Section 5321(a)(5)(A) provides that the Secretary of Treasury “may impose a civil money penalty” on anyone who violates the FBAR reporting requirements.  Originally, the penalty for willful violation was the greater of the amount in the account (not to exceed $100,000) or $25,000. In 2004, Congress amended the FBAR penalty provision to increase the maximum willful penalty from the amount in the account (up to $100,000) to the greater of $100,000 or 50% of the amount in the account.  Section 5321(a)(5)(C)(i).  Because the penalty is one that the Secretary “may” impose, the amount of the penalty is in his discretion, as long as it does not exceed the statutory maximum.

Since the the penalty can now be up to 50% in the account with no cap, why do I say it may be illegal for the IRS to assess more than $100,000 for a willful FBAR violation?  Check the regulations. In 2010, the Treasury issued new Bank Secrecy Act regulations.  31 C.F.R. §1010.820 was issued in 2010 and amended in 2016.  It states that the maximum penalty for a willful FBAR violation may not “exceed the greater of the amount (not to exceed $100,000) equal to the balance in the account at the time of the violation, or $25,000.”  31 C.F.R. §1010.820(g)(2). In issuing and amending this regulation long after the willful penalty provision was amended, one might assert that the Secretary exercised his discretion to cap the FBAR penalty at $100,000 per year, regardless of the size in the account.

No one has raised this issue in any FBAR case, but it would be interesting to see how the Government reacts.  It would be strange for the Government to challenge its own regulation, especially a regulation issued and then amended years after the underlying statute was enacted. The Government might just concede (though unlikely), or amend the regulation to reflect the new statutory language. Or maybe the Secretary realized all along that a 50% penalty was confiscatory and capped it at $100,000.

ROBERT S. HORWITZ – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney 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, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com

At the 2017 Annual Meeting of the California Tax Bars, Steve Toscher received the 2017 Joanne M. Garvey Award from the Taxation Section of the State Bar of California recognizing his lifetime achievements and outstanding contributions in the field of tax law!

With respect to this award, the official statement of Taxation Section provides “Joanne M. Garvey was the founder of the Taxation Section of the State Bar of California. She is an exceptional California tax attorney who is loved and respected by her colleagues. Throughout her long and distinguished career she has served the Bar in many capacities on the federal, state and local level with unsurpassed dedication and enthusiasm. In her name, the Taxation Section established the Joanne M. Garvey Award to recognize lifetime achievement and outstanding contribution in the field of tax law.” Established in 1994, previous Joanne M. Garvey Award recipients include Bruce I. Hochman (1999) and Avram Salkin (2007), also of Hochman, Salkin, Rettig, Toscher & Perez, PC.

For more than 35 years, Steve Toscher has been representing clients before the Internal Revenue Service, the Tax Divisions of the U.S. Department of Justice and the Office of the United States Attorney (C.D. Cal.), numerous state taxing authorities and in federal and state court litigation and appeals. Mr. Toscher’s tax practice includes a wide array of substantive areas including income taxes, estate taxes, employment taxes, excise taxes, sales taxes and property taxes. He is routinely involved in sensitive issue or complex civil tax examinations and administrative appeals on behalf of wealthy individuals and their closely held entities as well as large corporations involving both domestic and foreign tax related issues.

Mr. Toscher enjoys a unique combination of solid criminal defense experience and extensive substantive tax experience to assist individuals and entities subject to sensitive government inquiries. Recently, Steve Toscher received a judgment of acquittal in a matter involving allegations of a conspiracy between the client, the client’s independent certified public accountant and others relating to the clients personal taxes as well as those of the clients son and his business enterprise, including the use of a foreign bank account and a foreign trust. Others included in the indictment previously pled guilty and the former accountant testified at trial as a cooperating witness for the Government. This is believed to be among the first unsuccessful prosecutions relating to the use of matter involving use of foreign trusts and foreign financial accounts in the Government’s ongoing, extensive international enforcement efforts.

Before entering private practice, Steve Toscher served as a trial attorney for the Tax Division of the United States Department of Justice in Washington, D.C. and, before that, as a Revenue Agent with the Internal Revenue Service.

Steve Toscher is a Certified Specialist in Taxation, the State Bar of California Board of Legal Specialization. He has been a featured speaker and panelist at hundreds of tax conferences throughout the United States on tax-related topics and is frequently quoted in publications such as The Wall Street Journal, USA Today, Forbes, Bloomberg, Reuters, Financial Times, Tax Analysts-Tax Notes, and Bloomberg BNA Daily Tax Report. He was selected by his peers to be included in “The Best Lawyers in America,” holds an “A-V” rating from Martindale-Hubbell and is a Fellow of the American College of Tax Council (ACTC). Mr. Toscher is the author or co-author of numerous articles, and is the principal author of the Tax Management Portfolio “Tax Crimes” (Pub. 636) (3d.) published by the Bureau of National Affairs (BNA).

