IRS Error in Extending Statute of Limitations for Wrong Year is Disregarded

When a taxpayer files a federal tax return, the IRS generally has a 3 year statute of limitations period to assess additional tax beyond that reported on the return. If the tax year is audited, the auditor may ask the taxpayer to file a Form 872 that extends the statute of limitations so there is more time to complete the audit.

In a recent Tax Court case, an auditor had obtained a Form 872 from the taxpayer. However, the Form 872 was filled in with the wrong tax year. The IRS ultimately issued a notice of proposed assessment. This was done beyond the original 3 year statute of limitations period, but before the expiration date indicated in the erroneous Form 872 extension. The taxpayer claimed that the proposed assessment was barred by the statute of limitations since the Form 872 did not apply to the subject tax year.

The Tax Court ruled in favor of the government. It reviewed the facts and found that BOTH the taxpayer and the government had made a mistake – they both thought the Form 872 applied to the tax year under audit. Based on a mutual mistake theory, the Tax Court reformed the Form 872 to apply to the audit tax year.

Under the Tax Court’s theory, a different result may arise if the taxpayer had noticed the IRS’ mistake on the Form 872, but signed it anyway (and could otherwise provide this). In that circumstance there would not have been a mutual mistake – the IRS would have made a mistake but the taxpayer would have signed intending to extend the statute of limitations on the year described in the form. Perhaps there may be some case law that already supports the taxpayer or the government in that scenario – I haven’t checked.

Hartland Management Services, Inc., et al. v. Commissioner, TC Memo 2015-8, January 12, 2015

The Law is an Ass

The law is an ass, or so says Charles Dickens. After reading the IRS’ latest missive on sales of marijuana, I think I agree.

The tension between federal and state law on the sale of marijuana carries over to federal income taxes. While the sale of marijuana is legal in some states at varying levels (e.g., medical use only vs. recreational use), it is still a controlled substance under federal criminal law. Thus, a state-legal marijuana seller is still an illegal enterprise. Interestingly, under federal tax law, the proceeds of criminal operations are still subject to income tax – as Al Capone learned.

Complicating the life of an illegal drug seller is Code Section 280E that says a taxpayer may not deduct any amount for a trade or business when the business consists of trafficking in Schedule I or Schedule II controlled substances.However, due to constitutional concerns that the income tax cannot be a gross receipts tax, the Senate Report to that code section said the reduction of gross receipts by the cost of goods sold should still be allowed.

A few years later, the uniform capitalization rules of Code Section 263A were enacted. These rules can create reduction in income from the sale of goods by capitalizing expenses that previously would not be included in cost of goods sold.

So getting us to the recent announcement, the IRS is now advising that these new expenses that would be capitalized under Code Section 263A cannot be capitalized for persons selling marijuana, because this would allow a taxpayer to have more in deductions than Code Section 280E should allow under the extra-official allowance of a reduction for cost of goods sold that is allowed by a mere Senate Report and not the law itself. Did I lose you? To implement this ridiculousness, the IRS is telling taxpayers to use the “old” Code Section 471 rules (under regulations issued before Code Section 263A) in determining what goes into cost of goods sold for these taxpayers. This doesn’t even get to the craziness of applying an anti-drug dealer provision of the Code (Code Section 280E) to businesses authorized under state law.

The IRS also struggled with the question of whether sellers of marijuana that nonetheless still use the cash method of accounting, should be forced onto the inventory/accrual method so as to be able to get these reductions. Persons that have that as an issue should consult the IRS pronouncement.

Chief Counsel Advice 201504011

Applicable Federal Rates–February 2015

No Private Letter Rulings in These Estate Planning Areas

Taxpayers who have questions about the applicability of tax law can submit a Private Letter Ruling request to the IRS. If the IRS rules, then the taxpayer can rely on the ruling as to how the law applies to their situation (although other taxpayers may not rely on the ruling). In recent years, the cost of applying has become very expensive. Nonetheless, under the right circumstances, a Private Letter Ruling can provide value and important guidance to taxpayers.

