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Substantial Changes to Partnership Tax Audit Procedures will Severely Impact Partner Liability and Rights Before the IRS

Does your client own an interest in a partnership or an entity treated as a partnership for US tax purposes?  If so, you better take notice because the new partnership tax audit rules are making drastic changes as of January 1, 2018.  The new rules, known as “BBA,” will administer a tax deficiency at  the partnership level, unless certain elections are made.  These rules are a significant departure from the old rules, known as “TEFRA”, which administered a tax deficiency at the individual partner level.  All partnerships will need to amend their respective partnership agreements to take the BBA changes into consideration.  What should a partnership or its partners be concerned about?

Below is a non-exhaustive list of some of the major concerns of these new procedures:

Have you chosen a Partnership Representative (“PR”) under the BBA rules? If so, have you set forth the limitations and obligations of the PR?

  • Once the BBA Rules are effective, all authority over the partnership tax audit lies with the PR
  • The BBA procedures give the PR statutory authority to bind all partners with respect to all actions taken by the partnership in the BBA administrative proceeding and in any judicial proceeding
  • Since the PR is the exclusive party to act on behalf of the partnership, the PR may also, in effect, bind all partners to extensions of the statute of limitations, settlements and available elections

Does your existing partnership agreement require the partnership or the PR to provide notice to all partners of a IRS audit?

  • The BBA procedures abolish all partner-level notices of IRS actions that existed under TEFRA
  • Unlike the TEFRA rules, under BBA there is no affirmative obligation for the Internal Revenue Service, the partnership or the PR to send a notice of an IRS audit to each partner
  • Without revising the partnership agreement, a partnership audit could occur and be resolved without the partners’ knowledge

Does your existing partnership agreement contemplate who will be responsible for tax deficiencies?

  • Under the BBA procedures, unless the PR takes certain actions, tax deficiencies are assessed against the partnership in the year the controversy is resolved (known as the adjustment year) and not in the year which generated the tax deficiency (known as the reviewed year)
  • In effect, the economic burden of a tax deficiency could be borne by partners who had no interest in the partnership when the income/deduction was generated

Does your existing partnership agreement provide for opting-out of the BBA procedures?  If so, does the PR have an affirmative obligation to opt-out?

  • The BBA procedures allow smaller partnerships (with fewer than 100 partners) to elect to opt-out of the BBA rules and have the audit be administered at the partner rather than partnership level
  • Do you desire to have the audit administered at the partner level?  Are you concerned about the IRS expanding the audit to other parts of your business?
  • Are you willing to continue to be responsible for tax deficiencies for the years in which you held an interest in a partnership, even if you later sell such interest.

Does your existing partnership agreement provide for pushing-out tax deficiencies to the reviewed year partners?

  • The push-out election allows the partnership to pass on an adjustment to a former partner without providing them an opportunity to comment, contest, or even receive notice of the adjustment
  • If you exit a partnership are you willing to leave this decision up to the current PR?
  • As a former partner would you desire some control over these decision for which you are ultimately responsible?

The above items address some of the questions partnerships and partners should be thinking about before the BBA procedures go into effect on January 1, 2018.  It is recommended that all partnerships work with their tax counsel to perform a thoughtful and thorough review of their partnership agreements.  The only way to control the results of these new procedures is to be pro-active now before the rules go into effect.

Please contact Jeff Erney at jeffry.erney@dentons.com or Sunny Dhaliwal at sunny.dhaliwal@dentons.com

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IRS To Revise Guidance for In-Person Appeals Conferences

According to Andrew Keyso, Acting Deputy Director of Appeals, the IRS will be issuing new guidance “within the next few weeks” regarding when it will hold an in-person appeals conferences.

Recently, the IRS made waves when it revised the Internal Revenue Manual to limit when a taxpayer was entitled to an in-person appeals conference. The guidance gave Appeals the discretion regarding when to hold an in-person. In making the decision, Appeals was to consider a limited set of facts and circumstances, such as whether a taxpayer had special needs or whether Appeals would have to consider the credibility of a witness. A taxpayer could request one but the decision rested with the Appeals.  The guidance was meant to dramatically limit the number of in-person conferences Appeals would hold.

According to Mr. Keyso, after receiving substantial feedback from the tax community, the IRS will issue new guidance expanding the scope of when in-person meetings will be held.

