Federal Tax Bulletin - Issue 135 - March 3, 2017

OMB Directive Offers Interim Guidance on Regulatory Cap; Dearth of New IRS Guidance Continues

The Office of Management and Budget (OMB) has provided guidance to assist the Treasury Department, the IRS, and other government agencies in implementing the President's regulatory cap (aka, the "two-for-one regulation order"). Despite the OMB guidance, the IRS has yet to issue any new regulations or substantive revenue rulings, procedures, or notices under the new administration.

On January 20, 2017, the White House issued a memorandum freezing the issuance of regulations pending a review by a department or agency head appointed or designated by President Trump (White House Memorandum Regarding Regulatory Freeze). This caused the IRS to withdraw several regulations that had not yet been published in the Federal Register, including proposed partnership audit regulations dealing with the change in partnership audit rules that takes effect for partnership tax years beginning after 2017.

On January 30, 2017, President Trump signed an Executive Order (EO) titled "Reducing Regulation and Controlling Regulatory Costs" (Regulatory Cap EO). Section 2 of the EO, which is titled "Regulatory Cap for Fiscal Year 2017," provides that whenever an executive department or agency publicly proposes for notice and comment or otherwise issues a new regulation, it must identify at least two existing regulations to be repealed. The EO states that the Director of the Office of Management and Budget (OMB) must provide the heads of agencies with guidance on the implementation of Section 2 of the EO.

Under Section 2(d) of the EO, the OMB Director is directed to provide the heads of agencies with guidance on the implementation of Section 2. Section 2(d) of the EO provides that:

"Such guidance shall address, among other things, processes for standardizing the measurement and estimation of regulatory costs; standards for determining what qualifies as new and offsetting regulations; standards for determining the costs of existing regulations that are considered for elimination; processes for accounting for costs in different fiscal years; methods to oversee the issuance of rules with costs offset by savings at different times or different agencies; and emergencies and other circumstances that might justify individual waivers of the requirements of this section. The Director shall consider phasing in and updating these requirements."

OMB Guidance on Regulatory Cap for Fiscal Year 2017

Shortly after the issuance of the Regulatory Cap EO, the OMB issued a memorandum to assist regulatory policy officers at various government agencies, including the Treasury Department and the IRS, with the implementation of the EO (OMB Guidance).

The OMB Guidance addresses in question and answer format the implications of Section 2 of the EO. Specifically, the guidance provides that, for purposes of implementing Section 2 in fiscal year 2017, regulatory policy officers must adhere to the following requirements:

(1) Unless prohibited by law, whenever an executive department or agency publicly proposes for notice and comment or otherwise issues a new regulation, it must identify at least two existing regulations to be repealed.

(2) For fiscal year 2017, the total incremental cost of all new regulations to be finalized, including repealed regulations, must be no greater than zero, unless otherwise required by law or consistent with advice provided in writing by the OMB Director.

(3) In furtherance of the requirement of (1), above, any new incremental costs associated with new regulations must, to the extent permitted by law, be offset by the elimination of existing costs associated with at least two prior regulations.

In complying with the EO, executive departments and agencies may issue two "deregulatory" actions for each new significant regulatory action that imposes costs. The savings of the two deregulatory actions must fully offset the costs of the new significant regulatory action. Actions that are considered deregulatory actions and thus qualify for savings include:

(1) any existing regulatory action that imposes costs and the repeal or revision of which will produce verifiable savings may qualify; and

(2) any meaningful burden reduction through the repeal or streamlining of mandatory reporting, recordkeeping or disclosure requirements may qualify.

Agencies must confirm that they will continue to achieve their regulatory objectives after the deregulatory action is undertaken.

Measuring Cost Savings

In determining the cost savings, costs must be measured as the opportunity cost to society as determined in accordance with OMB Circular A-4. OMB Circular A-4 provides that the principle of "willingness-to-pay" (WTP) captures the notion of opportunity cost by measuring what individuals are willing to forgo to enjoy a particular benefit. OMB Circular A-4 notes that while economists tend to view WTP as the most appropriate measure of opportunity cost, an individual's "willingness-to-accept" (WTA) compensation for not receiving the improvement can also provide a valid measure of opportunity cost.

The OMB Guidance also states that purely deregulatory actions that confer only savings to all affected parties generally will not trigger the requirement for the agency to identify two existing regulatory actions to be repealed. However, if such deregulatory actions impose costs on individuals or entities, agencies will need to offset those costs.

With respect to costs that occur over different time periods, the OMB directive provides that all cost estimates should be annualized in accordance with OMB Circular A-4. While timing issues will be handled on a case-by-case basis, in general, the start and end points for the annualization of costs should be directly comparable across the new and corresponding repealed regulatory actions.

Regs Cap is Also Affecting Revenue Rulings, Procedures, and Notices

Unfortunately, it is not entirely clear what type of documents are affected by the EO or the OMB Guidance. While the EO and the OMB Guidance generally refer to "regulations," the definition of the term "regulation" as defined in the EO also includes a reference to the term "rule." Does this then mean that IRS revenue procedures, IRS revenue rulings, IRS notices, and other forms of sub-regulatory guidance are subject to the regulatory cap? Specifically, Section 4 of the EO provides that:

"For purposes of this order, the term "regulation" or "rule" means an agency statement of general or particular applicability and future effect designed to implement, interpret, or prescribe law or policy or to describe the procedure or practice requirements of an agency, but does not include: (1) regulations issued with respect to a military, national security, or foreign affairs function of the United States; (2) regulations related to agency organization, management, or personnel; or (3) any other category of regulations exempted by the Director."

Revenue rulings and procedures could be seen as an "agency statement designed to implement, interpret, or prescribe law or policy or to describe the procedure or practice requirements of an agency." Besides appearing in the definition of the term "regulation," the only other place the term "rule" appears is in Section 2(d) of the EO which provides that the OMB Director must provide methods to oversee the issuance of rules with costs offset by savings at different times or different agencies.

