In the recent decision Davis v. United States, No. 13-16458 (9th Cir. 1/25/2016), the Ninth Circuit reversed a district court decision that had invalidated certain IRS assessments against Al Davis and his wife, relating to a TEFRA partnership proceeding involving the Oakland Raiders, a California limited partnership of which Al Davis had the largest interest.

The Davises had brought a refund suit for the amounts paid pursuant to the partner-level assessments the IRS made stemming from the terms of a settlement reached between the IRS and the partnership in the TEFRA case, which was documented in a closing agreement and a corresponding decision entered by the Tax Court. The closing agreement, which was signed by Al Davis as president of the Tax Matters Partner, contained a provision that provided that prior to assessing any amounts against the partners of the partnership pursuant to the settlement, the IRS must provide each partner of the partnership 90 days to review its proposed computational adjustments that implement the terms of the settlement, and 60 days to review any revised computational adjustments.  However, because the statute of limitations for assessment was about to expire, the IRS ultimately made an assessment against the partners without giving the partners the required 60-day period to review its revised computations, in breach of the terms of the settlement agreement.

The Davises brought the refund suit on the grounds that the assessments were invalid, making two arguments in support: (1) the assessments were invalid because they were not made in accordance with the terms of the closing agreement; and (2) the assessments were made after the statute of limitations had run. The district court granted summary judgment in the Davises’ favor, finding that the IRS’ breach of the closing agreement caused the assessments to be invalid.  On appeal, the Ninth Circuit reversed, holding that the district court erred in invalidating the assessments.

Closing Agreements. Section 7121 of the Internal Revenue Code allows the IRS to enter into closing agreements with taxpayers, which are final and conclusive agreements relating to the tax liability of a taxpayer, binding both the IRS and the taxpayer to the terms of the agreement.  Section 7121(b) provides that when a closing agreement is properly entered into, (1) the matters agreed upon cannot be later reopened or modified by the Government, and (2) any determination, assessment, payment, refund, etc. made in accordance with the closing agreement cannot be modified or set aside.

In Davis, the Ninth Circuit explained that closing agreements are contracts governed by federal common law that for “most purposes…are just like other contracts.” [i]   The Ninth Circuit cites two cases that involved the interpretation of terms in a closing agreement, which held that contract law principles should be applied in resolving the dispute.[ii]

Other cases, though, have acknowledged differences between closing agreements and contracts governed by state law, with one difference being that closing agreements do not require any consideration to be binding on both parties. In Perry v. Page, 67 F.2d 635 (1st Cir. 1933), the First Circuit held that consideration is not a requirement for a valid closing agreement unlike under contract law, explaining: “If entered into between the taxpayer and the Commissioner voluntarily, and approved by the Secretary of the Treasury or Undersecretary, [a closing agreement’s] effect is regulated by statute and takes on legal consequences by virtue of the statute, and not under the law of contracts….”[iii]

Remedy for Breach of a Closing Agreement. The Ninth Circuit was presented in Davis with the question of whether the remedy for the IRS’ admitted breach of the closing agreement should be the invalidation of the assessments that were made notwithstanding the fact that the IRS had not complied with its agreement to provide the taxpayers with a second opportunity to review the computations prior to assessment.

Section 7121 does not directly address what happens when an assessment is made contrary to the terms of the closing agreement. In Davis, the Ninth Circuit held that the taxpayers would be limited to the contractual remedy of damages for the IRS’ breach, reasoning that “damages are always the default remedy for breach of contract.”[iv]

The taxpayers cited in support of their position a Third Circuit case, Philadelphia & Reading Corp. v. United States, 944 F.2d 1063 (3d Cir. 1991), which held certain assessments to be invalid where they were made prematurely under the terms of a settlement agreement.  The settlement in that case provided that the taxpayers would waive their statutory right to a notice of deficiency, conditioned on the IRS delaying the assessments until after the IRS had approved a schedule of offsetting overpayments.  The Ninth  Circuit distinguished Philadelphia & Reading Corp. on the basis that the reason the assessments were invalid in that case was because the statutory notice of deficiency requirement had not been complied with as a result of the breached settlement agreement, whereas in Davis, the Ninth Circuit held that the IRS had complied with all statutory requirements to be able to make the assessments.[v]

The court’s holding turned on its conclusion that the IRS “violated no law in making the assessments.”[vi]  The Ninth Circuit explained that “the problem with Davis’s argument is that his obligation to pay taxes validly and accurately assessed comes from the Internal Revenue Code, not the Closing Agreement, which only specified the treatment of certain Partnership income as inputs to the calculation of his taxes.”[vii]  Because this was a TEFRA case, the taxpayers were not parties to the Closing Agreement—the closing agreement was between the IRS and the partnership and was signed by the attorney for the partnership’s Tax Matters Partner.  The Ninth Circuit further explained: “The IRS’s failure to perform its contract with the Partnership cannot relieve Davis of his statutory obligation to pay taxes; nothing in the Closing Agreement provided that any taxes assessed on the partners pursuant to statute would be rendered invalid if the government failed to perform.”[viii]

Rejecting the notion that a small breach should entitle the taxpayer to total relief from his “pre-existing obligation to pay taxes,”[ix] the Ninth Circuit suggested that the Davises’ remedy would be to file a refund claim to dispute the assessments if they believed the computations to be incorrect, and to seek damages for the additional costs involved in correcting the amount of the assessments.[x]

Statute of Limitations in TEFRA Cases. The taxpayers alternatively argued that regardless of the IRS’ breach of the closing agreement, the assessments were invalid because they were made after the statute of limitations had run.

While the TEFRA provisions provide that partnership tax disputes are to be resolved at the partnership level, the IRS may enter into settlement agreements with individual partners, which causes the individual’s partnership items to convert to nonpartnership items and the partner is dismissed from the partnership-level proceeding.[xi]  Generally, the statute of limitations for assessing the flow-through adjustments in a TEFRA case at the partner level is one year from when the Tax Court decision becomes final.[xii]  However, if the IRS enters into a settlement agreement with an individual partner, because the partner is then no longer a party to the TEFRA proceeding, the one-year statute of limitations begins to run from the date the settlement agreement is made final, instead of running from the date the Tax Court decision becomes final.

Davis argued that the closing agreement was “a settlement agreement with the partner,” causing the statute of limitations to begin running from the date the closing agreement was finalized and approved by the court instead of from when the Tax Court decision became final, which would cause the assessments to be untimely. The Ninth Circuit rejected this argument, holding that although individual partners are parties to and bound by the Tax Court TEFRA proceeding, it was the partnership, not Davis, who entered into the settlement agreement with the IRS and, therefore, the one-year statute of limitations ran from the date the Tax Court decision became final.

LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is a senior tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue domestic civil tax examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise, and in defending criminal tax fraud investigations and prosecutions. She has considerable expertise in handling matters arising from the U.S. government’s ongoing civil and criminal tax enforcement efforts, including various methods of participating in a timely voluntary disclosure to minimize potential exposure to civil tax penalties and avoiding a criminal tax prosecution referral. Additional information is available at http://www.taxlitigator.com.

 

[i] Davis v. United States,  No. 13-16458 at *8 (9th Cir. 1/25/2016) (9th Cir. 1/25/2016) (citing States S.S. Co. v. Comm’r, 683 F.2d 1282, 1284 (9th Cir. 1982) and United States v. Nat’l Steel Corp., 75 F.3d 1146, 1150 (7th Cir. 1996)).