This is good news for the taxpayer.

Once the new guidance is issued, we will blog about it.  Please check back for updates.

Choice of OVDP Program- Irrevocable?

Several taxpayers sued the IRS to remove them from the OVDP program and allow them entrance into the streamline program, an alternative program open to taxpayers after July 1, 2014.  The government moved to bar the suit under the Anti-Injunction Act.  The U.S. Court of Appeals for the D.C. Circuit agreed with the government, finding the OVDP / Streamline switch would “restrain” the government’s ability to collect tax if allowed.

The taxpayers raised a number of alternative arguments including that the alternative relief provisions of the OVDP (i.e., the transitional relief) violated the Administrative Procedure Act, for failure to provide proper notice and comment as well as equal treatment of similarly situated taxpayers.  It is notable that the IRS offshore voluntary disclosure programs did not receive publishing or commentary before being issued, changed and revised since their first issuance in 2009.  The argument did not persuade the Court.  The case is Maze v. IRS, D.C. Cir., No 16-05265.  Questions regarding the various IRS Offshore Voluntary Disclosure Programs can be directed to Jim Mastracchio, (james.mastracchio@dentons.com).  Mr. Mastracchio’s comments to Bloomberg BNA regarding the decision can be found in the July 17, 2017 issue of the Daily Tax Report.

Tax Court Disallows a $33 Million Charitable Donation Deduction Because Taxpayer Did Not Sufficiently Fill Out Form

Serving as a vivid reminder that it is vital that a taxpayer comply strictly and completely with the charitable deduction regulations, the Tax Court recently denied a $33 million charitable deduction in its entirety and imposed a gross valuation misstatement penalty because the taxpayer did not properly fill out Form 8283.

In Reri Holdings I, LLC v. Commissioner, 149 T.C. 1 (2017), a partnership donated an interest in a piece of property to the University of Michigan.  The donor retained an appraiser who assigned a fair market value of $33 million to the donation.  The taxpayer prepared a Form 8283 appraisal summary and included the form with its return.  The form indicated that the donor had acquired the donated interest through a purchase but did not include an amount for the donor’s “cost or other adjusted basis.”  Importantly, the Court does not state whether the taxpayer also attached the appraisal report prepared by the appraiser.

The Tax Court denied the entire deduction solely because the Form 8283 did not list the donor’s cost basis. According to the court, Congress prescribed strict substantiation requirements when claiming a charitable deduction over certain amounts in order “to alert the Commissioner to potential overvaluations of contributed property and thus deter taxpayers from claiming excessive deductions.”  A failure to comply with these requirements will result in a denial of the deduction, even if the amount of the deduction is correct.

A taxpayer can sometimes avoid this draconian result if it substantially complies with the regulations. Critically, a taxpayer does not do so if it fails to provide sufficient information to alert the IRS to a potential overvaluation.

That is precisely what the court determined happen here. By failing to list the adjusted cost basis of the property, as required by Treas. Reg. § 170A-13(c)(4)(ii)(E), the taxpayer did not comply with the regulations.  Omitting the cost basis “prevented the appraisal summary from achieving its intended purpose,” as “[t]he significant disparity between the claimed fair market value and the price [the taxpayer] paid to acquire [the property] just 17 months before it assigned [the property] to the University, had it been disclosed, would have alerted [the IRS] to a potential overvaluation of [the property].”  As such, the taxpayer did not substantially comply with the regulations and justified denying the entire deduction ab initio.

The Tax Court also imposed a 40% gross overvaluation penalty on the taxpayer. After finding the fair market value of the donation was only approximately $3 million, subjecting the taxpayer to the penalty, the court rejected the taxpayer’s reasonable cause defense.  Even though it had an appraisal, the court held that “a taxpayer must do more than simply accept the result of a qualified appraisal” and rejected, as immaterial, the taxpayer’s evidence of a second earlier appraisal that appeared to conform to the one prepared for the return.

Though not the subject of this litigation, it is important to note that there may be consequences to the appraiser, as well. With a judicial determination that the value claimed was grossly overstated, the appraiser may be subject to, among other things, a penalty pursuant to I.R.C. § 6695A.  If the IRS imposes a penalty on the appraiser, the IRS’s Office of Professional Responsibility (OPR) may also take action, see Circular 230 § 10.60, and can reprimand or even disqualify the appraiser.

