TAXLITIGATOR – Tax Controversy (Civil & Criminal) Report

“Friend of the JTPP, Robert S. Horowitz shares an update on penalties in The News from the FBAR Front Isn’t All Bad, It Only Seems That Way Sometimes. It’s good to hear the phrase “non-willful FBAR cases” even if it is a rare case. It seemed for a while that IRS wasn’t able to find an FBAR case it considered non-willful. Robert’s easy writing style and insight will guide you through the variety of cases he reviews.”

—Claudia Hill Editor-in-Chief

This year has seen several significant decisions in the FBAR penalty arena. While some taxpayers have been successful in defeating motions for summary judgment in FBAR willful cases, in those cases that have gone to trial the taxpayers have ultimately lost. In the non-willful FBAR area, however, the taxpayers this year were successful in convincing two district courts that the maximum non-willful penalty is $10,000 per annual form and not per account. This article will discuss some of the FBAR cases that were decided over the past year.

Click Here to read full article.

The IRS Criminal Investigation division isn’t focusing its enforcement efforts specifically on cannabis businesses, but is instead treating them like any other cash-intensive business, according to a division official.

Jonathan Kalinski of Hochman Salkin Toscher Perez PC told Tax Notes in part that “. . . practitioners with cannabis clients might need to keep a closer watch for potential criminal activity than they do for other clients.”

Click Here to see full article.

Steven Toscher recently had the opportunity to moderate a Federal Bar Association panel on the IRS new Office of Fraud Enforcement. While much attention was paid on the panel to the  unveiling some of IRS Crown Jewels by the new OFE Director Damon Rowe and it’s “Operation Hidden Jewels” in its cryptocurrency enforcement efforts, Steve was quoted in Forbes on his thoughts on the established of the new OFE and what it will mean for taxpayers and their advisors:

“The new Office of Fraud Enforcement looks like it will be a game changer in tax enforcement. We expect to see more referrals for criminal prosecution and assertions of the 75% civil fraud penalty. When the current leaders of the IRS took over a few years ago they decided that a more vigorous enforcement of the tax laws, including the use of criminal investigations and civil fraud penalties, was essential to fairness for all taxpayers. The Office of Fraud Enforcement is the product of that increased focus.”

Stay tuned.  Click Here for Full Article

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The price of Bitcoin rose dramatically in 2020 and even doubled in price since the beginning of 2021. On January 1, 2021, Bitcoin was $29,336.31 and on February 21, 2021, it was $58,012.09. Many who have sold their Bitcoin have made a profit. Where there’s profit, there’s income – and where there’s income, there’s tax. 

When it comes to money and taxes, one can expect that the IRS will be the most likely government entity to be interested in a financial transaction.  However, the Financial Crimes Enforcement Network (FinCEN) is also very involved with monitoring money and financial transactions. FinCEN’s mission is “to safeguard the financial system from illicit use, combat money laundering and its related crimes including terrorism, and promote national security through the strategic use of financial authorities and the collection, analysis, and dissemination of financial intelligence.”

The IRS and FinCEN have, at times, had interest in the same financial matters. For example, as part of FinCEN’s focus on money laundering, that agency requires the reporting of certain foreign financial accounts on a Foreign Bank Account Report (FBAR). It is no secret that the IRS has also showed a tireless  interest in FBARs beginning in earnest in 2008, after the Department of Justice obtained a deferred prosecution agreement against UBS, the Swiss banking regulator, and thereunder the disclosure of  information about United States citizens with undisclosed foreign accounts in Switzerland.

Now both agencies, in an apparent connection to FBAR disclosures, have also taken steps to publicize their respective, and arguably shared, interest in cryptocurrency. As part of the IRS’s focus on tax compliance, the IRS has designated cryptocurrency, including international transactions, an enforcement priority for the last few years.  Most recently, FinCEN has also make clear that agency’s interest in cryptocurrency, as evidenced by their latest proposed amendment.

