IRS Proposes Elimination of 36 Month Discharge of Indebtedness Reporting

Unless a statutory exception applies, when a debt is discharged without payment being made, the debtor will have discharge of indebtedness income under Section 108 of the Code. So that the IRS is alerted to this income, Section 6050P requires applicable financial entities to issue an information report to report the discharge of debt.

There are 8 events that give rise to this reporting – 7 of them relate to an event that coincide with an actual discharge of debt. One of them does not – under the 36 month rule reporting is required if no payment has been received on the indebtedness for 36 months (unless debt collection action occurs within 12 months or there are facts and circumstances showing the debt has not been discharged).

This can result in the debtor receiving notice on a Form 1099-C of a discharge, even though one may not really have occurred. There is no law that says that a debt discharge occurs either legally or for federal income tax purposes just because a payment hasn’t been made for 36 months.

This reporting can lead to various problems if the debt was not actually discharged. The IRS may initiate compliance activities based on the Form 1099-C, if the debtor does not report the corresponding income. The debtor may still be subject to collection enforcement activity from the creditor. The debtor may believe he has to report discharge of indebtedness income even though the debt has not been discharged. If the debt is discharged in a later tax year, the IRS may not be alerted to it in that later year.

For these reasons, the IRS has issued proposed regulations to remove the 36 month rule. Presumably neither debtors nor lenders will be interested in raising objections to this rule, and it will be made effective and incorporated in final regulations soon.

Prop Reg § 1.6050P-1

Federal Tax Lien Did Not Survive Death of Joint Tenant

Two individuals (Cunning and Wren) acquired real property in the U.S. Virgin Islands as joint tenants with rights of survivorship (JTWROS) in 2005. In 2010 the IRS filed a federal tax lien against Cunning in the U.S. Virgin Islands. Cunning died in 2011, so that Wren succeeded to 100% ownership of the real property.

The IRS sought to continue its tax lien against the real property.The District Court in the Virgin Islands ruled that the lien died with Cunning such that Wren owns the interest free of the tax lien.

In most states, when property is held in joint tenancy with a right of survivorship, liens issued against a deceased joint tenant's interest in the property are extinguished when the deceased joint tenant dies and any other living joint tenants succeed to his share. Federal tax liens do not create any property rights in favor of the IRS beyond those that otherwise exist under state law.  United States v. Craft, 535 U.S. 274, 278. Thus, the IRS has the same rights, and only the rights, of other lienholders in the subject jurisdiction, and is subject to the above general rule in those states where the rule applies.

The legal theory of this general rule is that the surviving joint tenant does not obtain ownership by succession to the the rights of the first joint tenant to die. Instead, the survivor’s interests in the property were established at the time the property was initially conveyed into the joint tenancy. Thus, the survivor did not receive property subject to a lien against the first joint tenant, and that lien is extinguished.

The District Court determined that while there was no case law in the U.S. Virgin Islands on this issue, it believed the Supreme Court of the U.S. Virgin Islands would apply the above general rule. Thus, it found that the IRS lien died with Cunning.

NPA ASSOCIATES, LLC, v. CUNNING, EST, 114 AFTR 2d 2014-XXXX, (DC VI), 10/17/2014

Applicable Federal Rates–November 2014

IRS Modifies Offshore Filing Procedures

The IRS has issued FAQs relating to the new streamlined procedures for offshore compliance, and for Delinquent International Information Return Submission Procedures.

The FAQs for the streamlined program provide more detailed guidance on how the 5% penalty will be computed, how 100% owners of an incorporated business will be treated, and how stock of a foreign corporation will be valued.

The FAQ for Delinquent International Information Return Submission Procedures remove an implied requirement of reporting in the prior IRS announcements – the FAQ provides that these procedures can be used even if the taxpayer has unreported income or unpaid tax from the unreported foreign financial assets. Interestingly, the corollary Delinquent FBAR Submission Procedures remain unavailable for taxpayers with such unreported income or unpaid tax.

Below is a more detailed analysis of the new provisions by my partner, Richard Josepher:

IRS ISSUES NEW FAQS–WHAT IS NOT SAID MAY BE MORE IMPORTANT THAN WHAT IS SAID REGARDING DELINQUENT OFFSHORE FILINGS WHERE THERE IS “REASONABLE CAUSE”–HAS DOOR BEEN OPENED TO FILINGS OUTSIDE OF OVDP and OUTSIDE OF NEW PROCEDURES?

