Posted by: Lacey Strachan | February 7, 2015

California’s New Form 3840 for Reporting Like-Kind Exchanges by Lacey Strachan

Section 1031 like-kind exchanges have been one of the California Franchise Tax Board’s (FTB) top audit issues in recent years. [i]  California’s Form 3840, which is new for the 2014 tax year, is one of the latest developments in the FTB’s focus on scrutinizing like-kind exchanges.

On June 27, 2013, Assembly Bill 92 was enacted, which imposed a new information reporting requirement for taxpayers who engage in certain like-kind exchanges under section 1031 of the Internal Revenue Code (IRC).[ii]  The new law creates an annual information reporting requirement for taxpayers who defer recognition of gain on an exchange of real property in California for property outside California.[iii]  This requirement applies to exchanges that occur during tax years beginning on or after January 1, 2014, making this filing season the first time that taxpayers will be required to file the new California Form 3840, titled California Like-Kind Exchanges, which the FTB recently released in final form.[iv]

Section 1031 allows taxpayers to defer recognition of gain or loss on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.[v]   California generally conforms to IRC section 1031 under Revenue and Taxation Code (R&TC) sections 18031 and 24941, allowing taxpayers non-recognition treatment for California tax purposes for like-kind exchanges that meet the requirements of section 1031.  The FTB has identified three general requirements to qualify for non-recognition treatment under section 1031: (1) there must be an exchange, as opposed to a separate sale and reinvestment, by the same taxpayer; (2) the relinquished property and the replacement property must be “like kind”; and (3) both the relinquished property and the replacement property must be held for investment or for productive use in a trade or business, which excludes property that is held primarily for sale or for personal use.[vi]  Real property interests are generally considered to be of a like kind to each other, except real property located in the United States and foreign real property are not considered to be of like kind.[vii]

In a section 1031 exchange, a taxpayer’s basis in the replacement property is generally equal to the taxpayer’s basis in the relinquished property, with adjustments for cash received in the transaction and for gain or loss recognized at the time of the exchange.[viii]  This creates a deferral of any gain until the replacement property is disposed of in a taxable transaction.  When the taxpayer later sells the property in a taxable transaction,  the taxpayer then pays tax on not only the appreciation on the property being sold, but also on the gain that was deferred in any earlier section 1031 exchange.

For state tax purposes, this creates the issue of how to source that gain, when part is attributable to a sale of a property in one state and part is attributable to a sale of property in another state.  In general, capital gains and losses from sales of real property located in California are sourced to California.[ix]  That means that the gain on the sale of any California real property is taxable by California, even if the taxpayer is a nonresident at the time of the sale or subsequently moves out of state.

In like-kind exchanges, the source of gain on the exchange of property is determined at the time the gain or loss is realized, i.e., at the time of the exchange.  Where the relinquished property in a like-kind exchange is located in California, the deferred gain on the exchange is sourced to California, regardless of the residence of the taxpayer or the location of the replacement property.[x]  California takes the position that the source of this gain or loss is preserved until the gain or loss is recognized — that is, when the replacement property is ultimately sold in a taxable transaction, the gain originally deferred on the California property will have its source in and be taxable by California.

In audits by the FTB of like-kind exchanges in recent years, the sourcing of gains to California is one of the audit issues that the FTB has been focused on.[xi]  The FTB was having difficulty tracking a taxpayer’s replacement property to determine whether it was later sold in a taxable transaction, triggering a tax liability to California on the California-sourced portion of the deferred gain.  This issue is made more complicated by the fact that taxpayers can engage in multiple consecutive section 1031 transactions, making it so the FTB would have no record of a subsequent exchange by a non-resident taxpayer that further deferred recognition of the gain.

To ensure that taxpayers do not escape California taxation on capital gains realized from the exchange of California real property, the new Form 3840 requires taxpayers to report to the FTB details about the relinquished properties, the replacement properties, and the amount and allocation of the taxpayer’s California source deferred gain.  The form is designed to help taxpayers and the FTB keep track of California sourced gain deferrals from section 1031 exchanges and is required to be filed by the taxpayer on an annual basis until the deferred gain is recognized, even if the taxpayer does not otherwise have any California filing obligation for that year.[xii]  This new filing requirement currently applies only to exchanges involving real property, not tangible personal property.

If a taxpayer fails to file a Form 3840, as required, the FTB may issue a Notice of Proposed Assessment that will adjust the taxpayer’s income to recognize the previously deferred gains, plus penalties and interest.[xiii]

As a result of the FTB’s heightened scrutiny and strict interpretation of the section 1031 requirements, certain exchanges may come under scrutiny by the FTB that would otherwise be respected for Federal tax purposes.  In its most recent list of Top Audit Issues, published in April 2014, the FTB explained that it is continuing to find noncompliance in section 1031 exchanges in the following areas: (1) errors in computing gain, particularly taxable boot due to debt netting and including non-exchange expenses in the computation; (2) failing to properly comply with the section 1031 rules for identifying the replacement property; (3) including the cost of property improvements made after the exchange closed in the calculation of taxable boot; and (4) withdrawing cash out of the proceeds from the relinquished properties.[xiv]  The FTB’s continued focus on section 1031 exchanges makes it especially important for taxpayers considering doing a like-kind exchange to pay careful attention to complying with all of the section 1031 requirements.

LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is an associate 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] FTB April 2014 Tax News, https://www.ftb.ca.gov/professionals/taxnews/2014/April/Article_6.shtml (hereinafter April 2014 Tax News); FTB January 2013 Tax News, https://www.ftb.ca.gov/Archive/Professionals/Taxnews/2013/January/Article_5.shtml; FTB January 2012 Tax News, https://www.ftb.ca.gov/archive/professionals/taxnews/2012/january/article_2.shtml (hereinafter January 2012 Tax News).

[ii] FTB September 29, 2014 Public Service Bulletin, “New FTB Form for Like-Kind Exchanges,” https://www.ftb.ca.gov/aboutFTB/Public_Service_Bulletins/2014/27_09292014.shtml (hereinafter September 29, 2014 Public Service Bulletin).

[iii] Id.

[iv] FTB January 2015 Tax News, https://www.ftb.ca.gov/professionals/taxnews/2015/January/03.shtml. The new Form 3840 is available here: https://www.ftb.ca.gov/forms/2014/14_3840.pdf. Instructions to the Form 3840 are available here: https://www.ftb.ca.gov/forms/2014/14_3840ins.pdf.

[v] 1031(a)

[vi][vi] January 2012 Tax News.

[vii] IRC § 1031(h).

[viii] IRC § 1031(d)

[ix] Cal. Rev. & Tax. Code § 25125(a).

[x] 2014 Instructions for Form FTB 3840.

[xi] See, e.g., January 2012 Tax News.

[xii] FTB December 2013 Tax News, “New 1031 Filing Requirements for California,” https://www.ftb.ca.gov/Archive/Professionals/Taxnews/2013/December/Article_8.shtml

[xiii] September 19, 2014 Public Service Bulletin.

[xiv] April 2014 Tax News.

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Posted by: Taxlitigator | January 23, 2015

Fraudulent Failure to File Tax Returns – 75% of the Tax Due!

Failing to file returns is not a reasonable response to the inability to pay the tax liability associated with the returns. If in doubt, file the returns and work out a payment arrangement with the IRS. Also, know that the civil “failure to file” penalty accrues at 5.0%/month (up to 25% of the tax deficiency). The civil “failure to pay” penalty accrues at the rate of 0.5%/month (up to 25% of the tax deficiency). When you do the math and factor in the numerous other risk factors associated with the failure to file a tax return, the decision to file becomes somewhat obvious in most cases.

Before contacting a non-filer, the IRS will often attempt to identify the non-filer’s occupation, location of bank/savings accounts, sources of income, age, current address, last file returned, adjusted gross income of last file returned, taxes paid on last file returned – amounts and methods of payment (withholding, estimated tax, pre-payments), number of years delinquent, and the non-filer’s standard of living.