FinCEN’s proposed amendment seeks to add virtual currency to the list of financial accounts that need to be reported on an FBAR. Current FBAR regulation, 31 CFR 1010.350(a), states “Each United States person having a financial interest in, or signature or other authority over, a bank, securities, or other financial account in a foreign country shall report such relationship to the Commissioner of Internal Revenue for each year in which such relationship exists…”  

Current regulations provide that  the types of reportable accounts include bank accounts; securities accounts; accounts with a person that is in the business of accepting deposits as a financial agency; insurance or annuity policies with a cash value; an account with a person that acts as a broker or dealer for futures or options transactions in any commodity on or subject to the rules of a commodity exchange or association; mutual funds or similar pooled funs; or other investment funds. (31 CFR 1010.350(c)).

Notably, virtual or cryptocurrency is not a type of account required to be reported to the government under the regulations.  Although that is not a shock, as the statute was enacted in 1970, many years before crypto currency was likely more than a twinkle in the eye of the dark web or any other exchange. It appears that 2021 may be the year that the regulation catches up and addresses foreign cryptocurrency accounts in the context of required disclosures on an FBAR.    

FinCEN recently announced its intention to propose amendments to the regulations implementing the Bank Secrecy Act (BSA) regarding the FBAR to include virtual currency as a type of reportable account under 31 CFR 1010.350.

Currently, the Report of Foreign Bank and Financial Accounts (FBAR) regulations do not define a foreign account holding virtual currency as a type of reportable account. (See 31 CFR 1010.350(c)). For that reason, at this time, a foreign account holding virtual currency is not reportable on the FBAR (unless it is a reportable account under 31 C.F.R. 1010.350 because it holds reportable assets besides virtual currency). However, FinCEN intends to propose to amend the regulations implementing the Bank Secrecy Act (BSA) regarding reports of foreign financial accounts (FBAR) to include virtual currency as a type of reportable account under 31 CFR 1010.350.[1]

FinCEN’s announcement would add a second reporting requirement to taxpayers that own virtual currency. The 2019 Form 1040’s Schedule 1 for the first time added a question to the top of the form that was not previously found in previous Form 1040’s:

“At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” The form provides a checkbox for either “yes” or “no”.

Requiring virtual currency reporting on an FBAR, like other reporting requirements, is often more than an exercise in filing additional paperwork.  As the penalties and potential criminal exposure surrounding FBAR non-compliance have shown, the failure to disclose reportable virtual currency accounts on the FBAR may lead to even greater consequences than the already, often daunting consequences of a failure to report taxable transactions on a Form 1040.

Failure to report virtual currency on a Form 1040 can not only lead to criminal prosecution, but also additional tax, interest, and penalties, including the civil fraud penalty.  The failure to report on the FBAR may lead to penalties as high as 50% of an account’s highest balance per failure to file.  Of course, there is also the potential that the government could pursue both forms of penalties for non-compliance on the two separate forms. 

Reminding Taxpayers of the obligation to report income from all sources, including virtual currency, couldn’t be timelier.  The requirements to report virtual currency transactions may soon extend beyond the Form 1040, Schedule 1. FinCEN’s proposed amendments to regulations reporting of virtual currencies could soon place on U.S. taxpayer a reporting requirement on the annual FBAR form. As the IRS and FinCEN join forces to focus on virtual currency, the message is clear that cryptocurrency enforcement is here to stay. 

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[1] FinCEN Notice 2020-2

[i] Jonathan Kalinski is a principal at Hochman Salkin 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.

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.

[ii] Gary Markarian is an Associate at Hochman Salkin Toscher Perez P.C., and a graduate of the joint JD/LL.M. Taxation program at Loyola Law School, Los Angeles. While in law school, Mr. Markarian served as an intern at the Tax Division of the U.S. Attorney’s Office (C.D. Cal) and Internal Revenue Service Office of Chief Counsel’s Large Business and International Division.

