We wrote yesterday that the Internal Revenue Service has issued guidance to taxpayers and practitioners about how the agency’s resumption of activities this week following the government shutdown is impacting pending matters, such as audits, collection cases, and Tax Court cases.  With respect to pending audits, the IRS has published helpful Frequently Asked Questions (entitled “Exam Resumption FAQs“) about a variety of issues impacted by the shutdown.  The text of those FAQs follows:

IRS employees returned to work on January 28, 2019 and resumed activities. Upon their return to the office, they will begin to review mail, voice messages, and their audit and collection files as well as completing administrative tasks to reopen operations.

1. I sent documents to my auditor but have not heard back.  What should I do?

Your auditor will be reviewing mail they have received and will reach out to you to re-establish contact. It may take several business days before your auditor is able to make contact.

2. I planned on sending material to my auditor but did not do so since the government was shut down. What should I do now?

If you have assembled the material requested, you can immediately send the material to your auditor. You may call your auditor to discuss any items on your document request if you need clarification.  Your auditor will also be reaching out to you to re-establish contact in the next several business days.  During this contact, your auditor will be able to answer questions you have and will address the timeframe on when the requested information is due.

3. I sent my signed audit report and a check to my auditor during the shutdown. How do I know if they were received?

Once your auditor has completed their initial review of their inventory and associated mail received with each audit, the auditor will reach out to you to confirm that they received your agreement and check.

4. How soon will examinations resume?

Once auditors have reviewed mail, voice messages, the status of their assigned inventory and completed administrative tasks to restart operations, they will begin to re-establish contact. This process will take several business days to complete.

5. My audit appointment was cancelled prior to the shutdown. When will it be rescheduled?

After completing the assessment of their assigned inventory, your examiner will reach out to you to reschedule your appointment.  It will take several business days before your auditor is able to reach out to their assigned taxpayers.

6. My audit appointment was scheduled for one of the days when the government was shutdown.  I have not heard from my auditor.  What should I do?

Since your auditor was furloughed during the shutdown, they were prohibited from performing their duties. Once your auditor has completed a review of their inventory, they will reach out to you to reschedule your appointment. This process will take several business days to complete.

7. I left a message for my auditor but have not received a call back.

Since your auditor was furloughed during the shutdown, they were prohibited from performing their duties. Upon their return, your auditor will assess the status of their inventory.  Your auditor will retrieve their messages and return calls, but it may take several business days before he or she is able to reach out.

8. When can I call my auditor to discuss my audit?

Each auditor will reach out to their assigned taxpayers after they review and assess the status of their assigned inventory.  This may take several days.  In the meantime, you can reach out to your auditor during normal business hours.

9. I received an audit report from my auditor giving me 10 days to respond.  I was unable to respond due to the shutdown. How should I proceed?

If you have additional information, you should send the information to your auditor or call them to discuss options.  If you agree with the report, you can sign the report and return it to your auditor.  Your auditor will also be reaching out to you to re-establish contact before they take additional actions on your case.  At that time, they will discuss any information still needed.  It will take a number of days for your auditor to contact all of their assigned taxpayers.

10. I received a 30-day letter asking for my position on audit issues.  Will the time limit be extended due to the shutdown?

If you are unable to meet the original due date, you may contact your assigned auditor to discuss options. Your auditor will also be reaching out to you to re-establish contact before taking additional actions on your case.

11. I received a Statutory Notice of Deficiency during the shutdown.  What should I do?

On cases where the statute of limitations was nearing expiration, the IRS issued a Statutory Notice of Deficiency to protect the government’s interest.  If you received a Notice, you have 90 days to petition the Tax Court if you want to protest the adjustments.  If you agree with the adjustments in the report, you can sign and return the report.  If you feel you received the Notice in error, you should contact the person listed on the letter or your assigned auditor.

12. I filed a petition with the Tax Court during the government shutdown. What happens next?

We recognize it will take time for the Tax Court to work through its backlog of petitions needed to be served on the IRS.  The IRS will only make assessments when the legal assessment period (statute of limitation) is near expiration.  For cases in which the legal assessment period (statute of limitation) is not nearing its expiration, the IRS will delay defaulting those Notices and making assessments for the period in which the Tax Court needs to work through its backlog of petition.