[ii] States S.S. Co. v. Comm’r, 683 F.2d 1282, 1284 (9th Cir. 1982); United States v. Nat’l Steel Corp., 75 F.3d 1146, 1150 (7th Cir. 1996)).

[iii] Perry v. Page, 67 F.2d 635, 636 (1st Cir. 1933).

[iv] Id. (citing the Supreme Court case United States v. Winstar Corp., 518 U.S. 839, 885 (1996) (plurality opinion), which cited the Restatement (Second) of Contracts § 346, cmt. a (Am. Law. Inst. 1981)).

[v] Id. at *9-*10.

[vi] Id.

[vii] Id.

[viii] Id.

[ix] Id. at *9.

[x] Id. at *10-*11.

[xi] IRC § 6231(b)(1).

[xii] IRC § 6229(d).

The Streamlined Filing Compliance Procedures represent an IRS effort to find a viable method of encouraging U.S. taxpayers to come into compliance with their reporting and filing requirements associated with varying interests in foreign financial accounts and assets.[i] The Streamlined Procedures require the filing of original or amended tax returns and FBARs as well as a Certification of Non-Willful conduct on IRS Form 14653.[ii]

For eligible U.S. taxpayers residing outside the United States, all penalties are waived under the streamlined procedures. For eligible U.S. taxpayers residing in the United States, the only penalty under the streamlined procedures will be a miscellaneous offshore penalty equal to 5 percent of the foreign financial assets that gave rise to the tax compliance issue (all income tax related penalties associated with the non-U.S. source income will be waived). All relevant facts and circumstances must be carefully analyzed before making a determination regarding the submission of a “non-willful” certification requesting participation in the Streamlined Procedures.

Douglas H. Shulman, Commissioner of Internal Revenue, Washington, D.C. , October 26, 2009 “If you are a US individual holding overseas assets, you must report and pay your taxes or we will be increasingly focused on finding you.”

DoJ Letter Re Investigation of Undeclared Foreign Financial Accounts. A few years back, various taxpayers received an unexpected warning letter from the Tax Division of the U.S. Department of Justice stating “The Department of Justice is conducting an investigation of U.S. taxpayers who may have violated federal criminal laws by failing to report they had a financial interest in, or signature authority over, a financial account located in a foreign country. We have reason to believe that you had an interest in a financial account in India that was not reported to the IRS on either a tax return or FBAR, Department of Treasury Form TD F 90-22.1, report of Foreign Bank and Financial Account. You are advised that the destruction or alteration of any document that may relate to this investigation constitutes a serious violation of federal law, including but not limited to obstruction of justice . . . You are further advised that you are a subject of a criminal investigation being conducted by the Tax Division [of the Department of Justice].”

Current Options for U.S. Taxpayers with Undisclosed Foreign Financial Assets

■ 2014+ Offshore Voluntary Disclosure Program (OVDP) [iii]

■ Streamlined Filing Compliance Procedures[iv]

■ Delinquent FBAR Submission Procedures[v]

■ Delinquent International Information Return Submission Procedures[vi]

Revisions to IRS Form 14653 – Certification by U.S. Person Residing Outside of the United States for Streamlined Foreign Offshore Procedures. Form 14653 was revised in January 2016. The previous Form 14653 was issued in January 2015 and contained the following note (in red): “Note: You must provide specific facts on this form or on a signed attachment explaining your failure to report all income, pay all tax, and submit all required information returns, including FBARs. Any submission that does not contain a narrative statement of facts will be considered incomplete and will not qualify for the streamlined penalty relief.” Form 14653 (Rev. 1-2016) retains the foregoing language but is no longer highlighted in red.

Form 14653 (Rev. 1-2016) now includes the following revisions:

(1). There is now a detailed request for information regarding presence outside the U.S. during the Streamlined Procedures submission period: “Note: Both spouses filing a joint certification must meet the non-residency requirements. Complete one of the following (two) sections regarding your residency status:

(a).       “If you are a U.S. citizen or lawful permanent resident (i.e., “green card holder”), complete this section: For the covered tax period, indicate whether you were physically outside the United States for each  year. You must have been physically outside the U.S. for at least 330 full days in any one or more of the most recent three years for which the U.S. tax return due date (or properly applied for extended due date) has passed, and you must not have had a U.S. abode. For more information on the meaning of “abode” see IRS Publication 54.I was physically outside the United States for at least 330 full days (answer Yes or No for each year) [with a chart containing “Yes/No” blocks to be completed for each of the 3-year Streamlined Procedures submission period]. Both spouses filing a joint certification must meet the non-residency requirement. If the number of days physically outside of the U.S. differs for each spouse, disclose that on the chart above or in an attachment to this certification.

(b).       If you are not a U.S. citizen or lawful permanent resident, complete this section: If you are not a U.S. citizen or a lawful permanent resident, please attach to this certification your computation showing that you did not meet the substantial presence test under I.R.C. sec. 7701(b)(3). Your computation must disclose the number of days you were present in the U.S. for the three years included in your Streamlined Foreign Offshore Procedures submission and the previous two years. If you do not attach a complete computation showing that you did not meet the substantial presence test, your submission will be considered incomplete and your submission will not qualify for the Streamlined Foreign Offshore Procedures.

(2).       Form 14653 (Rev. 1-2015) stated: “Provide specific reasons for your failure to report all income, pay all tax, and submit all required information returns, including FBARs. If you relied on a professional advisor, provide the name, address, and telephone number of the advisor and a summary of the advice. If married taxpayers submitting a joint certification have different reasons, provide the individual reasons for each spouse separately in the statement of facts. The field below will automatically expand to accommodate your statement of facts.” 

Form 14653 (Rev. 1-2016) now includes an expanded request for a factual explanation (similar to the recently issued FAQs[vii]), in bold: “Provide specific reasons for your failure to report all income, pay all tax, and submit all required information returns, including FBARs. Include the whole story including favorable and unfavorable facts. Specific reasons, whether favorable or unfavorable to you, should include your personal background, financial background, and anything else you believe is relevant to your failure to report all income, pay all tax, and submit all required information returns, including FBARs. Additionally, explain the source of funds in all of your foreign financial accounts/assets. For example, explain whether you inherited the account/asset, whether you opened it while residing in a foreign country, or whether you had a business reason to open or use it. And explain your contacts with the account/asset including withdrawals, deposits, and investment/ management decisions. Provide a complete story about your foreign financial account/asset. If you relied on a professional advisor, provide the name, address, and telephone number of the advisor and a summary of the advice. If married taxpayers submitting a joint certification have different reasons, provide the individual reasons for each spouse separately in the statement of facts. The field below will automatically expand to accommodate your statement of facts. Both spouses filing a joint certification must meet the non-residency requirement. If the number of days inside the U.S. differs for each spouse, disclose that on the chart above or in an attachment to this certification.

(3).       An additional signature line has been added for “For Paid Preparer Use Only (the signature of taxpayer(s) or fiduciary is required even if this form is signed by a paid preparer)” as well as an authorization for the IRS “allow another person to discuss this form with the IRS.”