The IRS publishes a list annually of items that they will not rule on. This year, the IRS added two new estate planning issues to the list. These new additions are rulings on:

1. Actuarial factors for valuing interests in the prospective gross estate of a living person; and
2. Classification for Federal tax purposes of a fideicomiso or other land trust created under local law, applying the principles of Rev. Rul. 2013-14, 2013-26 I.R.B. 1267 (relating to whether certain Mexican land trusts should be characterized as a trust under the Internal Revenue Code), or Rev. Rul. 92-105, 1992-2 C.B. 204 (relating to whether a taxpayer's interests in an Illinois land trust qualified as real property for purposes of a Section 1031 exchange).

Thus, taxpayers with questions in this area will not be able to receive the benefit of a Private Letter Ruling.

Rev Proc 2015-3, 2015-1 IRB 129 (Jan. 2, 2015)

National Taxpayer Advocate 2014 Annual Report to Congress

The National Taxpayer Advocate has issued her annual report. This report highlights areas of tax law and IRS administration that are not in compliance with law or that require improvement. While Congress and the IRS will review the report, they are not bound to address any of the problems or implement any of the recommendations.

There are a lot of items in the report. A good way to quickly absorb the report is to review the table of contents – so I have copied and reformatted it below, for your viewing pleasure. Read the whole report here.

THE MOST SERIOUS PROBLEMS ENCOUNTERED BY TAXPAYERS

The Right to Quality Service

TAXPAYER SERVICE: Taxpayer Service Has Reached Unacceptably Low Levels and Is Getting Worse, Creating Compliance Barriers and Significant Inconvenience for Millions of Taxpayers

TAXPAYER SERVICE: Due to the Delayed Completion of the Service Priorities Initiative, the IRS Currently Lacks a Clear Rationale for Taxpayer Service Budgetary Allocation Decisions

IRS LOCAL PRESENCE: The Lack of a Cross-Functional Geographic Footprint Impedes the IRS’s Ability to Improve Voluntary Compliance and Effectively Address Noncompliance

APPEALS: The IRS Lacks a Permanent Appeals Presence in 12 States and Puerto Rico, Thereby Making It Difficult for Some Taxpayers to Obtain Timely and Equitable Face-to-Face Hearings with an Appeals Officer or Settlement Officer in Each State

VITA/TCE FUNDING: Volunteer Tax Assistance Programs Are Too Restrictive and the Design Grant Structure Is Not Adequately Based on Specific Needs of Served Taxpayer Populations

The Right to a Fair and Just Tax System: Complexity

HEALTH CARE IMPLEMENTATION: Implementation of the Affordable Care Act May Unnecessarily Burden Taxpayers

OFFSHORE VOLUNTARY DISCLOSURE (OVD): The OVD Programs Initially Undermined the Law and Still Violate Taxpayer Rights

PENALTY STUDIES: The IRS Does Not Ensure Penalties Promote Voluntary Compliance, as Recommended by Congress and Others

COMPLEXITY: The IRS Does Not Report on Tax Complexity as Required by Law

COMPLEXITY: The IRS Has No Process to Ensure Front-Line Technical Experts Discuss Legislation with the Tax Writing Committees, as Requested by Congress

WORKLOAD SELECTION: The IRS Does Not Sufficiently Incorporate the Findings of Applied and Behavioral Research into Audit Selection Processes as Part of an Overall Compliance Strategy

The Right to Be Informed: Access to the IRS

ACCESS TO THE IRS: Taxpayers Are Unable to Navigate the IRS and Reach the Right Person to Resolve Their Tax Issues

CORRESPONDENCE EXAMINATION: The IRS Has Overlooked the Congressional Mandate to Assign a Specific Employee to Correspondence Examination Cases, Thereby Harming Taxpayers

AUDIT NOTICES: The IRS’s Failure to Include Employee Contact Information on Audit Notices Impedes Case Resolution and Erodes Employee Accountability

VIRTUAL SERVICE DELIVERY: Despite a Congressional Directive, the IRS Has Not Maximized the Appropriate Use of Videoconferencing and Similar Technologies to Enhance Taxpayer Services

