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Tax Reform is Here

Dentons is covering all of the latest news on the various tax reform plans that the United States Congress is currently considering.

The latest about the Senate’s plan can be found here.

Check back for more updates.

IRS Announces 13 Campaigns – New Focus

The Large Business and International division of the IRS has restructured its approach to examinations.  Yesterday, it released its list of 13 focus areas for issue- based examinations and concerns for compliance.   One of those areas involves the IRS Offshore Voluntary Disclosure Program.  Entitled, “OVDP Declines-Withdrawals Campaign,” this area of focus involves taxpayers who have applied for the offshore voluntary disclosure program through the pre-clearance process, but were either denied access to the program or withdrew from the program.

What happens next?  “The IRS will address continued noncompliance through a variety of treatment streams including examination.”  Examining those taxpayers who could not enter the program, because they are under civil audit, criminal investigation, or the IRS is otherwise aware of the account(s) at issue in the disclosure, is expected. Further, those who violated the law intentionally might expect a criminal tax investigation or possible referral for prosecution, depending on the circumstances and reasons for denial into the program.

We have seen an uptick in audits and FBAR inquiries associated with taxpayers who have not come forward, and certainly anyone who opts-out of the OVDP program is subject to an immediate audit of their tax returns and FBAR filings.  “Making this effort a ‘campaign’ certainly raises the awareness of the programs and need to quickly come into compliance and assures that resources are available to support the audits and other investigations,” says Jim Mastracchio, Co-Chair of Dentons National Tax Controversy Practice.

Partnership Proposed Regulations Issued – New Audit Rules For Partnerships

The IRS has issued Proposed Regulations addressing the Centralized Partnership Audit Regime.  Back in November of 2015, statutory changes were enacted to replace the traditional audit rules for partnerships and replacing them with a new centralized partnership audit which, in most instances, places the tax liability at the partnership level rather than at the partner level.

Partnerships are pass through entities for US tax purposes and items of income, expense and credits are taken on the personal income tax returns of the individual partners.  Under the new statute, an audit of the partnership could result in additional taxes being owed at the partnership level rather than flowing through to the individual partners.

“It has taken over a year for the proposed regulations to be issued,” said James N. Mastracchio, Co-Chair of Denton’s Tax Controversy Practice, “and that is a good thing.”  The proposed regulations are “extensive” and “cover a number of issues that we face as advisors to our clients.” added Mastracchio.

There will be a long comment period with the ultimate effective date of the regulations to take place in early 2018.

Is Your Conservation Easement a Listed Transaction?

If you invested in a partnership or other passthrough entity, which provides pass-through deductions for conservation easements, that arrangement may be considered a “syndicated conservation easement” and a “listed transaction,”  and you may be faced with  new IRS reporting obligations.

According to Notice 2017-10, if you entered into this type of arrangement on or after January 1, 2010, and if that arrangement is “the same as or substantially similar to” the syndicated conservation easements described in the Notice, the “listed transaction” provisions of  §1.6011-4(b)(2) and §§6111 and 6112 become effective December 23, 2016.  If these provisions apply, you must disclose the transaction to the IRS, for each taxable year in which you participated in the transaction, provided that the period of limitations for assessment of tax has not ended on or before December 23, 2016.  Failure to disclose your participation can result in stiff civil monetary penalties.

Further, according to the Notice, promoters, material advisors, including appraisers, who make a tax statement on or after January 1, 2010, with respect to transactions entered into on or after January 1, 2010, have disclosure and list maintenance obligations under §§6111 and 6112. See §§301.6111-3 , 301.6112-1.  Failure to comply with these provisions also carries significant civil monetary penalties.

With the 2016 income tax filing season opening this month, this issue may affect tax returns filed in the coming months and requires a look-back to 2010 as well.  For questions regarding syndicated conservation easements, or listed transactions, please contact Jim Mastracchio at (202) 496-7251; james.mastracchio@dentons.com

 

Foreign Exchange Rates and the Exit Tax

We have seen several advantages from the increase in the U.S. dollar strength against foreign currencies when tackling the Exit Tax.  Several clients have dropped below the $2 million thresholds and others find they have much lower gains on deemed sales when calculating the tax.  While dollar strength can cause other issues, abandoning green cards and U.S. citizenship renunciations are seeing benefits.  For advice regarding U.S. taxpayer status, filing requirements and related disclosure requirements contact Jim Mastracchio, james.mastracchio@dentons.com (202) 496-7251 for a confidential consult.

