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.

Questions relating to the Internal Revenue Code’s material participation rules for losses frequently arise in the context of real estate businesses, where losses are common as a result of depreciation deductions and deductions for other costs incurred by the owner. This series will provide the fundamentals of the material participation rules as they relate to the real estate industry and will highlight intricacies and exceptions in the rules that tax professionals and taxpayers in the real estate industry should be attuned to.

Overview of Section 469. Section 469 of the Internal Revenue Code generally disallows taxpayers from using a loss incurred in a taxable year from a “passive activity” to offset ordinary income on their income tax returns.[i]  These losses are suspended and will be treated as a loss from that activity incurred in the subsequent taxable year.[ii]  Passive losses will remain suspended until there is either (1) income from a passive activity in a subsequent year that can offset the loss,[iii] or (2) until the taxpayer disposes of his entire interest in the activity, at which time all suspended passive losses from that activity can be deducted.[iv]  The Code’s passive loss rules apply to individuals, estates, trusts, closely held C corporations, and personal service corporations.[v]

Definition of Passive Activity. A passive activity is defined generally as any activity which involves the conduct of any trade or business and in which the taxpayer does not “materially participate.”[vi]   However, notwithstanding this general definition, Section 469 specifies that any rental activity will be treated as a passive activity, regardless of whether the taxpayer materially participated in the rental activity.  This makes rental activities per se passive, requiring all losses from rental activities to be suspended.

Treatment of Rental Real Estate. The Code carves out one exception to the rule that “passive activity” by definition includes any rental activity for certain taxpayers in the real property business (generally referred to as a real estate professional).  If a taxpayer satisfies the requirements of Section 469(c)(7) to qualify as a real estate professional,[vii] the rule that all rental activities are passive does not apply.[viii]  However, even if a taxpayer qualifies as a real estate professional within the meaning of Section 469(c)(7), that doesn’t mean the taxpayer’s losses from real estate rental activities will automatically become deductible.  The taxpayer must still prove that the rental activity is not a passive activity under the general rule, with additional limitations that apply that make it more difficult to satisfy the material participation requirement.[ix]

Section 469 also allows a limited $25,000 offset for losses from rental real estate activities for certain taxpayers who are natural persons, actively participated in the rental activity, and who satisfy the income requirements.[x]

Treatment of Other Real Estate Businesses. These limitations to deducting losses from rental real estate activities do not apply to other trades and businesses in the real estate industry.  For example, taxpayers who have an interest in a construction business or a real estate development business are subject to the general definition of a passive activity, which treats the activity as non-passive (thereby making the losses deductible), if the taxpayer materially participated in the activity.[xi]

The passive loss rules do not apply to taxpayers who are simply holding real property for investment—gain or losses incurred by a taxpayer from the disposition of real property that had been held for investment are instead subject the Code’s capital gain/loss rules.[xii]  However, regardless of a taxpayer’s investment intent, an interest in a rental property is not treated as property held for investment for purposes of the passive loss limitation rules.[xiii]

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(a)(1).

[ii] IRC § 469(b).

[iii] The term “passive activity loss” for purposes of the Section 469 loss disallowance rules is defined as the amount by which the aggregate losses from all passive activities for the taxable year exceed the aggregate income from all passive activities for such year.  IRC § 469(d)(1).

[iv] IRC § 469(g).

[v] IRC § 469(a)(2).

[vi] IRC § 469(c)(1).

[vii] IRC § 469(c)7)(B), (C).

[viii] IRC § 469(c)(7)(A).

[ix] See Treas. Reg. § 1.469-9(e).

[x] IRC § 469(i).

[xi] See Treas. Reg. § 1.469-5T for the material participation tests.

[xii] IRC § 469(e)(1)(A)(ii); § 1221.

[xiii] IRC § 469(e)(1) (the flush language under § 469(e)(1) states that “any interest in a passive activity shall not be treated as property held for investment”).

The Financial Crimes Enforcement Network (FinCEN) just announced the issuance of revised Geographic Targeting Orders (GTOs) that require U.S. title insurance companies to identify the natural persons behind shell companies used to purchase for high-end residential real estate in seven metropolitan areas for the period September 22, 2017 to March 20, 2018. Following the recent enactment of the Countering America’s Adversaries through Sanctions Act, FinCEN has revised their previously issued GTOs to capture a broader range of transactions, include transactions involving wire transfers and expanded the GTOs to include transactions conducted in the City and County of Honolulu, Hawaii.