Thus, it is unclear what type of documents are subject to the regulatory freeze. What is known, however, is that in the first six weeks of the new administration, the IRS has released just four revenue rulings, procedures, and notices, all of a perfunctory nature. The IRS released 22 such documents during the corresponding period last year, indicating a sharp fall-off in sub-regulatory guidance.

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District Court Bucks the Trend of Penalizing Estates for Relying on Expert's Advice

A district court went against the grain of several recent court decisions and held that an estate was not liable for a late filing penalty where the estate's executors filed the estate tax return late based on their tax attorney's advice. In reaching its conclusion, the court noted that other courts had ruled the opposite way on substantially similar facts but said it was obliged to follow precedent set by the circuit court to which the case was appealable. Estate of Hake v. U.S., 2017 PTC 74 (M.D. Pa. 2017).

Background

The executors of the estate of Ester Hake filed the estate's tax return approximately six months late. The executors filed the return on the date that their tax attorney advised them that it was due, after the estate had been granted extensions of both its filing and payment deadlines. The executors paid the taxes that they believe were owed well before payment was due and in an amount that later proved to be more than $100,000 in excess of what was actually owed.

However, the executors were incorrectly advised by their tax professionals that they had been granted a one-year extension to file the return and to pay the taxes owed on the estate. This advice was incorrect as the law permits only a six-month extension of time to file an estate tax return for domestic executors, whereas it permits up to a one-year extension to pay the taxes owed. For this error, the executors were assessed a late penalty of almost $200,000 and interest of approximately $18,000.

The executors requested abatement of the penalty, arguing that they had reasonable cause for the late filing because it was the result of legal advice from counsel. After the IRS denied the request, the executors filed a protest with the Appeals Division, again requesting an abatement and refund of the penalty due to reasonable cause. The executors filed additional information, including a citation to the Third Circuit's decision in Thouron v. U.S., 2014 PTC 228 (3d Cir. 2014), for the proposition that erroneous expert advice of a legal professional constitutes reasonable cause for the failure to file. The executors supplemented this information with an affidavit from their tax counsel who attested that he gave the executors inaccurate advice.

The IRS denied the appeal and the estate sued the IRS in a district court. An appeal of the district court's decision would go before the Third Circuit.

Case Law Addressing Impact of Erroneous Expert Advice on Late Filing Penalties

Recently, several appellate cases have dealt with the impact of an executor's reliance on the erroneous advice of a tax expert as far as filing deadlines for an estate tax return. Decisions on whether the executor can avoid late filing penalties have been varied, but most come down on the side of the IRS because the general view is that no reasonable cause exists for missing a filing deadline.

Under Code Sec. 6651(a)(1), when a taxpayer fails to file a tax return by the due date, including any extension of time for filing, a late filing penalty applies unless it is shown that such failure is due to reasonable cause and not due to willful neglect. Reg. Sec. 301.6651-1(c)(1) provides that the reasonable cause exception will excuse a failure to file timely only if the taxpayer exercised ordinary business care and prudence and was nevertheless unable to file the return within the prescribed time.

In U.S. v. Boyle, 469 U.S. 241 (1985), the Supreme Court held that in order to gain the benefit of this exception, an executor bears the burden of proving that the failure to timely file the tax return was due to reasonable cause. In that case, Robert Boyle was the executor of his mother's estate, and retained a lawyer on behalf of the estate to assist with tax matters. Boyle relied on the lawyer's instruction and guidance, and although he repeatedly checked with the lawyer about the status of the estate's return, the lawyer overlooked the timely filing of the estate tax return because of a clerical oversight. As a result, the estate's return was filed three months' late. The Supreme Court held that, in such circumstances, the executor could not hide behind the oversight of his attorney because executors have a clear obligation to make sure that estate tax returns are filed timely and this obligation cannot be discharged by delegating responsibility to an attorney or accountant. The Court further found that the executor's reliance on his tax lawyer was not for substantive tax advice, but for the administrative act of filing the return.

Last year, in Specht v. U.S., 2016 PTC 363 (6th Cir. 2016), the Sixth Circuit, citing Boyle, held that an estate could not recover more than $1.2 million in penalties and interest paid as a result of the late filing of its federal estate tax return, even where the executor was a high-school educated homemaker and her legal counsel was incompetent. The Sixth Circuit held that, although the circumstances in the case were unfortunate, the law was clear that the filing of the estate tax return and the payment of the related taxes are non-delegable. The court concluded that mere good-faith reliance on an expert does not constitute reasonable cause to avoid late filing penalties.

In Liftin v. U.S., 2014 PTC 276 (Fed. Cir. 2014), the Federal Circuit held that an estate had reasonable cause to delay filing its tax return until the decedent's spouse became a U.S. citizen so that the estate could take the marital deduction; however, there was no reasonable cause for waiting nine months after the wife became a citizen and all ancillary matters were resolved to file the estate tax return. The court held that the executor's reliance on a legal expert's erroneous advice was reasonable to the extent the advice was to wait until the decedent's wife became a U.S. citizen. That advice, the court noted, concerned a substantive question of tax law regarding the interaction between the statutes and regulations providing for the marital deduction and the statutes and regulations setting the deadline for filing the estate's return. However, the court said, the executor had no reasonable cause for waiting an additional nine months to file the estate tax return. The court said that the legal advice that the estate could delay filing until all the ancillary matters were resolved was not an interpretation of substantive tax law. Thus, there was no reasonable cause for the delay in filing the estate tax return and late filing penalties were appropriate.

In Estate of Thouron v. U.S., 2014 PTC 228 (3d Cir. 2014), the Third Circuit addressed the issue of whether an executor had reasonable cause for late payment of tax when the executor relied on the advice of a professional. While Boyle is a late-filing case, the Third Circuit found that the holding in Boyle applied with equal force to a failure to pay a tax because the "reasonable cause" excuse for failing to file a return or pay a tax timely is the same in both Code Sec. 6651(a)(1) and Code Sec. 6651(a)(2).

The Third Circuit read Boyle to have identified three distinct categories of late-filing cases:

(1) Cases that involve taxpayers who delegate the task of filing a return to an agent, only to have the agent file the return late or not at all. The Third Circuit noted that in Boyle, the Supreme Court held that in such cases, reliance upon one's attorney to file a timely tax return was not reasonable cause to excuse the late filing.