13. I received a Form 872, Consent to Extend the Time to Assess Tax, from my auditor. It was mailed prior to the shutdown, but I received it after the shutdown started.  What are my options?

The Form 872, Consent to Extend the Time to Assess Tax, was solicited to allow additional time for you and your auditor to address issues still open on your exam. Included with Form 872 you also received Publication 1035.  Publication 1035 provides guidance and explains your options. If you have additional questions beyond those in the publication, you should contact your assigned auditor.  Your auditor will also be reaching out to you to discuss the process, but this may take several business days to accomplish.

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In the latest Tax Court opinion addressing the application of Section 280E to cannabis businesses there is no good news.  However, there is some new guidance.  In Patients Mutual Assistance Collective Corp. v. Comm’r, 151 T.C. No. 11, the taxpayer made a litany of arguments to convince the court that their business, or a portion of their business was not subject to Section 280E.  These include arguments we have seen before, including (1) that the business was not trafficking in controlled substances, here, because the government had abandoned a civil forfeiture action, and (2) that because a portion of the business involved branding and the sales of non-marijuana products, deductions related to these operations should not be subject to Section 280E.  These arguments failed and only make it clear that similar arguments are likely to be unavailing.  In fact, the Court spends ten pages discussing why the entire business is integrated and subject to Section 280E.  Taxpayers hoping to establish a separate trade or business that is not subject to Section 280E now have clarity, but also an extremely high bar.

New Holdings:  Inventory Accounting Rules

The new developments addressed in this case involve the application of inventory rules to cannabis businesses.  Previous cases focused primarily on the previously discussed arguments and failed to give any detailed guidance on how to apply the inventory rules.  The Court clearly and strongly concluded that the more expansive Section 263A  inventory cost rules do not apply to businesses subject to Section 280E.  The Court reasoned that “if something wasn’t deductible before Congress enacted section 263A, taxpayers cannot use that section to capitalize it..Section 263A makes taxpayers defer the benefit of what used to be deductions-it doesn’t shower that as grace on those previously damned.”  Slip Op. at 53.

The Court’s conclusion is based on the notion that we go back in time to 1982 to determine what is includible in inventory costs.  The Court refers to Treas. Reg. section 1.263A-1(c)(2) which states:

Any cost which (but for section 263A and the regulations thereunder) may not be taken into account in computing taxable income for any taxable year is not treated as a cost properly allocable to property produced or acquired for resale under section 263A and the regulations thereunder. Thus, for example, if a business meal deduction is limited by section 274(n) to 80 percent of the cost of the meal, the amount properly allocable to property produced or acquired for resale under section 263A is also limited to 80 percent of the cost of the meal.

While this reasoning is understandable, if we turn the question on its head, we could also ask whether the section 280E disallowance is determined before or after inventory costs are calculated.  For example, even if there is a meals and entertainment expense that is clearly includible in inventory costs, no one is going to argue that 100% of meals and entertainment is includible in inventory costs.  In this case, you are determining inventory costs and deductions, and then applying Section 274.   So, it is easy to see how those provisions overlap.  However, if inventory costs are determined based on the applicable inventory rules and then Section 280E is applied, then you have a different result because Section 263A expands what can be included in inventory costs, and the remaining deductions are subject to Section 280E.  That result is not inconsistent with the notion that items such as meals and entertainment and penalties are not deducted in determining taxable income regardless of whether they are a deduction under Section 162 or an inventory cost under Section 471 or 263A.

The Harsh Result

It is important to note that the Court analyzed and concluded that the taxpayer was a reseller and not a producer.  Because the taxpayer did not itself grow marijuana, this is not surprising.  The Section 471 rules that apply to resellers do not allow for extensive indirect costs to be included in inventory.  Thus, for businesses that do not produce or manufacture, they will continue to face significant challenges by the IRS if they are including indirect costs in inventory costs.  For cultivators and producers, careful consideration should be given to how the 471 rules apply, depending on the activities of the business.