In addition to his law practice, Mr. Toscher has long served as an Adjunct Professor at the University of Southern California, where he teaches Federal Tax Procedure. He previously served as an Adjunct Professor of Law, University of San Diego School of Law, Graduate Tax Program, where he taught Tax Procedure and Advanced Tax Procedure. A member of the California, Nevada and Colorado Bars, Steve Toscher has served on the Faculty of the American Bar Association Criminal Tax Fraud Program since 1998.

STEVEN TOSCHER – For more information please contact Steve Toscher – toscher@taxlitigator.com Mr. Toscher is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., specializing in civil and criminal tax litigation. Mr. Toscher is represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is also available at http://www.taxlitigator.com

The Government prevailed in each of the FBAR penalty cases that had previously been decided, but finally a taxpayer convinced a court that he was not liable for the 50% willful penalty. The Court in Bedrosian v. United States (E.D. PA Sept. 20, 2017) held that a taxpayer was not liable for the penalty based on the facts presented at trial.  The taxpayer paid $9,757 toward a $1 million FBAR penalty and sued to recover the money in federal district court.  Note: In non-tax District Courts have jurisdiction over lawsuits against the Government where the amount sought  does not exceed $10,000.  If Bedrosian had paid more than $10,000, he would have sued in the Court of Federal Claims, which has exclusive jurisdiction in non-tax cases in which the amount of money sought from the Government is more than $10,000.  The Government counterclaimed for the unpaid balance.

The case presented two legal issues: what is the Government’s burden of proof in FBAR penalty cases and what does “willful” mean for purposes of a civil FBAR case.  The Court in Bedrosian adopted the view advanced by the Government: it needs to prove that the taxpayer was willful by a preponderance of the evidence, and not by the heavier burden of proving willful by clear and convincing evidence.  It also held that “willful” means that a knowing or reckless failure to file an accurate FBAR form.  It rejected Bedrosian’s claim that willful required proof of a voluntary and intentional violation of a known legal duty.  According to the Court this was the standard used in criminal cases but not civil cases.  [Note: The “voluntary and intentional” standard is also used for willfulness civil trust fund recovery penalty cases.]. These legal holdings were consistent with the published decisions in the FBAR cases the Government won.

So why Bedrosian win when others have not? The facts and the witness.  The judge obviously found Bedrosian a credible witness.  He testified that he set up his Swiss bank account in the early. 1970s because he frequently travelled to Europe on business and wanted access to funds when he was there.  Ultimately the account became more of a savings account.  In 2005 a second account was opened and his first account was converted to an investment account.  He also testified that in the mid 1990s, he told his accountant that he had a Swiss account.  The accountant told him that he was breaking the law each year by not reporting the account on his tax return, that he could not “unbreak” the law and that he should do nothing because his estate would deal with it after he died.  The accountant in 2007 and Bedrosian got a new accountant, who filed Bedrosian’s 2007 return in 2008.  That return checked the box box “yes” to the question whether he had an offshore account and identified Switzerland as the country where the account was located.  In 2008 Bedrosian also filed for the first time an FBAR. The problem was, the FBAR form listed only the smaller of the two accounts.  On the advice of his attorney, Bedrosian filed amended tax returns for 2004 forward reporting his foreign income.  The IRS began an audit of Bedrosian in 2011.  Bedrosian cooperated with the IRS.  He was assessed a 50% penalty with respect to his 2007 FBAR filing.

The factual issue was whether Bedrosian knew that his 2007 FBAR form failed to disclose his second account, which had about $2 million, when he signed the form. Bedrosian said he did not pay close attention to the form when he signed it and that he considered the two accounts as being just one account.  The Court accepted his testimony: “even if he did know that he had a second account yet failed to disclose it on the FBAR, there is no indication that he did so with the requisite voluntary or intentional state of mind; rather, all evidence points to an unintentional oversight or a negligent act.”  The Court compared Bedrosian’s conduct to that of the taxpayers in U.S. v Williams, 489 F. App’x 655 (4th Cir. 2012), U.S. v McBride, 908 F.Supp. 2nd 1186 (D. Utah 2012), and U.S. v Bussel, (C.D. Cal. 2015), and found his less egregious.  Since the Government failed to meet its burden of proof, Bedrosian was entitled to a return of the money “illegally exacted from him.”

ROBERT S. HORWITZ – For more information please contact Robert S. Horwitz – horwitz@taxlitigator.com or 310.281.3200   Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney 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, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com

A taxpayer’s trade or business undertakings can be combined to form an “activity” for purposes of the material participation rules if the undertakings “form an appropriate economic unit for measuring gain or loss under the passive activity rules,” considering all relevant facts and circumstances.  Taxpayers have the freedom to group their undertakings using any reasonable method; however, there is an exception to the “appropriate economic unit” grouping rules for rental activities – in general, rental activities may not be grouped with a non-rental trade or business.[i]  Rental activities are by definition passive, and the income and losses from the activity generally cannot become active by considering them as part of a greater activity involving the conduct of an active trade or business.

