Federal Tax Bulletin - Issue 158 - December 14, 2017

Conference Committee Reaches Deal on Tax Bill; Votes in House and Senate Expected Next Week

As we go to press, the conference committee reconciling the House and Senate versions of the Tax Cuts and Jobs Act (TCJA) ("House Bill" and "Senate Bill", respectively) is reported to have reached a deal in principle and is working rapidly to finalize legislative language for the massive tax bill. The legislators are rushing to get a bill passed before the holiday recess, a self-imposed deadline made more urgent by a Democratic victory in the Alabama special Senate election earlier this week.

Practice Aid: For an in-depth explanation of the House Bill, see the November 7, 2017, issue of Parker's Federal Tax Bulletin (PFTB 2017-11-07). For an explanation of the Senate Bill, see the December 5, issue of Parker's Federal Tax Bulletin (PFTB 2017-12-05).

The conference committee has not released a summary of its agreement, but a number of key details have emerged through comments (on and off the record) by members of Congress close to the negotiations and their staffs. According to the sources, negotiations between the House and the Senate have yielded the following compromises, concessions, and changes:

• A top individual tax rate of 37 percent (compared with 39.6 percent rate in the House Bill and 38.5 percent rate in the Senate Bill);
• A top corporate rate of 21 percent (compared with a rate of 20 percent in both the House and Senate Bills);
• Full repeal of the corporate alternative minimum tax (AMT) (adopts provision from the House Bill; the Senate Bill had retained the corporate AMT);
• A 20 percent deduction against qualified business income from passthrough business entities (compared with a 23 percent deduction in the Senate Bill, from which the provision is derived) and a likely tightening of the rules for calculating "qualified business income" (moving them toward the generally stricter ones in the House Bill);
• Repeal of shared responsibility payments (individual healthcare mandate) under the Affordable Care Act (provision was in the Senate Bill but not the House Bill);
• A maximum $10,000 deduction for state and local property taxes for individuals, with taxpayers being able to choose between deducting either property taxes or income taxes (the House and Senate Bills allowed for only the deduction of property taxes up to the limit; it's not clear whether taxpayers would be able to deduct sales taxes instead of income taxes, as they can under present law);
• A lowered $750,000 limit on the loan amount for which a mortgage interest deduction can be claimed by individuals, with existing loans grandfathered (splits the difference between the House and Senate Bills; the limit under present law is $1 million);
• Continued deductibility of unreimbursed medical expenses of individuals (the House Bill repealed the deduction);
• Retention of individual AMT with an exclusion of $1 million for joint filers and $500,000 for all others (the House Bill repealed the individual AMT; the Senate Bill retained it with far less generous enhancements to the AMT exemption amounts);
• Likely enhancement in the refundability of the child tax credit, including either an increase in the amount that's refundable (currently $1,100 in both House and Senate Bills);
• Continued deductibility of student loan interest and exclusion from income of graduate student tuition waivers (both breaks would have been repealed by the House Bill);
• Continued tax-exempt status for qualifying private activity bonds (the House Bill ended the tax break).

How the final bill will pay for the many taxpayer-friendly changes on the above list and still stay within the $1.5 trillion dollar increase to the deficit (in a 10-year timeframe) allowed by the instructions constraining the Senate is not known. Relative to the bill that passed the Senate earlier this month, the only known "pay-fors" are the increase in the corporate tax rate, the decrease in the percentage of the deduction against passthrough business income and the tightening of the rules for calculating "qualified business income"; and the tightening of the mortgage interest deduction. Those changes would not be enough to pay for the enhancements to other tax breaks on the list.

Unconfirmed rumors circulating Wednesday suggest that another possible pay-for might be an increase in the repatriation rates for foreign-earned income. Another likely candidate would be a tightening of the generous child tax credit phase-out provisions in the Senate Bill. Phaseouts don't begin until modified adjusted gross income reaches $500,000, more than double the threshold for joint filers in the House Bill and more than four times the threshold single and head of household filers.

Beyond the pay-fors, the list of unknowns about the final tax bill remains long and will not be addressed until the text of the legislation is released, which could happen as early as Friday, according to the Wall Street Journal. Until then, the status of dozens of conflicting provisions in the House and Senate bills will likely remain a mystery.

Multiple reports have indicated that final votes on TCJA will follow quickly on the heels of the release of legislative text. The Senate is expected to vote first, possibly as soon as Monday.

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Prop. Regs Address Foreign Issues Relating to Centralized Partnership Audit Regime

The IRS issued proposed regulations which provide rules addressing how certain international tax rules operate in the context of the centralized partnership audit regime. The proposed regulations include rules relating to the withholding of tax on foreign persons, the withholding of tax to enforce reporting on certain foreign accounts, and the treatment of creditable foreign expenditures of a partnership. REG-119337-17 (11/30/17).

Background

In the Bipartisan Budget Act of 2015 (BBA), which was enacted into law on November 2, 2015, the current rules governing partnership audits were repealed, effective for tax years beginning after 2017. Under Section 1101 of the BBA, the current rules governing partnership audits are replaced with a new centralized partnership audit regime that, in general, assesses and collects tax at the partnership level. On June 14, 2017, in notice of proposed rulemaking (NPRM) REG-136118-15, the IRS issued the first set of proposed regulations relating to the centralized partnership audit regime. On November 30, the IRS issued a second set of proposed regulations, which provide rules addressing how certain international rules operate in the context of the centralized partnership audit regime.

