Withholding Agents–Obligation to Withhold On Payments to Foreign Persons When Source of Payment Uncertain

In recent guidance to auditors, the IRS discusses what happens when a payor withholding agent pays items to a foreign payee when the withholding agent is uncertain whether the payment is U.S. source.

By way of background, Code Sections 1441 and 1442 impose a 30% withholding obligation (less under treaties) on payors of U.S. source fixed or determinable annual or periodical income (FDAPI). In most cases, the payor will know if the source is U.S. source. The guidance notes these common rules:

• Interest income is generally sourced to the residence of the payor;
• Dividend income is generally sourced to the place of incorporation of the payor/issuer;
• Substitute dividends or substitute interest, as paid in securities lending or sale-repurchase transactions, are generally sourced the same as the interest or dividend paid on the transferred securities;
• Rental income is generally sourced to the location of the property;
• Royalty income arising from natural resources are generally sourced to the location of the property;
• Royalty income arising from patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises, and “other like property” are generally sourced to where the property is used; and
• Compensation for personal services is generally sourced to where the services are performed.

If the withholding agent cannot determine the source of the payment, it must assume it is U.S. source and withhold (although there is a procedure of escrowing it up to a year to provide time to determine the source). Withholding agents that should have withheld but didn’t may be subject to penalties and responsibility for the tax.

The guidance outlines one fact pattern that can be a trap for the unwary. It describes a payment to a foreign attorney for services. Since the attorney is foreign and situated abroad, the withholding agent may assume that the payment is for services rendered abroad and thus is foreign source compensation and not subject to withholding. The guidance warns that the withholding agent must first determine where the attorney actually performed the services, to see if any were performed in the U.S. – absent such a determination, the withholding agent falls into the “cannot determine source” rule above and needs to withhold on 100% of the payment.

Thus, in any situation where compensation is being paid for services rendered, the withholding agent should conduct due diligence to determine where in fact those services were performed, to avoid risk of penalty and liability for tax.

International Practice Service Concept Unit RPW/CU/P_08.1_04 (2016)

Applicable Federal Rates – July 2016

Whose Fraud Extends the Statute of Limitations on Assessment?

The IRS generally has 3 years to assess additional tax after a return is filed. Code Section 6501(a).However, an important exception is Code Section 6501(c)(1). Under that provision, if there is fraud in regard to the preparation of a return, there is no statute of limitations for assessment of tax relating to that return.

Clearly, if the taxpayer commits the fraud, the extended statute of limitations provision applies.

A recent case reminds us that if it is the return preparer, and not the taxpayer, that commits the fraud in regard to a return, the extended statute still applies. Seems a little unfair, but c'est la vie.

Finnegan v. Commissioner, T.C. Memo. 2016-118 (June 16, 2016)

IRS Tax Liens and Discretionary Trust Interests - Part 2

In April, I wrote how a U.S. District Court held that a beneficiary’s discretionary interest could be liened by the IRS for tax liabilities of the beneficiary. The interest was  “halfway” between a purely discretionary interest and a mandatory HEMS ascertainable standard interest (health, education, maintenance, support) clause - it provided for HEMS-like distributions, but only in the “sole discretion” of the trustee. You can read my post here.

The District Court has now issued an order relating to enforcement of the lien. The IRS sought an order forcing a distribution to pay the beneficiary’s liabilities. The District Court denied the IRS’ request.

The IRS’ rights under its lien only extend as far as the beneficiary’s right to trust funds. Here, that right “has no permanently fixed dollar value” and “is variable according to [his] needs.” The amount of the beneficiary’s interest is equal to “payments the withholding of which would constitute an abuse of discretion in applying an ascertainable standard.”  This could vary from $0 to some other dollar amount.

The Court noted that the beneficiary’s right can be “assigned a reasonably accurate dollar value by assessing [his] current needs and living demands.” The problem was that the IRS provided no evidence of the beneficiary’s needs or demands and therefore there is no reason to think the lien extends to all the trust funds.

Is this last part true - can a dollar value be assigned? If the clause was a mandatory HEMS clause, the answer should be yes (albeit difficult to calculate) because of the judicial and IRS fiction that HEMS standards are capable of being calculated and enforced. But here, the trustee had “sole discretion” to determine the distribution within the authorized standard for distribution. Typically, a trustee with sole discretion still has a duty to operate with good faith. Per the reference above to abuse of discretion, the court appears to be saying that there is some number that can be calculated - it is not the amount that a mandatory distribution under the standard would require but that minimum amount the trustee would need to distribute without being deemed to violate his or her discretion. If that is what the court is saying, then I would agree with the analysis. But heaven knows how a trial court in a tax case will determine that!

The government also argued that it should be able to force a distribution since at the death of the beneficiary the remaining trust assets would pass to the beneficiary’s estate. An interesting argument, but one which the court did not entertain since it was raised too late in the procedural process.

Duckett v. Enomoto, Et Al., 117 AFTR 2d 2016-XXXX, (DC AZ), 06/06/2016

Federal Tax Overpayment & Underpayment Interest Rates–3rd Quarter 2016

Taxpayer Required to Pay Tax Twice on the Same Income - Tax Court Unsympathetic

A taxpayer in the medical supply business received payments from Cigna before 2005. He reported those items in income and paid federal income tax on them.