Am I “Non-Willful”? Taxpayers pursuing resolution of a foreign account issue within the Streamlined Procedures are required to certify under penalties of perjury that their conduct was “non-willful.” For purposes of the streamlined procedures, non-willful conduct is defined as “conduct that is due to negligence, inadvertence, or mistake or conduct that is the result of a good faith misunderstanding of the requirements of the law.”[viii] The relatively more culpable standards of “willfulness” or “willful blindness” are not referenced in the Streamlined Procedures.

The streamlined certification process poses unique challenges to taxpayers and their representatives. The required certification Form 14653 (Rev. 1-2016) requires that the taxpayer “provide specific reasons” for the prior non-compliance can be troubling for those who simply did not know and/or were not advised of the requisite filing and reporting requirements. Beyond “I didn’t know,” it has often been difficult to get more specific.

The IRS is to be commended for now providing guidance within Form 14653 (Rev. 1-2016) suggesting that the taxpayer provide information “whether favorable or unfavorable to you, should include your personal background, financial background, and anything else you believe is relevant to your failure to report all income, pay all tax, and submit all required information re returns, including FBARs. Additionally, explain the source of funds in all of your foreign financial accounts/assets. For example, explain whether you inherited the account/asset, whether you opened it while residing in a foreign country, or whether you had a business reason to open or use it. And explain your contacts with the account/asset including withdrawals, deposits, and investment/ management decisions. Provide a complete story about your foreign financial account/asset.”

While experienced tax professionals may be familiar with case law and secondary source materials as to what factors bear relevance in these matters, the foregoing IRS guidance is intended to assist, to the extent possible, those taxpayers who choose to complete the forms without access to professionals. Moreover, expressly indicating that both “favorable or unfavorable” factors should be provided within Form 14653 (Rev. 1-2016) will remind potential participants that few, if any, streamlined cases involve only beneficial facts, and that individuals with a mixed bag of facts remain appropriate candidates for the expanded Streamlined Procedures.

Caution Required. Returns submitted under the Streamlined Procedures may be subject to IRS examination resulting in additional tax and penalties with respect to any audit related adjustments. Also, the Streamlined Procedures do not provide protection from a possible criminal prosecution referral to the U.S. Department of Justice. However, if a taxpayer satisfies the “non-willful” requirement for participation in the Streamlined Procedures, they should not be a candidate for a criminal prosecution in any event.

Further, the IRS Voluntary Disclosure Practice set forth in IRS Internal Revenue Manual (IRM) 9.5.11.9 would seem to provide a pass from a criminal referral if the appropriate “bells and whistles” set forth in IRM 9.5.11.9 are followed (a “truthful, timely, complete” disclosure, “willingness to cooperate”, “taxpayer makes good faith arrangements with the IRS to pay in full, the tax, interest, and any penalties determined by the IRS to be applicable,” etc.). If the taxpayer’s conduct is somehow deemed “willful,” they would not be a viable candidate for the Streamlined Procedures and should consider coming into compliance through the current IRS Offshore Voluntary Disclosure Program (OVDP).

The Streamlined Procedures do not limit the civil penalties otherwise associated with the reporting of U.S. (domestic) source income. IRS OVDP Frequently Asked Question 7.1 provides “The offshore penalty structure only resolves liabilities and penalties related to offshore noncompliance. Domestic portions of a voluntary disclosure are subject to examination.” The original OVDP was created in 2009 around the theory that those who failed to report any interest in a foreign financial account did so with the intent to evade a U.S. tax obligation. This theory obviously ignored the realities of life for most residing outside the U. S. as well as for many recent immigrants.

What to Anticipate from the IRS Regarding the “Non-Willful” Certification? The IRS has indicated it will review each certification of non-willful status seeking participation in the Streamlined Procedures. The source of funds held in the foreign account may be an important factor. If the source of funds in the account was from unreported income, the situation can become somewhat problematic. However, having inherited funds in a foreign financial account, without more, might not be considered deserving of non-willful status by the IRS. The IRS has expressed an intention to treat taxpayers consistently and numerous individuals having inherited funds in an undeclared foreign account have been subjected to the stated OVDP penalty.

Deposits and withdrawals to the foreign account can reveal intentions and knowledge of various individuals involved. In reviewing the “non-willful” certification, the government can be expected to inquire about the manner in which deposits and/or withdrawals were made to/from the foreign account(s); the mechanics of how deposits/withdrawals were made; the form in which deposits/withdrawals occurred (i.e. cash, check, wire, travelers’ check, etc.); amounts of each withdrawal/deposit; when such deposits/withdrawals occurred; where such deposits/withdrawals occurred; whether there were there limitations on the amounts that could be deposited/withdrawn; and documents received when a deposit/withdrawal occurred (i.e. receipt, credit memo, debit memo, etc.)?

Additional considerations regarding someone being “non-willful” often include whether the existence of the account was disclosed to the return preparer or others; whether the account was at some point moved to another foreign financial institution; whether the taxpayer’s advisors had some degree of knowledge about the account; the perceived degree of financial and business sophistication and education of the taxpayer; whether foreign entities were involved as accountholders; documents provided to open the account [i.e. U.S. or foreign passport(s), identification card, etc. – note that it might not be a good fact for a taxpayer having dual passports to open an account with their non-U.S. passport]; communications, if any, with others that occurred regarding bank secrecy, taxation, and/or disclosure of any foreign accounts; failure to seek independent legal advice about how to properly handle the foreign bank account and instructions or advice received regarding holding or receiving mail from the bank, etc. Further questions often lay within the responses to each of the foregoing questions.

Lastly, in reviewing the non-willful certification under the Streamlined Procedures, resident taxpayers should anticipate the government inquiring as to whether the foreign accounts remain open and if not, where the funds were transferred when the account(s) were closed. Some resident taxpayers closed accounts and transferred the funds directly to a domestic account. Others closed accounts and transferred the funds through various means to other foreign accounts. Further questions often lay within the responses to each of the foregoing questions. An interview by an IRS agent (in person or by phone) should be anticipated and is more likely with respect to resident taxpayers.

How Does the Preparer Impact the Determination? The IRM defines the test “willfulness” in the FBAR context as a determination of whether there was “a voluntary, intentional violation of a known legal duty.”[ix] The burden of establishing willfulness is on the IRS and may be demonstrated by the person’s knowledge of the reporting requirements and the person’s conscious choice not to comply with the requirements.[x] In the FBAR situation, the only thing that a person need know is that he has a reporting requirement.[xi] If a person has that knowledge, the only intent needed to constitute a willful violation of the requirement may a conscious choice not to file the FBAR.[xii]

Should the taxpayer have inquired of their return preparer about the need to report an interest in a foreign financial account? Should the preparer have gone beyond providing a tax organizer that recites the Schedule B reference relating to an interest in a foreign financial account and perhaps explained what types of foreign interests are reportable?[xiii] Will a return preparer actually step up and confirm they knew of the existence of a reportable interest in a foreign financial account and to some degree advised the taxpayer the FBAR was not required? Will the IRS punish the preparer who steps up and gave the wrong advice . . . or no advice when faced with an objective duty to inquire about the possible existence of a foreign financial account?

