Federal Tax Bulletin - Issue 170 - May 14, 2018

IRS Updates Accounting Method Change Procedure

The IRS updated Rev. Proc. 2015-13, the revenue procedure for requesting IRS consent (both automatic and non-automatic) for an accounting method change, and Rev. Proc. 2017-30, which lists the accounting method changes eligible for IRS automatic consent. The new procedure is necessary because of changes made by the Tax Cuts and Jobs Act of 2017 and because certain sections of Rev. Proc. 2017-30 have been obsoleted. Rev. Proc. 2018-31.

In Rev. Proc. 2015-13, the IRS provides the general procedures under Code Sec. 446(e) and Reg. Sec. 1.446-1(e) to obtain IRS consent to change a method of accounting for federal income tax purposes. Specifically, it provides the general procedures to obtain the advance non-automatic IRS consent to change a method of accounting, as well as the procedures to obtain automatic IRS consent to change a method of accounting.

On May 9, the IRS issued Rev. Proc. 2018-31, which updates Rev. Proc. 2015-13, as clarified and modified by Rev. Proc. 2017-30. In Rev. Proc. 2017-30, the IRS lists the changes in methods of accounting for which automatic IRS approval is available if the conditions in the procedure are met. Rev. Proc. 2018-31 supersedes much of Rev. Proc. 2017-30 by updating the list of automatic changes in method of accounting that have IRS approval. The new procedure is necessary because of changes made by the Tax Cuts and Jobs Act of 2017 (TCJA) and because certain sections of Rev. Proc. 2017-30 have been obsoleted.

Rev. Proc. 2018-31 makes the following significant modifications to Rev. Proc. 2017-30:

• Section 12.01, relating to certain uniform capitalization (UNICAP) methods used by resellers and reseller-producers, is modified to provide that a small reseller is not permitted to make a change from a permissible UNICAP method to a permissible non-UNICAP inventory capitalization method in any tax year that it qualifies as a small reseller for any tax year beginning after December 31, 2017;
• Section 15.03, relating to taxpayers changing to the cash method of accounting, and Section 21.03 (now Section 22.03 of Rev. Proc. 2018-31), relating to changes to the small taxpayer exception from requirement to account for inventories under Code Sec. 471, are modified to provide that these changes do not apply for any tax year beginning after December 31, 2017;
• Section 15.14, relating to nonshareholder contributions to capital, is modified to provide that the change to accounting methods by a regulated public utility does not apply to contributions made after December 22, 2017, the date of enactment of the TCJA;
• Pursuant to Notice 2018-35, which provides transitional guidance relating to advance payments, Section 16.07, is modified to provide that the eligibility rule in Rev. Proc. 2015-13, Sec. 5.01, does not apply to a taxpayer that changes from an overall accrual method of accounting to either the full inclusion or deferral method for the taxpayer's first or second taxable year ending on or after May 9, 2018;
• Section 16.07, relating to advance payments, is modified to provide that a taxpayer is not permitted to make a change in method from the overall accrual method of accounting to the method of including advance payments in income in the year of receipt for any tax year beginning after December 31, 2017;
• Section 21.15 (now Section 22.15 of Rev. Proc. 2018-31), relating to sales-based vendor chargebacks, is modified to remove a paragraph relating to the temporary waiver of the eligibility rule in Section 5.01(1)(f) of Rev. Proc. 2015-13 because it is obsolete;
• Section 23.01 (now Section 24.01 of Rev. Proc. 2018), relating to certain taxpayers that have elected the mark-to-market method of accounting under Code Sec. 475(e) or (f), is modified to provide that the waiver of the eligibility rule in Section 5.01(1)(f) of Rev. Proc. 2015-13 no longer applies to this change. The waiver of the eligibility rule in Section 5.01(1)(d) of Rev. Proc. 2015-13 continues to apply to this change; and
• Section 23.02 (now Section 24.02 of Rev. Proc. 2018-31), relating to a taxpayer changing its method of accounting for securities or commodities from the mark-to-market method of accounting to a realization method of accounting, is modified to provide that the waiver of the eligibility rule in Section 5.01(1)(f) of Rev. Proc. 2015-13 no longer applies to this change. The waiver of the eligibility rule in Section 5.01(1)(d) of Rev. Proc. 2015-13 continues to apply to this change.

For a discussion of accounting method changes that have the automatic approval of the IRS and the procedures that must be followed in such cases, see Parker Tax ¶241,590.

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IRS Does Not Bear Burden of Production in Partnership Level Proceedings

The Tax Court held that the IRS does not bear the burden of production with respect to penalties in partnership level proceedings and is therefore not required to provide evidence of written supervisory approval under Code Sec. 6751(b)(1). The court reasoned that the burden of production rule in Code Sec. 7491(c) applies only to individual liability for penalties, and concluded that partnership level proceedings do not determine individual liabilities and are not proceedings with respect to individuals. Dynamo Holdings Limited Partnership v. Comm'r, 150 T.C. No. 10 (2018).