A LOOK AT IRS’ LATEST OFFSHORE FAQs CONCERNING: (1) RELATIONSHIP BETWEEN 2012 OVDP FAQ 18 to 2014 DELINQUENT INTERNATIONAL INFORMATION RETURN PROCEDURES WHERE THERE IS OMITTED INCOME AND (2) STREAMLINED PROCEDURES and 3 YEAR INTERNATIONAL INFORMATION RETURN PENALTY vs. 6 YEAR FBAR PENALTY PERIODS

    The IRS issued updates to its 2014 Offshore Voluntary Disclosure Frequently Asked Questions (“FAQs”) on October 8, 2014.  A careful review of the ramifications of these FAQs results in what may be construed as a tacit admission by the IRS that taxpayers have available to them voluntary disclosure options in addition to four offshore voluntary disclosure options provided by the IRS in its June 18, 2014 changes to the 2012 OVDP (“Offshore Voluntary Disclosure Program). The four options were the (1) OVDP, (2) Streamlined Filing Compliance Procedures, (3) Delinquent FBAR Submission Procedures, and (4) Delinquent International Information Return Procedures (hereinafter the “Four Options”).

    While the IRS does has never expressly stated that there are no offshore voluntary disclosure options other of the Four Options, it has strongly discouraged taxpayers from making disclosures other than under the Four Options. 
   
    For an in-depth discussion of the New Offshore Procedures see the several Rubin On Tax Blog prior articles posted in July and August - the final posting which has links to the prior postings can be viewed here.

    I.     Discussion Regarding Former FAQ 18 and Delinquent International Information Return Procedures.  In Delinquent International Information Return FAQ 1, the IRS  clarifies that, unlike 2012 FAQ 18, under the 2014 Procedures:

“Taxpayers who have unreported income or unpaid tax are not precluded from filing delinquent international information returns (emphasis supplied).”

    The new FAQ was necessary because 2014 FAQ 18 had linked the new Delinquent International Information Return Procedures to 2012 FAQ 18 (the “former FAQ 18"). Former FAQ 18  applied only if a taxpayer had not omitted income from an offshore entity and had reported and paid all taxes.  Specifically,  2014 FAQ 18 stated the following:

“If you have circumstances covered by former FAQ 18, you should not  you should not use OVDP and should see section 3 of the “Options Available For U.S. Taxpayers with Undisclosed Foreign Accounts” (section 3 contains the “Delinquent International Information Return Procedures”).

    2012 FAQ 18 read in part as follows:

“The IRS will not impose a penalty for the failure to file the delinquent Forms 5471 and 3520 if there are no under-reported tax liabilities and you have not previously been contacted regarding an income tax examination or a request for delinquent returns.”

    The October 8, 2014 FAQ 1 clearly distinguishes the 2014 Delinquent International Information Return Procedures from the 2012 procedures. Under 2012 FAQ 18, the fact that there was omitted offshore income or unpaid tax does not disqualify a taxpayer from filing a delinquent international information return.

    Neither the October 8, 2014 FAQ, nor the prior information on the IRS Offshore Web-site explains the rationale for the new FAQ.

    The IRS has not previously stated that it will accept delinquent filings where there is omitted offshore financial asset income–even in cases where the taxpayer can establish “reasonable cause” for the non-reporting. 

    The logical inference from the new FAQ 1 is the following: If there is “reasonable cause” for a failure to file a return associated with a foreign financial asset, since there would be no delinquent information return penalty under current statutory law, there is no basis for the IRS’ imposition of an offshore penalty-whether under the OVDP, the Streamlined Procedures or otherwise.

    As explained in the new FAQ 1, as well as in the explanation of the Delinquent Information Return Procedures issued in June, 2014, the IRS may impose a late filing penalty if an IRS examination determines that “reasonable cause was not established.” Further, there are absolutely no assurances that taxpayers filing delinquent offshore returns outside of the OVDP won’t be subjected to significant penalties to contest or pay  if “reasonable cause” is not established.

    II.    Discussion Regarding Additional Streamlined FAQs (for taxpayers residing in the United States) .  The October 8, 2014 Streamlined FAQs clarify the requirement that while only 3 prior years of income tax returns must be amended and filed and whereas penalties for delinquent international information returns apply for only a three year period, there is 6 year FBAR (FinCen From 114) filing and penalty period. The  5% streamlined penalty base applies for such 3 and 6 year periods.  Further, as stated in FAQ 6 below, even if  delinquent international information returns were filed within the most recent 3 years, if related gross income was not reported, then the asset is included in the penalty base. This would be the case regardless of whether there was “reasonable cause” for the omission and should be considered when considering filing within or outside of the Streamlined Procedures.  FAQ 5 addresses the look-through treatment of disregarded entity as opposed to such assets owned by an entity which is not a disregarded entity. Bank accounts owned by the disregarded entity are considered as owned directly by the owning member whereas bank accounts owned by a corporation are not.