Was the definition of “non-willful” conduct set forth in the Streamlined Procedures intended to be significantly more user friendly than the historic definitions of “willfulness” and “willful blindness” in the FBAR context? Can taxpayers rely upon the Streamlined Procedures if their return preparer declines to confirm a lack of inquiry about the existence of an interest in a foreign financial account? Can taxpayers rely upon the Streamlined Procedures if they simply failed to advise their return preparer of the existence of an interest in a foreign financial account? The IRS Internal Revenue Manual affirmatively concludes that “The mere fact that a person checked the wrong box, or no box, on a Schedule B is not sufficient, by itself, to establish that the FBAR violation was attributable to willful blindness.”[xiv] Does a common sense definition of “non-willful” conduct apply . . . or not? Feel lucky?

Civil vs. Criminal Resolution? If there are material, possibly intentional, misstatements set forth in the non-willful certification, the taxpayer might anticipate exposure to the extensive criminal enforcement powers of the U.S. government. The certification Form 14653 (Rev. 1-2016) required to be signed by the taxpayer under the Streamlined Procedures provides “I recognize that if the Internal Revenue Service receives of discovers evidence of willfulness, fraud, or criminal conduct, it may open an examination or investigation that could lead to civil fraud penalties, FBAR penalties, information return penalties, or even referral to [IRS] Criminal Investigation.” If there are any uncertainties or potentially difficult factual scenarios involved, consult with experienced counsel.

The government may already have or might subsequently receive information that does not support non-willful conduct asserted in a completed Form 14653 (Rev. 1-2016). All relevant facts and circumstances must be carefully analyzed before making a determination regarding the submission of a “non-willful” certification requesting participation in the streamlined procedures.

What to do? Taxpayers not currently participating in an OVDP who meet the eligibility requirements for the Streamlined Procedures should consider requesting streamlined treatment if they are comfortable and have sufficient factual basis to certify their “non-willful” status.

Non-resident taxpayers might be better positioned to achieve their goal of a non-willful, no penalty resolution under the streamlined procedures. Their “foreign” account is actually in their own neighborhood; it is only “foreign” in the sense that it is located outside the territorial boundaries of the United States. The existence of the account does not, by itself, somehow represent an acknowledgment of tax non-compliance by the non-resident taxpayer. The Streamlined Procedures seem to represent a significant attempt by the government to acknowledge that at some point, non-resident taxpayers become residents of their home state, emotionally even if perhaps not technically.

Those directly involved in creating and maintaining the foreign account and assets are the only ones capable of determining whether determining non-willful status. If such status is not supported by sufficient objective facts, consider other methods of coming into compliance, including the OVDP.

Taxpayers (and their return preparers) will sleep better if they get it right, somehow get into compliance and move on in life . . .

 

[i] IRS Makes Changes to Offshore Programs; Revisions Ease Burden and Help More Taxpayers Come into Compliance, IR-2014-73, June 18, 2014

[ii] Forms FinCEN Form 114- Report of Foreign Bank and Financial Accounts (formerly Forms-TD F 90.22.1–Report of Foreign Bank and Financial Accounts)

[iii] https://www.irs.gov/uac/2012-Offshore-Voluntary-Disclosure-Program

[iv] https://www.irs.gov/Individuals/International-Taxpayers/Streamlined-Filing-Compliance-Procedures

[v] https://www.irs.gov/Individuals/International-Taxpayers/Delinquent-FBAR-Submission-Procedures

[vi] https://www.irs.gov/Individuals/International-Taxpayers/Delinquent-International-Information-Return-Submission-Procedures

[vii] https://www.irs.gov/Individuals/International-Taxpayers/Streamlined-Filing-Compliance-Procedures-for-U-S–Taxpayers-Residing-Outside-the-United-States-Frequently-Asked-Questions-and-Answers

[viii] Id.

[ix] FBAR Willfulness Penalty – Willfulness IRM4.26.16.4.5.3  (07-01-2008)

[x] Id.

[xi] Id.

[xii] Id.

[xiii] For 2013, Schedule B, Line 7a states “At any time during 2013, did you have a financial interest in or signature authority over a financial account (such as a bank account, securities account, or brokerage account) located in a foreign country? See instructions. . . . If ‘Yes,’ are you required to file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), formerly TD F 90-22.1, to report that financial interest or signature authority? See FinCEN Form 114 and its instructions for filing requirements and exceptions to those requirements.”  Further, Schedule B, Line 7b states “If you are required to file FinCEN Form 114, enter the name of the foreign country where the financial account is located.”

[xiv] FBAR Willfulness Penalty – Willfulness IRM4.26.16.4.5.3  (07-01-2008)

Justice Oliver Wendell Holmes once wrote, “Men must turn square corners when they deal with the Government.” When you deal with the IRS, deviation from the requirements of the Internal Revenue Code and regulations can be costly, as a bank learned the hard way in Commerce Bank & Trust Co. v. United States, 2016 TNT 21-27 (W.D. Ky. 1/29/2016).  Under Treasury Regulations, a taxpayer who pays more than $200,000 in tax is required to make deposits using the Electronic Federal Tax Payment System (EFTPS).  Commerce Bank routinely paid more than $200,000 in income withholding tax annually.  Following the departure of a bank officer, between 2004 and 2010 the Bank made deposits using paper deposit coupons, rather than electronically.  The IRS assessed failure to deposit penalties against the bank totaling $252,842.87 under Internal Revenue Code Sec. 6656.  That section requires parties to make deposits of tax “as required by this title or regulations.”  The Bank paid the total amount assessed plus interest for all periods (except 2009) and filed a refund claim.  After the claim was denied, the Bank filed a lawsuit in district court.  The Court ruled against the taxpayer, holding that in not depositing tax electronically the bank acted with willful neglect and not reasonable cause.  The court pointed out that the regulations are not complex, the bank was sophisticated and that the departure of an officer did not excuse its failure to follow the regulations.

In 2014, a Colorado marijuana dispensary, Allgreens, LLC, filed a petition with the Tax Court challenging a failure to deposit penalty where it paid by cash, since it was unable to open a bank account and could thus not electronically deposit taxes. The IRS ultimately abated the penalty and issued a directive, SBSE 04-0615-0045, that allows taxpayers who do not have bank accounts who timely make their tax deposits to avoid failure to deposit penalties if they can establish that they attempted to obtain a bank account but were unable to do so.

These cases teach a simple lesson: paying taxes on time may not always be enough to avoid penalties. You have to make sure you use the proper forms or payment methods.

Robert S. Horwitz – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former AUSA of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at http://www.taxlitigator.com

Posted by: khartwell85 | February 1, 2016

9100 Relief for Late Portability Elections by Krista Hartwell

Treasury recently updated the section 2010 Regulations to permit the IRS to grant 9100 relief for late portability elections.

On January 2, 2013, President Obama signed into law the American Tax Relief Act of 2012 (ATRA), which made permanent portability between spouses of the estate tax annual exclusion amount. Portability allows the second to die spouse to use any unused estate tax exclusion amount remaining from the first to die spouse.

Portability must be elected on a Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return.  An estate tax return is not required unless the value of the decedent’s estate exceeds the annual exclusion amount. [1]  If the value of the first to die spouse’s estate is significantly below the annual exclusion amount ($5.45 million for 2016), the estate of the first to die spouse may not file an estate tax return, thereby foregoing portability for the second to die spouse. The second to die spouse may need portability due to the acquisition of more assets or the significant growth in existing assets at the time of the second to die spouse’s death or significant gifting during the second to die spouse’s life.