Background

Beekman Vista, Inc. (BV) is a U.S. corporation that is wholly owned by a Canadian entity. BV develops property in Florida. Dynamo Holdings Limited Partnership (Dynamo) is a U.S. partnership that also develops property in Florida. BV and Dynamo have at least one direct owner in common and share other indirect beneficial owners.

Transfers of property occurred between BV and Dynamo during 2005-2007. The IRS argued that the transfers were gifts among the beneficial owners. BV and Dynamo treated the transfers as sales paid for with loans that were eventually repaid. The IRS argued that if they were loans, they were for less than fair market value, and that the discounts were constructive distributions subject to withholding taxes.

The IRS audited BV's returns for tax years 2004 through 2008 and Dynamo's partnership returns for 2005-2007. The examination of BV's returns raised the question of whether it had properly withheld taxes under Code Sec. 1442. In February 2012, the IRS issued a notice of deficiency to BV for 2005 and 2006. The IRS determined that the corporation was liable for withholding taxes and for an addition to tax under Code Sec. 6651(a) for failure to file, as well as a penalty under Code Sec. 6656(a) for failure to make deposits. BV petitioned the Tax Court to challenge these determinations. In an amended answer, the IRS asserted an increased deficiency, an increase to the addition to tax under Code Sec. 6651(a)(1), and an increase to the amount of the Code Sec. 6656(a) penalty for each year.

The IRS issued a final partnership administrative adjustment with respect to Dynamo for 2005-2007 in December 2010. In addition to various adjustments to partnership items, the IRS applied accuracy related penalties under Code Sec. 6662(a) for negligence and substantial understatements of tax. Dynamo also petitioned the Tax Court, but neither BV nor Dynamo raised the issue of whether the IRS complied with the supervisory approval requirement in Code Sec. 6751(b). The cases were consolidated and a trial was held in early 2017.

In December 2017, the Tax Court decided Graev v. Comm'r, 149 T.C. No. 23 (2017) (Graev). In that decision, the court held that in cases where the IRS bears the burden of production under Code Sec. 7491(c) with respect to penalties, it must provide evidence of written supervisory approval of the penalties as required by Code Sec. 6751(b)(1). The day after Graev was decided, the Tax Court ordered the IRS to address the effect of Code Sec. 6751(b) in that case and related cases and to provide evidence of supervisory approval.

The IRS filed a response arguing that under Code Sec. 6751(b)(2)(A), supervisory approval is not required for additions to tax under Code Sec. 6651. As for the penalties under Code Secs. 6656(a) and 6662(a), the IRS argued that it did not bear the burden of production because neither BV nor any of Dynamo's partners were individuals. BV and Dynamo responded that the IRS bore the burden of production for the Code Sec. 6656(a) penalty at issue in the BV proceeding and the Code Sec. 6662(a) penalty at issue in the Dynamo proceeding, and argued that the IRS did not meet its burden under Code Sec. 6751(b) because it did not establish that the penalties were approved by immediate supervisors.

The IRS filed a motion to reopen the record, arguing that the Tax Court should allow additional testimony from the supervisors and agents involved to reinforce the evidence of supervisory approval. However, the IRS did not indicate that it would offer evidence of supervisory approval of the increased penalties asserted in its amended answer. BV and Dynamo filed a motion to dismiss as to the Code Sec. 6656 and 6662 penalties, arguing that the IRS did not meet its burden to establish that the supervisors who approved the penalties were immediate supervisors.

Analysis

The Tax Court held that in a partnership level proceeding, the IRS does not bear the burden of production with respect to penalties under Code Sec. 7491(c). It further held that where the IRS does not bear such a burden, the taxpayer may raise the lack of supervisory approval as a defense, but it found that BV and Dynamo did not raise that defense in this case and it was therefore waived. The court denied the IRS's motion to reopen the record and denied the taxpayers' motion to dismiss as to the penalties.

The IRS did not bear the burden of production with respect to the penalties asserted against Dynamo because the court found that under Code Sec. 7491(c), the IRS bears the burden only in proceedings with respect to individual liabilities, and partnership level proceedings do not determine individual liabilities. In a partnership level proceeding, the tax treatment of partnership items, as well as the applicability of any penalties or additions relating to an adjustment to a partnership item, are determined at the partnership level. The court explained that the partners' liability, if any, is determined later at the partner level.

Partnership level proceedings also are not proceedings with respect to individuals, in the court's view, because partnerships themselves are not individuals under the Code. And while individual partners may be parties to a partnership level proceeding, the court found that Code Sec. 7491(c) focuses on the nature of the proceeding, and not the parties.

The court found evidence in the Code that Congress did not intend for Code Sec. 7491(c) to apply to partnership level proceedings and noted practical concerns that would result if the IRS bore the burden of production with respect to penalties in partnership level proceedings. Because partnerships are not individuals, the court would have to determine the burden by looking through to the taxpaying partners, which would be contrary to the intent of partnership level proceedings. Additional complexities would arise with tiered partnerships, in the court's view.