The proposed regulations address (1) provisions relating to Chapter 3 (Withholding of Tax on Nonresident Aliens and Foreign Corporations) and Chapter 4 (Taxes to Enforce Reporting on Certain Foreign Accounts) of subtitle A of the Code; (2) provisions relating to creditable foreign tax expenditures and foreign tax credits; (3) provisions relating to treaties and reductions to the rate of tax on foreign persons; and (4) provisions relating to certain foreign corporations.

Proposed Rules Relating to Chapters 3 and 4

In the preamble to the June 14 proposed regulations, the IRS explained that taxes that are not covered by the centralized partnership audit regime include taxes imposed by Chapters 3 and 4. Accordingly, the IRS said that it will continue to examine a partnership's compliance with its obligations under Chapters 3 and 4 in a proceeding outside of the centralized partnership audit regime.

To demonstrate the rules regarding the scope of the centralized partnership audit regime and the examination of the partnership's obligations under Chapters 3 and 4 outside of the centralized partnership audit regime, the November 30 proposed regulations provide examples that illustrate what occurs when (1) a partnership fails to withhold at the correct rate on an item of income allocable to a foreign partner, and (2) a partnership fails to report an item of income and, therefore, also fails to withhold on the additional income allocable to a foreign partner.

Example 1 under Prop. Reg. 301.6221(a)-1(f) clarifies that a partnership's withholding tax liability for failure to withhold at the correct rate on an item of income that the partnership received and properly reported on its partnership return may be adjusted by the IRS under the procedures applicable to an examination under Chapter 3 or Chapter 4, and that the procedures under the centralized partnership audit regime do not apply to the adjustment. The same result would occur on a partnership's failure to withhold at the correct rate under Code Sec. 1441 on a payment made to an unrelated foreign person, or upon a partnership's failure to withhold as a transferee of a U.S. real property interest at the correct rate under Code Sec. 1445.

Example 2 under Prop. Reg. 301.6221(a)-1(f) presents a case in which the partnership has failed to report on its partnership return an item of income that it received for which it would have had a withholding obligation under Chapters 3 and 4, and the failure to report the item is discovered in an examination of the partnership's compliance with its obligations under Chapters 3 and 4. Because an adjustment to increase the partnership's income would be an adjustment to an item of income of the partnership, it would be subject to the centralized partnership audit regime.

Under Code Sec. 6226, a partnership may elect to "push out" adjustments to its reviewed year partners rather than paying an imputed underpayment determined under Code Sec. 6225.The November 30 proposed regulations provide rules that apply withholding and reporting requirements under Chapters 3 and 4 to a partnership that makes a Code Sec. 6226 election with respect to a reviewed year partner that would have been subject to withholding in the reviewed year, and rules that apply to the reviewed year partner when taking these adjustments into account. Under Prop. Reg. Sec. 301.6227 - 2(b)(4), these same rules apply when a partnership elects to have its reviewed year partners take into account adjustments requested in an administrative adjustment request (AAR).

Prop. Reg. Sec. 301.6226 - 2(h)(3)(i) requires a partnership that makes a Code Sec. 6226 election to pay the amount of tax required to be withheld under Chapters 3 and 4 on any adjustment allocable to a reviewed year partner that would have been subject to withholding in the reviewed year. The partnership must pay the withholding tax (in the manner prescribed by the IRS in forms, instructions, and other guidance) on or before the due date for furnishing the Code Sec. 6226 statement that reports the adjusted item.

Proposed Rules Relating to the Foreign Tax Credit

A partnership is not eligible to claim an FTC under Code Sec. 901 (or a deduction for foreign taxes under Code Sec. 164). Instead, under Code Secs. 702(a)(6), 706(a), and Code Sec. 901(b)(5), each partner takes into account its distributive share of the creditable foreign taxes paid or accrued by the partnership in the partner's tax year with or within which the partnership's tax year ends. Under Code Sec. 702(a)(6), this amount, known as a creditable foreign tax expenditure (CFTE) is accounted for as a separately stated item. Under current rules, the partnership is not required to maintain records or report to the IRS whether its partners claimed credits or deductions with respect to their CFTEs or the extent to which any such credits are subject to a partner's FTC limitation.

As the IRS pointed out in the preamble to the November 30 proposed regulations, neither the statutory text of the centralized partnership audit regime nor the explanation of that text prepared by the staff of the Joint Committee on Taxation explicitly addresses any coordination with the foreign tax credit (FTC) rules. The IRS noted that nothing in the BBA indicates that the new procedures should increase the incidence of double taxation or alter the pre-existing restrictions, limitations, or obligations affecting a taxpayer's right to claim (or retain) an FTC. The IRS also found it unlikely that the enactment of the new centralized partnership audit regime was meant to change significant and well-established FTC rules without any explicit reference to those rules in the statutory text. As a result, the IRS concluded that, to the maximum extent possible, the long-standing FTC rules should be preserved while implementing the broader purpose of the centralized partnership audit regime.

Accordingly, the tax effects of an adjustment to the CFTEs reported by a partnership cannot be determined solely by examining the return and other records of the partnership. Similarly, the partnership lacks the necessary information to determine those tax effects in connection with an AAR.

Prop. Reg. 301.6225-1(a)(2) (June 14 NPRM) provides that for purposes of determining the imputed underpayment of a partnership, all applicable preferences, restrictions, limitations, and conventions will be taken into account to disallow netting of adjustments as if the adjusted item was originally taken into account in the manner most beneficial to the partners. Similarly, Prop. Reg. 301.6225-1(d)(1) (June 14 NPRM) provides that items within each grouping are divided into subgroups, for netting purposes, based on preferences, limitations, restrictions, and conventions, such as source, character, holding period, or restrictions under the Code applicable to such items.