Tax Evasion and Fraud? If a non-filer is contacted by the government, the examiner will determine the cause (does the non-filer lack records, ability to pay, lack of education, etc.) and may offer necessary information or assistance (preparation of returns, payment arrangement information, etc.) to secure full cooperation. If the non-filer is not cooperative (won’t respond or refuses to cooperate), third party contacts may be made to determine the non-filer’s income and make an assessment.

IRS Inquiries. On the initial screening of a non-filer case, the IRS will attempt to determine if the facts indicate potential fraud. Indicators of fraud for consideration set forth in the IRS Internal Revenue Manual (IRM) include:

  • History of non-filing or late filing, and an apparent ability to pay;
  • Repeated contacts by the IRS;
  • Knowledge of the filing requirements (i.e., advanced education, business (especially tax) experience, record of previous filing etc.);
  • Experience of the taxpayer in tax matters such as a law professor, CPA or tax attorney;
  • Failure to reveal or attempts to conceal assets;
  • Age, health, and occupation of the taxpayer;
  • Substantial tax liability after withholding credits and estimated tax payments;
  • Large number of cash transactions, i.e., purchases by cash and large cash deposits evidenced by documented cash transactions, payment of personal and business expenses in cash when cash payment is unusual and/or the cashing (as opposed to the deposit) of business receipts;
  • Indications of significant income per Information Return Processing (IRP) documents (i.e., substantial interest and dividends earned, investments in IRA accounts, stock and bond transactions, high mortgage interest paid);
  • Refusal or inability to explain the failure to file; and
  • Prior history of criminal tax prosecutions for Title 26 violations.

If the IRS believes the possibility of fraud exists, the IRM instructs the IRS examiner to not solicit returns. If returns are submitted, they should be accepted but not processed, and clearly documented in the case history. Agents are not to discuss tax liabilities, penalties, fraud, or criminal referral possibilities with the taxpayer.

Non-Filer Examinations. During non-filer examinations, the IRS examiner will determine if related returns (corporate, partnership, employment tax, and excise tax returns) have been filed as required. They will also search for spin-off cases involving relatives, employees, employers, subcontractors, partners, and even return preparers! If a non-filer is involved in a family business, the examiner will determine if all family members have filed returns. If the non-filer is involved in a partnership, the IRS will determine if partnership returns have been filed and determine if all partners have filed returns. For delinquent corporate returns, they will attempt to determine if all shareholders have filed returns. Penalties are not typically be easily waived in non-filer cases without reasonable cause.

During the non-filer examination, the IRM suggests that the examiner:

  1. Interview the taxpayer to determine the reason or the intent of the taxpayer’s noncompliance.
  2. Ask sufficient questions to determine the extent of the delinquency, including the periods and tax due.
  3. Document verbatim, if possible, the questions asked and the taxpayer’s response or lack of response.
  4. Identify any personal reasons that could affect the taxpayer’s ability to comply. If the information is not provided by the taxpayer, attempt to secure the information from third party sources.
  5. Attempt to get a definitive statement from the taxpayer regarding additional expenses not listed in the books and records. These expenses could include, but are not limited to, expenses paid in cash or “under-the-table” payments to employees.
  6. Attempt to establish year-end cash on hand for each year under investigation.

If the IRS receives sufficient information (often utilizing bank deposits plus some specific income items from payments diverted to or for the benefit of the taxpayer) it can prepare substitutes for returns under Internal Revenue Code (26 U.S.C.) § 6020(b). Bank deposits can be prima facie evidence of income.[1] Proof of gross receipts in the amounts shown by a bank deposits analysis is often sufficient to satisfy the Governments burden of showing that a taxpayer had an obligation to file returns.[2]

Fraudulent Failure to File Penalty. Code § 6651(f) provides a penalty of 75% of the amount required to be shown as tax on unfiled returns if the failure to file the returns is fraudulent. The civil fraud penalty is a sanction provided primarily as a safeguard for the protection of the revenue and to reimburse the Government for the heavy expense of investigation and the loss resulting from the taxpayer’s fraud.[3] The Government has the burden of proving fraud by clear and convincing evidence.[4]

Fraud may be proved by circumstantial evidence, and the taxpayer’s entire course of conduct may establish the requisite fraudulent intent.[5] Circumstantial evidence of fraud includes “badges of fraud” such as those present here: a longtime pattern of failure to file returns, failure to report substantial amounts of income, failure to cooperate with taxing authorities in determining the taxpayer’s correct liability, implausible or inconsistent explanations of behavior, and concealment of assets.[6]

In a recent decision by the U.S. Tax Court, the taxpayer contended that compensation for architectural services he performed in Hawaii was not subject to income tax and that therefore he was not required to file returns for the years in issue. Further, he apparently asserted that “his earnings for architectural services rendered in Hawaii are not taxable because he is a U.S. citizen and has no foreign earned income taxable under section 911 and related regulations. His argument is based on inapplicable statutes and circular reasoning. He denies that “worldwide income” includes domestic income, substituting his own reading of statutory and regulatory materials for those of every court that has spoken on the subject in innumerable cases decided over decades. He takes items out of context, treats “includes” as a term of limitation, and contends that references to certain categories within a statute or regulation exclude all others. He has not presented any reason to reject respondent’s recalculated deficiencies and additions to tax or penalties. He has refused to produce evidence of nontaxable bank deposits or deductible expenses.”[7]

The Tax Court noted that “Petitioner’s interpretative arguments have been consistently rejected in strong terms, even in judicial opinions sustaining criminal convictions. See, e.g., United States v. Ward, 833 F.2d 1538, 1539 (11th Cir. 1987) (“utterly without merit”); United States v. Latham, 754 F.2d 747, 750 (7th Cir. 1985) (“inane” and “preposterous”); United States v. Rice, 659 F.2d 524, 528 (5th Cir. 1981) (“frivolous non-sequitur”). In Takaba v. Commissioner, 119 T.C. 285, 292 (2002), the taxpayer and his counsel, Paul Sulla (the attorney who assisted petitioner in establishing entities used to conceal income), were sanctioned under section 6673(a)(1) and (2), respectively, for arguing, among other things, that a U.S. citizen residing in Hawaii was not taxable on compensation earned in Hawaii. No further discussion of petitioner’s stale theories is warranted. See Crain v. Commissioner, 737 F.2d 1417 (5th Cir. 1984).”[8]

In concluding that the taxpayer’s failure to file tax returns for the years at issue was due to fraud, the Tax Court rejected “any inference that petitioner’s persistence in his frivolous theories demonstrates sincerity or good faith or is otherwise a defense to the charge of fraud. . . . A person with his education and skills could be expected to abandon unsuccessful arguments if acting in good faith. We conclude that petitioner’s failure to file for each year in issue was due to fraud.”[9]

Additional Penalty for Delay or Where Taxpayer’s Position is “Frivolous.” Finally, the Tax Court apparently warned the taxpayer about the “possibility of a penalty under Code section  6673 if he persisted in his contention that he was not required to file returns and pay tax on his income for architectural services performed in Hawaii.”[10] The Tax Court noted that “section 6673(a)(1) provides for a penalty not in excess of $ 25,000 when proceedings have been instituted or maintained by the taxpayer primarily for delay or the taxpayer’s position is frivolous or groundless. It may seem that an additional $25,000 on top of the amounts petitioner already owes will not change his position. However, serious sanctions also serve to warn other taxpayers to avoid pursuing similar tactics. See Coleman v. Commissioner, 791 F.2d 68, 71-72 (7th Cir. 1986); Takaba v. Commissioner, 119 T.C. at 295. An award of $ 25,000 to the United States will be included in the decision to be entered here.”[11] (emphasis added).

The Path Forward. Generally, people who come forward and file returns prior to being contacted by IRS will not be subjected to a penalty associated with a Code § 6651(f) fraudulent failure to file return penalty nor will they likely be pursued through a criminal investigation.

The “willful” failure to file a tax return, pay a tax that is due or supply information requested can be subject to a criminal prosecution under Code § 7203. The IRS Voluntary Disclosure Practice set forth in Internal Revenue Manual 9.5.11.9 indicates that a timely, truthful voluntary disclosure is a factor to consider in deciding upon a possible criminal prosecution referral by the IRS to the Department of Justice. although this Practice does not technically absolve a taxpayer of civil penalties, it is an important factor in civil penalty determinations as well. Also,Treas. Reg. 1.6664-2(c)(2) generally encourages voluntary disclosures by eliminating accuracy-related (but not civil fraud) penalties on amounts reflected on an amended return that is filed before any IRS contact.