With respect to the increased Code Sec. 6656 penalty asserted against BV in the IRS's amended answer, the court found that the IRS bears the burden of proof on any such increases, and therefore left the issue of whether the IRS met that burden to be resolved on the merits in a separate opinion.

Observation: The court observed that in two of its previous decisions - RERI Holdings I, LLC v. Comm'r, 149 T.C. No. 1 (2017) and Curtis Inv. Co. v. Comm'r, T.C. Memo. 2017-50 (2017) -- the court took for granted that the burden of production was on the IRS. The court concluded that, to the extent those decisions stated that the IRS bears the burden with regard to penalties in partnership level proceedings, it would decline to follow those decisions.

For a discussion of the burden of production, see Parker Tax ¶263,525. For a discussion of procedural requirements in computing penalties, see Parker Tax ¶262,195.

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Alleged Non-profit Was Really a Facade for a Doctor's Consulting Activity

The Tax Court held that a corporation organized to deliver quality management consulting services to medical providers, and to advance government programs through patient safety initiatives, did not qualify for tax exemption under Code Sec. 501(c)(3) because it would be operated for commercial purposes and it benefits would inure to its owner, a military vet and medical doctor who was also the sole employee and service provider. The court was not persuaded that the organization would act on the government's behalf and found that the company was a facade for its owner's consulting activities, which were of the sort that ordinarily are carried on by commercial ventures organized for profit. Abovo Foundation, Inc. v. Comm'r, T.C. Memo. 2018-57.

Dr. Emmanuel Okonkwo is a military veteran, medical doctor, and board certified expert in patient safety and risk management. In 2011, Dr. Okonkwo incorporated Abovo Foundation, Inc. as a Texas nonprofit corporation. Abovo's primary purpose would be to deliver quality management consulting services to medical providers and advance government programs through patient safety initiatives. Its quality management services would include analyzing and controlling systems and processes to ensure desirable outcomes. In addition, Abovo would provide services for the elderly and veterans, housing for low income individuals, and internal auditing services.

Abovo would solicit donations and receive fees relating to its services. Dr. Okonkwo, Abovo's president, CEO and sole employee, would perform services at an hourly rate of $350. Dr. Okonkwo would receive an annual salary of $217,000 and be eligible for a performance based bonus not to exceed $100,000. Abovo's fee structure would be market based and dependent on the nature of the project and the expertise required to complete it.

In April 2012, Abovo submitted to the IRS an incomplete Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. At the IRS's request, Abovo sent an updated Form 1023, and later amended its certificate of formation to provide that Abovo was organized exclusively for charitable, religious, education, and scientific purposes as required by Code Sec. 501(c)(3).

Abovo received a final adverse determination with respect to its tax exempt status in 2015. It then petitioned the Tax Court for a declaratory judgment that it met the requirements of Code Sec. 501(c)(3) and was exempt from federal income tax. Abovo contended that its services would advance government programs pursuant to federal patient safety laws and lessen the government's burden.

The Tax Court held that Abovo did not qualify for tax exemption because its services would not serve an exempt purpose, would be commercial in nature, and would serve Dr. Okonkwo's interest rather than that of the public. The Tax Court was not persuaded that Abovo would act on the government's behalf or that Abovo's consulting services would lessen the government's burden.

The Tax Court found that Abovo was a facade for Dr. Okonkwo's consulting activities, which it found were of the sort which ordinarily are carried on by commercial ventures for profit. The court reasoned that Abovo would develop Dr. Okonkwo's business relationships, further his consulting career as an expert in patient safety and risk management, and potentially pay him annual compensation in excess of $300,000. In the court's view, the benefits relating to Abovo would inure to Dr. Okonkwo as Abovo's sole employee, service provider and primary source of funding.

The court concluded that because Abovo would be operated for commercial purposes and for the benefit of Dr. Okonkwo, it did not qualify for a tax exemption under Code Sec. 501(c)(3).

For a discussion of the requirements that must be met to be a Code Sec. 501(c)(3) organization, see Parker Tax ¶60,502.

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Federal Circuit Reverses Lower Court; Allows Partial Exclusion of Extraterritorial Income

The Federal Circuit reversed a Federal Claims Court's decision and held that Sec. 101(d) of the American Jobs Creation Act of 2004 unambiguously provides transitional relief for all extraterritorial income (ETI) received from transactions entered into in 2005 and 2006, even if the income is received in later years. The Federal Circuit found that the lower court erroneously interpreted the language of Sec. 101(d) and held that the plain language and legislative history showed Congress's intent for partial exclusions from income to apply to ETI derived from transactions entered into in 2005 and 2006, not just to income recognized in those years. DWA Holdings LLC v. U.S., 2018 PTC 131 (Fed. Cir. 2018).