Prop. Reg. Sec. 301.6225-1(d)(2)(iv)(A)(1) provides that the creditable expenditure grouping includes all adjustments to CFTEs. Prop. Reg. Sec. 301.6225-1(d)(2)(iv)(A)(2) further provides that adjustments to CFTEs are included in subgroupings based on the category of income to which the CFTEs relate in accordance with Code Sec. 904(d) and the regulations thereunder and in order to account for different allocations of CFTEs between partners. Prop. Reg. Sec. 301.6225-1(d)(2)(iv)(A)(3) provides rules used in computing the imputed underpayment when there are one or more adjustments to CFTEs. Specifically, Prop. Reg. Sec. 301.6225-1(d)(2)(iv)(A)(3) provides that a net reduction to CFTEs in any subgrouping is treated as a decrease to credits in the credits grouping and therefore increases the imputed underpayment (and safe harbor amount) on a dollar-for-dollar basis. A net increase to CFTEs in any subgrouping is an adjustment that does not result in an imputed underpayment and is therefore taken into account in the adjustment year in accordance with Prop. Reg. Sec. 301.6225-3 (June 14 NPRM).

Observation: According to the IRS, these CFTE subgrouping rules serve several goals. First, subgrouping prevents netting of CFTEs between partners, or between separate categories with respect to the same partner, a restriction which is necessary to preserve the application of the category-by-category limitation required under Code Sec. 904 and related regulations. Second, by subgrouping based on the sharing ratio of the partners in the reviewed year, adjustments that would be allocable to one partner cannot be netted against adjustments to CFTEs that would be allocable to another partner. This is intended to provide greater consistency with the requirement that CFTEs be allocated in accordance with the partners' interests in the partnership under Code Sec. 704 and the regulations thereunder. Subgrouping based on the category and allocation of the adjustment between the partners is necessary, the IRS said, to avoid a net reduction in the U.S. tax collected as the result of adjustments to CFTEs for which no credit would have been allowed to the partner if the CFTEs had been correctly reported in the reviewed year.

Proposed Rules Relating to Treaty-Related Issues

In the June 14 proposed regulations, the IRS provided seven enumerated types of modifications that it will consider if requested by a partnership. In the preamble to the June 14 proposed regulations, the IRS requested comments on modifications that could be considered appropriate where a partner is a foreign person and thus may be subject to gross basis taxation under Code Sec. 871(a) or Code Sec. 881(a), or where a partnership, partner, or indirect partner is entitled to a reduced rate of tax under the Code or as a resident of a country that has in effect an income tax treaty with the United States.

According to the IRS, it is still considering additional modifications to address circumstances where a partnership, partner, or indirect partner is a foreign person, and which potential modifications, such as modifications for portfolio interest and U.S. source capital gains, may already be addressed by one of the seven types of modifications included in the June 14 proposed regulations.

The IRS is continuing to request comments on what specific types of modifications available to partners or partnerships that are foreign persons (including partners that are foreign persons described under Code Sec. 501(c)) should be included in Prop. Reg. Sec. 301.6225-2(d) (June 14 NPRM). Pursuant to income tax treaties in effect between the United States and other jurisdictions, the IRS said it intends to allow access to mutual agreement procedures (MAP), when and where appropriate, for a partnership, partner, or indirect partner that is subject to the centralized partnership audit regime. However, the IRS said it is continuing to study this issue and requests comments on how to coordinate MAP with the centralized partnership audit regime.

Proposed Rules Relating to Foreign Corporations

In the preamble to the June 14 proposed regulations, the IRS said it intended to issue regulations to address situations where a partnership pushes out an adjustment under Code Sec. 6226 to a direct partner in the partnership that is a foreign entity, such as a trust or corporation, that may not be liable for U.S. federal income tax with respect to one or more adjustments, but an owner of the direct partner is, or could be, liable for tax with respect to that amount. According to the IRS, it is continuing to study this issue and is requesting comments both on how the reporting obligations concerning foreign entities should be modified to ensure that statements issued under Code Sec. 6226 are reflected on the returns of the U.S. owners of these entities, and more generally, on how to incorporate rules governing foreign corporations into the centralized partnership audit regime.

For a discussion of the centralized partnership audit regime rules, see Parker Tax ¶28,700.

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IRS Expands Relief for Late Actions by Partnerships and Certain Other Entities

The IRS issued guidance which provides that any act performed for the 2016 tax year of a partnership, real estate mortgage investment conduit (REMIC), or certain other entities will be treated as timely for all purposes under the Code, except with respect to interest under Code Sec. 6601, in situations where the act would have been timely if the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 had not changed the due date for partnership and certain other returns. This guidance supersedes Notice 2017-47, which gave only partial relief for 2016 late filings. Notice 2017-71.

Background

The Surface Transportation Act amended Code Sec. 6072 and changed the date by which a partnership must file its annual return with the IRS. The due date for filing the annual return of a partnership changed from the fifteenth day of the fourth month following the close of the tax year (April 15 for calendar-year taxpayers) to the fifteenth day of the third month following the close of the tax year (March 15 for calendar-year taxpayers). The new due date applies to the returns of a partnership for tax years beginning after December 31, 2015.