There is an additional rule in the regulations under Section 469 that applies to the treatment of rental activities: Treasury Regulation Section 1.469-4, which sets forth the grouping rules for purposes of Section 469 for determining the scope of an “activity” for purposes of Section 469. Separate from the exception to the per se passive rule for real estate professionals in Section 469(c)(7) and separate from the exceptions to the definition of “rental activity” in Treasury Regulation Section 1.469-1T(e)(3), Treasury Regulation Section 1.469-4(d)(1)(i) provides, in pertinent part, that a rental activity may be grouped with active trade or business activities if they constitute an appropriate economic unit and the rental activity is insubstantial in relation to the trade or business activity.[ii]

This grouping rule effectively provides an additional exception to the definition of rental real estate, as recognized in Treasury Regulation Section 1.469-9(b)(3) (definition of “Rental real estate” for purpose of Treasury Regulation Section 1.469-9: “Rules for certain rental real estate activities”), which provides: “[A]ny rental real estate that the taxpayer grouped with a trade or business activity under §1.469-4(d)(1)(i)(A) … is not an interest in rental real estate for purposes of this section.”

However, there has been little guidance that taxpayers can rely on for determining whether a rental activity can be combined with another trade or business because it is insubstantial in relation to the rest of the trade or business. In an earlier version of the regulations (Treas. Reg. § 1.469-4T), the IRS set forth a quantitative test to determine whether a rental activity is insubstantial in relation to a non-passive activity.  The regulation explained that the rule that rental operations and nonrental operations must generally be treated as separate undertakings does not apply if, in pertinent part, “more than 80 percent of the income of the undertaking determined under the basic rule is attributable to one class of operations (i.e., rental or nonrental).”[iii]

Although the regulations do not provide an example of a situation where a rental activity was allowed to be grouped with a non-passive activity pursuant to this rule, an example provided states:

“Attorney D is a sole practitioner in town X. D also wholly owns residential real estate in town X that D rents to third parties. D’s law practice is a trade or business activity within the meaning of paragraph (b)(1) of this section. The residential real estate is a rental activity within the meaning of §1.469-1T(e)(3) and is insubstantial in relation to D’s law practice. Under the facts and circumstances, the law practice and the residential real estate do not constitute an appropriate economic unit under paragraph (c) of this section. Therefore, D may not treat the law practice and the residential real estate as a single activity.”[iv]

In this example, the IRS acknowledges an example of where a real estate rental activity is insubstantial in relation to another trade or business, but in this example, the rental activity and the trade or business do not provide an appropriate economic unit because they are unrelated businesses. This suggests that these activities could be grouped if the activities were related, such as both involving aspects of a larger real estate business.

We have found only a few cases that have addressed this argument. In each case, the courts have found a rental activity to be insubstantial to a non-rental activity, or vice versa, based on the particular facts of the case.  Courts have considered both qualitative and quantitative factors in determining whether a rental activity is insubstantial.[v]  In one case, the qualitative factors included there being (1) a close operating relationship, (2) intertwined operations, and (3) a shared accounting system, among other factors.  For the quantitative analysis, the court applied an 80/20 test that was part of the old regulations on this topic – under this test, an activity is insubstantial if the gross income from the activity is less than 20% of the total gross income. The relative asset values of the activities will also be considered.[vi]

Most recently, a district court held in Stanley v. United States, 96 F. Supp. 2d 850 (W.D. Ark. 2015), that a taxpayer appropriately grouped together his rental and non-rental activities pursuant to Treas. Reg. § 1.469-4, rejecting the Government’s argument that the rule under Treasury Regulation § 1.469-9(e)(3)(i), which sets forth the rules for rental real estate, prohibits all grouping of non-passive activities with rental activities, notwithstanding the provisions in Treasury Regulation Section 1.469-4 that allow rental activities to be grouped with non-passive activities if the rental activity is insubstantial.

In Candelaria v. United States, 518 F. Supp. 2d 852, (W.D. Tex. 2007), the court found a taxpayer’s losses from a rental activity to be non-passive, because the rental activity was insubstantial in relation to another of the taxpayer’s business activities for the tax year at issue.  The court noted that the trade or business was “a rapidly expanding enterprise with multiple employees, three business locations and a provider of various services to the community at large,” while the rental activity was a “company with no employees, one client, and a gross income and net income that each represent less than 20 percent of the combined totals of the two companies.[vii]  Considering these facts and additional considerations, the “Court’s realistic economic sense of the situation is that CEL’s rental activity is insubstantial in relation to DIS’s business activity for the year 2000.”