THE GTO’s – U.S. title insurance companies are now required to report to FinCEN by filing a FinCEN Form 8300 within 30 days of the closing of the Covered Transaction. Each FinCEN Form 8300 filed pursuant to the GTO must be: (i) completed in accordance with the terms of this GTO and the FinCEN Form 8300 instructions (when such terms conflict, the terms of the GTO apply), and (ii) e-filed through the Bank Secrecy Act E-filing system. Further, they must: (1) retain all records relating to compliance with the GTO for a period of five years from the last day that the GTO is effective (including any renewals of the GTO); (2) store such records in a manner accessible within a reasonable period of time; and (3) make such records available to FinCEN or any other appropriate law enforcement or regulatory agency, upon request.

ADVISORY – In addition, FinCEN published an Advisory to provide financial institutions and the real estate industry with information on the money laundering risks associated with real estate transactions, including those involving luxury property purchased through shell companies, particularly when conducted without traditional financing. The Advisory provides information on how to detect and report these transactions to FinCEN.

In January 2016, FinCEN issued GTOs to require U.S. title insurance companies to report beneficial ownership information on legal entities, including shell companies, used to purchase certain luxury residential real estate in Manhattan and Miami—specifically, luxury residential property purchased by a shell company without a bank loan and made at least in part using a cashier’s check or similar instrument.  In July 2016 and February 2017, FinCEN reissued the original GTOs and extended coverage to all boroughs of New York City, two additional counties in the Miami metropolitan area, five counties in California (including Los Angeles, San Francisco, and San Diego), and the Texas county that includes San Antonio.

TRANSACTIONS COVERED BY THE GTO’s – The GTOs identify a Covered Transaction as a transaction in which: (a) a Legal Entity (generally a corporation, limited liability company, partnership or other similar business entity, whether formed under the laws of a state or of the United States or a foreign jurisdiction), (b) purchases residential real property, (c) without a bank loan or other similar form of external financing, (d) such purchase is made, at least in part, using currency or a cashier’s check, a certified check, a traveler’s check, a personal check, a business check, or a money order in any form, or a funds transfer, and (e) the total purchase price is (i) $2,000,000 or more in the California county of San Diego, Los Angeles, San Francisco, San Mateo, or Santa Clara, (ii) $3,000,000 or more in the City and County of Honolulu in Hawaii, (iii) $3,000,000 or more in the Borough of Manhattan in New York City, New York, (iv) $1,500,000 or more in the Borough of Brooklyn, Queens, Bronx, or Staten Island in New York City, New York, (v) $1,000,000 or more in the Florida county of Miami-Dade, Broward, or Palm Beach, and (vi) $500,000 or more in the Texas county of Bexar.

The GTOs require a Covered Business to collect and report certain identifying information about the Beneficial Owner(s) of the Purchaser in a Covered Transaction. For purposes of the GTOs, a “Beneficial Owner” means each individual who, directly or indirectly, owns 25% or more of the equity interests of the Purchaser. The GTOs provide that the Covered Business must obtain and record a copy of the Beneficial Owner’s driver’s license, passport, or other similar identifying documentation. The Covered Business may reasonably rely on the information provided to it by third parties involved in the Covered Transaction, including the Purchaser or its representatives, in determining whether the individual identified as a Beneficial Owner is in fact a Beneficial Owner

SUSPICIOUS ACTIVITY REPORTS – Within the scope of real estate transactions covered by the GTOs, FinCEN data indicate that about 30 percent of reported transactions involve a beneficial owner or purchaser representative that was also the subject of a previous suspicious activity report. A covered financial institution is required to file a SAR if it knows, suspects, or has reason to suspect a transaction conducted or attempted by, at, or through the financial institution involves funds derived from: illegal activity, attempts to disguise funds derived from illegal activity, is designed to evade regulations promulgated under the BSA, lacks a business or apparent lawful purpose, or involves the use of the financial institution to facilitate criminal activity. According to FinCEN, beneficial owners or purchaser representatives in a significant portion of transactions reported under the GTO had been previously connected to a wide array of suspicious activities, including:

  • A beneficial owner suspected of being connected to over $140 million in suspicious financial activity since 2009 and who sought to disguise true ownership of related accounts.
  • Two beneficial owners (husband and wife) involved in a $6 million purchase of two condominiums were named in nine SARs filed from 2013 – 2016 in connection with allegations of corruption and bribery associated with South American government contracts.
  • A beneficial owner suspected of being connected to a network of individuals and shell companies that received over $6 million in wire transfers with no clear business purpose from entities in South America. Much of these funds were used for payments to various real estate related businesses.
  • Eleven SARs filed from 2008 through 2015 named either the buyer (an LLC), beneficial owner, or purchaser’s representative involved in a GTO-reported $4 million purchase of a residential unit. Law enforcement records indicate that both the purchaser’s representative and his business associate were associated with a foreign criminal organization involved in narcotics smuggling, money laundering, health care fraud, and the illegal export of automobiles.

FORM 8300 DUE WITHIN 30 DAYS – If the Covered Business is involved in a Covered Transaction, then the Covered Business shall report the Covered Transaction to FinCEN by filing a FinCEN Form 8300 within 30 days of the closing of the Covered Transaction. Each FinCEN Form 8300 filed pursuant to this Order must be: (i) completed in accordance with the terms of this Order and the FinCEN Form 8300 instructions (when such terms conflict, the terms of this Order apply), and (ii) e-filed through the Bank Secrecy Act E-filing system.

FinCEN is concerned about this small segment of the market in which shell companies are used to buy luxury real estate in “all-cash” transactions. In addition, feedback from law enforcement to FinCen apparently indicates that the reporting has advanced criminal investigations.  FinCEN believes the expanded GTOs will further help law enforcement and inform FinCEN’s future efforts to assess and combat the money laundering risks associated with luxury residential real estate purchases.

Additional information is available at:

FinCEN Targets Shell Companies Purchasing Luxury Properties in Seven Major Metropolitan Areas

https://www.fincen.gov/news/news-releases/fincen-targets-shell-companies-purchasing-luxury-properties-seven-major

Advisory to Financial Institutions and Real Estate Firms and Professionals (FIN-2017-A003)

https://www.fincen.gov/sites/default/files/shared/Real%20Estate%20GTO%20Order%20-%208.22.17%20Final%20for%20execution%20-%20Generic.pdf

FinCEN Geographical Targeting Order (GTO) dated August 22, 2017

https://www.fincen.gov/sites/default/files/advisory/2017-08-22/Risk%20in%20Real%20Estate%20Advisory_FINAL%20508%20Tuesday%20%28002%29.pdf

FinCEN Frequently Asked Questions re Geographical Targeting Order (GTO) dated August 22, 2017

https://www.fincen.gov/sites/default/files/shared/FAQs%20on%20Phase%204%20Real%20Estate%20GTO%208.22.2017%20FINAL.pdf

CHARLES RETTIG – Chuck Rettig is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., specializing in civil and criminal tax controversies as well as tax, business and estate planning, and family wealth transfers. Listed as the only Eminent Practitioner by Chambers USA specializing in “Tax: Fraud – Nationwide, Chuck is internationally recognized for his expertise in the representation of US Persons having undeclared interests in foreign financial accounts and assets, including sensitive civil examinations, IRS voluntary disclosure programs and procedures. Mr. Rettig is a Certified Specialist both in Taxation Law and in Estate Planning, Trust & Probate Law by the State Bar of California, Board of Legal Specialization 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 For more information please contact Chuck Rettig directly – rettig@taxlitigator.com

On June 19, 2017, the IRS’s LB&I Division issued a “Practice Unit” to provide guidance on the meaning of “substantially complete” for international information return penalty purposes[1].  Practice Units[2] are developed to serve as both job aids and training materials for the IRS and to provide explanations of tax concepts as well as information about specific types of transactions.

