Internal Revenue Service (IRS)

Bitcoin

The Internal Revenue Service has prevailed in its long-running dispute with Coinbase, the largest U.S.-based Bitcoin exchange, with a federal judge ordering Coinbase to comply with a “John Doe” summons seeking customer information. In an opinion issued on November 28, 2017, the court in San Francisco found that the government’s narrowed request for information on Coinbase’s customers served the legitimate purpose of investigating whether Bitcoin users properly reported gains or losses on their income tax returns. The Court also found that the customer records sought by the government were relevant because they can be used by the IRS to determine whether a particular Coinbase customer is tax compliant. Coinbase must now hand over to the IRS records for accounts that had at least one transaction of at least $20,000 value during the period 2013 to 2015. According to Coinbase, this will require it to divulge trading records regarding nearly 9 million transactions conducted by over 14,000 customers. With this data in hand, it will be relatively easy for the IRS to cross-check filed tax returns to determine if Coinbase customers properly reported Bitcoin transactions on their returns. Individuals who failed to do so can expect to hear from the IRS and should consider prompt corrective action, if necessary, to mitigate the consequences of any such inquiry.

A “John Doe” summons is an information-gathering tool that is being used with increasing frequency by the IRS to obtain information and records about a class of unidentified taxpayers if the IRS has a reasonable belief that such taxpayers are engaged in conduct violating U.S. tax laws. Because the identities of the targeted taxpayers are unknown, the summons is denoted with a “John Doe” moniker. Expressly authorized by the Internal Revenue Code, a John Doe summons must first be approved by a federal judge before it can be served. The IRS sought to serve a summons on Coinbase because of its concern that the anonymous nature of virtual currencies like Bitcoin may allow users to engage in tax evasion and other illegal conduct:

Virtual currency, as generally defined, is a digital representation of value that functions in the same manner as a country’s traditional currency. There are nearly a thousand virtual currencies, but the most widely known and largest is bitcoin. Because transactions in virtual currencies can be difficult to trace and have an inherently pseudo-anonymous aspect, taxpayers may be using them to hide taxable income from the IRS.

In late 2016, a federal judge authorized the IRS to serve a “John Doe summons” on Coinbase seeking information about U.S. taxpayers who conducted transactions in virtual currency during 2013, 2014, and 2015. In court documents, the Justice Department stated that Coinbase was the fourth largest exchanger globally of Bitcoin and the largest exchanger in the United States. The Justice Department further stated that Coinbase offered buy/sell trading functionality in 32 countries, maintaining over 4.9 million wallets with wallet services available in 190 countries, serving 3.2 million customers, with $2.5 billion exchanged in Bitcoin. According to the IRS, only 2,500 taxpayers reported transactions in Bitcoin on their U.S. income tax returns during the three years in question, as compared to nearly 500,000 U.S. customers reported by Coinbase during the same period. Coinbase has vigorously resisted the John Doe summons, and the matter has been in litigation for the past year, with the IRS eventually agreeing to narrow the scope of its summons.

In its ruling approving the Coinbase summons, the Court determined that the summons “serves the legitimate purpose of investigating the ‘reporting gap between the number of virtual currency users Coinbase claims to have had during the summons period’ and ‘U.S. bitcoin users reporting gains or losses to the IRS during the summoned years.’” The Court found that Coinbase is the largest U.S. exchange of bitcoin into dollars with at least 5.9 customers served and 6 billion in transactions while only 800 to 900 taxpayers a year have electronically filed returns with a property description related to Bitcoin from 2013 through 2015. This discrepancy, wrote the Court, creates an inference that more Coinbase users are trading bitcoin than reporting gains on their tax returns.

As narrowed, the IRS summons seeks information regarding 8.9 million Coinbase transactions and 14,355 Coinbase account holders. That only 800 to 900 taxpayers reported gains related to Bitcoin in each of the relevant years and that more than 14,000 Coinbase users have either bought, sold, sent or received at least $20,000 worth of Bitcoin in a given year suggests, the Court concluded, that many Coinbase users may not be reporting their Bitcoin gains. Under these circumstances, the Court ruled that IRS has a legitimate interest in investigating these taxpayers.

In a victory for Coinbase, the Court ruled that the scope of information sought by the IRS was overbroad, and trimmed the types of records that would be required to be turned over by Coinbase. Coinbase is only required to produce the following data for its customers: taxpayer identification number; name; date of birth; and address. The Court refused the government’s request for additional information, including account opening records; copies of passports and/or driver’s licenses; wallet addresses; and public keys for accounts/wallets/vaults; “know your customer” due diligence records; and customer correspondence.