This issue was also addressed in a Summary Opinion, Schumacher v. Commissioner, T.C. Summary Opinion 2003-96.  In finding that a leasing activity was insubstantial in relation to a non-rental activity, the court reasoned:

“We find that, in ascertaining whether the leasing activity was insubstantial in relation to the PFC activity, the most significant fact in this case is that petitioner created and operated the leasing activity solely for PFC’s benefit. In furtherance of this goal, petitioner spent very little time conducting the affairs of the leasing activity in comparison with the very substantial amount of time and effort expended by petitioner in carrying on PFC’s business. The leasing activity was intended to, and in fact did, provide a service solely to PFC. Its purpose was to enhance PFC’s ability to generate business, maintain PFC’s viability as an ongoing concern, and possibly enable PFC to become profitable in the future, not to provide an income stream independently from PFC. Consistent with this purpose, the leasing activity had gross receipts of $ 9,500 in 1998 and $ 34,940 in 1999, compared to PFC’s gross receipts and other income of $ 804,492 and $ 1,092,295 in each respective year.”[viii]

Finally, in an earlier case, Glick v. U.S., 96 F. Supp. 2d 850 (S.D. Ind. 2000), the district court addressed a situation involving rental real estate; however, the court was presented with the reverse situation, where an active trade or business was turned passive, thereby allowing it to offset passive losses. Glick v. United States involved an apartment management corporation which managed a series of apartments on behalf of over a hundred partnerships.  The court noted that they were an integrated business unit with operational tie-ins, such as the use of a single accounting system.  Where there  was 116 limited partnerships that rent properties with a single C corporation that manages them, the court found the that the management company was insubstantial relative to the rest of the rental business.

Although not explicitly identified in the Code or regulations as an exception to the per se passive rules applicable to rental real estate, the above cases demonstrate that if a taxpayer can establish that the rental real estate activity is insubstantial in relation to another of the taxpayer’s businesses and that together they make an appropriate economic unit, the taxpayer may be able to convert a passive rental activity into a part of an active trade or business that is not subject to the loss limitation rules of Section 469.

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 in complex civil tax litigation and criminal tax prosecutions (jury and non-jury). She represents U.S. taxpayers in litigation before both federal and state courts, including the federal district courts, the U.S. Tax Court, the U.S. Court of Federal Claims, and the Ninth Circuit Court of Appeals. Ms. Strachan has experience in a wide range of complex tax cases, including cases involving technical valuation issues. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue 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. Additional information is available at http://www.taxlitigator.com.

[i] Treas. Reg. § 1.469-4(d)(1)(i); Treas. Reg. § 1.469-9(e)(3)(i).

[ii] Treas. Reg. § 1.469-4(d)(1)(A). § 1.469-4(d)(1)(B) also allows grouping where a trade or business activity is insubstantial in relation to the rental activity and § 1.469-4(d)(1)(C) allows grouping where each owner of the trade or business activity has the same proportionate ownership interest in the rental activity, in which case the portion of the rental activity that involves the rental of items of property for use in the trade or business activity may be grouped with the trade or business activity.”

[iii] Treas. Reg. 1.469-4T(a)(3)(iv).

[iv] Treas. Reg. 1.469-4(d)(1)(ii)(Example 2).

[v] Note the distinction between the term “insubstantial” as it is used in this section, and “incidental” as it is used in the exception to the definition of rental activity in Treasury Regulation Section Treas. Reg. §

[vi] Candelaria v. United States, 518 F. Supp. 2d 852, 858-859 (W.D. Tex. 2007) (explaining that although Temporary Treasury Regulation § 1.469-4T is no longer in place and there is no equivalent bright line test in the current regulations, the current regulations call for a facts and circumstances analysis, under which it will take into consideration the quantitative guidelines from the old regulation).

[vii] Id. at 859-860.

[viii] Schumacher v. Commissioner, T.C. Summary Opinion 2003-96.

For taxpayers with rental properties, qualifying as a real estate professional under IRC Section 469(c)(7) is only the first obstacle in avoiding passive activity treatment for rental properties.

Definition of Rental Activity. As a threshold matter, it is important to determine whether an activity is in fact a rental activity for purposes of Section 469.  A rental activity is defined generally as an activity where the gross income from the activity consists of amounts paid principally for the use of property held by the taxpayer in connection with the activity.[i]  In addition to the real estate professional exception to the rule that rental activity is per se passive, there are also exceptions to what is considered a “rental activity.”  If an activity is not considered a rental activity within the meaning of Section 469, the per se passive rule will not apply, allowing the Taxpayer to group the activity with other activities that constitute an appropriate economic unit, making it easier to satisfy the material participation test with respect to the activity.  An activity will not be treated as a “rental activity” if:

