TAXLITIGATOR – Tax Controversy (Civil & Criminal) Report

This post addresses the circumstances under which the government may forfeit currency for failure to file IRS Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business.

Any person engaged in a trade or business who receives $10,000 or more in cash from a transaction (in the course of their trade or business), must file Form 8300. The requirement to file Form 8300 is located in both Title 26 (Internal Revenue Code § 6050I) [1] and Title 31 (Money and Finance § 5331(a)).[2]

Section 5317(c) of Title 31 provides that property involved in a violation of Section 5313, 5316, or 5324 whether civil or criminal, may be seized and forfeited. See 31 U.S.C. § 5317(c).

Section 5313 requires domestic financial institutions to report certain currency transactions. Section 5316 places a reporting obligation on any person transporting or receiving $10,000 of monetary instruments transported into or out of the United States.

Section 5324(a) imposes a criminal penalty for structuring to avoid the requirements of Section 5313(a) and Section 5324(b) imposes a criminal penalty for causing or attempting to cause a nonfinancial trade or business to fail to file Form 8300, causing or attempting to cause a nonfinancial trade or business to file Form 8300 that contains a material omission or misstatement of fact, or for structuring or assisting in structuring or attempting to structure or assist in structuring any transaction with a nonfinancial trade or business.

Section 6050I of Title 26 and Section 5331 of Title 31 impose a requirement to file a Form 8300 when more than $10,000 of cash is received in a trade or business transaction. A failure to file Form 8300 on its own is not sufficient to permit forfeiture of currency. In United States v. Seher, 686 F.Supp. 2d 1323, the court stated, “significantly, unlike 31 U.S.C. § 5324, a violation of 31 U.S.C. § 5331 does not trigger criminal forfeiture.”  However, a violation of Section 5331 in the context of violations of Section 5313, 5316 and 5324(b) can result in forfeiture of currency.

[1] Section 6050I of the Internal Revenue Code states:

Any person—

(1) who is engaged in a trade or business, and

(2) who, in the course of such trade or business, receives more than $10,000 in cash in 1 transaction (or 2 or more related transactions),

shall make the return described in subsection (b) with respect to such transaction (or related transactions) at such time as the Secretary may by regulations prescribe.

26 U.S.C. § 6050I. The form prescribed by the Secretary is Form 8300. 26 CFR § 1.6050I-1(e)(2).

[2] Section 5331(a) of Title 31 contains language similar to Section 6050I:

Any person—

(1)

(A) who is engaged in a trade or business, and

(B) who, in the course of such trade or business, receives more than $10,000 in coins or currency in 1 transaction (or 2 or more related transactions), or

(2) who is required to file a report under section 6050I(g) of the Internal Revenue Code of 1986,

shall file a report described in subsection (b) with respect to such transaction (or related transactions) with the Financial Crimes Enforcement Network at such time and in such manner as the Secretary may, by regulation, prescribe.

The form prescribed by the Secretary is Form 8300. The FinCen website provides only IRS Form 8300 for reporting Section 5331(a) transactions. http://www.fincen.gov/forms/bsa_forms/. See also, United States v. Chaplin, Inc., 646 F.3d 846 (11^th Cir. 2011) (Section 5331(a) requires any person “engaged in a trade or business” to report any transactions involving more than $10,000 in currency—i.e., to file Form 8300.); United States v. Calmes, 574 Fed. Appx. 295 (5^th Cir. 2014); United States v. Sapyta, 390 F. Supp. 2d 563 (D. Tex. 2005). The instructions to Form 8300 state:

Important Reminders: Section 6050I (26 United States Code (U.S.C.) 6050I) and 31 U.S.C. 5331 require that certain information be reported to the IRS and the Financial Crimes Enforcement Network (FinCEN). This information must be reported on IRS/FinCEN Form 8300.

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

[On November 2, 2015, President Obama signed into law H.R. 1314, the Bipartisan Budget Act of 2015 (the “Budget Act”). This document outlines the key provisions (new procedural rules for partnership audits and adjustments, and amendments to sections 704(e) and 761(b)) relating to the determination of who is a partner in a partnership relating to TEFRA.]

REVISED PARTNERSHIP AUDITS AND ADJUSTMENTS RULES. The Bipartisan Budget Agreement (“Budget Act”) repeals the unified audit rules (TEFRA – Tax Equity and Fiscal Responsibility Act of 1982) and the special rules for electing large partnerships (“ELPs”).   The new partnership rules are intended to once again streamline partnership audits by replacing them with a single system of centralized audit, adjustment, and collection of tax for all partnerships.  Partnerships with 100 or fewer qualifying partners would be permitted to affirmatively opt-out of the new rules, electing to be subject to audits at the individual partner level.  The opt-out procedure is available provided that each partner is an individual, C corporation, foreign entity that would be a C corporation under U.S. law, an S corporation, or the estate of a deceased partner.

Since 1982, there have been numerous procedural and litigation issues raised regarding the implementation of TEFRA and over the years various proposal have been considered by Congress to overhaul the taxation of partnerships as TEFRA has been viewed as inefficient and complex.

As of today partnerships are audited one of the following three ways:

• Partnerships with more than 10 partners are audited under the unified TEFRA procedures and binding on the partners;
• Partnerships with 100 or more partners that elected to be treated as Electing Large Partnerships (ELPs) are subject to a unified audit. Any adjustments are reflected on the partner’s current return rather than on an amended return; and
• Partnerships with 10 or fewer partners are audited as part of each partner’s individual audit.

The new Budget Act will apply to partnership returns filed for tax years beginning after December 31, 2017 and may allow a partnership to elect out of the new regime.  Specifically, the act replaces the current TEFRA partnership audit rules (Code sections 6221 through 6255).  It also repeals the current rules for electing large partnerships for electing large partnerships (sections 771 through 777).  In their place, the new rules are designed to assess and collect underpaid tax at the partnership level rather from the partners even though partnerships are flow through entities.