(2) Cases where a taxpayer, in reliance on the advice of an accountant or attorney, files a return after the actual due date, but within the time that the taxpayer's lawyer or accountant advised the taxpayer was available.

(3) Cases where an accountant or attorney advises a taxpayer on a matter of tax law.

The Third Circuit expressly noted that Boyle did not rule on when taxpayers rely on the advice of an expert, whether that advice relates to a substantive question of tax law or identifying the correct deadline. In Thouron, the Third Circuit concluded that a taxpayer's reliance on the advice of a tax expert may be reasonable cause for failure to pay tax by the deadline depending on the circumstances. The court held that the estate in that case should be permitted to present evidence to show that it should not have been assessed late payment penalties because of its reasonable reliance on the legal advice of counsel.

The Third Circuit sent the case back to the lower court to apply the law in light of the Third Circuit's analysis. The Third Circuit took care to note that Boyle had recognized a split of authority regarding the second category of cases, where the estate either paid or filed late, but did so by or before the deadline that its lawyer had instructed. In observing that the Supreme Court in Boyle had explicitly declined to resolve this circuit dispute, the Third Circuit noted that the Supreme Court had previously held that "a taxpayer could show reasonable cause where he or she filed (or paid) before what he or she was erroneously advised was the deadline."

The Third Circuit also underscored that in the third category of cases where a taxpayer has relied on erroneous advice of tax counsel regarding a question of law, Boyle found that courts have frequently held that "reasonable cause" is established when a taxpayer shows that he reasonably relied on the advice of an accountant or attorney that it was unnecessary to file a return, even when such advice turned out to have been mistaken.

IRS's Argument

The IRS argued that it was irrelevant whether the executors wholly delegated their duty to administer the estate to their lawyer, since Boyle should be read more broadly for the proposition that the statutory requirement for timely filing a return is solely the duty of the taxpayer, and is non-delegable. The IRS also contended that the district court should read Boyle to foreclose the executors from demonstrating reasonable cause under the undisputed facts in the case.

District Court's Decision

The district court held that the executors had reasonable cause to avoid the penalties assessed by the IRS. Given the Third Circuit's limited interpretation of Boyle's holding in Thouron, and the fact that the Supreme Court itself noted that its holding in Boyle did not reach the very circumstances presented in the instant case, the district court concluded that the executors exercised ordinary business care and prudence in relying upon their counsel's erroneous assertion that the deadline for filing the return and paying taxes owed had been extended.

The district court was not persuaded that Boyle or other binding authority compelled a contrary finding. In fact, the court noted, it was bound to follow the interpretive guidance that the Third Circuit provided in Thouron, which carefully isolated the holding of Boyle and construed it to apply to first-category cases only, where executors have delegated entirely their obligations to prepare and file returns and make payment of taxes owed. The Supreme Court, the district court observed, has not yet held that in the second category of cases - where the executor relied upon the advice of tax counsel when filing a return after the actual deadline but within the period instructed by counsel - an executor may not demonstrate that such reliance was reasonable.

In reaching its conclusion, the court recognized that some other courts have interpreted Boyle in the manner urged by the IRS, and on facts substantially similar to those presented in the instant case. However, the court said, it was obliged to follow Third Circuit precedent unless that precedent has been overruled. The district court noted that in Thouron, the Third Circuit construed Boyle narrowly, concluding that Boyle addresses only cases of "clerical oversight," where a taxpayer has simply relied on a third party to file a return by the prescribed deadline.

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Pursuant to Executive Order, IRS Won't Reject Returns That Don't Provide Health Insurance Information

Recent IRS changes to the system of processing returns meant that 2016 Forms 1040 that did not provide information about the taxpayer's health insurance coverage would be rejected for processing. However, as a result of a January 20, 2017, Executive Order relating to the Affordable Care Act, the IRS has changed its tax return processing procedures and will not reject any Forms 1040 that do not provide information regarding a taxpayer's health insurance coverage. IRS Website.

The instruction for Form 1040, Line 61, address the Affordable Care Act (ACA) and requires individuals to indicate on their 2016 Form 1040 filing whether they had health insurance, an exemption from coverage, or made a shared responsibility payment. In recent years, tax returns silent in that regard were still processed. For 2016 returns, the IRS had made system changes that would reject tax returns during processing in instances where the taxpayer didn't provide health insurance coverage information.

A January 20, 2017, Executive Order directed federal agencies to exercise all authority and discretion available to them to waive, defer, grant exemptions from, or delay the implementation of any provision or requirement of the ACA that would impose a fiscal burden on any state or a cost, fee, tax, penalty, or regulatory burden on individuals, families, healthcare providers, health insurers, patients, recipients of healthcare services, purchasers of health insurance, or makers of medical devices, products, or medications. As a result, the IRS announced changes to its return processing system that will allow electronic and paper returns to continue to be accepted for processing in instances where a taxpayer doesn't indicate his or her health insurance coverage status.

However, the IRS noted that legislative provisions of the ACA law are still in force until changed by Congress, and taxpayers are still required to follow the law and pay what they may owe.

Processing returns that don't include the required health insurance information on Line 61 means that taxpayer returns will not be systemically rejected by the IRS at the time of filing. According to the IRS, this will allow the returns to be processed and will minimize burdens on taxpayers, including those expecting a refund. When the IRS has questions about a tax return, taxpayers may receive follow-up questions and correspondence at a future date, after the filing process is completed. This is similar to how the IRS handled this in previous years, the IRS statement said, and reflects the normal IRS post-filing compliance procedures followed by the IRS.

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Substance-Over-Form Doctrine Doesn't Authorize IRS to Reclassify Transfers from DISC to Roth IRAs

The Sixth Circuit reversed the Tax Court and held that, because a corporation used a domestic international sales corporation and Roth IRAs for their congressionally sanctioned purposes - tax avoidance - the IRS had no basis for recharacterizing transactions involving the transfer of funds from the DISC to the Roth IRA accounts. Nor, the court said, did the IRS have any basis for recharacterizing the law's application to the transactions at issue. Summa Holdings v. Comm'r, 2017 PTC 58 (6th Cir. 2017).