For non-filers, opportunities exist to file returns before any IRS contact that could reduce or eliminate potential civil penalties and any potential criminal prosecution, and may be able to coordinate an effective installment payment arrangement (or Offer in Compromise) for any resulting deficiencies. Regardless, a non-filer should not wait since the “first knock on the door” might not be user friendly . . .

[1] See Tokarski v. Commissioner, 87 T.C. 74, 77 (1986); Estate of Mason v. Commissioner, 64 T.C. 651, 656-657 (1975), aff’d, 566 F.2d 2 (6th Cir. 1977).

[2] See Hamlet C. Bennett v. Commissioner, T.C. Memo. 2014-256 (December 22, 2014)

[3] Helvering v. Mitchell, 303 U.S. 391, 401 (1938).

[4] See Code section 7454(a); Tax Court Rule 142(b).

[5] Rowlee v. Commissioner, 80 T.C. 1111, 1123 (1983).

[6] See, e.g., Bradford v. Commissioner, 796 F.2d 303, 307-308 (9th Cir. 1986), aff’g T.C. Memo. 1984-601; Powell v. Granquist, 252 F.2d 56, 60 (9th Cir. 1958); Grosshandler v. Commissioner, 75 T.C. 1, 19-20 (1980); Gajewski v. Commissioner, 67 T.C. 181, 199-200 (1976), aff’d without published opinion, 578 F.2d 1383 (8th Cir. 1978).

[7]See Hamlet C. Bennett v. Commissioner, T.C. Memo. 2014-256 (December 22, 2014)

[8] Id.

[9] Id.; See also Miller v. Commissioner, 94 T.C. 316, 332-336 (1990); Chase v. Commissioner, T.C. Memo. 2004-142; Tonitis v. Commissioner, T.C. Memo. 2004-60; Madge v. Commissioner, T.C. Memo. 2000-370, aff’d, 23 Fed. Appx. 604 (8th Cir. 2001); Greenwood v. Commissioner, T.C. Memo. 1990-362.

[10] See Hamlet C. Bennett v. Commissioner, T.C. Memo. 2014-256 (December 22, 2014)

[11] Id.

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Posted by: Taxlitigator | January 20, 2015

PERENNIAL NOL QUESTION (WITH ANSWER) by EDWARD M. ROBBINS, JR.

I get this question from practitioners and taxpayers several times a year . . .

Question: We are under examination for our corporation in an open loss year, and now the IRS wants to go back and look at a closed year where we took part of the loss as a carryback.  How can they do that?  The carryback year is closed!  Not only that, the IRS already subjected the now closed carryback year to a full-blown examination and issued a “no-change.”  Isn’t this a second unnecessary examination on the carryback year?

Short Answer:  In its attempt to determine the correct taxable situation for your open loss year, the IRS may look at any other year, open or closed, that may relate to the examination.  The IRS can calculate or even recalculate the taxes for the carryover years to see their impact on the open examination of your loss year.  The overriding issue is “What’s the correct tax liability in the open year under examination?”  No facts are off limits.  No, it is not a second unnecessary examination.

Longer Answer:  Section 6501 (h) establishes an exception to the general 3 year limitations period.[1] Section 6501 (h) provides an enlargement of the general limitations period when a taxpayer carries back to the taxable year in question a net operating loss from a subsequent tax year. Section 6501(h) permits the Commissioner to assess a deficiency stemming from a net operating loss carryback deduction before the expiration of the limitations period for the taxable year in which the net operating loss was created.[2]  A similar rule exists under 6501(k) for enlargement of the assessment statute with a tentative carryback that has been applied, credited, or refunded under section 6411.

This rule, however, is often misunderstood.  Taxpayers frequently file refund claims based upon net operating losses, business tax credits, or capital losses on the basis of a claim carrying back a loss to an otherwise closed taxable year.  The easy way to remember the assessment rule is to remember that the year controlling the assessment statute is the year the loss arose.  If a loss arose in 2009 and was carried back to 2007 to obtain a 2007 refund the assessment statute for the 2007 year attributable to a deficiency because of the 2009 carryback is controlled by the 2009 statute of limitations – the year the loss arose. The Code permits assessment of a deficiency in one taxable year (2007) attributable to the carryback of an NOL from a later year (2009) before the expiration of the statute of limitations for the taxable year in which the NOL arose (2009).[3]

Section 6501(h) states:

In the case of a deficiency attributable to the application to the taxpayer of a net operating loss carryback or a capital loss carryback (including deficiencies which may be assessed pursuant to the provisions of Section 6213(b)(3) [dealing with assessments that may arise out of tentative carryback or refund adjustments arising out of excess refunds made under Section 6411]), the deficiency may be assessed at any time before the expiration of the period within which a deficiency for the taxable year of the net operating loss or net capital loss which results in such carryback may be assessed.

Congress enacted this section to provide the Service with an additional amount of time to properly review the claim and determine if any deficiencies are associated with the year in which the loss is carried back.  In our hypothetical situation with a 2009 loss carried back into 2007, the Service would have 3 years from the time the 2009 return was filed to determine any deficiencies for the 2007 year resulting from the carryback.  A carryback extends the assessment period for the carryback year for the loss carryback.[4]

Because the assessment period for both the loss year and the carryback year are the same the assessment period can be extended by agreement, and its running may be suspended for several reasons (e.g., by filing a Tax Court petition). [5] If the normal assessment period for the loss year is extended by agreement, the extension also applies to the carryback years.  If the normal 3 year statute has expired for the carryback year the IRS can only assess a deficiency attributable to items related to the loss carryback, but not any items unrelated to the loss carryback.  The taxpayer is only at risk for a deficiency for the carryback.  The IRS could not assess any amounts above the loss carryback.[6]

IRS Ability To Adjust Attributes In Closed Years For NOL Determinations

Pursuant to IRC § 6501(a) – Limitations on Collection and Assessment a tax year is subject to adjustment for 3 years from filing the federal tax return.  Section 6501(b) states that if a return is filed prior to the due date then the return will be deemed filed on the last day prescribed by law or the regulations.  Therefore, the statute of limitations for each federal tax year will close 3 years from the due date of the federal return, including extensions, or the filing date, whichever is later.

When a company carries forward or back a tax loss or credit, however, the IRS may examine the loss year, and any intervening or prior year, to determine the correct loss or credit available for carryover purposes, even if the statute of limitations on assessment for those years has expired.[7]   The IRS could examine and adjust any “closed” year if the statute for the tax year in which the attribute was utilized remains open.  Note that the IRS could make no additional assessment in the closed year, the IRS’s adjustments would go only to adjusting the carryover amounts.

The IRS may adjust items in any closed year to correctly compute the tax in an open year.[8]  In Lone Manor Farms, the court held that when a taxpayer claimed an NOL for an open year, it was necessary to determine whether the NOLs claimed for that year were still available, or should have been absorbed in closed years, allowing adjustment to the income in such closed years, regardless of whether the taxpayer had claimed the NOL in the closed years.[9]

In Revenue Ruling 85-64,[10] the taxpayer timely filed returns for 1978 through 1981 and reported no tax liability for each of these years.  The IRS examined the returns and found that 1978 had taxable income of $15,000 and 1979 had taxable income of $8,000.   The IRS also found that 1981 had an NOL of greater than $23,000.  At the time of examination, the 1978 year was closed for assessment.  The ruling holds that the 1982 NOL must first be carried back and “absorbed” in 1978, so that only if the NOL exceeded $15,000 would the NOL be available to carry back to 1979.