The new Section 6221 provides that:

Any adjustment to items of income, gain, loss, deduction, or credit of a partnership for a partnership taxable year (and any partner’s distributive share thereof) shall be determined, any tax attributable thereto shall be assessed and collected, and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to any such item or share shall be determined, at the partnership level pursuant to this subchapter.

Certain partnerships with 100 or fewer partners can elect out of this provision.

For adjustments that result in tax underpayments the Service will be allowed to collect additional tax directly from the partnership in the year of an adjustment[i] and the tax could be collected at the highest individual tax rate.

The new section 6222 requires that a partner must treat “each item of income, gain, loss, deduction, or credit attributable to a partnership” consistently with how those item are treated on the partnership return.  Any underpayment resulting from a partner’s failure to treat an item consistently with the partnership return will be assessed as a math error on the partner’s return.  However, partners can avoid this provision if, before filing their return, they notify the IRS that there will be an inconsistency.

The new Section 6223 requires partnerships to designate a partnership representative, “who shall have the sole authority to act on behalf of the partnership in this subchapter.”  The partnerships and all partners will be bound by the actions of the partnership and by any final decision in a proceeding with respect to the partnership.  The Act also introduces new procedural rules regarding notices of proceedings and adjustment; assessment, collection, and payment; interest and penalties; judicial review of partnership adjustments; and the limitation period on making adjustments.

A Congressional Summary of the new provision explains that partnerships “would have the option of demonstrating that the adjustment would be lower if it were based on certain partner level information from the year under audit rather than imputed amounts determined solely on the partnership’s information in such year.”  However, the Budget Act also provides an elective mechanism by which a partnership could push out the payment of underpaid amounts in the current year to those who were partners in the year to which the adjustment relates.

The Service will need to develop regulation to reflect the repeal of the TEFRA and ELP rules and the enactment of its replacement regime.  On a positive note, Congress provided a delayed effective date (returns filed for partnership tax years beginning after 2017) giving taxpayers an opportunity to provide comments and allowing Treasury and IRS time to digest the changes and issue regulations, guidance and clarification. Already questions are being raised about the impact to multi-tier partnerships and impact on foreign and tax-exempt partners, as well as changes in partnership allocations and partners from year to year.  Also, it is unknown how state and local taxing authorities will respond to this new regime.

Reason for the Regime Change

Although, partnerships are among the fastest growing type of business entity, the Service audits very few large partnerships.  Most partnership audits resulted in no change to the partnership’s return or the aggregate change was small. According to the Service, the number of partnerships has grown at an annual rate of 3.9% since 2003. Almost two-thirds of large partnerships had more than 1,000 direct and indirect partners, had six or more tiers and/or self-reported being in the finance and insurance sector, with many being investment funds.

In recent years, there has been increased focus on problems the Service faces in auditing large partnerships. In July 2014, the U.S. Government Accountability Office (GAO) provided testimony before the Permanent Subcommittee on Investigations of the Senate Committee on Homeland Security and Governmental Affairs assessing the Service’s ability to audit “large” partnerships (defined for this purpose as partnerships with $100 million or more in assets and 100 or more direct and indirect partners). The GAO testified, among other things, that although the number of large partnerships more than tripled from tax years 2002 to 2011, the IRS audits few large partnerships. The GAO noted that, in 2012, the Service audited only 0.8% of large partnerships, compared to 27.1% for large corporations. Compare that to the amount of income that passed through partnerships.  In 2012, $1.4 billion in income was reported by partnerships – a 43.4% increase from 2011.

A few months later, the GAO issued a report recommending that Congress consider legislation requiring a large partnership to identify a partner to represent it during audits and to pay taxes on audit adjustments at the partnership level. The report’s findings concluded that under the existing TEFRA regime:

• The Service audits few large partnerships, most audits result in no change to the partnership’s return, and the aggregate changes are small.
• These audit results may be due to challenges—such as finding the sources of income within multiple tiers while also complying with TEFRA within specified time frames.
• Service auditors said that it can sometimes take months to identify the partner that represents the partnership in the audit, reducing time available to conduct the audit.
• Service officials stated that the process of determining each partner’s share of the adjustment is paper and labor intensive. When hundreds of partners’ returns have to be adjusted, the costs involved limit the number of audits the Service can conduct.

Subsequently, several similar legislative proposals were introduced to reform the partnership audit rules by, among other things, imposing a partnership-level tax in the case of audit adjustments. Prior to the Budget Act, the most recent of these proposals was H.R. 2821, the Partnership Audit Simplification Act.  However, numerous concerns were raised about aspects of H.R. 2821, including that it would have applied to more than the kinds of “large” partnerships addressed by GAO reports and would have imposed joint and several liability for the assessment of underpaid tax on the partnership and all its direct and indirect partners in both the year to which the adjustment relates and the year in which the adjustment finally is determined. H.R. 2821 also would have required past-year partners to file amended returns in many situations for the amount of the assessment to reflect the character of the income underpaid and the characteristics of the partners. In late October 2015, the partnership audit reform was added to the Budget Act but it included significant changes to the proposed H.R. 2821. It should also be noted that the modified version of the TEFRA provisions had not previously been made public.

The Budget Act’s partnership audit regime includes changes to the proposed H.R. 2821. The key changes are as follows:

• It allows relatively more partnerships to elect out of the new regime,
• It does not include the “joint and several” liability provision from H.R. 2821,
• It allows the amount of an underpayment to be adjusted to better reflect the particular facts without requiring amended returns, and
• It provides an elective mechanism by which those who were partners in the year to which the adjustment relates (rather than the partnership) can be responsible for payment of underpaid amounts in the current year.