Facts

Summa Holdings is the parent corporation of a group of companies that manufacture a variety of industrial products. Its two largest shareholders are James Benenson, Jr. (who owned 23.18 percent of the company in 2008) and the James Benenson III and Clement Benenson Trust (which owned 76.05 percent of the company in 2008). James Benenson, Jr. and his wife serve as the trust's trustees, and their children, James III and Clement, are the beneficiaries of the trust. In 2001, James III and Clement each established a Roth IRA and contributed $3,500 apiece to the IRA. Just weeks after the Benensons set up their accounts, each Roth IRA paid $1,500 for 1,500 shares of stock in JC Export, a newly formed domestic international sales corporation (DISC).

Observation: DISCs were designed by Congress to incentivize companies to export goods by deferring and lowering their taxes on export income. The exporter avoids corporate income tax by paying the DISC "commissions" of up to 4 percent of gross receipts or 50 percent of net income from qualified exports. The DISC pays no tax on its commission income (up to a specified amount) and may hold onto the money indefinitely, though the DISC shareholders must pay annual interest on their shares of the deferred tax liability. Once the DISC has assets at its disposal, it can invest them, including through low-interest loans to the export company. Money and other assets in the DISC may exit the company as dividends to shareholders. Dividends paid to individuals are taxed at the qualified dividend rate, which (since 2003) is lower than the corporate income rate that otherwise would apply to the company's export revenue. Generally, the DISC's shareholders are the same individuals who own the export company. In those cases, the net effect of the DISC is to transfer export revenue to the export company's shareholders as a dividend without taxing it first as corporate income. Corporations and other entities, including IRAs, may own shares in DISCs. A corporation that owns DISC shares still has to pay the full corporate income tax on any dividends, which cancels out any tax savings. For a time, tax-exempt entities like IRAs paid nothing on DISC dividends, which enabled export companies to shield active business income from taxation by assigning DISC stock to controlled tax-exempt entities like pension and profit-sharing plans. But Congress closed this gap in 1989 and required tax-exempt entities to pay an unrelated business income tax, set at the same rate as the corporate income tax, on DISC dividends.

Traditional IRAs or Roth IRAs, each of which has different qualities, may be shareholders in a DISC. Traditional IRA owners deduct contributions to the IRA and pay income tax on withdrawals, including accrued gains in their accounts. Roth IRAs work in the other direction. Roth IRA owners do not deduct their contributions from pre-tax income, but they take withdrawals, including accrued gains, tax-free. Contribution limits are imposed on traditional and Roth IRAs. In 2008, the maximum annual contribution to each was $5,000. The maximum annual contribution to a Roth IRA decreases as an individual's income increases. In 2008, single filers who made over $116,000 could not make any contributions to a Roth IRA.

For tax advantageous reasons, the owner of a closely held export company might want to transfer money from his company to a DISC and pay some or all of that money as a dividend to the DISC shareholders, which may include Roth IRAs. The IRA account holder would have to pay the high unrelated business income tax when the DISC dividends go into the IRA. But once the Roth IRA receives the money, the account holder can invest it freely without having to pay capital gains taxes on increases in the value of each share or incomes taxes on the dividends received - just like other Roth IRA owners who buy shares of stock in companies that generate considerable dividends and rapid growth in share value. As with all Roth IRAs, the owner would not have to pay any individual income or capital gains taxes when the assets leave the account after he hits the requisite retirement age.

The Benensons, in order to prevent the Roth IRAs from incurring any tax-reporting or shareholder obligations by owning JC Export directly, formed another corporation, JC Holding, which purchased the shares of JC Export from the Roth IRAs. From January 31, 2002, to December 31, 2008, each Roth IRA owned a 50 percent share of JC Holding, which was the sole owner of JC Export. With this chain of ownership in place, the family, trust, and company were a few steps away from the possibility of considerable future tax savings. Summa Holdings paid commissions to JC Export, which distributed the money as a dividend to JC Holding, its sole shareholder. JC Holding paid a 33 percent income tax on the dividends, then distributed the balance as a dividend to its shareholders, the Benensons' two Roth IRAs. From 2002 to 2008, the Benensons transferred approximately $5.2 million from Summa Holdings to the Roth IRAs in this way, including approximately $1.5 million in 2008. By 2008, each Roth IRA had accumulated over $3 million.

In 2012, the IRS issued notices of deficiency to Summa Holdings, the Benensons, and the Benenson Trust for the 2008 tax year but did not do so for the earlier tax years. The IRS informed Summa Holdings that it would apply the substance-over-form doctrine and reclassify the payments to JC Export as dividends from Summa Holdings to its major shareholders. As recast, the transfers did not count as commissions from Summa Holdings to JC Export. That meant Summa Holdings had to pay income tax on the DISC commissions it deducted, and JC Holding obtained a refund for the corporate income tax it had paid on its dividend from JC Export. The commissions became dividends to Benenson Jr. and the Benenson Trust, all in proportion to their ownership shares. The IRS determined that each Roth IRA received a contribution of approximately $1.1 million. Because James III and Clement both made over $500,000 in 2008, they were not eligible to contribute anything to their Roth IRAs. The IRS imposed a 6 percent excise tax penalty under Code Sec. 4973 on the contributions and imposed a $56,000 accuracy-related penalty on Summa Holdings.

Summa Holdings and the Benensons challenged the IRS's action in the Tax Court. The Tax Court upheld the IRS's recharacterization of the transactions but not the accuracy-related penalty. Summa Holdings challenged that decision in the Sixth Circuit. The Benensons and the Benenson Trust have related appeals pending before the First and Second Circuits.

