Federal Tax Bulletin - Issue 178 - August 27, 2018

Proposed Regs Prevent Taxpayers from Working Around SALT Limitation

The IRS issued proposed regulations which limit certain charitable contribution deductions when an individual, a trust, or a decedent's estate receives or expects to receive a corresponding state or local tax credit. The proposed rules, which apply to contributions made after August 27, 2018, are designed to prevent taxpayers from circumventing the $10,000 limitation on the personal deduction for state and local tax (SALT) by substituting an increased charitable contribution deduction. REG-112176-18 (8/23/18).

Background

In recent years, it has become increasingly common for states and localities to provide state or local tax credits in return for contributions by taxpayers to, or for the use of, certain entities listed in Code Sec. 170(c).

As the use of such tax credit programs by states and localities became more common, the IRS, in multiple Chief Counsel Advice (CCA) memoranda, considered whether the receipt of state tax credits under these programs were quid pro quo benefits that would affect the amount of taxpayers' charitable contribution deductions under Coder Sec. 170(a). In CCA 2000238041 and CCA 200435001, the IRS Chief Counsel reviewed programs involving the issuance of state tax credits in return for the transfer of conservation easements and for payments to certain child care organizations. In these CCAs, the IRS Chief Counsel recognized that these programs raised complex questions and recommended that the tax credit issue be addressed through official published guidance.

In CCA 201105010, the IRS offered further advice while also explaining that published guidance would not be forthcoming. The IRS observed that a payment to a state agency or charitable organization in return for a tax credit might be characterized as either a charitable contribution deductible under Code Sec. 170 or a payment of state tax possibly deductible under Code Sec. 164. The IRS advised that a deduction under Code Sec. 170 was available for the full amount of a contribution made in return for a state tax credit, without subtracting the value of the credit received in return. The analysis in the CCA assumed that after the taxpayer applied the state or local tax credit to reduce the taxpayer's state or local tax liability, the taxpayer would receive a smaller deduction for state and local taxes under Code Sec. 164. The CCA cautioned, however, that "there may be unusual circumstances in which it would be appropriate to recharacterize a payment of cash or property that was, in form, a charitable contribution as, in substance, a satisfaction of tax liability."

In Maines v. Comm'r, 144 T.C. 123 (2015), the IRS took the position that the amount of a state or local tax credit that reduces a tax liability is not an accession to wealth under Code Sec. 61 or an amount realized for purposes of Code Sec. 1001, and the Tax Court has accepted that view. The Tax Court held that the non-refundable portion of a state income tax credit, the amount of which was based on previously-paid property taxes, reduced the taxpayer's current year's tax liability and was not taxable or treated as an item of income. In Tempel v. Comm'r, 136 T.C. 341 (2011), the Tax Court held that state income tax credits, received by a donor for the transfer of a conservation easement, were capital assets; however, the donor had no adjusted basis in the credits.

The application of Code Sec. 61 and Code Sec. 1001 to state or local tax credits presents different issues than the application of Code Sec. 170. None the cases cited above addressed whether a taxpayer's expectation or receipt of a state or local tax credit may reduce a taxpayer's charitable contribution deduction under Code Sec. 170. Nor has the IRS ever addressed this question in published guidance.

Change in Law Required IRS to Act on State Credit Issue

At the time CCA 201105010 was issued, Code Sec. 164 generally allowed an itemized deduction - unlimited in amount - for the payment of state and local taxes. Accordingly, the question of how to characterize transfers pursuant to state tax credit programs had little practical consequence from a federal income tax perspective because, unless the taxpayer was subject to the alternative minimum tax (AMT), a deduction was likely to be available under either Code Sec.164 or Code Sec. 170. Permitting a charitable contribution deduction for a transfer made in exchange for a state or local tax credit generally had no effect on a taxpayer's federal income tax liability because any increased deduction under Code Sec. 170 would be offset by a decreased deduction under Code Sec. 164.

However, effective for tax years beginning after 2017 and before 2026, the Tax Cuts and Jobs Act of 2017 (TCJA) amended Code Sec. 164 to provide a $10,000 limitation on the deductibility of state and local taxes under Code Sec. 164(b)(6). Thus, treating a transfer pursuant to a state or local tax credit program as a charitable contribution for federal income tax purposes may reduce a taxpayer's federal income tax liability. When a charitable contribution is made in return for a state or local tax credit and the taxpayer has pre-credit state and local tax (SALT) liabilities in excess of the $10,000 limitation, a charitable contribution deduction under Code Sec. 170 would no longer be offset by a reduction in the taxpayer's SALT deduction under Code Sec. 164. As a consequence, SALT credit programs now give taxpayers a potential means to circumvent the $10,000 limitation in Code Sec. 164(b)(6) by substituting an increased charitable contribution deduction for a disallowed SALT deduction.

The IRS noted that several state legislatures are also now considering, or have adopted, proposals to enact new SALT credit programs with the aim of enabling taxpayers to characterize their transfers as fully deductible charitable contributions for federal income tax purposes, while using the same transfers to satisfy or offset their state or local tax liabilities. In light of the tax consequences of Code Sec. 164(b)(6) and the resulting increased interest in preexisting and new state tax credit programs, the IRS determined that it was appropriate to review the question of whether amounts paid, or property transferred, in exchange for state or local tax credits should be fully deductible as charitable contributions under Code Sec. 170.

In May, the IRS issued Notice 2018-54, in which it announced its intention to propose regulations addressing the federal income tax treatment of payments made by taxpayers for which the taxpayers receive a credit against their state and local taxes. The notice stated that federal tax law controls the proper characterization of payments for federal income tax purposes and that proposed regulations would assist taxpayers in understanding the relationship between the federal charitable contribution deduction and the new limitation on the deduction for SALT payments. Although Notice 2018-54 was issued in response to state legislation proposed after the enactment of the limitation on SALT deductions under Code Sec. 164(b)(6), the IRS said it would be issuing regulations which would apply longstanding federal tax law principles equally to taxpayers regardless of whether they are participating in a new SALT credit program or a preexisting one.

On August 23, the IRS issued the proposed regulations. According to the IRS, the proposed regulations, and the analysis underlying the proposed regulations, are intended to apply to transfers pursuant to SALT credit programs established under the recent state legislation as well as to transfers pursuant to SALT credit programs that were in existence before the enactment of Code Sec. 164(b)(6).

Observation: While the impetus for the proposed regulations was the recent enactment of tax credit workarounds designed to circumvent TCJA's limitation on the SALT deduction, the rules will also affect taxpayers seeking to claim a charitable contribution deduction for other programs that provide state or local tax credits in exchange for contributions to designated funds or entities, such as educational scholarship funds. The proposed regs do not include any special rules or exceptions for such programs, many of which have been in place for years.