Taxpayer’s Ability To Make Adjustments To Items In Closed Years For NOL Determinations

The Service has stated frequently that for Section 172 of the Internal Revenue Code, “taxable income” means “correct taxable income.”[11]     Revenue Ruling 56-285,[12] holds that the fact that the statutory period for assessment of income taxes for the year in which a loss was sustained has expired does not preclude the Service from making such adjustments as may be necessary to correct the net operating loss deduction.   The rationale underlying these rulings and the authority to be discussed following is that when a prior year’s taxable income has impact on another taxable year, it is that year’s “correct” taxable income controlling in the related year not the taxable income previously erroneously stated on the return.

In Revenue Ruling 81-87,[13] 1981-1 C.B. 580, the IRS ruled that the correct tax must be considered in determining the amount of an overpayment of tax.  The correct tax is determined by including all adjustments (adjustments that decrease the tax and adjustments that increase the tax), regardless of the expiration of the periods of limitation.  Any excess of tax paid over the correct tax is an overpayment and will be credited or refunded if adjustments decreasing the tax are covered by timely claims for refund.  Revenue Ruling 81-87 was applied by the IRS in rulings involving the computation of foreign tax credit carryovers which have been interpreted to be governed by the same rules applicable to net operating loss carryovers.

The concept of utilizing “correct taxable income” in computing the amount of loss carryovers or carrybacks has long been recognized by the courts.  In Phoenix Coal Company v. Commissioner,[14] the Court of Appeals for the Second Circuit affirmed the Tax Court’s holding that the amount of a net operating loss carryover from a prior and otherwise barred year could be recalculated to determine the amount available for that year.  This rule was repeated by the Tax Court in ABKCO Industries, Inc. v. Commissioner,[15] and in State Farming Co. v. Commissioner.[16]  

With, Hill v. Commissioner,[17] the Tax Court, citing  Mennuto, again allowed the Commissioner to adjust a prior year and reduce unused investment credit available to be carried over to a later year even though the prior year was “barred” to assess additional tax as provided in IRC §6501(a).[18]

While the above cases and rulings concern adjustments to prior years which reduced the loss or credit carryover available to the year in dispute, the taxpayer in Springfield Street Railway Company v. United States[19] could decrease its 1953 taxable income by an available but unclaimed deduction to determine its 1955 net operating loss carryback to be applied against its 1953 and 1954 income.  Similarly, in Situation 2 described in Rev. Rul. 81-88, supra, the Service held that the taxpayer could increase a net operating loss carryover to consider a deduction it had failed to claim in a prior year.  In GCM 38292 (which authorized the issuance of Revenue Ruling 81-88), the Office of the Chief Counsel noted that the cited court decisions concerned adjustments made to the taxpayer’s net operating losses that were favorable to the government but added:

We think that the same logic that allows the Commissioner to correct a NOL with an upward adjustment in a year barred by the statute of limitations also allows the taxpayer to correct a NOL with a downward adjustment in such year.  It would appear inequitable to allow the government to be able to make an upward adjustment in the taxpayer’s NOL, even though the statute of limitations has run, without also permitting the taxpayer to make a downward adjustment in similar circumstances.

Revenue Rulings 81-88 and 56-285 (discussed above) were cited as authority in PLR 9504032 (October 31, 1994) where the Service ruled that the taxpayer was not barred by the statute of limitations from recharacterizing events that occurred in Year 1 to redetermine net operating loss carryovers (either from Year 1 or prior years) that are available for the taxpayer to deduct as net operating loss deductions in subsequent tax years.  While the IRS often states that private letter rulings are not to be cited as precedent, the conclusion reached in this ruling is in accord with previously issued revenue rulings and judicial opinion and appears to be a correct statement of current law.

The ability to adjust items in a closed year to correctly compute tax in an open year is also available to a taxpayer.  In PLR 9504032, Taxpayer determined that as a result of the bankruptcy reorganization it had realized an amount of income from discharge of indebtedness. Pursuant to section 108 of the Internal Revenue Code, Taxpayer excluded this amount from gross income, but reduced its NOL carryovers to Year 1 by the amount of debt discharged.

Subsequently, in May of Year 5, Taxpayer’s liquidating trustee filed an amended federal income tax return for Year 1, asserting that Taxpayer’s net operating loss carryover from Year 1 should be increased, on the ground that all but a small amount of the indebtedness in question was not in fact discharged in Year 1. The Service Center responded that Taxpayer’s claim was being disallowed because the statute of limitations for Year 1 had expired.

The IRS, following Phoenix Coal v. Commissioner and Rev. Rul. 56-285, ruled:

The real question is whether, in determining the NOL deduction for an open year, taxpayers (and the service) may redetermine correct taxable income in a closed year in order to ascertain either the amount of an NOL, or the amount of an NOL that is absorbed, in the closed year.

Rev. Rul. 56-285, 1956-1 C.B. 134, holds that the fact that the statutory period for assessment of income taxes for the year in which a loss was sustained has expired does not preclude the Service from making such adjustments  [*7]  as may be necessary to correct the net operating loss deduction.

Rev. Rul. 81-88, 1981-1 C.B. 85, applies the same principle to the refund limitations period. It holds, in part, that in determining the amount of a net operating loss that may be carried from a closed year forward to an open year, all adjustments to taxable income, whether or not barred by the statute of limitations, will be taken into account.

Accordingly, we conclude that Taxpayer is not barred by the statute of limitations from recharacterizing events that occurred in Year 1 for purposes of redetermining net operating loss carryovers–either from Year 1 or from prior years–that are available for Taxpayer to deduct as net operating loss deductions in subsequent tax years.

The cases and rulings cited above support a general rule that when the tax liability for a prior year is necessary to a determination of the correct tax liability for a year placed in issue that is otherwise an open year, either the Taxpayer or the Commissioner can recompute the “correct tax liability” for a prior year to correct for errors or omissions in such prior year.  Taxpayers can correct and increase its NOL carryover schedule to reduce its taxable income.  Taxpayers are not required to file amended returns to increase its NOL for a subsequent return rather it can reflect the changes on its NOL schedule.

There Is No Second Unnecessary Examination Here, Even If the Carryover Year Was Previously Examined

The IRS published policy on reopening closed examinations section 7605(b) is found in Revenue Procedure 2005-32, 2005-1 C.B. 1206 which states that the examination may be reopened if one of the following three conditions is met:

(1) there is evidence of fraud, malfeasance, collusion, concealment, or misrepresentation of material fact;

(2) the closed case involved a clearly-defined, substantial error based on an established Service position existing at the time of the examination; or

(3) other circumstances exist indicating that a failure to reopen the case would be a serious administrative omission.

The decision whether to reopen an examination pursuant to this administrative policy must be reviewed and approved by the Chief, Examination Division or Chief, Compliance Division, for cases under his/her jurisdiction and based upon historical experience reopening is a rare occurrence.  Under the Revenue Procedure examining an amended return or verifying a net operating loss carryover year is not considered a reopening as it is a separate tax matter, even if the particular loss year or refund year was previously subjected to an examination.

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

[1] For Amended Corporate Returns, Form 1120X, see Rev. Rul. 81-88, 1981-1 C.B. 585.  Application of otherwise barred deduction in NOL carryback year.  The taxpayer is permitted to carryback an NOL to the full extent possible, without first applying the barred deduction to reduce taxable income in the carryback year.  If the barred deduction were taken into account first, the taxpayer would be denied that portion of the refund attributable to the barred deduction (as the claim would not be timely).  For a further analysis of this rule, see GCM 38292.

[2] IRC § 6501(h); see also Colestock v. Commissioner, 102 T.C. 380 (1994); and Schneer v. Commissioner, T.C. Memo 1993-372.

[3] IRC § 6501(h).  See also, Bryce E. Nemitz et ux. v. Commissioner, 130 T.C. 9 (2008).

[4]  See Mennuto v. Commissioner, 56 tc 910 (1971); see also Rev. Rul. 69-543, 1969-2 c.B. 1.)  Similarly a taxpayer with a NOL carryover generated in years for which the statute of limitations on assessment is closed may increase the amount of the NOL as long as the statute of limitations is open for the year the NOL is utilized.  PLR 9504032.