DWA Holdings LLC (DWA) is a U.S. corporation that was spun off from DreamWorks Studios in a 2004 public offering. DWA produces animated motion pictures and relies on third parties to distribute its films. In 2005, DWA entered into a distribution agreement with Paramount Pictures Corp., giving Paramount exclusive worldwide rights to distribute some of DWA's animated films. After Paramount acquired DreamWorks in 2006, a new distribution agreement was executed. The 2006 agreement gave an affiliate of Paramount the rights to distribute DWA's films outside of the United States and Canada. The films that were the subject of the 2006 agreement were produced in the U.S., and all licenses granted under the 2006 transaction were for use abroad.

DWA attempted to exclude 60 percent of the extraterritorial income (ETI) it received from the 2006 transaction under a provision of the American Jobs Creation Act of 2004 (AJCA). The AJCA was the result of decades of dialogue between the U.S. and other countries with whom it has treaty obligations. Congress believed that the exemption from tax for income earned abroad in European and other tax systems put domestic exporters at a disadvantage. However, the U.S.'s European trading partners objected each time Congress enacted laws intended to level the playing field for U.S. companies. With the passage of each new tax regime, Congress sought to ease the burden on U.S. companies by providing transitional relief for transactions occurring during specified years.

In 2000, Congress enacted the FSC Repeal and Extraterritorial Income Exclusion Act (ETI Act). The ETI Act allowed previously established foreign sales corporations (FSCs) to continue receiving favorable tax treatment for transactions occurring before 2002. The European Union (EU) challenged the ETI Act's transitional relief for FSCs in the World Trade Organization (WTO), which ruled against the U.S. in 2004. Congress responded by repealing the ETI Act and enacting the AJCA.

The AJCA phased out the relevant portions of the ETI Act in order to help U.S. companies transition to a new regime. The AJCA repealed Code Sec. 114, the provision that excluded ETI from tax, effective for transactions beginning in 2005. A grandfather provision in Sec. 101(f) of the ACJA exempted certain preexisting binding contracts.

The AJCA provision at issue in this case, Sec. 101(d), provided transitional rules for 2005 and 2006. Under Sec. 101(d)(1), the amount includible in income for transactions during 2005 and 2006 was subject to the percentages specified in Sec. 101(d)(2). For 2006, the year at issue, 40 percent of ETI was includible in gross income. The EU objected to the AJCA before the WTO, and Congress responded by repealing Sec. 101(f). However, it did not repeal or revise the Sec. 101(d) transition rules.

Under the 2006 DWA transaction, DWA recognized qualifying ETI as provided under former Code Sec. 114 for 2006. DWA excluded 60 percent of its ETI for that year under Sec. 101(d) of the AJCA. DWA continued to receive income from the 2006 license in years 2007-2009. It did not exclude ETI income attributable to the 2006 transaction for those years until its returns were selected for a routine IRS examination. DWA then realized that it had not applied Sec. 101(d) for those years and filed refund claims totaling in excess of $4.4 million. The IRS disallowed the refunds.

DWA sued the government in the Court of Federal Claims. The government moved for summary judgment, arguing that the benefits provided in Sec. 101(d) were limited to income recognized in 2005 or 2006. The Claims Court agreed; it concluded that the phrases "for 2005" and "for 2006" in Sec. 101(d)(2) referred to the phrase "the amount includible in gross income" in Sec. 101(d)(1) rather than to "transactions during 2005 and 2006." The Claims Court found that the binding contract rule in Sec. 101(f) supported the government's position because it found that this provision was the only way in which Congress sought to confer long term benefits to taxpayers. The Claims Court reviewed the legislative history and concluded that nothing in it supported DWA's position. The Claims Court also concluded that Congress's decision to repeal Sec. 101(f) supported the government's interpretation, because it showed a congressional desire to comply with the WTO rulings. DWA appealed the Claims Court's decision to the Federal Circuit.

The Federal Circuit reversed the Claims Court's decision and held that Sec. 101(d) unambiguously provides transitional relief for all ETI received from transactions entered into in 2005 and 2006, even if the income is received in later years. The Federal Circuit found that the plain language of Sec. 101(d) strongly suggests Congress's intent to provide tax benefits for ETI derived from transactions entered into in 2005 and 2006, regardless of the year in which the income was earned. The court focused on the word "transaction," which the AJCA's predecessor statute defined to include deals such as leases or rentals, from which income would be received in installments over time.

The Federal Circuit found that the phrase "in the case of transactions during 2005 or 2006" in Sec. 101(d)(1) describes the circumstances in which transitional relief is available. Sec. 101(d)(2) specifies the applicable percentages to be used for purposes of Sec. 101(d)(1), providing that "for 2005" the percentage was 20 percent and "for 2006" the percentage was 40 percent. Thus, the court found that Sec. 101(d)(2) explains how to calculate the treatment of a given transaction by plugging the percentages into Sec. 101(d)(1), and did not, as the Claims Court concluded, act as a standalone provision limiting the scope of available transitional relief. The Federal Circuit also noted that in Sec. 101(d)(1), the word immediately preceding "during 2005 or 2006" is "transactions," not "income." The Federal Circuit characterized the Claims Court's interpretation as an effort to read the word "transactions" out of the statute. The Federal Circuit further found that other provisions in the AJCA demonstrated that the drafters knew how to craft a transitional rule based on when income was recognized, and that such language was absent in Sec. 101(d).