Fast Track Settlements for Collection Cases

Late last year the IRS issued guidance on Fast Track settlement procedures for collection cases.  The goal of the process is to provide resolution of disputed issues within 30-40 calendar days.  Generally, issues involving an offer-in-comprise or trust fund recovery penalties can be brought before an Appeals mediator.  The new program is called SB/SE Fast Track Mediation- Collection (FTMC) and should provide a meaningful avenue to resolve differences.  Ultimate settlement authority continues to reside with Collections and not with IRS Appeals.  See guidance at Rev. Proc 2016-57.

Israel Cleared to Implement FATCA and Report on U.S. Persons

A recent decision by the Israeli Supreme Court has cleared the way for FATCA implementation by lifting a temporary injunction on the disclosure of information to U.S. authorities under Israel’s intergovernmental agreement (IGA). In connection with the decision, the Israeli government has agreed to give individual taxpayers at least thirty days to object to the inclusion of their information in data transferred to U.S. authorities under the IGA.

The government also agreed to delay the implementation of the IGA to September 30, 2016. Israeli financial institutions now have until September 20, 2016, to provide the Israeli Tax Authority with the required data on U.S. taxpayers. This is a notable development in Israel where, reportedly, as much as five percent of the population – upwards of 300,000 people – holds U.S. citizenship.

The decision arose from Republicans Overseas-Israel, et al. v. Israel, et al, where the plaintiffs challenged the constitutionality of FATCA implementation under Israeli law, claiming that the IGA’s required reporting to U.S. authorities violated Israel’s sovereignty. Earlier in September, the Israeli Supreme Court issued a temporary injunction preventing the disclosure of financial information to U.S. authorities under the IGA. In its more recent decision, however, the Court rejected the challenge to Israeli sovereignty and analyzed the claim as an issue of privacy. The Court considered whether the privacy of U.S. taxpayers was being infringed and, if so, whether the harm was reasonable. It assumed that there was some infringement on privacy, but found that the privacy concerns were outweighed by the need for Israel to abide by its agreement to provide international financial cooperation, and that Plaintiffs failed to show that the State did not limit the impact on privacy as much as was possible.

For those U.S. persons with Israeli bank accounts who have yet to come into compliance with U.S. tax filings, there is little time remaining. The IRS has announced a series of voluntary disclosure programs and options, some of which can give rise to zero penalties. Should you have questions regarding this post or the IRS disclosure options, please contact Jim Mastracchio (james.mastracchio@dentons.com) or Jennifer Walrath (jennifer.walrath@dentons.com).

IRS Seeks to Speed Up FATCA Reporting with Imposition of Year End Deadline to Finalize IGAs

The Foreign Account Tax Compliance Act (“FATCA”) was enacted in 2010 by Congress to target non-compliance by U.S. taxpayers using foreign accounts. FATCA requires foreign financial institutions (FFIs) to report to the Internal Revenue Service (“IRS”) information about financial accounts held by U.S. taxpayers, or by foreign entities in which U.S. taxpayers hold a substantial ownership interest.   FATCA obliges all U.S. paying agents to withhold tax, at a rate of 30 per cent, from payments of U.S. source income to non-U.S. persons who are classified as FFIs unless that FFI is located in a country which has entered into an intergovernmental agreement (“IGA”) with the IRS to report information on relevant account holders to the IRS.

An IGA is a bilateral agreement with the U.S. to simplify reporting compliance and avoid FATCA withholding. Under a Model 1 IGA, FFIs in partner jurisdictions report information on U.S. account holders to their national tax authorities, which in turn will provide this information to the IRS. Under a Model 2 IGA, FFIs report account information directly to the IRS.