The Right to Be Informed: Adequate Explanations

MATH ERROR NOTICES: The IRS Does Not Clearly Explain Math Error Adjustments, Making it Difficult for Taxpayers to Understand and Exercise Their Rights

NOTICES: Refund Disallowance Notices Do Not Provide Adequate Explanations

The Rights to Privacy and to a Fair and Just Tax System

COLLECTION DUE PROCESS: The IRS Needs Specific Procedures for Performing the Collection Due Process Balancing Test to Enhance Taxpayer Protections

FEDERAL PAYMENT LEVY PROGRAM: Despite Some Planned Improvements, Taxpayers Experiencing Economic Hardship Continue to Be Harmed by the Federal Payment Levy Program

OFFERS IN COMPROMISE: Despite Congressional Actions, the IRS Has Failed to Realize the Potential of Offers in Compromise

OFFERS IN COMPROMISE: The IRS Does Not Comply with the Law Regarding Victims of Payroll Service Provider Failure

MANAGERIAL APPROVAL FOR LIENS: The IRS’s Administrative Approval Process for Notices of Federal Tax Lien Circumvents Key Taxpayer Protections in RRA 98

STATUTORY NOTICES OF DEFICIENCY: Statutory Notices of Deficiency Do Not Include Local Taxpayer Advocate Office Contact Information on the Face of the Notices

LEGISLATIVE RECOMMENDATIONS

Taxpayer Bill of Rights

TAXPAYER RIGHTS: Codify the Taxpayer Bill of Rights and Enact Legislation that Provides Specific Taxpayer Protections

The Right to Quality Service

ACCESS TO APPEALS: Require that Appeals Have At Least One Appeals Officer and Settlement Officer Located and Permanently Available within Every State, the District of Columbia, and Puerto Rico

RETURN PREPARATION: Require the IRS to Provide Return Preparation to Taxpayers in Taxpayer Assistance Centers and Via Virtual Service Delivery

VIRTUAL SERVICE DELIVERY (VSD): Establish Targets and Deadlines for the Development and Implementation of VSD in Brick & Mortar Locations, in Mobile Tax Assistance Units, and Over the Internet

The Right to a Fair and Just Tax System: Complexity

SECTION 501(c)4) POLITICAL CAMPAIGN ACTIVITY: Enact an Optional “Safe Harbor” Election That Would Allow IRC § 501(c)(4) Organizations to Ensure They Do Not Engage in Excessive Political Campaign Activity

FOREIGN ACCOUNT REPORTING: Legislative Recommendations to Reduce the Burden of Filing a Report of Foreign Bank and Financial Accounts (FBAR) and Improve the Civil Penalty Structure

PENALTIES: Improve the Proportionality of the Civil FBAR Penalty

PENALTIES: Require the Government to Prove Actual Willfulness Before Imposing the Penalty for Willful FBAR Violations

CLOSING AGREEMENTS: Authorize the IRS to Modify Closing Agreements to Treat Taxpayers Who Correct Violations Early the Same As (or Better Than) Those Who Correct Them Later

FBAR FORMS: Reduce the Burden of Foreign Account Reporting

FILING STATUS: Clarify the Definition of “Separate Return” in IRC § 6013 and Allow Taxpayers Who Petition the Tax Court to Change Their Filing Status to Married Filing Jointly in Accordance with the Tax Court’s Rules of Practice and Procedure

ERRONEOUS REFUND PENALTY: Amend Section 6676 to Permit “Reasonable Cause” Relief

The Right to Be Informed: Access to the IRS

ACCESS TO THE IRS: Require the IRS to Publish a Public Phone Directory and Report on Implementing an Operator System Similar to “311” Lines

IRS CORRESPONDENCE: Codify § 3705(a)(1) of RRA 98, Define “Manually Generated,” and Require Contact Information on Certain Notices in All Cases

The Right to Be Informed: Adequate Explanation

ANNUAL NOTICES: Require the IRS to Provide More Detailed Information on Certain Annual Notices it Sends to Taxpayers