The Federal Circuit also noted that the IRS's continued use of Form 8873, Extraterritorial Income Exclusion, supported its finding that Sec. 101(d) was transaction based. The court explained that, if the transitional benefits were not available after 2006, Form 8873 would be obsolete.

Although the Federal Circuit concluded that the text of Sec. 101(d) was unambiguous, it reviewed the legislative history of the AJCA and found that it also supported DWA's interpretation. The court noted that the 2004 House Report referred to the ETI benefits applicable to "transactions" during 2005 and 2006. The court also observed that the ETI regime enacted years before the AJCA used a broad definition of transaction that included not just sales but leases or rentals from which income would be received in installments over time. The court further determined that all of the prior tax regimes relating to the taxation of ETI employed a transaction based structure.

The Federal Circuit found that by repealing the grandfather provision in Sec. 101(f), but not Sec. 101(d), Congress was focused on halting benefits for transactions entered into after 2006, rather than on altering tax rules for transactions that had already occurred. The court noted a senator's remark that the EU's only real objection to the AJCA was to the grandfather clause, and that the EU was willing to accept the remaining time on the two year transition period, including "the grandfathering of leasing contracts."

Finally, the Federal Circuit disagreed with the government's contention that in enacting both the ETI Act and the AJCA, Congress was attempting to comply with WTO rulings indicating that the U.S. should withdraw prohibited subsidies "without delay." In the court's view, this argument failed to recognize that even under the government's interpretation, Sec. 101(d) would run afoul of the U.S.'s treaty obligations. The court reasoned that it was just as likely Congress intended to quell concerns over Sec. 101(f), the most objectionable provision in the AJCA, while leaving relief in place for all other transactions. The court concluded by pointing out that, in any event, WTO decisions are not binding on the U.S. or on the Federal Circuit.

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Rev. Proc. Addresses Accounting Method Changes Due to New FASB and IASB Standards

The IRS issued a revenue procedure for taxpayers changing their method of accounting for the recognition of income for federal income tax purposes to a method for recognizing revenues described in the new financial accounting standards issued by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) (New Standards). In particular, Rev. Proc. 2017-30 is modified to provide procedures under Code Sec. 446 and Reg. Sec. 1.446-1(e) to obtain automatic consent of the IRS to change to an otherwise permissible method of accounting that uses the New Standards to identify performance obligations, allocate transaction price to performance obligations, and/or consider performance obligations satisfied, if such method change is made for the tax year in which the taxpayer adopts the new financial accounting standards. Rev. Proc. 2018-29.

On May 28, 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standard Board (IASB) jointly announced new financial accounting standards for recognizing revenue (New Standards), titled "Revenue from Contracts with Customers." While the New Standards were effective for publicly-traded entities, certain not-for-profit entities, and certain employee benefit plans for annual reporting periods beginning after December 15, 2017, for all other entities, the New Standards are effective for annual reporting periods beginning after December 15, 2018. However, early adoption is allowed for reporting periods beginning after December 15, 2016.

Since the joint announcement in 2014, FASB and IASB have revised the New Standards and provided guidance on how to implement them in certain situations. In 2015, the IRS issued Notice 2015-40, which requested comments on federal tax accounting issues relating to the adoption of the new standards, including, whether the New Standards were permissible methods of accounting for federal income tax purposes, the types of accounting method change requests that might result from adopting the new standards, and whether the current procedures for obtaining IRS consent to change a method of accounting were adequate to accommodate those requests. Last year, the IRS issued Notice 2017-17, which provided proposed guidance on procedures for requesting consent to change an accounting method where the change is made as a result of, or directly related to, the adoption of new financial accounting standards relating to the accounting for revenue from contracts with customers.

On May 10, 2018, after considering the comments to Notice 2017-17, the IRS issued Rev. Proc. 2018-29. In Rev. Proc. 2018-29, the IRS modified Rev. Proc. 2017-30 to provide procedures under Code Sec. 446 and Reg. Sec. 1.446-1(e) for obtaining automatic IRS consent to change to an otherwise permissible method of accounting that uses the New Standards to identify performance obligations, allocate transaction price to performance obligations, and/or consider performance obligations satisfied, if such method change is made for the tax year in which the taxpayer adopts the New Standards.

In Rev. Proc. 2018-29, the IRS adopts some of the suggestions submitted by practitioners in response to Notice 2017-17. For example, Rev. Proc. 2018-29 allows for more book-tax conformity and allows taxpayers to easily file accounting method change requests associated with adopting the New Standards. Specifically, Rev. Proc. 2018-29 creates new automatic accounting method change procedures, applies rules similar to the small business exception in the proposed revenue procedure in Notice 2017-17 to more taxpayers, and provides taxpayers the option of implementing the accounting method change on either a cut-off basis or with a Code Sec. 481(a) adjustment.