Since the implementation of FATCA, the IRS has permitted numerous jurisdictions to benefit from having status as IGA, even if they did not have a finalized IGA in force. Notice 2013-43 (2013-31 I.R.B.113) provided that a jurisdiction that had signed but not yet brought into force an IGA was treated as if it had an IGA in effect as long as the jurisdiction was taking the steps necessary to bring the IGA into force within a reasonable period of time. Announcement 2014-17 (2014-18 I.R.B. 1001) and Announcement 2014-38 (2014-51 I.R.B. 951) provided that jurisdictions treated as if they have an IGA in effect also include jurisdictions that, before November 30, 2014, had reached an agreement in substance with the United States on the terms of an IGA as long as the jurisdiction continued to demonstrate firm resolve to sign the IGA as soon as possible. Notice 2015-66 (2015-41 I.R.B. 541) announced that FFIs in partner jurisdictions with a signed or “agreed in substance” Model 1 IGA that had not entered into force as of September 30, 2015, would continue to be treated as complying with, and not subject to withholding under, FATCA so long as the partner jurisdiction continued to demonstrate firm resolve to bring the IGA into force and any information that would have been reportable under the IGA on September 30, 2015, is exchanged by September 30, 2016, together with any information that is reportable under the IGA on September 30, 2016.

In Announcement 2016-17, however, the IRS pressures jurisdictions that have been lagging on this process to substantially complete it by year-end, or risk their FFIs to be subject to the 30 percent withholding in coming years. Specifically, the Announcement provides that, on January 1, 2017, Treasury will begin updating the IGA List to provide that certain jurisdictions that have not brought their IGA into force will no longer be treated as if they have an IGA in effect. Each jurisdiction with an IGA that is not yet in force and that wishes to continue to be treated as having an IGA in effect must provide to Treasury by December 31, 2016, a detailed explanation of why the jurisdiction has not yet brought the IGA into force and a step-by-step plan that the jurisdiction intends to follow in order to sign the IGA (if it has not yet been signed) and bring the IGA into force, including expected dates for achieving each step. In evaluating whether a jurisdiction will continue to be treated as if it has an IGA in effect, Treasury will consider whether: (1) the jurisdiction has submitted the explanation and plan (with dates) described above; and (2) that explanation and plan, as well as the jurisdiction’s prior course of conduct in connection with IGA discussions, show that the jurisdiction continues to demonstrate firm resolve to bring its IGA into force.

This Announcement reflects the IRS’s eagerness to gather information on U.S.-owned bank accounts in foreign jurisdictions, which has been repeatedly delayed due to the complexities that arose in the implementation of FATCA. The risk of the substantial withholding tax under FATCA for FFIs in non-IGA jurisdictions may incentivize lagging jurisdictions to speed the process along.

The Streamline Program Turns Two

The Streamlined Filing Compliance Procedure (SFCP) is now two years old. The SFCP was designed for taxpayers whose failure to disclose their offshore accounts was “non-willful,” due to a lack of understanding or knowledge of reporting requirements for U.S. persons. Unlike the full blown Offshore Voluntary Disclosure Program (“OVDP”), the SFCP places the burden of proving that the taxpayer’s noncompliance was willful on the IRS once the taxpayer has asserted that their non-compliance was not willful. Taxpayers who’s tax returns and informational filing requirements satisfy the SFCP are only required to file tax returns for the previous 3 years and FBAR’s for the previous 6 years while taxpayers in the OVDP must file tax and information returns and FBAR’s for the previous eight years.

One point of contention for taxpayers who entered into the OVDP before the SFCP was introduced in 2014, and whose noncompliance would have qualified them for the SFCP, is that they should be able to switch to the SFCP and take advantage of the reduced penalties on the income tax liability and file only 3 years of income tax returns. While the reduced miscellaneous penalty is available under the OVDP by requesting transitional relief, such relief is not guaranteed and often denied.

Recently, a group of taxpayers brought suit in the Washington D.C. District Court to challenge the IRS’s position that taxpayers who were enlisted in the OVDP prior to the implementation of the SFCP, cannot have their matter transferred to the SFCP. The taxpayers in this case contend they were being treated unfairly under this system as they were no different than those who came forward later in time and entered the SFCP.

