IRS Large Business and International (LB&I) Division

The Internal Revenue Service Large Business and International division (LB&I) has announced the approval of five additional compliance campaigns. LB&I announced on January 31, 2017, the rollout of its first 13 campaigns, followed by 11 campaigns on November 3, 2017, five campaigns on March 13, 2018, six campaigns on May 21, 2018, and five more on July 2, 2018. In addition, LB&I continues to review the tax reform legislation enacted on December 22, 2017, to determine which existing campaigns, if any, could be impacted as a result of a change in the law.

LB&I is moving toward issue-based examinations and a compliance campaign process in which it decides which compliance issues that present risk require a response in the form of one or multiple treatment streams to achieve compliance objectives. This approach makes use of IRS knowledge and deploys the right resources to address those issues. The campaigns are 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.

These five additional campaigns were identified through LB&I data analysis and suggestions from IRS employees. LB&I’s goal is to improve return selection, identify issues representing a risk of non-compliance, and make the greatest use of limited resources.

The five campaigns selected for this rollout are:

  • IRC Section 199 – Claims Risk Review

Public Law 115-97 repealed the Domestic Production Activity Deduction (DPAD) for taxable years beginning after December 31, 2017.  This campaign addresses all business entities that may file a claim for additional DPAD under IRC Section 199. The campaign objective is to ensure taxpayer compliance with the requirements of IRC Section 199 through a claim risk review assessment and issue-based examinations of claims with the greatest compliance risk.

  • Syndicated Conservation Easement Transactions

The IRS issued Notice 2017-10, designating specific syndicated conservation easement transactions as listed transactions, requiring disclosure statements by both investors and material advisors. This campaign is intended to encourage taxpayer compliance and ensure consistent treatment of similarly situated taxpayers by ensuring the easement contributions meet the legal requirements for a deduction, and the fair market values are accurate. The initial treatment stream is issue-based examinations. Other treatment streams will be considered as the campaign progresses.

  • Foreign Base Company Sales Income: Manufacturing Branch Rules

In general, foreign base company sales income (FBCSI) does not include income of a controlled foreign corporation (CFC) derived in connection with the sale of personal property manufactured by such corporation. However, if a CFC manufactures property through a branch outside its country of incorporation, the manufacturing branch may be treated as a separate, wholly owned subsidiary of the CFC for purposes of computing the CFC’s FBCSI, which may result in a subpart F inclusion to the U.S. shareholder(s) of the CFC.

The goal of this campaign is to identify and select for examination returns of U.S. shareholders of CFCs that may have underreported subpart F income based on certain interpretations of the manufacturing branch rules. The treatment stream for the campaign will be issue-based examinations.

  • 1120F Interest Expense/Home Office Expense

This campaign addresses compliance on two of the largest deductions claimed on Form 1120-F, U.S. Income Tax Return of a Foreign Corporation. Treasury Regulation Section 1.882-5 provides a formula to determine the interest expense of a foreign corporation that is allocable to their effectively connected income. The amount of interest expense deductions determined under Treasury Regulation Section 1.882-5 can be substantial. Treasury Regulation Section 1.861-8 governs the amount of Home Office expense deductions allocated to effectively connected income. Home Office Expense allocations have been observed to be material amounts compared to the total deductions taken by a foreign corporation.

The campaign compliance strategy includes the identification of aggressive positions in these areas, such as the use of apportionment factors that may not attribute the proper amount of expenses to the calculation of effectively connected income. The goal of this campaign is to increase taxpayer compliance with the interest expense rules of Treasury Regulation Section 1.882-5 and the Home Office expense allocation rules of Treasury Regulation Section 1.861-8. The treatment stream for this campaign is issue-based examinations.

  • Individuals Employed by Foreign Governments & International Organizations

In some cases, individuals working at foreign embassies, foreign consular offices, and various international organizations may not be reporting compensation or may be reporting it incorrectly. Foreign embassies, foreign consular offices and international organizations operating in the U.S. are not required to withhold federal income and social security taxes from their employees’ compensation nor are they required to file information reports with the Internal Revenue Service.