As a result of the Court’s ruling, Coinbase must now turn over to the IRS the following documents for accounts with at least the equivalent of $20,000 in any one transaction (buy/sell/send/receive) in any one year during the 2013 through 2015 time period:

  • Taxpayer identification number;
  • Name;
  • Birth date;
  • Address;
  • Records of account activity including transaction logs or other records identifying the date, amount, and type of transaction (purchase/sale/exchange), the post transaction balance, and the names of counterparties to the transaction; and
  • Periodic statements of account or invoices (or their equivalent).

Once it receives the summoned data from Coinbase, the IRS will cross-check tax returns filed by the individuals in question to determine if they properly reported their Bitcoin trading gains and losses. Individuals who have not properly reported their Bitcoin holdings will likely be contacted by the IRS, and the nature of that contact will be dictated by the magnitude of each individual’s tax non-compliance. For Coinbase customers with a relatively small number of unreported transactions, the IRS may simply send a “soft” letter advising them to file amended tax returns. Coinbase users with a greater number of unreported transactions may be selected for audit and face penalties for not properly reporting Bitcoin transactions. The most egregious examples of non-compliance may well face criminal investigation by the IRS, if there is evidence those customers deliberately intended to evade their tax obligations by trading in Bitcoin. As we previously reported, drug trafficking organizations and other illicit actors are using digital currencies with increasing frequency to engage in money laundering.

Coinbase has not stated publicly whether it intends to appeal, but in a blog post the company said it was “in the process of reviewing the order” and would “continue to keep our customers updated.” In that same piece, Coinbase noted that the summons affected less than 1 percent of its customer base. Coinbase also said that “[i]n the event that we ultimately produce the documents under this Court order, we intend to notify impacted users in advance of any disclosure.” This advance notice will presumably afford concerned accountholders an opportunity to quickly rectify their tax filings, if they deem it advisable.

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

The Plan

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

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

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

The Problem

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

The Kicker

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

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

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

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

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

Executive Orders

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

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

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

Priority Guidance Plan

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

Items identified for near-term burden reduction include:

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

Additional guidance projects include:

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

 

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

IRS Commissioner John Koskinen cautioned:

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

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

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

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

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

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

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

 

Tax Court

The issue before the Tax Court in Huzella v. Commissioner, T.C. Memo. 2017-210, centered around a coin business on eBay, and whether the petitioner, Thomas Huzella, could substantiate his cost of goods sold and expense deductions for his business.

The petitioner had been collecting coins as far back as 1958.  The problem was that the petitioner did not keep records to establish the basis in any of his coins.  In 2013, the petitioner actively bought and sold coins on eBay and was paid through PayPal.  PayPal issued the petitioner a Form 1099-K, Payment Card and Third Party Network Transactions, which reflected the payments he received from PayPal.  The petitioner earned $37,000 from almost 400 separate transactions in 2013.  But he also incurred eBay fees and Paypal fees, as well as packaging and shipping costs.

When he filed his tax return, the petitioner did not report anything on his Schedule C, and the IRS audited his return and issued a notice of deficiency.  The IRS alleged that the petitioner had unreported income of $37,000 from his eBay business and asserted penalties.  At trial, the IRS conceded that the petitioner was engaged in a trade or business in 2013.  The IRS also conceded that the petitioner was entitled to deduct the eBay and PayPal fees, and the Tax Court held that he was entitled to deduct $700 of postage and packaging costs.  The petitioner conceded that he earned – but did not report – gross proceeds of $37,000 from his eBay business.

The court then turned to the cost of goods sold issue.  Taxpayers are required to substantiate any amount they claim as cost of goods sold, and they must maintain sufficient records.  If a taxpayer with insufficient records, however, proves he incurred expenses but cannot substantiate the exact amount, the Tax Court may, in certain circumstances, estimate the amount.

Here, the Tax Court (and the petitioner) relied on the Cohan decision.  See Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930).  In that case, the taxpayer was an actor, playwright, and producer who spent large sums travelling and entertaining actors, employees, and critics.  Although Cohan did not keep a record of his spending on travel and entertainment, he estimated that he incurred $55,000 in expenses over several years.

The Board of Tax Appeals, now the Tax Court, disallowed these deductions in full based on Cohan’s lack of supporting documentation.  On appeal, however, the Second Circuit concluded that Cohan’s testimony established that legitimate deductible expenses had been incurred, holding that “the Board should make as close an approximation as it can, bearing heavily if it chooses upon the taxpayer whose inexactitude is of his own making.”  The Cohan rule has been followed by the Tax Court and other federal courts in numerous decisions.

The petitioner in Huzella did not have any records to establish his cost or bases in the coins.  He purchased some coins and inherited others.  But the Tax Court relied on Cohan and, after evaluating the evidence and the petitioner’s testimony, held that the petitioner could substantiate a cost of goods sold of $12,000.  Thus, the petitioner had taxable income of just under $20,600 (gross receipts of $37,000, less cost of goods sold and deductions).