Here, the IRS issued an LB&I Concept Unit to discuss the meaning of “substantially complete” with respect to international information return penalties, and in particular, the failure to complete parts of the Form 5471. The Concept Unit also notes that a court might apply the generally applicable substantial compliance doctrine to other international information returns, including:

  1. Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships;
  2. Form 8858, Information Return of U.S. Persons With Respect to Certain Foreign Disregarded Entities;
  3. Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation;
  4. Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts; and
  5. Form 3520-A, Annual Information Return of Foreign Trusts With a U.S. Owner

While the three examples provided in this particular “Concept Unit” illustrate when the IRS may NOT apply the substantial compliance doctrine, the examples set forth seven factors that should be considered in determining whether the taxpayer has substantially complied:[3]

  1. The magnitude of the underreporting, or of the over-reporting, of the erroneous reported
  2. transaction(s) in relation to the actual total amount of that reported type of transaction(s).
  3. Whether the reporting corporation has reportable transactions other than the erroneoustransactions.
  4. reported transaction(s) with the same related party and correctly reported such other
  5. The magnitude of the erroneous reported transaction(s) in relation to all of the other
  6. reportable transactions as correctly reported.
  7. The magnitude of the erroneous reported transaction(s) in relation to the reporting
  8. corporation’s volume of business and overall financial situation.
  9. The significance of the erroneous reported transaction(s) to the reporting corporation’s
  10. business in a broad functional sense.
  11. Whether the erroneous reported transaction(s) occur(s) in the context of a significant
  12. ongoing transactional relationship with the related party.
  13. Whether the erroneous reported transaction(s) is (are) reflected in the determination and
  14. computation of the reporting corporation’s taxable income

The guidance also reminds IRS representatives to keep in mind that estimates are allowed in completing, for instance, Form 5472, if information is not readily available.

The guidance also cites analogous areas of the law, such as when a taxpayer may be “substantially compliant” with the qualified appraisal requirements under IRC Section 170, and the regulations thereunder. In Bond v. Commissioner,[4]  as described in the guidance, the Tax Court evaluated whether the requirements in the regulations related to the substance or essence of the statute.  The Tax Court ultimately determined that the regulatory requirement was held to be directory rather than mandatory, and the taxpayer was held to have substantially complied.  The guidance then concludes that Substantial compliance generally applies to regulatory requirements, but strict compliance applies to statutory requirements, although it also notes that such compliance is a heavily litigated area and is based on the facts and circumstances of each case.

Ultimately, the guidance consults that there is no available guidance on whether other international information returns are subject to the judicial substantial compliance doctrine, but if a Revenue Agent believes it may apply, then Field counsel should be consulted. For practitioners though, the development of the concept of the substantial compliance doctrine reminds preparers and representatives that reasonable cause is not the only exception that may be raised when disputing international informational reporting penalties.

CORY STIGILE – For more information please contact Cory Stigile – stigile@taxlitigator.com  Mr. Stigile is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a CPA licensed in California, the past-President of the Los Angeles Chapter of CalCPA and a Certified Specialist in Taxation Law by The State Bar of California, Board of Legal Specialization. Mr. Stigile specializes in tax controversies as well as tax, business, and international tax. His representation includes Federal and state civil and criminal tax controversy matters and tax litigation, including sensitive tax-related examinations and investigations for individuals, business enterprises, partnerships, limited liability companies, and corporations. His practice also includes complex civil tax examinations. Additional information is available at www.taxlitigator.com

[1] https://www.irs.gov/pub/int_practice_units/iga_c_17_03_01_02.pdf.

[2] Practice/Process Units are not official pronouncements of the law, and cannot be used, cited or relied upon as such.  Still, they provide useful roadmaps for the underlying authorities related to concepts that are applied during examinations.

[3] CCA 200429007.

[4] Bond v. Commissioner – 100 T.C. 32 (1993)

For the first time, Avram Salkin, Chuck Rettig, Steve Toscher & Dennis Perez of Hochman, Salkin, Rettig, Toscher & Perez, PC join together for a panel presentation to be held at noon on Friday, Aug 25 for the CalCPA Hollywood/Beverly Hills Discussion group at the Olympic Collection, 11301 Olympic Blvd., West Los Angeles.

Avram Salkin, Chuck Rettig, Steve Toscher & Dennis Perez have practiced together for 30+ years and have handled literally every type of tax dispute (civil and criminal, federal and state) that might be encountered by you or your clients.