We are pleased to announce that Steven Toscher, Michel Stein and Jonathan Kalinski will be speaking at the upcoming Strafford webinar, “Handling Cannabis Tax Examinations: Sec. 280E, Audits, IRS Guidance, Reporting Requirements” on Wednesday, March 24, 2021, 1:00 pm-2:30 pm (EDT), 10:00 am-11:30 am (PDT).

This CLE/CPE webinar will provide tax counsel and advisers guidance on effective methods in handling IRS cannabis tax examinations for businesses engaged in the cannabis industry. The panel will discuss key federal and select state tax law provisions impacting marijuana businesses, key items of focus by the IRS when examining cannabis operations, and techniques in managing audits.

The sale and distribution of cannabis for recreational or medical use is a powerful economic engine generating billions in annual revenue, with over 40 states and the District of Columbia having some form of legalization of the substance. Despite state relaxation of marijuana prohibition laws, without careful planning, regulated cannabis businesses can be subject to hefty tax assessments and penalties.

Under Section 61, all gross income must be reported from whatever source it is derived. However, under Section 280E, cannabis businesses cannot deduct rent, wages, and other expenses unless it is for cost of goods sold (COGS), resulting in a substantially higher tax rate than other companies on their income. The IRS issued guidance to its agents on conducting audits of cannabis businesses giving IRS agents the authority to change a cannabis business’ accounting method. Under Section 280E, certain costs are not included in COGS. Thus, they remain non-deductible for income tax purposes.

As more states legalize cannabis and make available licenses to grow, manufacture, distribute, and sell cannabis, the IRS has increased cannabis tax audits, which could result in unbearable tax liabilities.

Listen as our panel discusses federal and select state tax law provisions impacting cannabis businesses, key items of focus by the IRS when examining cannabis operations, and tactics for managing audits. We are also pleased to announce that we will be able to offer a limited number of complimentary and reduced cost tickets for this program on a first come first serve basis. If you are interested in attending, please contact Sharon Tanaka at sht@taxlitigator.com

Click Here for more information.

On December 16, 2020, the Eighth Circuit issued its opinion in Coffey v. Commissioner, holding that a tax return filed with the U.S. Virgin Islands Bureau of Internal Revenue (“VIBIR”) was not a filing with the IRS and, thus, the three year statute of limitations on assessment was not triggered. See https://www.taxlitigator.com/a-return-by-any-other-name-by-robert-s-horwitz/.  On February 10, 2021, the Eighth Circuit granted a petition for rehearing before the three-judge panel that wrote the December 16 opinion.  On February 12, the Eighth Circuit issued its new opinion, which reached the same result as its earlier opinion: filing a return with VIBIR was not the same as filing it with the IRS.

The result was the same and the reasoning of the Eighth Circuit in its new opinion in Coffey was similar.  The Coffeys claimed to be residents of the U.S.V.I.  They filed a Form 1040 with the VIBIR, which sent the first two pages of the return to the IRS.  More than three years after receipt of the two pages, the IRS determined that the Coffeys were not residents of the U.S. Virgin Islands and issued a notice of deficiency.  The Coffeys petitioned the Tax Court, which held that since the IRS received the first two pages of the return, it had been “filed” with the IRS, thus starting the statute of limitations on assessment.  Since the notice of deficiency was issued more than three years after filing, it was time barred.

After reciting briefly the facts, the new opinion stated that the U.S. Virgin Islands non-resident must “file” their “return” with both VIBIR and the United States under IRC sec. 932(a)(2).  For purposes of the appeal, the Court assumed that the Coffeys were not U.S.V.I. residents.

The taxpayers’ first argument was that the document sent by the VIBIR to the IRS was “filed” for purposes of both secs. 932(a)(2) and 6501(a).  The Tax Court had agreed with this argument since the first two pages of the Coffeys’ return wound up at the IRS.  According to the Eighth Circuit, this was not enough: returns are filed “if delivered, in the appropriate form, to the specific individual or individuals identified in the Code or Regulations.”  A taxpayer must show “meticulous compliance” with the Code and Regulations.  The Court noted that the Coffeys did not intend to file tax returns with the IRS, but only with the VIBIR.  That the IRS had actual knowledge of the taxpayers’ tax liability was not a filing and without a filing, the statute of limitations on assessment did not begin to run.  The Coffeys had not complied with the federal tax return filing requirements, the VIBIR did not file the Coffeys’ returns with the IRS and the Coffeys had never authorized the VIBIR to do so.

