TAXLITIGATOR – Tax Controversy (Civil & Criminal) Report

On April 13, 2020, the Tax Court issued an opinion in Hakkak v. Comm’r, T.C. Memo 2020-46, holding that a taxpayer was not a real estate professional in the tax years at issue for purposes of being able to qualify for the exception to the rule that rental activities are per se passive under the Section 469 passive loss limitation rules.[i]  The issue before the Tax Court was whether the taxpayer, a California attorney practicing primarily in personal injury, was a real estate professional within the meaning of Section 469(c)(7) as a result of his activities with respect to his investments in certain flow-through entities owning rental property.[ii]

The taxpayer at trial took a contrary position to his tax return.  On his tax return for the years at issue (2011 and 2012), the taxpayer reported his losses from his real estate rental activities as passive losses.  He then used these losses to offset shareholder income from his personal injury law practice, which he reported as passive income.  In the Notice of Deficiency issued following an audit, the IRS asserted that his income from his law practice was nonpassive (active) income, and as a result, could not be netted against the taxpayer’s passive losses from his rental activities.

At trial, the taxpayer contended not that the income from his law practice was passive, as stated on his return, but rather that his losses from two of his rental activities were in fact nonpassive, which would then allow the taxpayer to offset the losses against the nonpassive income from his law practice.  The rental properties at issue were two commercial rental properties located in Texas.  In addition to these two properties, the taxpayer had an interest in two additional commercial rental properties in Texas, two residential rental properties in California, and a gas station in California.

A taxpayer is a real estate professional under Section 469(c)(7) if, during the taxable year, the taxpayer spent more than 750 hours and half of his personal service hours in a real estate trade or business.  If a taxpayer qualifies as a real estate professional, the per se passive rule will not apply to the taxpayer’s rental properties and the taxpayer may demonstrate that he materially participated in the rental activities, making them nonpassive activities.[iii]

At trial, the taxpayer submitted the following evidence in support of his contention that he was a real estate professional during the years at issue: his testimony at trial, handwritten calendars (together with a partial transcription of these calendars), and documents consisting of emails and other written correspondence, lease agreements, bank account and credit card statements, invoices, loan statements and documents, photos, insurance documents, financial reports, property tax records, and various commercial real estate news articles.[iv]  He contended that he “exerted comprehensive and extensive time, effort, labor, and consideration relating to his operation, control and oversight” over the two properties in Texas.[v]  The Tax Court was unpersuaded, finding that the taxpayer’s “vague testimony discussing (at best) generalities about what he might have done and how long he might have spent does not sufficiently supplement or explain the calendar entries.”  The Tax Court further found that the evidence showed that much of his time was spent on investor-type activities, which don’t count for purposes of the 750-hour requirement.[vi]  In fact, day-to-day management of the rental properties was handled by a property management company and a leasing agent was used to find new tenants.

Moreover, the Tax Court found no evidence that the taxpayer spent over half of his personal service hours on real estate trade or business activities during the taxable year, other than the taxpayer’s self-serving testimony it found to be unreliable.[vii]  This is a particularly difficult obstacle to overcome for taxpayers who have a full time job in a non-real estate trade or business.  It is important for taxpayers seeking to take advantage of the real estate professional exception to document the time the taxpayer spent on all personal services during the relevant tax years, both real estate-related activities and non-real estate activities, such as the practice of law.

Because the Tax Court held that the taxpayer was not a real estate professional, the court did not have to decide the question of whether the taxpayer materially participated in the rental activities at issue.

Lacey Strachan is a Principal at Hochman Salkin 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).  Ms. Strachan has experience in a wide range of civil and criminal tax cases, including cases involving technical valuation issues, issues of first impression, and sensitive examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise. 

[i] Hakkak v. Comm’r, T.C. Memo 2020-46.  The Petitioners were a husband and wife who filed a joint return.  In this blog post, the “taxpayer” refers to the husband.

[ii] For a background discussion on the Section 469 passive loss limitation rules as they pertain to rental real estate, see Lacey Strachan, “A Primer on Material Participation Rules for Real Estate Businesses, Part 1: General Overview,” Taxlitigator – Tax Controversy (Civil & Criminal) Report, August 29, 2017, https://taxlitigator.me/2017/08/29/a-primer-on-material-participation-rules-for-real-estate-businesses-part-1-general-overview-by-lacey-strachan/.

[iii] For additional discussion about the real estate professional exception to the passive loss rules, see Lacey Strachan, “A Primer on Material Participation Rules for Real Estate Businesses, Part 2: Who is a Real Estate Professional?” Taxlitigator – Tax Controversy (Civil & Criminal) Report, September 12, 2017, https://taxlitigator.me/2017/09/12/a-primer-on-material-participation-rules-for-real-estate-businesses-part-2-who-is-a-real-estate-professional-by-lacey-strachan/ and Lacey Strachan, “A Primer on Material Participation Rules for Real Estate Businesses, Part 4: Special Considerations for Real Estate professionals with Rental Activities,” Taxlitigator – Tax Controversy (Civil & Criminal) Report, October 14, 2017, https://taxlitigator.me/2017/10/14/a-primer-on-material-particiation-rules-for-real-estate-businesses-part-4-special-considerations-for-real-estate-professionals-with-rental-activities-by-lacey-strachan/.

[iv] Hakkak at *16-*17.

[v] Id. at *17.

[vi] Id.

[vii] Id. at *18-*19.

IRC Section 7508A gives the Treasury Secretary the power to postpone certain deadlines in the case of a Presidentially-declared disaster.  Previously, the Secretary had postponed until July 15, 2020, the time for filing income tax returns and paying federal income tax due April 15, 2020.  On April 9, the IRS issued Notice 2020-23, which postpones until July 15, 2020, the filing of returns and the payment of tax due on or after April 1, 2020, and by July 14, 2020.  Notice 2020-23 also postpones the time for filing refund claims, Tax Court petitions and refund suits and for the IRS to assess and collect tax and to bring lawsuits regarding taxes.

Postponement of the Time to File Returns and Pay Taxes

The affected returns and payments are individual income tax returns, corporate income tax returns, partnership returns, estate and trust income tax returns, estate and generation skipping transfer tax returns, gift and generation transfer tax returns, exempt organization business income tax returns, certain excise tax payments on investment income, quarterly estimated tax payments, and any forms, schedules or returns required to be filed with such returns.  Any election required to be made on an affected return (or accompanying form or schedule) is timely if filed on or before July 15, 2020.  The period between April 1 and July 15, 2020, will be disregarded in calculating interest, penalties and additions to tax for failure to file or pay.  These will begin to accrue on July 16, 2020.

A taxpayer who wants an extension beyond July 15, 2020, must file a request for extension beyond that date, but no extensions will be allowed “beyond the original statutory or regulatory extension date.”  Thus, if an estate is on extension to file an estate tax return by May 1, 2020, will have until July 15, 2020, to file and may not get a further extension.  An estate whose return was originally due on May 1, 2020, however, can file for an extension if it does so by July 15, 2020. The affected tax returns and forms are listed at the end of this blog, for those who are interested.

Relief is given to Opportunity Zone investors.  Where the 180 day period for making an investment at the election of the taxpayer under sec. 1400Z-2(a)(1)(A) falls between April 1 and July 14, 2020,  the taxpayer will have until July 15, 2020, to make the investment.