If you have any questions about this post or about how to ensure that you comply with the substantiation requirements before donating property, please contact Jeff Erney at Jeffry.Erney@dentons.com or Peter Anthony at peter.anthony@dentons.com

Supreme Court Agrees to Review Sweeping Tax Obstruction of Justice Decision

In a decision that could have far reaching consequences in both the civil and criminal tax realms, on June 27th, the U.S. Supreme Court agreed to review the conviction of Carlo Marinello, who was found guilty of obstructing justice by failing to maintain proper books and records and failing to file tax returns.

The Supreme Court will likely settle a dispute that emerged among the lower courts about the proper scope of the obstruction statute under the Internal Revenue Code. The Supreme Court’s decision will have obvious consequences in the criminal tax world.  That is plain.  What is less apparent, is the power the decision could have in a civil audit.  Depending on how the Supreme Court rules, it could provide the IRS a substantial criminal hammer to wield against taxpayers who dispose of, or fail to maintain, business records, even if they have no knowledge that a criminal investigation has begun.

The Supreme Court will likely hear argument on this case in the fall and issue a decision sometime after that. We will keep you updated on the case, so be sure to check back.

Background

The below facts come from the opinion of the U.S. Court of Appeals for the Second Circuit.

In 1990, Carlos Marinello founded a freight service company that couriered packages between the United States and Canada. He kept little documentation of his income and expenses, and shredded or threw away any documentation that he may have had.  From 1992 onward, Mr. Marinello did not file personal or corporate tax returns.

In 2004, the IRS received an anonymous tip and opened a criminal investigation into Mr. Marinello and his company. That criminal investigation was closed the next year because the IRS could not determine if the unreported income was significant.  Mr. Marinello had no knowledge of that investigation.  Around that same time, he consulted with an attorney and an accountant who advised him he must file returns and maintain proper business records.  Despite that advice, Mr. Marinello did not do so.

The IRS was not done with Mr. Marinello yet. In 2009, the IRS re-opened the investigation and interviewed him. Mr. Marinello admitted to not filing returns and to shredding most of his business records.

The United States charged Mr. Marinello with nine counts of tax-related offenses. The conduct alleged in the indictment occurred prior to Mr. Marinello’s interview with the IRS in 2009.  One of the offenses charged was for obstruction of justice under 26 U.S.C. § 7212(a).  Section 7212(a) makes it a crime to “obstruct or impede . . . the due administration of this title.”  The government alleged that Mr. Marinello violated this section by, among other things, “failing to maintain corporate books and records for [his company]” and “destroying, shredding and discarding business records of [his company].” Mr. Marienllo was found guilty of the offense.

Decisions Below

Before the trial court, Mr. Marinello argued that to commit obstruction of justice under section 7212, one must have knowledge of a pending IRS investigation. The trial court rejected such an argument, holding that all that was necessary was for the jury to find that Mr. Marinello intended to obstruct the due administration of the Internal Revenue laws.  He appealed to the U.S. Court of Appeals in New York City.

Before the Appeals Court, Mr. Marinello again argued that the obstruction statute requires knowledge of a pending investigation. A panel of the Second Circuit disagreed, holding that the statute “criminalizes corrupt interference with an official effort to administer the tax code, and not merely a known IRS investigation.”  In doing so, the Second Circuit aligned itself with 3 other appeals courts.  It also reinforced a circuit split, as the Sixth Circuit in Cincinnati, Ohio had reached a different conclusion on the same question.

Mr. Marinello sought review before the full Second Circuit. While the court declined to review the decision of the panel, two judges dissented from the denial of review and warned of the consequences of the court’s decision.  Judge Jacobs wrote ominously that if this decision was allowed to remain the law of the land, “nobody is safe: the jury charge allowed individual jurors to convict on the grounds, variously, that Marinello did not keep adequate records; that, having kept them, he destroyed them; or that, having kept them and preserved them from destruction, he failed to give them to his accountant.”  The decision affords, he wrote, “oppressive opportunity for prosecutorial abuse.”