Treasury Regulation section 301.9100-3 gives the IRS discretion to grant extensions of regulatory, but not statutory due dates (9100 relief). The Preamble to the final regulations on portability (Reg. § 20.2010-2(a)(1)), which were issued in June of 2015, notes that commenters on the proposed regulations requested that the final regulations address the availability of 9100 relief to extend the time to file an estate tax return to elect portability. The Preamble states 9100 relief is not available for estates that were required to file a timely estate tax return because such deadline is prescribed by statute. However, 9100 relief is available to estates that were not required to file an estate tax return because the due date to elect portability is prescribed by regulation, not statute. The Preamble to the final regulations cites Revenue Procedure 2014-18 in concluding that an extension of time to elect portability may be granted under regulation section 301.9100-3 to estates with a gross estate value below the threshold amount and not otherwise required to file an estate tax return.

The IRS issued Revenue Procedure 2014-18 on January 27, 2014, which authorized 9100 relief for late portability elections for estates that did not file estate tax returns. The Revenue Procedure noted the IRS had issued several private letter rulings granting extensions of time to elect portability. Relief under Revenue Procedure 2014-18 was permitted only for estate tax returns filed on or before December 31, 2014.  The final regulation permitting the IRS to grant 9100 relief to make late portability elections where an estate tax return was not required and was not previously filed is regulation section 20.2010-2(a)(1). Accordingly, the IRS may grant extensions (via 9100 relief) of the due date to file a Form 706 electing portability for estate’s that were not required to timely file a Form 706.

KRISTA HARTWELL – For more information please contact Krista Hartwell at Hartwell@taxlitigator.com or 310.281.3200. Ms. Hartwell is a tax lawyer at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at http://www.taxlitigator.com.

[1] 26 U.S.C. § 6018.

A recent opinion by the U.S. District Court in the Northern District of Georgia in Dileng v. Commissioner, 1:15-CV-1777-WSD (ND GA) (January 15, 2016), suggests a new era in international tax enforcement.  The opinion discusses the Internal Revenue Service’s (“IRS”) effort to collect Danish taxes pursuant to the Convention for the Avoidance of Double Taxation between the United States and Denmark (the “Treaty”).

While most tax treaties contain provisions for resolving issues of double taxation and for sharing of information by the respective treaty partners, only a few tax treaties contain provisions that provide for the collection of taxes by the treaty partners. These tax collection provisions are more likely to be found in newer tax treaties—such as the U.S.-Danish treaty, which was ratified in 1999. But even where there are tax collection provisions in the treaties, it’s been relatively unheard of for one treaty partner to seek to collect the taxes of the other treaty partner.  Dileng may suggest more tax collection cooperation with our treaty partners in the future.

Historically, the United States has been unwilling to collect taxes owed to a  foreign sovereign.  This is based in part on the common law rule referred to the  “revenue rule.”  The revenue rule “generally barred courts from enforcing the tax laws of a foreign soverign.”   Pasquantino v. United States, 544 U.S. 349 (2005).  It arose from “a line of cases prohibiting the enforcement of tax liabilities of one sovereign in the courts of another sovereign, such as a suit to enforce a tax judgment.” Id.  The revenue rule is an exception to the general rule that “judgments from a foreign country are recognized by the courts of this country when the general principles of comity are satisfied.” Her Majesty the Queen v. Gilbertson, 597 F.2nd 1161, 1163 (9th Cir. 1979).  It appears that the long-standing revenue rule can be over ridden by a treaty provision which has the force of law.

The taxpayer in Dileng is a Danish national who has lived with his family for a number of years in the United States.  He alleged that the Danish Ministry of Taxation (SKAT) had recently informed him that it had assessed a significant tax liability against him and that he was challenging that assessment in the Danish courts, in accordance with Danish law.  He further alleged that SKAT had requested the assistance of the IRS to collect the assessment, in contravention of the US-Denmark tax treaty, which provides in pertinent part that a party to the treaty could apply for assistance in collection of a tax that “has been finally determined.”  Under the treaty, a tax was “finally determined” after “all administrative and judicial rights of the taxpayer to restrain collection in the applicant State have lapsed or been exhausted.”  The taxpayer alleged that IRS’s seeking to collect the Danish tax violated the treaty, was contrary to the revenue rule and was an unconstitutional deprivation of property.  He sought declaratory and injunctive relief.  The IRS moved to dismiss on the grounds that the suit was barred by the Anti-Injunction Act and the Declaratory Judgment Act for Taxes.

The Court’s opinion deals with the taxpayer’s claim that his suit fell within an exception to the Anti-Injunction Act and the Declaratory Judgment Act for Taxes.  The Court found the taxpayer’s arguments unpersuasive and granted the IRS’s motion to dismiss.  The case presents very interesting jurisdictional issues, but the real take away from the opinion and a reminder to practitioners is that the world is changing.  If there is a Treaty between the U.S. and another country and that Treaty provides for the collection of taxes similar to that under the Danish Treaty, we may be see IRS collection efforts on behalf of a foreign jurisdiction.  Equally important, these foreign jurisdictions will be asked for and will be taking collection action on behalf of the IRS.

The Opinion raises an interesting issue as to why the taxpayer was not accorded collection due process (“CDP”) rights.  The complaint alleges that the IRS was seeking to collect the Danish tax through administrative levy and that the taxpayer had filed a Collection Appeal Request, which was verbally denied.  The complaint does not allege that the IRS issued a CDP notice.  According to the Opinion, under the terms of the Treaty, the IRS was required to treat the Danish tax as an IRS assessment and to collect them as if they were a tax owed to the U.S.  It would seem that the taxpayer should be accorded the same rights if the IRS was using the administrative assessment procedure. Nowhere in the Opinion or the pleadings is there any mention of whether the taxpayer was afforded CDP rights.

For years it was the conventional wisdom that assets beyond our borders were beyond the reach of IRS collection efforts—with very limited exceptions—such as the use of the writ ne exeat republica.  The Dileng opinion shows that the world has become a much smaller place.  Stay tuned.

AGOSTINO & ASSOCIATES –To download a great article prepared by our very close friends at the Law Firm of Agostino & Associates in Hackensack, NJ ( http://www.agostinolaw.com ), see the Agostino & Associates January Newsletter – http://files.ctctcdn.com/f7d16a55201/11d1f7e4-92e8-45c9-bcf0-a1c696aa823a.pdf

EVALUATING COLLECTION ALTERNATIVES: WHETHER TO FILE FOR BANKRUPTCY OR REQUEST AN OFFER IN COMPROMISE by By Frank Agostino, Esq. and Patrick Binakis, Esq. – Debt-saddled taxpayers frequently ask their tax advisors whether a Chapter 7 or Chapter 13 bankruptcy or an offer in compromise (“OIC”) is the best option for resolving tax debts. The short answer is, not surprisingly, that “it depends,” because one size does not fit all. Evaluating the alternative that best suits a client’s needs requires familiarity with bankruptcy law, tax procedure, and evolving case law involving the overlap of the two. This article explores the considerations that inform the choice between seeking a bankruptcy or an OIC as a means of resolving tax debts. GREAT ARTICLE!!