Postponement of Time to File Refund Claims, Tax Court Petitions and Refund Suits

The IRS also postponed until July 15, 2020, the time to perform any of the following “time-sensitive acts” that were due to be performed between April 1 and July 14, 2020: filing claims for refund or credit of any tax, filing a petition with the Tax Court, filing for review of a decision of the Tax Court, and filing a suit based upon a claim for credit or refund.  The Notice does not list other suits that a taxpayer can file, such as a wrongful levy suit, a suit for illegal collection action, or a suit to quash an Internal Revenue Service summons.  How does the Secretary have the power to extend the time for filing a refund suit in district court or the Court of Federal Claims or a petition with the Tax Court?  Sec. 7508A grants the Secretary the power to postpone any act that can be postponed under sec. 7508 (postponements for military personnel on service in a combat zone).  Sec. 7508(a)(1)(C) and (F) authorize the Secretary to postpone the date for filing petitions with the Tax Court or for review of a Tax Court decision and to file a suit on any claim for credit or refund.

Postponement of Certain “Time-Sensitive” Acts by the IRS

Finally, the Notice postpones the time within which the IRS is to perform certain time sensitive acts described in Treas. Reg. sec. 301.7508A-1(c)(2) with regard to the following persons: a) those under examination; b) those whose cases are with the Independent Office of Appeals; and c) those who between April 6, 2020 and July 15, 2020, file amended returns or make payments for a tax for which the time for assessment would otherwise expire.  The time-sensitive acts are: (i) assessing any tax; (ii) giving or making any notice or demand for the payment of any tax, or with respect to any liability to the United States in respect of any tax; (iii) collecting by levy or otherwise, of the amount of any tax liability; (iv) filing by the United States, or any officer on its behalf, of any suit in respect of any tax liability; (v) allowing a credit or refund of any tax; and (vi) any other act specified in a revenue ruling, revenue procedure, notice, or other guidance published in the Internal Revenue Bulletin).  If any of these acts were required to be performed between April 6 and July 15, 2020, the IRS has 30 days following the last date for performance (i.e., 30 days from July 15, 2020).

List of Affected Tax Returns and Forms

For tax nerds and others who may be interested, here are the specific returns and forms affected by the notice:

1. Individual federal income tax returns: Forms 1040, 1040SR, 1040NR, 1040NR-EZ, 1040PR, 1040SS
2. Corporate income tax returns: Forms 1120, 1120C, 1120F, 1120FSC, 1120H, 1120L, 1120PC, 1120POL, 1120REIT, 1120RK, 1120S, 1120SF
3. Partnership returns: Forms 1065, 1066
4. Estate and trust income tax returns: Forms 1041, 1041-N, 1041QFT
5. Estate and generation skipping transfer tax returns: Forms 706, 706-NA, 706-A, 706-QGT, 706-GS(T), 706-GS(D), 706-GS(D-1)
6. Gift and generation skipping transfer tax returns: Form 709
7. Form 8971
8. Estate tax payments of principal or interest due as a result of an election under secs. 6166, 6161, or 6163 and annual recertification requirements under sec. 6166
9. Exempt organization business income tax form: Form 990-T
10. Excise tax payments on investment income and return filings: Forms 990-PF, 4720
11. Quarterly estimated income tax payments: Forms 990-W, 1040-ES, 1040-ES(NR), 1040-ES(PR), 1041-ES, 1120-W
12. All schedules, returns and other forms that are filed as an attachment to the forms listed above or required to be filed by the due date of any of those forms, including Schedules H and SE and Forms 3520, 5471, 5472, 8621, 8858, 8865, 8938
13. Any installment payment due under sec. 965(h) on or after April 1 and before July 15, 2020

Contact Robert S. Horwitz at horwitz@taxlitigator.com or 310.281.3200   Mr. 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.

The Internal Revenue Service (“IRS”) has several tools to utilize in obtaining information about a taxpayer’s financial records.  One of these tools involves contacting third parties.  Those third parties may be a taxpayer’s business associates or even friends and relatives.  Third parties may, however, also be governmental agencies.  While there are rules in place as to when the IRS must provide a taxpayer with advance notice that the agency intends to contact third parties, there are also exceptions to such rules.  One such example for which the IRS has recently provided notice of such an exception involves contacts with governmental agencies.  As discussed below, pursuant to IRS Office of Chief Counsel Memorandum 202013015, the IRS is now taking the position that contact with government agencies is not considered prohibited third-party contact for which notice, which would otherwise be required by law, must be provided to the taxpayer in advance of such contact.

What are Third-Party Notices

An IRS third-party notice is used to verify or collect information about the taxpayer when the taxpayer is unable or, perhaps, unwilling, to provide the information directly to the IRS. This type of notice is a common tool used by the IRS and is codified in the Internal Revenue Code (“IRC”) in § 7602. There are interpretive regulations published in Treas. Reg. § 301.7602-2 as well.  In 2019, the law surrounding third-party notices was amended to provide taxpayers with additional protections.

Taxpayer First Act, the 9^th Circuit, and Third-Party Notices

On July 1, 2019, the Taxpayer First Act (“TFA”) was signed into law.[i]  The TFA, a pro-taxpayer legislation[ii], modified numerous policies at the IRS concerning organizational structure, customer service, enforcement procedures, IRS free file program, and cybersecurity.  It also provided additional procedural protections to taxpayers with regards to the IRS’s issuance of third-party notices.

Provision 1206 of the TFA amended IRC § 7602 and the regulations thereunder with respect to the  requirement for IRS third-party notices.[iii]  Previously, the IRS would issue a relatively generic notice of an intent to contact third parties by simply providing the taxpayer with Publication 1 entitled “Your Rights as a Taxpayer” and sending Letter 3164 to the taxpayer at some point prior to contacting third parties.[iv]  It was this specific practice that in 2018, prior to the enactment of the TFA, was the subject of litigation in the 9th Circuit Court of Appeals.  Ultimately, just months prior to the enactment of the TFA, the 9^th Circuit ruled in favor of the taxpayer and held that Publication 1 did not provide taxpayers with reasonable advance notice as was then required under the prior § 7206(c).[v] Recognizing that the third parties whom the IRS may contact could include the taxpayer’s neighbors, employer, employees, or the bank that the taxpayer has accounts with, the court recognized major privacy and reputational concerns for taxpayers came into play when the IRS utilized a third party notice. [vi] As such, the 9^th Circuit concluded that a reasonable notice must provide the taxpayer with a meaningful opportunity to volunteer records on his own, so that third-party contacts can be avoided if the taxpayer complies with the IRS’s demand.[vii]

Consistent with the 9^th Circuit’s decision, published in February 2019, the TFA amended IRC §7602(c)(1), effective August 15, 2019, providing that:

• The auditor must notify the taxpayer that he or she intends to contact third parties
• When the auditor notifies the taxpayer, he or she must actually intend to contact the third parties
• The auditor must notify the taxpayer at least forty five (45) days before he or she contacts the third party and
• The auditor must tell the taxpayer the time period in which he or she intends to make the contact and the period must not exceed more than a year.