     New FAQs 4,  6 and 7 read as follows:

 “FAQ 4: Q:  I am a U.S. resident making a Streamlined Domestic Offshore submission. I am the 100-percent owner of an incorporated business with various assets, including financial accounts. Does the 5-percent penalty base include the stock in the corporation or just the underlying financial accounts?

 A. The penalty base includes the stock in the corporation (and not the underlying financial accounts) unless it is a disregarded entity for federal income tax purposes. Under the instructions for Form 8938, stock in a foreign corporation is a specified foreign financial asset. Whether the stock in the foreign corporation or the underlying foreign financial accounts are reportable on Form 8938, and therefore are included in the penalty base, depends on whether the corporation is a disregarded entity. If it is, the instructions require the reporting of the underlying foreign financial accounts, which would then be included in the penalty base. However, if the corporation is not a disregarded entity, then the instructions provide that the taxpayer is not considered the owner of the underlying assets solely as a result of the taxpayer’s status as a shareholder. The same principle would apply to assets that are held in a foreign partnership or trust.”

“FAQ 6:Q.     How do I calculate the 5-percent penalty for Streamlined Domestic Offshore filers?

 A.    Begin the computation by identifying the assets included in the penalty base for each of the last six years. These assets include:

--For each of the six years in the covered FBAR period, all foreign financial accounts (as defined in the instructions for FinCEN Form 114) in which the taxpayer has a personal financial interest that should have been, but were not reported, on a FBAR;

--For each of the three years in the covered tax return period, all foreign financial assets (as defined in the instructions for Form 8938) in which the taxpayer has a personal financial interest that should have been, but were not, reported on Form 8938.

  --For each of the three years in the covered tax return period, all foreign financial accounts/assets (as defined in the instructions for FinCEN Form 114 or IRS Form 8938) for which gross income was not reported for that year. (Emphasis added).
        
   Once the assets in the penalty base have been identified for each year, enter the value of the taxpayer’s personal financial interest in each asset as of December 31 of the applicable year on the Certification by U.S. Person Residing in the United States for Streamlined Domestic Offshore Procedures (Form 14654). For any year in which a foreign financial account was FBAR compliant and (for the most recent three years) in which a foreign financial asset was both Form 8938 and Form 1040 compliant, the amount entered on the form will be zero. Once the asset values have been entered on the form, add up the totals for each year and select the highest aggregate amount as the base for the 5-percent penalty.”

“FAQ 7:Q.      I am a U.S. resident who filed compliant tax returns (including Forms 8938) and FBARs for the most recent three years for which tax returns were due. However, I failed to properly report a foreign financial asset in years prior to that and did not make a voluntary disclosure. I am otherwise eligible to make a Streamlined Domestic Offshore submission. May I make a streamlined submission and, if so, how is the 5-penalty calculated?

A.     You may make a streamlined submission. Because the most recent three years are fully compliant, there will be no assets in the penalty base for those years. Follow the procedure in answer 6 above for the three years prior to that to calculate the aggregate year-end account balances and year-end asset values for each of those three years. The penalty is 5 percent of the highest aggregate amount.”

    III.    Conclusion.  The IRS has clarified that  filing of delinquent international information returns is permitted under the 2014 Delinquent International Information Return Procedures even though there is omitted income from the offshore entity. Although the October 8, 2014 FAQs don’t concern late filed FBARs in cases where there is omitted income, by analogy to the Delinquent Information Return Procedures, there is now “FAQ precedent” for the proposition that if the taxpayer has “reasonable cause,” delinquent FBAR filings outside of the Streamlined Procedures should be considered where “reasonable cause” can be demonstrated. There appears to be no reason for the distinctions between late international information return procedures and late FBAR procedures, and a late filed FBAR should not automatically result in a streamlined filing and a 5% penalty. This is especially the case where the filings under the Streamlined Procedures carry no assurances of limited penalties.

    Based upon the foregoing, non-compliant taxpayers who have wondered whether they must pay at least a 5% offshore penalty under the Streamlined Procedures as the price of coming into offshore compliance may now have an  answer from the recent FAQs: A viable compliance option is a filing outside of the OVDP and outside of the Four Options in cases where reasonable cause can be established. The cautious taxpayer should consider obtaining “pre-clearance” similar to that available under the OVDP to assure that he is not disqualified from making a voluntary disclosure. Further, all other appropriate due diligence should be performed so that the filing does not result in unanticipated civil or criminal penalties.  After all, surprises are for kids.