FOR THE FULL ARTICLE SEE http://files.ctctcdn.com/f7d16a55201/11d1f7e4-92e8-45c9-bcf0-a1c696aa823a.pdf

AGOSTINO & ASSOCIATES, with a national practice based in Hackensack, NJ, specializes in tax and tax controversies (civil and criminal), offers in compromise, voluntary disclosures, tax lien discharges,  innocent spouse determinations, forfeitures, estate planning and probate, contract and contract litigation.  A firm comprised truly great, caring people who want the best for their clients !

For further information, contact Frank Agostino or Patrick Binakis directly at (201) 488-5400 or visit http://www.agostinolaw.com

In most cases in which a person pleads guilty to a tax-related crime in federal district court, the U.S. Attorney’s Office will require him to agree that the district court can order the payment of restitution to the IRS for the years for which he pleads guilty plus any years constituting relevant conduct. Following conviction for a tax-related crime in federal district court, the court can order restitution as a condition of probation or of supervised release.  The amount of restitution will often be substantial.  In addition, following the criminal case, the IRS can issue a notice of deficiency asserting additional tax liabilities for the same years, plus fraud and/or accuracy penalties and interest.   The good news is that the taxpayer can do an offer in compromise of the additional taxes, penalties and interest assessed by the IRS.  The Tax Court in Rebuck v. Commissioner,  T.C. Memo 2016-3, reminded taxpayers of the bad news: to do so, they need to pay the full amount of restitution, which cannot be compromised.

The taxpayer in Rebuck was indicted along with a number of co-defendants of conspiring to defraud the United States by marketing foreign and domestic trusts that falsely claimed that they would help taxpayers legally avoid paying federal income tax, in violation of 18 U.S.C. §371.  Rebuck was convicted of one count of conspiracy.  At sentencing, the district court ordered Rebuck to pay restitution to the IRS of $16,399,199 jointly and severally with his co-defendants.

After his conviction, Rebuck filed income tax returns with the IRS for 1999, 2000, 2001 and 2002.  The IRS assessed the tax shown due on the returns together with penalties and interest.  Because Rebuck neither paid his tax liabilities for 1999 – 2002 nor entered into an installment agreement for those years, the IRS issued a Final Notice/Notice of Intent to Levy under IRC §6330.  Rebuck’s attorney filed a timely request for a Collection Due Process (CDP) hearing.  His attorney submitted an offer in compromise to the Settlement Officer assigned the CDP case.  The offer encompassed Rebuck’s income tax liabilities for 1996-2002 plus promoter penalties that had been assessed against him.  The Settlement Officer concluded that an OIC could only be considered if Rebuck agreed to pay the entire amount of restitution owed the IRS.  Rebuck appealed the determination to the Tax Court, which held that the IRS did not abuse its discretion in rejecting the OIC.

In so holding, the Tax Court stated that under the Internal Revenue Manual, part 5.1.5.24.5, an OIC may not be considered from a taxpayer who owes criminal restitution to the IRS unless the offer proposes an amount that is no less than the full amount of restitution owed. The “refusal to consider petitioner’s OIC unless it met the IRM requirement that criminal restitution be satisfied as part of an OIC does not constitute an abuse of discretion.  Indeed, it appears reasonable for the Commissioner to decline an OIC made by a taxpayer who has committed a crime related to Federal tax but who fails to satisfy a restitution order by a District Court in the criminal case.”   Previously, in Isley v. Commissioner, 141 TC 349 (2013), the Court held that under §7122 and Treas. Reg. §301.7122–1(d)(2), the IRS could not unilaterally accept an offer involving tax years that had been referred for prosecution to the Department of Justice, even where the taxpayer’s offer is submitted post-conviction.

Rubeck and Isley both involve restitution orders entered before 2010.  In 2010, Congress added §6401(a)(4) to the Internal Revenue Code, which requires the IRS to assess and collect the amount of restitution ordered in a criminal case for failure to pay any tax imposed under Title 26 in the same manner as if such amount were a tax. This section allows the IRS to use its administrative collection tools to collect the amount of the restitution order issued by the federal district court.

In addition, §6201(a)(4)(C) restricted a defendant’s ability to challenge an IRS assessment of restitution ordered by a district court in a criminal case.  Under §6213(b)(5), a restitution-based assessment is not subject to deficiency procedures. Additionally, under §6501(c)(11), a restitution-based assessment can be made at any time.

In Notice 2013-12, IRS Chief Counsel determined that court-ordered criminal restitution may only be modified or reduced by the district court in the limited circumstances set out in 18 U.S.C. §3664(o)(1). Thus, if the IRS determines that the amount of restitution ordered exceeds the amount of tax actually owed, the IRS cannot reduce the amount of restitution assessed. Similarly, if the taxpayer has a net operating loss in a subsequent year that would reduce the tax owed, it does not affect the taxpayer’s obligation to pay restitution in the amount ordered by the court.

Not only may a taxpayer not compromise an order to pay restitution to the IRS, restitution may not be discharged in bankruptcy, since under 11 U.S.C. §523(a)(13) a debt is not dischargeable that is “for any payment of an order of restitution issued under title 18, United States Code.” And since a criminal restitution order is part of a federal judgment, it is enforceable beyond the ten-year period during which tax assessments are normally enforceable.

If you represent a defendant in a criminal tax case, you must take steps early on to ensure that any amount of restitution ordered by the court does not exceed the amount of tax actually owed, since, once the court enters a restitution order, the amount of restitution cannot be challenged in any other proceeding, cannot be compromised, is not dischargeable in bankruptcy, and is enforceable for longer than normal tax assessments. And as the Tax Court reminds us in Rebuck, if the taxpayer owes restitution to the IRS, he cannot compromise other tax liabilities unless he agrees to pay an amount that is no less than the total amount owed as restitution.

Robert S. Horwitz – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former AUSA of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at http://www.taxlitigator.com

The IRS recently gave unexpected Chanukah and Christmas presents to tax cheats and other assorted ne’er do wells. The present came from an unexpected source, Criminal Investigation (CI), in the form of CI’s 2015 Annual Report, released at the beginning of December, in time for holiday shopping.

All you need to know about the current state of CI is contained in the opening paragraph of the message of CI Chief Richard Weber: “We began the year facing deep cuts in our budget. Having hired only 45 agents in the last three years, attrition was catching up to us and our staffing levels hit their lowest levels since the 1970’s. We finally came to realize that fewer agents and staff really do mean fewer cases.”  Fewer special agents, fewer cases, fewer tax cheats brought to justice.  I guess less is NOT more.

Most of the remainder of the report is an attempt to make a silk purse out of a sow’s ear, with feel good stores about successful prosecutions and initiatives, many with CI’s “partners” in other law enforcement agencies. While CI has had accomplishments with the diminished resources at its disposal, the dire condition of criminal tax enforcement is revealed in the statistics contained in the report.  The number of special agents and professional staff is the lowest since the early 1970s and has fallen by almost one-third in 10 years.

Per capita, CI now has approximately 1 special agent for every 137,000 people living in the United States. That is probably a level that has not been seen since prior to World War II.  Elmer Irey, the first chief of CI and the man who brought Al Capone to justice, must be spinning in his grave.