[5] Note that the IRS may offset tax, interest, and penalties, the assessment of which is otherwise time-barred, against a claim for refund so long as the items fall within the same tax year.  Fisher v. United States, 96-1 USTC ¶50,204 (Fed. Cir. 1996).  This is consistent with the long-standing doctrine of Lewis v. Reynolds, 284 U.S. 281 (1932), 52 S. Ct. 10 that permits the IRS to offset a tax refund by any additional time-barred amounts the taxpayer owes for the year.  See also Dysart v. United States, 340 F.2d 624 (Ct. C1. 1965). For an exception see Pacific Gas & Electric Co. v. U.S. 417 F. 3d 1375 (Fed. Cir. 2005).

[6]  See Rev. Rul. 56-285, 1956-1 C.B. 134—NOL carried over to a subsequent open year and claimed as a deduction could be adjusted to reflect proper depreciation even though the statute of limitations on assessment for the year of the NOL had expired.

[7]   ABKO Industries v Commissioner, 56 T.C 1083, 1088-89 (1971; State Farming Co. v. Commissioner, 40 T.C 774, 781 (1963).

[8]  See Lewis v. Reynolds, 284 U.S. 281 (1932); Lone Manor Farms, Inc., v. Commissioner, 61 T.C. 436 (1974).

[9]  See also, Rev. Rul. 81-87, 1981-1 C.B. 580 and Rev. Rul. 81-88, 1981-1 C.B. 585.

[10]  Rev. Rul. 85-64, 1985-1 C.B. 365.

[11]  See, e.g., G.C.M. 39358; G.C.M. 38292; Rev. Rul. 81-88, 1981 C.B. 585; Rev. Rul. 85-64, 1985-1 C.B. 7.

[12]  Rev. Rul. 56-285, 1956-1 C.B. 134.

[13]  Rev. Rul. 81-87, 1981-1 C.B. 58.

[14]  Phoenix Coal Company v. Commissioner, 231 F. 2d 420 (2d Cir. 1956).

[15]  ABKCO Industries, Inc. v. Commissioner, 56 T.C. 1083 (1971) aff’d on other grounds 482 F. 2d 150 (3d Cir. 1973).

[16]  State Farming Co. v. Commissioner, 40 T.C. 774 (1963).  See also Mennuto v. Commissioner, 56 T.C. 910 (1971)(affirming the Commissioner’s right to adjust a prior year’s taxable income in order to determine the amount of unused investment credit available to be carried over to the year in dispute).

[17]  Hill v. Commissioner, 95 T.C. 437 (1990).

[18]  See also Calumet Industries, Inc. v. Commissioner, 95 T.C. 257 (1990); Lone Manor Farms v. Commissioner, 61 T.C. 436 (1974) aff’d without opinion 510 F. 2d 970 (3d Cir. 1975); Rev. Rul. 77-225, 1977-2 C.B. 73.

[19]  Springfield Street Railway Company v. United States, 160 Ct. Cl. 111, 312 F.2d 754 (Cl. Ct. 1963).

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Posted by: Taxlitigator | January 15, 2015

FILE LATE AT YOUR PERIL by AVRAM SALKIN

In its recent opinion in Mallo v. United States of America,[1] the Tenth Circuit Court of Appeals included broad language indicating that a late filed tax return is not a tax return for purposes of determining a discharge of tax liabilities in bankruptcy.

The underlying district court denied a discharge on the grounds that the return was filed after the taxes were assessed based on a substitute return being filed by the Commissioner on the taxpayer’s behalf.  Although this holding is consistent with decisions in several other circuits, this opinion contains reasoned dicta that effectively says that tax obligations created by any late filed return are not dischargeable in bankruptcy. The Tenth Circuit’s opinion interprets Section 523(a) of the Bankruptcy Code, which excludes from discharge “any debt”

(1) for a tax or customs duty —

(B) with respect to which a return, or equivalent report notice, if required —

( i ) was not filed or given; or

( ii ) was filed or given after the date on which such return, report, or notice was last due, under applicable law or under any extension, and after two years before the date of the filing of the petition; or

(C) with respect to which the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax;

. . . .

For purposes of this subsection, the term ‘return” means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements).

The Tenth Circuit in Mallo first refers to the decisions of a majority of the courts that have determined that returns filed after assessment are not returns under Sec. 523 of the Bankruptcy Act.  The Tenth Circuit noted that nearly all courts determined whether a document qualified as a tax return by applying a test fashioned from Justice Cardozo’s decision in Zellerbach Paper Co. v. Helvering,[2] and approved by the United States Court of Appeals for the Sixth Circuit in Beard v. Commissioner.[3] This test, often referred to as the Beard test, has four elements: “[f]irst, there must be sufficient data to calculate tax liability; second, the document must purport to be a return; third, there must be an honest and reasonable attempt to satisfy the requirements of the tax law; and fourth, the taxpayer must execute the return under penalties of perjury.”[4]

Since the taxpayer in Mallo did not attempt to file a return until after assessment, the Tenth Circuit could have affirmed the denial of a bankruptcy discharge without analyzing whether any late filing eliminates the right to a bankruptcy discharge.  After summarizing the positions of both the Taxpayer and the Commissioner, the tenth Circuit concludes:

“…we agree with the Fifth Circuit’s decision in McCoy [666 F.3d 924 (5th Cir. 2012)] that the plain and unambiguous language of Sec. 523(a) excludes from the definition of ‘return’ all late-filed tax forms, except those prepared with the assistance of the IRS under Sec. 6020(a).”[5]

Although the law is not yet settled, anyone concerned about the ability to discharge tax liabilities through bankruptcy should make sure that all relevant tax returns are timely filed.  Also, the first funds available should be used to pay off tax liabilities attributable to delinquent returns in order to avoid the issue.

AVRAM SALKIN – For more information please contact Avram Salkin at AS@taxlitigator.com. Mr. Salkin 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

[1] Mallo et vir et al. v. United States of America, (No. 13-1464)  __   F.3d __  (10th Cir., December 29,2014, affirming Mallo v. United States, No. 1:13-cv-00098 (D. Colo. 2013)

[2] 293 U.S. 172 (1934)

[3] 793 F.2d 139 (6th Cir. 1986) (per curiam), aff’g 82 T.C. 766 (1984)

[4] Beard v. Comm’r, 82 T.C. 766, 777 (1984), aff’d, 793 F.2d 139 (6th Cir. 1986) (per curiam).

[5] The Tenth Circuit noted that the hanging paragraph added by Congress in 2005 defines return as a document that “satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements).” 11 U.S.C. section 523(a)(*). They then proceeded to the question whether the reference to “applicable filing requirements” includes the date a tax form is due, thereby excluding a late-filed Form 1040, which otherwise satisfies the Beard test, from the definition of return in section 523(a)(*). To determine what falls within that definition, they looked to the nonbankruptcy law found in the Internal Revenue Code noting that Chapter 61 of the Internal Revenue Code governs “Information and Returns.” In particular, subchapter A, Part V — Time for Filing Returns and Other Documents, provides:

“In the case of [income tax] returns, returns made  on the basis of the calendar year shall be filed on or before the 15th day of April following the close of the calendar year and returns made on the basis of a fiscal year shall be filed on or before the 15th day of the fourth month following the close of the fiscal year.” 26 U.S.C. section 6072(a).

The Tenth Circuit noted that the “phrase ‘shall be filed on or before’ a particular date is a classic example of something that must be done with respect to filing a tax return and therefore, is an ‘applicable filing requirement.’ Indeed, in a different context, the Supreme Court has characterized the date a document ‘shall be filed’ as a ‘filing requirement.’ See Pace v. DiGuglielmo, 544 U.S. 408, 414-15 (2005). There, the Supreme Court concluded that timeliness was a ‘condition to filing’ as required for a habeas petition to be ‘properly filed,’ where the state rule listed as a mandatory condition that the petition ‘shall’ be filed within the time limit. Id. The court reasoned, ‘We fail to see how timeliness is any less a ‘filing’ requirement than the mechanical rules that are enforceable by clerks.’ Id. at 414-15. And this court has characterized a time limit in a different section of the Bankruptcy Code as a “filing requirement.” Matter of Colo. Energy Supply, Inc., 728 F.2d 1283, 1285 (10th Cir. 1984) (referring to a bankruptcy rule that a notice of appeal “shall be filed within 10 days”); see also United States v. Bourque, 541 F.2d 290, 293 (1st Cir. 1976) (characterizing a provision of the Tax Code that returns of corporations “shall be filed on or before March 15” as a “filing requirement”). We agree with these decisions and hold that, because the applicable filing requirements include filing deadlines, section 523(a)(*) plainly excludes late-filed Form 1040s from the definition of a return.”