The taxpayers’ second argument was that filing a return with the VIBIR began the statute of limitations under sec. 6501(a) because they intended to comply with all filing requirements under the belief that they qualified as U.S.V.I. residents.  The Court held that the taxpayers’ intent was irrelevant to whether they filed an honest and genuine return.  To be an honest and genuine return, it must be filed with the correct individual.  The U.S.V.I. is a separate taxing entity from the United States.  That the Coffeys may have made an honest attempt to satisfy the tax law is irrelevant, since the filing requirements do not contain an exception for a mistaken belief about residency.  The mistake does not create a “filing.”  While the VIBIR uses the same tax forms as the IRS, filing a return with the VIBIR is not filing it with the IRS.  Thus, the Tax Court was reversed.

Same facts, same legal arguments, slightly different route to get to the same result. Does the Eighth Circuit’s emphasis on “meticulous compliance” indicate that the Beard test for determining what is a return may come under attack?  Only time will tell.

Robert S. Horwitz is a Principal at Hochman Salkin Toscher & Perez P.C., former Chair of the Taxation Section, California Lawyers’ Association, a Fellow of the American College of Tax Counsel, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division.  He 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.

In Soboyede v. Comm’r, T.C., T.C. Summary Opinion 2021-3, the Tax Court addressed whether the taxpayer’s travel expenses while performing legal work in Washington were incurred “while away from home” such that they could be deducted as ordinary and necessary travel expenses under IRC Section 162.   While this is a non-precedential opinion, it is a helpful preview of the many issues return preparers will face in filing 2020 and 2021 tax returns as taxpayers work remotely in the post-COVID world.

In Soboyede, the taxpayer performed document review work as an attorney.  Aside from traveling to Nigeria for almost two months, he spent at least 161 days in Washington D.C. and 115 days in Minnesota during 2015.  Soboyede earned over twice as much revenues conducting work in Washington D.C. than he did in Minnesota during the year at issue.  For purposes of section 162(a)(2), “tax home” generally “means the vicinity of the taxpayer’s principal place of employment [or business] and not where his or her personal residence is located.”  There is also an exception to this rule if the working location is “temporary” in a particular year.  The taxpayer introduced several exhibits in trying to establish that he had a greater presence in Minnesota, but his documentation contained “materials gaps in time that ranged from days to weeks.”  Ultimately, the Tax Court determined that Washington D.C. was his tax home and he could not deduct rent or hotel expenses while staying there.  The Tax Court reached this conclusion, even though he also paid “office rent” in Minneapolis and resided there when he filed his Petition with the Tax Court.

Separate from the issue of business expenses paid for “away from home travel,” several other federal and state tax provisions may be implicated as people adjust to COVID circumstances by remote working, working (and schooling your children) from a vacation home (or Airbnb residence), living with family, or other unique COVID working arrangements.

States are already fighting over how they may tax workers within and without their states during COVID. For instance, New Hampshire recently filed a Petition to the Supreme Court for leave to file an action challenging Massachusetts’s taxation of New Hampshire residents who work remotely from their homes for Massachusetts businesses.  Several other states have also filed  amicus curiae briefs urging the court to grant the motion.   As described by Counsel for New Hampshire,

In the middle of a global pandemic, Massachusetts has taken deliberate aim at the New Hampshire Advantage by purporting to impose Massachusetts income tax on New Hampshire residents for income earned while working within New Hampshire. Upending decades of consistent practice, Massachusetts now taxes income earned entirely outside its borders. Through its unprecedented action, Massachusetts has unilaterally imposed an income tax within New Hampshire that New Hampshire, in its sovereign discretion, has deliberately chosen not to impose.