Still to Come

The Court reserved its analysis of whether penalties apply for a opinion to be issued at a later date.  However, the Court hints that there might be some relief when it states that the overlap between Section 280E and 263A created a “confusing legal environment.”  One can hope that given the lack of guidance addressing the specifics of how the inventory rules apply to cannabis businesses, the IRS and the court will give taxpayers  doing their best to apply Section 280E the benefit of reprieve from penalties.

Other Notes

If you are entertained by Judge Holmes’ opinions, be sure you read the footnotes.  Footnotes 3 and 6 are my favorites.

Yesterday the Internal Revenue Service’s Large Business and International Division announced that it was adding six more compliance campaigns to its previously-announced list of 29 such campaigns. The compliance campaigns signify LB&I’s move toward “issue-based examinations” premised upon pre-selected issues that present the greatest risk of non-compliance. According to LB&I, the stated goal of this effort is to “improve return selection, identify issues representing a risk of non-compliance, and make the greatest use of limited resources.”

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. In November 2017, LB&I announced the identification and selection of 11 additional compliance campaigns. At the time, LB&I stated that more campaigns would continue to be identified, approved, and launched in the coming months. On March 13, 2018, LB&I announced the addition of five more issues to the growing list of compliance campaigns.

In yesterday’s announcement, LB&I stated that is currently reviewing the tax reform legislation signed into law on December 22, 2017, “to determine which existing campaigns, if any, could be impacted as a result of a change in the controlling statutory framework.” LB&I further stated that “[i]nformation regarding any identified impact will be communicated after that analysis has been completed.”

According to LB&I, the six new campaigns were identified through data analysis and suggestions from IRS employees.  The six campaigns selected for this rollout, and a description of each, are as follows:

Interest Capitalization for Self-Constructed Assets

When a taxpayer engages in certain production activities they are required to capitalize interest expense under Internal Revenue Code (IRC) Section 263A. Interest capitalization applies to interest a taxpayer pays or incurs during the production period when producing property that meets the definition of designated property. Designated property under IRC Section 263A(f) is defined as (a) any real property, or (b) tangible personal property that has: (i) a long useful life (depreciable class life of 20 years or more), or (ii) an estimated production period exceeding two years, or (iii) an estimated production period exceeding one year and an estimated cost exceeding $1,000,000.

The goal of this campaign is to ensure taxpayer compliance by verifying that interest is properly capitalized for designated property and the computation to capitalize that interest is accurate. The treatment stream for this campaign is issue-based examinations, education soft letters, and educating taxpayers and practitioners to encourage voluntary compliance

Forms 3520/3520-A Non-Compliance and Campus Assessed Penalties

This campaign will take a multifaceted approach to improving compliance with respect to the timely and accurate filing of information returns reporting ownership of and transactions with foreign trusts. The Service will address noncompliance through a variety of treatment streams including, but not limited to, examinations and penalties assessed by the campus when the forms are received late or are incomplete.

Forms 1042/1042-S Compliance

Taxpayers who make payments of certain U.S.-source income to foreign persons must comply with the related withholding, deposit, and reporting requirements. This campaign addresses Withholding Agents who make such payments but do not meet all their compliance duties. The Internal Revenue Service will address noncompliance and errors through a variety of treatment streams, including examination.

Nonresident Alien Tax Treaty Exemptions

This campaign is intended to increase compliance in nonresident alien (NRA) individual tax treaty exemption claims related to both effectively connected income and Fixed, Determinable, Annual Periodical income. Some NRA taxpayers may either misunderstand or misinterpret applicable treaty articles, provide incorrect or incomplete forms to the withholding agents or rely on incorrect information returns provided by U.S. payors to improperly claim treaty benefits and exempt U.S. source income from taxation. This campaign will address noncompliance through a variety of treatment streams including outreach/education and traditional examinations.

Nonresident Alien Schedule A and Other Deductions

This campaign is intended to increase compliance in the proper deduction of eligible expenses by nonresident alien (NRA) individuals on Form 1040NR Schedule A. NRA taxpayers may either misunderstand or misinterpret the rules for allowable deductions under the previous and new Internal Revenue Code provisions, do not meet all the qualifications for claiming the deduction and/or do not maintain proper records to substantiate the expenses claimed. The campaign will address noncompliance through a variety of treatment streams including outreach/education and traditional examinations.