While a real estate mortgage investment conduit (REMIC) is not a partnership, it is generally treated as a partnership under Code Sec. 860F(e) for purposes of subtitle F, Procedure and Administration, of the Code. For example, under Reg. Sec. 1.860F-4(b)(1), the due date and availability of any extension of time for filing a REMIC's annual return are determined as if the REMIC were a partnership. As a result, the new due date enacted under the Surface Transportation Ace also applies to the returns of a REMIC for tax years beginning after December 31, 2015. Further, the due date for the return of a bank with respect to a common trust fund, commonly filed on Form 1065, is administratively tied to the due date of the return of a partnership. Similarly, under Reg. Sec. 1.6033-2T(e), the annual return filed by a religious or apostolic association or corporation on Form 1065 is to be filed on the due date of a partnership return. Other returns affected by the due date change in the Surface Transportation Act are Form 1065 B, U.S. Return of Income for Electing Large Partnerships; Schedules K-1 of Form 1065; Form 8804, Annual Return for Partnership Withholding Tax (Section 1446); and Form 8805, Foreign Partner's Information Statement of Section 1446 Withholding Tax. Some partnerships must also file additional returns, such as Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, by the due date of the Form 1065 or 1065-B.

A partnership can obtain a six-month extension of time to file Forms 1065, 1065 B, or 8804, and a REMIC can obtain a six-month extension of time to file Form 1066, by filing Form 7004, Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns, by the statutory due date of those returns. A partnership that receives an extension of time to file Form 1065 receives a concurrent extension of time to furnish its partners with Schedules K-1. Also, a partnership that receives an extension of time to file Form 8804 receives a concurrent extension of time to file Forms 8805 and to furnish respective copies of the Forms 8805 to its partners. The six-month extension may apply to additional returns that a partnership may be required to file by the due date of its Form 1065 or 1065-B, but it does not affect the due date for a partnership filing Form 1065-B to furnish its partners with Schedules K-1.

Compliance Tip: An entity that fails to timely meet its obligations to file and furnish returns is subject to penalties. An entity that fails to file Form 1065, 1065-B, 1066, or 8804 by the due date (with regard to extensions) is subject to penalty under Code Sec. 6698 or Code Sec. 6651. A partnership that fails to file Forms 8805 by the due date (with regard to extensions) is subject to penalty under Code Sec. 6721. A partnership that fails to furnish Schedules K 1 or the partner copies of Forms 8805 by the due date is subject to penalty under Code Sec. 6722. A partnership that fails to file Form 5471 by the due date is subject to penalty under Code Sec. 6038 or Code Sec. 6679. An entity that fails to file additional documents that it is required to file by the due date of its Form 1065, 1065-B, or 1066 may also be subject to other penalties.

Observation: In addition to the obligation to file returns with the IRS and furnish copies to recipients, an entity may be required to take various other actions, such as making elections (e.g., an election under Code Sec. 475(e) to elect mark-to-market accounting), contributing to an employee pension plan, or paying tax, by the due date of its return, either with or without regard to any extension of time to file, depending upon the particular action.

In Notice 2017-47, the IRS provided penalty relief to partnerships and REMICs that filed untimely returns or untimely requests for extension of time to file those returns as a result of changes to tax return due dates that were made by the Surface Transportation Act. The relief was granted automatically for penalties for failure to timely file Forms 1065, 1065-B, 8804, 8805, 1066, and any other returns, such as Form 5471, for which the due date was tied to the due date of Form 1065 or Form 1065-B.

Relief under Notice 2017-71

In Notice 2017-71, the IRS has expanded the penalty relief first issued in Notice 2017-47 to include additional acts, and not just the acts of filing a return or an extension request. According to Notice 2017-71, the IRS will treat acts of any (1) partnership, (2) REMIC, or (3) entity that may properly file a Form 1065 - such as a bank (with respect to the return of a common trust fund), or a religious or apostolic association or corporation - and in fact filed a Form 1065, as timely for the first tax year that began after December 31, 2015, and ended before January 1, 2017, if the entity took the act by the date that would have been timely under Code Sec. 6072 before amendment by the Surface Transportation Act (April 18, 2017, for calendar-year taxpayers, because April 15 was a Saturday and April 17 was a legal holiday in the District of Columbia). However, the entity will be liable for any interest due under Code Sec. 6601 from the date prescribed for payment until the date the payment was actually made.

Procedures for Entities That Have Already Been Assessed a Penalty

An entity that has already been assessed a penalty for failure to timely file a return that is deemed timely filed under Notice 2017-71 can expect to receive a letter within several months after November 30, 2017, notifying it that the penalty has been abated. For other acts deemed timely under Notice 2017-71, such as elections, an entity should file its returns consistent with the treatment of the acts as being performed timely as provided by Notice 2017-71, and need not take further action to obtain relief unless contacted by the IRS.

For reconsideration of a penalty covered by Notice 2017-71 that has not been abated by February 28, 2018, taxpayers should contact the number listed in the letter that notifying the taxpayer of the penalty or should call (800) 829-0115 and state that relief is being requested under Notice 2017-71.

Taxpayers who qualify for relief under Notice 2017-71 will not be treated as having received a first-time abatement under the IRS's administrative penalty waiver program.

Notice 2017-71 supersedes Notice 2017-47.

For a discussion of filing dates for partnership and REMIC tax returns, see Parker Tax ¶28,550 and ¶49,135, respectively.

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Court Petition Was Validly Postmarked Before Filing Deadline Using Non-USPS Label

The Tax Court held that it had jurisdiction over a petition it received seven days after the last day for filing because it was timely filed using postage prepaid through Stamps.com, an online postage services provider. The Tax Court followed Tilden v. Comm'r, 2017 PTC 17 (7th Cir. 2017) in holding that the envelope bearing the Stamps.com label, which it found was a postmark not made by the United States Postal Service (USPS), was timely mailed under Code Sec. 7502 because it was dated before the last day for filing and was received by the Tax Court no later than the time it would ordinarily be received if postmarked by the USPS. Pearson v. Comm'r, 149 T.C. No. 20 (2017).