This lack of withholding and reporting results in unreported income, erroneous deductions and credits, and failure to pay income and Social Security taxes. Because this is a fluid population, there may be a lack of knowledge regarding tax obligations. This campaign will focus on outreach and education by partnering with the Department of State’s Office of Foreign Missions to inform employees of foreign embassies, consular offices and international organizations. The IRS will also address noncompliance in this area by issuing soft letters and conducting examinations.

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BitcoinEarlier this week the Internal Revenue Service announced creation of a virtual currency compliance initiative that will focus on tax compliance by taxpayers engaging in virtual currency transactions. The IRS intends to address non-compliance in this area by conducting audits and engaging in taxpayer outreach, and by issuing future guidance. As part of this announcement, the IRS urged taxpayers with unreported virtual currency transactions to correct their tax returns, but also cautioned that it has no plans to offer a voluntary disclosure program in this area.

As we have previously reported, the IRS is focusing significant attention on tax compliance with respect to cryptocurrency transactions. Last year, the IRS prevailed in its long-running litigation with Coinbase seeking the names of clients who engaged in cryptocurrency transactions during 2013-2015, and Coinbase announced that it was disclosing transaction data to the IRS for 13,000 of its customers. In addition, the IRS-Criminal Investigation Division is ramping up its scrutiny of cryptocurrency transactions by assembling a team of specialized investigators in this area. And earlier this year, the IRS issued a very public “reminder” to taxpayers about reporting cryptocurrency transactions and threating audits, penalties, and even criminal prosecution for non-compliance.

The virtual currency announcement by the IRS Large Business and International Division (LB&I) was part of its roll-out of five additional “compliance campaigns” which are targeted at specific issues presenting risks of non-compliance. In early 2017, LB&I announced that it would be moving toward a risk-based approach to taxpayer examinations, and to date has identified 35 compliance issues that will guide its examination strategy moving forward.

The IRS described its newly-announced virtual currency campaign as follows:

U.S. persons are subject to tax on worldwide income from all sources including transactions involving virtual currency. IRS Notice 2014-21 states that virtual currency is property for federal tax purposes and provides information on the U.S. federal tax implications of convertible virtual currency transactions. The Virtual Currency Compliance campaign will address noncompliance related to the use of virtual currency through multiple treatment streams including outreach and examinations. The compliance activities will follow the general tax principles applicable to all transactions in property, as outlined in Notice 2014-21. The IRS will continue to consider and solicit taxpayer and practitioner feedback in education efforts, future guidance, and development of Practice Units. Taxpayers with unreported virtual currency transactions are urged to correct their returns as soon as practical. The IRS is not contemplating a voluntary disclosure program specifically to address tax non-compliance involving virtual currency.

The four other new compliance campaigns unveiled by LB&I this week include (1) restoration of sequestered AMT credit carryforward; (2) S corporation distributions; (3) repatriation via foreign triangular reorganizations; and (4) Section 965 transition tax. These campaigns are decribed in more detail as follows:

  • Restoration of Sequestered AMT Credit Carryforward

LB&I is initiating a campaign for taxpayers improperly restoring the sequestered Alternative Minimum Tax (AMT) credit to the subsequent tax year. Refunds issued or applied to a subsequent year’s tax, pursuant to IRC Section 168(k)(4), are subject to sequestration and are a permanent loss of refundable credits. Taxpayers may not restore the sequestered amounts to their AMT credit carryforward. Soft letters will be mailed to taxpayers who are identified as making improper restorations of sequestered amounts. Taxpayers will be monitored for subsequent compliance. The goal of this campaign is to educate taxpayers on the proper treatment of sequestered AMT credits and request that taxpayers self-correct.

  • S Corporation Distributions

S Corporations and their shareholders are required to properly report the tax consequences of distributions. We have identified three issues that are part of this campaign. The first issue occurs when an S Corporation fails to report gain upon the distribution of appreciated property to a shareholder. The second issue occurs when an S Corporation fails to determine that a distribution, whether in cash or property, is properly taxable as a dividend. The third issue occurs when a shareholder fails to report non-dividend distributions in excess of their stock basis that are subject to taxation. The treatment streams for this campaign include issue-based examinations, tax form change suggestions, and stakeholder outreach.