NRA Tax Credits

This campaign is intended to increase compliance in nonresident alien individual (NRA) tax credits. NRAs who either have no qualifying earned income, do not provide substantiation/proper documentation, or do not have qualifying dependents may erroneously claim certain dependent related tax credits. In addition, some NRA taxpayers may also claim education credits (which are only available to U.S. persons) by improperly filing Form 1040 tax returns. This campaign will address noncompliance through a variety of treatment streams including outreach/education and traditional examinations.

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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.

As many readers know, the Bipartisan Budget Act of 2015 (“BBA”) repeals the long standing TEFRA procedures governing IRS examinations of partnerships.  As a result, beginning January 1, 2018, partnerships are subject to a centralized partnership audit regime.  However, partnerships are permitted to make an election to have the BBA rules apply to partnership returns filed for tax periods beginning after November 2, 2015 and before January 1, 2018.  For most partnerships, this will apply to the 2016 and 2017 tax years.

Early Election Procedures under Section 1101(g)(4) of the BBA

Partnerships who receive written notification that a partnership return for an eligible year has been selected for examination have 30 days after the date of such notification to file an election to be subject to the BBA centralized partnership regime for that year.  The election can be made on Form 7036,  or by preparing a statement that complies with the regulations.  The election statement requires the partnership representative to represent that the partnership (1) is not insolvent and does not reasonably anticipate becoming insolvent before resolution of any adjustment for the partnership taxable year for which the election is being made; (2) is not currently and does not reasonably anticipate become subject to the bankruptcy petition under Title 11; and (3) has sufficient assets, and reasonably anticipates having sufficient assets, to pay a potential imputed underpayment.

IRS Guidance

On June 29, 2017, the Commissioners of the LB&I division and the SB/SE division issued a memo addressing procedures initial contacts with taxpayers eligible to make the early election.  The memo educates managers and examiners on which partnerships are eligible to make the election, how and when the election is made, the proper content of the election statement, and related correspondence procedures.  The memo requires the issuance of a new Initial Contact Letter, Letter 2205-D, at the beginning of a partnership examination.  If the partnership responds by making an early election, the process outlined below is followed.  If an early election is not made, examiners are instructed to follow existing TEFRA or NonTEFRA procedures.

The memo instructs examiners who receive elections to verify that no amended returns or administrative adjustment requests have been filed as this would disqualify the partnership from making the early election.  The memo also instructs examiners to ensure that Form 7036 is properly completed or that an election not on Form 7036 meets the requirements of Treas. Reg. section 301.9100-22T, request any missing information from the taxpayer if the 30-day election window is still open, and determine whether the election is valid.  The memo further instructs the examiner to wait 30 days after the valid election is received before issuing a notice of administrative proceeding.  The reason for the 30-day waiting period is to allow the partnership to file any administrative adjustment requests as permitted under Section 6227 as amended by the BBA.  During this 30-day period, examiners are instructed to perform a “cursory check” to determine whether the partnership representative’s name, address, identification number and phone number are correct.  Examiners are not permitted to issue a notice of administrative proceeding until the 30-day period expires.

We expect to see continued guidance from the IRS on BBA centralized partnership examination procedures as the rules become effective.

I was recently interviewed by the Wall Street Journal about the IRS LB&I audit campaigns discussed here.  An interesting part of the conversation included a discussion of why the IRS would tell taxpayers what issues they are targeting.  The bottom line is to increase compliance.  The IRS has identified issues it believes a significant number of taxpayers are non-compliant and is focused on those for one reason: to generate revenue and collections.  There are a few things to keep in mind as you evaluate how to respond to the IRS audit campaigns:

  • The use of “soft letters” indicates the IRS is encouraging taxpayers to self-correct.  It is always better to self-correct than to deal with an issue in audit.  Especially when that issue is something the IRS has highlighted publicly as an issue they are targeting.
  • Failure to self-correct may give the IRS a stronger position for asserting penalties.
  • The 13 IRS audit campaigns identified is not a finite list.  It is an initial list which we expect will evolve over time.

Due to budget constraints, it makes sense that the IRS is targeting significant issues and encouraging self-correction which allows the IRS to increase revenues without significant manpower.

You can read the Wall Street Journal article here.

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.