Proposed Regulations

General Rule. When a taxpayer receives or expects to receive a state or local tax credit in return for a payment or transfer to an entity listed in Code Sec. 170(c), the proposed regulations provide that the receipt of this tax benefit constitutes a quid pro quo that may preclude a full deduction under Code Sec. 170(a). In applying Code Sec. 170 and the quid pro quo doctrine, the IRS said it does not believe it is appropriate to categorically exempt state or local tax benefits from the normal rules that apply to other benefits received by a taxpayer in exchange for a contribution. Thus, the IRS believes that the amount otherwise deductible as a charitable contribution must generally be reduced by the amount of the state or local tax credit received or expected to be received, just as it is reduced for many other benefits. Accordingly, the IRS is amending the regulations under Code Sec. 170 to clarify this general requirement, to provide for a de minimis exception from the general rule, and to make other conforming amendments.

The proposed regulations generally provide that if a taxpayer makes a payment or transfers property to or for the use of an entity listed in Code Sec. 170(c), and the taxpayer receives or expects to receive a state or local tax credit in return for such payment, the tax credit constitutes a return benefit, or quid pro quo, to the taxpayer and reduces the charitable contribution deduction.

In addition to credits, the proposed regulations also address state or local tax deductions claimed in connection with a taxpayer's payment or transfer. Although deductions could be considered quid pro quo benefits in the same manner as credits, the IRS said it believes that sound policy considerations as well as considerations of efficient tax administration warrant making an exception to quid pro quo principles in the case of dollar-for-dollar state or local tax deductions. Because the benefit of a dollar-for-dollar deduction is limited to the taxpayer's state and local marginal rate, the risk of deductions being used to circumvent Code Sec. 164(b)(6) is comparatively low. In addition, if SALT deductions for charitable contributions were treated as quid pro quo benefits, the IRS said, it would make the accurate calculation of federal taxes and state and local taxes difficult for both taxpayers and the IRS. For example, the value of a deduction could vary based on the taxpayer's marginal or effective state and local tax rates, making for more complex computations and adding to administrative and taxpayer burden. The proposed regulations thus allow taxpayers to disregard dollar-for-dollar state or local tax deductions. However, the proposed regulations state that, if the taxpayer receives or expects to receive a state or local tax deduction that exceeds the amount of the taxpayer's payment or the fair market value of the property transferred, the taxpayer's charitable contribution deduction must be reduced.

Observation: The IRS is requesting comments from practitioners on how to determine the amount of this reduction.

In drafting the proposed regulations, the IRS also considered whether a taxpayer may decline the receipt or anticipated receipt of a state or local tax credit by taking some affirmative action at the time of the taxpayer's payment or transfer. The IRS pointed to Rev. Rul. 67-246, which allows a full charitable contribution deduction if the taxpayer does not accept or keep any indicia of a return benefit.

Observation: The IRS noted that, because procedures for declining a state or local tax credit would depend on the procedures of each state and locality in administering the tax credits, it is requesting guidance from practitioners on a rule that would allow taxpayers to decline state or local tax credits and receive full deductions for charitable contributions under Code Sec. 170.

The proposed regulations also apply to trusts and decedents' estates with respect to income tax deductions they may claim for charitable contributions under Code Sec. 642(c).

De Minimis Rule. The proposed regulations also include a de minimis rule. Under this rule, a taxpayer may disregard a state or local tax credit if such credit does not exceed 15 percent of the taxpayer's payment or 15 percent of the fair market value of the property transferred by the taxpayer. The de minimis exception reflects that the combined value of a SALT deduction, that is the combined top marginal state and local tax rate, currently does not exceed 15 percent. Accordingly, under the proposed regulations, a state or local tax credit that does not exceed 15 percent does not reduce the taxpayer's federal deduction for a charitable contribution.

Qualitative Analysis. The proposed regulations provide a qualitative analysis section which provides details regarding the anticipated impact of the proposed regulations. For informational and analytical purposes, this analysis assumes as a baseline that SALT credits are generally not treated as a return benefit or consideration and therefore do not reduce a taxpayer's charitable contribution deduction under Code Sec. 170(a). The qualitative analysis then:

(1) describes the tax effects of the contributions prior to enactment of the SALT cap;

(2) provides examples comparing the enactment of the SALT cap but absent the proposed rule (the baseline) to the proposed rule; and

(3) provides a qualitative assessment of the potential costs and benefits of the proposed rule compared to the baseline.

Example: Assume that John, who has a state tax liability of more than $1,000 above the SALT cap and is not subject to the AMT, makes a $1,000 contribution to Charity A and receives a $1,000 state tax credit. The state has a 5 percent state tax rate. As a result, the deduction for charitable contributions increases by $1,000, but the deduction for state and local taxes paid is unchanged. Consequently, itemized deductions increase by $1,000, and taxable income decreases by $1,000. If John is in the 24 percent bracket, his federal liability will decrease by $240, and his state tax liability will decrease by the $1,000 state tax credit. The combined federal and state tax benefits of the $1,000 contribution are therefore $1,240, and John receives a $240 net benefit while the federal government has a loss of $240. Under the proposed regulations, John's entire $1,000 contribution is not deductible and his deduction for state and local taxes is unchanged due to the SALT cap. John's itemized deductions, taxable income, and federal tax liability are unchanged from what they would be in the absence of the contribution. John's state tax liability decreases by $1,000 because of the state tax credit. The combined federal and state tax benefits of the $1,000 contribution are therefore $1,000, or $240 less than under the baseline.

According to the qualitative analysis provided in the preamble to the proposed regulations, prior to enactment of the SALT caps, for a taxpayer not subject to the AMT, a $1,000 contribution to a charity (Charity B), in which the contribution results in a one-for-one state income tax deduction and not a state credit, yielded a smaller combined federal and state tax benefit than to Charity A. The state tax benefit was $50 ($1,000 times the 5 percent state tax rate). The taxpayer's itemized deductions at the federal level increased by $950 (the $1,000 charitable contribution deduction less than $50 reduction in state taxes paid). The federal tax benefit of this increase was $228 ($950 times the 24 percent federal tax rate), resulting in a combined federal and state tax benefit of $278. The net cost to the taxpayer of the $1,000 contribution was $722.