The Rights to Appeal and to Challenge the IRS’s Position and Be Heard

EO JUDICIAL AND ADMINISTRATIVE REVIEW: Allow IRC § 501(C)(4), (C)(5), or (C)(6) Organizations to Seek a Declaratory Judgment to Resolve Disputes About Exempt Status and Require the IRS to Provide Administrative Review of Automatic Revocations of Exempt Status

STANDARD OF REVIEW: Amend IRC § 6330(d) to Provide for a De Novo Standard of Review of Whether the Collection Statute Expiration Date Is Properly Calculated by the IRS

APPELLATE VENUE IN NON-LIABILITY CDP CASES: Amend IRC § 7482 to Provide That the Proper Venue to Seek Review of a Tax Court Decision in Collection Due Process Cases Lies with the Federal Court of Appeals for the Circuit in Which the Taxpayer Resides

The Rights to Privacy and to a Fair and Just Tax System

OFFERS IN COMPROMISE: Authorize the National Taxpayer Advocate to Determine Whether an Offer in Compromise Submitted by a Victim of Payroll Service Provider Fraud Is “Fair and Equitable”

MANAGERIAL APPROVAL FOR LIENS: Require Managerial Approval Prior to Filing a Notice of Federal Tax Lien in Certain Situations

MANAGERIAL APPROVAL: Amend IRC § 6751(b) to Require IRS Employees to Seek Managerial Approval Before Assessing the Accuracy Related Penalty Attributable to Negligence under IRC § 6662(b)(1)

CONTACT INFORMATION ON STATUTORY NOTICES OF DEFICIENCY: Revise IRC § 6212 to Require the IRS to Place Taxpayer Advocate Service Contact

Information on the Face of the Statutory Notice of Deficiency and Include Low Income Taxpayer Clinic Information with Notices Impacting that Population

LATE-FILED RETURNS: Clarify the Bankruptcy Law Relating to Obtaining a Discharge

IRS Hammers Offshore Lending and Underwriting Structure

In a recent Chief Counsel Advice, in an extended analysis the IRS determined that an offshore partnership with a U.S. manager that was engaged in the finance transactions was determined to be engaged in a U.S. trade or business. This conclusion subjects the non-U.S. partners to U.S. income taxes.

The partnership had no employees, and conducted all of its activities through a U.S. manager. The partnership, through the manager, engaged in commercial lending transactions and stock distribution (underwriting) activities. The CCA is interesting both to its in-depth analysis of the trade or business issues, and its conclusions.

In finding taxability, the CCA found:

   a. The U.S. activities of the manager were attributable to the partnership. This is in line with general authority that agent activities are attributable to principals in determining the trade or business status of a foreign principal. This is a typical fatal flaw in the desire to set up a business in a tax haven jurisdiction and avoid U.S. income taxes, while running the business with people in the U.S.

   b. The level of activities of the partnership were significant enough to cross the line from investment activities to trade or business activities. Generally, to be a trade or business the activities must be considerable, continuous and regular. Here, there were “numerous loans” and “dozens of underwriting agreements” justifying trade or business status.

   c. The partnership then sought the protection of Code Section 864(b) which has two safe harbors against trade or business status for the effecting of transactions in stocks or securities. The IRS first found that the lending and underwriting activities were not “the effecting of transactions in stocks or securities” and thus could not use the safe harbors. But even if that was not the case, it went on to pronounce:

1. The first exception for trading through an independent agent if the taxpayer does not have a U.S. office does not fly here because an agent with “discretionary authority” is not an independent agent. The CCA went through the history of the exception in making this conclusion as to discretionary agents.

2. The second exception, which allows the use of a non-independent agent, and which relates to trading for one’s own account, was swatted down because the CCA viewed the partnership as a “dealer” – dealers cannot use this exception.

Now a CCA is not law, just the IRS’ view on the law. Nonetheless, taxpayers with similar structures should be alerted to potential challenges to any filing positions that are inconsistent with these conclusions.