  1. The average period of customer use for such property is seven days or less;
  2. The average period of customer use for such property is 30 days or less, and significant personal services are provided by or on behalf of the owners of the property in connection with making the property available for use by customers (the nature of personal service provided is a facts and circumstances determination, with certain exceptions specified in Treasury Regulation Section 1.469-1T(e)(3)(iv)(B));
  3. Extraordinary personal services are provided by or on behalf of the owner of the property in connection with making such property available for use by customers (without regard to the average period of customer use). Examples provided include a hospital’s boarding facilities, where the rentals are incidental to their receipt of the personal services provided by the hospital’s staff, and the use by students of a schools’ dormitories is generally incidental to their receipt of the personal services provided by the school’s teaching staff.[ii]
  4. The rental of such property is treated as incidental to a non-rental activity of the taxpayer under paragraph (e)(3)(vi) of this section;[iii]
  5. The taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers; or
  6. The provision of the property for use in any activity conducted by a partnership, S corporation, or joint venture in which the taxpayer owns an interest is not rental activity under paragraph (e)(3)(vii).

Special Grouping Rules for Rental Real Estate.  The general rule is that each rental property must be treated as a separate activity.[iv]  However, real estate professionals have the option of grouping all of their rental properties together as a single activity under the regulations setting forth rules for certain rental real estate activities (Treasury Regulation Section 1.469-9).[v]  For a taxpayer who has many rental properties, it may be difficult if not impossible for the taxpayer to satisfy the material participation tests with respect to each and every rental property, even if he works full time in the rental real estate business.  The election allows taxpayers to treat their rental activities as a single activity, though taxpayers are still precluded from grouping their interests in rental property with other activities in the real estate industry or other activities that would create an appropriate economic unit.

While making the election could allow taxpayers with multiple rental properties to be able to deduct their losses on an annual basis, taxpayers must consider before making the election the potential consequences of such an election. In particular, if the taxpayer has suspended losses from rental activities despite grouping all of the real estate properties, the election presents a drawback for the taxpayer—if the taxpayer disposes of his interest in one of the rental properties that had a suspended loss, that loss will continue to be suspended until the taxpayer has disposed of all of his rental properties which he had elected to group together as a single activity.

Making an Election to Group Rental Activities. An election to treat all of a taxpayer’s interests in rental real estate as a single rental real estate activity can be made by the taxpayer in any year in which he is a qualified taxpayer (that is, meets the requirements to be considered a real estate professional under Section 469(c)(7)), and the election will be binding for the taxable year in which it is made and for all future years in which the taxpayer is a qualifying taxpayer, even if there are intervening years where the taxpayer does not qualify.[vi] The election may be made during any year in which the taxpayer is eligible.

The election is made by filing a statement with the taxpayer’s original income tax return for the taxable year that contains a declaration that the taxpayer is a qualifying taxpayer for the taxable year and is making the election pursuant to Section 469(c)(7)(A).[vii]

The election can be revoked only by a showing of a material change in the taxpayer’s facts and circumstances. To revoke an election, the taxpayer must file a statement with the taxpayer’s original income tax return for the year of revocation, containing a declaration that the taxpayer is revoking the election under Section 469(c)(7)(A) and an explanation of the nature of the material.[viii]

Satisfying One of the Material Participation Tests. Even if owners of rental real estate have elected to group their real estate activities as one activity, there are still challenges in satisfying the material participation tests.  The taxpayer is limited to considering only the real estate professional’s hours spent on the rental activity and cannot consider the taxpayer’s other hours spent working for the taxpayer’s other real estate business(es).  Moreover, the significant participation activity test—which taxpayers often rely on when they have multiple different activities that may not exceed 500 hours—is not available to taxpayers trying to satisfy the material participation test with respect to their interest in rental real estate.  A significant participation activity is defined in pertinent part by reference to a “trade or business…other than rental activities…,” specifically excluding rental activities from qualifying for the significant participation activity material participation test.[ix]  When applying the material participation tests to a rental activity, it is important to ensure that the material participation test being considered applies to the taxpayer’s facts and circumstances and takes into account only those hours spent participating in the rental activity.

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 in complex civil tax litigation and criminal tax prosecutions (jury and non-jury). She represents U.S. taxpayers in litigation before both federal and state courts, including the federal district courts, the U.S. Tax Court, the U.S. Court of Federal Claims, and the Ninth Circuit Court of Appeals. Ms. Strachan has experience in a wide range of complex tax cases, including cases involving technical valuation issues. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue 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. Additional information is available at http://www.taxlitigator.com.

[i] See Treas. Reg. § 1.469-1T(e)(3).

[ii] Treas. Reg. § 1.469-1T(e)(3)(v).

[iii] Requirements for this exception are set forth in Treas. Reg. § 1.469(e)(3)(vi).

[iv] Treas. Reg. § 1.469-9(e).

[v] Treas. Reg. § 1.469-9(g).