The qualitative analysis notes that, under the baseline and the proposed rule, for a taxpayer with state and local taxes paid over the SALT cap, the value of a contribution to Charity B, in which the contribution results in a one-for-one state income tax deduction and not a state tax credit, is slightly higher than it was before the SALT cap applied. This increase is because the state deduction does not reduce the federal deduction for state and local taxes for a taxpayer above the SALT cap. Under the baseline and the proposed rule, the value of a $1,000 contribution to Charity B is $290 - the charitable contribution deduction from federal tax ($1,000 times the 24 percent federal tax rate, or $240), plus the value of the deduction from state tax ($1,000 times the 5 percent state tax rate, or $50) - compared to $278 for contributions under prior law (described above). By comparison, in the example above, a contribution by John to Charity A, eligible for a state tax credit, yields a $1,240 tax benefit under the baseline and a $1,000 benefit under the proposed rule.

Effective Date

The regulations are proposed to apply to contributions made after August 27, 2018.

Caution: While the proposed regulations clearly apply to charitable contributions made after the effective date, they do not create a safe harbor for earlier contributions. To the contrary, the IRS's stance that the proposed regulations apply longstanding federal tax law principles suggests that the IRS may challenge the deductibility of contributions made on or before the effective date.

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Rev. Proc. Addresses Accounting Method Changes for an Eligible Terminated S Corp

The IRS issued guidance which requires an eligible terminated S corporation that is required to change from the overall cash method of accounting to an overall accrual method of accounting as a result of revoking its S corporation election, and that makes this change for the C corporation's first tax year after such revocation, to take into account the resulting positive or negative adjustment required by Code Sec. 481(a)(2) ratably during the six-year period beginning with the year of change. The guidance also provides that an eligible terminated S corporation that is permitted to continue to use the cash method after the revocation of its S corporation election and that changes to an overall accrual method for the C corporation's first tax year after such revocation, may take into account the resulting positive or negative adjustment required by Code Sec. 481(a)(2) ratably during the six-year period beginning with the year of change. Rev. Proc. 2018-44.

The Tax Cuts and Jobs Act of 2017 enacted new Code Sec. 481(d). Code Sec. 481(d)(1) requires an eligible terminated S corporation to take into account ratably during the six-year period beginning with the year of change any adjustment required by Code Sec. 481(a)(2) that is attributable to the corporation's revocation of its S corporation election. An eligible terminated S corporation is any C corporation (1) which (i) was an S corporation on December 21, 2017, and (ii) during the two-year period beginning on December 22, 2017, revokes its election under Code Sec. 1362(a), and (2) the owners of the stock of which, determined on the date such revocation is made, are the same owners (and in identical proportions) as on December 22.

Code Sec. 1362(e)(1) provides that generally in the case of an S termination year, the portion of such year ending before the first day for which the termination is effective is treated as a short tax year for which the corporation is an S corporation, and the portion of such year beginning on such first day is treated as a short tax year for which the corporation is a C corporation. Generally, an S termination year is any tax year of a corporation in which the termination of its S election takes effect (other than on the first day thereof).

Code Sec. 481(a) requires those adjustments necessary to prevent amounts from being duplicated or omitted to be taken into account when the taxpayer's taxable income is computed under a method of accounting different from the method of accounting used to compute taxable income for the preceding taxable year. Generally, except as otherwise provided, a taxpayer must secure IRS consent before changing a method of accounting. In Rev. Proc. 2015-13, the IRS provides procedures by which a taxpayer obtains automatic IRS consent to change a method of accounting. Rev. Proc. 2015-13, as modified, provides the general procedures by which a taxpayer may obtain automatic consent to a change in method of accounting described in the List of Automatic Changes as contained in Rev. Proc. 2018-31. Section 15.01 of Rev. Proc. 2018-31 provides automatic changes for certain taxpayers that want to change their overall method of accounting from the cash method to an accrual method, including taxpayers required to make this change by Code Sec. 448.

The IRS has now issued Rev. Proc. 2018-44, which provides that an eligible terminated S corporation required to change from the cash method to an accrual method as a result of a revocation of its S corporation election, and that makes this accounting method change under Section 15.01 of Rev. Proc. 2018-31 for the first tax year that it is a C corporation, must take the resulting positive or negative adjustment required by Code Sec. 481(a)(2) into account ratably during the six-year period beginning with the year of change. Rev. Proc. 2018-44 also allows an eligible terminated S corporation that is permitted to continue to use the cash method after the revocation of its S corporation election and that changes to an accrual method under Section 15.01 of Rev. Proc. 2018-31 for the first tax year that it is a C corporation, to take the resulting positive or negative adjustment required by Code Sec. 481(a)(2) into account ratably during the six-year period beginning with the year of change.

Observation: In addition to the change to an accrual method described in Section 15.01 of Rev. Proc. 2018-31, an eligible terminated S corporation may have other accounting method changes that result in adjustments required by Code Sec. 481(a) that are attributable to such corporation's revocation of its S corporation election as described in Code Sec. 481(d)(2). However, the IRS makes clear that such changes are not within the scope of Rev. Proc. 2018-44.

For a discussion of Code Sec. 481 adjustments required by a change in method of accounting, see Parker Tax ¶241,595.

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IRS Voluntary Annual Filing Season Program Withstands AICPA's Challenge

The D.C. Circuit held that the IRS Annual Filing Season Program, a voluntary arrangement which allows unenrolled preparers to obtain a limited right to represent taxpayers in IRS audits, does not violate the Administrative Procedure Act. Reversing the district court, the D.C. Circuit held that the American Institute of Certified Public Accountants (AICPA) had standing to challenge the validity of the program; however, the court upheld the validity of the Program because it found that it was within the IRS's statutory authority, complied with procedural requirements, and was not arbitrary and capricious. AICPA v. IRS, 2018 PTC 270 (D.C. Cir. 2018).

Background

There are four categories of people who may assist taxpayers with their returns: attorneys, certified public accountants (CPAs), enrolled agents, and unenrolled preparers. Unenrolled preparers were not subject to any licensing requirements until 2011, when the IRS adopted a rule requiring them to become registered tax return preparers. This entailed paying a fee, passing a competency exam, and completing a continuing education course each year. The IRS adopted the program by issuing Rev. Proc. 2014-42, which it did without notice and comment.

In Loving v. IRS, 2013 PTC 10 (D.D.C. 2013) (Loving I), the D.C. district court held that the IRS lacked statutory authority to regulate unenrolled preparers. In Loving v. IRS, 2013 PTC 13 (D. D.C. 2013) (Loving II), the district court allowed the IRS to continue the testing and continuing education portions of the program as long as it did not require any tax preparer to take a test, enroll in continuing education, or pay a fee for either service. The D.C. Circuit affirmed the district court's judgment in Loving v. IRS, 2014 PTC 73 (D.C. Cir. 2014) (Loving III), and the IRS opted to continue with testing and continuing education as parts of its Voluntary Annual Filing Season Program.