Treasury Makes Life Easier for Holders of Canadian Retirement Account Interests

Summary: Treasury automates the process for U.S. taxpayers making an election to defer taxation of Canadian RRSPs and RRIFs and to eliminate some information reporting requirements as to those accounts.

U.S. persons are generally not subject to U.S. income tax on individual retirement accounts ("IRAs") until distributions are taken. Canada has retirement accounts similar to IRAs. These are known as Canadian registered retirement savings plans (“ RRSPs” ) and registered retirement income funds (“ RRIFs” ). Similar to U.S. treatment, Canada does not impose its income tax on these accounts until distributions are made from them.

If the beneficiary of an RRSP or an RRIF is a U.S. citizen or resident for U.S. income tax purposes, the deferral of U.S. income tax on earnings of the funds that applies to U.S. IRAs does not apply under U.S. income tax law because these are not U.S. IRAs. This can leave the beneficiary in the unhappy situation of being taxed by the U.S. on the earnings of the Canadian retirement accounts as those earnings accrue but are not distributed, and then being taxed by Canada when distributions are made from the account. Since these events may occur in different tax years, foreign tax credits may not be available to eliminate this double taxation.

The Income Tax Convention between the U.S. and Canada provides a relief mechanism for U.S. taxpayers who are beneficiaries of RRSPs and RRIFs. Under Article XVIII(7) of the Convention, as amended by the 2007 Protocol, a natural person who is a citizen or resident of the United States and who is a beneficiary of a trust, company, organization or other arrangement that is a resident of Canada, generally exempt from income taxation in Canada and operated exclusively to provide pension or employee benefits, may elect to defer taxation in the United States, subject to rules established by the competent authority of the United States, with respect to any income accrued in the plan but not distributed by the plan, until such time as and to the extent that a distribution is made from the plan or any plan substituted therefor.

In Rev.Proc. 2002–23, a procedure for making the treaty election was established, which required the filing of a statement each year with the beneficiary's income tax return. In 2004, the IRS released Form 8891, U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans. This Form facilitated the required reporting and the making of the election.

In Rev.Proc. 2014-55, Treasury has now further simplified the treaty election and reporting process. Essentially, qualified taxpayers are treated as having made the treaty election simply by including in gross income distributions made from the RRSP or RRIF. There is no other notice or filing requirement necessary.

This is a little confusing, since most tax elections require some type of statement or filing with the IRS. Here, while the plan is being held and no distributions are being made, no income is reportable pursuant to the election. But the election itself is not made until a later distribution is made that is reported as income. Even that election itself is odd because no statement is made or boxes checked  - the reporting of the income on the return is the whole election. Such election is then given retroactive effect per the statement in the Rev.Proc. that provides the taxpayer "will be treated as having made the election in the first year in which the individual would have been entitled to elect the benefits under Article XVIII(7) with respect to the plan." The election procedures under Rev.Proc. 2002-23 or under Form 8891 no longer apply.

There are 4 requirements before this automatic, retroactive election applies. These are that the beneficiary:

        A) is or at any time was a U.S. citizen or resident (within the meaning of section 7701(b)(1)(A)) while a beneficiary of the plan;

        B) has satisfied any requirement for filing a U.S. Federal income tax return for each taxable year during which the individual was a U.S. citizen or resident;

        C) has not reported as gross income on a U.S. Federal income tax return the earnings that accrued in, but were not distributed by, the plan during any taxable year in which the individual was a U.S. citizen or resident; and

        D) has reported any and all distributions received from the plan as if the individual had made an election under Article XVIII(7) of the Convention for all years during which the individual was a U.S. citizen or resident.

Once made, the election cannot be revoked without the consent of the Commissioner.

If a beneficiary has previously reported the undistributed income of the Canada plan in his or her U.S. gross income, this election is not available without the consent of the Commissioner.

The Rev.Proc. also simplifies the U.S. information reporting in regard to these accounts. Regardless of whether the beneficiary is eligible to make the above election, Forms 8891, 3520 and 3520-A need no longer be filed for these accounts. However, information reporting on Form 8938 and on FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR) will still apply. Previously, there was an exception for Form 8938 reporting if Form 8891 reporting occurred - but since Form 8891 is now obsolete this exception should not apply anymore.

Rev. Proc. 2014-55, 2014-44 IRB, 10/07/2014

Hidden Gift in Merger Transaction

Summary: Disguised gifts found in a merger transaction, along with an interesting story on how the gifts came about.

Most tax practitioners are trained to look behind the transfers occurring in family corporate transactions to determine if a disguised gift is being made. A recent Tax Court case provides a real world example of such gifts

In the case, the parents' manufacturing company was merged with another company owned by their sons. The Tax Court found that the parents' company was substantially undervalued in the merger. Therefore, the parents received less stock in the resulting entity (and the sons received more) than was appropriate based on the relative values of the two companies. This resulted in a taxable gift of $29.6 million from the parents to the sons.