Taxpayer First Act and Post-Contact Reports of Third-Party Notices

The TFA did not impact IRC § 7602(c)(2) which requires the IRS to provide taxpayers with post-contact reports, both periodically and upon request.[viii] As such, in addition to advance notice requirements under the new law, the taxpayer can  also request post-contact reports from the IRS for information as to who the agency  contacted with third party notices.[ix] The availability of both provisions is important. But it should be noted that there are actually three types of notice that a taxpayer should be aware of: (1) the advance notice provision which only covers every third-party contact that the IRS “may” make; (2) the post-contact notice provision which covers only “persons contacted” while excluding third-party contacts authorized by the taxpayer, where notice would jeopardize collection or could lead to reprisals against the person contacted, and in criminal cases; and (3) a copy of any third-party summons sent by the IRS to the taxpayer.[x] In the 9^th Circuit case discussed above, for example, the advance notice provision would have required the IRS to notify the taxpayers before contacting the third-party, which in that case was the California Supreme Court, a governmental agency.  However, because those taxpayers received a copy of the summons which the IRS ultimately sent to the California Supreme Court, under § 7206(c)(2), the IRS would not need to include the California Supreme Court on a list of “persons contacted”.[xi]

IRS Chief Counsel Says Contacts with Other Governmental Agencies Are Not Subject to TFA’s Advance Notice Requirements

Pursuant to a recently published Chief Counsel Memorandum, the IRS has stated that IRS contacts with foreign, federal, state and local government agencies are generally not considered prohibited third-party contacts under Treas. Reg. §301.7602-2(f)(5).[xii] In issuing this memorandum, the IRS is taking this position, not simply in matters where cases are being referred to the Department of Justice for enforcement, but in matters where the IRS is seeking information from a third-party governmental agency involved in a nontax-related settlement with a taxpayer.

The Chief Counsel Memorandum dealt with a taxpayer and the tax treatment of a settlement under IRC §162(f).  In a situation where the underlying settlement was between the taxpayer and the Department of Justice, the IRS sought information from the DOJ attorney with knowledge of the case as well as a request for a DOJ-generated Financial Management Information System (FMIS) audit report and/or other information about the manner in which DOJ handled and/or settled the lawsuit with the taxpayer, similar to information the IRS might seek from a private party who had entered into a monetary settlement with the taxpayer.  The primary issue in the above instance was whether the IRS request for information from the DOJ regarding the government’s settlement with a taxpayer (in a non-tax case) should be considered third-party contacts for which IRC §7602(c) advance notice and post-contact reporting rules apply.

The new amendments to IRC § 7602(c)(1), which generally apply to IRS contacts with any “person other than the taxpayer” contain no explicit exception for contacts with governmental entities.[xiii] Treasury Regulation § 301.7602-2(f)(5), however, specifically excepts governmental entities from the § 7602(c) notice rules[xiv] Citing Congressional concerns about a taxpayer’s reputation, third parties privacy, and the IRS’s enforcement of the law underlying the change in the law governing such notice provisions, Chief Counsel concluded that the exception for governmental entities is consistent with the Congressional intent in amending § 7602(c) of the TFA.  Whether this position will stand is open for debate, particularly in the 9^th Circuit, where the Court found the IRS’s use of Publication 1 as insufficient for a contact with a governmental entity, specifically the California Supreme Court, under a less taxpayer-friendly version of § 7206(c).

Sandra R. Brown is a Principal at Hochman Salkin Toscher & Perez P.C.  Prior to joining the firm, Ms. Brown served 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  specializes in representing individuals and organizations who are involved in criminal tax investigations, including related grand jury matters, court litigation and appeals, as well as representing and advising taxpayers involved in complex and sophisticated civil tax controversies, including representing and advising taxpayers in sensitive-issue audits and administrative appeals, as well as civil litigation in federal, state and tax court. 

Tenzing Tunden is a Tax Associate at Hochman Salkin Toscher Perez P.C. Mr. Tunden is a 2019 graduated from the Graduate Tax Program at NYU School of Law and the J.D. Program at UC Davis School of Law. During law school, Mr. Tunden served as an intern at the Franchise Tax Board Legal Division and at the Tax Division of the U.S. Attorney’s Office (N.D. Cal).

[i] Taxpayer First Act of 2019, H.R. 3151; Pub.L. 116-25.

[ii] According to the House Ways & Means Committee, the TFA’s passage was the result of the committee’s effort to implement pro-taxpayer reforms at the IRS for the first time in more than 20 years.

[iii] See https://www.congress.gov/bill/116th-congress/house-bill/3151/text. Also see https://www.finance.senate.gov/imo/media/doc/Taxpayer%20First%20Act_Section%20by%20Section-converted.pdf at 3.

[iv] Publication 1 Your Rights as a Taxpayer. Letter 3164 Notification of Third Party Contact.

[v] J.B. v. United States, 916 F.3d 1161, 1173 (9^th Cir. 2019); http://cdn.ca9.uscourts.gov/datastore/opinions/2019/02/26/16-15999.pdf.

[vi] Id. at 1165. Also see Publication 1.

[vii] Id.

[viii] IRC § 7602(c)(2). Also See Treas. Reg. § 301.7602-2(e)(1).

[ix] Id.

[x] Cf. I.R.C. § 7602(c)(1) with I.R.C. § 7602(c)(2); see also Treas. Reg. § 301.7602- 2(e)(4), Ex. 4 (“providing a copy of the third party summons to the taxpayer pursuant to section 7609 satisfies the post-contact recording and reporting requirement”).

[xi] Id.

[xii] See IRS Office of Chief Counsel Memorandum 202013015, The Application of I.R.C. §7602(c) to Government Contacts in the Context of DOJ Settlements with a Taxpayer, at 2.

[xiii] IRC §7602(c).

[xiv] See Treas. Reg. §301.7602-2(f)(5) (“Section 7602(c) does not apply to any contact with any office of any local, state, Federal or foreign governmental entities” and that “the term office includes any agent or contractor of the office acting in such capacity.”)

Do-overs are rare in criminal law, unlike a weekend golf game.  Finality is an important factor in what appellate courts do, which is why they establish hard-to-meet standards for reversal such as “plain error.”  Another tip: judges don’t like defendants to use the time between pleading guilty and being sentenced to commit the same crimes that they have pled to, and the sentence imposed may underscore this point.

Rule 11 of the Federal Rules of Criminal Procedure establishes what a district court must do when taking a guilty plea. When a defendant changes her plea to guilty and doesn’t object to any Rule 11 violations, she can only throw out her guilty plea on appeal if she shows the district court committed “plain error.”  Plain error in this context means that there’s an obvious error in the Rule 11 process, it affected substantial rights, and there’s a reasonable chance the defendant wouldn’t have pled guilty if the district court had done the Rule 11 colloquy correctly.  Each of these is difficult to show, and showing all three is rare.

Enter David Adams, a man with a 14-year history of

obstruct[ing] the IRS’s efforts to collect his delinquent tax payments and to secure overdue tax returns.  He lied to and manipulated his accountant, filed extension requests containing false information, claimed to have made payments that he had not made, missed deadlines, lied that checks were in the  mail, unjustifiably blamed his accountant for errors and delays, bounced checks, and fraudulently claimed financial distress at times when he had the funds necessary to pay his tax liability, all the while spending lavishly on a lifestyle that included purchasing and leasing multiple luxury vehicles, spending millions to construct a mansion in East Lyme, Connecticut, and staying at upscale hotels.

Given this history, it’s not surprising that he was indicted for a variety of tax crimes, including filing false returns, tax evasion, and obstructing the IRS.  When he decided he didn’t want to go to trial the government apparently made him “eat the sheet,” meaning, Adams had to plead guilty to all six counts in his indictment instead of just picking one or two (as the government often agrees to when a defendant agrees to plead guilty early rather than late in the game).  Each count carried a three-year or five-year statutory maximum sentence.

Can’t Withdraw Guilty Plea

When a defendant is convicted of multiple offenses, district judges have discretion to run sentences consecutively (stacking) instead of concurrently, to achieve what the court believes is an appropriate sentence.  Adams’ presentence report showed the recommended sentence under the Federal Sentencing Guidelines was 78-97 months – well above the 60-month maximum for any of his individual counts of conviction.  The district court sentenced Adams to 90 months, and he sought to withdraw his guilty plea by claiming that he didn’t understand that sentences could run consecutively.  Relying on well-established precedent, the Second Circuit rejected Adams’ attempt to “manufacture plain error,” and noted that Adams had plenty of chances to object or ask questions and he didn’t.