The Voluntary Annual Filing Season Program grants an annual Record of Completion to any participant who obtained a preparer tax identification number, took the annual federal tax filing season refresher course, passed a comprehension test, completed at least 18 hours of continuing education, and consented to be subject to the duties and restrictions relating to practice before the IRS in Circular 230.

The IRS offers two incentives to participate in the Program. First, unenrolled agents with a Record of Completion are listed in the IRS's online directory of tax preparers alongside attorneys, CPAs and enrolled agents. Second, unenrolled agents gain a limited practice right to represent a taxpayer in the initial stages of the audit of a return the unenrolled agent prepared. Before the Program was established, all unenrolled agents had this limited practice right.

The AICPA sued the IRS, challenging its authority to conduct the Program. In AICPA v. IRS, 2014 PTC 555 (D. D.C. 2014), the district court initially dismissed the case on the ground that the AICPA lacked standing. In AICPA v. IRS, 2015 PTC 391 (D.C. Cir. 2015), the D.C. Circuit reversed and remanded, holding that the AICPA had standing as the representative of competitors to unenrolled agents.

On remand, the IRS argued that the AICPA did not have statutory standing because its interests were not protected or regulated by 31 U.S.C. Sec. 330, which authorizes the IRS to regulate the practice of taxpayer representatives before it and to require such representatives to demonstrate good character, reputation, and the necessary qualifications and competency. The district court agreed and dismissed the case for lack of statutory standing.

D.C. Circuit Reverses Lower Court on AICPA's Standing

The AICPA again appealed. It argued that it had constitutional standing as a competitor and statutory standing under 31 U.S.C. 330. According to the AIPCA, its members were employers of unenrolled preparers who suffered harm because the Program withdrew the limited practice right unenrolled preparers previously enjoyed. The AICPA also claimed that the Program imposed new supervisory requirements on its members because the Record of Completion is conditioned on consent to be subject to the rules for practicing before the IRS under subpart B of Circular 230. In addition, supervisors must take reasonable steps to ensure the firm has adequate procedures in place for its employees to comply with subparts A, B, and C of Circular 230. Thus, the AICPA claimed that as employers of unenrolled preparers, its members could now be subject to sanctions for Circular 230 violations.

On the merits, the AICPA claimed that the Program exceeded the IRS's authority under 31 U.S.C. Sec. 330 and the APA. According to the AICPA, making the law relevant to tax returns a subject of continuing education showed the IRS's improper intent to regulate tax preparation, contrary to the decision in Loving III. The AICPA also argued that the IRS should have followed the APA notice and comment requirements before issuing Rev. Proc. 2014-42. According to the AICPA, Rev. Proc. 2014-42 withdrew a benefit (the right of all unenrolled preparers to practice before the IRS) which had been created through notice and comment rulemaking, and a rule promulgated by notice and comment should be amended by the same procedure. Finally, the AICPA claimed that the Program is arbitrary and capricious because the IRS never responded to its concern that a public database of provider credentials might confuse taxpayers and the IRS failed consider all reasonable alternatives before adopting the Program.

The IRS did not dispute that the AICPA had constitutional standing based on its competitive injury. The IRS argued that statutory standing was lacking because neither the AICPA nor its members are regulated or protected by 31 U.S.C. Sec. 330. The IRS argued it had statutory authority for the Program under both 31 U.S.C. Sec. 330 as well as under Code Sec. 7803, which gives the IRS the power to administer the tax laws and related statutes.

The D.C. Circuit held that the AICPA had constitutional and statutory standing to challenge the validity of the Program. In the court's view, the AICPA had constitutional standing based on its competitive injury and as a result of the supervisory burden imposed by the Program. The court explained that, by extending Circular 230 to a new class of preparers, the Program expanded the supervisory responsibilities of the AICPA members and increased the supervisory responsibility and hence the potential liability faced by members of the AICPA. The court further found that the AICPA had statutory standing because 31 U.S.C. Sec. 330 regulates AICPA members (albeit indirectly) by imposing supervisory duties on them.

Court Upholds IRS Position on the Merits

Turning to the merits, the court determined that the Program did not exceed the IRS's authority under 31 U.S.C. Sec. 330. The court found that the Program's education, testing and certification portions ensured that participating unenrolled preparers demonstrate the qualifications and competence necessary to practice before the IRS. The court saw nothing in the Program that attempted to impermissibly resurrect regulations of the type enjoined in the Loving decisions because participating unenrolled preparers consented to be governed only by the sections of Circular 230 relating to practice before the IRS, not those pertaining to tax preparation.

However, the D.C. Circuit rejected the AICPA's procedural challenges after concluding that notice and comment rulemaking was not required because the Program did not bind unenrolled preparers but merely provided them an opportunity to participate and satisfy the Program requirements. The court further found that the Program imposed no new or different requirement on supervisors or unenrolled preparers because both were already bound by Circular 230 before the Program took effect. The court explained that the limited practice right afforded unenrolled preparers before 2011 was the product of Rev. Proc. 81-38, which was issued without notice and comment, so no notice and comment were required to withdraw that right. In the court's view, Rev. Proc. 2014-42 was an interpretive rule, which did not require notice and comment procedures, because the Program requirements were the IRS's interpretation of the term "competency" in 31 U.S.C. Sec. 330.

Finally, the court rejected the AICPA's argument that the Program was arbitrary and capricious. The court found that the IRS considered the AICPA's concern over taxpayer confusion because the directory of provider credentials allows users to filter search results by each provider category; it also links to a primer describing the various qualifications in detail. The court further found that the AICPA never proposed an alternative method for the IRS to deal with the problem of incompetent tax preparers, so the IRS could not be faulted for failing to consider an alternative that was never proposed.

For a discussion of the Voluntary Filing Season Program, see Parker Tax ¶271,160.

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Ten-Year Statute Doesn't Apply to Refund Arising from Foreign Tax Deduction

The Second Circuit held that a company that elected to deduct foreign taxes from its U.S. taxable income for a prior tax year was barred by the three-year statute of limitations from claiming a refund for an overpayment arising from the deduction. The Second Circuit rejected the taxpayer's argument that the special 10-year statute of limitations period under Code Sec. 6511(d)(3)(A) applied after concluding that Code Sec. 6511(d)(3)(A) applies only to refund claims relating to an overpayment attributable to a credit for foreign taxes paid, and does not apply where a taxpayer elects to deduct foreign taxes. Trust Media Brands, Inc. v. U.S., 2018 PTC 260 (2d Cir. 2018).

Background

Trusted Media Brands, Inc. paid taxes to foreign countries in 1995, 1997, and 2002 and opted to claim a foreign tax credit (FTC) on its returns for each year. For 2002, Trusted Media incurred a net operating loss (NOL) of approximately $61 million, unrelated to the payment of foreign taxes. Trusted Media had no U.S. tax liability to offset with its FTC for 2002, so it carried back its NOL to 1997.