[vi] Treas. Reg. § 1.469-9(g)(1).  The election will not apply in any year where the taxpayer is not a qualifying taxpayer.

[vii] Treas. Reg. § 1.469-9(g)(3).

[viii] Id.

[ix] See Treas. Reg. § 1.469-5T(c)(1)(i) (a significant participation activity is a trade or business activity “within the meaning of § 1.469-1T(e)(2)….”); § 1.469-1T(e)(2) (refers to § 1.469-1(e)(2)); § 1.469-1(e)(2) (“Trade or business activities are activities that constitute trade or business activities within the meaning of § 1.469-4(b)(1); § 1.469-4(b)(1) (“Trade or business activities are activities, other than rental activities….”).

The dominoes continue to fall from last year’s Supreme Court reversal of former Virginia governor Bob McDonnell’s conviction for honest services fraud, for his having set up meetings in exchange for money. On July 12, 2017, the Second Circuit reversed a politician’s convictions for honest services fraud and money laundering because the jury instruction ran afoul of the Supreme Court’s McDonnell decision. United States v. Silver, No. 16-1615-cr.  This decision highlights the difference between law and morality – what we expect from our public figures isn’t the same as what the law requires them to do.

Unlike term-limited California, New York allows its Assembly members to serve forever. That system permitted Sheldon Silver, a 20-year Speaker of the Assembly, to become “the most powerful man in New York,” according to a witness in his criminal trial.  Unscrupulous businesspersons were willing to pay for this influence, and Silver was willing to sell it.  Silver was indicted for committing honest services fraud, primarily for his having engaged in a string of actions that benefitted persons who were generating business for his part-time law practice.  The most-egregious actions occurred outside the statute of limitations period, so the government’s case rested on proving that the last few actions – including obtaining Assembly accolades for one of Silver’s co-conspirators – constituted illegal conduct.  Silver caught a big break when the trial judge accepted the government’s “honest services fraud” jury instruction, which defined the fraud as involving “any action” by a politician undertaken in exchange for something of value.  The jury convicted Silver based on this broad language, but the Second Circuit decided that the language was too broad under the later-decided McDonnell because it allowed the jury to convict based on setting up meetings or performing other tasks that non-politicians can perform.  The Supreme Court limited honest services fraud to actions that only politicians can take, such as voting on legislation, instead of more-subtle exercises of power such as introducing people to each other.  Because the final few alleged criminal actions weren’t obviously illegal, the government couldn’t show that the erroneous jury instruction was harmless beyond a reasonable doubt.  Mr. Silver will get a new trial with a jury instruction consistent with McDonnell, although the evidence will be unchanged and the optics of his earlier actions – steering public funds to his co-conspirators in exchange for referral fees – remain difficult for Silver to overcome.

What does this mean for white-collar criminal defendants? The Supreme Court is requiring that prosecutors and judges be precise and not rely on bringing charges and making arguments before juries that test the outer boundaries of amorphous crimes and statutes.  Appellate courts have taken notice and are no longer turning a blind eye to unreasonably broad interpretations of criminal statutes. 

What does this mean for tax cases? The Second Circuit’s Silver decision confirms that appellate courts got the Supreme Court’s message and that McDonnell’s legacy will continue to grow.  The McDonnell case may be a gift that keeps on giving for tax defendants, particularly those charged with a violation of 26 U.S.C. Section 7212, which prohibits the interference with IRS functions and has long been an example of a troublingly broad criminal statute.  The Supreme Court recently agreed to review a Section 7212 conviction, Carlos Marinello, II, v. United States, to determine whether the statute, at least as applied to Marinello’s actions and inactions such as not maintaining books and records, runs afoul of the U.S. Constitution.  DOJ can’t be happy about the Supreme Court’s decision to grant certiorari in Marinello, a case that DOJ won.

Although Silver isn’t the sort of person who would earn my vote, his unseemly political actions don’t obviously equal criminal actions simply because they fall short of what we expect of our elected officials. Fortunately, appellate courts generally know the difference between moral corruption and criminal actions.

EVAN J. DAVIS – For more information please contact Evan Davis – davis@taxlitigator.com or 310.281.3288. Mr. Davis 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) handling civil and criminal tax cases and, subsequently, of the Major Frauds Section of the Criminal Division of the Office of the U.S. Attorney (C.D. Cal) handling white-collar, tax, and other fraud cases through jury trial and appeal. He has served as the Bankruptcy Fraud coordinator, Financial Institution Fraud Coordinator, and Securities Fraud coordinator for the USAO’s Criminal Division, and the U.S. Attorney General awarded him the Distinguished Service Award for his work on the $16 Billion RMBS settlement with Bank of America.