 Partnerships Impacted by the Changes

The new audit and adjustment regime applies to all partnerships unless the qualifying partnerships affirmatively elect out for a tax year. A partnership can elect out of the new regime for a tax year only if:

• It is required to furnish 100 or fewer statements under section 6031(b) (i.e., Schedules K-1) with respect to its partners for the tax year;[ii]
• Each of its partners is an individual, a decedent’s estate, a C corporation, an S corporation, or a foreign entity that would be treated as a C corporation if it were domestic; and
• Certain procedural requirements are met relating to the election.

In addition special rules apply for a partnership with an S corporation partner to elect out of the regime. The partnership generally must provide the IRS with the names and taxpayer identification numbers of the S corporation’s shareholders (in accordance with procedures prescribed by Treasury). If the partnership has an S corporation partner, then the Schedules K-1 furnished by the S corporation are treated as statements of the partnership for purposes of the “100 or fewer” rule. In addition, Treasury can issue rules similar to those applicable to S corporation partners to other kinds of partners.

To elect out, a partnership should consider whether any partners that are foreign entities would be treated as C corporations if domestic. Under the entity classification rules, the only domestic eligible entities that are classified as corporations for federal tax purposes are those that are either per se (such as incorporated entities or certain special taxpayers such as insurance companies and REITs) or those that elect to be classified as a corporation. Thus, it is unclear what is intended by referencing foreign entities that would be treated as C corporations if domestic.

Another challenge is the rules do not specifically address how a partnership interest that is owned by an entity that is disregarded as an entity separate from its owner will be treated. Generally, such an entity is disregarded, and its activities are treated in the same manner as a sole proprietorship, branch or division of the owner, for federal income tax purposes. The fact a disregarded entity owned by an individual or a C corporation holds a partnership interest seemingly should not disqualify the partnership from electing out of the new regime[iii]. However, note that in Rev. Rul. 2004-88, the IRS concluded that the disregarded entity itself, and not its owner, was treated as the owner of a partnership interest for purposes of the small partnership exception from TEFRA.

 Opt Out or Not To Opt Out of the new Regime: Things to Consider

The opt-out procedure is available provided that each partner is an individual, C corporation, foreign entity that would be a C corporation under U.S. law, an S corporation, or the estate of a deceased partner (“eligible partnership”). In order to elect out of the new regime, an eligible partnership must file an election with its timely filed return for each year for which the election would apply, plus must disclose the name and taxpayer identification number of each partner in the partnership (unless the Treasury provides alternative identification for foreign partners). The partnership also must notify each partner of the election.

Partnerships that are eligible to elect out of the new regime will need to consider whether they want to elect out; an affirmative election will need to be made for each tax year that the partnership wants to elect out. Because the election is made with respect to a tax year, it appears that an eligible partnership could elect out of the regime for some years, but not for others.

One thing to consider is the impact of the assessment and refund statutes.  If a partnership elects out, the general “non-TEFRA” assessment and collection rules that were not modified by the Budget Act would apply.  In other words, the Service could still audit the partnership at the partnership level, but the partnership could not extend the statute of limitations for assessment for partnership items for the partners.  Rather, each partner’s period for assessment and refunds for partnership items would correspond to the partner’s individual limitation period for other items under section 6501 and 6511, and the Service would need to enter into a separate agreement to extend the period with each partner. Likewise, the partnership could not settle partnership items on behalf of the partners. In its place, the Service would need to enter into a separate settlement with each partner. For partners that do not resolve their partnership issues with the Service, the IRS would have to issue each partner a statutory notice of deficiency within the partner’s limitation period under section 6501. Each partner would have an option to petition the deficiency to the U.S. Tax Court or to pay the deficiency and seek a refund in the appropriate federal district court for that partner or the U.S. Court of Federal Claims. The result could be more than one case on the same issue or issues from the partnership could occur at the same time.

One other thing to keep in mind is the impact of the timing of the adjustment.  Under the old TEFRA regime an adjustment would be made to the “reviewed year” partners return (year under examination) versus the current year partner’s return. Under the new audit regime, these items are taken into account by the partnership in the current year. The partnership’s ability to elect the alternative method, described below, to push back the payment of underpaid amounts to those who were partners in the year to which the adjustment relates appears limited to items that result in an “imputed underpayment.” Accordingly, any partnership that has not elected out of the new regime, and is eligible to, may be prohibited from sending any adjustment items related to net losses or net deductions back to the partners who were in the partnership during the reviewed year.

 Now What: Creative Adjustment and Collection Mechanisms

Under the new audit regime applies, the Service will audit items of income, gain, loss, deduction, or credit of the partnership (and any partner’s distributive share thereof) at the partnership level. The IRS likewise will assess and collect any taxes, interest, or penalties relating to an adjustment at the partnership level. This mechanism is provided to those partners in the year that is the subject of the adjustment and can pay their shares of the adjustment (instead of the partnership), as a result of a Schedule K-1 approach that does not involve the partners amending past year returns.

If the Service determines that adjustments are required for the partnership tax year being audited (the “reviewed year”), the partnership is required to pay any “imputed underpayment” with respect to the adjustment in the year in which the adjustment is finalized (the “adjustment year”). An adjustment that does not result in an imputed underpayment generally is taken into account by the partnership in the adjustment year as a reduction in non-separately stated income or an increase in non-separately stated loss (or, in the case of a credit, as a separately stated item).