The report lists CI’s priorities as:

  • Identity Theft Fraud
  • Abusive Return Preparer Fraud & Questionable Refund Fraud
  • International Tax Fraud
  • Fraud Referral Program
  • Political/Public Corruption
  • Organized Crime Drug Enforcement Task Force (OCDETF)
  • Bank Secrecy Act and Suspicious Activity Report (SAR) Review Teams
  • Asset Forfeiture
  • Voluntary Disclosure Program
  • Counterterrorism and Sovereign Citizens
  • In each of these categories the number of investigations initiated and cases referred for prosecution has declined over the last three years. The total numbers of investigations initiated and prosecutions recommended in 2013, 2014, and 2015 were:
FY 2015 FY 2014 FY 2013
Investigations Initiated 3853 4297 5314
Prosecution Recommendations 3289 3478 4364

CI’s top priority is identity theft fraud, i.e. criminal gangs who steal taxpayer’s identification numbers, electronically file false returns and obtain refunds. This crime affects hundreds of thousands of taxpayers and costs the U.S. Treasury billions of dollars in illegally obtained refunds each year.  Investigations initiated and prosecutions commenced between 2013 and 2015 were:

FY 2015 FY 2014 FY 2013
Investigations Initiated 776 1063 1492
Prosecution Recommendations 774 970 1257

 

General tax fraud is traditionally CI’s bread and butter. It is the investigation and prosecution of tax fraud committed by people who are engaged in legitimate businesses.  Like other priority areas of CI, investigations and prosecutions declined in this area:

FY 2015 FY 2014 FY 2013
Investigations Initiated 1202 1358 1554
Prosecution Recommendations 863 923 1190

 

And next we come to a program that has been widely touted by CI and the Department of Justice as a top priority: the investigation and prosecution of taxpayers who cheat the government out of employment withholding tax.  Here to, investigations initiated and prosecutions referred are down:

FY 2015 FY 2014 FY 2013
Investigations Initiated 102 120 140
Prosecution Recommendations 80 92 97

CI has a well-deserved reputation as the being the best financial crimes investigation agency in the world. Its special agents were well-trained, highly-motivated and CI has an unmatched level of success in obtaining convictions:  the conviction rate for federal tax prosecutions has never fallen below 90%.  CI has always been a key to ensuring voluntary compliance.  It has also been instrumental in the prosecution of drug trafficers, health care fraud, money laundering and the financing of terrorist organizations, among other things. With budget cuts and attrition, its ability to fulfill its mandate will only suffer, much to the relief of tax cheats and other perpetrators of financial crimes.

Robert S. Horwitz – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former AUSA of the Tax Division of the Office of the U.S. Attorney (C.D. Cal)  and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at http://www.taxlitigator.com

Section 2503(b) of the Internal Revenue Code provides the annual exclusion, which excludes from taxable gifts the first $10,000 (adjusted for inflation) of “present interest” gifts. The current annual exclusion amount is $14,000. Crummey v. Comm’r, 397 F.2d 82 (9th Cir. 1968) supplies the rule for present interest gifts in trust. In order to have a present interest in a gift held in a trust, the beneficiary must have an unconditional right to withdraw upon demand. The IRS expressed its agreement with Crummey in Rev. Rul. 73-405.  In Estate of Cristofani v. Comm’r, 97 T.C. 74 (1991), the Tax Court adopted the reasoning in Crummey, finding that the proper focus of the present interest test analysis is not the likelihood that beneficiaries would actually receive enjoyment of the property, but the legal right of the beneficiaries to demand payment from the trustee. The IRS acquiesced to the result in Cristofani, noting that although it will not contest annual gift tax exclusions for Crummey powers where the trust instrument gives the power holders bona fide unrestricted legal right to demand immediate possession and enjoyment of trust income corpus, it will deny Crummey exclusions where the withdrawal rights are not in substance what they purport to be in form.

In Mikel v. Comm’r, T.C. Memo 2015-64, the IRS challenged donor-grantors claims of the annual exclusion for gifts contributed to a trust where the trust granted each beneficiary (many of whom were under 18 years of age) the right to withdraw trust principal (the Crummey provision), but also contained an in terrorem (“no contest”) clause, which provided the following:

“In the event a beneficiary of the Trust directly or indirectly institute, conduct or in any manner whatever take part in or aid in any proceeding to oppose the distribution of the Trust Estate, or files any action in a court of law, or challenges any distribution set forth in this Trust in any court, arbitration panel or any other manner, then in such event the provision herein made for such beneficiary shall thereupon be revoked and such beneficiary shall be excluded from any participation in the Trust Estate.”

Each petitioner made gifts of $1,631,000 to a family trust, reported the gifts on gift tax returns and claimed annual exclusions pursuant to Section 2503(b) of $720,000. Petitioners computed their $720,000 annual exclusion amounts by multiplying $12,000 (the annual exclusion for the taxable year) by the number of beneficiaries to the trust (60). The trust also contained a provision requiring notification to all beneficiaries that the trust received property as to which the beneficiary had a demand right. Such notification must occur within a reasonable time after the contribution of property subject to a demand right. The trust complied with the notification provision after petitioners made their gifts. The trust directed mandatory distributions in response to withdrawal demands and empowered trustees to make discretionary distributions during the term of the trust for “health, education, maintenance or support” (“HEMS” provision).

The trust also provided if any disputes arose regarding the proper interpretation of the declaration the dispute shall be submitted to arbitration before a panel consisting of three persons of the Orthodox Jewish faith (a “beth din”). The beth din was directed to enforce the provisions of the declaration of trust and give any party the rights he is entitled to under New York law.

The IRS conceded that the trust provided each beneficiary with an unconditional right to withdraw (via the Crummey provision), but argued that regardless of the Crummey provision, the beneficiaries did not receive a present interest in property because the beneficiaries “would be reluctant” to enforce their rights in state court as a result of the no contest clause and the beth din requirement. Respondent further argued that beneficiaries’ withdrawal rights were “illusory.” Significantly, the IRS challenged the provision because the drafters did not make it clear that the in terrorem provision did not apply to the right to demand.

In finding for Petitioners, the Tax Court noted the beth din was directed to enforce the declaration of trust and give any party all rights he is entitled to under New York law. As a result, “a beneficiary would suffer no adverse consequences from submitting his claim to a beth din.” The Tax Court also noted Respondent’s concession that the beneficiaries have a state court remedy, and that the no contest clause was meant to discourage legal actions seeking to challenge the trustees discretionary (not mandatory) distributions. Therefore, the Tax Court reasoned, a suit to honor a timely withdrawal demand would not trigger the application of the no contest clause.

Since the trustee did not have discretion to deny a timely made withdrawal demand, the in terrorem provision did not apply to the demand right. Thus, the right to judicially enforce it was not illusory. Because the beneficiaries had an unconditional right to withdraw, they had present interest in the trust.

The Tax Court noted that the no contest clause was poorly drafted and devoted significant analysis to whether the no contest clause should be read narrowly. In finding for Petitioners, the Tax Court concluded a Crummey provision existed, beneficiaries’ “literally” had state court enforceable rights, and “the [no contest] provision, properly construed, would not deter beneficiaries from pursuing judicial relief.” Accordingly, although the IRS will have difficulty challenging the application of the annual exclusion to gifts to Crummey trusts, practitioners should carefully and clearly draft other trust provisions so that the Court is not in a position to consider whether other terms of the trust create present interest test issues.

KRISTA HARTWELL – For more information please contact Krista Hartwell at Hartwell@taxlitigator.com or 310.281.3200. Ms. Hartwell is a tax lawyer at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at http://www.taxlitigator.com.

