The Timing of E&P to US Parent Corporations of CFCs

The earnings and profits (E&P) of a corporation dictate the income tax treatment of non-liquidating distributions it makes to its shareholders. Distributions from a corporation to the extent of its current or accumulated E&P are taxable as dividends, which generally results in ordinary income treatment. Other distributions are treated as return of capital, which can result in no taxation or capital gains to the recipient shareholder.

Controlled foreign corporations (CFCs) are non-US corporations owned and controlled by US persons, within specific statutory parameters. US shareholders of CFCs generally must include in income a pro rata share of the Subpart F income of the CFC as such income is earned, and must also include in income non-Subpart F income when it is invested in the US by the CFC.

So what happens to the E&P of a domestic parent corporation of a CFC when that domestic corporation must include income under the above rules? Does the income create E&P as earned, or only upon later distribution of those earnings from the CFC to the domestic parent corporation?

Arguments for delaying the E&P until distribution include (1) the US parent’s ability to make dividend distributions is not increased until it receives an actual distribution from the CFC, (2) a corporation does not generally have E&P on receipt of a corporate distribution until received, and (3) the E&P cannot be in two places at once (both in the parent corporation and the CFC). Despite these arguments, the Associate Chief Counsel (International), in a legal advice memorandum, concludes that E&P is increased at the time the domestic parent corporation incurs income through the Subpart F rules.

This conclusion was based on various aspects of the E&P rules (bearing in mind that E&P is not defined under the Internal Revenue Code). For example, Treasury Regulations Section 1.312-6 ties the initial computation of E&P to gross income when it provides that items “entering into the computation of corporate earnings and profits for a particular period are ... all items includible in gross income under section 61.” Further, such treatment dovetails with Code Section 312(f)(2). Distributions of a CFC are nontaxable to its domestic shareholder to the extent of income previously taxed under these Subpart F rules, and the tax basis of the domestic shareholder is similarly decreased (to offset the increase in basis that occurred when the income was taxable to the domestic shareholder). Code Section 312(f)(2) provides that a nontaxable distribution in which the tax basis of stock is decreased, does not increase the E&P of the distributee corporation. These general E&P rules work in the context of CFC ownership only if E&P increases as income is earned by the CFC.

Legal Advice Issued by Associate Chief Counsel 2015-001

Hollow Taxpayer Victory When IRS Unlawfully Discloses Taxpayer Information to Japan

By law, the U.S. is not permitted to disclose false return information, even if the release of false return information is authorized by law and treaty. Code Section 7431 imposes liability on the U.S. if it discloses return information, the information is false, and the U.S. knew the information was false.

A recent case addressed the application of this Code provision in regard to disclosure of return information by the U.S. to Japan. It makes for interesting reading – one doesn’t read too much about Code Section 7431.

In the case, the U.S. was found liable for violating Code Section 7431 when it made up figures for unreported income in preparing a Simultaneous Examination Proposal that sought to have a joint examination of taxpayers with Japan. The U.S. argued that the estimate was not “return information.”  It also argued that an estimate of unreported income cannot be false because it is only an estimate. The appeals court disagreed and found the U.S. violated the statute.

Code Section 7431(c) provides the damages for a violation. The taxpayers sought an award of $52 million in actual damages, consisting of $47 million in economic damages and $5 million in attorneys’ fees in a successful defense of Japanese tax assessments (although these damages included damages for other disclosures which were found not to violate Code Section 7431). Code Section 7431(c) does allow for actual and punitive damages. However, the appeals court was not convinced that the disclosure caused any damages to the taxpayer, since the taxpayers could not prove that “but for” the false information, Japan would not have otherwise audited the taxpayer. That is, the taxpayers did not meet their burden of proof that Japan would not have audited if they had not received this information – the court noted that there was other information that could have triggered the audit.

In the absence of actual or punitive damages, the statute provides for $1,000 per incident statutory damages. Finding three violations, the appellate court awarded $3,000 in damages. Thus, the taxpayers won their case for liability, but were unable to prove any material actual damages. The taxpayers surely did not pursue this matter solely for $3,000 in damages.

The taxpayers may still be able to get their attorneys fees paid – that issue has not yet been decided.

ALOE VERA INC v. U.S., 115 AFTR 2d 2015-XXXX, (DC AZ), 02/11/2015

Applicable Federal Rates–March 2015

Getting to Appeals In an Estate or Gift Tax Audit with Pending Information Requests

Ain’t gonna happen! So says the IRS in guidance released by the IRS, at least in most circumstances.

In a memo to IRS estate and gift tax examination employees, the IRS advises:

1. If information requested by the IRS in an IDR (Form 4564, Information Document Request) or other correspondence is not provided, the auditor’s group manager will discuss the case with the taxpayer to facilitate receipt of the information. Generally, the case should not be sent to Appeals until the information has been provided.
2. If the requested information is provided, or the taxpayer advises there is no additional information, then the auditor should issue a 30-day letter and provide the taxpayer with the opportunity to request an Appeals conference.
3. If the requested information is not provided and the taxpayer has not advised there is no additional information, then the initial examination report should be issued,along with Letter 5262-D, Additional Information Due – Estate and Gift, along with the original IDR or a new IDR incorporating the undelivered items. The taxpayer will then have 15 days to provide or confirm they do not have the requested information. After certain prescribed contacts with the taxpayer, if the taxpayer refuses to provide the requested information, then the examiner should close the case to Technical Services for issuance of a statutory notice of deficiency.

The policy is that the examiners are to be the first finders of fact and are responsible for taking relevant testimony and examining books, papers, records, memoranda, and returns. As such, factual items should not first be introduced at the appellate level, at least as to items requested by the IRS. The penalty for not providing the requested items is the loss of access to Appeals review.