Sixth Circuit's Decision

The Sixth Circuit reversed the Tax Court and held that, because the transactions at issue were legal, Summa Holdings did not owe the IRS a dime. According to the court, the IRS had denied relief to a set of taxpayers who complied in full with the printed and accessible words of the tax laws. The Benenson family, the court noted, had the time and patience and money to understand how a complex set of tax provisions could lower its taxes. Tax attorneys advised the family to use a congressionally innovated corporation a DISC to transfer money from their family-owned company to their sons' Roth IRAs. When the family did just that, the court observed, the IRS balked. The IRS, the court stated, acknowledged that the family had complied with the relevant tax provisions and acknowledged that the purpose of the relevant provisions was to lower taxes, but reasoned that the effect of these transactions was to evade the contribution limits on Roth IRAs and applied the substance-over-form doctrine.

According to the court, when the IRS said that the transaction at issue amounted in substance to a Roth IRA contribution, the IRS was really saying that the purpose of the transaction was to funnel money into the Roth IRAs without triggering the contribution limits. And the court agreed that this was the end result. However, the court said, the substance-over-form doctrine does not authorize the IRS to undo a transaction just because taxpayers undertook it to reduce their tax bills. The transactions at issue, the court stated, were not against the law.

In conclusion, the Sixth Circuit opined that if Congress sees DISCRoth IRA transactions of this sort as unwise or as creating an improper loophole, it should fix the problem. Until then, the court observed, DISCs will continue to provide tax savings to the owners of U.S. export companies, just as Congress intended even if subsequent changes to the Code have increased the scale of the savings beyond Congress's original estimation. The last thing the federal courts should be doing, the court said, is rewarding Congress's creation of an intricate and complicated Internal Revenue Code by closing gaps in taxation whenever that complexity creates them.

For a discussion of the taxation of Roth IRA transactions and DISCs, see Parker Tax ¶135,160.

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IRS Gears Up to Report Unpaid Taxes to State Dept; Revocation or Denial of Passports Could Result

The IRS announced that it will begin certifying seriously delinquent tax debts to the State Department in early 2017. As a result, any taxpayer such a debt could have his or her passport revoked or the State Department could refuse to issue or renew a passport to that individual. IRS Website.

On December 4, 2015, the Fixing America's Surface Transportation Act (the Act) was enacted into law. The Act added Code Sec. 7345, which allows for the revocation or denial of a passport where a taxpayer has a seriously delinquent tax debt. Under the provisions of Code Sec. 7345, the IRS is authorized to certify to the State Department that an individual has a seriously delinquent tax debt in which case the State Department may revoke or refuse to issue or renew a passport to that individual.

While the IRS has not yet started certifying tax debts to the State Department, it recently announced that it will begin making such certifications in early 2017.

Seriously Delinquent Tax Debt

Seriously delinquent tax debt is defined in Code Sec. 7345(b) as an individual's unpaid, legally enforceable federal tax debt totaling more than $50,000 (including interest and penalties) for which a:

(1) a notice of federal tax lien has been filed under Code Sec. 6323 and all administrative remedies under Code Sec. 6320 have lapsed or been exhausted; or

(2) a levy has been issued under Code Sec. 6331.

Some tax debt is not included in determining if a taxpayer has a seriously delinquent tax debt, even if it meets the above criteria. Under Code Sec. 7345(b)(2), a tax debt is excluded if it is a tax debt:

(1) being paid in a timely manner under an installment agreement entered into with the IRS;

(2) being paid in a timely manner under an offer in compromise accepted by the IRS or a settlement agreement entered into with the Justice Department;

(3) for which a collection due process hearing is timely requested in connection with a levy to collect the debt; or

(4) for which collection has been suspended because a request for innocent spouse relief under Code Sec. 6015(f) has been made.

Before denying a passport, the State Department will hold a taxpayer's passport application for 90 days to allow the taxpayer to:

(1) resolve any erroneous certification issues;

(2) make full payment of the tax debt; or

(3) enter into a satisfactory payment alternative with the IRS.

With respect to a passport that has already been issued, there is no grace period for resolving the debt before the State Department revokes the passport.

Taxpayer Notification - Notice CP 508C

The IRS is required to notify a taxpayer in writing at the time the IRS certifies a seriously delinquent tax debt to the State Department. The IRS is also required to notify the taxpayer in writing at the time it reverses certification. The IRS will send written notice by regular mail to the taxpayer's last known address.

Reversal of Certification - Notice CP 508R

Under Code Sec. 7345(c), the IRS is required to notify the State Department of the reversal of the certification when: (1) the tax debt is fully satisfied or becomes legally unenforceable; (2) the tax debt is no longer seriously delinquent; or (3) the certification is erroneous.

The IRS must provide notice as soon as practicable if the certification is erroneous. The IRS will provide notice within 30 days of the date the debt is fully satisfied, becomes legally unenforceable, or ceases to be seriously delinquent tax debt.

A previously certified debt is no longer seriously delinquent when: (1) the taxpayer and the IRS enter into an installment agreement allowing the taxpayer to pay the debt over time; (2) the IRS accepts an offer in compromise to satisfy the debt; (3) the Justice Department enters into a settlement agreement to satisfy the debt; (4) collection of the debt is suspended because the taxpayer has requested innocent spouse relief under Code Sec. 6015(f); or (5) the taxpayer makes a timely request for a collection due process hearing in connection with a levy to collect the debt.

The IRS has stated that it will not reverse certification where a taxpayer requests a collection due process hearing or innocent spouse relief on a debt that is not the basis of the certification. Also, the IRS will not reverse the certification because the taxpayer pays the debt below $50,000.

Judicial Review of Certification

If the IRS certifies a debt to the State Department, the taxpayer may file suit in the U.S. Tax Court or a U.S. district court to have the court determine whether the certification is erroneous or if the IRS failed to reverse the certification when it was required to do so. If the court determines the certification is erroneous or should be reversed, it can order reversal of the certification.

Code Sec. 7345 does not provide the court authority to release a lien or levy or award money damages in a suit to determine whether a certification is erroneous. A taxpayer is not required to file an administrative claim or otherwise contact the IRS to resolve the erroneous certification issue before filing suit in the U.S. Tax Court or a U.S. District Court.

Payment of Taxes

If a taxpayer can't pay the full amount of the tax debt owed, he or she can make alternative payment arrangements such as an installment agreement or an offer in compromise and still keep his or her U.S. passport.