In 2011, Trust Media filed an amended 2002 return in which it changed its election to take a FTC to a deduction for the foreign taxes it paid that year. This change increased Trusted Media's 2002 NOL to approximately $74.4 million. Trusted Media carried this larger NOL back to 1997, reducing its taxable income for that year. The decrease in taxable income resulted in a decrease in the limit on the FTC Trusted Media could claim for 1997. As a result, some of the FTC Trusted Media had claimed in 1997 could no longer be used for that year, but instead could be carried back to other years. Trusted Media carried the 1997 excess FTC back to 1995, resulting in an overpayment of taxes of approximately $2.1 million.

Trusted Media filed an amended 1995 return in 2011 to claim a refund of its alleged $2.1 million tax overpayment. The IRS disallowed the claim as untimely. After an administrative appeal, Trusted Media sued for the refund in a district court. Trusted Media argued that the 1995 overpayment was attributable to its election to deduct foreign taxes paid in 2002 and thus was timely under the special 10-year limitations period in Code Sec. 6511(d)(3).

The district court disagreed and held that Trusted Media's refund claim was untimely for two reasons. First, the district court concluded that the 10-year limitations period applies only to overpayments attributable to foreign taxes for which the taxpayer elects to claim a credit, not for foreign taxes for which a deduction is elected. Second, the district court found that Trusted Media's 1995 refund claim was not attributable to its 2002 foreign taxes within the meaning of Code Sec. 6511(d)(3). Trusted Media appealed to the Second Circuit.

Analysis

U.S. taxpayers are required to pay tax on their worldwide income. In order to prevent such income from being taxed both by the United States and a foreign country, taxpayers can either claim a credit under Code Sec. 901 for the foreign taxes paid or deduct the foreign taxes from taxable income under Code Sec. 164(a)(3). Under Reg. Sec. 1.901-1(d), the deadline by which a taxpayer must choose between claiming an FTC or a deduction for a particular year is generally the period prescribed by Code Sec. 6511(d)(3)(A), which is 10 years.

Under Code Sec. 6511(a), a refund for an overpayment of taxes generally must be filed within the later of three years from the filing of the return or two years from the payment of the tax. Additionally, Code Sec. 6511(b) contains a default rule limiting the amount of refund to which a taxpayer is entitled, which varies depending on when the taxpayer files the refund claim. However, under Code Sec. 6511(d)(3)(A), a special 10-year period applies to refund claims attributable to foreign tax credits, and Code Sec. 6511(d)(3)(B) provides an exception to the refund limit if the overpayment is attributable to a credit for foreign taxes.

On appeal, Trusted Media argued that the special 10-year period for overpayments resulting from a credit was simply one way, but not the only way, by which the longer period is available. The taxpayer also argued that because Reg. Sec. 1.901-1(d) sets a single period within which a taxpayer can elect to toggle between an FTC or a deduction, there is also a single period within which a taxpayer can claim a refund based on either an FTC or a deduction.

The Second Circuit rejected Trusted Media's arguments and held that the 10-year limitations period applies only to overpayments attributable to foreign taxes for which the taxpayer elects a credit, not for which the taxpayer chooses a deduction, but was otherwise eligible to claim a credit.

The Second Circuit said that its conclusion was compelled by the plain language of Code Sec. 6511(d)(3)(A), which provides that the 10-year period applies only to claims for which an FTC is allowed. The court reasoned that the options to deduct foreign taxes or take a credit are mutually exclusive. Having elected a deduction for 2002, Trusted Media was not eligible to elect an FTC. Thus, by its express terms, Code Sec. 6511(d)(3)(A) did not apply.

The court further found that Reg. Sec. 301.6511(d)-3(a) supported its conclusion by confirming that the extended limitations period applies to overpayments resulting from a credit. The court rejected Trusted Media's argument that this provision provided only one condition under which the 10-year period applies; in the court's view, the regulation sets forth the only way by which the special 10-year period is available.

Next, the court found that the exception in Code Sec. 6511(d)(3)(B) to the refund limit in Code Sec. 6511(b)(2) also supported its holding. The court explained that without Code Sec. 6511(d)(3)(B), many taxpayers would effectively be denied the benefit of the 10-year period because, although they would have 10 years to file for a refund, the refund amount would be limited to the portion of the tax paid within the prior two years. Code Sec. 6511(d)(3)(B) solves this problem by providing that the refund limit does not apply to the extent an overpayment is attributable to the allowance of an FTC. In the view of the Second Circuit, this provision unambiguously refers to credits, not deductions, further reinforcing the conclusion that Code Sec. 6511(d)(3)(A) is limited to refunds resulting from an FTC.

The court found that limiting the 10-year period to overpayments arising from an FTC made sense considering the timing problems that can arise when foreign taxes are contested. As the court explained, when a deduction is claimed for foreign taxes paid or accrued, the taxpayer takes the deduction in the year in which the foreign tax liability is conclusively determined. Conversely, an accrual method taxpayer must claim a credit for the year to which the foreign tax relates, even if the amount is not determined until a later year. Thus, in the court's view, the extended limitations period is necessary where a credit is claimed for a contested foreign tax liability, but not required for a taxpayer electing a deduction.

Finally, the Second Circuit disagreed with Trusted Media's argument that the single period for electing whether to claim an FTC or a deduction under Reg. Sec. 1.901-1(d) implies a single period within which taxpayers can claim refunds based on either FTCs or deductions. The court found that the requirements governing refund claims are found in Code Sec. 6511 and Reg. Sec. 301.6511(a)-1 to (g)-1, not Code Sec. 901, and that Trusted Media was asking it to conflate these separate time limitations.

For a discussion of the statute of limitations for refunds or credits of overpayments, see Parker Tax ¶261,180. For a discussion of deductions and credits for foreign taxes, see Parker Tax ¶83,140.

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IRS Finalizes Rules for Determining a Partnership Representatives

The IRS issued final regulations, which affect partnerships for tax years beginning after 2017, regarding the designation and authority of a partnership representative under the centralized partnership audit regime. The IRS also issued final regulations and removed temporary regulations regarding the election to apply the centralized partnership audit regime to partnership tax years beginning after November 2, 2015, and before January 1, 2018. T.D. 9839.

In mid-August, the IRS issued final regulations on -

(1) the designation and authority of a partnership representative under the centralized partnership audit regime, and

(2) final regulations regarding the election to apply the centralized partnership audit regime to partnership tax years beginning after November 2, 2015, and before January 1, 2018.