Potential Consequences

As Judge Jacobs warned, should the Supreme Court uphold the decision, a taxpayer should be weary about engaging in any of the conduct, such as disposing of business records, that landed Mr. Marinello in jail. As Judge Jacobs so succinctly put it, “How easy it is under the panel’s opinion for an overzealous or partisan prosecutor to investigate, to threaten, to force into pleading, or perhaps (with luck) to convict anybody” (emphasis in the original).  Now, more than ever, it is important that taxpayers in civil cases are represented by competent counsel aware of the potential criminal pitfalls an otherwise cautious taxpayer may find themselves in.

Contact Jeff Erney for questions about this post.  Jeffry.Erney@dentons.com

Partnership Proposed Regulations Re-Released

Today, the prior January 2017 partnership audit proposed regulations were re-released.  A pubic hearing is scheduled for September 18th with comments due by August 14th.  We will monitor the commentaries as they are filed and post them HERE.

The Other Testimony on June 8th

While it seems the world was watching the testimony of the former FBI director yesterday, another hearing was underway.  The Acting Assistant Attorney General for the Tax Division provided a report to Congress on the Tax Division’s activities and requests.  Staffing and funding requests for the next fiscal year remain about the same, $107 million and 499 direct employees.

Included in the 18-page report were examples of criminal prosecutions and investigations involving five main areas of focus: (1) abusive tax shelters; (2) offshore tax evasion; (3) employment tax enforcement; (4) stolen identity refund fraud; and (5) tax defiers.  Notably, there was a large uptick in the number of criminal employment tax enforcement investigations and prosecutions.  The report suggested continued focus in the employment tax arena.

Also noted in the report was the amount of information received through the DOJ/Swiss bank settlement program and related treaty requests for additional information.  Whistleblowers were also mentioned as a source of off-shore investigations.  The report mentioned that new criminal and civil cases were being pursued as the tremendous amount of information is still being reviewed by the government.

There was no mention of changing the current focus in the above mentioned areas nor was there any mention of the termination of the IRS Offshore Voluntary Disclosure Program or Streamline procedures, although there seems to be some rumblings that those programs may be ending in 2017.

All of this means taxpayers should take advantage of the settlement programs if tax non-comliance is an issue.  Contact Jim Mastracchio for questions about this post or IRS OVDP programs in general James.Mastracchio@dentons.com.

Partnership Audit Guidance Soon?

On January 1, 2018 the new partnership audit rules become effective.  Proposed regulations were issued in January of this year to provide broad-based guidance on the implementation and operation of the new statutory regime, but those proposed regulations were withdrawn in the same month due to the new administration’s position freezing proposed regulations and requiring agency review before re-issuance.  With a little over six months to go before the new rules become effective, a considerable amount of uncertainty associated remains and regulatory guidance is desperately needed.  At this point, gaining an understanding of the proposed/withdrawn regulations is the best course of action, as there is no current indication that the proposed rules will be altered in a material way, if issued by the end of the year.

OVDP Campaign – Declines and Withdrawals

In January, the IRS released a list of 13 audit campaigns designed to focus resources on areas of concern for the IRS examination teams.  Since that time, additional campaign areas have been added to the list of IRS priorities.  Most recently, comments regarding the Offshore Voluntary Disclosure Program campaign have clarified the focus of this particular initiative.  Taxpayers selected for review will include those taxpayers who made an application for pre-clearance into one of the OVDP programs available since 2009, but were denied entry.  Historically, a denial occurred if the taxpayer was under civil examination, criminal investigation, or the foreign account activity was already known to the IRS or DOJ Tax Division.

The second prong of the campaign focuses on those taxpayers who withdrew from participation after receiving pre clearance but before acceptance into one of the OVDP programs.  Recent clarifications revealed that an “opt out” was not part of the campaign- given the fact that opt-outs or IRS removals made once the taxpayer was accepted into the OVDP, receive almost immediate civil examinations as part of the on-going OVDP procedure.

“While we have represented taxpayers who were denied entrance into the OVDP programs over the past eight years, a renewed focus on those individuals raises the stakes for this class of taxpayer,” said Jim Mastracchio, Chair of Dentons U.S. Tax Controversy Practice.  Under the campaign audit process, taxpayers will be evaluated as (i) subsequently compliant, (ii) requiring soft-letters for immaterial noncompliance, or (iii) regular examination process.  “It is the latter group of taxpayers with the most exposure to civil and possible criminal referral,” added Mastracchio.