1. Amount of Imputed Underpayment

In the case of an underpayment, the imputed underpayment generally is determined by

1. netting adjustments of items of income, gain, loss, or deduction for the reviewed year, and
2. multiplying this net amount by the “highest rate of tax in effect for the reviewed year under section 1 or 11” (i.e., the highest individual or corporate rate). Thus, under the current rate structure, the 39.6% individual rate appears to be the “default” rate used for computing the imputed underpayment (even if there are C corporation partners). It is anticipated that Treasury will establish procedures under which the imputed underpayment amount can be modified to better reflect the amount properly owed to the government based on the character of underpaid income and the nature of the partners. In fact, the Budget Act directs the IRS to establish procedures that “shall” provide for:

• Adjusting the amount of the underpayment to reflect amended returns filed by one or more partners for the tax year of such partners that includes the end of the partnership’s reviewed year.
• Determining the amount of the imputed underpayment without regard to the portion thereof that the partnership demonstrates is allocable to a partner that would not owe tax by reason of its status as a tax-exempt entity (as defined in Code section 168(h)(2)).
• Taking into account a rate of tax lower than the highest rate in effect under Code section 1 or 11 with respect to any portion of the imputed underpayment that the partnership demonstrates is allocable to a C corporation partner (in the case of ordinary income) or to an individual or S corporation (in the case of capital gain or a qualified dividend). If a portion of an imputed underpayment is subject to a lower rate, the portion is determined by reference to the partners’ distributive share of items to which the imputed underpayment relates. If it is attributable to more than one item, and any partner’s share of such items is not the same with respect to all such items, then the portion of the imputed underpayment to which the lower rate applies is determined by reference to the amount which would have been the partner’s distributive share of net gain or loss if the partnership had sold all of its assets at their fair market value as of the close of the reviewed year.

In addition, the Budget Act provides Treasury with authority to provide for additional procedures for modifying the amount of the imputed underpayment based on other factors, as appropriate. Things that should be considered include:

• Clarification of the tax rate (35%) for the imputed underpayment.
• Use of a “fair market value” sale approach may cause additional burdens by requiring a determination of fair market value.
• Impact of tax attributes of the partners such as net operating losses (NOLs) or lower, treaty-based, rates that may be applicable for certain foreign partners.
• Impact of the modification of the underpayment amount to reflect items included on the amended return of the partners for the reviewed year is limited if the adjustment is one that reallocates the distributive share of any item from one partner to another. In this case, the adjustment to the partnership’s underpayment amount to reflect items for which a partner filed an amended return is restricted to only those items for which all affected partners file amended returns.

1. Payment of Imputed Underpayment by Partnership

As a general matter, the Budget Act requires a partnership to pay the imputed underpayment with respect to the adjustment by the due date of the partnership’s tax return (without regard to extensions of time to file) for the year for which the adjustment is finally determined (i.e., the adjustment year). Further, no deduction is allowed under the income tax title of the Code for any payment required to be made by the partnership. However, the non-deductiblity of the payment should reduce the partner’s tax basis in the partnership and the partner’s tax basis would be increased to reflect the partner’s share of the Service’s adjustment to the partnership’s income.

1. Alternative Mechanism for Payment by Partners

Payment of the imputed underpayment by the partnership puts the economic burden of underpaid tax with respect to a past year on the current partners of the partnership. The Budget Act provides an elective alternative mechanism that puts the burden on the partners in the reviewed year. Specifically, a partnership that receives a notice of final partnership adjustment can elect to furnish to each partner in the reviewed year a statement of the partner’s share of the adjustment. In such case, each partner’s tax imposed for the tax year that includes the date the statement is furnished (i.e., the current tax year) is increased to reflect the adjustment amount, as well as any associated penalties or interest. The general rate of interest on underpayments is determined by adding three percentage points to the federal short- term rate. Significantly, however, under the new law, interest is determined by adding five percentage points, rather than three percentage points, to the federal short-term rate. Thus, there appears to be an interest “toll charge” to having the reviewed-year partners, rather than the partnership, pay the imputed underpayment. In addition, any subsequent year tax attribute that would have been affected if the adjustment had been taken into account in the reviewed year is “appropriately adjusted.”

In order to apply this alternative collection regime, the partnership will have to make an election no later than 45 days after the date of the notice of final partnership adjustment. Use of this alternative mechanism can be expected to be attractive to partnerships in which the partners, or the interests of partners, change from time to time because it allows the economic burden of the imputed underpayment to fall upon those who were partners in the year of the underpayment based on their interests in such year. Nonetheless, additional administrative costs, as well as higher interest calculations, would be involved in using the approach. To the extent that there is an adjustment to be taken into account by a reviewed year partner as a result of the use of the alternative mechanism, there will likely be an increased burden on the partner to determine the increase in tax liability not only for the reviewed year, but also for years subsequent to the reviewed year. For example, if a partner sells its interest between the reviewed and the adjustment year, the partner’s basis in the partnership interest may be affected by the adjustment amount. Other tax attributes, such as NOLs, passive activity losses, and other loss limitations, may need to be redetermined as a result of an adjustment amount.

Another question arises with respect to tiered partnerships. If a lower-tier partnership elects to use the alternative mechanism and furnishes an upper-tier partnership with a Schedule K-1 showing an adjustment for the reviewed year, can that upper-tier partnership in turn elect to use the alternative mechanism to pass the adjustment through to its partners (notwithstanding that it was not the partnership that received the notice of adjustment)? How would the “45-day” rule apply? Seemingly, the mechanism is intended to allow the adjustment to flow up tiers of partnerships. This is another area that clarity and guidance will be need before the new law begins to apply.

Although the alternative collection regime appears to only apply to “imputed underpayments” one would hope for consistency with an overpayment – resulting in an ordinary deduction to partners in the adjustment year (even though the partners of the adjustment year may be different than the reviewed year).

ADMINISTRATIVE ADJUSTMENT REQUEST (AAR)

The new law imposes a substantially similar approach to payment of tax on an underpayment in the case of administrative adjustment requests filed by the partnership. When a partnership files an administrative adjustment request, the adjustment is taken into account for the partnership tax year in which the administrative adjustment request is made (i.e., the year of the filing, not the prior year). In addition, the payment of tax on an understatement is to be made generally using either the partnership level tax provisions, or under rules similar to the alternative method for payment by partners. When the adjustment would not result in an imputed underpayment, the partnership must use the alternative payment method for payments by partners.