Their presentation will provide invaluable insight and advice drawn from their combined 150+ years of professional experience in the tax trenches including practical advice for real-life client issues, focusing on current tax enforcement priorities and procedures, practitioner representation strategies and techniques, and ethical considerations – truly a “can’t miss” presentation by three of the most respected tax controversy practitioners in the United States.

LEARNING OBJECTIVES:

• Practice tips: learn current IRS tax priorities and procedures.
• Gain defensive representation strategies and techniques.
• Define legal issues and evidentiary benchmarks for government engagements
• Understand how to better represent your client in preparing returns and when facing IRS examination.

DISCUSSION TOPICS:

Civil and criminal tax disputes, privileges, conflicts, defending the indefensible tax return on audit and in litigation, overview of current IRS Wealth Squad examination techniques, voluntary disclosures – domestic and foreign (streamlined vs. the OVDP; “noisy” vs. “quiet”), practical advice regarding previously undeclared offshore financial accounts and assets (FBARs), benefits of Qualified Amended Returns and FOIA requests, and various ethical considerations and the avoidance of penalties for your clients and for you!

REGISTRATION AND LOCATION:

Online registration is available at http://www.calcpa.org/events-and-programs/event-details?id=9adf907a-a2ab-470b-a11c-7e840b91a7da (online registration will close on Aug 25 but walk-ins are welcome to attend and pay at the door). To ensure there is space available, call CalCPA Program Associate Tracey Zink at (818) 546-3554.

The program will start promptly at Noon.
•Fees: $42/member, $52/nonmember
•Add $5 for same day and at door registration
Parking and lunch included
•Address: Olympic Collection Banquet Hall and Conference Center, 11301 Olympic Blvd., West Los Angeles 90064

Posted by: Steven Toscher | August 15, 2017

THE ARM OF THE U.S. TAX MAN IS LONG by Steven Toscher

After defending taxpayers for more than thirty years, I have read a lot of court opinions and you know it is not a good sign when the opinion starts “The arm of the U.S. tax man is long….” That was the language recently used by the District Court in Dewees v. United States, Case No. 16-cv-01579 (CRC) (District of Columbia, August 8, 2017).

Mr. Dewees was a “refugee” from the Internal Revenue Service’s (“IRS”) Offshore Voluntary Disclosure Program (“OVDP”).  It appears he decided not to go forward with the OVDP, but to opt out.  No doubt because he felt the penalties sought to be imposed under the OVDP were excessive.  Mr. Dewees is a U.S. citizen who lives and operates a consulting business in Canada.  One of the compliance issues he faced was the failure to file the Forms 5471 for his consulting business.

As part of the Voluntary Disclosure Program, the IRS proposed to assess a penalty of $185,862 for failing to file FBARs for the years 2003 through 2008.  That was too much for the taxpayer, so he withdrew from the OVDP.

It is not clear from the opinion what the IRS did regarding the FBAR penalties, but they did, in September 2011, assess $120,000 in penalties for Dewees’ failure to file Forms 5471 for the years 1997 through 2008.  Code Section 6038(c) authorized the IRS to impose a $10,000 penalty for each yearly failure to file, unless  it was due to “reasonable clause.”  It appears Dewees did request an  abatement based upon reasonable cause, but the IRS denied it.

Here is where it gets interesting.  In May 2015, the Canadian Revenue Agency notified Mr. Dewees that it was holding a Canadian tax refund due to his outstanding $120,000 penalty  to the IRS.  The Canadian offset  was based upon Article XXVI (A) of the United States-Canada Income Tax Convention.  Dewees paid the amounts due, plus interest and filed a claim seeking a refund which was rejected in May 2016.

The taxpayer brought an action in the District Court of the District of Columbia, (likely because he was a non-U.S. resident) and raised a number of interesting claims requesting that the Court find that the collection assistance provisions of the United States-Canada Tax Convention were unconstitutional for violating (1) the excessive fines clause of the Eight Amendment; (2) the due process clause of the Fifth Amendment; and (3) the equal protection of the Fifth Amendment.

The claims raised by the taxpayer are worth noting, but more interesting is the use of the provision of the United States-Canada Income Tax Convention which does provide for assistance in tax collection matters. Most existing United States income tax treaties do not provide for assistance in tax collection matters, but some do.  Under the common law rule, international collection is not in the cards.  However, a treaty provision can provide for collection assistance.