Background

On January 22, 2015, the IRS sent Lincoln and Victoria Pearson a notice of deficiency for tax years 2010, 2011 and 2012. The notice determined deficiencies totaling over $80,000. Under Code Sec. 6213, the deadline for the Pearsons to file a Tax Court petition challenging the deficiency was April 22, 2015 - 90 days after the mailing of the notice. The Tax Court does not have jurisdiction over a petition filed after the deadline.

An administrative assistant at the law firm representing the Pearsons mailed their petition using a postage label from Stamps.com, an online postage services provider. The label showed a date of April 21, 2015, which was the date the label was created. However, the earliest entry in the USPS's online tracking system showed the envelope arriving at a USPS facility on April 23, 2015. A USPS specialist said that the envelope was most likely deposited at the post office in the afternoon of April 22, 2015. The Tax Court received the petition on April 29, 2015.

Code Sec. 7502(a) provides that the date an envelope is postmarked is treated as the date of delivery. The Pearsons therefore needed only to postmark their petition by April 22 to meet the deadline. Under Code Sec. 7502(b), if a postmark is made other than by the USPS, it must comply with the regulations under that section.

Under Reg. Sec. 301.7502-1(c)(1)(iii)(B)(1), a non-USPS postmark must be legibly dated on or before the last day for filing, and the Tax Court must receive the mailing within the time it ordinarily takes for a USPS-postmarked package to arrive. If the non-USPS postmarked item is received late, then Reg. Sec. 301.7502-1(c)(1)(iii)(B)(2) treats it as being timely filed if the sender can prove it was deposited in the mail on or before the filing deadline. Under Reg. Sec. 301.7502-1(c)(1)(iii)(B)(3), if the envelope has both a USPS and a non-USPS postmark, the non-USPS postmark is disregarded and the USPS postmark is treated as the date mailed and filed.

The IRS filed a motion to dismiss the Pearsons' petition for lack of jurisdiction. The Tax Court delayed ruling on the motion pending the outcome of a Seventh Circuit appeal of its decision in Tilden v. Comm'r, T.C. Memo. 2015-188, a case involving the same law firm that represented the Pearsons and with virtually identical facts.

In Tilden, the Tax Court held that the USPS tracking information was a postmark. It therefore decided under Reg. Sec. 301.7502-1(c)(1)(iii)(B)(3) that there were competing postmarks and the Stamps.com postmark should be disregarded. Because the earliest date of the tracking information was April 23, 2015, the day after the deadline, the Tax Court concluded that the petition was not timely filed. The Seventh Circuit reversed, finding that the Stamps.com label was the only postmark on the envelope and that it met the requirements for a timely filed non-USPS postmark under Reg. Sec. 301.7502-1(c)(1)(iii)(B)(1).

After the Seventh Circuit's reversal in Tilden, the IRS joined the Pearsons in urging that the Tax Court deny its motion to dismiss for lack of jurisdiction. The IRS concluded that the petition was most likely deposited with the USPS on April 22, which was within the time prescribed by Code Secs. 6213 and 7502(b).

Analysis

The Tax Court adopted the Seventh Circuit's reasoning in Tilden and held that the Pearsons' petition was timely filed using the Stamps.com label as a non-USPS postmark. The Tax Court acknowledged that the date on a Stamps.com label does not mark the package's entry into the post but indicates only the date the label was created. But it joined the Seventh Circuit in finding that the Stamps.com label is a postmark not made by the USPS. The Tax Court noted that the IRS had conceded the Pearsons' petition was timely mailed and reasoned that the IRS's construction of its own regulations was entitled to deference.

The Tax Court found nothing in the legislative history of Code Sec. 7502(b) or in the regulations to suggest that a Stamps.com postage label, or one like it, should be regarded as something other than a non-USPS postmark. The Tax Court reviewed several of its own decisions holding that a stamp created by a private postage meter qualifies as a non-USPS postmark, and adopted the reasoning in Tilden that a Stamps.com postage label is the modern equivalent of the output of a postage meter. The Tax Court found no basis for distinguishing between these two means of affixing postage.

The Tax Court then found that under Reg. Sec. 301.7502-1(c)(1)(iii)(B)(1), the Stamps.com postmark had a legible date (April 21) which was on or before the last day for filing (April 22). And, because the IRS acknowledged that certified mail often takes eight days to reach the Tax Court from Utah, the Pearsons' petition, which was received on April 29, arrived no later than the time when a document would ordinarily be received if postmarked by the USPS. It therefore met the requirements for a timely filing using a non-USPS postmark.

The Tax Court also determined that the Pearsons' petition was timely under Sec. 301.7502-1(c)(1)(iii)(B)(2). The Tax Court found that the Pearsons' envelope was deposited in the mail either on April 21 or 22; in either case, it was timely filed under Reg. Sec. 301.7502-1(c)(1)(iii)(B)(2). Finally, the Tax Court reiterated that because there was no USPS postmark, there was no issue of competing postmarks and Reg. Sec. 301.7502-1(c)(1)(iii)(B)(3) did not apply.

Observation: In a dissenting opinion, two judges challenged the majority's conclusion that a postage label printed by an individual customer on his own printer using an internet vendor like Stamps.com, and placed by the individual on his own piece of mail, constitutes a non-USPS postmark. The dissenters reasoned that the rules for non-USPS postmarks were intended to apply to postage meters and that the majority failed to explain in what sense Stamps.com might be the equivalent of a postage meter. The dissenters also argued that the majority failed address whether an item postmarked using Stamps.com was required to be mailed the same day that the label was created, which it said was the basis for treating a stamp from a postage meter as a postmark.