Penalties and Interest Included in Guideline Tax Loss Despite No Tax Evasion Conviction

Additionally, and as an issue of first impression, Adams complained that only tax, and not penalties and interest, should be used to compute his tax loss for Sentencing Guidelines purposes, because he hadn’t been convicted of “evasion of payment” or “willful failure to pay” taxes.  There is an important distinction in computing criminal tax loss between evasion of assessment and evasion of payment: in assessment cases, only the tax and not interest or penalties is included, primarily because when you take evasive action generally no interest or penalties are due; whereas in collection cases, the IRS is trying to collect assessed penalties and accrued or assessed interest, so it’s logical to include both in the criminal tax computation.  The Guidelines state the distinction at U.S.S.G. § 2T1.1 cmt. n.1, noting penalties and interest don’t count “except in willful evasion of payment cases under 26 U.S.C. § 7201 and willful failure to pay cases under 26 U.S.C. § 7203.”

Adams raised the issue whether one must be convicted of evasion of payment or failure to pay for a district judge to be allowed to include penalties and interest in tax loss, as the district judge did to Adams.  This, a legal issue reviewed de novo (meaning the district court’s decision isn’t given any weight), is a closer question than whether Adams could show plain error in the district court’s refusal to allow him to withdraw his plea.

Noting it was an issue of first impression in the Second Circuit, the appellate court stated the First and Seventh Circuits had already decided that a district court could include penalties and interest in the tax computation even if the defendant hadn’t been convicted of evasion of payment or failure to pay, where the defendant’s conduct included evading payment.  The Guidelines permit judges to include conduct related to the offense(s) of conviction when computing the accurate Guideline.  Relying on the Guidelines and the First and Seventh Circuit decisions, the Second Circuit determined that the Guideline comment regarding penalties and interest did not trump the Guidelines’ general rule that relevant conduct is included regardless of the counts of conviction.

Post-Plea Obstruction Merits 2-Point Enhancement

Adams had the temerity to object to an “obstruction of justice” enhancement as well, which arguably could have been based on his pre-indictment conduct (described in great detail above) but the Second Circuit didn’t need to decide that harder question.  Instead, the district court and Second Circuit zeroed-in on Adams’ conduct after pleading guilty that included “concealing, transferring and failing to disclose his assets” tantamount to a “game of ‘cat and mouse’” with both the IRS and the district court.  This is primarily a reminder not to stick a thumb in the eye of the person who will be sentencing you.

Tax Restitution Only Permissible as Supervised Release Condition

Finally, the district court erred in treating taxes like normal losses for restitution purposes.  Absent a plea agreement where a defendant agrees to it, taxes can only be ordered as a condition of supervised release or probation, and not during custody or after supervision has terminated (unlike fraud losses, for example).  However, the district court ordered that Adams’ restitution obligation began immediately after sentencing, when it should have ordered it solely as a condition of supervised release.  The Court of Appeals fixed this problem without sending it back down to the district court.

Takeaways

In addition to the obvious takeaway that constructing a mansion and leasing luxury vehicles while claiming poverty with the IRS might result in the Revenue Officer referring you to Criminal Investigation, the other takeaway is that, even once you’ve been charged, your conduct matters.  Had Mr. Adams accepted responsibility early, he might have negotiated fewer charges of conviction and, therefore, a lower statutory maximum.  Halting the cat-and-mouse game after pleading guilty would have saved a two-point enhancement and avoided the ire of the district judge.  Tax sentences tend to be lower, and sometimes much lower, than the low end of the Guideline range, but here it was above the mid-range.  Why?  Only the district judge knows, but post-indictment obstructive conduct and the late guilty plea is the likely answer.

The case is United States v. David M. Adams, No. 18-3650 (2d Cir. April 7, 2020), and the decision is available at http://www.ca2.uscourts.gov/decisions/isysquery/fc3a03ee-eb58-44b1-8480-325829418c50/2/doc/18-3650_opn.pdf#xml=http://www.ca2.uscourts.gov/decisions/isysquery/fc3a03ee-eb58-44b1-8480-325829418c50/2/hilite/

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 Toscher Perez PC.  He spent 11 years as an AUSA in the Office of the U.S. Attorney (C.D. Cal), spending three years in the Tax Division of the where he handed civil and criminal tax cases and 11 years in the Major Frauds Section of the Criminal Division where he handled white-collar, tax, and other fraud cases through jury trial and appeal.  As an AUSA, he served as the Bankruptcy Fraud coordinator, Financial Institution Fraud coordinator, and Securities Fraud coordinator.  Among other awards as a prosecutor, the U.S. Attorney General awarded him the Distinguished Service Award for his work on the $16 Billion RMBS settlement with Bank of America.  Before becoming an AUSA, Mr. Davis was a civil trial attorney in the Department of Justice’s Tax Division in Washington, D.C. for nearly 8 years, the last three of which he was recognized with Outstanding Attorney awards. 

Mr. Davis represents individuals and closely held entities in criminal tax (including foreign-account and cryptocurrency) 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 including campaign finance, FARA, money laundering, and health care fraud. 

Transfer pricing tax disputes are the highest dollar for dollar cases that are before the U.S Tax Court currently, with cases that involve cross-border transactions of large multinational corporations. These are particularly important tax matters for states where multinational corporations are headquartered and/or conduct business.  But transfer pricing controversies are not limited to large multinationals—the transfer pricing rules apply to every company engaged in cross-border transactions with related parties.  Transfer pricing issues will sometimes even be raised in domestic transactions involving related parties, where the related parties have different tax situations.

Transfer pricing has now gotten the attention of states.  States have been hiring outside experts and consultants, many of whom are former senior government officials, for transfer pricing expertise to assist the tax agencies in transfer pricing examinations of intercompany transactions.

What is Transfer Pricing

Transfer pricing refers generally to the setting of prices for property and service sold between controlled entities, such as a parent corporation selling goods to a subsidiary. These intercompany transactions often occur between “high tax” jurisdictions and “low tax” jurisdictions, such as Ireland and Luxembourg.[i]

IRC §482 and the regulations thereunder[ii] govern the pricing between these entities. IRC §482 is designed to prevent income shifting through controlled transactions, by allowing the IRS to adjust the amount charged in related-party transactions for purpose of determining a related party’s taxable income, if the amount charged is determined to not be “arm’s length.” Under §482’s transfer pricing rules, the IRS has the power to distribute, apportion, or allocate gross income, deductions, credits or allowances between or among related parties if it determined that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or to clearly reflect their income.

If the IRS makes an adjustment, the adjustment may be subject to a substantial or gross valuation misstatement penalty.^[iii] Areas covered by IRC §482 and the Treasury Regulations include: loans, use of tangible property, sale of tangible property, transfer and use of intangible property, services, and cost-sharing arrangements. Under IRC §482, controlled entities should price transactions in the same way that uncontrolled entities would under similar circumstances.  Obtaining a transfer pricing study when setting prices will help taxpayers be prepared for an audit and potentially avoid penalties.[iv]

State Tax Implications

Numerous states have a statutory provision that either conforms or substantially conforms to IRC §482.  While some states still retain a separate reporting regime for taxpayers, a majority of states have combined reporting (such as a water’s edge combined reporting). This filing method requires affiliated domestic companies that are engaged in a unitary business to report their total income—regardless of where earned—as though the group were a single unified business.