 

 

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Posted by: khartwell85 | January 3, 2015

Application of TEFRA to Employment Tax Examinations By Krista Hartwell

On December 12, 2014 the Office of IRS Chief Counsel published Legal Advice Issued by Field Attorneys (LAFA) 20145001F, concluding that the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), as codified in Sections 6221 through 6324, “does not apply to employment tax examinations or worker classification proceedings for entities that are otherwise subject to TEFRA for income tax purposes. For that reason, there are no special procedures that revenue agents must follow when conducting employment tax examinations of TEFRA partnerships.”

TEFRA provides procedural rules that apply in most partnership audits. An audit of a TEFRA partnership begins with the issuance of a Notice of Beginning of Administrative Proceedings, which must be mailed to the Tax Matters Partner (TMP) and each “notice partner.”[i] All partners have the right to participate in a TEFRA proceeding.[ii]  Upon completing the TEFRA partnership audit, the revenue agent must send notice of the Final Partnership Administrative Adjustment (FPAA).[iii] If any partner protests the FPAA, the IRS will transfer the partnership case to the applicable Appeals Office. There are specific procedures applicable to TEFRA Appeals Office proceedings.[iv]  If any partner disagrees with the result at Appeals, Appeals will issue an FPAA that commences the ninety-day period in which the TMP may petition the Tax Court, the applicable district court, or the Court of Federal Claims for readjustment of the partnership items in the FPAA.[v]

Section 7436(a) provides the procedures for proceedings to determine employment status:

(a) Creation of Remedy

If, in connection with an audit of any person, there is an actual controversy involving a determination by the Secretary as part of an examination that—

(1) one or more individuals performing services for such person are employees of such person for purposes of subtitle C, or

(2) such person is not entitled to the treatment under subsection (a) of section 530 of the Revenue Act of 1978 with respect to such an individual,

upon the filing of an appropriate pleading, the Tax Court may determine whether such a determination by the Secretary is correct and the proper amount of employment tax under such determination. Any such redetermination by the Tax Court shall have the force and effect of a decision of the Tax Court and shall be reviewable as such.

Several of the deficiency proceeding rules apply in Section 7436(a) employment proceedings.  Section 7436(d) states that the principles of sections 6213(a), (b), (c), (d) (restrictions on deficiencies and Tax Court petition rules) and (f) (waivers of deficiencies); 6214(a) (Tax Court jurisdiction to redetermine deficiencies); 6215(a) (assessment of deficiencies found by the Tax Court); 6503(a) (suspension of limitations periods); 6512 (limitations in the case of Tax Court petitions); and section 7481 (date when Tax Court decisions become final) apply to Section 7436(a) proceedings.

The IRS concluded that an LLC is “subject to TEFRA for income tax purposes, but that the TEFRA procedures do not apply to employment tax examinations or to worker classification proceedings.”

In its analysis, the IRS noted that within the sections incorporated in section 7436, “the only references to TEFRA relate to suspending the statute of limitations and to the overpayments relating to partnership items… [and] the TEFRA statutes make no reference to I.R.C. § 7436 or to Subtitle C of the Code (Employment Taxes and Collection of Income Tax).”

The IRS also reasoned that under sections 6221 and 6231(a)(3), the TEFRA partnership procedures are limited to “partnership items,” which are items under Subtitle A of the Code, whereas employment taxes are imposed under Subtitle C of the Code. The IRS also stated that “employment tax liability…does not meet the I.R.C. § 6211(a) definition of ‘deficiency’ to which the TEFRA restriction on assessment under I.R.C. § 6225 could apply…[and therefore] no notice of final partnership administrative adjustment would be required under I.R.C. § 6225 in order to make an employment tax assessment.”

The IRS also cited Chef’s Choice v. Comm’r, 95 T.C. 388 (1990) for its assertion that “the intent of the intent of the TEFRA provisions was merely to aggregate the partners’ income tax deficiency proceedings into a single proceeding insofar as their income tax liability derived from a partnership. Since the partnership does not pay income tax, it is not even a party to the TEFRA proceeding relating to income tax determinations.”

LAFA 20145001F, which concludes that TEFRA does not apply to employment tax examinations, is legal advice prepared by field attorneys in the Office of Chief Counsel and is issued as legal advice to the revenue agent and team manager listed in the LAFA.  The LAFA is not to be cited as precedent.

KRISTA HARTWELL – For more information please contact Lacey Strachan at Hartwell@taxlitigator.com. 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.

 

 

 

 

 

[i] 26 U.S.C. § 6223

[ii] 26 U.S.C. § 6224

[iii] 26 U.S.C. § 6223

[iv] See IRM 8.19

[v] 26 U.S.C. 6226(a)

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Posted by: Lacey Strachan | December 24, 2014

SECTION 6901’s TWO-PRONG INQUIRY by LACEY STRACHAN

Although shareholders are generally not liable for debts of a corporation, shareholders may be liable for a corporation’s tax liability if they are considered transferees under a state’s fraudulent conveyance laws.  Where such liability exists, § 6901 of the Internal Revenue Code (“IRC”) allows the IRS to assess and collect the tax liability from the transferee.  In a decision published December 22, 2014, the Ninth Circuit explains the two-prong inquiry required by this code section—a determination must be made under federal law of whether the IRS may procedurally assess the tax against a party if transferee liability exists, and an independent, substantive determination must be made under the applicable state law of whether such liability exists.

In Salus Mundi Foundation v. Commissioner, 2014 U.S. App. LEXIS 24240 (9th Cir. Dec. 22, 2014), the Ninth Circuit reversed the Tax Court’s holding that a foundation was not liable under IRC § 6901 as a transferee of a transferee for a corporation’s tax liability resulting from a “Midco” transaction.  In that case, the shareholders of the corporation Double-D Ranch, Inc. sold their stock in the corporation to an intermediary that had losses that the intermediary expected to be able to use to offset gains on the sale of Double-D Ranch, Inc.’s assets.[i]  The intermediary in turn sold the assets of the corporation, keeping the difference between the price it paid for the stock and the amount it received for the corporation’s assets.  However, after determining that the intermediary’s losses were artificial losses resulting from a Son-of-BOSS transaction, the IRS recharacterized the Midco transaction as a sale by the shareholders of the assets of Double-D Ranch, Inc., followed by a liquidating distribution to the shareholders.[ii]  The IRS assessed a capital gains tax liability against Double-D Ranch, Inc. for the gain on the sale of its assets, which the corporation did not dispute.[iii]

When the IRS was unable to collect the tax liability from either Double-D Ranch, Inc. or the intermediary corporation, the IRS pursued transferee liability under IRC § 6901 against the selling shareholders of Double-D Ranch, Inc.[iv]  Section 6901 allows the IRS to assess a tax liability against the transferee of assets of a taxpayer who owes the income tax liability, as well as against the transferee of a transferee.[v]  The term “transferee” is defined for income tax purposes as a “donee, heir, legatee, devisee, and distribute,” which includes, in pertinent part, the shareholder of a dissolved corporation and the successor of a corporation.[vi]  Section 6901 is a procedural statute that allows the IRS to collect taxes from a transferee, but it does not create a substantive liability—it is state law that determines the existence of a substantive liability.[vii]

On appeal, the Ninth Circuit clarified the two-prong test for liability under § 6901, which requires two inquiries: (1) is the party a “transferee” under § 6901 and federal tax law?; and (2) is the party substantively liable for the transferor’s unpaid taxes under state law?[viii]  The Ninth Circuit held that these two tests are separate and independent inquiries, concluding that the two prongs of § 6901 are “independent requirements, one procedural and governed by federal law, the other substantive and governed by state law.”[ix]  That is, the state law substantive inquiry of whether a transferee is liable for the transferor’s tax liability is independent of the procedural inquiry under Federal law of whether a party is considered a “transferee” under § 6901.