PARTNERSHIP REPRESENTATIVE

Another area of difficulty with TEFRA involved the issue was who had the ability to represent the partnership.  Under the new law it will require each partnership that does not elect out of the new regime to designate a partner, or other person, with a substantial presence in the United States as the partnership representative (“Partnership Representative”). The Partnership Representative will have the sole authority to act on behalf of the partnership for purposes of the new regime. If the partnership does not make such a designation, the Service can select any person as the Partnership Representative. Further, the partnership and all its partners will be bound by actions taken under the new regime by the partnership and by any final decision in a proceeding brought under the new regime with respect to the partnership.

STATUTE OF LIMITATIONS

Under the new regime, no adjustment for a partnership tax year can be made after the latest of the date which is three years after the latest of the following three dates: (1) the date on which the partnership return for such tax year was filed, (2) the return due date for the tax year, or (3) the date on which the partnership filed an administrative adjustment request (AAR) with respect to such year.

There are also new rules that allow the period to remain open for adjustment: (1) in the case of any modification of the imputed underpayment, to a date that is 270 days after the date everything required to be submitted is submitted to the IRS; and (2) in the case of any notice of proposed partnership adjustment, to a date that is 270 days after the date of such notice.

The major change here is the impact of filing an AAR.  Under the new regime the Service is provided 3 years from the filing of an AAR to assess tax.  One wonders why the Service would need this additional time to keep the assessment statute open especially in a situation in which the partnership has paid the tax.  Like the Service taxpayers want finality and adding three years to the statute is a mystery.

AMENDMENTS TO CODE SECTION 704(e) AND SECTION 761

The Budget Act strikes section 704(e)(1) and changes the heading of section 704(e) to “Partnership Interests Created by Gift” (instead of “Family Partnerships”). It also adds a new sentence to the end of section 761(b) providing that, in the case of a capital interest in a partnership in which capital is a material income-producing factor, whether a person is a partner with respect to such interest will be determined without regard to whether such interest was derived by gift from any other person. These amendments are effective for partnership tax years beginning after December 31, 2015. The section by section explanation of the budget agreement explains that:

The provision would clarify that Congress did not intend for the family partnership rules to provide an alternative test for whether a person is a partner in a partnership. The determination of whether the owner of a capital interest is a partner would be made under the generally applicable rules defining a partnership and a partner. In addition, the family partnership rules would be clarified to provide that a person is treated as a partner in a partnership in which capital is a material income-producing factor whether such interest was obtained by purchase or gift and regardless of whether such interest was acquired from a family member. The rule, therefore, is a general rule about who should be recognized as a partner. 

EFFECTIVE DATE

The Budget Act is effective for returns filed for partnership tax years beginning after December 31, 2017.  That said, a partnership could elect for the provisions to apply earlier.  It is anticipated that guidance will be issued and welcomed before the effective date.

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

[i]   See the new Section 6225.

[ii] Note that the “100 or fewer” requirement is based on the requirement to furnish Schedules K-1 not the number actually furnished.  Partnerships that routinely provide a separate Schedule K-1 for each class of interest one partner may hold may want to revisit the potential implications of issuing the additional Schedules K-1 on whether that partnership is eligible to elect out. To the extent that there are multiple transfers of the same interest during the tax year, it appears that each transfer generally will be taken into account for purposes of the “100 or fewer” requirement.

[iii]  See, Rev. Rul. 2004-88, in which the Service concluded that the disregarded entity itself, and not its owner, was treated as the owner of a partnership interest for purposes of the small partnership exception from TEFRA and such exception was not applicable.

In Brown v. Commissioner, T.C. Summary Op. 2015-62 (October 15, 2015), the Tax Court held that the taxpayers’ losses from rental activities were non-passive. The case illustrates how the Tax Court will review the real estate professional test as well as the separate material participation tests to determine if rental activities are non-passive.

The taxpayer in Brown operated a real estate construction business as a sole proprietor. The taxpayer, his wife, and their family, lived in the first floor of a multifamily house, and rented out the remaining floors. The passive loss issue relates to rental losses incurred with respect to the upper floors and common areas. The taxpayer maintained a contemporaneous log of time spent on cleaning and extensive repairs that he performed with respect to the property, although this log included both the time spent on the rental floors, as well as common areas and the floor that the taxpayer used personally.

Real Estate Professional – Rental activity is generally treated as a per se passive activity.[i] Such losses are restricted in how and when they may be utilized to offset non-passive income.[ii] Under the real estate professional exception, rental activity is not treated as per se passive provided that the taxpayer satisfies the following two requirements:

1. more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
2. such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates[iii]

Material Participation – A taxpayer is treated as materially participating in an activity if the taxpayer participates for more than 500 hours per year on the rental activity.[iv] Real property trade or businesses is defined as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.” [v] Here, the Court applied this definition to the taxpayer’s activities and concluded that both his real estate construction activities (i.e. from his sole proprietorship) and his maintenance and repair activities (i.e. on the rental property) were material participation activities because they each exceeded 500 hours. Together, the husband’s activities exceeded the 750 hours test for a real estate professional, and these activities constituted more than half of his time. As such, he established that he was a real estate professional. Ultimately, the Tax Court also held that the taxpayers materially participated in the rental activity[vi].

Contemporaneous Log – The case illustrates how a taxpayer’s historical documents used for tracking a real estate activity may be less than perfect when scrutinized in preparation for trial. Here, the contemporaneous log included information hours that did not “count” because they were hours related to parts of the property that were not rented, such as common areas they used personally, or their own residence.   In anticipation of trial, the Petitioners prepared and submitted additional documentation that carved out such hours, to help meet their burden of proof to show that they still had sufficient hours to meet the material participation tests. The record also contains references to specific repairs that the taxpayer performed on the upper floors on which the taxpayers did not reside. Credible testimony regarding actual work performed (i.e. from a bike hitting the rental floor hallway), combined with schedules, can help a trier of fact weigh the evidence in a case. Despite efforts by the government to establish inconsistencies in between the contemporaneous logs and the materials prepared for trial, the taxpayers met their burden in establishing their material participation.