If a taxpayer disagrees with the tax amount or the certification was made in error, the taxpayer should contact the phone number listed on Notice CP 508C. If the tax debt has already been paid, the taxpayer must send proof of that payment to the address on the Notice CP 508C.

If the taxpayer recently filed a tax return for the current year and expects a refund, the IRS will apply the refund to the debt and, if the refund is sufficient to satisfy the taxpayer's seriously delinquent tax debt, the account will be considered fully paid.

The State Department will notify a taxpayer in writing if his or her U.S. passport application is denied or if his or her U.S. passport is revoked.

If a taxpayer needs a U.S. passport to keep his or her job, once a seriously delinquent tax debt is certified, the taxpayer must fully pay the balance, or make an alternative payment arrangement to keep his or her passport.

If the Secretary of State decides to revoke a passport, the Secretary of State, before making the revocation, may: (1) limit a previously issued passport only for return travel to the United States; or (2) issue a limited passport that only permits return travel to the United States.

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Dentist Qualifies as Real Estate Professional; Rental Real Estate Losses Are Deductible

The Tax Court held that a dentist's logs of real estate activities, as well as testimony from various witnesses, established that he spent the requisite amount of time on real estate activities to qualify as a real estate professional. Accordingly, he was entitled to deduct his rental real estate losses against the income from his and his wife's dental practice. Zarrinnegar, T.C. Memo. 2017-34 (2/13/17).

Background

Mohammad Zarrinnegar and his wife, Mary, owned and operated two businesses during 2010, 2011, and 2012: a dental practice and a real estate business. They are both dentists and, during the years at issue, worked at their joint dental practice in shifts. Mary worked Mondays, Wednesdays, Thursdays, and Fridays from 9 a.m. until 2:30 p.m. and some Saturdays from 8 a.m. until 12 p.m. Mohammad worked at the dental practice Mondays, Wednesdays, Thursdays, and Fridays from 2:30 p.m. until 6 p.m.

The couple's real estate business consisted of Mohammad's real estate brokerage activity and four rental properties that the couple owned and that Mohammad managed. Mary did not participate in the real estate business.

Mohammad spent hundreds of hours on brokerage-related activities, including brokers' tours, listing searches, open houses, property viewings, and client meetings. He also spent significant time each year managing the couple's four rental properties. All told, Mohammad spent over 1,000 hours on the real estate business during each year at issue.

The dental business showed a net profit of approximately $468,000, $322,000, and $381,000 for 2010, 2011, and 2012, respectively. These amounts were reported on the couple's tax returns for those years along with losses from the real estate business of $222,000 for 2010; $242,000 for 2011, and $221,000 for 2012. The IRS disallowed the losses because it determined that they were passive activity losses. The couple disagreed and took their case to the Tax Court.

Analysis

As a general rule, Code Sec. 469(c)(2) provides that rental activities are per se passive whether or not the taxpayer materially participates. Thus, losses from such activities are passive losses that are deductible only against passive income. As an exception, however, rental activities of taxpayers in real property trades or businesses (i.e., a real estate professionals) are not treated as passive if the material participation requirement under Code Sec. 469(c)(7) is satisfied. Under that provision, a taxpayer is a real estate professional if:

(1) more than one-half of the personal services performed in trades or businesses by the taxpayer during such tax year are performed in real property trades or businesses in which the taxpayer materially participates; and

(2) such taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.

Before the Tax Court, the couple offered Mohammad's testimony and logs of hours for 2010, 2011, and 2012. Mohammad testified at great length about the logs' contents and was able to recall extensive details relating to the entries. Each log showed that Mohammad spent more than 1,000 hours per year on real estate activities. Mary also testified, as well as several other witnesses.

The court found that all the testimony offered in the case was credible and that it corroborated Mohammad's logs and testimony. Accordingly, the court concluded that Mohammad worked more than 1,000 hours per year at the real estate business and worked fewer than 1,000 hours per year at the dental practice, satisfying both elements of the real estate professional test. Thus, the taxpayers had met material participation requirement under Code Sec. 469(c)(7) and were entitled to deduct the rental real estate losses incurred during the years at issue.

For a discussion of the deductibility of rental real estate losses by real estate professionals, see Parker Tax ¶247,120.

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D.C. Circuit Shoots Down Preparer's Claim Relating to Suspension to Practice Before IRS

The D.C. Circuit affirmed a lower court and held that a tax return preparer was not entitled to damages as a result of his suspension to practice before the IRS as an enrolled agent. The court concluded that since the return preparer had never obtained enrolled-agent status, the IRS could not have deprived him of his interest in that status, however careless their actions were. Bowman v. Iddon, 2017 PTC 81 (D.C. Cir. 2017).

Background

The IRS recognizes four primary groups of individuals who prepare tax returns: CPAs, lawyers, enrolled agents, and unenrolled preparers (i.e. tax preparers). CPAs, lawyers, and enrolled agents must be licensed, while tax preparers are subject to less stringent regulation. As of 2005, IRS regulations permitted the first three of these groups - all but tax preparers - to practice before the IRS.

Circular 230, which then governed practice before the IRS, defined these groups as "practitioners" and allowed them to act in all matters connected with a presentation to the IRS or any of its officers or employees relating to a taxpayer's rights, privileges, or liabilities, including through filing documents, corresponding with the IRS, and representing a client at conferences. Tax preparers, by contrast, could obtain only "limited practice" authorization, which allowed them to represent taxpayers before certain line officers of the IRS, excluding "appeals officers, revenue officers, Counsel or similar officers or employees."

In 2011, after an IRS review found problems in the tax-preparation industry, the IRS issued a new rule governing tax preparers. That rule created a new category of "registered tax preparers," who counted as "practitioners" obligated to register with the IRS by paying a fee and passing a qualifying exam. Under the rule, and except as otherwise prescribed, only attorneys, CPAs, enrolled agents, and registered tax preparers could for compensation prepare or assist with the preparation of all or substantially all of a tax return or claim for refund. The D.C. Circuit invalidated these regulations in Loving v. IRS, 2014 PTC 73 (D.C. Cir. 2014) holding that tax-return preparers fall outside the IRS's statutory authority to regulate "the practice of representatives of persons before the Department of the Treasury."