One of the shareholders of Double-D Ranch, Inc. was a charitable foundation that had distributed the proceeds of the sale to three foundations organized by the children of the foundation’s founder, one of which is the Salus Mundi Foundation, the appellee in this case.  The Tax Court had treated the two-prongs of section 6901 as independent inquiries, and held that the children’s foundations were not liable as transferees of transferees, because the shareholder foundation did not have actual or constructive knowledge of the entire scheme that renders its exchange with the debtor fraudulent, which is required under the New York Uniform Fraudulent Conveyance Act for a transaction to be recharacterized.[x]

On appeal, the IRS argued that the tests are not independent, such that the Federal tax law “substance over form” doctrine can be used to recharacterize a transaction for purposes of determining both whether a party is a “transferee” for procedural purposes under § 6901 as well as for purposes of determining a party’s substantive liability under state law.  The Ninth Circuit rejected this argument, and held that federal tax law cannot be used to recharacterize a transaction for purposes of determining whether a substantive transferee liability exists for the party under state law.[xi]

However, the Ninth Circuit found on appeal that the transaction should be recharacterized under the New York Uniform Fraudulent Conveyance Act, reversing the Tax Court’s finding that the foundation did not have constructive knowledge of the entire scheme.[xii]  The Tax Court’s holding had also been appealed to the Second Circuit by another of the foundations on the same issue, in the case Diebold Foundation, Inc. v. Commissioner, 736 F.3d 172 (2nd Cir. 2013).  In that case, the Second Circuit held on the same set of facts, issues, and applicable law that the foundation had constructive knowledge sufficient to support transferee liability under New York law.

The Ninth Circuit decided to follow the Second Circuit’s reasoning in vacating the Tax Court’s decision, explaining that “absent a strong reason to do so, we will not create a direct conflict with other circuits.”[xiii]  The Ninth Circuit concluded that “[w]hile the question of the shareholders’ constructive knowledge is a difficult issue, we conclude that the Second Circuit’s decision is not demonstrably erroneous.”   The Ninth Circuit accordingly reversed the Tax Court’s holding, and remanded the case to the Tax Court for a determination on (1) whether the foundation was a “transferee” under the first prong of the two-prong test; and (2) whether the tax was assessed within the statute of limitations.

LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan 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.

[i] Salus Mundi Found. v. Comm’r, 2014 U.S. App. LEXIS 24240, 9-12 (9th Cir. Dec. 22, 2014).

[ii] Id. at 12-15.

[iii] Id. at 15-17.

[iv] Id.

[v] IRC § 6901(a)(1)(A)(I), (c)(2).

[vi] IRC § 6901(h); Treas. Reg. § 301.6901-1(b).

[vii] Salus Mundi Found. v. Comm’r, 2014 U.S. App. LEXIS 24240 (9th Cir. Dec. 22, 2014) (citing Comm’r v. Stern, 357 U.S. 39, 42, 44-45 (1958)).

[viii] Salus Mundi Found. v. Comm’r, 2014 U.S. App. LEXIS 24240 (9th Cir. Dec. 22, 2014).

[ix] Id. at 22-23 (quoting Diebold Foundation v. Comm’r, 736 F.3d 173, 186 (2nd Cir. 2013)).

[x] Salus Mundi Found. v. Comm’r, 2014 U.S. App. LEXIS 24240, 17 (9th Cir. Dec. 22, 2014).

[xi] Id. at 19-23.

[xii] Id. at 23-25.

[xiii] Id. at 24 (quoting United States v. Chavez-Vernaza, 844 F.2d 1368, 1374 (9th Circuit)).

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Posted by: Taxlitigator | December 20, 2014

The Effect of Latent Tax Liabilities on Stock Values by Avram Salkin

The IRS has consistently taken the position that potential tax liabilities of C corporations, S Corporations, and individuals should not be considered when valuing stock or other assets.  For example, should the stock of an S Corporation’s stock be reduced if the corporation holds assets that are worth far more than their tax basis?  If the appreciated assets are depreciable or amortizable, should the loss of future depreciation or amortization diminish value? If inventory has appreciated, will a hypothetical buyer consider the taxes payable on sale of the inventory when determining price?

Interestingly, the Department of Justice has just taken the position that taxes count in its fraudulent conveyance complaint filed against Deutsche Bank in the Southern District of New York.[1]  Included among the allegations in the Complaint are:

“First, a Deutsche Bank entity sold the corporation holding the appreciated stock to BMY for a price that did not represent fair value of it in light of, at a minimum, the tens of millions of dollars of tax liabilities on the built-in-gains.”

“The economic value of the stock to the shareholders of the company owning the appreciated stock is less than the market price of the stock.  Other factors being equal, the economic value of the stock is the market price less the taxes that will be due when the stock is sold.”

“The approximately $150 million purchase price paid by Deutsche Bank for the Charter stock was significantly greater than the economic value of the Charter stock if the built-in-gains associated with the BMY shares owned by Charter are taken into account.”

“At a minimum, the sales price did not account for the tax liabilities associated with the built-in-gain on the BMY shares owned by Charter.”

If the Department of Justice is willing to make such allegations, it is difficult to understand how the National Office of the Internal Revenue Service can take the position that tax liabilities based on built in gains or reduced benefits available from depreciation on undervalued assets do not affect the value of stock. It is inconsistent for the Government to make the foregoing allegations in a fraudulent conveyance case while constantly claiming that transfer taxes are underpaid when appraisers consider tax liabilities as part of their valuation process. They have it right in the Deutsche Bank case -potential tax liabilities affect value.  They have backed off to some extent in C corporation cases, but should get it right in S corporation, partnership and individual cases where taxpayers’ valuations reflect built-in-tax burdens.

AVRAM SALKIN – For more information please contact Avram Salkin at AS@taxlitigator.com. Mr. Salkin  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

 

[1] See U.S.. v. Deutsche Bank (Tax Case) 14 Civ 9669 (SDNY, 12/08/14). A copy of the Complaint is available at  http://www.justice.gov/usao/nys/pressreleases/December14/DeutscheBankTaxCasePR/Deutsche%20Bank%20(Tax%20Case)%2014%20Civ%209669%20Complaint.pdf

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Posted by: Taxlitigator | December 7, 2014

How Long Should I Keep Tax Records?

Many taxpayers hoard records such that they can be appropriately prepared “if and when” an IRS examination occurs. Others often inquire as to which records should be maintained and for how long. Some routinely destroy relevant documents on the mistaken belief that an examination result will somehow be enhanced if certain documents simply don’t exist.

The length of time documents should be retained often depends upon the action, expense, or event the document records. Generally, records that support an item of income or deduction on a tax return should be retained until the applicable statute of limitations for that return runs out. The statute of limitations is the period of time in which return can be amended to claim a credit or refund, or that the IRS can assess additional tax. Returns filed before the due date are treated as filed on the due date.

General Rule. The general federal statute of limitations is 3 years from the filing date of the return. Many states have statutes that are one year beyond the expiration of the federal statute of limitations. However, the federal statute of limitations can be extended to 6 years in certain situations where there has been an omission of more than 25% of the gross income required to be hown on the return and is indefinite in the event of a civil fraud determination or the failure to file a return.

Taxpayers should keep copies of filed tax returns for at least 6 tax years to help in preparing future tax returns and making computations if an amended return is required. Generally:

  1. If the taxpayer owes additional tax and situations (2) and (3), below, do not apply; keep records for 3 years.
  2. If there is an omission of more than 25% of the gross income required to shown on the return; keep records for 6 years.
  3. If a return is not filed; keep records indefinitely.
  4. If a claim for credit or refund is filed after the filing of the original return; keep records for 3 years from the date the original return was filed or 2 years from the date the tax was paid, whichever is later.
  5. If a claim for a loss from worthless securities or bad debt deduction was filed; keep records for 7 years.
  6. Keep all employment tax records for at least 4 years after the date that the tax becomes due or is paid, whichever is later.