Although a summary opinion, and not citable as precedent in other cases, the case provides a helpful analysis of how the real estate professional rules work in conjunction with the material participation rules in the regulations. It is also a practical reminder that even taxpayers who maintain contemporaneous logs may face challenges in establishing that their rental activities were non-passive. When the scope of time spent on a rental activity may be unclear, such as here where a taxpayer lived in a building she also owned and rented, it may be helpful to keep additional records to differentiate and prove the specific activities each year.

https://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=10579

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

[i] IRC § 469 (c)(2).

[ii] IRC § 469 (a).

[iii] IRC §469(c)(7)(A)(i).

[iv] IRC § 1.469-5T(a)(1).

[v] IRC § 469(c)(7)(C). See sec. 1.469-5T(a)(1)

[vi] The real estate professional authorities also may trigger favorable consequences with respect to “grouping” of real estate rental activities for purposes of applying the material participation rules, but as noted above, the taxpayer only rented one property.

The Internal Revenue Code Section 166 allows taxpayers a deduction for debts that have become uncollectible, if certain requirements are met.  These requirements were evaluated by the Tax Court recently in the case Cooper v. Commissioner, T.C. Memo 2015-191 (September 28, 2015), which denied a couple a deduction for a bad debt, on the grounds that the taxpayers did not prove that the debt became worthless during either of the tax years at issue.

Bona Fide Debt.  Section 166(a) provides generally that “There shall be allowed as a deduction any debt which becomes worthless within the taxable year.”[i]  A threshold issue is whether there is a bona fide debt, defined as a “debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.”[ii]  The regulations distinguish a bona fide debt from a gift or contribution to capital, which are not considered debts for purposes of Section 166.[iii]

Business Bad Debt vs. Nonbusiness Bad Debt.  In the case of taxpayers other than corporations, Section 166 distinguishes business bad debts from nonbusiness bad debts, providing that a business bad debt can be deducted against a taxpayer’s ordinary income, whereas a nonbusiness bad debt must be treated as a short-term capital loss.[iv]  The Code defines a business debt as a “debt created or acquired (as the case may be) in connection with a trade or business of the taxpayer” or “a debt the loss from the worthlessness of which is incurred in the taxpayer’s trade or business.”[v]  Taxpayers have the burden of proving that a bad debt loss is “proximately related” to the conduct of a trade or business, or that the debt was created in the course of a trade or business.[vi]

In Cooper v. Commissioner, the Tax Court rejected the taxpayers’ argument that an amount they had loaned to a real estate development business run by an acquaintance was a business bad debt, explaining that “the right to deduct bad debts as business losses is applicable only to the exceptional situations in which the taxpayer’s activities in making loans have been regarded as so extensive and continuous as to elevate that activity to the status of a separate business.”[vii]  Factors that courts consider include: the total number of loans made and the time period over which the loans were made; the records kept by the taxpayer of the lending activity; whether the taxpayer’s loan activities were kept separate and apart from the taxpayer’s other activities; whether the taxpayer sought out the lending business; the amount of time and effort expended in the lending activity; the relationship between the taxpayer and his debtors; and whether the taxpayer used normal money-lending methods and practices.”[viii]

Although this was not an isolated loan and the taxpayer husband, Mr. Cooper, had made sporadic loans to friends and acquaintances over the years, the Tax Court held that his lending activities did not rise to the level of being in the business of lending money, for the following reasons: (1) Mr. Cooper made only 12 loans over a six-year period and did not devote a significant amount of time to his lending activity, especially given that he held an unrelated full-time job; (2) Mr. Cooper only lent money to friends and acquaintances; (3) Mr. Cooper did not following typical business formalities, such as performing credit checks, executing promissory notes, and protecting the collateral; (4) Mr. Cooper did not publicly hold himself out as being in the lending business or maintain a separate office or other business presence for his lending business; and (5) Mr. Cooper did not keep adequate business records, with the records produced at trial being created after the fact instead of contemporaneously.

As a result, the Court in Cooper determined that the taxpayers were not entitled to a business bad debt, limiting any deduction to a capital loss.  The question then turned to whether the taxpayers had proved that the debt became wholly worthless during either 2008 or 2009, the years at issue in the case.  

General Rule for Worthlessness.  The Tax Court has stated that “[a] debt is ordinarily thought to become worthless in the year in which identifiable events clearly mark the futility of any hope of further recovery thereon.”[ix]  A debt is considered worthless if the “surrounding circumstances indicate that a debt is worthless and uncollectible and that legal action to enforce payment would in all probability not result in the satisfaction of execution on a judgment.”[x]

The Tax Court had stated that “worthlessness is not determined by an inflexible formula or slide rule calculation, but upon the exercise of sound business judgment.”[xi]  In determining whether a debt is worthless, a “taxpayer must follow a rule of reason, avoiding alike the Scyllian role of the ‘incorrigible optimist’ and the Charybdian character of the ‘stygian pessimist.’”[xii]  Although a subjective belief of worthlessness is not sufficient, a “bare hope that something might be recovered in the future constitutes no sound reason for postponing the time for taking a deduction.”[xiii]  A taxpayer is “not required to postpone his entitlement to a deduction in the expectancy of uncertain future events.”[xiv]