This blog does not address the consequences of Massachusetts’s tax regime, or “sourcing” regimes in other states, but states will certainly evaluate how they should tax persons working in their states.

Finally, the “Big One” is how tax agencies in high-tax states will evaluate COVID-related habitations when conducting state residency audits.  A growing list of significant taxpayers and their businesses are moving from high income tax states to states with low or no income tax.  While taxpayers from California, for instance, may have intended to permanently change their domicile to a different state in 2020, the facts and circumstances may make it appear that the stay is temporary or transitory.  Perhaps a taxpayer visited with family in another state for a temporary childcare purpose, or they sought to put their kids in full time school for a school year, or some other temporary reason.  Normally, moving to a different state and putting your children in school or daycare in the state where you move to is a factor that supports a taxpayer claim to have permanently left California and taken up residence elsewhere.  Unique COVID-related facts may result in these facts being reviewed with a different perspective.  Similarly, taxpayers may experience a split year, as was the case in Soboyede, where they lived with family or a loved one in California for a significant part of the year, even though they did not plan for California to be their residence for the year.  Unlike the “tax home” requirements under IRC Section 162, California places significant weight on the  number of days stayed in California, as well as several other facts and circumstances, in determining the taxpayer’s subjective intent for being in, or moving out of, California.

As the taxpayer learned in Soboyede, record keeping can be critical when it comes to proving residency or “tax home” during an audit or subsequent litigation.  Taxpayers should carefully retain records to document where they spend time during years when residency may become an issue.  COVID poses additional challenges.  For instance, it may be difficult to sell a residence when establishing a new domicile, or to complete a remodel of a home.  Even getting a new Driver’s License could present difficulties in 2020 or 2021.  While many people are figuring out which way is up in these unique times, in the future tax agencies will have the benefit of hindsight when applying residency rules.  Representatives may need to distinguish facts unique to the pandemic in order to get a fair result for their clients. 

As returns are prepared for these tax years, taxpayers should provide all available information to their advisors and consult with them early.  They should also consider disclosing positions on their tax returns, and consider filing non-resident tax returns with disclosures, even if the taxpayer arguably had no income sourced to the state, so that the taxing agencies can see the basis for the positions, and also so that the statute of limitations can begin on those returns.

CORY STIGILE – For more information please contact Cory Stigile – stigile@taxlitigator.com  Mr. Stigile is a principal at Hochman Salkin 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.  His representation includes Federal and state 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.

Historically, most—if not all—states in the U.S. have not required the disclosure of the beneficial owners of corporations, LLCs, or similar entities formed under the laws of the State.[i]  However, with the enactment of the Corporate Transparency Act (CTA)[ii], as part of the 2021 National Defense Authorization Act, the non-disclosure approach has come to an end.

The CTA adds section 5336 to Title 31, which will require “a corporation, limited liability company or other similar entity” that are under the laws of any State or Indian Tribe or formed under the laws of a foreign country and registered to do business in the United States[iii] (Reporting Companies) to disclose to the Financial Crimes Enforcement Network (FinCEN)[iv] specific information on those Beneficial Owners from the company.  The preamble to the CTA, states that the purpose and rationale for the CTA is to, among other things, better enable law enforcement to counter illegality, including “serious tax fraud.”[v]  More specifically, the CTA is an effort to address foreign government concerns and join a growing international trend to require more disclosure of beneficial ownership.  This effort seemingly targets the identity of “malign actors”[vi] who seek to conceal their ownership behind U.S. shell companies that try to hide illicit funds[vii] and facilitate illicit activity.