Even where there is a provision to provide for international assistance in collection, it has been rarely used. The Dewees case indicates this is changing.

One of the impediments of implementing international collection is resources.  If the United States does not have enough resources to collect its own taxes, how can it devote resources to collecting other countries taxes?  However, a mere offset done by computer, like what the Canadian Revenue Agency did, is easy.  Another  sign of our ever changing tax world in the digital age.

As for the claims under the Eight Amendment and the Fifth Amendment, they were all interesting, but disposed of quickly by the District Court.  The one claim that did get more attention was the Eighth Amendment claim for “excessive fines.”  The District Court devoted quite a bit of its opinion reviewing the historical case law that a “tax penalty” is outside the Eighth Amendment’s reach.  This however should be contrasted with the FBAR penalty which the courts so far have held is a penalty subject to Eighth Amendment review.  See United States v. Bussell, 117 A.F.T.R. 2d 2016-439.  2015 WL 9957826, (C.D. Calif. 2015), appeal pending (9th Cir). See also, Toscher and Lubin “When Penalties Are Excessive – The Excess Fines Clause as a Limitation of the Imposition of the Willful FBAR Penalty,” Journal of Tax Practice and Procedure, December 2009-January 2010.

Another take away from the case is the IRS assessment of $120,000 in Form 5471 penalties—for twelve (12) years.  We of course do not know what happened to the FBAR penalties, but some might think the IRS was being  vindictive here because the taxpayer opted out of the OVDP penalty.  Twelve (12) years of Form 5471 penalties—penalties  that the IRS used to waive routinely— seems like piling on.

Some things in the tax world are changing; other things never change.

STEVEN TOSCHER – For more information please contact Steven 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 a Certified Tax Specialist in Taxation, the State Bar of California Board of Legal Specialization 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

In a case that proves even the most-respected judges get reversed, Manhattan district judge Jed Rakoff’s decision to permit an informant’s testimony after the informant read transcripts of the defendants’ U.K. government-compelled testimony, was unanimously reversed by a Second Circuit panel on July 19, 2017.

Immunity comes in two flavors: “direct use” and “derivative use.” Direct use immunity is limited to preventing the government from introducing the immunized statements in its case-in-chief (the government’s part of the case) against the declarant if he goes to trial. Derivative use immunity includes use immunity and is co-extensive with the Fifth Amendment; it prevents the government from using the immunized statements for any purposes, and if they end up going to trial against the declarant they must prove that evidence being introduced didn’t derive from the declarant’s immunized statements. In the United States, forcing someone to testify or give a statement while only giving use immunity is considered “compelling” their testimony for Fifth Amendment purposes. Any compelled statements can’t be used against them in their trials. That’s why in the United States a court or government can only compel testimony – on pain of civil contempt – if they grant derivative use immunity.

Cue “God Save the Queen.”

The Brits appear not to share the U.S.’s enlightened view of immunity. In the U.K. investigation into LIBOR manipulation – rigging a benchmark exchange/interest rate to benefit certain traders – the U.K. government compelled testimony by Anthony Allen and Anthony Conti after giving them only direct use immunity. If prosecuted in the U.K., the prosecutors couldn’t introduce their testimony directly but they could use it for a variety of other purposes, including to develop and track down new evidence.

The U.S. government recognized that this incomplete immunity could prove to be a problem if Allen and Conti were prosecuted in the U.S., so the U.S. interviewed both before they testified under compulsion of use immunity. If the transcripts had never surfaced in the U.S. case, then they would have been irrelevant. But they did surface.

Another target of the U.K. LIBOR investigation, Paul Robson, received “discovery” of the evidence against him, including transcripts of Allen’s and Conti’s testimony compelled subject only to direct use immunity. Robson read the testimony, marked up the transcripts, and then was told the U.K. had dropped its investigation. Turns out this wasn’t good news for Robson, Allen, and Conti, as it just signaled that the U.K. was stepping aside to permit the U.S. to prosecute the three men along with a handful of others.

Robson agreed to plead guilty and cooperate against his co-defendants including Allen and Conti. At that point, the fact that Robson had reviewed their compelled testimony became a ticking time bomb for the U.S. government. It exploded not at trial, but on appeal.