  • Repatriation via Foreign Triangular Reorganizations

In December 2016, the IRS issued Notice 2016-73 (“the Notice”), which curtails the claimed “tax-free” repatriation of basis and untaxed CFC earnings following the use of certain foreign triangular reorganization transactions. The goal of the campaign is to identify and challenge these transactions by educating and assisting examination teams in audits of these repatriations.

  • Section 965 Transition Tax

Section 965 requires United States shareholders to pay a transition tax on the untaxed foreign earnings of certain specified foreign corporations as if those earnings had been repatriated to the United States. Taxpayers may elect to pay the transition tax in installments over an eight-year period. For some taxpayers, some or all of the tax will be due on their 2017 income tax return. The tax is payable as of the due date of the return (without extensions).

Earlier this year, LB&I engaged in an outreach campaign to leverage the reach of trade groups, advisors and other outside stakeholders to raise awareness of filing and payment obligations under this provision. The external communication was circulated through stakeholder channels in April 2018.

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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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On March 13, 2018, the Internal Revenue Service’s Large Business and International Division announced that it was adding five more compliance campaigns to its previously-announced list of 24 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.

LB&I noted that the newest campaigns were identified through data analysis and suggestions from IRS compliance employees. The five new campaigns are the following:

  • Costs that Facilitate an IRC Section 355 Transaction
    Practice Areas: Enterprise Activities
    Lead Executives: Scott Ballint
    Description: Costs to facilitate a tax-free corporate distribution under IRC Section 355, such as a spin-off, split-off or split-up, must be capitalized and are not currently deductible. Some taxpayers may execute a corporate distribution and improperly deduct the costs that facilitated the transaction in the year the distribution was completed. The goal of this campaign is to ensure taxpayer compliance with the requirement to capitalize, not deduct, the facilitative costs when the distribution is completed. The treatment stream for this campaign is issue-based examinations.
  • Self-Employment Contributions Act (SECA) Tax
    Practice Areas: Pass Through Entities and Northeastern Compliance
    Lead Executives: Cliff Scherwinski and Darlena Billops-Hill
    Description: Partners report income passed through from their partnerships. If the partner is an individual who renders services, the partner’s distributive share of income is subject to self-employment tax under the Self-Employment Contributions Act (SECA). Some limited partners and limited liability company (LLC) members who render services to clients on behalf of the partnership or LLC do not report flow-through income as earnings from self-employment and do not pay SECA tax. The Service’s goal in this campaign is to increase compliance with the law as supported by several recent court decisions. The treatment streams for this campaign will be issue-based examinations and outreach to practitioners, professional service provider associations, and software vendors.
  • Partnership Stop Filer
    Practice Areas: Pass-Through Entities and Western Compliance
    Lead Executives: Cliff Scherwinski and Eric Slack
    Description: Partners report income, losses, and other items passed through from their partnership. Some partnerships stop filing tax returns for various reasons yet still have economic transactions that are not being reported to their partners. That activity is likely not being reported by the partners. The treatment streams for this campaign include issue-based examinations, soft letters encouraging voluntary self-correction, and stakeholder outreach.
  • Sale of Partnership Interest
    Practice Areas: Pass-Through Entities and Eastern Compliance
    Lead Executives: Cliff Scherwinski and Joseph Banks
    Description: A partner must report the sale of a partnership interest on their tax return. This campaign will address taxpayers who do not report the sale or report the gain or loss incorrectly. Incorrect reporting includes the amount and character of the gain or loss. Taxpayers may report the entire gain as long-term capital gain (usually 15 percent) when a portion of the gain may be ordinary gain or subject to the 25 percent or 28 percent long-term capital gain rates. A variety of treatment streams will address noncompliance, including, but not limited to, examinations and soft letters.
  • Partial Disposition Election for Buildings
    Practice Area: Eastern Compliance
    Lead Executive: Judith McNamara
    Description: IRC Section168 disposition regulations (Treas. Reg. Section 1.168(i)-8), issued August 2014, provide rules for recognizing gain or loss on the disposition of MACRS property and allow taxpayers to elect to recognize partial dispositions of property. To comply with the Section168 disposition regulations and make a partial disposition election, a taxpayer must be able to substantiate that it:

1. disposed of a portion of a MACRS asset owned by the taxpayer;

2. identified the asset that was partially disposed;

3. determined the placed-in-service date of the partially disposed asset;

4. determined the adjusted basis of the disposed portion; and

5. reduced the adjusted basis of the asset by the disposed portion.