The IRS stated that Rev. Proc. 2018-29 is not intended to provide guidance for taxpayers changing their method of accounting to comply with Code Sec. 451, as amended by the Tax Cuts and Jobs Act of 2017 (TCJA). Rather, it provides guidance for taxpayers changing a method of accounting to an otherwise permissible method of accounting that recognizes revenue in income in a manner described in the New Standards. For example, Rev. Proc. 2018-29 provides procedures under which a taxpayer that has adopted the New Standards may make a corresponding change in its method of accounting for federal income tax purposes, provided the new method of accounting is otherwise permissible under the Code, including under amended Code Sec. 451. The time for making a change under Rev. Proc. 2018-29 is the taxpayer's first, second, or third tax year ending on or after May 10, 2018.

A taxpayer making a change under Rev. Proc. 2018-29 may implement the change with either a Code Sec. 481(a) adjustment or on a cut-off basis. In addition, Rev. Proc. 2018-29 provides for reduced Form 3115 filing requirements.

The IRS also requested comments on the following issues:

(1) What additional change in accounting method requests do taxpayers anticipate requesting due to the New Standards?

(2) What additional procedural guidance might be helpful as a result of the New Standards?

(3) What industry-specific guidance might be helpful as a result of the New Standards?

For a discussion of obtaining automatic IRS consent to change a method of accounting, see Parker Tax ¶241,590.

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Ten Year Limitations Period Did Not Apply to Taxpayer's Foreign Tax Credit Refund Claim

The Fifth Circuit held that the ten year limitations period applicable to refund claims for overpayments attributable to the allowance of a foreign tax credit did not apply to a taxpayer's refund claim because the taxpayer had a net decrease in the foreign tax credit for the year at issue. The Fifth Circuit also held that the taxpayer did not file the refund claim within two years of any payment of the tax because the adjustments to, and carryforward of, the taxpayer's credits on amended returns did not constitute payments for purposes of the statute of limitations. Schaeffler v. U.S., 2018 PTC 125 (5th Cir. 2018).

Background

Georg and Bernadette Schaeffler filed a joint tax return for 2002 in October 2003. They later filed multiple amended returns for 2002. In April 2013, they filed an amended return for 2002 that reflected two changes: a net decrease in foreign tax credit (FTC) of approximately $1.5 million, and an increase in minimum tax credit (MTC) of $6.7 million. A minimum tax credit arises where a taxpayer pays alternative minimum tax (AMT); some or all of the AMT amount is treated as a credit that can be used to reduce regular income tax in future years.

The reduced FTC resulted from an overall reduction in the Schaefflers' German tax liabilities, which stemmed from Mr. Schaeffler's involvement in rental activities and a partnership in Germany. The increase in the Schaefflers' MTC was due to changes made to the Schaefflers' amended return for 2001.

The Schaefflers' original 2001 return showed they paid only regular income tax. In April 2012, they filed an amended 2001 return reflecting a net increase in FTC of $5.6 million and a reduction in MTC of $3.1 million. These changes resulted in an AMT liability of $2.4 million. The Schaefflers said that the changes in their amended return for 2001 did not cause any additional tax liability or payments for that year. That resulted in an increase in their 2002 MTC of $6.7 million -- the sum of the $2.4 million MTC generated by the AMT incurred in 2001, and a $4.3 million MTC carried forward from earlier years.

On their original 2002 return, the Schaefflers elected to claim their FTC in the year when their foreign taxes accrued rather than the when they were paid. The Schaefflers were therefore required under Code Sec. 905(c)(1)(A) to notify the IRS if the accrued foreign taxes, when paid, differed from the amounts claimed as credits. They satisfied this requirement by filing their amended return for 2002 and redetermining their U.S. taxes. This involved incorporating the revised figure for their 2002 MTC, which resulted in an overpayment of approximately $5.1 million.

The Schaefflers requested a refund for the overpayment, which the IRS denied as untimely in January 2014. The Schaefflers then sued for the refund in a district court. The IRS moved to dismiss for lack of subject matter jurisdiction on the basis that (1) the refund claim was filed after the three year limitations period in Code Sec. 6511(a) and (2) the overpayment was not attributable to an FTC, so the special ten year limitations period in Code Sec. 6511(d)(3)(A) did not apply. The district court granted the government's motion to dismiss, and the Schaefflers appealed to the Fifth Circuit.

Analysis

Generally, a refund claim must be filed within the later of three years from the time the return was filed or two years from the time the tax was paid. However, a special ten year period is provided Code Sec. 6511(d)(3)(A), which applies if the refund claim is for an overpayment that is attributable to foreign taxes for which a credit is allowed. The government's position, with which the district court agreed, was that the changes in the German tax liabilities for 2002 resulted in a net decrease in the Schaefflers' foreign tax credit, so their overpayment was therefore not "attributable to" the allowance of the FTC.