We could stop here and view this as an instructive case on how, if the IRS can successfully challenge values in mergers involving family entities, gifts can arise. However, this case has another interesting aspect.

This is that it is possible that this taxable gift would not have arisen but for the involvement of estate planning attorneys. At a point in time prior to the merger, estate planning attorneys determined that it would be more beneficial for the family if certain intellectual property relating to a manufacturing process for computer circuit boards belonged to the sons' company and not the parents' company. This is because the value of the process would thus not need to be transferred from the parents to the sons during their lifetime or at death in a taxable gift or taxable transfer at death. Factually, however, there was no transfer documentation showing a transfer of ownership of the process from the parents' company where it had been originally developed. Nonetheless, through interviews with the principals and other review of available evidence, the estate planning law firm believed there was enough support to treat the process as having previously been transferred to the sons' company at the time of the formation of that company. They were able eventually to convince the CPAs of the same, even though prior tax returns did not support such a change in ownership of the process. To have some documentation for the ownership in the event of a later IRS examination, the law firm prepared a bill of sale to memorialize a prior transfer of the process to the sons' company.

In valuing the companies in the merger, the position was taken that the ownership of the process was in the sons' company. The Tax Court determined that such a transfer of ownership to the sons' company never took place and thus that the parents' company was worth a lot more in the merger (per the substantial value of the process) than the parents received stock for. This was the source of the large gift found by the Tax Court. One has to wonder whether this gift would have arisen if the estate planning attorneys had not gotten involved.

This case was just resolved. However, the merger and resulting gift occurred in 1995. Thus, in addition to the large gift tax liability, there will be a substantial interest amount due on that gift tax liability. Luckily for the taxpayers, the Tax Court found that based on their reliance on counsel they had reasonable cause for their underpayments of gift tax and are not liable for accuracy -related penalties.

William Cavallaro et ux. v. Commissioner, T.C. Memo. 2014-189

Court Grants 44.75% Fractional Discount in Artwork, but Don't Get Too Excited

SUMMARY: An appellate opinion granting a 44.75% discount for a fractional ownership interest in artwork has limited precedential value.

The Fifth Circuit Court of Appeals recently overruled the Tax Court's 10% fractional interest discount allowed for artwork in an estate tax valuation case. Instead, the appellate court allowed in full the 44.75% discount taken on the Form 706.

The case is of benefit to taxpayers because it does affirm the Tax Court's conclusion that a fractional interest discount is allowable for divided family ownership interests in artwork. The IRS had argued (and lost) before the Tax Court that no fractional interest discount was appropriate. After determining that some fractional discount was appropriate, the Tax Court crafted its own appropriate discount of 10%.

However, the case is not an endorsement the 44.75% discount is appropriate. Instead, the appellate court allowed the full discount taken based more on procedural issues than an objective determination that such a large discount is sustainable in a bona fide valuation dispute. This is because in the Tax Court proceeding, the IRS offered no testimony or evidence on value other than its zero discount position. Once the Tax Court determined that the zero discount position was incorrect, the Tax Court had to determine the value based on the evidence before it. Since the only evidence before it was evidence of the taxpayer supporting the 44.75% discount, the appellate court found that the Tax Court was obligated to accept that 44.75% discount because there was no contrary testimony or evidence offered by the government.

So what does this case offer us? It does sustain a fractional interest discount in artwork in a family situation, but only provides limited guidance as to what an appropriate discount should be. Also, the Tax Court opinion conclusion that restrictions in a co-tenancy agreement that limited the sale of the co--owned art only upon agreement of all owners was not a restriction that could be considered in valuing the fractional interests (i.e., it could not be used to reduce value) is an item to consider in transfer tax valuations. The Tax Court's conclusion was that Code Section 2703(a)(2) prevented the consideration of such a restriction. That Code provision provides that "[f]or purposes of this subtitle, the value of any property shall be determined without regard to... any restriction on the right to sell or use such property." Interestingly, the Tax Court did not hold that the unanimous consent provision was a restriction on sale per se, because cotenants cannot sell the jointly owned property without the consent of all joint owners even without such an agreement. Instead, the unanimous consent provision was interpreted as a waiver of the right of partition of the cotenants, which restriction was nonetheless still described under Code Section 2703(a)(2) and thus was not allowed to enter into the valuation equation.

Estate of Elkins, Junior V. Comm., 114 AFTR 2d 2014-5985 (CA5), 09/15/2014