The goal of this campaign is to ensure taxpayers accurately recognize the gain or loss on the partial disposition of a building, including its structural components. The treatment stream for this campaign is issue-based examinations and potential changes to IRS forms and the supporting instructions and publications.

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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.

The Tax Court has issued its long-awaited decision addressing captive insurance arrangements. In Avrahami v. Commissioner, 149 T.C. No. 7 (2017), the Tax Court held that payments made from a number of businesses owned by the Avrahamis to a microcaptive insurance company that was wholly-owned by Mrs. Avrahami were not for “insurance,” and thus were not deductible as insurance premiums paid. Here is what you need to know.

Captive Insurance Generally

Amounts paid for insurance are deductible as ordinary and necessary business expenses. Insurance companies are generally taxed on the insurance premiums they receive. However, small insurance companies that satisfy certain requirements are eligible to make a section 831(b) election, in which case they are only taxed on their taxable investment income (which does not include premiums received). For 2009 and 2010, an insurance company other than a life insurance company that had written premiums that did not exceed $1.2 million could elect to be taxed under section 831(b) as long as they met all other requirements.

A pure captive insurance company is one that only insures the risks of companies related to it by ownership. A captive insurance company that is eligible to make a section 831(b) election (referred to as a “microcaptive”) does not pay tax on the premiums it receives. Thus, if a business owner creates a microcaptive that insures only the risks of the business owner’s business, the business is able to deduct up to $1.2 million for insurance premiums paid to the related microcaptive while the microcaptive does not pay tax on the premiums received. However, the premiums are only deductible if the payments are for “insurance,” which begs the question: what is “insurance”? This is the question Avrahami addressed in the context of payments made to microcaptives.

Case Background

The Avrahamis owned jewelry stores and commercial real estate companies (the “Avrahami Entities”). In November 2007, they created an insurance company (the “Captive”) to insure the risks of the Avrahami entities. The Captive was wholly-owned by Mrs. Avrahami. In 2009 and 2010 – the years at issue in this case – the Avrahami entities paid the Captive premiums for direct insurance policies of approximately $730,000 and $810,000, respectively, for policies covering seven types of risk including: administrative actions, business risk indemnity, business income protection, employee fidelity, litigation expense, loss of key employee, and tax indemnity. In addition to its direct policies, the Captive participated in a risk distribution program with other small captive insurance companies through Pan American. Through Pan American’s risk distribution program, the Avrahami Entities paid approximately $360,000 to Pan American for terrorism coverage only. Pan American then reinsured all of the risk it had assumed and would make sure that the Captive received reinsurance premiums equal to the amount paid by the Avrahami Entities to Pan American ($360,000), and in exchange the Captive would reinsure a small percentage of Pan American’s total losses. In total, the Avrahamis deducted approximately $1.1 million and $1.3 million in 2009 and 2010, respectively, for insurance premiums paid from the Avrahami Entities to the Captive or Pan American for both direct policies and for the terrorism coverage obtained through the risk distribution program. Only the Avrahami Entities were covered by the direct policies while over 100 insureds were included in the risk distribution program.

The IRS argued that neither the Captive nor Pan American sold “insurance”, meaning the premiums paid by the Avrahami Entities were not deductible as ordinary and necessary business expenses. The Tax Court agreed.

The Court’s Analysis

To be considered insurance, the arrangement must: (1) involve risk-shifting; (2) involve risk-distribution; (3) involve insurance risk; and (4) meet commonly accepted notions of insurance. The Tax Court analyzed only two of these elements: risk distribution and commonly accepted notions of insurance.

Risk distribution occurs when the insurer pools a large enough collection of unrelated risks. The Tax Court looked to the number of companies the Captive insured and the “number of independent risk exposures” (i.e., how many policies does the Captive issue and what do those policies cover). Ultimately, the Court determined that insuring 3 companies in 2009 and 4 in 2010, issuing 7 direct policies that covered 3 jewelry stores, 3 commercial real estate companies, 2 key employees, and 35 other employees did not cover a sufficient number of risk exposures to achieve risk distribution through the affiliated entities. The Court distinguished the facts present in this case from other cases where they have determined that insurers adequately distributed risk.