Some states, such as Connecticut and Washington D.C., also require taxpayers to include in their water’s edge reporting affiliates that are doing business in overseas “tax havens,” regardless of the amount of U.S. activity they have conducted.[v] If there are transactions between entities that are within and without the water’s edge group, then there exists the potential for intercompany transfer pricing issues. While the IRS’s focus is mostly on cross-border transactions, states are also focused on ensuring that income is clearly reflected for domestic related companies, where a company may want to take advantage of another state’s more favorable regime.

Cooperation Amongst State Tax Agencies

The Multistate Tax Commission (MTC) is an intergovernmental state tax agency with the mission of promoting uniform and consistent tax policy and administration among the states.[vi] The MTC developed a plan in 2015 to help states jointly address intercompany transactions.[vii]  This led to the creation of the MTC’s “Arm’s Length Adjustment Service Committee” the following year.  The MTC’s goal was to create a program of services for participating states, including the ability to combine their resources to make more efficient use of top transfer-pricing experts.  Although the program did not come to fruition since few states participated in the program, this kickstarted an effort by numerous states to cooperate together in transfer pricing audit issues.

The MTC’s most recent two-day training on transfer pricing took place in March 2019 and was attended by revenue staff from 16 states, including staff from the following eight new participating jurisdictions: Arkansas, Delaware, Kansas, Missouri, Oregon, Utah, West Virginia and Wisconsin.

In the past five years, consulting firms have most frequently been retained by state tax departments to train their staff. The contracts have been for services ranging from training on transfer pricing methods to assistance in selecting taxpayers for audit, preparation of economic reports that support a state’s adjustments, and serving as expert witnesses during litigation.

We expect to see increased audit activity by states into intercompany transacting pricing matters, as state agencies become better trained on transfer pricing matters and have greater resources through cooperation of other states to hire transfer pricing experts.

Steven Toscher is a Principal at Hochman Salkin Toscher & Perez P.C., and specializes 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.

Lacey Strachan is a Principal at Hochman Salkin 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).  Ms. Strachan has experience in a wide range of civil and criminal tax cases, including cases involving technical valuation issues, issues of first impression, and sensitive examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise. 

Tenzing Tunden is a Tax Associate at Hochman Salkin Toscher Perez P.C. Mr. Tunden recently graduated from the Graduate Tax Program at NYU School of Law and the J.D. Program at UC Davis School of Law. During law school, Mr. Tunden served as an intern at the Franchise Tax Board Legal Division and at the Tax Division of the U.S. Attorney’s Office (N.D. Cal).

[i] See Veritas Software Corp. et al. v. Comm’r, 133 T.C. 297 (2009) and Amazon v. Comm’r, 148 T.C. No. 8 (2017).

[ii] Treas. Reg. §1.482-0 through §1.482-9.

[iii] IRC §6662(e)(1)(B)(i) 40% gross valuation misstatement if the price is 400% or more or 25% or less. Also see IRC §6662(h)(2)(A)(ii)(1).

[iv] See ”IRS Increases Focus on Transactions Between Commonly Controlled Entities in the Mid-Market Segment,” by Lacey Strachan, TAXLITIGATOR – Tax Controversy (Civil & Criminal Report) (June 8, 2017), https://taxlitigator.me/2017/06/08/irs-increases-focus-on-transactions-between-commonly-controlled-entities-in-the-mid-market-segment-by-lacey-strachan-2/.

[v] See D.C. Code Sections 47-1805.02a(a)-(b);-1810.07(a)-(c). Also see Conn. Gen. Stat. sections 12-213(a)(29) and 222(g)(1).

[vi] Multistate Tax Commission, http://www.mtc.gov.

[vii] MTC History, http://www.mtc.gov/The-Commission/MTC-History.

On March 30, 2020, the California Franchise Tax Board (FTB) issued Notice 2020-02.  Based on Governor Newson’s March 12, 2020, executive order authorizing the FTB to use its administrative powers to grant extensions, the notice extends the deadline for filing claims for refund, protests of Notices of Proposed Assessment (NPA), appeals and petitions for rehearing to the Office of Tax Appeals (OTA), and issuing NPAs.

Refund Claims:  A taxpayer’s claim for refund is timely if filed within the later of four years of the date the return was filed (if timely), four years from the original due date for the return, or one year from the date of payment.   Where the statute of limitations on a refund claim expires between March 12 and July 15, 2020, the refund claim will be considered timely if filed on or before July 15, 2020.

Protests:  Protests of a NPA are normally due within 60 days.  Where the time for filing a protest expires between March 12 and July 15, 2020, the protest is timely if filed on or before July 15, 2020.

Appeal and Petitions for Rehearing to OTA:  A taxpayer can file appeal to the OTA within thirty days from a Notice of Action on a protest of an NPA and within 90 days from the denial of a refund claim.  Any appeal due between March 12, 2020, and July 15, 2020, is timely if filed by July 15, 2020.  A petition for rehearing from a decision by the OTA that was to be filed between March 12, 2020, and July 15, 2020, is timely if filed by July 15, 2020.

Issuance of NPAs:  If the statute of limitations on issuing an NPA was to expire between March 12, 2020, and July 15, 2020, the NPA is timely if issued by July 15, 2020.

This action follows OTA Legal Notice 2020-01, issued March 18, 2020.  That notice automatically extended by 60 days all briefing and other filing deadlines that fall between March 12 and May 18, 2020, by 60 days.

The FTB’s authority to extend deadlines is contained in Revenue & Taxation Code sec. 18572, which incorporates IRC sec. 7508A.  Besides authorizing the Secretary of the Treasury to extend the date for filing returns and paying taxes in the case of a federally declared disaster, sec. 7508A authorizes the Secretary to extend the time for, among other things: a) filing Tax Court petitions, b) allowing claims for credit or refund; c) filing suit upon a claim for credit or refund, and d) filing suit by the Government in respect of any tax liability.  Secretary Mnuchin has already extended the time for filing returns and paying tax from April 15, 2020 to July 15, 2020.  Given the coronavirus pandemic and its effect on the public, the IRS and the Tax Court, will he also extend the time for filing Tax Court petitions, refund claims and refund suits?

The FTB has not yet issued guidance similar to the IRS’s recently released “People First Initiative” regarding suspension of collection actions. IR-2020-59, March 25, 2020. Accordingly, it is unclear whether the FTB has suspended the issuance of new Notices of State Income Tax Due or subsequent enforced collection actions.  The CDTFA has also recently released guidance regarding collection relief in the form of a 90 day relief for taxpayers in payment plans.

Contact Robert S. Horwitz at horwitz@taxlitigator.com or 310.281.3200   Mr. 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.

The U.S. real property market has always been attractive to foreign investors, not just for it’s potential for profit, but also because of the country’s robust financial and legal system in case investors need to efficiently liquidate their ownership or if a dispute arises.

For the 12 months ending in March 2016, NRAs purchased $43.5 billion of U.S. property.

Tax compliance in this area has historically been limited.   While there have been improvements in this area for tax compliance and reporting, it is not yet sufficient for the U.S. Treasury and IRS.