For further discussion of when a tax return or Tax Court petition is considered timely filed, see Parker Tax ¶250,120.

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Legal Fees to Recoup Alimony Payments Were Nondeductible Personal Expenses

The Tax Court held that a taxpayer could not deduct legal fees incurred in an action to recover alimony payments that he alleged were made in excess of the amount provided for under a separation agreement with his ex-wife. The Tax Court found that the legal fees were nondeductible personal expenses because the underlying claim did not originate from any profit seeking activity. Barry v. Comm'r, T.C. Memo. 2017-237.

William and Beth Barry were divorced in 2002. The judgment of dissolution ordered Mr. Barry to pay alimony of $2,400 per month. In 2011, Mr. Barry sued Ms. Barry for breach of contract. He alleged that under a separation agreement they had previously signed, Ms. Barry was entitled to total alimony of approximately $45,000 and that he had paid that amount in full. He said that Ms. Barry was in default of the separation agreement when she filed for divorce in 2000 and demanded alimony. Mr. Barry sought a judgment of approximately $201,000 - an amount equal to the excess of the total alimony he paid over the amount he claimed Ms. Barry was entitled to under the separation agreement. Mr. Barry's lawsuit was dismissed in 2011 as time barred.

On his 2013 tax return, Mr. Barry claimed a deduction of over $34,000 for the legal fees he paid with respect to the action against Ms. Barry. The IRS determined a deficiency of approximately $5,000 and an accuracy-related penalty of $1,000. Mr. Barry petitioned the Tax Court for redetermination of the deficiency.

Personal and family expenses are generally not deductible. However, a deduction is allowed under Code Sec. 212 for ordinary and necessary expenses for (1) the production or collection of income, or (2) the maintenance or conservation of property held for the production of income. In U.S. v. Gilmore, 372 U.S. 39 (1963), the Supreme Court held that legal fees incurred by a taxpayer in resisting his wife's property claims in a divorce were not deductible because the claims that gave rise to the fees stemmed from the marital relationship rather than from any profit seeking activity. The Supreme Court stated that the origin of the claim with respect to which an expense was incurred, rather than its potential consequences, is the controlling test of whether an expense is deductible.

Barry argued that Gilmore was decided based on the language of Code Sec. 212(2), which applies to expenses incurred in the conservation of property held for the production of income, but that his his claim was based on Code Sec. 212(1), which allows a deduction for expenses paid for the production of income. Barry said that the origin of the claim test therefore did not apply. Barry also cited Wild v. Comm'r, 42 T.C. 706 (1964), where the Tax Court held that legal fees paid by a wife in obtaining alimony includible in gross income were deductible under Code Sec. 212(1). Barry argued that his legal expenses should also be deductible because they were incurred for the purpose of collecting money that would be included in his income under the tax benefit rule.

The Tax Court held that Barry's legal fees were not deductible under Code Sec 212(1). First, it found that, contrary to Barry's argument, the Gilmore origin of the claim test applied to both paragraphs (1) and (2) of Code Sec. 212. According to the Tax Court, Gilmore interpreted the predecessor statute to Code Sec. 212, which contained in one paragraph the provisions now codified in Code Sec. 212(1) and Code Sec. 212(2). The Tax Court also cited language from the Gilmore opinion stating that the only kind of expenses deductible under the predecessor to Code Sec. 212 were those that related to a profit seeking purpose and did not include personal, living, or family expenses.

Next, the Tax Court cited several of its previous decisions applying the origin of the claim test to deductions for legal fees under Code Sec. 212(1). The Tax Court noted that in Sunderland v. Comm'r, T.C. Memo. 1977-116, it applied the Gilmore test to disallow a deduction claimed under Code Sec. 212(1) for legal expenses the taxpayer incurred in a legal action which resulted in a reduction of the alimony paid to his former wife. The Tax Court also cited Favrot v. U.S., 550 F. Supp. 809 (E.D. La. 1982), where a district court applied Gilmore in disallowing a claimed deduction for legal expenses incurred in an attempt to recoup alimony payments. The Tax Court rejected Barry's assertion that his legal fees should be deductible because any recovered alimony payments would have been includible in his income. In the Tax Court's view, Barry improperly focused on the potential consequences of his lawsuit rather than on the origin and character of his claim.

The Tax Court also disagreed with Barry's reading of its decision in Wild, finding that it turned on an exception to the Gilmore rule in the regulations under Code Sec. 262 specifically providing for the deductibility of legal fees of a wife incurred for the collection of alimony and similar amounts received by a wife in connection with a marital relationship. The Tax Court concluded by citing the general rule as stated in the regulations under Code Sec. 262, which is that attorney's fees and other costs paid in connection with a divorce, separation, or decree for support are not deductible by either the husband or the wife.

Finally, the Tax Court reasoned that if Barry had filed suit in the same year as his divorce to challenge the alimony obligations, his legal expenses would have been nondeductible personal expenses. In seeking to deduct legal expenses incurred in an action to recoup the alimony payments, Barry was seeking to do indirectly what could not have been done directly, according to the Tax Court.

For a discussion of the deductibility of legal fees, see Parker Tax ¶80,185.

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IRS Entitled to Examine Cryptocurrency Exchange's Client Records

A district court partially granted a petition to enforce a summons the IRS served on Coinbase, Inc., a virtual currency exchange, seeking information on transactions by Coinbase customers during 2013 through 2015. The court said that the records, which Coinbase claimed applied to 8.9 million transactions and 14,355 users, served a legitimate purpose of investigating whether gains on bitcoin transactions had been properly reported. U.S. v. Coinbase, Inc., 2017 PTC 536 (N.D. Cal. 2017).