Unfortunately, the court did not decide the merits of the case. Rather, the court held that the suit hinders the IRS’s ability to make decisions regarding the enforcement of tax liabilities and dismissed the suit as being barred under the Tax Anti-Injunction Act (26 U.S.C. § 7421), which prohibits suits that restrain the assessment and collection of taxes.   This case highlights the difficulties that can arise when the Service creates settlement programs independent from regulatory oversight and commentary.

Tax Court Finds Predictive Coding Satisfies Reasonable Inquiry Standard for Responding to Discovery Requests

The Tax Court recently denied the Internal Revenue Service’s (“IRS”) motion to compel the production of electronically stored information by Petitioner, Dynamo Holding Limited Partnership, which was not delivered as part of a discovery response based on the mutually agreed-upon use of “predictive coding.” Dynamo holdings, Ltd. v. Comm’r, Docket Nos. 2685-11, 8393-12. Predictive coding is an electronic discovery method that involves the use of keyword search, filtering and sampling to automate portions of an e-discovery document review. This method attempts to reduce the number of irrelevant and non-responsive documents that need to be reviewed manually.

The IRS and Petitioners had agreed that Petitioners would run a search for terms determined by the IRS on the potentially relevant documents. Petitioners used the predictive coding model to provide the IRS with a selection of documents that the model determined to be relevant.

The IRS, believing the response to be incomplete, served Petitioners with a new discovery request asking for all documents containing any of a series of search terms under a simple keyword or Boolean search, speculating that these documents were “highly likely to be relevant.”   Petitioners objected to this new discovery request as duplicative of the previous discovery responses made through the use of predictive coding. Petitioners contended that the predictive coding algorithm worked correctly, and that the 765 documents excluded as not relevant by the predictive coding algorithm, were properly excluded because they were outside the relevant time frame or otherwise are not relevant. The IRS thereafter filed a motion to compel the production of these documents.

The Tax Court denied the motion, asserting that it was predicated on two myths. The first of these stated myths was the “myth of human review” that “manual review by humans of large amounts of information is as accurate and complete as possible – perhaps even perfect – and constitutes the gold standard by which all searches should be measured.” The second myth was “the myth of a perfect response,” which is beyond the requirements of the Tax Court Rules. The Tax Court found that that the Tax Court Rules and the Federal Rules of Civil Procedure require only that the responding party make a “reasonable inquiry” when making a discovery response. The court explained that “when the responding party is signing the response to a discovery demand, he is not certifying that he turned over everything, he is certifying that he made a reasonable inquiry and to the best of his knowledge, his response is complete.”  As this standard was satisfied by Petitioners in their utilization of predictive coding to locate the relevant documents, the IRS’s attempt to expand e-discovery beyond the agreed upon predictive coding was unsuccessful.

IRS on Alert of Partners Attempting to Slip Through the Cracks Before New Partnership Audit Regime Takes Effect

Despite the significant uncertainty surrounding the new partnership audit regime implemented under the 2015 Bipartisan Budget Act (Pub. L. No. 114-74) (“BBA”), the IRS expressed its intention to watch for partners exiting partnerships to avoid tax, during a District of Columbia Bar event on June 23, 2016.

The new rules, effective in 2018, require partnership-level audits of large partnerships, and make it simpler for IRS examiners to undertake an audit because the system will be able to calculate and collect adjustments at the partnership level.   Since there can be several years between when a return is filed and when an audit adjustment is levied, however, it leads to the possibility that partners could sell their interest before the commencement of an audit and avoid adjustments that may have been attributable to them.

Although the panel suggested amending partnership agreements so that partners who sell their interests would still be on the hook for any tax due later, it is unclear whether partners intending on exiting partnerships in light of the new rules would agree to such an amendment. Further, because of the vast uncertainty regarding various areas of the partnership audit rules, most partnerships are not amending their agreements at this time.

The IRS intends to issue regulations with an effective date of January 1, 2018, which would address the scope of the rules and how statute of limitations are applied in this context.   Many areas of uncertainty with the new rules, however, have not yet been addressed by the IRS.