On Friday, November 3, 2017, the IRS Large Business and International division (LB&I) announced the identification and selection of 11 additional compliance campaigns. In January 2017, LB&I unveiled its first 13 campaigns to be implemented as part of its effort to move toward issue-based examinations of taxpayers based upon risk assessments so as to make the greatest use of limited audit resources. (See prior coverage here and here.) According to the IRS, the LB&I compliance campaigns represent “the culmination of an extensive effort to redefine large business compliance work and build a supportive infrastructure inside LB&I. Campaign development requires strategic planning and deployment of resources, training and tools, metrics and feedback. LB&I is investing the time and resources necessary to build well-run and well-planned compliance campaigns.” The 11 new campaigns represent the second wave of LB&I’s issue-based compliance work. According to the IRS, more campaigns will continue to be identified, approved and launched in the coming months.

The 11 new compliance campaigns were selected based upon LB&I data analysis and feedback from IRS compliance employees. The 11 new campaigns, along with LB&I’s brief description of each, are as follows:

Form 1120-F Chapter 3 and Chapter 4 Withholding Campaign

  • This campaign is designed to verify withholding at source for 1120-Fs claiming refunds. To make a claim for refund or credit to estimated tax with respect to any U.S. source income withheld under chapters 3 or 4, a foreign entity must file a Form 1120-F. Before a claim for credit (refund or credit elect) is paid, the IRS must verify that withholding agents have filed the required returns (Forms 1042, 1042-S, 8804, 8805, 8288 and 8288-A). This campaign focuses upon verification of the withholding credits before the claim for refund or credit is allowed. The campaign will address noncompliance through a variety of treatment streams including, but not limited to, examinations.

Swiss Bank Program Campaign

  • In 2013, the U.S. Department of Justice announced the Swiss Bank Program as a path for Swiss financial institutions to resolve potential criminal liabilities. Banks that are participating in this program provide information on the U.S. persons with beneficial ownership of foreign financial accounts. This campaign will address noncompliance, involving taxpayers who are or may be beneficial owners of these accounts, through a variety of treatment streams including, but not limited to, examinations.

Foreign Earned Income Exclusion Campaign

  • Individuals who meet certain requirements may qualify for the foreign earned income exclusion and/or the foreign housing exclusion or deduction. This campaign addresses taxpayers who have claimed these benefits but do not meet the requirements. The Internal Revenue Service will address noncompliance through a variety of treatment streams, including examination.

Verification of Form 1042-S Credit Claimed on Form 1040NR

  • This campaign is intended to ensure the amount of withholding credits or refund/credit elect claimed on Forms 1040NR, U.S. Nonresident Alien Tax Return, is verified and whether the taxpayer has properly reported the income reflected on Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding. Before a refund is issued or credit allowed, the Internal Revenue Service verifies the withholding credits reported on the Form 1042-S. The campaign will address noncompliance through a variety of treatment streams including, but not limited to, examinations.

Agricultural Chemicals Security Credit Campaign

  • The Agricultural chemicals security credit is claimed under Internal Revenue Code Section 45O and allows a 30 percent credit to any eligible agricultural business that paid or incurred security costs to safeguard agricultural chemicals. The credit is nonrefundable and is limited to $2 million annually on a controlled group basis with a 20-year carryforward provision. In addition, there is a facility limitation as outlined in Section 450(b). The goal of this campaign is to ensure taxpayer compliance by verifying that only qualified expenses by eligible taxpayers are considered and that taxpayers are properly defining facilities when computing the credit. The treatment stream for this campaign is issue-based examinations.

Deferral of Cancellation of Indebtedness Income Campaign

  • During 2009 and 2010, taxpayers who incurred cancellation of indebtedness (COD) income from the reacquisition of debt instruments at an issue price less than the adjusted issue price of the original instrument may have elected to defer the COD income. Taxpayers must report the COD income ratably over five years beginning in 2014 and running through 2018. Further, when a taxpayer defers the COD income, any related original issue discount (OID) deductions on the new debt instrument, resulting from debt-for-debt exchanges that triggered the COD must also be deferred ratably and in the same manner as the deferred COD income. The goal of this campaign is to ensure taxpayer compliance by verifying that taxpayers who properly deferred COD income in 2009/2010 properly report it in subsequent years beginning in 2014, unless an accelerating event requires earlier recognition under IRC §108(i); and/or properly defer reporting OID deductions during the deferral period under IRC Section 108(i)(2). The treatment stream for this campaign is issue-based examinations. The use of soft letters is under consideration.

Energy Efficient Commercial Building Property Campaign

  • The Energy Efficient Commercial Building Deduction (Section 179D) allows taxpayers who own or lease a commercial building to deduct the cost or portion of the cost of installing energy efficient commercial building property (EECBP). If the equipment is installed in a government-owned building, the deduction is allocated to the person(s) primarily responsible for designing the EECBP. This goal of this campaign is to ensure taxpayer compliance with the section 179D deduction. The treatment stream for this campaign is issue-based examinations.