The Large Business & International Division (LB&I) of the IRS recently launched a new compliance campaign on rental income of nonresident aliens (NRAs).  IRS campaigns are intended to improve tax compliance with respect to certain ”hot” tax issues. This new campaign will target taxpayers through several treatment streams, from soft letters (pre-audit notices to taxpayers identifying potential campaign issues and encouraging compliance) to issue-based examinations. It also contemplates education and outreach to promote tax compliance. The LB&I has indicated that the majority of the future examination workload will be selected using various campaigns.[i]

Relevant Law and Reporting Obligation

A nonresident alien’s US taxable income is divided into the following two categories:

(i) Income that is effectively connected to a trade or business in the United States

(ii) Income that is not effectively connected to a trade or business in the United States (“FDAP income”)

Income that is effectively connected to a U.S. trade or business, after allowable deductions, is taxed at the graduated rates applicable to U.S. citizens and resident aliens, while income that is not effectively connected to a U.S. trade or business is subject to tax at a flat rate of 30% that is withheld at the source.[ii]

Nonresident aliens who own U.S. property that generates rental payments are subject to the flat 30 % withholding tax on the gross rent unless the nonresident alien makes an election to treat the rental income as effectively connected to a U.S. trade or business.[iii]  Nonresident aliens who make this election can reduce their rental income by offsetting rental income with expenses pertaining to the rental activity.

For those that make the election they must report  on Schedule E of Form 1040NR. For those that do not make the election, the withholding agent is responsible to remit the  30 % withholding tax. They must submit a Form W-8BEN to the withholding agent.

A withholding agent is a U.S. or foreign person that has control, receipt, custody, disposal, or payment of any item of income of a foreign person that is subject to withholding.[iv]  A withholding agent may be an individual, corporation, partnership, trust, association, or any other entity, including any foreign intermediary, foreign partnership, or U.S. branch of certain foreign banks and insurance companies.[v]  Thus, in the real estate context, a withholding agent would be either the tenant or the property manager since they have control and custody over the property owned by the NRA.

TIGTA Report[vi]

This campaign is in part influenced by a Treasury Inspector General  for Tax Administration (TIGTA) report published in August 2017. The  report pointed out the failure  to  identify NRAs  who failed to report U.S. property rental income. The TIGTA conducted a random stratified sample of 149 filers from over 33,000 Tax Year 2013 Form 1040 NR Schedule E filers who were first-time filers that year.[vii]  The random stratified sample was conducted to determine whether or not taxpayers were in compliance with the IRC §871(d)(1) election and Treasury Regulation §1.871-10 (statement that accompanies the election to have the income be effectively connected income with a  U.S. trade or business).[viii] The TIGTA report noted a considerable number of NRAs were claiming net income treatment on annual Forms 1040NR despite never making the appropriate election to treat the income as effectively connected income. Only 47 (32%) of the 149 taxpayers complied with the reporting requirements of rental income by NRA and included the mandatory election statement in accordance with IRC §871(d)(1).[ix]  Only six of the election statements included all of the elements required by the Treasury Regulation §1.871-10.[x] The 68% that did not attach the election statement still reported their rental income as effectively connected to a U.S. trade or business. These taxpayers should have been subject to the flat 30% tax on gross income, which would have yielded the IRS approximately $534,000 in income taxes (30% of $1.78 million).[xi] When this is projected over the entire population, the TIGTA estimates that the IRS loses about $56 million per year.[xii] The TIGTA report also found that some NRAs taking inconsistent positions – e.g. deducting rental expenses and subjecting remaining net income to IRC §1 tax rates while not reducing their basis of property when later disposing of the property. Other issues that  TIGTA discovered are some NRAs never filing Form 1040NR and never notifying withholding agents that they should be subject to a 30% tax rate on gross income.

Furthermore, based on a reported sample data from 5 counties in four states, 13% of foreign property owners failed to pay tax in 2013.[xiii] The TIGTA estimated that 5,600 NRAs may not have complied with filing requirements in those counties.

Conclusion

The Commissioner of the IRS has stated  that the IRS will have a much greater presence on enforcement  and that “we will be in every neighborhood that we can be.”[xiv] The new LB&I campaign makes clear that if you  are a NRA landlord, the IRS will be visiting your neighborhood.   With the extra focus now on NRA taxpayers by the IRS , it is important for   taxpayers and withholding agents to  review  their compliance or otherwise face costly deficiencies, penalties, and interest.

Steven Toscher is a Principal at Hochman Salkin Toscher & Perez P.C., and specializes 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.

Tenzing Tunden is a Tax Associate at Hochman Salkin Toscher Perez P.C. Mr. Tunden recently graduated from the Graduate Tax Program at NYU School of Law and the J.D. Program at UC Davis School of Law. During law school, Mr. Tunden served as an intern at the Franchise Tax Board Legal Division and at the Tax Division of the U.S. Attorney’s Office (N.D. Cal).

[i] IRS Advisory Council 2017 Public Report at 31-32. Available at https://www.irs.gov/pub/irs-utl/2017-irsac-public-report.pdf.

[ii] IRC §1 for income that is ECI and IRC §871(a) for income that is not ECI.

[iii] IRC §871(d).

[iv] IRS Publication 515 at 3.

[v] Id.

[vi] Treasury Inspector General For Tax Administration, Additional Controls Are Needed to Help Ensure That Nonresident Alien Individual Property Owners Comply With Tax Laws, August 23, 2017, available at https://www.treasury.gov/tigta/auditreports/2017reports/201730048fr.pdf.

[vii] Id. at 7.

[viii] Id.

[ix] Id.

[x] Id.  The election statement includes: (A) a complete schedule of all real property, or any interest in real property, of which the taxpayer is a titular or beneficial owner, which is located in the U.S. (B) an indication of the extent to which the taxpayer has direct or beneficial ownership in each such item of real property, or interest in real property (C) the location of real property or interest therein (D) a description of any substantial improvements on any such property and (E) an identification of any taxable year or years in respect of which a revocation or new election under this section has previously occurred.

[xi] Id. at 9.

[xii] Id.

[xiii] Id. at 17-18.

[xiv] Joshua Rosenberg, Rettig’s Vow To Have IRS in Every Neighborhood A Tall Order, LAW360 Tax Authority, Nov. 7, 2019 (comments from his speech at various tax law conferences). Also see Daniel Hood,  IRS Commissioner: You’re Going to Be Seeing A Lot of Me, Accounting Today, June 10, 2019.

Serial Non-Filer Pleads Guilty to Tax Evasion[i]

From 2009 through 2016, Daryl Brown received taxable income. Nonetheless, Mr. Brown did not file his tax returns to report his income nor did he pay the taxes he owed on such taxable income.  Mr. Brown did, however, take steps to evade his tax obligations, such as opening bank accounts and lines of credit in nominee names and using credit and debit cards from those accounts to pay for personal expenses. Additionally, he bought money orders with cash, directed others to buy money orders for him, and structured his purchase of money orders–sometimes from several locations on the same day–to avoid triggering reporting requirements that would have flagged his activity to the Internal Revenue Service (IRS).[ii]  Mr. Brown pled guilty to a charge of tax evasion and now faces a sentence of five years in prison.[iii]

While the recent press release in the above criminal tax case specifically referenced Mr. Brown’s failure to file his federal tax returns for multiple years, it is important to note that this case was not simply about his lack of filing timely tax returns. Rather, this case is about the intentional “affirmative” steps Mr. Brown took to conceal and misrepresent his financial dealings that resulted in his attempted evasion of his taxes.  In simple terms, it was the affirmative acts, not Mr. Brown’s serial non-filing of his tax returns, that resulted in the government charging him with tax evasion and which now has Mr. Brown facing five years in prison.[iv]

Does that mean the federal government can’t prosecute someone based only on evidence of an intentional failure to comply with a legal duty to file a timely (and honest) tax return?  The simple answer is – No.  While the willful failure to file a tax return is a misdemeanor, the government will bring failure to file charges in appropriate circumstances which can result in incarceration for the non-filer.  For example, actor Wesley Snipes was sentenced to 3 years in prison for his conviction for intentionally failing to file his tax returns[v] with the IRS for the years 1999, 2000 and 2001[vi], and  singer and actress Lauryn Hill was sentenced to 3 months in prison and 3 months of home detention in connection with her guilty plea for intentional failure to file tax returns for the years 2005, 2006, 2007, 2008 and 2009.[vii]

According to the IRS’s most recent published statistics which relate to the fiscal year 2016, 206 non-filer criminal tax investigations were opened and 157 non-filer tax cases were charged,[viii] while the overall criminal tax investigations and charged cases for that same year were reported to be 3,395 and 2,761, respectively.[ix]  Doing the math, that calculates to about 17% of the annual criminal tax cases involving non-filers.  The Commissioner’s recent announcement focusing on high income non-filers[x] should be a signal that more than ever that a willful failure to file will be vigorously pursued by the IRS, even if you are not a high profile taxpayer like Mr. Snipes or Ms. Hill.