Mr. Davis represents individuals and closely held entities in criminal tax investigations and prosecutions, civil tax controversy and litigation, sensitive issue or complex civil tax examinations and administrative tax appeals, and federal and state white collar criminal investigations. He is significantly involved in the representation of taxpayers throughout the world in matters involving the ongoing, extensive efforts of the U.S. government to identify undeclared interests in foreign financial accounts and assets and the coordination of effective and efficient voluntary disclosures (OVDP, Streamlined Procedures and otherwise).

Posted by: jkalinski | October 6, 2017

FOR WHOM THE COLLECTION STATUTE TOLLS by Jonathan Kalinski

Every tax practitioner knows the general rule that the IRS has 10 years to collect a tax after the assessment. That isn’t blog material.  Less well known because it is infrequently litigated, is the flush language of IRC §6502(a), which states that the collection statute of limitations is tolled if a timely proceeding in court is commenced when the collection statute is open.  As a result, the government can collect after the 10-year period has expired.

That brings us to a recent Michigan District Court[1] case filed by the government to reduce the liability to judgment that focused on what constitutes a proceeding in court.  The facts are this: In 2005 the IRS timely assessed a 2002 liability against Albert Chicorel, who subsequently died in 2006.  The IRS sent a proof of claim to the estate’s representative and filed it with the Oakland County Probate Court.  The proof of claim was docketed and never disputed.  Mr. Chicorel’s probate case is still pending.  The estate argued that the collection statue expired because 10 years from assessment had passed.  The estate lost.

The parties agreed the issue was a question of Federal law that turned on the nature, function, and effect of submitting a probate claim under local law. The Court held that the “nature, function, and effect” of the proof of claim constituted a proceeding in court and tolled the limitations period.  In doing so it did not rely on Federal tax law, but likened the case to ERISA, SEC, and Title VII precedents.  Michigan’s probate statute provides that for purposes of a statute of limitations, the proper presentation of a claim…is the equivalent to commencement of a proceeding on the claim.

It is important to note that in California and Massachusetts the decision likely would have been different. In United States v. Silverman[2], the Ninth Circuit held that the filing of a claim in California Probate Court did not constitute a proceeding before that court because it would undermine a state statute of limitations.  In United States v. Saxe[3], the First Circuit held that a proof of claim did not commence an actual proceeding, but served to extend the time for service of process in an action already commenced.

In New York, Illinois, and Kentucky, the decision would have been the same. This illustrates the importance of checking state law where relevant, and not simply relying on a Federal case.

Although the decision is bad news for taxpayers in Michigan, there is a potential silver lining. The government is generally hesitant to file a proof of claim because doing so can allow the taxpayer to challenge the liability.    In this case the estate never challenged the claim.

Jonathan Kalinski a senior tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and specializes in both civil and criminal tax controversies as well as sensitive tax matters including disclosures of previously undeclared interests in foreign financial accounts and assets and provides tax advice to taxpayers and their advisors throughout the world.  He handles both Federal and state tax matters involving individuals, corporations, partnerships, limited liability companies, and trusts and estates. He routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue 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.

Mr. Kalinski has considerable experience handling complex civil tax examinations, administrative appeals, and tax collection matters.  Prior to joining the firm, he served as a trial attorney with the IRS Office of Chief Counsel litigating Tax Court cases and advising Revenue Agents and Revenue Officers on a variety of complex tax matters.  Jonathan Kalinski also previously served as an Attorney-Adviser to the Honorable Juan F. Vasquez of the United States Tax Court.

Mr. Kalinski can be contacted at kalinski@taxlitigator.com. Additional information is available at http://www.taxlitigator.com.

[1] United States v. Estate of Albert Chicorel, Eastern District of Michigan, Case No. 16-10894.

[2] United States v. Silverman, 621 F.2d 961 (9th Cir. 1980), cert. denied, 450 U.S. 913 (1981).

[3] United States v. Saxe, 261 F.2d 316, 319 (1st Cir. 1958).

Posted by: Steven Toscher | September 28, 2017

Evan Davis and I recently published an article you may find of interest for the 2017 USC Tax Institute entitled ” 30 Years After- What the Federal Sentencing Guidelines Have Meant for Criminal Tax Enforcement. Here is the link https://lnkd.in/gssJch2

Posted by: Steven Toscher | September 26, 2017

CRIMINAL TAX ENFORCEMENT— IT HAPPENED AGAIN AND WE SHOULD NOT BE SURPRISED by Steven Toscher ©2017

The Treasury Inspector General for Tax Administration (“TIGTA”) issued a report September 13, 2017, concluding that “declining resources have contributed to unfavorable trends in criminal investigation business results.” That’s Government speak that the IRS criminal tax enforcement program is falling behind.

This is not a surprise for those of us in the trenches.  It reminds us of another report issued almost 20 years ago, the so-called “Webster Report” issued in 1999, in which an independent review by former FBI and CIA Director William Webster concluded the IRS Criminal Investigation Division had suffered “mission drift” and that its lack of investigations of income tax fraud would have a negative impact on taxpayer compliance.