Background

In Notice 2014-21, the IRS determined that virtual currencies that can be converted into traditional currency are considered property. Thus, a taxpayer can have a gain or a loss on the sale or exchange of bitcoin and other virtual currencies.

In 2016, the IRS served an initial summons on Coinbase, Inc., a virtual currency exchange, seeking records regarding almost all of Coinbase's customers for 2013 through 2015. The summons requested a broad range of documents including complete user profiles, know-your-customer (KYC) due diligence, documents regarding third party access, transaction logs, records of payments, and other documents. A district court granted permission for the IRS to serve the initial summons on Coinbase, but Coinbase refused to comply.

The IRS filed a petition to enforce the initial summons. The petition included a declaration from David Utzke, a senior agent in the IRS's offshore compliance program specializing in virtual currency, stating that the IRS was trying to determine the identity and tax liability of U.S. persons who conducted virtual currency transactions during 2013 through 2015. According to Utzke, the IRS believed that virtual currency gains are underreported. He said the IRS had found that only 800 to 900 taxpayers reported a virtual currency transaction on Form 8949, Sales and Other Dispositions of Capital Assets, for the relevant years. Utzke cited information from Coinbase's website that it operates in 33 countries, has 5.9 million customers and has exchanged $6 billion in bitcoin. By the end of 2015, Coinbase was the largest bitcoin exchange in the U.S. and the fourth largest globally, according to Utzke.

Eight months after the initial summons, the IRS requested permission to serve a narrowed summons on Coinbase. The narrowed summons requested information on accounts with at least $20,000 in any one transaction type (buy, sell, send or receive) in any one year and excluded users who only bought and held bitcoin as well as users for whom Coinbase filed Forms 1099-K. The IRS said that the narrowed summons was the result of discussions between it and Coinbase regarding the scope of records Coinbase would be willing to provide. Coinbase claimed that the narrowed summons applied to 8.9 million transactions and 14,355 users.

The narrowed summons requested registration records for each account, records of KYC customer due diligence, third-party access agreements, account activity records, correspondence between Coinbase and users or third parties regarding account opening, closing, or transaction activity, and all account invoices. Coinbase refused to comply with the narrowed summons and the IRS petitioned the district court for an order to enforce it.

Code Sec. 7602 authorizes the IRS to issue a summons to ascertain the correctness of any return, make a return where none has been made, and determine and collect the tax liability of any person. Under U.S. v. Powell, 379 U.S. 48 (1964), the IRS can obtain a court order enforcing a summons if it establishes that (1) the summons is issued for a legitimate purpose, (2) the summons seeks information relevant to that purpose, (3) the information sought by the summons is not already in the IRS's possession, and (4) the IRS satisfies all required administrative steps. If the IRS meets these requirements, the burden shifts to the taxpayer to show an abuse of process or lack of good faith by the IRS.

The parties did not dispute that the IRS satisfied the third and fourth elements of the Powell test. Coinbase argued that the summons lacked a legitimate purpose and sought irrelevant information. Coinbase argued that the term "likely related to bitcoin" in the summons was vague. It asserted that taxpayers who bought bitcoin at high prices in 2013 and sold in 2014 and 2015 probably had losses due to a fall in the price of bitcoin. Coinbase argued that the narrowing of the subpoena was arbitrary. Finally, Coinbase contended that the IRS was not permitted to use its summons power to conduct a general research.

The IRS argued that the records it sought would allow it to determine if users filed tax returns correctly reflecting any bitcoin gain or loss during the summoned period. The IRS also said that it requested broad swaths of records so that it would not need to return to court later to ask for them if and when needed.

Analysis

The district court partially granted and partially denied the IRS's petition to enforce the summons. In looking at the question as to whether the summons served a legitimate purpose and sought relevant information, the court concluded that the answer to the first question was yes and the answer to the second question was yes in part.

The court found that the summons served the legitimate purpose of investigating the reporting gap between the number of Coinbase's users and those reporting bitcoin gains and losses to the IRS. The court noted that the summons was supported by Utzke's declaration and that Utzke had sufficient personal knowledge to support his declaration. The court found it was reasonable for the IRS to premise an investigation on the assumption that taxpayers were reporting bitcoin transactions on Form 8949, and said that Coinbase offered nothing to suggest otherwise. The court rejected Coinbase's suggestion that its customers would be more likely to file paper returns, noting that 83 to 84 percent of taxpayers file electronically. The IRS was not required to define "likely related to bitcoin," the court found, but only to make a minimal showing that there were more Coinbase users transacting in bitcoin than filing electronic tax returns. Coinbase's argument that bitcoin prices fell in 2014 and 2015 was unpersuasive to the court because the narrowed summons sought information on accounts with transactions occurring within any one of the relevant years. Finally, the narrowing of the summons was not arbitrary, according to the court, because it was based on information the IRS learned after discussions with Coinbase in an attempt to reach an agreement regarding the records Coinbase would produce.

Coinbase's argument that the IRS was not permitted to use its summons power for general research was also rejected. The court found that the purpose of the investigation was related to tax compliance, not research, and that the IRS had provided a declaration describing how the disparity between the number of Coinbase users and the number of electronic returns created an inference that many users were not reporting their gains.