We will provide additional information as this particular campaign progresses.  Questions regarding the OVDP process, Streamline program, or litigation of FBAR penalties can be forwarded to James.Mastracchio@Dentons.com, (202) 496-7251.

IRS Won’t Shut Down

It appears both the House and Senate will pass H.R. 244, to appropriate funds for the IRS sometime later this week.  The IRS is slated to receive $11.2 billion in new funding through next September 30.  This  funding is at a level about equal to the last full year appropriations bill.

The IRS will need to slate sufficient funds for enforcement while balancing compliance and customer service.  The latter receiving criticism on a number of fronts over the past year.  We will comment on the appropriation specifics once released.

The Dirty Dozen – Top Concerns For 2017

With the tax filing season now open, the IRS has listed its top 12 tax scams and warned U.S. taxpayers that participation in these prohibited activities could result in civil and criminal tax exposure.

In addition to false refund claims, once again, Abusive Tax Shelters and Offshore Tax Avoidance made the list.  Below is a copy from the text of the release:

Abusive Tax Shelters: Don’t use abusive tax structures to avoid paying taxes. The IRS is committed to stopping complex tax avoidance schemes and the people who create and sell them. The vast majority of taxpayers pay their fair share, and everyone should be on the lookout for people peddling tax shelters that sound too good to be true. When in doubt, taxpayers should seek an independent opinion regarding complex products they are offered. (IR-2017-31)

Offshore Tax Avoidance: The recent string of successful enforcement actions against offshore tax cheats and the financial organizations that help them shows that it’s a bad bet to hide money and income offshore. Taxpayers are best served by coming in voluntarily and getting caught up on their tax-filing responsibilities. The IRS offers the Offshore Voluntary Disclosure Program to enable people to catch up on their filing and tax obligations. (IR-2017-35)

The IRS Offshore Voluntary Disclosure programs offer a range of filing options, with many taxpayers qualifying for low or no penalties when coming into compliance.  If you have questions about the IRS programs and U.S. filing obligations, please contact, Jim Mastracchio (202-496-7251) or james.mastracchio@dentons.com.

The Destination Based Cash Flow Tax – Is it a VAT?

As tax reform proposals are considered over the next few months, the concept of a destination based cash flow tax remains in the GOP proposal.  This type of corporate tax acts like a VAT, but with some allowable deductions, such as payroll.  And the boarder adjustment is a driving feature of the proposal.

The boarder adjustment feature would exempt from tax sales of goods exported outside of the U.S.  However, the cost of goods purchased by a U.S. company from foreign sources would not be deductible against the the corporate tax.  So, the tax would be imposed on goods produced and sold in the U.S.

The proposal also allows for full deductions of capital investments with no depreciation required (but does not allow interest payments to be deducted).  This is similar to most VAT systems and is touted as a provision that will spur investment.

A reconciliation between the current administration’s tax plan and the GOP plan is underway, and we won’t have wait too much longer to see if the corporate rate drops to 15% or 20% and whether we the destination based cash flow tax survives.

Tax Regulations on Hold-The New Regulatory Freeze

According to a memorandum issued to all agency heads, no federal agency may send regulations to the Federal Register for publishing until advised by the appropriate OMB personnel or designee.   For those regulations that have already been submitted to the Federal Register the agency heads must seek to withdraw them.  Any regulation that has been published in the Federal Register, but aren’t yet effective, those regulations will be postponed a minimum of 60 days with the ability of the agency heads to request a longer suspension.

The only exception are regulations needed for “urgent circumstances relating to health, safety, financial, or national security matters, or otherwise.”  The memorandum explains that the department heads and newly appointed personnel need time to review the regulations and the memorandum is particularly clear that those regulations addressing “questions of fact, law, or policy” could be subject to “further notice-and-comment rule making,” thus further delaying implementation.

There is no carve out in the memorandum for regulations addressing tax matters.  Which tax regulations will become promulgated is not known.  We will keep you posted on any new developments.

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 Records Exception – 2nd Circuit Remands

Yesterday, the Second Circuit remanded a case involving foreign bank records for further development.  In U.S. v. Natalio Fridman, the taxpayer asserted his act of production privilege over certain foreign bank records demanded by an IRS summons.  The District Court held that such records must be produced based on the foregone conclusion doctrine, the collective entity doctrine, and/or the required records exceptions to the Fifth Amendment’s protection.  The Second Circuit found that the record was insufficient to allow meaningful Appellate review of these rulings, and remanded this portion of the case for further development.