By January 1, 2022 (at the latest), the Secretary of the Treasury is required to promulgate regulations consistent with CTA and FinCEN will set up a registry to store information on Beneficial Owners of Reporting Companies.[viii]

CTA defines a Reporting Company as any corporation, limited liability company, or other similar entity that is created under the laws of any State or Indian Tribe or a foreign company that is registered to do business in the United States[ix] with the following exclusions: companies with more than 20 full-time employees, gross receipts or sales of more than $5 million and a physical presence in the United States (for example an office).[x]  Various entities that are already subject to supervision or otherwise highly regulated by the Federal government are also excluded.[xi]  These exclusions include: banks, credit unions, registered brokers or dealers, registered exchange or clearing agencies, registered investment companies, insurance companies, public accounting firms, public utility companies and Internal Revenue Code Section 501(c)(3) organizations.[xii]

The definition of Beneficial Owner of a Reporting Company, which is identified as someone who either (1) exercises substantial control over the company; or (2) owns or controls 25% or more of the ownership interest of the company,[xiii] is arguably imprecise as the CTA does not define “substantial control” or clarify how to measure “25% or more ownership.”[xiv]  The CTA, however, is clear as to who is excluded: minor children, acting nominees, intermediaries, custodians, creditors, agents, those acting solely as an employee, and those whose interest in a “privately held company”[xv] is only through a right of inheritance.[xvi]

The Reporting Company must file an “acceptable identification document”[xvii] when it is formed or, for those formed prior to CTA, in a timely manner.  A timely manner is within two years after the effective date of the Treasury Department’s final regulations on CTA.[xviii]  An acceptable identification document must include the full legal name, date of birth, current residential or business address, and unique identifying number (such as driver’s license or passport number)[xix] of all Beneficial Owners.  If there is any change with respect to the “Beneficial Owner”[xx] of the company an updated must be provided as to that change and identification information no later than one year after the change.

The information reported to FinCEN will be made available, under protocols prescribed by the Treasury, to financial institutions and regulatory agencies.  The information is also to be accessible to Treasury employees under procedures and safeguards to be prescribed by Treasury and, of course, to the IRS “for tax administration purposes….”[xxi]  

The CTA will also make it illegal for a Reporting Company formed under the laws of any State or Indian Tribe to issue a certificate in bearer form evidencing an interest in the entity.[xxii] And the CTA imposes civil and criminal penalties on any person who willfully files a false or fraudulent report or makes an unauthorized use or disclosure of information.[xxiii] With the rationale for the CTA being, in large part, to target “malign actors,” such as money launderers, narcotics traffickers, financers of terrorism and people engaged in “serious tax fraud,” to the extent that there is a lack of clarity or complete answers, such as exactly which Beneficial Owners must be disclosed to FinCEN, one can expect that as Treasury fills in the blanks through regulations and procedures, one message will remain clear: the Federal government wants information about beneficial ownership in the U.S., and it is on the path to ensuring that companies provide the information.

SANDRA R. BROWN – Ms. Brown has been a principal at Hochman Salkin Toscher Perez P.C. since March 2018.  Prior to joining the firm, Ms. Brown spent more than 26 years as a federal trial attorney, including serving as the Acting United States Attorney, the First Assistant United States Attorney, and the Chief of the Tax Division of the Office of the U.S. Attorney (C.D. Cal).  Ms. Brown’s broad range of experience in complex civil tax controversies and criminal tax investigations and litigation includes having handled over 2,000 cases on behalf of the United States before the United States District Court, the Ninth Circuit Court of Appeals, the United States Bankruptcy Appellate Panel, and the California Superior Court.  Ms. Brown represents individuals and entities on a national and local level in complex federal criminal investigations and litigation as well as sensitive civil tax controversy examinations and litigation matters.  Ms. Brown obtained her LL.M. in Taxation from the University of Denver, is a fellow of the American College of Tax Counsel, co-chair of the NYU Tax Controversy Section, and a member of the Women’s White Collar Defense Association. Ms. Brown may be reached at brown@taxlitigator.com or 310.281.3217.

