PENALIZE FIRST, ASK QUESTIONS LATER

U.S. persons and entities with interests in non-U.S. corporations take heed – noncompliance with information reporting requirements will soon lead to automatic imposition of substantial U.S. penalties. The reporting at issue is for Form 5471, which must be filed by U.S. persons with certain stated interests in foreign corporations. The persons who must file are listed in the instructions to the form, which can be reviewed at http://www.irs.gov/pub/irs-pdf/i5471.pdf. 

The penalties for nonfiling are significant, especially since they do not relate to any specific amount of tax being due and are imposed even if the taxpayer owes no U.S. income tax.  Each failure to file results in a $10,000 penalty, and a 10% reduction in available foreign tax credits.

In the past, such penalties were typically imposed only at the discretion of a tax auditor after a return is audited. Now, starting January 1, 2009, all late filed returns will automatically be assessed penalties. Taxpayers will then need to be able to show reasonable cause for nonfiling to be able to get the penalties removed.

Perhaps this wouldn’t be such a big deal, if there weren’t so many taxpayers that did not file the Forms due to ignorance of the filing requirement. Of course, the larger taxpayers who have and can afford knowledgeable tax advisors, will likely not run afoul of the rules. Thus, it is likely that the penalties will disproportionately fall on smaller taxpayers who can ill afford such substantial penalties.

Anyone with interests in foreign corporations who may be subject to the reporting should check immediately with their tax advisors to determine if it is advisable whether filings should be undertaken prior to January 1, 2009, especially as to returns due for prior years.

ENHANCED BROKER REPORTING

A new provision enacted under the Emergency Economic Stabilization Act of 2008 has stepped up the record keeping and reporting obligations of securities brokers. Brokers are presently required to report sale information to the IRS each year, to assist the IRS in determining if taxpayers are properly reporting their securities gains and losses.

The new provision now requires the broker to include in the report information on the taxpayer's adjusted basis in sold securities, and whether the gain or loss on sale is long-term or short-term. I am sure the brokerage industry is thrilled with the additional headaches and compliance costs imposed on them by Congress. This reporting kicks in after 2010.

APPLICABLE FEDERAL RATES - NOVEMBER 2008

NEW TAX LAW DEFUSES TAXPAYER VS. PREPARER CONFLICT

As previously discussed, changes to preparer penalties had created a conflict between tax return preparers and taxpayers. The essence of the controversy was that taxpayers could report a tax issue based upon a "reasonable basis," and would be insulated from penalties if the position turned out to be wrong. However, a preparer could be penalized for the same reporting, unless he or she could show that the reported position was more likely than not to be sustained, a substantially higher standard than the taxpayer's "reasonable basis" standard. Thus, to protect themselves from penalty, preparers might encourage their clients to adopt a safer tax position than the taxpayer had to adopt under the reasonable basis standard and had to struggle to protect both themselves and their clients on issues where there was uncertainty.

The recently enacted tax act has now dropped the preparer standard down to the same "reasonable basis" standard as applies to the taxpayer. This is a welcome provision that avoids preparers having to make defensive disclosures to taxpayers to protect themselves and otherwise complicating their practice and making them a policeman for the IRS.

To summarize the revised rules:

a. Both taxpayers and their preparers can avoid penalties relating to a tax return position if there is "substantial authority" for the position. Generally, substantial authority exists if the weight of authorities supporting the taxpayer's treatment is substantial in relation to the weight of those that take a contrary position. Substantial authority includes the Code and other statutes, regs (final, temporary, and proposed), court cases, tax treaties, statements of Congressional intent, and administrative pronouncements (revenue rulings, revenue procedures, private letter rulings, technical advice memoranda, actions on decisions, general counsel memoranda, press releases, notices, and similar documents).

b. If the tax return position is adequately disclosed to the IRS in accordance with IRS requirements, the standard for avoiding penalties is dropped to a lower "reasonable basis" standard.

c. However, for tax shelters and listed transactions, penalties can be avoided only if there was a reasonable belief that it was more likely than not that the position would be sustained on its merits.

Interestingly, the change in the law does not allow for a reduction in the "more likely than not" standard under c. even with disclosure, which is a change from prior law.

Code Section 6694(a), as revised.

"SHORT SALE" CONTROVERSY RESOLVED [FLORIDA]

In my posting of September 6, 2008, I discussed the controversy that had arisen over real property "short sales" in Florida. If you recall, a "short sale" occurs when a buyer purchases encumbered real property for less than the existing debt on the property, and the existing lender allows the buyer to obtain the property without a mortgage lien relating to the portion of the debt that the buyer is not taking over. Problems arose when the Florida Department of Revenue indicated that documentary stamp taxes on the real property deed would be based on the amount of the existing mortgage debt, not the lesser purchase price paid by the buyer.

The Department of Revenue has now resolved this issue in a manner favorable to taxpayers. At least in situations involving unrelated buyers and sellers, it has indicated in a recently issued Technical Assistance Advisement that the documentary stamp taxes will be calculated on the lower purchase price paid by the buyer, without regard to the portion of the mortgage debt that is not taken over by the buyer. It has based its position on the interpretation that consideration passing between the buyer and the seller is equal only to what the buyer is paying. The fact that there is a simultaneous reduction in the mortgage debt by the lender should not affect the consideration amount between the buyer and seller.