Chief Counsel Advice 201501013

House of Representatives Adopts Dynamic Scoring

Proposed legislation is subject to an analysis that estimates its effect on the budget deficit. Under static scoring, the legislation itself is not assumed to change the economy. Thus, for example, if a 1% drop in tax rates is proposed, the effect on the deficit can be easily computed by reducing anticipated tax revenues from that tax by 1%.

Dynamic scoring recognizes that the change in taxes will further influence taxpayer behavior, which will further affect revenues received (separate and apart from the change in rate itself). In the above example, it would say that the drop in revenue will actually be less than 1%, because taxpayers would be encouraged to participate more in the taxed activity, thus increasing overall amounts subject to the tax. Alternatively, a tax hike of 1% would not bring in 1% additional revenue, but something less because taxpayers would now be disincentived from participating in the taxed activity, so less tax revenues from it will arise than if the tax was unchanged.

This is probably more intellectually honest than static scoring. But since it involves estimates, it has a greater chance of error and/or manipulation. Given that the budget estimates themselves tend to be far off from reality anyway, with or without dynamic scoring, perhaps the intellectually honest approach is the best approach. The politics are that those who want to cut taxes generally favor dynamic scoring, while those who oppose tax cuts prefer static scoring. The politics are more muddied when looking at the question of whether or how much to raise taxes.

The House of Representatives this week adopted dynamic scoring, but only as to big ticket legislation.

Another Circuit Finds Federal Substance over Form Doctrine Inapplicable in Transferee Liability Case

For a transferee of assets to be held liable under Section 6901 for the income taxes of the transferor, two elements must be met. First, the party must be a transferee under Section 6901. This is a federal law question, and state law concepts are not relevant. In the subject case, lower tier shareholders of a corporation that received proceeds relating to a sale of stock of the corporation, were deemed to receive proceeds from the sale of assets of the corporation when the IRS applied the substance over form doctrine to create a deemed sale of assets. Thus, they were transferees under this first element by reason of the federal substance over form doctrine. The IRS was seeking to impose transferee liability on the lower tier  shareholders for the corporate income tax imposed on the deemed sale of corporate assets.

The second requirement is that the transferee be subject to liability at law or in equity, applying state law (and not federal law). This often involves the question of whether state fraudulent conveyance law applies. In the subject case, the IRS argued that once the taxpayers were found to be transferees under federal law under the first element above, then they would be deemed to be transferees when testing liability under state fraudulent conveyance law. That is, the IRS was arguing that state law liability is assessed based upon the transaction as recharacterized by federal tax law.

The Ninth Circuit Court of Appeals held that the IRS position was wrong. That the taxpayers were "transferees" under federal substance over form law, did not make them "transferees" in determining state law transferee liability. This was based on the observation that allowing the federal determination to apply would put the IRS in a different status as creditor than other creditors seeking to collect under the applicable state law.

The subject case is not the first pronouncement of this principle. It had previously been enunciated by the Second Circuit Court of Appeals in a case involving the same facts, and by two other circuits.

Interestingly, the Circuit Court of Appeals nonetheless found that the taxpayers were "transferees" under state law anyway, without the assistance of the federal substance over form doctrine.

Salus Mundi Foundation, 114 AFTR 2d ¶2014-5556 (CA 9 12/22/2014)

PLR Confirms Section 332 Coverage of Check-The-Box Election of Wholly-Owned Subsidiary

When an existing corporation makes a check-the-box election to be a disregarded entity, this is treated as a corporate liquidation. This can result in gains to the electing entity under Code Section 337 pursuant to a deemed sale of assets, and gains to the shareholder on a deemed disposition of its stock.

Regs. Section 301.7701-3(g)(2)(ii) implies that Code Section 332 applies to a conversion of an existing corporation to a disregarded entity when it is owned wholly by a domestic parent corporation. A recent private letter ruling expressly confirms this. The ruling further confirms the application of all of the benefits and consequences of a Code Section 332 liquidation applying at the time of the election (when otherwise applicable), including no gain or loss to the parent corporation, no gain or loss to the electing subsidiary, carryover basis for the subsidiary’s assets, carryover holding periods for those assets, and carryover of corporate attributes under Code Sections 381-384.

PLR 201452016, December 26, 2014