With respect to who can serve as a partnership representative, the proposed regulations had provided that a partnership could designate any person that has a substantial presence in the United States (i.e., the substantial presence test of Code Sec. 6223(a)) and that has the capacity to act to be the partnership representative. If an entity is designated as the partnership representative, the partnership must appoint a designated individual to act on the entity's behalf.

One practitioner recommended that the final regulations explicitly provide that a disregarded entity can serve as the partnership representative. The IRS adopted this recommendation. Any person, as defined in Code Sec. 7701(a)(1), including an entity, can serve as the partnership representative provided that person meets the requirements of Reg. Sec. 301.6223-1(b). Therefore, the final regulations were revised to clarify that a disregarded entity can be a partnership representative. Because a disregarded entity is not an individual and is an entity partnership representative, the partnership must appoint a designated individual to act on behalf of the disregarded entity.

In addition, both the disregarded entity and the designated individual must meet the substantial presence test. The final regulations were also revised to clarify that a partnership may designate itself as its own partnership representative. The rules regarding eligibility to serve as a partnership representative, the IRS noted, are designed to permit the partnership to designate the person it believes is most appropriate to serve as partnership representative, provided that person meets the applicable requirements. Therefore, a partnership may serve as its own partnership representative if the partnership has substantial presence in the United States and also appoints a designated individual that has a substantial presence in the United States to act on the partnership's behalf in the partnership's role as partnership representative.

Another comment suggested that the entity partnership representative itself, rather than the partnership, should appoint the designated individual. The partnership makes the initial designation of the partnership representative on the partnership's return. When an entity is chosen, the partnership must appoint a designated individual to act on behalf of the entity partnership representative. While this rule requires that the partnership appoint the designated individual, the IRS said, nothing in the regulations precludes the entity partnership representative from identifying who the designated individual should be and communicating that decision to the partnership.

Ultimately, however, the partnership must determine who will be the partnership representative. Determining who will be the designated individual to act on behalf of an entity partnership representative is part of that determination. Therefore, the IRS retained in the final regulations the proposed regulation rule that the partnership must appoint the designated individual on its partnership return for the relevant tax year. According to the IRS, this rule ensures that designation of the entity partnership representative and appointment of the designated individual occur simultaneously on the partnership return with the result that it will be clear to both the partnership and the IRS at the time the partnership return is filed who has the authority to act on behalf of the partnership for the tax year for which the return is filed for purposes of the centralized partnership audit regime.

Under the proposed regulations, one of the components of eligibility to serve as a partnership representative or designated individual was the capacity to act. The proposed regulations described five specific events that caused a person to lose the capacity to act and included a catch-all provision for any unforeseen circumstances in which the IRS reasonably determined a person may no longer have the capacity to act. If a partnership representative lost the capacity to act, the IRS could determine that the designation of the partnership representative or appointment of a designated individual was not in effect. By setting forth specific capacity factors, like bankruptcy, for making someone ineligible to act on behalf of the partnership, the IRS said that the regulations would be unnecessarily supplanting the partnership's judgment with that of the government.

Accordingly, the final regulations removed the capacity-to-act requirement entirely in order to enable the partnership to have as much flexibility as possible in determining a partnership representative so long as the person meets the substantial presence requirements. The IRS noted that, although the capacity-to-act section has been removed from the final regulations, the IRS may still determine that a designation of the partnership representative is not in effect due to circumstances that would have resulted in a partnership representative not having capacity to act because at least some of the capacity-to-act requirements overlapped with substantial presence. For instance, the IRS said, it may determine that a partnership representative designation is not in effect if the partnership representative is incarcerated because that partnership representative cannot make him or herself available to the IRS, which means the partnership representative would not satisfy the substantial presence requirement.

For a discussion of the rules relating to who can be a partnership representative, see Parker Tax ¶28,725.

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Conservation Easement Donation Was Nondeductible Because Its Purpose Was Not Protected in Perpetuity

The Fifth Circuit held that the donor of a conservation easement was not entitled to deduct the value of the contribution because the deed that conveyed the property did not protect the conservation purpose in perpetuity. The court found that while the deed had a valid conservation purpose, it failed to comply with the extinguishment regulation in Reg. Sec. 1.170A-14(g) because it permitted sale expenses, and the value of any improvements, to be subtracted from the proportionate share of proceeds to the donee in the event the easement was extinguished. PBBM-Rose Hill, Ltd. v. Comm'r, 2018 PTC 269 (5th Cir. 2018).

Background

In 1996, Rose Hill Plantation Development Company Limited Partnership (RHP Development) conveyed 241 acres of property in South Carolina to Rose Hill Country Club, Inc. (RHCC). The deed conveying the property contained a use restriction requiring the property to be used only for recreational facilities or open space for 30 years.

In 2002, RHCC conveyed the property to PBBM Rose Hill, Ltd. (PBBM) for approximately $2.4 million. The deed to PBBM contained a use restriction. When PBBM operated the property, it consisted primarily of a 27-hole golf course as well as a club house for the neighboring residential community. The golf course was not profitable and PBBM closed it in 2006. Two months later, PBBM filed for Chapter 11 bankruptcy. PBBM initiated an adversary proceeding against RHP Development, RHCC, Red Star Capital, L.P., and the Rose Hill Plantation Property Owners Association, Inc. (POA) seeking to invalidate the use restriction.

The POA opposed the removal of the use restriction. In early 2007, PBBM and the POA entered into a settlement agreement in which POA agreed not to interfere with PBBM seeking removal of the use restriction. POA also acquired an option to purchase the property. In August 2007, POA exercised its option and the bankruptcy court approved the sale of the property for $2.3 million. In December 2007, the bankruptcy court entered judgments invalidating the use restriction on the property as to RHCC, RHP Development, and Red Star Capital.

Before the sale to the POA closed in January 2008, PBBM conveyed a conservation easement of 234 acres to the North American Land Trust (NALT). The conservation area consisted of the 27-hole golf course but excluded two acres of maintenance areas and the five acres that held the club house.

The deed to NALT provided that the conservation purpose was in part to preserve the area for outdoor recreation by the general public. The deed stated that the property would continue to remain open for substantial and regular use by the general public for outdoor recreation, whether for use as a golf course or for other outdoor recreation. The deed permitted the charging of fees as long as the property remained open for the substantial and regular use of the general public and the fees did not defeat such use or result in the operation of a private membership club. However, another paragraph stated that nothing in the deed could be construed to create any right of access to the conservation area by the public.

PBBM reserved several rights, including the right to build a tennis facility and other improvements. It also retained the right to install no trespassing signs. The deed stated that the reserved rights could be exercised only if they had no material adverse effect on the conservation purposes.

