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!

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.

 

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.

Two members of Congress have introduced a bill that would exempt from income tax transactions under $600 conducted using Bitcoin or other digital currencies. Currently, the Internal Revenue Service treats digital currencies like Bitcoin as property, meaning that on every transaction using Bitcoin, the taxpayer must recognize either a gain or loss for tax purposes depending on his or her basis in the digital currency and report such gain or loss on an income tax return. The IRS does not recognize any de minimus transaction amount, meaning that a taxpayer using Bitcoin to purchase a cup of coffee must recognize gain or loss on the transaction. Representatives Jared Polis (D-Colo.) and David Schweikert (R-Ariz.), co-chairs of the Congressional Blockchain Caucus, have introduced the Crytocurrency Tax Fairness Act of 2017 to exempt small purchases with digital currency up to $600 from tax reporting and burdensome recordkeeping requirements.

In a press release announcing the bill, Rep. Polis said that “[c]ryptocurrencies can be used for anything from buying a cup of coffee to paying for a car, to crowdfunding a new startup and more and more consumers are choosing to use this type of payment. To keep up with modern technology, we need to remove outdated restrictions on cryptocurrencies, like Bitcoin, and other methods of digital payment. By cutting red tape and eliminating onerous reporting requirements, it will allow cryptocurrencies to further benefit consumers and help create good jobs.”

Rep. Schweikert added that “[i]ndividuals all over the world are starting to use cryptocurrencies for small every day transactions, yet here in the States we have fallen behind and make cryptocurrency use more of a challenge than it needs to be. “With this simple legislative change, anyone can make digital payments to buy a newspaper or a bike without worrying about tax code challenges.”

According to their press release, Polis and Schweikert relaunched the Congressional Blockchain Caucus in February. The caucus educates, engages, and provides research to help policymakers implement smart regulatory approaches to the issues raised by blockchain-based technologies and networks. Blockchain is a decentralized distributed ledger that is the main technology powering cryptocurrencies such as Bitcoin and Ethereum. By using math and cryptography, blockchain supplies a decentralized database of every transaction involving value. This creates a record of authenticity that is verifiable by a user community, increasing transparency and reducing fraud. Crytocurrencies, like Bitcoin and Ethereum, are used for purchases, trade, and payment across the globe. The estimated value of the cryptocurrecy economy is $162 billion.

Meanwhile, the IRS is continuing its aggressive efforts to identify the users of digital currency through litigation involving a “John Doe summons” on Coinbase Inc., a leading virtual currency exchanger. The IRS believes that because virtual currency transactions are difficult to trace, offer relative anonymity, and lack third-party information reporting, taxpayers may be using them to hide taxable income.  In a press release announcing the John Doe summons, then-Principal Deputy Assistant Attorney General Caroline D. Ciraolo, head of the Justice Department’s Tax Division, said that “[a]s the use of virtual currencies has grown exponentially, some have raised questions about tax compliance.  Tools like the John Doe summons authorized today send the clear message to U.S. taxpayers that whatever form of currency they use – bitcoin or traditional dollars and cents – we will work to ensure that they are fully reporting their income and paying their fair share of taxes.”  According to the IRS, there is a significant reporting gap between the number of virtual currency users reported by Coinbase during the period 2013 through 2015 and the total number of taxpayers reporting gains or losses to the IRS during that same period (807, 893, and 802, respectively). In addition, it has been reported that the IRS is utilizing Chainanalysis software to identify owners of virtual currencies.

Recently, a Colorado business protested the IRS’ disallowance of their business expenses.  The IRS alleges that the taxpayer was a Colorado medical marijuana dispensary to which Section 280E applies, as a result the IRS asserted that the taxpayers owed additional tax.  The taxpayers paid the tax and sued for a refund in Federal Court.  In a motion for summary judgment, the taxpayer asserted that the IRS did not have the authority to investigate whether the taxpayer violated the Controlled Substances Act (“CSA”), that Section 280E violates the Sixteenth Amendment, that the taxpayer properly deducted its expenses, and that the IRS did not produce evidence that Section 280E applies to the taxpayer.  The taxpayer also asserted that the application of Section 280E violated their Fifth Amendment rights and that Section 280E violates the Eighth Amendment prohibition against excessive fines and penalties.

The District Court ruled that:

  • the IRS application of Section 280E to a business it determined was selling marijuana was within its authority to apply the Internal Revenue Code;
  • the IRS’ application of Section 280E was a “purely tax-based determination” that did not violate the taxpayer’s Fifth Amendment rights;
  • the taxpayer did not allege that the IRS disallowed costs other than cost of goods sold and therefore the court could not determine that the Sixteenth Amendment was not violated;
  • the taxpayer did not allege enough facts for the court to determine whether Section 280E is an excessive fine and penalty in violation of the Eighth Amendment; and
  • the taxpayer did not allege any facts to show that the IRS lacked evidence to show that the taxpayer was violating the CSA.