In June of 2005, while working as a tax preparer, John Bowman pled guilty to mail fraud, wire fraud, and money laundering and was sentenced to 57 months in prison. He began serving his sentence in August of 2005. Three months later, while Bowman was still in prison, IRS agent Kimberly Iddon submitted a report of Bowman's suspected misconduct to the IRS Office of Professional Responsibility (OPR). The form on which Iddon submitted the report required her to identify whether Bowman was an attorney, CPA, enrolled agent, or enrolled actuary. Though Bowman had never been an enrolled agent, Iddon erroneously identified him as one, citing "personal knowledge" and attaching newspaper articles on Bowman's prosecution. None of those articles, however, identified Bowman as an enrolled agent, and Iddon never searched the IRS's records to confirm Bowman's status.

A few weeks later, Iddon faxed Bowman's IRS Centralized Authorization File to an OPR paralegal. Although the space on the form for "Enrollment Number" is empty, someone handwrote the words "Enrolled Agent" at the bottom of the page. An IRS official who later searched the agency's records reported that she "did not find any record indicating that [Bowman] was authorized to practice before the IRS as an enrolled agent."

OPR nonetheless initiated disciplinary proceedings to suspend Bowman from doing what, as a tax preparer, he had no authority to do: practice before the IRS. Due to a second mistake by the IRS, Bowman received neither the complaint that initiated those proceedings nor an opportunity to correct the agency's obvious error. Specifically, the IRS mailed a copy of the complaint to his business address, even though the IRS knew Bowman was incarcerated and had forfeited his business property to the government as restitution. Unsurprisingly, the letter was returned undelivered.

The IRS announced Bowman's suspension in its quarterly bulletin, as well as on a website listing disciplinary actions for "Attorneys, Certified Public Accountants, Enrolled Agents, and Enrolled Actuaries." An OPR manager emailed more than 20 people informing them that Bowman had been suspended from practice before the IRS and should not be recognized as a taxpayer's representative. Having left prison, and having received no correspondence from the IRS, Bowman learned of OPR's disciplinary decision through a Freedom of Information Act request in September 2011. By this time, the IRS had issued its "registered tax return preparer" rule extending Circular 230 to tax preparers. In November of 2012, Bowman filed a petition for reinstatement with OPR pursuant to Circular 230.

Two years later, after the D.C. Circuit's Loving decision invalidated the 2011 rule, the IRS responded to Bowman's petition. Now recognizing that Bowman was not and had never been an enrolled agent, OPR sent him a letter informing him that "[a]ccording to the [IRS's] Enrolled Agent database, you are not an Enrolled Agent." OPR went on to warn Bowman that "unless you currently possess a license under section 10.3 of Circular 230, you may not engage in full practice before the Internal Revenue Service . . . ." But OPR concluded by restoring Bowman's "ability to engage in limited practice before the IRS, as defined in section 10.7 of Circular 230, by removing [his] name from the list of individuals currently barred from practice before the IRS."

Bowman's Lawsuit

Bowman filed suit in a district court alleging that five IRS employees barred him from representing taxpayers before the IRS without due process in violation of the Fifth Amendment. In his lawsuit, Bowman sought damages under Bivens v. Six Unknown Named Agents of the Federal Bureau of Narcotics, 403 U.S. 388 (1971). The district court dismissed the case, concluding that the Internal Revenue Code's remedial scheme for tax practitioners foreclosed a Bivens action. Bowman appealed to the D.C. Circuit. In Atherton v. District of Columbia Office of the Mayor, 567 F.3d 672 (D.C. Cir. 2009), the D.C. Circuit held that a procedural due process violation occurs when an official deprives an individual of a liberty or property interest without providing appropriate procedural protections. In his complaint, Bowman alleged a serious procedural defect, i.e., that he received neither notice of his suspension nor an opportunity to challenge it.

D.C. Circuit's Decision

The D.C. Circuit affirmed the district court's decision but on the alternative ground that Bowman failed to state a claim under Federal Rule of Civil Procedure 12(b)(6) because his complaint contained no allegation that the IRS agents deprived him of a constitutionally protected interest. The court noted that Bowan identified no constitutionally protected interest lost through the IRS's actions. His complaint, the court said, repeatedly identified a property interest in his enrolled-agent status and then describes his Bivens claim in one sentence: "Because Plaintiff has not received the quantum of process he was due before being suspended indefinitely as an Enrolled Agent [he] has suffered damage to his reputation and business in perpetuity." However, the court noted, to enjoy a "property interest in a benefit," Bowman had to have a legitimate claim of entitlement to it. Yet, the court stated, Bowman disclaimed any claim of entitlement to enrolled-agent status in his court affidavit, which stated "[a]t no time was I an Enrolled Agent." Obviously, the court concluded, if Bowman never obtained enrolled-agent status, the IRS could not have deprived him of his interest in that status, however careless their actions.

Amicus Argument

An amicus brief filed in the case argued that "Bowman's claim involves . . . the deprivation of his liberty interests in the ability to engage in his chosen profession as a tax preparer and in his reputation." Indeed, the D.C. Circuit noted that it has recognized that when the government formally debars an individual from certain work, there is a cognizable deprivation of liberty that triggers the procedural guarantees of the Due Process Clause. An individual may also bring a "stigma-plus" claim, the court said, if a defendant has harmed a taxpayer's reputation and deprived the taxpayer of some benefit to which he or she has a legal right. According to the amicus, Bowman satisfied both of these theories of liability because "he has alleged injury to his liberty interest in pursuing his chosen profession as a tax preparer in addition to damage to his reputation."

According to the amicus, the IRS's 2006 decision suspended Bowman from practice before the IRS, and although at that time the suspension only prevented him from working as an enrolled agent, the IRS later amended its regulations to permit only practitioners including registered tax preparers to prepare taxes. From then until the D.C. Circuit's decision in Loving, the amicus argued, the suspension barring Bowman from practicing before the IRS prohibited him from becoming a practitioner and thus from preparing taxes.