Another deed provision stated that in the event of the extinguishment of the easement, NALT was entitled to a portion of the sale proceeds equal to the greater of the easement's fair market value or a defined share of the proceeds remaining after deducting both the expenses of the sale and the value of any improvements constructed pursuant to PBBM's reserved rights. The defined share was the fair market value of the easement divided by the value of the land not burdened by the easement.

After POA bought the property, it operated 18 holes of golf but converted part of the property into a park. Access to the property was controlled by a gatehouse, and visitors were given a pass which limited their access to certain areas, such as the golf course and club restaurant, but warned that access to other areas constituted trespassing. The public had no access to the park. A sign on the road to the park stated that only property owners, residents and guests were allowed beyond that point.

On its 2007 partnership tax return, PBBM claimed a charitable contribution deduction of approximately $15.1 million for its donation of the conservation easement. The IRS issued a final partnership administrative adjustment (FPAA) determining that PBBM was not entitled to the deduction and assessing a penalty for overvaluing the easement. PBBM challenged the FPAA in the Tax Court. The Tax Court held that the easement donation was not deductible because it was not exclusively for conservation purposes and did not protect the conservation purpose in perpetuity. The Tax Court also found that the value of the easement was only $100,000 and that PBBM was subject to a gross valuation misstatement penalty. PBBM appealed to the Fifth Circuit.

Analysis

To be deductible under Code Sec. 170(h)(1)(C), the contribution of a conservation easement must be exclusively for conservation purposes. The preservation of land for recreational use by the public is one of the conservation purposes enumerated in Code Sec. 170(h)(4)(A). An easement is exclusively for conservation purposes only if the purpose is protected in perpetuity. Under Reg. Sec. 1.170A-14(g)(6)(ii) (the extinguishment regulation), upon judicial extinguishment of the easement, the donee must be entitled to a portion of the proceeds (such as from a sale) at least equal to the proportionate value of the proceeds. Thus, the donation must give rise to a property right with a fair market value at least equal to the proportionate value that the use restriction bears to the value of the property as a whole at the time of the donation. If an unexpected change occurs, the donee must be entitled to at least that proportionate share of the post-extinguishment proceeds of a sale.

PBBM argued that the Tax Court erroneously looked beyond the language of the deed and to the actions of POA in determining whether the contribution was exclusively for a conservation purpose. It cited Reg. Sec. 1.170A-14(d)(5)(iv)(C) which states that, with respect to a historic preservation easement, the amount of public access should be determined only by reference to the terms of the easement, not the amount of access actually provided by the donee. PBBM argued that the easement was exclusively for conservation purposes because it provided a right of public access for outdoor recreation and that NALT could fulfill its public use mandate by conveying licenses to members of the general public to play golf or engage in other recreational activities. With respect to the deed's extinguishment provision, PBBM contended there was no requirement entitling the donee to the value of improvements on the property. PBBM also cited an IRS private letter ruling (PLR) in which a deed permitting the value of an improvement to be deducted from the proceeds satisfied the extinguishment regulation.

The IRS contended that the Tax Court did not err in looking at the actions of the POA after the donation because Reg. Sec. 1.170A-14(d)(5)(iv)(c) did not apply to recreation easements. The IRS also contended that PBBM knew at the time of the donation that the POA opposed the removal of the use restriction and inferred that PBBM therefore was aware at the time that the POA objected to the property's use by the public. According to the IRS, the deed did not satisfy the public access requirement because it permitted NALT to prevent the general public from accessing substantial areas of the land. Regarding the extinguishment provision, the IRS argued that such a provision could not include factors (such as the value of improvements) that could decrease the amount of proceeds below the minimum the donee must receive under the regulation.

The Fifth Circuit held that the easement fulfilled the public access requirement but agreed with the IRS that it failed to satisfy the extinguishment regulation. First, the court found that the regulations applicable to conservation easements strongly suggested that, in determining whether the public access requirement is fulfilled, the focus should be on the terms of the deed and not on the actual use of the land after the donation. The court did not agree with the IRS's contention that PBBM knew at the time of the donation that the POA was opposed to public use of the property; in the court's view, PBBM's dealings with the POA informed it only that the POA was opposed to development on the property. The court found that PBBM's donation did not qualify for a deduction after determining that the extinguishment provision permitted the deduction of the value of improvements from the proceeds of a sale prior to the donee taking its share in violation of the perpetuity requirement. In the court's view, the plain language of the regulation did not permit any amount to be subtracted before the donee received its proportionate share of the sale proceeds.

The Fifth Circuit also found that the Tax Court did not err in valuing the easement at $100,000 based on a finding that development of the property was unlikely. The court also upheld the application of the gross valuation misstatement penalty based on that valuation.

For a discussion of the rules for contributions of partial interests in property, see Parker Tax ¶84,155.

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Corporation's Former Shareholders Liable as Transferees for Tax Liability on Asset Sale

The Ninth Circuit reversed the Tax Court and held that a corporation's former shareholders were liable as transferees for the tax liability arising from a sale of all of the corporation's assets, which was followed by a sale of stock to another entity. The Ninth Circuit found that the subsequent stock sale was, in substance, a liquidating distribution by the corporation to the shareholders because the sale lacked economic substance apart from tax avoidance under federal law and the former shareholders were thus liable under the state fraudulent transfer statute since the corporation did not receive equivalent value and the shareholders were on notice that the tax liability would not be paid. Slone v. Comm'r, 2018 PTC 231 (9th Cir. 2018).

In 2001, Slone Broadcasting Co., a closely held corporation, sold all of its assets to Citadel Broadcasting Co. for $45 million, resulting in an estimated tax liability of over $15 million. The asset sale was followed by a sale of Slone's stock to another company, Berlinetta, Inc. Berlinetta assumed Slone's liability for the tax on the asset sale.

Using borrowed funds, Berlinetta paid Slone's shareholders an amount representing the net value of the company after the asset sale plus a premium representing almost two-thirds of the amount of Slone's tax liability. The former shareholders thus received two-thirds of the amount Slone should have paid in taxes on the asset sale. Berlinetta and Slone then merged into a new company called Arizona Media Holdings, Inc., which claimed to be in the business of debt collection. After Arizona Media repaid the loan to Berlinetta, it had no assets with which to pay the taxes due from the Slone asset sale.

The IRS sought to hold the former Slone shareholders liable as the transferees of the asset sale proceeds. The Tax Court held in favor of the shareholders, and the IRS appealed to the Ninth Circuit. The Ninth Circuit remanded to the Tax Court, finding that the Tax Court did not apply the correct test to determine whether the shareholders were transferees under Code Sec. 6901. The Ninth Circuit explained that the shareholders would be liable as transferees if (1) the transaction with Berlinetta lacked independent economic substance apart from tax avoidance under federal law, and (2) the shareholders were liable under the Arizona fraudulent transfer statute.