MICHAEL GREENWADE – Mr. Greenwade is an Associate at Hochman Salkin Toscher Perez P.C.  Mr. Greenwade concentrates his practice in tax audits and examinations, deductibility of business expenses, and substantiation of cost basis.  Mr. Greenwade is a former law clerk in the Major Crimes Division at the L.A. County District Attorney’s Office, a former tax policy Research Assistant at USC Gould School of Law, where he earned his J.D., and was a Teacher’s Assistant at USC Leventhal School of Accounting.  He graduated Cum Laude from USC Marshall School of Business, earning his Bachelor of Science.  Contact Michael Greenwade at mg@taxlitigator.com

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[i] WILLIAM M. (MAC) THORNBERRY NATIONAL DEFENSE AUTHORIZATION ACT FOR FISCAL YEAR 2021, PL 116-283, 134 Stat 3388 (2021).

[ii] Sec. 6401.

[iii] 31 U.S.C. § 5336(a)(11); Senate and House Override Veto and Pass 2021 National Defense Authorization Act With Significant AML Updates, Practical Law Legal Update w-028-9579.

[iv] The FinCEN is a bureau of the U.S. Department of the Treasury that uses strategic efforts to collect and analyze information about financial transactions to combat money laundering, terrorist financing and other financial crimes.  https://www.fincen.gov/about/mission.

[v] Sec. 6402(3) of the WILLIAM M. (MAC) THORNBERRY NATIONAL DEFENSE AUTHORIZATION ACT FOR FISCAL YEAR 2021, PL 116-283, 134 Stat 3388 (2021).

[vi] Id.

[vii] https://www.wealthmanagement.com/high-net-worth/new-law-requires-disclosure-beneficial-owners-companies.

[viii] Senate and House Override Veto and Pass 2021 National Defense Authorization Act With Significant AML Updates, Practical Law Legal Update w-028-9579.

[ix] Id.

[x] https://www.wealthmanagement.com/high-net-worth/new-law-requires-disclosure-beneficial-owners-companies.

[xi] Senate and House Override Veto and Pass 2021 National Defense Authorization Act With Significant AML Updates, Practical Law Legal Update w-028-9579.

[xii] https://www.wealthmanagement.com/high-net-worth/new-law-requires-disclosure-beneficial-owners-companies.

[xiii] 31 U.S.C. § 5336(a)(3).

[xiv] https://www.wealthmanagement.com/high-net-worth/new-law-requires-disclosure-beneficial-owners-companies.

[xv] Id.

[xvi] Senate and House Override Veto and Pass 2021 National Defense Authorization Act With Significant AML Updates, Practical Law Legal Update w-028-9579.

[xvii] 31 U.S.C. § 5336(a)(1).

[xviii] https://www.wealthmanagement.com/high-net-worth/new-law-requires-disclosure-beneficial-owners-companies.

[xix] Id.

[xx] Id.

[xxi] 31 U.S.C. § 5336(c)(5)(B).

[xxii] 31 U.S.C. § 5336(f).

[xxiii] 31 U.S.C. § 5336(h).

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Many businesses either have closed or will be forced to close due to the lockdowns imposed during the COVID-19 pandemic, Closing a business can result in the loss of jobs, a loss of the business owner’s livelihood and the destruction of the business owner’s credit rating.  It can also have adverse tax consequences in the form of Cancellation of Debt (“COD”) income.   This was brought home by the recent Tax Court case of Hohl v. Commissioner, T.C. Memo. 2021-5 where the Court held that the partners of a defunct partnership owed tax from the cancellation of debt.

COD income is recognized as gross income under Internal Revenue Code §61(a)(12), but Congress has created many exceptions to the recognition of COD income.  Discharge of a debt occurs when it becomes clear that the debt will not be repaid or when the creditor forgives all or part of the debt.  Whether there was in fact a debt and, if so, when the debt became discharged are determined by the facts and circumstances of the case.

The partnership in the Hohl case, Echo Mobile Marketing Solutions, LLC, was formed in 2009 and ceased operations in 2012, having sustained losses in each year of operation.  It had four partners, three of whom, Michael Hohl, Braden Blake, and James Bowles, operated the business and a fourth, Eduardo Rodriguez, who funded the business. Although Mr. Rodriguez was the only one who provided funds for the business, the three operating partners each had a 30 percent ownership interest in the partnership while Mr. Rodriguez had a 10 percent ownership interest.  