Corporate Direct (Section 901) Foreign Tax Credit (“FTC”)

  • Domestic corporate taxpayers may elect to take a credit for foreign taxes paid or accrued in lieu of a deduction. The goal of the Corporate Direct FTC campaign is to improve return/issue selection (through filters) and resource utilization for corporate returns that claim a direct FTC under IRC section 901. This campaign will focus on taxpayers who are in an excess limitation position. The treatment stream for the campaign will be issue based examinations. This is the first of several FTC campaigns. Future FTC campaigns may address indirect credits and IRC 904(a) FTC limitation issues.

Section 956 Avoidance

  • If a Controlled Foreign Corporation (CFC) makes a loan to its US parent, Section 956 generally requires an income inclusion equal to the amount of the loan. This campaign focuses on situations where a CFC loans funds to a US Parent (USP), but nevertheless does not include a Section 956 amount in income. The goal of this campaign is to determine to what extent taxpayers are utilizing cash pooling arrangements and other strategies to improperly avoid the tax consequences of Section 956. The treatment stream for this campaign is issue based examinations.

Economic Development Incentives Campaign

  • Taxpayers may be eligible to receive a variety of government economic incentives. These incentives include refundable credits (refunds in excess of tax liability), tax credits against other business taxes (i.e. payroll tax), nonrefundable credits (refunds limited to tax liability), transfer of property including land, and grants including cash payments. Taxpayers may improperly treat government incentives as non-shareholder capital contributions, exclude them from gross income and claim a tax deduction without offsetting it by the tax credit received. The goal of this campaign is to ensure taxpayer compliance. The treatment stream for this campaign is issue based examinations.

Individual Foreign Tax Credit (Form 1116)

  • Individuals file Form 1116 to claim a credit that reduces their U.S. income tax liability for the amount of foreign taxes paid on foreign source income. This campaign addresses taxpayer compliance with the computation of the foreign tax credit limitation on Form 1116. Due to the complexity of computing the Foreign Tax Credit and challenges associated with third-party reporting information, some taxpayers face the risk of claiming an incorrect Foreign Tax Credit amount. The IRS will address noncompliance through a variety of treatment streams including examinations.

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

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

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

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

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

In a case of first impression, the Tax Court held that the U.S.–Canada Tax Treaty (Treaty) did not exempt a Canadian citizen from U.S. income tax on the unemployment compensation she received from the State of Ohio. Pei Fang Guo v. Commissioner, 149 T.C. No. 14. The taxpayer came to the U.S. in 2010 as a post-doctoral fellow at the University of Cincinnati. She worked at UC from 2010 through 2011 on a nonimmigrant professional visa. When her employment contract ended in November 2011, she returned to Canada after she was unable to find other work in the U.S., where she stayed through 2012. When her UC employment contract ended, the taxpayer applied to the State of Ohio for unemployment compensation, which she received in 2012. When the taxpayer filed her 2012 U.S. tax return, she took the position that her unemployment compensation was exemption from income tax under Article XV of the Treaty. Instead, she reported the unemployment compensation on her Canadian tax return. The IRS disagreed, and the taxpayer filed a petition in Tax Court.

Tax Court SealThe Tax Court said that the taxpayer was a nonresident alien in 2012, which means she was neither a U.S. citizen nor resident. Generally, nonresident aliens must pay U.S. tax on their U.S.–source income. Everyone agreed that the taxpayer’s unemployment compensation was U.S.–source income. As a result, the only question left for the Tax Court to decide was whether the taxpayer’s unemployment compensation was exempt from U.S. income tax under the Treaty. But the Treaty does not mention unemployment compensation, except to say it does not count as social security.

The taxpayer focused her argument on the term “remunerations” in Article XV of the Treaty. Article XV governs the treatment of “salaries, wages, and other similar remunerations derived . . . in respect of an employment.” But the Treaty does not define “remunerations” either, so the Tax Court turned to the Code. “Remuneration” appears twice in the Code. Section 3401(a) says that “the term ‘wages’ means all remunerations . . . for services performed by an employee for his employer,” and section 3121(b) says that the “term ‘wages’ means all remuneration for employment.”

The Tax Court held that, just as unemployment compensation is not the same thing as “wages,” unemployment compensation does not constitute “similar remuneration derived. . . in respect to employment” under Article XV. The taxpayer wasn’t employed by UC when she received her unemployment compensation. And she did not receive it from her former employer.  She received it from the State of Ohio. As a result, the Tax Court concluded she was required to pay U.S. taxes on her unemployment compensation.

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

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

Other highlights from the report include:

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

TIGTA’s report can be accessed here.