As noted, if the taxpayer advises that there is no additional information available to respond to the request, this serves the same function as actually providing the information.

Memorandum for all SB/SE Estate and Gift Tax Employees regarding Interim Guidance on Letter 5262-D, Additional Information Due – Estate and Gift, dated January 30, 2015 (Control #: SBSE-04-0115-0015

Does a Tenant Cohabitate?

Marital agreements and trust agreements often employ the term “cohabitate” or “cohabitation.” Typically, these agreements provide for the end of trust distributions, alimony, occupancy of property, or other benefits, when the subject persons commences to cohabitate with another.

In a recent Florida case, a marital settlement agreement provided that the husband would no longer have to pay alimony to his former spouse if she remarried or if she engaged in “cohabitation with a male.” The former wife owned a two bedroom townhouse. At some point, she took on a male tenant, who paid her $400 of monthly rent. The tenant and the former wife lived largely separate lives. They slept in separate bedrooms and did not have an intimate relationship. They dated other people, and usually ate separately. One would not expect that this constituted cohabitation, as generally used in these type of agreements.

Nonetheless, the trial ruled that the former wife was cohabitating with the tenant, and thus her former husband no longer had to pay her alimony. Coming to the rescue of the usual meaning of cohabitation in this context, the appellate court reversed, finding no cohabitation.

The court did not develop a working definition of cohabitation. It did note that it requires something more the mere presence of someone else under the same roof. In effect, it also found that a mere landlord/tenant relationship does not create cohabitation. It suggested that one party economically supporting the other could create cohabitation.

In the end it reviewed other case law, mostly from outside of Florida, and noted that the former wife and the tenant “shared a roof but they did not share their lives” and thus did not cohabitate.  Not exactly a precise definition, but more precise than U.S. Supreme Court Justice Potter Stewart’s infamous definition of obscenity as “I know it when I see it!”

Atkinson v. Atkinson, 40 Fla. L. Weekly D404a (2nd DCA, February 11, 2015)

CARE Act Battleground

The Republicans to date have not put forth an alternative to Obamacare. To fill this vacuum, Senator Richard Burr has put forth an alternative to Obamacare – the Patient Choice, Affordability, Responsibility, and Empowerment Act (the “CARE” Act). This proposed act is likely to be a battleground in the 2016 congressional and presidential races. If the Republicans should win majorities in both houses of Congress and the presidency, there is a reasonable likelihood that many of the provisions of this act, in some form, could find its way into law. The act would repeal Obamacare in its entirety, other than its Medicare provisions, and replace it.

 

Since this is a tax blog, let’s focus on key tax aspects of such a repeal and replacement, with a few minor comments. Items that would disappear if passed include:

1. The individual insurance mandate and employer responsibility provisions, as well as the associated penalty tax provisions and refundable tax credit for lower income families to buy health insurance.
2. The increased hospital insurance (HI) tax for high-earning workers and self-employed taxpayers.
3. The 3.8% surtax on unearned income of higher-income individuals (good riddance – the unnecessary complexity of this tax borders on the absurd and makes me nauseous).
4. The higher threshold for deducting medical expenses.
5. The $2,500 dollar cap on contributions to health FSAs.
6. The ban on the cost of over-the-counter medicines being reimbursed with excludible income through a health flexible spending arrangement (FSA), health reimbursement account (HRA), health savings account (HSA), or Archer MSA, unless the medicine is prescribed by a doctor.
7. The $500,000 compensation deduction limit for health insurance issuers.
8. The excise tax on medical device manufacturers (good riddance – taxing medical innovations of course leads only to less medical innovation).
9. The excise tax on health insurance providers.
10. The 40% nondeductible excise tax on high-cost employer-provided health insurance coverage.

What will come in for lower income persons is a tax credit to assist in purchase their own plans on the open market – an attempt to instill competition and free market benefits into medical insurance while still providing an insurance safety net.

 

Coverage for pre-existing medical conditions will continue – but ONLY if the insured has kept up at least catastrophic coverage for a period of time. That is, individuals are incentivized to buy at catastrophic coverage when healthy instead of waiting until they get a serious condition and then buying insurance.

 

Information on the CARE Act can be found HERE, which includes links to other summaries and a comparison to Obamacare.

 

Patient Choice, Affordability, Responsibility, and Empowerment Act

At What Price Certainty?

The complexity of federal tax law is well known. Oftentimes, questions come up that are not answered clearly in the law. To help taxpayers obtain answers they can rely on, the IRS will issue private letter rulings as to the IRS’ take on a specific question (if on a subject that the IRS will rule on). The IRS will be bound by its ruling (but only as to the requesting taxpayer).

If my memory serves me correctly, once-upon-a-time the IRS did not charge for these rulings. Then, to help offset costs for this “service” the IRS started to charge for them. The user fees have increased significantly over the years.

Per Rev.Proc. 2015-1, the user fee for a private letter ruling is now the astonishing sum of $28,300. One has to seriously doubt whether the IRS has crossed from obtaining an offset to costs to making a significant profit on such requests. Such a high cost also acts as a significant deterrent to taxpayer requests, even as the complexity of the tax law expands each year.

The user fee is reduced to $2,200 for taxpayers with a gross income under $250,000 and $6,500 for gross income between $250,000 to $1 million. Apparently, the politics of regressive income tax rates also applies to user fees. Kind of like having your cable TV bill vary by what your income is – a swell idea!

There are special rates for certain types of rulings that are also lower. For example, Section 9100 relief for late elections will cost less than $28,000 – but lower income taxpayers will pay the same as for a regular private letter ruling. Such fees in effect constitute a penalty for taxpayers that were untimely in making an election and that need a private letter ruling to make a late election.