The Avrahamis argued that they adequately distributed risk because, in addition to the Captive insuring the Avrahami Entities, the Captive participated in the Pan American risk distribution program and reinsured third-party risk. The Court determined that Pan American was not a bona fide insurance company in the first place, meaning the policies it issued were not “insurance” and the Captive could not have distributed risk by reinsuring policies that were not insurance to begin with. The Court looked to a number of factors to determine whether Pan American was a bona fide insurance company, ultimately concluding that it was not for the following reasons:

  • There was a circular flow of funds. Avrahami Entities paid Pan American, Pan American turned around and reinsured all of the risk it had assumed, making sure that the Captive received reinsurance premiums equal to those paid by the Avrahami Entities. Thus, money was effectively transferred from an entity owned by the Avrahamis (one of the Avrahami Entities) to an entity wholly-owned by Mrs. Avrahami (the Captive).
  • The premiums charged for terrorism coverage were “grossly excessive”. The only policy Pan American issued was for terrorism coverage, and the policy was worded in a way that it was highly unlikely that the triggering event would ever occur.
  • Pan American charged high premiums for an event that was unlikely to ever occur (and had never occurred in the past), and if the event did occur Pan American may have not been able to pay the claims.
  • Because the risk distribution program was not recognized by the Court, when the Court reviewed the direct policies it determined that on a stand-alone basis they also did not adequately distribute risk because the direct policies only covered the Avrahami Entities and the combination of risks and entities covered by the direct policies did not distribute risk among an adequate number of independent insurance risks.

For these reasons, the Court concluded that the Captive did not adequately distribute risk.

The Tax Court then analyzed whether the Captive met commonly accepted notions of insurance, which required the Court to work through a number of factors. The Court determined that the Captive was not selling insurance in the commonly accepted sense. The Court explained:

  • The Captive did not operate like an insurance company. No claims were filed until the IRS began its audit. The Captive only invested in illiquid, long-term loans to related parties and failed to get regulatory approval before transferring funds to them.
  • The Captive returned substantial portions of its surpluses to the insureds and owners of the insured through various loans and distributions.
  • The Captive policies were questionable because they were unclear and contradictory.
  • The Captive charged unreasonable premiums even though an actuary priced the policies. The Court did not find the actuary’s pricing methodology at all persuasive, noting that the actuary consistently chose inputs that would generate higher premiums. The Court noted that before creating the Captive, the Avrahami Entities paid $150,000 for commercial insurance policies. After creating the Captive, the Avrahami Entities paid $1.1 million and $1.3 million in 2009 and 2010, and paid $90,000 for a commercial insurance policy.

As a result, the Court concluded that payments made from the Avrahami Entities to the Captive and Pan American were not for insurance, and thus were not deductible as ordinary and necessary business expenses.

It is worth noting that the Captive was incorporated under the laws of the Caribbean nation of Saint Christopher and Nevis (St. Kitts). The Captive made a section 953(d) election to be treated as a domestic corporation for federal income tax purposes, and also made an election to be taxed as a small insurance company under section 831(b). However, since the Captive’s policies were not for “insurance”, both elections were invalid, and it was thus treated as a foreign corporation for federal income tax purposes. The parties stipulated that the taxable premiums earned by the Captive were not subject to U.S. Federal income tax.

Impact on Continuing IRS Scrutiny of Captive Insurance Arrangements

For several years, the IRS has devoted significant resources to examinations of captive insurance arrangements and numerous cases are the subject of Tax Court petitions.  There are several cases pending in the Tax Court post-trial.  The IRS increased its scrutiny of microcaptives when it issued Notice 2016-66, requiring self-reporting by taxpayers engaging in captive insurance arrangements where there has been a low incidence of claims or where significant loans have been made to related parties. In light of the Avrahami decision, the IRS is likely to continue devoting resources to scrutinizing and challenging captive insurance arrangements it believes are abusive.

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.