The Schaefflers argued that their 2002 overpayment was attributable to the changes in their German tax liabilities because those changes triggered the reporting requirement under Code Sec. 905(c)(1)(A), which required the redetermination in their U.S. taxes that resulted in the overpayment. They contended that, but for the Code Sec. 905 notification, their MTC carryforward would have been carried forward indefinitely to a future year. They also argued that if their refund claim was barred, the result would be to disallow the computational carryforward credit, and the special ten year period would affect only taxpayers whose returns were computed without being affected by MTCs. The Schaefflers also offered two arguments for why they filed their refund claim within two years of making a tax payment. First, they said that the processing of the 2001 increase in their FTC, and the reduction in their MTC for that year on their 2001 amended return, constituted a payment. Second, they argued that a payment resulted from the carryforward of the credit from their amended 2001 return, which offset the 2002 reduction in their FTC.

The Fifth Circuit held that the Schaefflers' refund claim was not timely because the ten year limitations period did not apply and the refund claim was not filed within two years of making a payment. The court found that the Schaefflers' overpayment could not be "attributable to" their German taxes which ultimately resulted in a net decrease in their 2002 FTC. In the court's view, the Code Sec. 905(c)(1)(A) notification requirement did not cause the overpayment, but merely triggered an obligation to report the MTC increase.

The court found that the Schaefflers' MTC carryforward would have been allowable, and therefore absorbed, as an MTC in 2002 regardless of whether they submitted an amended return for that year. Thus, the 2002 absorbed amount would automatically be taken into consideration for all years after 2002, according to the court. The court also rejected the argument that denying the refund claim as untimely would disallow the use of the carryforward credit. It explained that, while there are a variety of scenarios where Code Sec. 6511(a)(3)(A) might apply, they all involve a change in foreign tax liability resulting in an FTC increase that generates an overpayment. Even assuming the Schaefflers' MTC amount for 2002 did not change, Code Sec. 6511(d)(3)(A) would not apply, in the court's view.

The court held that the refund was not filed within two years of a payment because neither the offsetting on the Schaefflers' 2001 amended return, nor the MTC carryforward to 2002, constituted a payment under Code Sec. 6511(a). First, the court found that the payment must be for taxes the year for which the refund is sought (in this case, 2002). Thus, even if the 2001 offsetting constituted a payment, it would not be a payment for 2002, the year for which the Schaefflers claimed the refund. Next, the court found that under Fifth Circuit precedent, adjustments for a single tax year are not a payment for purposes of the limitations period. The court also noted that the Schaefflers stated in their complaint that the changes that prompted the filing of their amended 2001 return did not cause any additional tax liability or payments.

The court concluded that, although the crediting of an overpayment is a payment under Code Sec. 6511(a), the application of an FTC is not. The court explained that neither the FTC nor the MTC are refundable tax credits; as such, neither can generate an overpayment that would constitute a payment for purposes of the statute of limitations. In reaching this conclusion, the Fifth Circuit rejected the portion Dresser Industries, Inc. v U.S., 73 F. Supp. 2d 682 (N.D. Tex. 1999), aff'd 2001 PTC 22 (5th Cir. 2001) holding that the application of an FTC is a payment under Code Sec. 6511(a).

For a discussion of the ten year limitations period for refund claims based on foreign tax credits, see Parker Tax ¶261,180.

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Taxpayers Must Exhaust Administrative Remedies before Recovering Costs for Bankruptcy Violations

A bankruptcy court held that two former debtors who sought damages and attorney fees from the IRS for violating their bankruptcy discharge injunctions by attempting to collect discharged taxes were first required to exhaust administrative remedies before seeking recourse from the bankruptcy court. The bankruptcy court found that, although the debtors may have been entitled to seek attorney fees and costs, they had not exhausted the administrative remedies provided in the applicable IRS regulations. In re Thal, 2018 PTC 128 (Bankr. S.D. Fla. 2018).

Background

Lucy Thal filed for Chapter 13 bankruptcy in February 2009. The IRS filed a proof of claim that listed a priority claim for approximately $7,100 and an unsecured general claim for around $60,500. The IRS did not object to Thal's Chapter 13 plan, in which she proposed to pay the full amount of the priority claim, and the bankruptcy court confirmed her plan in October 2009. Thal received her discharge in September 2016 and her case was closed.

In February 2017, the IRS sent four notices of intent to levy to Thal for tax years 2002-2005 for charges of approximately $37,100. Thal received a notice of the IRS's intent to seize up to 15 percent of her social security benefits for taxes due for years 2002-2005; the IRS said the unpaid taxes totaled over $17,200. Thal filed a motion for contempt against the IRS for violation of the discharge injunction by attempting to collect the discharged debts. Thal asked the bankruptcy court to order the IRS to pay punitive damages as well as attorney's fees and costs.