For those who intentionally fail to file their tax returns in a timely fashion, particularly those “serial non-filers” like Mr. Brown who find themselves being prosecuted, there is often more going on. What is often going on is a series of intentional acts to defraud or conceal from the IRS information that would evidence an individual’s correct tax obligations.  Such affirmative acts not only moves a taxpayer into the realm of greater exposure for a criminal tax investigation and prosecution, but also increases the likelihood that such investigation will involve a charge of felony tax evasion

Tax evasion, which is shorthand for a crime of willfully attempting to evade or defeat the assessment or payment of a tax, requires the government to prove that the individual engaged in some affirmative conduct for the purpose of misleading the IRS or concealing tax liability or assets.[xi] While a common method used to attempt to evade or defeat assessment of a tax is the filing of a false tax return that understates tax liability, either by omitting income, claiming deductions to which the taxpayer is not entitled, or both, the filing of a false tax return is not the only way in which a taxpayer can attempt to evade or defeat taxes or the payment thereof.  Failing to file a return, coupled with an affirmative act of evasion and a tax due and owing, which is known as Spies[xii]-evasion, qualifies as tax evasion.  A mere failure to file a return, standing alone, cannot constitute an attempt to evade taxes.[xiii]

So what constitutes an “affirmative willful attempt” to evade?  Here is a list of examples provided by the Supreme Court[xiv]: keeping a double set of books, making false entries or alterations, or false invoices or documents, destruction of books or records, concealment of assets or covering up sources of income, handling of one’s affairs to avoid making the records usual in transactions of the kind, and any conduct, the likely effect of which would be to mislead or to conceal.  That means, the acts, or attempts, by which defendants can attempt to evade are virtually unlimited.

Although the IRS reserves the right to investigate and prosecute those who intentionally don’t file or pay taxes, the IRS is focused on tax compliance—its ultimate mission– and would rather work to encourage those individuals to come forward voluntarily or work out a payment plan instead of filing charges.  In other words, if you cooperate and come in before the IRS finds you, you’re less likely to be prosecuted.  On the other hand, the more blatantly fraudulent a taxpayer’s actions are, the more likely it is that the IRS will pursue prosecution.

Sandra R. Brown is a principal at Hochman Salkin Toscher Perez P.C. Prior to joining the firm, Ms. Brown served 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 specializes in representing individuals and organizations who are involved in criminal tax investigations, including related grand jury matters, court litigation and appeals, as well as representing and advising taxpayers involved in complex and sophisticated civil tax controversies, including representing and advising taxpayers in sensitive-issue audits and administrative appeals, as well as civil litigation in federal, state and tax court.

[i]   https://www.justice.gov/opa/pr/serial-non-filer-pleads-guilty-tax-evasion.

[ii]  Id.

[iii]  Id.

[iv]  26 U.S.C. § 7201.

[v]  26 U.S.C. § 7203.

[vi]https://www.justice.gov/archive/tax/usaopress/2008/txdv08_20080806_SnipesProsecutionCost.pdf

[vii] https://www.justice.gov/usao-nj/pr/singer-and-actress-lauryn-hill-sentenced-prison-failing-file-tax-returns-more-23-million

[viii] https://www.irs.gov/compliance/criminal-investigation/statistical-data-nonfiler-investigations

[ix] https://www.irs.gov/compliance/criminal-investigation/current-fiscal-year-statistics

[x] https://www.irs.gov/newsroom/irs-increases-visits-to-high-income-taxpayers-who-havent-filed-tax-returns

[xi] 26 U.S.C. § 7201.

[xii] Spies v. United States, 317 U.S. 492, 499 (1943).

[xiii] Id.; United States v. Hoskins, 654 F.3d 1086, 1091 (10th Cir. 2011); United States v. Nelson, 791 F.2d 336, 338 (5th Cir. 1986).

[xiv] Spies, 317 U.S. at 499.

The IRS unveiled a new “People First initiative” today in IR-2020-59 as part of a continued COVID-19 relief effort for taxpayers.  While a primary feature of the announcement is a targeted and significant suspension of collection enforcement and other compliance functions, the People First Initiative provides a rare opportunity for non-filers and procrastinators to get into compliance.

Opportunities for Non-Filers

The benefits of the initiative are particularly unique because of the confluence of two events.  First, the IRS is suspending lien and levy activity until July 15^th.   These are two of their primary enforcement tools to collect taxes.  While the initiative leaves in an exception when warranted, this is a very significant relief provision.  The relief permits of the filing delinquent returns together with an installment request or other collection alternative with a completely different dynamic of suspended enforced collection.  Second, a significant part of the recent economic stimulus is being administered through the IRS so the filing of a 2019 return, or prior returns, may result in a refund, or at least an offset due to the relief provisions as summarized in our recent blog.  As noted in the announcement, “[m]ore than 1 million households that haven’t filed tax returns during the last three years are actually owed refunds; they still have time to claim these refunds.”

Complex Collection Cases

For more complex ongoing collection cases, the People First Initiative also provides an extraordinary opportunity to re-approach collection solutions in a new environment.  As we noted in our blog last week, the financial statements reported to the IRS in recent months have substantially changed.  Often taxpayers working with the IRS Collection Division or Collection Appeals are in the process of selling a home or a business, or perhaps securing a loan.  Many of these transactions have stopped entirely, if any businesses are even still operating under cessation orders issued by various states.  Taxpayers can now work through these realities with a suspended levy and lien framework.

For taxpayers struggling to meet installment obligations that were agreed to before their new post-COVID-9 reality, the announcement permits Taxpayers who are currently unable to comply to suspend payments until July 15^th.  The IRS will not default Installment Agreements during this period, although interest will continue to accrue on unpaid balances.

For taxpayers with pending offers in compromise, the IRS extended information request due dates until July 15^th, and will not close pending requests without taxpayer consent.  Additionally, Offer In Compromise payments on accepted offers may be suspended until July 15, 2020.  This can be particularly relevant for taxpayers who made deferred payment offers over a two year period.  Finally, while delinquent return filings can default an offer in compromise, the announcement provides that the IRS will not default offers for taxpayers delinquent on their 2018 return filings, provided their 2018 and 2019 returns are filed before July 15, 2020.

A key component to any collection case is current compliance, as taxpayers need to be current on return filing and estimated payment obligations in order to qualify for alternatives such as offers in compromise or installment agreements.  The Treasury’s recent extension of filing and estimated tax payment deadlines until July 15, 2020, combined with the suspension of liens and levies, provides a unique opportunity to be eligible for collection alternatives to pay some or all of their tax liabilities over time while potentially also qualifying for significant tax stimulus benefits.