The taxpayer has filed a motion for reconsideration and an amended complaint to add allegations necessary to support its claims, so the case may move forward based on those new allegations.   However, the taxpayer’s attempt to stop the IRS from enforcing Section 280E was not successful under the facts of this case.

The case is Alpenglow Botanicals, LLC v. U.S., Colorado Dist. Ct. Case No. 16-cv-00258-RM-CBS.  Opinion and Order Continue Reading Colorado District Court: IRS Enforcement of Section 280E Is Not A Criminal Investigation

In a strongly worded opinion that is very favorable for taxpayers who engage in sophisticated tax planning, the Sixth Circuit overturned a Tax Court opinion denying the benefits of a domestic international sales corporation (“DISC”) under the theory that the transaction violated the substance over form doctrine.  In short, a DISC was used to channel large amounts to a Roth IRA, permitting accumulation of substantial funds which will be available tax free to the owners of the Roth IRA after they reach a certain age.  The details are not as fun as the opinion, which, assuming it stands, will surely be cited many times over.  The Court’s words are strong:

  • “If the government can undo transactions that the terms of the Code expressly authorize, it’s fair to ask what the point of making these terms accessible to the taxpayer and binding on the tax collector is.”
  • Because the taxpayer “used the DISC and Roth IRAs for their congressionally sanctioned purpose – tax avoidance – the Commissioner has no basis for recharacterizing the transaction and no basis for recharacterizing the law’s application to them.”
  • “It’s one thing to permit the Commissioner to recharacterize the economic substance of a transaction-to honor the fiscal realities of what taxpayers have done over the form in which they have done it.  But it’s quite another to permit the Commissioner to recharacterize the meaning of statutes-to ignore their form, their words, in favor of his perception of their substance.”
  • “The line between disregarding a too-clever-by-half accounting trick and nullifying a Code-supported tax-minimizing transaction can be elusive.”
  • “Decisions from our sister courts also straddle the line between holding that the transactions were a sham and suggesting that the Commissioner has a broad power to recharacterize transactions that minimize taxes, though none of them holds that a tax-avoidance motive alone may nullify an otherwise Code-compliant and substantive set of transactions.”
  • “The substance-over-form doctrine does not authorize the Commissioner to undo a transaction just because taxpayers undertook it to reduce their tax bills.”

The case is Summa Holdings, Inc. v. Comm’r.

passportThe Internal Revenue Service is moving forward with implementation of new rules requiring the State Department to deny, or revoke, the U.S. passports of individuals with seriously delinquent federal tax debt.  According to Mary Beth Murphy, commissioner of the IRS Small Business/Self-Employed Division, the new rules will be rolled out in phases.  The first phase will focus on denying passport renewal applications for delinquent taxpayers.  In the second phase, the IRS and State Department will focus on revocation of passports held by delinquent taxpayers.  According to an article published by Bloomberg BNA, Murphy said “[w]e don’t want to have people stuck in foreign countries.”  See Bloomberg BNA, “IRS Hashing Out Debt Collection, Passport Revocation Plans” (Nov. 18, 2016).

The passport revocation measure became law approximately one year ago, when President Obama signed a five-year, $305 billion highway funding bill that included several controversial tax measures designed to help fund the legislation. One provision in the legislation authorizes the State Department to revoke U.S. passports of taxpayers who owe the U.S. Treasury more than $50,000 in tax liabilities. Another provision authorizes the Internal Revenue Service to use private debt collectors.

The new passport revocation provision provides the IRS with a powerful tool to force tax compliance, particularly for non-residents or dual citizens who regularly travel to the United States.  Newly-enacted Internal Revenue Code section 7345 authorizes the Treasury Secretary to certify, to the Secretary of State, that a taxpayer has a “seriously delinquent tax debt.” A “seriously delinquent tax debt” is defined as a federal tax liability which been assessed and is greater than $50,000, and for which the IRS has either filed a lien or levy. (The dollar threshold will be adjusted for inflation after 2016.)

Upon receipt of such certification, the Secretary of State is authorized to take action with respect to denial, revocation, or limitation of such taxpayer’s U.S. passport. The law prohibits the Secretary of State from issuing a passport to any individual who has a “seriously delinquent tax debt,” with exceptions provided for emergency circumstances or humanitarian reasons. The law authorizes the Secretary of State to revoke a passport previously issued to an individual with a “seriously delinquent tax debt.” If the Secretary of State decides to revoke a passport under these circumstances, he or she is authorized to limit such passport to return travel to the United States only.