A dispute later arose and the taxpayer returned payments to Cigna. He did not deduct the repayments in the year of repayment, even though Code Section 1341 might have allowed it.

In 2010, Cigna paid the funds back to the taxpayer in resolution of the dispute. The taxpayer did NOT report those payments, reasoning that he had already paid income tax on them the first time he received them.

The IRS disagreed, and the Tax Court concurred - the taxpayer was required to include the 2010 payments in income. Maybe this is the correct technical result, but there is no doubt here that the taxpayer did pay tax twice on the same income. Sometimes that expression “the law is an _ss” is absolutely true.

Perhaps the tax year(s) for the refunding he made had not expired, and he was able to file a refund claim and gain some type of tax benefit to offset the double tax - since the opinion is silent in that regard, I am guessing the taxpayer did not.

Worse yet, the taxpayer got hit with a substantial underpayment of tax penalty. That penalty does not apply if the taxpayer acted with reasonable cause. I would think that a lay taxpayer could easily believe that the income taxed before 2005 was the same income that he received in 2010 and that he need not pay tax on it again, and thus such a belief would be reasonable. The Tax Court did not, perhaps on facts not disclosed in the opinion, and it upheld the penalty.

Ita A. Udeobong v. Commissioner, TC Memo 2016-109

What Happens to Jointly Owned Property When One of the Owners Owes the IRS

Leonard and Joyce owned 50% of a commercial property. Their son, Derek, owned the other 50%. The IRS liened the property due to amounts owed by Leonard and Joyce to the IRS for unpaid taxes. The IRS sought to foreclose its tax liens and force a sale of the property. 50% of the proceeds would go to the IRS, and 50% would go to Derek.

The taxpayers argued that the district court should not order the sale.

Code Section 7403 provides authority to the government to file suit to enforce its lien and force a sale of the liened property. There is no exception in Section 7403 that prevents its operation even though there are “innocent third-party” interest holders in the subject  property that do not owe taxes to the IRS. The U.S. Supreme Court, in US v. Rodgers, 461 US 677 (1983), confirmed that the Code Section authorizes the sale of the whole property in these circumstances, and that the Supremacy Clause of the U.S. Constitution overrides any state law to the contrary that seeks to protect innocent third-party interest holders.

However, Code Section 7403 says the district court “may” order a forced sale, not “shall.” The Supreme Court in Rodgers acknowledged the district court has discretion to not order a sale, but that discretion is not unbridled and should be exercised only sparingly. It provided four factors for consideration in making this determination: (1) the prejudice to the government's interest as the result of a partial, rather than a total, sale, (2) whether the third party with a non-liable separate interest in the property would, in the normal course of events ... have a legally recognized expectation that that separate property would not be subject to forced sale by the delinquent taxpayer or his or her creditors, (3) the prejudice to the third party as the result of a total sale, and (4) the relative character and value of the non-liable and liable interests held in the property.

The district court considered the four Rodgers factors, and determined to allow the sale to proceed. In so ruling, the court noted:

a. the government would be unduly prejudiced without a forced sale, since a partial sale is not viable;

b. the prejudice to Derek is minimal since he does not live on the premises and will receive 50% of the sale proceeds - further Derek could bid on the sale to either buy the full property himself or attempt to bid up the ultimate purchase price; and

c. as a 50/50 ownership split, the relative ownership considerations weighed in favor of neither party.

U.S. v. Adent, 117 AFTR 2d 2016-1505 (CA7 5/10/16)

Make Sure the Corporation is in Good Standing Before Filing a Tax Court Petition

Many states will involuntarily or administratively dissolve a corporation for not paying or filing annual reports, fees, or tax returns. The ability of a dissolved corporation to engage in activities after dissolution depends on applicable state law, and typically there are procedures for reinstating such a dissolved corporation.

So what happens if such a dissolved corporation receives a notice of deficiency and petitions the Tax Court for review? Under applicable state law, there may be specific guidance on whether a dissolved corporation can prosecute or defend a lawsuit. Also, some states allow for a dissolved corporation to conduct winding up activities after the dissolution. Such state law provisions have at times allowed authority for a dissolved corporation to file a valid Tax Court petition.

A recent case indicates there are limits, however. In the case, a corporation had been dissolved for over 10 years before receiving a notice of deficiency and filing of a Tax Court petition. The government was able to strike the Tax Court petition as unauthorized under law due to the dissolved status, and thus the taxpayer corporation lost its ability to contest the deficiency in Tax Court. While noting that a dissolved corporation could undertake winding up activities under state law, since the deficiency came after the dissolution, and the dissolution had occurred more than 10 years prior, the Tax Court determined there was no state law authority for the dissolved corporation to file its petition.

The simple solution to avoid such a problem is to reinstate a dissolved corporation before filing the Tax Court petition. This may involve state penalties, and additional expenses relating to curing the deficiency that led to the dissolution. As a practical matter, however, the officers of the corporation may be oblivious to the fact that the corporation has been involuntarily dissolved (and I speak from experience on that), so if they don’t know, they are not going to take timely corrective action to reinstate the corporation.

The real lesson here is that the attorney or representative of the taxpayer should always check on the good standing of a corporate taxpayer that is filing a Tax Court petition to avoid these problems.

Allied Transportation, Inc., TC Memo 2016-102