IRS Examination Functions

Under the People First Initiative, the IRS will generally not start new examinations, although the IRS will make an exception if the statute of limitations may expire in the near future.  Moreover, if your client recently received a statute of limitation request in an ongoing audit, be aware that a decision to the not extend the statute of limitations will often result in the issuance of a Notice of Deficiency.  The United States Tax Court has announced that the statutory deadlines for filing a Petition to the Tax Court for a Notice of Deficiency (typically 90 days) are still in place and timely filing of a Tax Court Petition must be  proven by the taxpayer.  Use verified mail.  Please note that the United States Tax Court building remains closed and trial sessions through June 30, 2020 are canceled.

Revenue Agents continue to work their existing examinations remotely, where possible, although in person meetings will be suspended.  Taxpayers’ representatives should continue to review and attempt to respond to document requests but should communicate any difficulties to the Revenue Agents, or their managers if necessary.

While the IRS quickly initiated this People First Initiative today, and FAQs regarding the 2019 filing and payment deadline extensions yesterday, the announcement notes that the People First Initiative may be modified or expanded based on circumstances going forward.

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. Mr. Stigile specializes in tax controversies as well as tax, business, and international tax. 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

The Internal Revenue Service (IRS) began sending contact letters this week reminding certain taxpayers that it has their information relating to deductions claimed for micro-captive insurance arrangements. The letters also asked taxpayers who stopped claiming deductions to provide certain information under penalty of perjury, including the final year a micro-captive deduction was claimed.  As for those taxpayers continuing to participate in micro-captive insurance transactions, the IRS recommends that the taxpayer consult an independent competent tax advisor on the proper treatment of past and future tax years and consider best options for any improperly claimed deductions, including the filing of amended returns.  The IRS refers to these as Letter 6336 (3-2020) on its web page and provides a hotline number to call for assistance.

Letters similar to these were generally expected after the IRS roll-out of its time-limited settlement offer made to certain taxpayers under examination, followed by its stern warning to the public on January 31, 2020 that the IRS will continue to vigorously pursue those involved in these and other similar abusive micro-captive transactions going forward.

We consider these letters, however, as an opportunity to revisit the legitimacy of the tax benefits claimed with respect to captive transactions.  Moreover, for appropriate taxpayers, these letter may present an opportunity to take proactive, corrective measures that may assist in avoiding onerous examinations and steep penalties that could otherwise be asserted against them.

Why are Micro-Captive Insurance Letters Issued?

The letter explains why the IRS is writing this letter and what steps are requested of the taxpayers.

The IRS states that:

         Why we’re writing to you

We have information that you’ve taken a deduction or other tax benefit related to micro-captive insurance on a prior year tax return and disclosed pursuant to Notice 2016-66 and Notice 2017-08.

Several recent U.S. Tax Court decisions have confirmed that certain  micro-captive  arrangements  are not eligible for claimed Federal tax benefits. We’re notifying you regarding IRS compliance activity in this area so you can make informed  decisions  about claiming  tax deductions for micro-captive insurance premiums. The IRS is increasing enforcement activity in this area and has deployed several examination teams to open additional examinations of returns that included micro-captive insurance transactions. Examinations may result in full disallowance of claimed micro-captive insurance deductions, inclusion of income by the captive entity, and imposition of applicable penalties.

What information is the IRS Requesting?

The letter requests that if a taxpayer is no longer claiming deductions or other tax benefits it should notify the IRS in writing  of:   (1) The last tax year in which the taxpayer claimed deductions or other tax benefits for micro-captive insurance premiums, and, if applicable, (2) the date the taxpayer ceased participating in the micro-captive insurance transaction.

If a taxpayer continues to participate in a micro-captive insurance transaction covered under Notice 2016-66, the letter states the taxpayer must continue to disclose participation in the transaction.  The letter also cautions that before filing the 2019 Federal income tax return, the IRS recommends the taxpayer consult an independent, competent tax advisor on the proper treatment for past and future tax years and consider the best options for any improperly claimed deductions or other tax benefit, including filing amended returns.

If there is a need to file amended tax returns for individual filers, the letter states write “Microcaptive”  at the top of the first page of the Form 1040X and mail the amended return to:

Internal Revenue Service
2970 Market Street
Philadelphia, PA 19104

For business filers using paper returns write “Microcaptive” at the top of the amended return and mail to the address listed on the instructions to the amended return.  Business filers filing electronic amended returns should list “Microcaptive” as the reason for filing the amended return.

The letter further  states that “We’ll take your actions in response to this letter into account when considering future compliance activity related to your micro-captive insurance arrangement.” and that it does not consider this letter an examination under the Internal Revenue Code or an audit of a tax return.

The IRS warns that if the IRS does not hear from the taxpayer by the “respond by” date it may refer the returns for examination.

Prior IRS Announcement – IR-2020-26

These letters follow the IRS announcement on January 31, 2020 stating that IRS enforcement activity in this area will be significantly increased.  On that date, the IRS informed  that it will deploy additional resources, which includes starting up 12 new examination teams comprised of employees from the IRS Large Business and International (LBI) and Small Business/Self-Employed (SB/SE) divisions that will address abusive transactions and open additional exams.   The IRS Announcement warned that examinations impacting micro-captive insurance transactions of several thousand taxpayers will be opened by these teams in the coming months.   Potential outcomes can include full disallowance of claimed captive insurance deductions, inclusion of income by the captive entity and imposition of all applicable penalties.

The Letter May Present an Opportunity to Potentially Avoid Protracted Examination and Penalties.

While typically receiving an inquiry from the IRS is never a good thing, the letter does raise the question whether taking proactive steps, such as reversing the transactions  on amended tax returns, could avoid an onerous examination that many individuals and captive entities endured, along with the steep penalties asserted in these examinations.  We are hopeful that it would.

We would like to think that when the IRS invites taxpayers to file amended tax returns and states it will take the taxpayers actions into account when considering future compliance activity, it will consider these corrective actions as good faith gestures warranting the elimination  of penalties.  Moreover,  the IRS should  treat amended returns filed in response to these letter as Qualified Amended Returns, warranting penalty mitigation.

On the other hand, ignoring the letter is rarely the correct response.  Even those taxpayers with sound micro-captive transactions positions should fashion a response that addresses the merits of their position, and offers an explanation for the micro-captive benefits claimed.  Many individuals and businesses have legitimate reasons for micro-captive insurance arrangements.  In this COVID-19 new reality we all are facing, one can now plainly see the benefits of additional or gap insurance, such as business interruption insurance or the like.  However, absent a detailed explanation, the IRS may require the taxpayer to expend considerable resources before the legitimacy of the captive insurance plan is known to it.

Moreover, it is possible that for those taxpayers who respond appropriately, the IRS would at a minimum offer terms similar to the time-limited settlement initiative afforded to those under examination, in lieu of opening a full-blown examination against the taxpayer.   Importantly, the time-limited settlement initiative protected the IRS’ interests for years closed by statute, and it is likely that the IRS would want closed years considered as part of any resolution with the taxpayer. As such, amended tax returns alone may not fully address all of the concerns by the IRS.

As the IRS works through these cases, only time will tell how the IRS will respond.   For the time being, taxpayers have 45-days from the date of the letter to sort these issues out and respond accordingly.

For more information regarding this topic please contact Michel Stein – ms@taxlitigator.com   Mr. Stein is a principal at Hochman, Salkin,  Toscher & Perez, P.C. He is a former Attorney-Adviser of the U.S. Tax Court and is a Certified Specialist in Taxation Law by the State Bar of California, Board of Legal Specialization.  Mr. Stein represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. He has extensive experience with micro-captive insurance, voluntary disclosures and foreign account and asset reporting, and he frequently lectures throughout the country on these and other tax related topics.  Additional information is available at www.taxlitigator.com .