While the D.C. Circuit found the amicus's theory clever, it noted that the theory appeared nowhere in Bowman's complaint. Not once, the court observed, did Bowman allege that he was prevented from preparing taxes. Instead, the court said, he repeatedly referred to himself as an enrolled agent and linked his harm to his enrolled-agent status.

Observation: Two of the judges separately wrote that the resolution of the case avoided the need to address Bowman's Bivens claim. However, they found it important to note that the issue was one of first impression in the D.C. Circuit and they would have concluded that Bowman was entitled to pursue his claim against the IRS if he had alleged that the IRS barred him from preparing taxes.

For a discussion of the rules relating to practice before the IRS, see Parker Tax ¶271,100.

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Amicus Brief Couldn't Sway Supreme Court to Hear Bankruptcy Discharge Case

The Supreme Court declined to hear an appeal of a Ninth Circuit case affirming a district court's decision that had reversed a bankruptcy court holding, which had been favorable to the taxpayer. The Court was apparently unswayed by an amicus brief filed on behalf of the taxpayer which argued that, because the circuits are divided on the issue of the dischargeability of tax debts, the ability of debtors to discharge tax debt in a bankruptcy will depend upon their geography, leading to disparate treatment of debtors and an inconsistent application of federal bankruptcy law. In re Smith, 2016 PTC 249 (9th Cir. 2016), cert. denied (2/21/17); Amicus Brief in re Smith.

After Martin Smith failed to timely file his 2001 tax return, the IRS prepared a Substitute for Return (SFR) based on information it gathered from third parties. In March 2006, the IRS mailed Smith a notice of deficiency. Smith did not challenge the notice of deficiency within the allotted 90 days and the IRS assessed a deficiency against him of $70,662. Three years later, in May 2009, Smith filed a Form 1040 for the year 2001 on which he wrote "original return to replace SFR." On this late-filed form, Smith reported a higher income than the one the IRS calculated in its assessment, thereby increasing his tax liability. The IRS added the additional arrearage to its assessment. Two months after that, in July 2009, Smith submitted an offer in compromise, hoping to resolve his tax liability. The IRS rejected his offer. Smith later lost his job and the IRS allowed him to pay his tax bill in monthly installments of $150.

Several months later, Smith declared bankruptcy and sought to discharge his 2001 tax debt before the bankruptcy court. Smith and the IRS agreed that the increase in the assessment based on Smith's late-filed form was dischargeable, but they disputed whether the IRS's original $70,662 assessment was also dischargeable. The bankruptcy court ruled that it was but a district court reversed that holding and the Ninth Circuit affirmed the district court's decision.

Bankruptcy Code Section 523(a)(1)(B)(i) exempts from discharge "any . . . debt for a tax . . . with respect to which a return, or equivalent report or notice, if required . . . was not filed or given." In In re Hatton, 220 F.3d 1057 (9th Cir. 2000), the Ninth Circuit adopted the Tax Court's widely-accepted definition of "return" for purposes of Bankruptcy Code Section 523(a)(1)(B)(i). In Hatton, the Ninth Circuit stated that in order for a document to qualify as a tax return: (1) it must purport to be a return; (2) it must be executed under penalty of perjury; (3) it must contain sufficient data to allow calculation of tax; and (4) it must represent an honest and reasonable attempt to satisfy the requirements of the tax law.

When the Ninth Circuit decided Hatton, the Bankruptcy Code did not define the term "return." Congress subsequently amended the Bankruptcy Code in 2005 and added the following definition of a return: "the term return' means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements)." While observing that it had not yet interpreted this new definition, the Ninth Circuit noted that both Smith and the IRS, the Tax Court, and several circuit courts agreed that Hatton's four-factor test still applied.

The dispute between Smith and the IRS centered on whether Smith's filing met the fourth requirement of the operative test. In other words, was his filing of his 2001 tax return an honest and reasonable attempt to satisfy the requirements of the tax law?

The Ninth Circuit held that Smith's belated acceptance of responsibility was not a reasonable attempt to comply with the Tax Code. The court noted that many of its sister circuits have held that post-assessment tax filings are not "honest and reasonable" attempts to comply and are therefore not "returns" at all. In the instant situation, the court observed, Smith failed to make a tax filing until seven years after his return was due and three years after the IRS went to the trouble of calculating a deficiency and issuing an assessment. To the court, this meant that the filing of Smith's 2001 tax return was not an honest and reasonable attempt to comply with the tax law.

Smith appealed the decision to the Supreme Court. Two nonprofit organizations, the National Consumer Bankruptcy Rights Center (NCBRC) and the National Association of Consumer Bankruptcy Attorneys (NACBA), filed an amici curiae in support of certiorari being granted in Smith's case. In the brief, the organizations stated that the primary issue in this case whether tax liability based on late-filed tax returns is dischargeable in bankruptcy directly implicates the interests of the consumers whose rights NCBRC and NACBA support. This issue, they said, has been widely litigated across the circuits, and the courts are fractured in their approach. The ability of debtors to discharge tax debt in a bankruptcy, they contened, will depend upon their geography, leading to disparate treatment of debtors and an inconsistent application of federal bankruptcy law. Deeply divided circuits, they argued, have multiple, conflicting answers to the question of whether the filing of a late tax return absolutely bars bankruptcy discharge of related tax obligations.

The brief noted that the Eighth Circuit may permit discharge if a bankruptcy petition is filed two years after a late-filed return, but in the Fourth, Sixth, Seventh, Ninth and Eleventh Circuits, by contrast, any return filed after the IRS has made its own assessment of tax liability is not considered a return for purposes of bankruptcy dischargeability. The First, Fifth and Tenth Circuits have taken a more severe approach, the brief stated, ruling that all taxes described on late-filed returns even those filed one day late for any reason are barred from discharge.

The Supreme Court was apparently unswayed by the amicus brief and declined to grant certiorari in the case.

For a discussion of discharges of tax debts in bankruptcy, see Parker Tax ¶16,169.