One major area of uncertainty revolves around the “partnership representative,” which is an expanded version of the “tax matters partner” role under prior law. The partnership representative, which is not required to be a partner, will have sole authority to act on behalf of the partnership in an audit proceeding, and will bind both the partnership and the partners by its actions in the audit. The IRS no longer will be required to notify partners of partnership audit proceedings or adjustments, and partners will be bound by determinations made at the partnership level.

It appears that partners neither will have rights to participate in partnership audits or related judicial proceedings, nor standing to bring a judicial action if the partnership representative does not challenge an assessment. Accordingly, the partnership representative is vested with significant responsibility and power under the BBA, and would likely need to devote the majority of his or her time addressing these issues. This raises the possibility that certain individuals might be compensated for this role, and the role might be limited by the provisions of the partnership agreement. At the very least, there should be provisions in place to have a degree of control over elections made at the entity level, or final determinations at the entity level.

Another noteworthy area of concern is how the new rules would impact State tax filings. States have not yet reacted to the new rules, and thus, partners may be reluctant to make amendments until they are aware of both the state and federal implications of the audit rules. The IRS expects to issue guidance in stages to alleviate some of the concerns expressed by practitioners and allow them to move forward with amendments to partnership agreements.

Notwithstanding the uncertainty, it is clear that the IRS is watching for those seeking to take advantage of the new regime to avoid tax.

The Ninth Circuit Holds Equitable Recoupment Not Time-Barred

In a taxpayer win, the Ninth Circuit recently reversed the Tax Court and held equitable recoupment was not time barred.  Revah v. Comm’r, No. 11-70211 (9th Cir. Sept. 17, 2014) (unpublished opinion).  Relying on longstanding precedent, the Ninth Circuit held the taxpayers were not statutory barred from applying for equitable recoupment because it’s permitted even with respect to an untimely refund claim.  Thus, even though the taxpayers failed to timely file their refund claims, “untimeliness is not a ground upon which the tax court may deny equitable recoupment.”  Id.

Equitable recoupment is a judicial doctrine that applies where one transaction or event is subject to two taxes based on inconsistent theories.  The equitable recoupment doctrine “allows a litigant to avoid the bar of an expired statutory limitation period” and “prevents an inequitable windfall to a taxpayer or to the Government that would otherwise result from the inconsistent tax treatment of a single transaction, item, or event affecting the same taxpayer or a sufficiently related taxpayer.”  Menard, Inc. v. Comm’r, 130 T.C. 54, 62 (2008).  To establish equitable recoupment a taxpayer must prove: (1) the overpayment or deficiency for which recoupment is sought by way of offset is barred by an expired period of limitation, (2) the time-barred overpayment or deficiency arose out of the same transaction, item, or taxable event as the overpayment or deficiency before the Court, (3) the transaction, item, or taxable event has been inconsistently subjected to two taxes, and (4) if the transaction, item, or taxable event involves two or more taxpayers, there is sufficient identity of interest between the taxpayers subject to the two taxes that the taxpayers should be treated as one.  Id. at 62-63.  In practice, taxpayers often have difficulty mounting arguments of equitable recoupment against the IRS, although the Government typically has more success in this area.

The IRS audited and made adjustments to the Revahs’ 1999 and 2000 tax returns related to inventory and bad debt, and resulting in a decrease in the net operated losses the taxpayers reported on their 1997 and 1998 returns.  The taxpayers accepted the adjustments assuming that, as the examiner acknowledged, they would be able to reduce income in 2001 through amended returns.  After the exam and in 2005, the taxpayers filed amended returns in accordance with the examiner’s adjustments, but the refund claims were denied as untimely.  The taxpayers petitioned the Tax Court for relief asserting the equitable recoupment doctrine.  The Tax Court (Judge Cohen) found the taxpayers’ inability to use the NOLs to reduce tax liabilities was not the result of the inequitable application of inconsistent theories of taxation contemplated by the equitable recoupment doctrine, and thereby denied the petition.  The Ninth Circuit reversed and remanded in favor of the doctrine’s application, illustrating that there is hope for future taxpayers seeking to offset current IRS liabilities with past credits under the doctrine.