This case is important in that it will again examine whether a taxpayer is compelled to produce foreign bank records that may be incriminating under the required records exception.  If the summons is ultimately upheld for those records falling within the 5-year record retention requirement of the required records exception, any remaining records falling outside of that timeframe may need to be analyzed under the forgone conclusion and collective entity doctrines, which were raised by the government.  If the case proceeds in this manner, it will be interesting to see how those doctrines will be applied to foreign bank records involving a trust structure, in yet another foreign bank record production case.

 

2017 US Tax Filing News

As we head into a new year, some tax reporting news to keep in mind.  The first day that you can file your 2016 US individual income tax return by paper or by electronic submission is January 23, 2017.  The regular filing season ends April 18, 2017, as April 15 falls on a Saturday and Monday, April 17 is Emancipation Day observed in Washington, DC.

While we expect tax law changes to be announced in 2017, here are some current standard dollar limits:   Start of the Top Tax Bracket for joint filers (39.6%)  –  $466,950 (2016); $470,700 (2017); Gift Tax Annual Exclusion  $14,000 (2016 and 2017); Personal Exemptions $4,050 (2016 and 2017).

And don’t forget, those with foreign accounts or signatory authority over non-US accounts must file the FBAR (FinCEN Form 114) on the due date of the US Income tax return.  If you seek an extension for your income tax return you can seek an extension to file the FBAR.  Other rules apply to U.S. persons residing outside of the United States.  We will keep you posted on these and other new tax developments as they arise in what will be a busy tax news year.

 

 

 

Data Protection and the Swiss – DOJ Settlement Program

The program for non-prosecution agreements for Swiss Banks is largely settled. However, in a ruling by the Swiss Courts a few weeks ago, a bank in the Canton of Ticino was prohibited from releasing the names of two Swiss attorneys who acted as proxies for American customer accounts. Further, the name of a law firm who assisted U.S. persons was also withheld.

The participating bank was in the process of complying with the Settlement Program and it intended to release the names of the lawyers and law firm as part of the disclosure process, but a suit followed to block the release of the information.  Ultimately, the Swiss court held that the names should be protected from disclosure under its laws. The Court also found that the U.S. lacks similar legislation to provide adequate data protection.

Last week, U.S. authorities have indicated that by mid-November an expanded list of banks and facilitators would be published. That list mandates a 50% penalty, as opposed to a 27.5% penalty, for U.S. persons entering the Offshore Voluntary Disclosure Program.   For those U.S. persons who have not yet come into compliance with their U.S. tax obligations, time is growing short. Please contact Jim Mastracchio with any questions regarding the IRS disclosure programs (james.mastracchio@dentons.com).

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.

Next Up: Singapore? Summonses Could Hit More Global Financial Institutions

A recent summons showdown with UBS shows that DOJ and the IRS are far from done with offshore enforcement efforts, and are expanding those efforts beyond Europe Among the most likely of new targets is Singapore, and since there is no Tax Information Exchange Agreement (TIEA) or other tax treaty between the United States and Singapore, foreign financial institutions could see IRS summonses being served on their U.S. branches.

Such summonses often are referred to as Bank of Nova Scotia summons. In the recent case involving UBS, the IRS served a third-party summons on a branch of UBS AG in the United States seeking records for an account at UBS in Singapore held by a U.S. citizen living in Hong Kong UBS refused to turn over the records on grounds that Singapore’s bank secrecy laws prohibited disclosure without permission from the accountholder. The IRS sought to enforce the summons in federal court – and the case was teed up for litigation – until the accountholder consented to release of the records and UBS complied with the summons. The IRS thereafter withdrew the enforcement action.

We cannot know whether UBS or the government ultimately would have won the day in court. Many factors are taken into consideration in such enforcement actions, and past cases have had varied results. What we do know is that the government maintains the summons served on UBS was enforceable, and was willing to go the distance. With Singapore – and potentially other jurisdictions without TIEA’s or tax treaties – on the enforcement horizon, more global financial institutions are likely to see IRS summonses coming their way.

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.