Are the records connected to assets? Keep records relating to property until the period of limitations expires for the year in which the property is disposed of in a taxable disposition. These records will be relevant for purposes of determining any depreciation, amortization, or depletion deduction and to figure the gain or loss upon disposition of the property.

Generally, for property in a nontaxable exchange, the tax basis in that property is the same as the bases of the property transferred, increased by any money paid for the acquisition. Retain records applicable to the old property, as well as on the new property, until the period of limitations expires for the year in which the new property was disposed of in a taxable disposition.

When records are no longer needed for tax purposes, do not discard them until determining whether the records might be needed for other purposes such as for insurance purposes.

Many people have moved forward into the electronic world and operate within a paperless environment. Electronic storage of relevant documents provides a hassle free method of retaining documents far beyond the confines of an upper shelf in a closet or garage. If comfortable with a paperless environment, consider retaining rather than destroying documents for a considerably longer period of time than referenced above.

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Posted by: Taxlitigator | November 24, 2014

Random Thoughts re IRS Examination Representation

It is extremely important to have a working knowledge and appreciation for the administrative process in which tax returns are fi led, reviewed and examined. This knowledge allows the practitioner an opportunity to provide an efficient, invaluable service to his clients and to the system of tax administration. The administrative process should not be abused merely because of the taxpayer’s desire to delay the determination and collection of any potential liability. Collection-related issues should be sorted out through an installment payment arrangement that would be negotiated through the normal collection process following conclusion of the audit.

ISSUE SPOTTING. A practitioner cannot know everything that one’s client will expect the practitioner to know. However, a practitioner should be able to “issue spot” matters within his field of expertise and, to a lesser extent, matters outside his field of expertise. The internet may be a practitioner’s best initial resource. There is a tremendous amount of information available on the Internet for the IRS and various state taxing authorities. Get comfortable accessing their sites.

Tax people need to be sensitive to non-tax issues. Otherwise, resolution of a tax dispute might inadvertently set up a securities case, a money-laundering structuring case, etc. against one’s client.

IRS AUDIT TECHNIQUES GUIDES. Be familiar with IRS Audit Technique Guides (ATG) when providing tax advice, preparing tax returns, preparing for an IRS examination and when preparing a client for an interview with the government. There are many publicly available ATGs that have been prepared by the IRS. Each ATG instructs the examining agent on typical methods of auditing a particular group of taxpayer, including typical sources of income, questions to be asked of the taxpayer and his representative during the audit, etc. These groups have been defined by type of business (i.e., gas stations, grocery stores, etc.), technical issues (passive activity losses), types of taxpayer (i.e., returns lacking economic reality) or method of operation (i.e., cash businesses).

A practitioner should not blindly proceed with an examination without being generally familiar with any potentially relevant IRS ATGs. Effective representation requires the ability to utilize all available resources, including the ATGs. Often, it may be beneficial to review relevant ATGs earlier in the process…perhaps while preparing the return. Preparers representing clients in an industry or having issues covered by an ATG should consider thoroughly reviewing the ATG with the client, before the return is filed.

ENGAGEMENT LETTERS. Engagement letters for tax-related matters should specify the scope and terms of the engagement. Services rendered should be within the scope of the engagement as clearly set forth in the engagement letter. If additional services are to be provided, additional engagement letters should be obtained. If a client relationship is terminated for any reason, written confirmation of the termination should be promptly provided to the client and the opposition. If the government has been involved, the government should also be clearly advised of the termination of the client relationship.

EXTENSIONS OF THE STATUTE OF LIMITATIONS. It is often a good practice to provide an extension of the applicable statute of limitations during the course of any audit or examination. However, it is also good practice to have extensions signed by the client, rather than the client’s authorized representative (even though authorized by a power of attorney). Years later, the client may not recall having given authorization to extend the statute of limitations. If their signature is on the extension (Form 872), the situation will not likely escalate. Further, it is almost always preferred to sign a limited extension with a specified expiration date (Form 872) rather than an indefinite extension for an unspecified term (Form 872-A).

FREEDOM OF INFORMATION ACT REQUESTS. It is often advisable to submit a request under the Freedom of Information Act (FOIA) following the unagreed resolution of a federal tax examination. It should also help tailor discussions at the next administrative level while providing insight into what the next government representative assigned to the case will be reviewing. The process is relatively simple and inexpensive. Relevant information regarding the submission of a FOIA request is readily available at irs.gov by searching “FOIA.”

TAXPAYER ADVOCATE SERVICE. If an examination problem seems overwhelming, consider contacting the Taxpayer Advocate Service (TAS). TAS is an independent organization within the IRS whose employees assist taxpayers who are experiencing economic harm, who are seeking help in resolving tax problems that have not been resolved through normal channels or who believe that an IRS system or procedure is not working as it should.

RESPOND TIMELY AND SEEK RESOLUTION AT THE EARLIEST OPPORTUNITY. Throughout, treat all government representatives with respect and act like the professional that you want others to know and respect. Cooperate within your client responsibilities and respond timely to all requests, even if the response is a request for additional time to respond.

It is generally advisable to attempt to resolve any civil tax dispute at the earliest opportunity. A lengthy examination may be costly from the perspective of the expenditure of time and effort involved, as well as the taxpayer’s degree of frustration with the normal administrative process. Further, a prolonged audit is more likely to uncover potentially sensitive issues that could generate increased tax deficiencies, penalties or the possibility of criminal sanctions.

WHEN IN DOUBT . . . GET A DOG! A busy tax practice can be surrounded by minefields. Never underestimate the IRS’s ability, desire and resources to examine tax returns and collect taxes. Document your client advice in writing, limit the nature and scope of services to be provided in your engagement letter, establish a system of checklists (and follow the system) and use your best judgment.

If the taxpayer is unwilling to accept and follow your advice, strongly consider terminating the engagement. Life is short and the headaches of trying to convince someone to do the right thing may simply not be worth your effort. There is a reason many people become clients, and it is not because they routinely coordinate all relevant information necessary to the preparation of a return nor do they routinely provide such information in a timely manner. If you encounter an undeserving or possibly disrespectful taxpayer-client, let them go and move on with your practice.

Lastly, you cannot be all things to all people, regardless of the effort and personal sacrifice. Perhaps most importantly, remember that the taxpayer is your client, not your friend . . . if you feel the need for friends . . . get a dog!

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Posted by: Taxlitigator | November 20, 2014

AGOSTINO & ASSOCIATES NEWSLETTER – The Taxpayer Advocate Service: Guarantors of the Taxpayer Bill of Rights

AGOSTINO & ASSOCIATES –To download a great article prepared by our very close friends at the Law Firm of Agostino & Associates in Hackensack, NJ ( www.agostinolaw.com ), see the Agostino & Associates November Newsletter https://drive.google.com/file/d/0B719qAMBEjGQUjlDb3VJTDVkZDA/view?pli=1

The Taxpayer Advocate Service – Guarantors of the Taxpayer Bill of Rights By Frank Agostino & Matthew Turtoro –  The Taxpayer Advocate Service (“TAS”) is often the most viable means available and is tasked with assisting taxpayers resolve problems with the IRS; identifying areas in which taxpayers have problems dealing with the IRS; proposing changes in the administrative practices of the IRS to mitigate problems; and identifying potential legislative changes that may mitigate problems. Tax professionals should understand that a TAS filing can help preserve the rights of their client and remedy IRS malfeasance.

Representatives must know when to contact TAS and how TAS may be able to provide immediate assistance for even the most difficult, complex scenarios. GREAT ARTICLE – FOR THE FULL ARTICLE SEE https://drive.google.com/file/d/0B719qAMBEjGQUjlDb3VJTDVkZDA/view?pli=1

AGOSTINO & ASSOCIATES, with a national practice based in Hackensack, NJ, specializes in tax and tax controversies (civil and criminal), offers in compromise, voluntary disclosures, tax lien discharges,  innocent spouse determinations, forfeitures, estate planning and probate, contract and contract litigation.  A firm comprised truly great, caring people who want the best for their clients !

For further information, contact Frank Agostino or Matthew Turtoro directly at (201) 488-5400 or visit  www.agostinolaw.com

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