Given that Florida is one of the states suffering the most from real estate value declines, and the continued need for short sales to help clear the market of properties which are encumbered in excess of their current values, it is noteworthy that the Department of Revenue adopted a position that is both legally sound and will help provide relief to the current real estate crisis.

Technical Assistance Advisement 08B4-006, September 23, 2008

SURPRISE! NEW FBAR EXPANDS OFFSHORE ACCOUNT REPORTING

There are three certainties in life - death, taxes, and increases in U.S. information reporting requirements. In compliance with the third of these certainties, the U.S. Treasury Department has issued a new FBAR form that expands reporting of foreign accounts beyond those previously required.

The Form TD F 90-22.1 (known as the "FBAR") is a reporting form required of U.S. persons that have interests in non-U.S. accounts. It is a Treasury Department form, not an IRS form. It is not filed with a tax return, but is due on a different day and location than income tax returns. The Form is problematic, since many persons that are required to file it do not know about it, and the penalties for noncompliance can be severe. The extension of the reporting requirements will only exacerbate these problems.

Some of the expansions in reporting include the inclusion of interests in foreign mutual funds, and the inclusion of reporting by foreign entities (such as the extension of reporting to U.S. unincorporated branches of foreign entities).

The new Form must be used after 12/31/08. Click on the following link to view a summary of who is subject to the reporting requirements under the instructions to the new Form - http://tinyurl.com/3es5jx.

A copy of the Form and instructions is available at http://www.irs.gov/pub/irs-pdf/f90221.pdf.

TAX CHANGES ENACTED AS PART OF THE BAILOUT LAW

The bailout law passed by Congress included a number of tax provisions - some related to the bailout and some not. Some of the principal changes include:

a. Compensation Deductions Limited. The new law limits to $500,000 the compensation deduction for pay of principal officers of employers who have assets acquired by the federal government that meet the thresholds including in the new law. The golden parachute nondeduction rules and the excise tax on golden parachute payments are also being expanded to include golden parachutes to such employers.

b. Mortgage Debt Forgiveness Relief Extended. The exclusion from gross income for up to $2 million of mortgage debt relief has been extended for 3 more years.

c. Alternative Minimum Tax Relief. AMT exemption amounts are increased, but only for 2008. Absent further legislative changes, in 2009 the exemptions will return to 2000 levels.

d. Various Tax Provisions are Extended. The deduction for state and local sales taxes has been retroactively extended through 2009. Also extended is the above-the-line deduction for higher education expenses and educator expenses, the additional standard deduction for state and local property taxes, the allowance of nontaxable transfer of IRAs to charities has been extended two years, the research credit has been extended and modified, the tax credit for new markets has been extended one year, the Subpart F extension for active financing income has been extended for one year, and various charitable deduction enhancements have been extended, along with many other narrowly focused extensions.

IRS TO EASE LOSS CARRYOVER RESTRICTIONS

Code Section 382 limits trafficking in net operating losses by imposing restrictions on use of net operating losses of a corporation after a substantial change in ownership. One of the restrictions that arises after such a change in ownership is that the available net operating losses are effectively written down to the fair market value of the corporation at the time of change in ownership.

Given such restrictions, taxpayers are encouraged to make capital contributions to a loss corporation before a change in ownership to beef up its value and thus reduce the write-down of its NOLs. To restrict this gamesmanship, Code Section 382(l)(1)(A) will disregard any capital contribution received by a loss corporation as part of a plan a principal purpose of which is to avoid or increase any limitation under Code Section 382. Code Section 382(l)(1)(B) then goes on to provide that any capital contributions made during the two years leading up to the change in ownership will be presumed to be part of such a plan and disregarded, except as provided in regulations.

Surprisingly, the IRS has indicated that regulations will be issued that will not provide for a per se presumption of a plan to avoid Code Section 382limitations for contributions in the two years leading up to the change in ownership. Instead, it will apply a facts and circumstances analysis to determine if there was a plan to avoid the Code Section 382 limitations. Further, the regulations will have certain safe harbor capital contribution situations that will not give rise to a finding of a plan to avoid the limitations.

These safe harbor capital contributions are:

(1) The contribution is made by a person who is neither a controlling shareholder (determined immediately before the contribution) nor a related party, no more than 20% of the total value of the loss corporation's outstanding stock is issued in connection with the contribution, there was no agreement, understanding, arrangement, or substantial negotiations at the time of the contribution regarding a transaction that would result in an ownership change, and the ownership change occurs more than six months after the contribution.

(2) The contribution is made by a related party but no more than 10% of the total value of the loss corporation's stock is issued in connection with the contribution, or the contribution is made by a person other than a related party, and in either case there was no agreement, understanding, arrangement, or substantial negotiations at the time of the contribution regarding a transaction that would result in an ownership change, and the ownership change occurs more than one year after the contribution.

(3) The contribution is made in exchange for stock issued in connection with the performance of services, or stock acquired by a retirement plan, under the terms and conditions of certain regulations under Code Section 355.

(4) The contribution is received on the formation of a loss corporation (not accompanied by the incorporation of assets with a net unrealized built in loss) or it is received before the first year from which there is a carryforward of a net operating loss, capital loss, excess credit, or excess foreign taxes (or in which a net unrealized built-in loss arose).

The inclusion of practical safe harbors is always welcome!

Notice 2008-78