LB&I Introduces New Examination Process Designed to Provide Transparency and Collaboration

The Internal Revenue Service (“IRS”) Large and International Business (LB&I) has announced it will be implementing changes to its examination process, effective May 1, 2016.  LB&I’s new procedures are designed to provide an organizational approach for conducting professional examinations from the first contact with the taxpayer through the final stages of issue resolution.  By adopting these procedures, the IRS hopes to add efficiency to the examination process and permits the taxpayer and the examination team to work together in “the spirit of cooperation, responsiveness, and transparency.” Under the new procedures, the examination will be divided into three phases: planning, execution, and resolution, each of which focus on achieving certain specified goals.

The planning phase is focused upon identifying specific issues in the taxpayer’s case.  Once issues are identified, the exam team will explain to the taxpayer why each issue is being considered.  Thereafter, an issue team, comprising LB&I employees most familiar with the particular issue, will work with the taxpayer to establish the relevant facts.  Although a case manager will have overall responsibility for the case, each issue will have a designated manager who oversees the planning, execution and resolution of the issue.

During the execution phase, the issue teams will fully develop their particular issue, including determining the facts, applying the law to those facts, and understanding the various tax implications of the issue.  This process will include interactive discussions with the taxpayer followed by the issuance of Information Document Requests (IDRs) to develop the facts.  The new procedures note that a meaningful discussion with the taxpayer prior to issuing an IDR will result in a more effective process.  After gathering relevant facts, the issue team will document the agreed facts and obtain acknowledgement from the taxpayer with respect to the unagreed facts.

Finally, in the resolution phase, LB&I encourages its employees to use all available tools to resolve issues.  As facts have been fully developed and documented in the execution phase, the taxpayer and the issue team will be able to work more productively in the resolution stage.  Although there are numerous strategies to work towards resolution, LB&I requires its employees to consider Fast Track Settlement for all unagreed issues.  Fast Track consists of a mediation where the taxpayer, the issue team and Appeals must agree to participate and agree to a mutual resolution.   The goal of the resolution phase is tax certainty for both the taxpayer and LB&I.  Thus, at the conclusion of the resolution phase, taxpayers and LB&I may be asked to perform a joint critique of the exam process and recommend improvements.

LB&I emphasizes the significance of bringing all information to light as soon as possible to avoid issues relating to the expiration of the statute of limitations, or the possibility of new information coming to light during the Appeals process, which would return the case to Examination.  This policy is reflected in LB&I’s request that taxpayer’s bring any potential refund claim to the exam team’s attention as soon as possible.  LB&I specifically indicated it would only accept informal claims that are provided to the exam team within 30 calendar days of the opening conference.  If such claims are brought within that time period, they can be developed and processed by exam, providing higher possibilities for tax certainty for both the taxpayer & LB&I.  Refund claims submitted within this time period must meet the standards of Treas. Reg. § 301.6402-2, which provides that a valid claim must set forth in detail each ground upon which credit or refund is claimed, present facts sufficient to apprise the IRS of the exact basis for the claim, and contain a written declaration that it is made under penalties of perjury.   However, in the interest of incentivizing taxpayer’s to bring refund claims forward in a timely manner, LB&I has indicated it will discuss deficiencies not meeting the Treasury Regulations and provide the taxpayer an opportunity to correct the deficiencies.  If refund claims are not brought within the specified 30 days, they must be filed using the applicable amended tax return or Form 843, Claim for Refund and Request for Abatement.

The reorganization of the LB&I examination process reflects the IRS’s desire to achieve fair and final resolutions during the Examination Process that is achieved with an issue specific approach, involving issue teams that are well versed on the facts to fully develop the facts relevant to each issue.  Notably, Publication 5125 mentions the significance of meaningful discussions with the taxpayer on numerous occasions, including conversations to ensure the taxpayer fully understands the issues are identified, conversations prior to issuing IDRs, and acknowledgements of agreed and unagreed issues.  Upon its implementation, the IRS hopes the new examination process will allow LB&I to work transparently in a collaborative manner with the taxpayer to understand their business and share the issues that have been identified for examination.  This, in turn, should lead to LB&I’s ultimate goal of increasing the final resolutions reached during the exam process.

Please contact Jeffry Erney (jeffry.erney@dentons.com) or Sunny Dhaliwal (sunny.dhaliwal@dentons.com).