he was required to file Forms 5471 for his foreign corporations. The Court therefore evaluated the taxpayer’s reasonable cause assertion through the legal standards utilized when a taxpayer claims reliance on a professional. To establish reasonable cause through reliance on a tax adviser’s advice, the Court noted that the taxpayer must prove: (i) the adviser was a competent professional with sufficient expertise; (ii) the taxpayer provided necessary and accurate information to the adviser; and (iii) the taxpayer relied in good faith on the adviser’s judgment. See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 98-99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).

At trial, the taxpayer testified that he did not inform his return preparer of his interests in the two foreign corporations. The Court thus held the taxpayer failed to satisfy the second prong of the Neonatology prong because he did not provide his preparer with all necessary information. As a result, the taxpayer was barred from reasonably relying on his tax return preparer’s advice and therefore failed to show reasonable cause for his failure to file Forms 5471.

Notably, while the Flume opinion notes that the taxpayer failed to make full disclosure to his return preparer, it does not provide important additional details relevant to evaluating that finding. The opinion does not state whether the preparer affirmatively asked the taxpayer about ownership of foreign corporations, and the taxpayer withheld information in response, or if instead the return preparer did not inquire, and the taxpayer failed to affirmatively volunteer information about his foreign corporations without prompting. There is a significant difference between these two scenarios, particularly in the case of a taxpayer (like Flume) who resides outside of the United States and may not be familiar with the obligation to disclose ownership of foreign corporations.

The Tax Court’s decision in Flume confirms that the interaction between the taxpayer and his or her return preparer is of critical importance in assessing reasonable cause. The opinion seemingly forecloses the ability to assert reasonable cause where the taxpayer fails to advise the return preparer of the existence of foreign corporations. Reasonable cause would only be found where the taxpayer makes full disclosure of the foreign ownership, and the return preparer nonetheless advises that no Forms 5471 are required. Flume does not address how this outcome might change if the preparer failed to inquire of the taxpayer, and the taxpayer is unsophisticated and unaware of the Form 5471 duty to disclose foreign corporation ownership; this scenario may still present an opportunity for reasonable cause relief.