Next, the court considered the relevance of the requested records to the IRS's investigation. It found that the relevant identity documents were the taxpayer ID numbers, names, dates of birth, and addresses of account holders. Identity records that the court found were not relevant included account opening records, copies of passports or driver's licenses, wallet addresses, and public keys. The court held that transaction history records were relevant and ordered Coinbase to produce transaction logs, post transaction balances, and the names of counterparties. However, the court found that requests or instructions to send or receive bitcoin, and information identifying the users of such accounts where counterparties transact through their own Coinbase accounts and their contact information, were not relevant. The court also denied the request for Coinbase's records of KYC diligence, agreements granting third party access, and correspondence between Coinbase and users or third parties regarding account opening, closing or transaction activity.

Finally, the court found that the IRS did not commit an abuse of process in seeking to enforce the summons. It found that the IRS had met its burden of showing that the narrowed summons served the legitimate investigative purpose of enforcing tax laws against those who profit from trading in virtual currency and that the information the court ordered Coinbase to produce was relevant and no more than necessary to serve that purpose.

For a discussion of the IRS's summons authority, see Parker Tax ¶263,120. For a discussion of the treatment of gains and losses on virtual currency transactions, see Parker Tax ¶110,120.

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Pfizer Settlement Payment Was Not Excludible from Income as Payment for Physical Injury

A district court held that a payment received by a taxpayer under a settlement with his former employer was not excludible from gross income as damages for physical injuries under because the underlying claim was not a tort and was not for a physical injury. The district court also found that FICA tax was properly withheld because the payment fell under the broad definition of remuneration for employment. Bell v. U.S., 2017 PTC 533 (D. Conn. 2017).

Michael Bell began working in Pfizer's information technology department in 2002. Bell was declared legally blind in his left eye in 1995 and began losing vision in his right eye in 1998 or 1999. By the time he began working for Pfizer, his vision problems were so severe that he struggled to read handwriting or distinguish details of photographs. He stopped driving and was declared legally blind in 2005. Bell's doctors did not conclusively diagnose a reason for his blindness.

Bell claimed that, when he was hired, he was told that Pfizer would pay to move him from New Jersey to Connecticut. Bell said that he bought a house in Connecticut based on that representation but, after he moved, he was told that most of the money he received would have to be repaid. Bell said he would not have bought the house without the promise and payment of a large sum of money and that the experience caused him much stress. Bell also claimed that he was taunted and harassed at work on account of his disability.

Bell and Pfizer began settlement negotiations after Bell asked for compensation due to his physical injuries. Bell and Pfizer negotiated a settlement agreement under which Pfizer agreed to pay Bell $190,000 in 2007 and $990,000 in 2008. Pfizer treated both payments as taxable wage income. It withheld state and local income taxes as well as the Federal Insurance Contributions Act (FICA) tax.

According to the IRS, the payments to Bell were taxable as wages subject to withholding and represented amounts before withholding. Although the agreements with Pfizer did not specify the grounds for the payments, they did state that Bell had been paid in full any and all monies owed to him in connection with his employment with Pfizer and in connection with his termination from active service. The IRS assessed tax deficiencies which Bell paid. Bell then filed a refund claim which the IRS denied.

Bell sued the IRS in a district court, claiming that the payments were made on account of lost wages and personal injury. Specifically, he said that the 2007 payment was for lost wages and that the 2008 payment was not for any wage or benefit, and therefore was paid for claims for personal injury. Bell argued that the settlement agreement represented payment for a physical injury and therefore should have been excluded from his income. The IRS moved for summary judgment, arguing that Pfizer appropriately withheld taxes from the settlement payment because the payment was taxable wages.

Under Code Sec. 104(a)(2), gross income generally does not include the amount of damages for personal physical injuries or physical sickness. To claim the exception, a taxpayer must show that (1) the underlying cause of action was based on a tort type right and that (2) the damages were received for personal injuries or physical sickness. Bell argued that the settlement payment was excludable because, had he not settled with Pfizer, he would have brought claims of intentional and negligent infliction of emotional distress, both of which are tort claims. With respect to the second element, Bell claimed that he sought recovery not for emotional distress but rather relief from the physical injuries resulting from emotional distress.

The district court granted the IRS's motion for summary judgment. First, the court found that the underlying cause of action was not a tort type right. Because the agreement did not state that it was for a particular type of damages, the court looked to Pfizer's intention in making the payment and found that Pfizer was released from any liability related to Bell's employment and his termination. The court also noted a statement by Pfizer's general counsel that the agreement with Bell was related to his demand for compensation on account of various claims arising from his employment, including a claim of disability discrimination. The district court cited two Second Circuit decisions where similar settlement agreements were determined to be in the nature of severance pay or extra compensation, and not in settlement of a possible tort claim. Bell's testimony that the underlying causes of action was intentional and negligent infliction of emotional distress conflicted with the plain language of the release agreement, the court found.

The district court also held that the damages Bell received were not on account of personal injuries or physical illness. Code Sec. 104(a)(2), the court noted, was amended by Congress to add the word "physical" to the phrase "personal injuries or sickness," thereby expressly excluding damages for emotional distress. Thus, regardless of whether the underlying claims were torts, Bell's claims for recovery under emotional distress theories were foreclosed by Congress. The court concluded that the payment under the settlement agreement could not be excluded from Bell's gross income for that reason.

The district court also found that FICA taxes were properly withheld. It concluded that the settlement agreement was remuneration for Bell's employment with Pfizer because it was intrinsically related to his work there. All of his claims derived from his relationships with his employer and coworkers, and the settlement made clear that it represented payment in connection with his employment with Pfizer and his termination from active service. The court reasoned that, whether the agreement was called a settlement or a severance agreement, it was a contract that would have been entered into only with employees. The payment from the contract was therefore wages under the broad FICA definition of the term.

For a discussion of the taxability of damages received from a settlement agreement, see Parker Tax ¶74,130.