At trial, Allen and Conti moved to dismiss the indictment and reverse the trial conviction based Robson’s trial testimony and on the grand jury having heard Robson’s exclusive (and arguably tainted) accounts of Allen’s and Conti’s actions and statements. Judge Rakoff, a recognized expert in securities cases and one of the most-respected trial judges nationwide, denied the motions and permitted Robson to testify against Allen and Conti. He accepted, among other things, a conclusory statement by Robson that the transcripts hadn’t tainted his testimony.

After Allen and Conti were convicted, they appealed and argued that allowing Robson’s hearsay statements before the grand jury and his trial testimony after his having reviewed and internalizing transcripts of their compelled testimony meant that the government had to prove that all its evidence – including Robson’s trial testimony – had not been derived from the compelled testimony. This so-called Kastigar analysis, named after the Supreme Court decision, is supposed to be very difficult for the government to meet. Allen and Conti complained that Judge Rakoff had accepted at face value the witness’s blanket statements that his testimony hadn’t been affected by the transcripts despite that he couldn’t segregate what he knew before and after reading the transcripts, thereby lowering what is supposed to be a high Kastigar bar.

The Second Circuit, relying on the D.C. Circuit’s analysis in reversing Oliver North’s conviction in the Iran-Contra scandal, reversed the convictions based on the government’s use of Robson’s possibly-tainted testimony in obtaining the indictment. An indictment returned after presentation of involuntary testimony – a federal agent summarized Robson’s possibly-tainted statements to the grand jury – must be dismissed unless the government can prove beyond a reasonable doubt that the grand jury would have indicted without the testimony. Robson’s statements were essential to the indictment, to the extent that he was the sole witness for much of the most-damaging evidence. Although Judge Rakoff was convinced that Robson’s statements weren’t tainted by his having reviewed the defendant’s transcripts, once the Second Circuit decided Robson’s statements were tainted, it was nearly a foregone conclusion that the government couldn’t prove beyond a reasonable doubt that his tainted statements were irrelevant to the grand jury’s decision to indict.

What’s the takeaway? The very same coordination that DOJ touts in its FCPA and tax prosecutions can lead to a poison pill for resulting U.S. prosecutions. Skilled defense counsel will use this holding and the logical underpinnings – including quotations such as that coordination with foreign law enforcement “need not affect the fairness of our trials at home” – to push back against any coordination that directly or indirectly undermines a defendant’s constitutional protections.

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: Steven Toscher | August 8, 2017

A BILLION HERE, A BILLION THERE – IT ADDS UP by Steven Toscher

The Treasury Inspector General for Tax Administration (“TIGTA”) recently issued a report suggesting that the Internal Revenue Service (“IRS”), by failing to properly implement its wage reporting matching program is leaving at least $7 billion on the table.

The IRS and the Social Security Administration have a computer matching program called the Combined Annual Wage Reporting (“CAWR”) Program which compares employee wage and withholding information reported to the IRS on employment tax forms to withholding documents filed with the Social Security Administration.  The purpose of the IRS-CAWR Program is to ensure that employers report the proper amount of employment taxes and Federal income tax withholding on their employment tax returns.  In today’s digital driven world, it is a program which makes great sense.

The TIGTA report found that in “most” cases where discrepancies are found, the IRS does followe-up with the taxpayer.  In 2013,  of  137,272 discrepancy cases, the IRS only worked approximately 17% or 23,184.  The remaining 114,088  (83%) discrepancy cases which were not worked had potential unreported tax difference of more than $7 billion.

In addition to not working all  the cases, the TIGTA report found that the IRS case selection process did not properly ensure  priority was given to discrepancy cases with the highest potential tax assessment.  TIGTA analyzed 114,088 discrepancy cases that were not worked to identify those with the highest potential unreported tax amounts case type.  Their analysis indicated that there had been total potential unreported tax of more than $6.8 billion.

TIGTA recommended that the Small Business/Self-Employed Division evaluate the current agreement and workload processes with the Social Security Administration to determine if changes could be made and  to revise its case selection criteria to include cases with the highest potential tax assessment.  TIGTA also recommended that the IRS take actions to include prior year discrepancy cases when the current year discrepancy case was selected for the same employer.