The Tax Court Rejects the IRS’s Section 6901 Analysis

On May 29, 2014, the Tax Court, in a division opinion, decided another transferee liability case in favor of the taxpayers.  See Swords Trust v. Commissioner, 142 T.C. No. 19 (2014). In Swords, the taxpayers (which were four separate trusts) together owned all the outstanding shares of stock in a C corporation, Davreyn.  Davreyn was a personal holding company that owned a substantial amount of stock in Reynolds Metal (which produced the popular aluminum foil brand, Reynolds Wrap).  Prior to the transaction at issue, Reynolds Metal merged with Alcoa, Inc., another aluminum company, and Davreyn’s existing Reynolds Metal stock was converted into shares of Alcoa stock.

Sometime in 2000, the taxpayers’ accountant learned about an opportunity for shareholders of a personal holding company to sell their appreciated stock to a financial buyer in a tax-efficient manner.  The taxpayers eventually agreed to enter into such proposed stock sale and on February 15, 2001, the taxpayers executed a stock purchase agreement wherein the taxpayers sold all of their stock in Davreyn to Alrey Trust (an entity that was affiliated with the investment banking firm, Integrated Capital Associates or ICA).  Unbeknownst to the taxpayers, Alrey Trust immediately liquidated Davreyn and then sold the Alcoa stock.  On its tax return, Alrey Trust reported a substantial gain on the subsequent sale of the Alcoa stock and offset such gain with an artificial loss that was generated from a Son-of-Boss transaction.

After assessing substantial tax liabilities against Alrey Trust and Davreyn—both to no avail—the IRS proceeded to attempt to collect Davreyn’s unpaid tax liability from the taxpayers, as transferees of Davreyn’s assets.  The IRS argued that a two-step analysis applies in determining whether the taxpayers, as transferees, are liable under Section 6901 for Devreyn’s unpaid taxes:  (1) analyze whether the subject transactions are recast under Federal law, which in Swords was primarily the Federal substance over form doctrine, and then (2) apply State law to the transactions as recast under Federal law.  Of course, to anyone familiar with transferee liability cases, this argument should not come as a surprise—it has functioned as the constant mantra of the IRS in several prior transferee liability cases.  Even though the First, Second and Fourth Circuit Courts had all recently rejected this argument, the IRS found itself once again in front of the Tax Court reiterating its Section 6901 argument.  See Diebold Found., Inc. v. Commissioner, 736 F.3d 172, 184-185 (2d Cir. 2013); Sawyer Trust of May 1992 v. Commissioner, 712 F.3d 597, 604-605 (1st Cir. 2013); Starnes v. Commissioner, 680 F.3d 417, 428-429 (4th Cir. 2012).  This time though, the Tax Court explicitly rejected the IRS’s proposed two-step analysis.  As the Fourth Circuit held in Starnes, the question of whether a transfer occurred for purposes of Section 6901 is separate from the question of whether the transfer was fraudulent for state law purposes.  See Starnes, 680 F.3d at 428-429.  Accordingly, the Tax Court found that Section 6901 requires that the court apply state (rather than Federal) law to determine whether a transaction is recast under a substance over form (or similar) doctrine.

The IRS argued alternatively that the applicable state law, Virginia, has a substance over form doctrine that applies to recast the series of transaction as one transfer between each of the taxpayers and Davreyn.  Again, the Tax Court disagreed, finding that the IRS “has left us unpersuaded that the Supreme Court of Virginia would apply a substance over form analysis to the present setting.”  Swords, 142 T.C. *15.  The IRS had not identified an adequate Virginia case wherein the court applied a substance over form or similar doctrine.  Moreover, even if such an analysis would apply in Virginia, the Tax Court was unpersuaded that the taxpayers or their representatives had the requisite actual or constructive knowledge of Alrey Trust’s plans to sell the Alcoa stock and to illegitimately avoid any resulting tax liability.  The Tax Court concluded that the transaction was in form and substance a sale of stock and that the transaction should not be recast as a sale of assets followed by a liquidating distribution.  After analyzing the transaction in light of Virginia’s actual fraud statute, constructive fraud statue and trust fund doctrine, the Tax Court found that the IRS failed to establish an independent basis under Virginia state law for holding the taxpayers liable for Davreyn’s unpaid tax.  Accordingly, Section 6901 did not apply to this case.