The IRS responded that it was not advised that a notice of intent to seize was sent to Thal, and that it was not notified until September 2017 that the U.S. Attorney's Office had taken $227 from Thal. The IRS claimed that it immediately placed a stop on all future collection actions and refunded the $227. For these reasons, the IRS argued that it would be inappropriate for the court to issue a sanction. The IRS also argued that Thal's request for attorney's fees and costs should be denied because Thal failed to exhaust her administrative remedies as required by Code Sec. 7433.

Robert Lee Slattery had a similar experience with the IRS. He filed a Chapter 13 petition in April 2011 and scheduled the IRS as a creditor. The IRS filed a proof of claim listing an unsecured priority claim for $37,700 and a general unsecured claim for $6,900 for tax years 2006 and 2008-2010. Slattery filed a plan in August 2011 proposing to pay the full amount of the IRS's priority claim. The IRS did not object and the court confirmed the plan in October 2011. Slattery completed his plan payments in August 2016 and received his discharge in October 2016.

In December 2016, Slattery received two notices of intent to levy for tax years 2008 and 2009 for over $1,400. Slattery's counsel advised that the debt owed was paid in full and that no further contact should be made with Slattery. In August 2017, Slattery received another letter from the IRS stating that $785 from his 2016 tax refund was applied to an amount owed for tax years, 2006, 2008 and 2009, and that $700 was still due and owing for 2008. Slattery filed a motion to reopen his bankruptcy case and to have the IRS held in contempt for violating the discharge injunction. Slattery asked that the funds the IRS withheld be returned and for the IRS to pay his attorney fees and costs. The IRS responded by arguing that the taxes at issue were excepted from discharge, and therefore its actions to collect any balance did not violate the discharge injunction. The IRS also argued that Slattery's request for attorney fees and costs should be denied because Slattery failed to exhaust his administrative remedies under Code Sec. 7433.

Analysis

Under Code Sec. 7430, a taxpayer must exhaust administrative remedies before suing the government to recover litigation costs in connection with the collection of any tax. Code Sec. 7433 gives a taxpayer the right to bring a civil action for damages against the U.S. when the IRS recklessly, intentionally or negligently disregards any provision of the Code. Under Code Sec. 7433(e), if the IRS violates a bankruptcy discharge injunction, the taxpayer may petition the bankruptcy court for damages. However, before doing so, Code Sec. 7433(d)(1) requires the taxpayer to first exhaust all available IRS administrative remedies provided for in the regulations.

Thal and Slattery argued that exhaustion of administrative remedies was not required under In re Jove Engineering, 92 F.3d 1539 (11th Cir. 1996) and In re Jha, 2011 PTC 129 (Bankr. N.D. Cal. 2011). In Jove, the Eleventh Circuit held that a corporate debtor could seek damages against the IRS based on the agency's intentional violation of the automatic stay. The Eleventh Circuit held that the district court had discretion to award attorney fees, but such awards had to be consistent with Code Sec. 7430. In Jha, a California bankruptcy court held that a debtor need not exhaust administrative remedies before seeking relief in a bankruptcy court; the court found that there was no mention in Code Sec. 7433(e) of the need for exhaustion.

The bankruptcy court first found that the IRS violated both Thal's and Slattery's discharge injunctions by attempting to collect discharged taxes. Turning to damages, the court found that they could be entitled to recover attorney fees and costs, but were first required under Code Sec. 7433 to exhaust the administrative remedies provided by the applicable IRS regulations.

The bankruptcy court found that Code Sec. 7433(d)(1) clearly applied to a claim for violation of a discharge injunction. The court found the holding in Jove to be unclear and noted that the Eleventh Circuit never discussed exhaustion of administrative remedies. The court explained that if Code Sec. 7433(e) had never been enacted, Jove would support the debtors' position. However, in the court's view, Code Sec. 7433(e) made clear that the exhaustion requirement applies to any claim for damages for violation of a discharge injunction. The court also court noted that Code Sec. 7433(e) was enacted two years after the Jove decision, but it found nothing in the legislative history to suggest it was enacted in response to Jove.

The court also found that the Jha holding ignored the plain meaning of Code Sec. 7433(e) by disregarding the clear cross references in the statute. As the bankruptcy court explained, Code Sec. 7433(b), which provides for damages and costs, clearly applies to petitions brought under Code Sec. 7433(e). The exhaustion requirement in Code Sec. 7433(d)(1) explicitly applies to damages awards under Code Sec. 7433(b). Therefore, the court concluded that the exhaustion requirement applies to actions for damages under Code Sec. 7433(b).

The court found that Thal's claim for punitive damages was barred under 11 U.S.C. Sec. 106(a)(3), which permits a money recovery for violation of a discharge injunction but does not allow any award of punitive damages. Slattery's claim for a return of the money the IRS improperly took was granted because the court found that nothing in Code Sec. 7433 prevented it from ordering the funds to be returned.

For a discussion of recovering litigation or administrative costs, see Parker Tax ¶263,540. For a discussion of taxpayer claims for damages for unauthorized collection, see Parker Tax ¶260,550.