Interestingly, the IRS agreed with 6 of the 7 TIGTA recommendations.  IRS management did not agree to include the prior year discrepancy cases, but that it would consider employers that  had a prior discrepancy case as part of a selection criterion for current year cases.  The full report can be found at https://www.treasury.gov/tigta/auditreports/2017reports/201740038fr.pdf.

In today’s digital world, the only possible excuse for leaving $7 billion on the table is a lack of manpower at the IRS.  Some may blame the IRS, but the blame could with the Congress and  inadequate funding of the IRS.  This is a simple fix.  Resources should be put toward this $7 billion problem.  Hit a button, find   the discrepancies and  collect the additional employment tax liability.  A billion here and a billion there adds up.

STEVEN TOSCHER – For more information please contact Steven 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 a Certified Tax Specialist in Taxation, the State Bar of California Board of Legal Specialization 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

In Canna Care, Inc. v. Commissioner, No. 16-70265 (9th Cir. July 25, 2017), the Ninth Circuit Court of Appeals  affirmed the Tax Court’s decision that a marijuana dispensary was not entitled to the deduct its operating expenses because it was in the business of trafficking in a “controlled substance.”  Yes, under Federal law, marijuana is still a “controlled substance”  and Section 280E of the Internal Revenue Code precludes the deduction of what would otherwise be ordinary and necessary business expenses.  Appellate counsel for the dispensary raised some  novel arguments on appeal, including  (1) whether Section 280E as applied violates the excessive fines clause of the Eighth Amendment to the Constitution; (2) whether Section 280E precludes  state and local tax deductions; and (3) whether Section 280E precludes appellant’s net operating loss carryover deduction from  a prior year.

Unfortunately the Circuit Court  decided not address these issues because none of the  novel arguments were  raised in the Tax Court and not preserved on appeal.  The Ninth Circuit noted that “absent exceptional circumstances, this court will not consider an argument that was not first raised in the Tax Court.”

The undersigned saw the oral argument (one can go to the Ninth Circuit’s website and still see it) and appellate counsel  did a great  job with these  very difficult  arguments, but the Ninth Circuit judges were not biting.  The argument was premised on the fact “things have changed.”  That is, most states now have legalized marijuana for medical purposes and more and more states are enacting laws legalizing recreational use.

The states’ interest in these local laws is not only  medical and compassion for  people who  benefited from marijuana, but also the ever increasing need for tax revenue.  California also recently went the way of Colorado, and other states, legalizing the recreational use of marijuana and it is anticipated that the sales will generate significant a tax revenue for the state.

There are ongoing lobbying efforts to repeal Section 280E in light of the “changes” which have happened, but the statute is clear and marijuana is still a controlled substance within the meaning of the statute.

The point to be made here though is that the current state of affairs is a mess regarding tax policy.  Marijuana dispensaries which operate legally under state law are unable to bank like any other business and  in most cases are required to deal in cash.  Not only does this present risks to all involved,  cash businesses tend to be less compliant than non-cash businesses and  that may  be a bit of an understatement.

Equally important, a state law compliant marijuana dispensary is unable to deduct it to ordinary and necessary expenses substantially raising the effective marginal tax rate. That also is a temptation for the less than compliant taxpayer.

With the disallowance of expenses, the question raised in the Ninth Circuit was whether the income tax on the dispensary was in fact not a tax, but a “penalty” subject to restrictions and limitations imposed by the Eight Amendment to the Constitution.  While this argument has gained traction regarding the FBAR penalty (which is not a tax),[i] the Circuit Court recognized that Congress has plenary authority to impose a very high tax rate so the excessive fines clause argument went nowhere.  It was a nice try though.

We need a rational system of taxation for businesses which are allowed to legally operate in the states.  The irrationality of the current system will not help tax compliance.

STEVEN TOSCHER – For more information please contact Steven 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 a Certified Tax Specialist in Taxation, the State Bar of California Board of Legal Specialization 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 www.taxlitigator.com

[i]  See United States v Bussell, 117 A.F.T.R. 2d 2016-439. 2015 WL 9957826, (C.D Calif. 2015)  See also,  Toscher and Lubin “When Penalties Are Excessive—The Excess Fines Clause as a Limitation of the Imposition of the Willful FBAR Penalty, Journal of Tax Practice and Procedure, December-2009- January 2010.

 

 

 

 

 

 

 

 

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