Taxpayers who have entered into installment agreements or offers-in-compromise, or have requested collection due process hearings or innocent spouse relief, are exempt from the new law. If the Treasury Secretary has already certified a taxpayer to the Secretary of State, such certification must be revoked within 30 days of the taxpayer making full payment and obtaining a release of lien; requesting innocent spouse relief; entering into an installment agreement; or making an offer-in-compromise which is accepted. In the event that the Treasury Secretary issues an erroneous certification, such certification must be revoked as soon as practicable.

The law does include certain safeguards to protect taxpayer rights. Taxpayers who are certified to the Secretary of State as having a “seriously delinquent tax debt,” or whose certifications are subsequently revoked, are entitled to prompt written notice. Such notice must specify that the taxpayer is entitled to file a lawsuit in the U.S. Tax Court or a federal district court to challenge the certification. The court may determine that the certification was erroneous and, if so, order the Treasury Secretary to so notify the Secretary of State. Taxpayers who are serving in a combat zone are granted relief from the law’s provisions.

In addition, the new law amends existing Internal Revenue Code provisions to ensure that taxpayers are warned in advance that they could be subject to U.S. passport denial, revocation, or limitation. For example, notices of federal tax lien and notices of intent to levy must now include language advising the taxpayer that they may be certified to the Secretary of State as having a “seriously delinquent tax debt” with attendant passport consequences.

Finally, the law amends the Internal Revenue Code provision addressing confidentiality of tax returns and return information in order to permit the sharing of such information with the Secretary of State. In particular, for each taxpayer certified as having a “seriously delinquent tax debt,” the law authorizes the Treasury Secretary to share information regarding the taxpayer’s identity and the amount of the tax debt.

In 2015, the IRS first included micro-captives, or small insurance companies which have elected under section 831(b) to exclude premiums from their income, on its annual dirty dozen list. At the end of 2015, Congress eliminated the use of micro-captives in estate planning but also expanded use of micro-captives by raising the threshold for tax exempt premiums for micro-captives from $1.2 million to $2.2 million, effective January 1, 2017.

For several years, the IRS has been examining hundreds of micro-captives as well as conducting promotor examinations of several captive managers. On November 2, 2016, the IRS took one more step in focusing on these transactions when it issued Notice 2016-66 which identified certain micro-captive transactions as transactions of interest. As a result, the IRS has added additional reporting and disclosure requirements for micro-captives which do not incur significant claims or which make loans to related entities, such as the insured. It appears the IRS is focused on finding taxpayers it has not already identified who have set up micro-captive structures.

Who Should Care?

  • Micro-captives with insured losses and expenses which, over a five-year period, are less than 70% of the premiums earned (reduced by policyholder dividends)
  • Micro-captives who loaned or transferred funds through some other means to the insured or any related parties
  • Promoters who market micro-captive transactions

What Must I Do?

  • Consult a tax advisor to determine whether you are required to file Form 8886, Reportable Transaction Disclosure Statement
  • For promoters, determine whether you are in compliance with material advisor rules under section 6111 and 6112

When Must I Act?

  • The deadline for filing Form 8886 if required for prior years is January 30, 2017
  • Deadlines for filing Form 8886 for 2016 tax years will depend on annual income tax return deadlines

Why Should I Care?

  • The minimum penalties for failure to file Form 8886 are $5,000 for individuals and $10,000 for entities per year
  • Promoter penalties for failing to comply with the material advisor rules start at $50,000

The notice is available here:  https://www.irs.gov/pub/irs-drop/n-16-66.pdf

 

Tax and accounting issues you should not ignore when setting up your cannabis business:

The Trouble With Cash-Based Businesses

  • Internal Controls – any cash-based business is closely scrutinized by the IRS and other taxing authorities. Having robust internal control procedures, in writing, which are strictly enforced, will go a long way in establishing credibility with taxing authorities.
  • Form 8300 requirements – educate yourself or hire an accountant who can work with you to comply with this filing requirement.
  • Bank Secrecy Act – take precautions to avoid violations

Find Good Help

  • Hiring reputable Certified Public Accountants (CPA) and legal counsel to assist you in operating your business is very important.
  • CPAs often do not have guidance from their licensing boards regarding representation of marijuana businesses and many are therefore reluctant to offer advice.
  • Many large law firms are still reluctant to assist marijuana businesses despite actions by numerous state bar associations to assure attorneys they will not be violating state ethics rules when representing businesses in the legalized marijuana industry.
  • However, sophisticated advisers are starting to work with the industry, both in-house and as external advisers.

Comply, Comply, Comply

  • Abide by Internal Revenue Code section 280E – this requires knowledgeable and diligent accounting advice.
  • Be ready for an audit and for dealing with very aggressive revenue agents. Even though federal law enforcement in many cases is easing up on enforcement under CSA, the IRS has not adopted that view – marijuana businesses have a huge target on their back and the IRS is holding marijuana businesses to a very high standard.
  • Be timely and fully pay your taxes – tax liens can create issues with licensing authorities.