On remand, the Tax Court once again held in favor of the shareholders, concluding that it could disregard the form of the stock sale only if the shareholders knew that the scheme was intended to avoid taxes. The Tax Court determined that the shareholders lacked such knowledge. The IRS again appealed, arguing that the Tax Court misinterpreted the Arizona statute regarding actual or constructive knowledge. According to the IRS, the substance of the transaction showed that Berlinetta was merely the entity through which Slone passed a liquidating distribution to its shareholders.

The Ninth Circuit reversed the Tax Court's decision and remanded with instructions to enter a judgment in favor of the IRS. The Ninth Circuit found that the purpose of the stock sale was tax avoidance and that reasonable actors in the shareholders' position would have been on notice that Berlinetta never intended to pay Slone's tax obligation. The court found that Slone was not engaged in any business activities after the asset sale; it held only the cash proceeds of the sale and the $15 million tax liability. There was no legitimate economic purpose to the stock sale other than to avoid paying the taxes on a liquidating asset and distribution to shareholders, the court concluded.

According to the Ninth Circuit, reasonable actors in the position of the shareholders would have been on notice that Berlinetta intended to avoid paying Slone's tax obligation. The court found that Berlinetta communicated its intention to eliminate the tax obligation and that Slone's leaders and advisors, despite their suspicions, asked no pertinent questions. The Ninth Circuit said that the Tax Court in effect allowed the shareholders to shield themselves through willful blindness.

It was clear to the Ninth Circuit that Berlinetta's assumption of Slone's tax liability and payment to the shareholders of an amount representing the net value of the company after the asset sale and most of the amount that Slone owed in taxes operated in substance as a liquidating distribution in a form designed to avoid tax liability. The court concluded that the distribution by Slone to its shareholders was a constructively fraudulent transfer under Arizona law and the shareholders were liable for Slone's taxes as transferees under Code Sec. 6901.

For a discussion of transferee liability, see Parker Tax ¶262,530.

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IRS Summonses of Law Firm's Escrow and Trust Bank Account Records Upheld

The Eleventh Circuit affirmed a district court's decision denying the quashing of IRS summonses of a law firm's bank records, including escrow and trust account records containing information about client finances. The court held that (1) the IRS was not required to demonstrate probable cause because the firm's clients did not have a reasonable expectation of privacy in the bank records, and (2) the IRS was not required to issue John Doe summonses to the clients and petition the district court for an ex parte hearing before obtaining the records. Presley v. U.S., 2018 PTC 232 (11th Cir. 2018).

In 2016, the IRS sent three summonses to Bank of America in the course of investigating the 2014 tax liabilities of Michael Presley, Cynthia Presley, BMP Family Limited Partnership, and Presley Law and Associates, P.A. Michael operates the law firm, Presley Law and Associates, P.A. (Presley Law)

The summonses sought bank records pertaining to all accounts over which the Presleys, the partnership, and Presley Law had signature authority including bank statements, loan proceeds, deposit slips, records of purchase, sources for all deposited items, and copies of all checks drawn. Among the bank records the IRS sought were the firm's escrow and trust account records, which were held in the names of Presley Law and BMP. Both accounts contained information about client finances. The IRS notified the Presleys, BMP, and Presley Law of the summonses. The IRS did not provide notice to the firm's clients because it was not investigating them.

Presley objected to the bank's production of records related to his firm's escrow and trust accounts and moved to quash the summonses, contending that the records revealed his clients' financial information. The IRS made a motion to dismiss and the district court granted the motion. The district court found that the summonses were narrowly drawn and relevant to the IRS's investigation as required under U.S. v. Powell, 379 U.S. 48 (1964). The district court also concluded that Presley lacked standing to challenge the summonses as violations of his clients' privacy because the clients lacked a reasonable expectation of privacy in records held by the

In Powell, the Supreme Court ruled that for the IRS to establish a prima facie case for enforcement of a summons, it must show that (1) the investigation has a legitimate purpose, (2) the information sought is relevant to that purpose, (3) the IRS does not already possess the information, and (4) the IRS has followed the procedural steps required by the Code. If the government establishes these elements, the burden shifts to the taxpayer to either disprove one of the criteria or to demonstrate that judicial enforcement would be an abuse of the court's process.

Presley did not dispute that the IRS satisfied the Powell factors. Instead, he argued that Powell did not apply. According to Presley, the Fourth Amendment obligated the IRS to demonstrate probable cause because his clients had a reasonable expectation of privacy in the records held by the bank.

The Eleventh Circuit affirmed the district court's denial of Presley's motion to quash the summonses. The court concluded that Presley's the clients lacked a reasonable expectation of privacy in the bank records and the IRS was not required to issue John Doe subpoenas. First, the court determined that it did not have to resolve issue of whether Presley had standing to bring a Fourth Amendment challenge on his clients' behalf. The court determined that Fourth Amendment standing is not jurisdictional, so the court could decide on the merits whether the firm's clients had a privacy interest in the bank records.

Turning to the merits, the court found that the clients did not have a reasonable expectation of privacy. The court explained that under the third party doctrine, there is no privacy interest where information is revealed to a third party and conveyed by the third party to the government. The court also found that U.S. v. Miller, 425 U.S. 435 (1976) foreclosed the privacy argument.

In Miller, the IRS subpoenaed a taxpayer's banks seeking financial documents including monthly statements, and the taxpayer objected, invoking the Fourth Amendment. The Supreme Court rejected the challenge because it found that Miller had neither ownership nor possession of the bank records, and that the nature of the records the IRS was seekingcheckslimited Miller's privacy expectation because the checks were not confidential communications but negotiable instruments to be used in commercial transactions. Applying Miller, the Eleventh Circuit found that the account records were held by a third party bank and were not confidential communications but simply registries of financial transactions. In the court's view, the fact that the clients gave their records to the law firm, rather than directly to the bank, did not change the outcome, because the clients knew that the firm would deposit their records and checks with the bank.

The court concluded its privacy analysis by explaining that, even if probable cause does not apply, the IRS's summons authority is nevertheless constrained because under the Fourth Amendment, disclosures of bank records cannot be unreasonable. The court explained that when it comes to the IRS's issuance of a summons, compliance with the Powell factors satisfies the Fourth Amendment reasonableness requirement. Noting that Presley did not contest that the summonses satisfied Powell nor suggest that the summonses were subterfuge so the IRS could investigate the clients or invade attorney-client privilege, the court concluded that it saw no reason why the summonses should not be enforced.

For a discussion of the IRS's summons authority, see Parker Tax ¶263,120.