In Cooper, the Tax Court held that Mr. Cooper did not establish that he had reasonable grounds to abandon any hope of recovery in either 2008 or 2009 (the years at issue), even though the debtor had declared bankruptcy.[xv]  The Tax Court held that it is not sufficient to show that the debtor is in bankruptcy, because in some cases, a debt may not become worthless until a settlement in bankruptcy has been reached.[xvi]  In Cooper, the Tax Court held that it was not until 2010 that the value of the assets in the bankruptcy estate were known and a determination of worthlessness could be made, because an asset of the bankruptcy estate was a mechanic’s lien that was of unknown value when the debtor filed for bankruptcy.[xvii]  In contrast, the Tax Court has previously held that a loan that a taxpayer had made to his son-in-law was worthless because it was clear that the debtor at that time was insolvent, even though the debtor had not even declared bankruptcy.[xviii]

Moreover, the Tax Court noted that Mr. Cooper had not even treated the debt as worthless in 2008 and 2009, having listed the loan as an asset on a net worth statement on two occasions in 2009 and failing to claim the loan as a bad debt on his original filed returns for 2008 and 2009.[xix]  It was not until 2010 that the taxpayers claimed the bad debt deduction on an amended return that they filed for 2008.[xx]

As the Tax Court cases demonstrate, worthlessness is a question of fact that depends on all of the facts and circumstances.  Courts will consider not only the objective financial position of the debtor and his ability to repay the debt, but also whether the actions of the taxpayer-lender are consistent with a determination that there is no reasonable hope of recovery.

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

[i] IRC § 166(a).

[ii] Treas. Reg. § 1.166-1(c).

[iii] Id.

[iv] IRC § 166(d)(1).

[v] IRC § 166(d)(2).

[vi] Cooper v. Commissioner, T.C. Memo 2015-191 (September 28, 2015).

[vii] Id. (internal quotation marks omitted) (citing Imel v. Commissioner, 61 T.C. 318, 323 (1973); Sales v. Commissioner, 37 T.C. 576 (1961); Barish v. Commissioner, 31 T.C. 1280 (1959)).

[viii] Cooper v. Commissioner, T.C. Memo 2015-191.

[ix] James A. Messer Co. v. Commissioner, 57 T.C. 848, 861 (T.C. 1972).

[x] Treas. Reg. § 1.166-2(b).

[xi] Washington Institute of Technology, Inc. v. Commissioner, 10 T.C.M. 17, 20 (1951).

[xii] Minneapolis, St. Paul & Sault Ste. Marie R. R. Co. v. United States, 164 Ct. Cl. 226 (1964).  The United States Court of Federal Claims has described the determination of worthlessness as follows:  “It is obvious that there is no precise test for determining worthlessness within the taxable year and neither the statutory enactment, its regulations, nor the decisions attempt such an all-inclusive definition. From the numerous decisions, we are taught that a determination of whether or not a debt becomes worthless in a particular year must be confined to the fact[s] of the particular case. Furthermore, it is often impossible to select a single factor or ‘identifiable event’ which clearly establishes the time at which a debt becomes worthless and thus deductible. More often it is a series of events which in the aggregate present a picture establishing that the debt in question has become worthless. Such a decision of necessity requires a practical approach, not a legal test.…It must be flexible in nature, varying according to the circumstances of each particular case, so that whatever inferences a court might draw from a particular fact in another case are not binding on the examining court, although the same fact may be present.” Id.

[xiii] Id.

[xiv] Id.

[xv] Cooper v. Commissioner, T.C. Memo 2015-191.

[xvi] Id.

[xvii] Id.

[xviii] See Andrew v. Commissioner, 54 T.C. 239 (1970) (holding that it was irrelevant that the taxpayer had not demanded payment, because the law does not require the taxpayer to do a useless act); see also Shirar v. Commissioner, TC Memo 1987-492 (holding that a loan made by a taxpayer to his brother was worthless notwithstanding the fact that the taxpayer had not made any formal collection efforts, where his brother had informed the taxpayer after his business had failed that he would be unable to pay the loans).

[xix] Id.

[xx] Id.

If the IRS is unable to collect a tax liability from a taxpayer, state laws may allow the IRS to collect the liability from a third party in certain situations where the taxpayer has transferred assets to another person. Although liability of a transferee for a transferor’s tax debt is based on state law, the IRS is not bound by the state statute of limitations for collecting such a liability against a transferee.[i]

Summary Collection Procedures Under Section 6901. Section 6901 provides the IRS with procedural tools to use to collect a tax liability against a transferee, which allow the IRS to assess and collect the liability against the transferee in the same way that the IRS can assess and collect a tax deficiency against a taxpayer. Section 6901 provides, in pertinent part, that an income tax liability may generally “be assessed, paid, and collected in the same manner and subject to the same provisions and limitations as in the case of the taxes with respect to which the liabilities were incurred.”[ii]

Section 6901(c) sets forth an extended period of limitations for assessing a tax liability against a transferee compared to the period of limitations for assessing the liability against the original taxpayer. Section 6901(c)(1) provides generally that the period of limitations for assessment of a transferee liability against an initial transferee expires 1 year after the expiration of the period of limitation for assessment against the transferor; and Section 6901(c)(2) provides that the period of limitations for assessment against a transferee of a transferee expires 1 year after the expiration of the period of limitation for assessment against the preceding transferee, but not more than 3 years after the expiration of the period of limitation for assessment against the initial transferor.[iii] Since the period of limitations for assessment against a taxpayer is generally three years from the date the return is filed,[iv] the period of limitations for assessing a transferee liability against an initial transferee is generally four years from the date the return is filed (regardless of when or whether during that period the tax is assessed against the transferor).[v]

Judicial Proceeding to Collect a Tax Liability Against a Transferee. While Section 6901 gives the IRS the power to collect a tax liability against a transferee without going to court, it is not required to follow the procedures set forth in Section 6901 and may pursue its case against a transferee under state law in a judicial proceeding. The 9^th Circuit has held that Section 6901 “is not mandatory”; “rather, it adds to other methods available for collection.”[vi]

As mentioned above, although a lawsuit is brought pursuant to state law, the Government is not bound by the state law statute of limitations – the Government instead has ten years from the date a tax is assessed to bring a suit to collect the tax pursuant to Section 6502.