When the Webster Report was issued, the mission drift was a function of IRS devoting too many resources toward drug enforcement.   Today the  mission drift is more due to shrinking government resources and a focus on taxpayer identity theft by the Criminal Investigation Division.

The point is that if we are going to have an IRS criminal investigation function that serves as a deterrent against taxpayers committing tax crimes, the TIGTA Report is alarming on a number of counts.

Most strikingly, for fiscal year 2016, the Criminal Investigation Division (“CI”) initiated 3,395 cases or an overall decrease of 44%, compared to 5,125 cases initiated in fiscal year 2012.  That’s a big drop.

The other important statistic is that the percentage of cases initiated from functions within the IRS (the examination function and collection function), has decreased 5% from fiscal 2012 to 2016.   One of the key takeaways from the Webster Report was to increase the “fraud referral program” which in fact was reinvigorated post-Webster Report; however, that reinvigoration seems to have lost steam– likely due to  budget constraints within the  IRS operating divisions.

Finally, the other key takeaway is that in fiscal year 2016, it took an average of 540 days or 1.5 years to determine  there was no prosecution potential in a case.  In 2012, it only took an average of 422 days to make that determination.

The TIGTA Report is a good read for anybody interested in tax enforcement and it raises the fundamental question of whether we are serious in a vibrant and effective criminal tax enforcement program.  After all, with a $458 billion tax gap—even a one (1%) percentage point uptick in taxpayer compliance translates  to  almost $5 billion of additional revenue.  Under CI’s current budget of $576 million, that could be very good return on investment.

Taxpayers in Real Property Business. Although the general rule is that all rental activities are by definition passive, the Code has created an exception for certain professionals in the real estate business.  A real estate professional (as that term is defined under Section 469(c)(7), the section that sets forth the exception to the rule that all rental activities are per se passive) is defined as a taxpayer who (1) spends more than 750 hours in the tax year working in a real property trade or businesses in which he materially participates and (2) performs more than one-half of his personal services during the tax year for real property trades or businesses.[i]

Definition of a real property trade or business. A “real property trade or business” is defined to include “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”[ii]  Although this list is quite comprehensive, it is important to note that the definition of a real property business does not explicitly include real estate financing.  In a recently issued Tax Court Summary Opinion, Hickam v. Commissioner (TC Summary Opinion 2017-66, August 17, 2017)[iii], the Tax Court held that a taxpayer who brokered real estate mortgages and originated residential and commercial loans was not a real estate professional within the meaning of Section 469(c)(7), because the taxpayer’s mortgage brokerage and loan origination businesses were not real property trade or business as defined in Section 469(c)(7)(C).  The Tax Court concluded that although the loans he brokered and originated were secured by real property, his mortgage brokerage services and his loan origination services did not involve operating the real properties that secured those loans—although he had a “brokerage” trade or business, it was not a “real property brokerage.”

Qualifying as a Real Estate Professional. In determining whether a taxpayer qualifies as a real estate professional, the only hours that count towards the real estate professional test are those in which the taxpayer has an interest and materially participates.  Services performed for a real estate business as an employee generally do not count for qualifying as a real estate professional, unless the taxpayer is at least a 5% owner of the employer.  In the case of taxpayers filing a joint return, spouses may not combine their hours to satisfy these requirements.[iv]  This differs from the rules applicable to satisfying the material participation rules, which allow spouses to combine hours worked.

If a taxpayer qualifies as a real estate professional, he avoids the per se passive rule for rental activities.  However, he will still have to satisfy the material participation tests (subject to additional limitations applicable to rental activities), in order to establish that the rental activity is a non-passive activity for purposes of Section 469.  These obstacles include prohibiting rental activities from being grouped with other real estate-related undertakings in applying the material participation tests, and prohibit a taxpayer from grouping his rental real estate activities together as a single activity, unless the taxpayer affirmatively makes an election to do so.

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 in complex civil tax litigation and criminal tax prosecutions (jury and non-jury). She represents U.S. taxpayers in litigation before both federal and state courts, including the federal district courts, the U.S. Tax Court, the U.S. Court of Federal Claims, and the Ninth Circuit Court of Appeals. Ms. Strachan has experience in a wide range of complex tax cases, including cases involving technical valuation issues. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue 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. Additional information is available at http://www.taxlitigator.com.

[i] IRC § 469(c)(7)(B).

[ii] IRC § 469(c)(7)(C).

[iii] Hickam v. Commissioner, Docket No. 3901-16S (TC Summary Opinion 2017-66, August 17, 2017), available here: http://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=11368.

[iv] However, note that in satisfying the material participation test for purposes of determining whether an activity is a passive activity, hours contributed by the spouse may be included in the number of hours of participation by the taxpayer in the activity.

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