 

 

 

 

 

 

 

Section 481 provides that where a taxpayer’s taxable income for a tax year is computed under a method of accounting different from that previously used, an adjustment will be made to prevent amounts from being duplicated or omitted solely by reason of the change in accounting method.[i]  Section 481 applies regardless of whether the change in accounting method is initiated by the taxpayer or by the IRS, and regardless of whether the prior accounting method was a correct or incorrect method of accounting.

If the requirements of Section 481 are met, the section allows an adjustment for amounts that would have been reported in prior years if the new method of accounting had been consistently used, even if adjustments for those earlier years are otherwise barred by the statute of limitations.  As a result, it is important to have an understanding of what changes are considered to be a change in accounting method, and what changes do not fall under Section 481.

Definition of a Change in Accounting Method.  Section 481 and the regulations thereunder do not include a definition of “accounting method” or explain what constitutes a change in an accounting method—the terms are defined only by reference to Section 446 (“General rule for methods of accounting”).[ii]  Section 481 applies to a change in a taxpayer’s over-all method of accounting for gross income or deductions, such as a change from the cash method of accounting to the accrual method of accounting, as well as to any change in the “treatment of a material item.”[iii]  The regulations define “material item” as “any item that involves the proper time for the inclusion of the item in income or the taking of a deduction.”[iv]

Section 481 Applies Only to Changes in Timing.  Any change that does not relate to the proper time for the inclusion of an item in income or the proper time for the taking of a deduction is not a change in accounting method under Section 481.  Treasury Regulation Section 1.446-1(e)(2)(ii)(b) provides that a change in accounting method does not include any “adjustment of any item of income or deduction that does not involve the proper time for the inclusion of the item of income or the taking of a deduction.”[v]    The test that courts generally use to determine whether an adjustment involves the timing of an item of income or deduction is whether the change permanently distorts the taxpayer’s lifetime taxable income (that is, the taxpayer’s cumulative taxable income for all taxable periods of its existence).[vi]

The regulation provides two examples to illustrate this rule: (1) corrections of items that are deducted as interest or salary, but that are in fact payments of dividends, are not changes in method of accounting; and (2) corrections of items that are deducted as business expenses, but that are in fact personal expenses, are not changes in method of accounting.[vii]  In both instances, a corporation’s overall taxable income is permanently changed as a result of the disallowed deductions—the changes disallow the deduction instead of merely deferring the deduction.

For example, in Pelton & Gunther P.C., TC Memo 1999-339, the Tax Court held that Section 481 was not applicable where the IRS determined that a law firm’s practice of deducting litigation expenses that it advanced on behalf of clients was erroneous, recharacterizing those amounts instead as non-deductible loans.  The Tax Court concluded that it was not a timing question even though the law firm had been including the reimbursed amounts into income in the year the reimbursements were received, because the IRS determined that the item was not deductible ab initio, finding that the petitioner’s payments of litigation costs were non-deductible loans to its clients.  Because the deductions were disallowed entirely, the Tax Court determined there was not a change in method of accounting.

However, in Humphrey, Farrington & McClain, TC Memo 2013-23, another Tax Court case involving advanced litigation expenses, the Tax Court found there to be a change in accounting method where the IRS had disallowed an ordinary and necessary business deduction for such expenses but instead allowed a bad debt deduction for the unreimbursed expenses in a later tax year, because the amount of the net deduction was the same under both the taxpayer’s treatment of the expenses and under the IRS’ treatment of the expenses.

Section 481 Does Not Apply to Mathematical and Posting Errors.  The regulations specify that a change in accounting method does not include a correction of a mathematical or posting error.[viii]  In Korn Industries, Inc. v. United States, 532 F.2d 1352 (Ct. Cl. 1976), the Court of Claims considered whether a taxpayer’s omission of three items of inventory in prior years was a “change in method of accounting” when those errors were corrected in a subsequent year.  The taxpayer’s income tax return for the tax year at issue reported a beginning inventories amount that was greater than the company’s closing inventories amount for the prior year, as a result of including the value of these additional amounts in inventory.  The taxpayer had conceded that the error resulted in an understatement in the year of the omission, so the only issue was whether an adjustment for those prior years was barred by the statute of limitations.  The IRS argued that the adjustment in the taxpayer’s beginning inventory was a “change in method of accounting” necessitating an adjustment under Section 481, but the Court of Claims held there to be no change in method of accounting.  Even though the change affected a balance sheet item in the current tax year, the court held that the taxpayer did not change its method of accounting because the taxpayer had simply made an error analogous to a mathematical or posting error—there was no change to the taxpayer’s method of valuing inventories.

Section 481 Does Not Apply to a Change Caused by a Change in the Underlying Facts.  There is no change in accounting method if the change in treatment of an item results from a change in the underlying facts.[ix]  For example, a change in the tax year that a taxpayer accrues a liability for a vacation pay plan is not a change in the method of accounting if the change results from a change the company made in the type of vacation pay plan.[x]  Similarly, in an IRS National Office Technical Advice Memorandum dated June 3, 2010, the IRS concluded that a change in the treatment of a loss from an entity from active to passive pursuant to Section 469 is not a change in a method of accounting for purposes of Sections 446(e) and 481(a).[xi]  In the Technical Advice Memorandum, the IRS states: “We do not believe that a determination of whether a taxpayer materially participates in an activity is a method of accounting.”[xii]

It is important to keep these concepts in mind during the course of an audit, as the IRS may take the position that an adjustment affecting the timing of an item of income or deduction triggers the application of Section 481, giving rise to an adjustment for the item not only in the year under audit, but also for each prior year relating to the item.  Having an understanding of what is and is not an accounting method change will assist practitioners in evaluating any potential Section 481 issue.  In addition to the above concepts, the detailed regulations in Section 1.446-1(e) provide specific rules and illustrate several examples of how the Section 481 rules apply to various situations.

LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is a senior tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue domestic civil tax examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise, and in defending criminal tax fraud investigations and prosecutions. She has considerable expertise in handling matters arising from the U.S. government’s ongoing civil and criminal tax enforcement efforts, including various methods of participating in a timely voluntary disclosure to minimize potential exposure to civil tax penalties and avoiding a criminal tax prosecution referral. Additional information is available at http://www.taxlitigator.com.

[i] IRC § 481(a).

[ii] Treas. Reg. § 1.481-1(a)(1) (“For rules relating to changes in methods of accounting, see section 446(e) and paragraph (e) of § 1.446-1.”).

[iii] Treas. Reg. § 1.481-1(a)(1); 1.446-1(e)(2)(ii)(a).

[iv] Treas. Reg. § 1.446-1(e)(2)(ii)(a).

[v] Treas. Reg. § 1.446-1(e)(2)(ii)(b).

[vi] See, e.g., Schuster’s Express, Inc. v. Commissioner, 66 TC 588 (1976).

[vii] Treas. Reg. § 1.446-1(e)(2)(ii)(b).

[viii] Treas. Reg. § 1.446-1(e)(2)(ii)(b).

[ix] Treas. Reg. § 1.446-1(e)(2)(ii)(b).

[x] See Treas. Reg. § 1.446-1(e)(2)(iii) Examples (3) & (4).

[xi] TAM 201035016, June 3, 2010.

[xii] Id.

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