Section 6502 provides, in pertinent part, that where the assessment of any tax has been made within the period of limitations properly applicable thereto, such tax may be collected by levy or by a proceeding in court within 10 years after the assessment of the tax. IRC § 6502(a). In the case of transferee liability, the Supreme Court has interpreted this statute to allow the IRS to collect a properly assessed tax against a transferee who is liable for the debt, even if the IRS has not assessed the liability against the transferee pursuant to Section 6901.[vii]

In United States v. Updike, the Supreme Court rejected the argument that the language “such tax may be collected . . . by a proceeding in court” in the predecessor to Section 6502 refers only to a direct proceeding against the taxpayer against whom the tax is assessed, explaining:

It seems plain enough, without stopping to cite authority, that the present suit, though not against the corporation but against its transferees to subject assets in their hands to the payment of the tax, is in every real sense a proceeding in court to collect a tax. The tax imposed upon the corporation is the basis of the liability, whether sought to be enforced directly against the corporation or by suit against its transferees.[viii]

More recently, the Supreme Court addressed the question of whether Section 6502 applies to persons liable for a partnership’s tax debt because they were general partners of the partnership who were jointly and severally liable for the debts of the partnership.[ix] The IRS had not assessed the tax against the individual partners and the issue was whether the IRS was required to in order for the statute of limitations in Section 6502 to apply. Because this case involved persons liable as general partners and not as transferees, Section 6901 was not relevant in this case.

The Court followed Updike and held that the “Government’s timely assessment of the tax against the partnership was sufficient to extend the statute of limitations to collect the tax in a judicial proceeding, whether from the partnership itself or from those liable for its debts.”[x] The Supreme Court reasoned that after analyzing the term “assessment” as it is used in the Code, “it is clear that it is the tax that is assessed, not the taxpayer.”[xi] The Court concluded: “Once a tax has been properly assessed, nothing in the Code requires the IRS to duplicate its efforts by separately assessing the same tax against individuals or entities who are not the actual taxpayers but are, by reason of state law, liable for payment of the taxpayer’s debt.”[xii]

Transferees of a transferee. The applicability of the ten-year statute of limitations under Section 6502 where there has not been an assessment against the transferee is less clear in the case of transferees of a transferee. The Supreme Court has held, in the case United States v. Continental Nat’l Bank & Trust Co., 305 U.S. 398 (1939), that the predecessor section to Section 6502 “is not broad enough” to impose a liability on a transferee of a transferee on account of an assessment against an initial transferee, based on its conclusion that a transferee of a transferee is not a “transferee of the property of the taxpayer.”[xiii] In Signal Oil & Gas Co. v. United States, 125 F.2d 476 (9th Cir. 1942), the 9^th Circuit held that “Since appellant, a second transferee, is not a transferee of property of a taxpayer, the six-year period of section 278(d) [the predecessor to Section 6502] to sue the first transferee of the taxpayer after assessment of the taxpayer does not apply to appellant.”[xiv] The court noted that since there was no Supreme Court decision overruling Continental National Bank, the 9^th Circuit was constrained to follow that decision.[xv]

As a result of these Supreme Court decisions, although the IRS is far more limited in its options for collecting a tax liability against a transferee after the statute of limitations in Section 6901 has passed for assessing a liability against a transferee, the IRS remains able to bring a lawsuit against a person who may be liable under state law as a transferee for the tax liability of the transferor. Even if the IRS has not timely assessed a transferee liability under Section 6901, it is important to remember that the IRS may be able to bring such a suit up to ten years after the IRS assesses the tax liability against the original taxpayer.

LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is a tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and tax litigation. Additional information is available at http://www.taxlitigator.com.

[i] See Phillips v. Commissioner, 283 U.S. 589, 602-603 (1931) (holding that the United States is not bound by state statutes of limitations when proceeding under Section 6901); United States v. Decker, 241 F. Supp. 283, 285 (D. Ariz. 1965) (applying the holding of Phillips to transferee liability cases brought outside of Section 6901); Bresson v. Commissioner, 213 F.3d 1173, 1176 (9th Cir. 2000) (holding that the extinguishment provision in California Uniform Fraudulent Transfer Act does not bind the IRS when collecting a liability against a transferee on the basis of that statute).

[ii] IRC § 6901(a).

[iii] The statute provides that in both cases, if before the expiration of the period of limitation for the assessment of the liability of the transferee, a court proceeding for the collection of the tax or liability in respect thereof has been begun against the initial transferor or the last preceding transferee, respectively, then the period of limitation for assessment of the liability of the transferee shall expire 1 year after the return of execution in the court proceeding. IRC § 6901(c).

[iv] IRC § 6501(a).

[v] See Alexander v. Commissioner, 61 T.C. 278, 298 (1973).

[vi] Culligan Water Conditioning of Tri-Cities, Inc. v. United States, 567 F.2d 867, 870 (9th Cir. 1978).

[vii] United States v. Updike, 281 U.S. 489, 493-94 (1930); Leighton v. United States, 289 U.S. 506, 509 (U.S. 1933) (following the holding in Updike).

[viii] Updike, 281 U.S. at 493-94.

[ix] See United States v. Galletti, 541 U.S. 114 (2004).

[x] Id. at 116.

[xi] Id. at 123.

[xii] Id.

[xiii] See United States v. Continental Nat’l Bank & Trust Co., 305 U.S. 398, 404 (1939).

[xiv] Signal Oil & Gas Co. v. United States, 125 F.2d 476, 480 (9th Cir. 1942) (internal citations and quotation marks omitted).

[xv] Id.