The IRS audited the individual partners’ 2012 tax returns and determined that each of the three operating partners had $178,210 of COD income.  The three operating partners filed petitions with the Tax Court to challenge the IRS’s determination.  The taxpayers claimed that funds provided by Mr. Rodriquez were capital contributions. They pointed to Echo’s operating agreement, which termed Mr. Rodriquez’s initial infusion of funds ($265,000) as a capital contribution, to the lack of any written loan agreement, and to the lack of any collection or repayment activity. 

The Tax Court found the taxpayer’s argument unconvincing because Echo’s tax returns treated the funds provided by Mr. Rodriguez as loans. These loans were allocated among the partners, giving the three operating partners basis in the partnership.  Consistent with the advances being loans, Mr. Rodriquez’s capital account was not credited with any of the funds he advanced to Echo.  Additionally Echo never gave written notice to the partners that it needed additional capital contributions, as required by the operating agreement.  Thus, the Court held that all the funds advanced by Mr. Rodriguez were loans and not capital contributions and that the partnership had COD income when it ceased operation.

This led to the next issue: the allocation of the COD income among the partners.  Under IRC §704(a), a partner’s distributive share of income is determined by the partnership agreement.  If the partnership agreement does not provide for the partner’s share, or if the allocation made by the agreement does not have substantial economic effect, IRC §704(b) provides that the partner’s distributive share of income is determined “in accordance with the partner’s interest in the partnership (determined by taking into account all facts and circumstances).”  To have substantial economic effect, allocations must be consistent with the underlying economic arrangement of the partners.  Treas. Reg. §1.704-1(b)(2)(ii)(a).

Echo’s operating agreement allocated distributive shares of income and losses to its partners according to a formula based on the partner’s capital accounts.  Echo, however, had never followed the formula in allocating its losses among the partners.  Instead, on each year’s tax return it allocated to each of the operating partners 30% of the losses and to Mr. Rodriquez 10% of the losses.  The Court held that the allocations made by Echo’s operating agreement thus did not have substantial economic effect.  The Court therefore upheld the IRS’s allocation of 30% of the COD income to each of the operating partners.

The taxpayers made several additional arguments that aren’t germane to the cautionary tale of this blog:   First, when a business closes due to financial losses, the owners may discover unexpectedly that they had income due to unpaid debts owed by the business.  Second, the failure of a partnership to follow the partnership agreement for the treatment of advances by partners and for the allocation of partnership items can lead to the IRS challenging the way the partnership allocated income, losses, gain and credits during an audit. 

Of course, what would have happened had Echo treated Mr. Rodriguez’s advances as capital contributions and followed the terms of the partnership agreement for allocating profits and losses?  First, the three operating partners would have had zero basis in the partnership, instead of basis from treating the advances as loans allocated among the partners on a 30-30-30-10 basis.  Second, the operating partners would not have been able to deduct the losses (if any) that should have been allocated to them had they followed the partnership agreement, since a partner cannot deduct losses in excess of basis.  So the net tax effect of the case was the same as it would have been had the partnership treated the advances as capital contributions with the operating partners being unable to deduct losses but not having COD income.

Robert S. Horwitz is a Principal at Hochman Salkin Toscher & Perez P.C., former Chair of the Taxation Section, California Lawyers’ Association, a Fellow of the American College of Tax Counsel, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division.  He 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.

Tenzing Tunden is a Tax Associate at Hochman Salkin Toscher Perez P.C.

When the IRS’s processes are not working as they should, the Taxpayer Advocate Service (TAS) may be able to help. Sec. 7811 authorizes TAS to issue a taxpayer assistance order if the taxpayer is suffering, or about to suffer, a significant hardship as a result of the way the internal revenue laws are being administered.

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