See the Appellate Brief we just filed in the U.S. Circuit Court of Appeals for the Fourth Circuit in a Reasonable Compensation Tax Case

Pacer:  No. 22-1573, Clary Hood, Inc. v. Commissioner, USCA4 Appeal 22-1573  Doc 19 Filed 9/27/2022 (47 Pages)

Are You Prepared to File Your Partnership Tax Return under the New Centralized Partnership Audit Rules?

As partners and members of U.S. partnerships and limited liability companies (or their CPAs) gleefully came back to work after ringing in the new year, many started a familiar process: preparation of their partnership’s tax return. This year, however, most have discovered a few changes to their partnership’s Form 1065 that will prompt some new questions like: “Can our partnership elect out of the centralized partnership audit regime under section 6221(b)?,” which will be quickly followed by “Wait, what is the centralized audit regime?” and “What is a partnership representative?” and “Do we have a partnership representative?” 

While these questions seem innocuous, they grow out of the largest change to the taxation of partnerships in over 30 years. In late 2015 Congress passed the Bipartisan Budget Act of 2015 (“BBA”). For all tax years beginning after December 31, 2017 (or starting with all 2018 tax years), the BBA, and the regulations thereunder, does away with the TEFRA audit regime that has been in effect since 1982.

Make no mistake, these new partnership audit rules are for the benefit and convenience of the IRS. And while the new centralized audit system largely accomplishes this goal of making partnership audits much easier for the IRS, it can create significant burdens for the partners subject to the new system if they fail to properly address key issues.

Under the BBA the IRS is generally allowed to adjust most partnership-related items for the tax years subject to audit (the “Reviewed Years”) at the partnership level. After making such adjustments, the IRS then calculates any potential underpayment by multiplying the net positive audit adjustments for partnership items by the highest marginal federal income tax rate in effect for the relevant Reviewed Year. Importantly, unless the partnership takes affirmative action through its newly-minted partnership representative, the default BBA rules grant the IRS authority to collect this underpayment directly from the partnership in the year of the adjustment (“Adjustment Year”).

Put differently, the BBA’s default rules will result in the partners in the Adjustment Year bearing the economic burden for the audit, even if they were not partners in one or more of the partnership’s Reviewed Years that gave rise to the adjustments. And, because the partnership must pay the tax, not the individual partners, the partners cannot use beneficial tax attributes, such as a lower marginal tax rate or suspended losses, to reduce or offset the tax liability.

Have I mentioned that these changes are solely for the benefit and convenience of the IRS?

Mercifully, the BBA gives partners 3 options to address or minimize the impact of the default rules:

-          Elect Out. In certain limited scenarios, the partnership representative may elect, on the partnership’s timely-filed tax return, to not be subject to the new centralized audit rules of the BBA. If a partnership elects out of the BBA, any partnership audit for that tax year will follow the pre-TEFRA rules. As many practitioners have noted, if the partnership qualifies to elect out of the BBA’s regime, there is no reason to forgo this election. To be eligible to elect out of the BBA, the partnership must have no more than 100 K-1s (including all indirect owners through parent entities) and the partners must all be individuals, C or S corporations, estates, or certain foreign corporations. Having other partnerships, trusts, and even disregarded entities (such as grantor trusts and single-member LLCs) as partners will prevent the partnership from being able to elect out of the regime.

-          Push-out. If the partnership cannot elect out of the new BBA regime, the rules permit the partnership to avoid paying the entity-level tax by having the partnership representative elect to “push-out” the adjustments to the partnership’s partners in the Reviewed Years. This option ensures the economic burden of the adjustments is borne by the partners in the years giving rise to the adjustments. To the extent the partnership is part of a multi-tier structure, the BBA rules also permit the push-out election to be made at each level (or requires an entity that fails to make the election to pay the entity level tax). It is important to note that the push-out election presents a number of administrative costs for the partnership that the partnership representative must weigh in deciding if the election makes sense. The partnership representative must make the push-out election within 45 days of the mailing of the notice of final audit adjustments.

-          Amended Tax Returns/ Pull-In Procedure. If a partnership fails (or is unable) to elect out of the BBA’s rules and does not make a push-out election, it will pay the imputed underpayment, unless one or more of the partners from the Reviewed Years amends its tax returns for the Review Years to reflect its share of the proposed adjustments. The IRS will reduce the partnership’s liability for the underpayment by any amount of the adjustment that a partner in the Reviewed Years accounts for on an amended tax return. Recognizing that the amendment process may present significant administrative burdens, including a potential restart of the statute of limitations for the amending partner, a Technical Corrections Bill created a simplified “pull-in” process. Under the pull-in process, the partnership’s liability for the underpayment is reduced by the amount paid by any partner from the Reviewed Years if that partner (1) substantiates the amount of tax that would have been owed if the partner had amended its returns for the Reviewed Years, (2) pays that amount, and (3) makes adjustments to its tax attributes. This process ensures the partners from the Review Years bear the burden of the adjustments without a higher interest rate or a new statute of limitations.   

Considering the far-reaching effect of the new BBA rules, it is also important for partners to consider who will act as the liaison between the partnership and the IRS. The BBA replaced the old tax matters partner with a new position––the partnership representative––who wields sole authority to act on behalf of the partnership in all matters relating to the examination of the partnership’s tax return, including administrative appeals, litigation, settlements, statute of limitations extensions, elections under the BBA, and payment of the tax liability. State law (such LLC or partnership statutes or state contract law) cannot alter or limit the duties of the partnership representative.

The designation of the partnership representative must be made annually and will remain in effect for that partnership year unless it is formally revoked with the IRS, even if the partnership changes its representative in later years. The partnership representative is not required to be a partner of the partnership, and, if the partnership fails to make an effective designation, the IRS may unilaterally designate the representative upon commencement of an examination.

Due to this monumental shift in the partnership audit regime caused by the BBA, owners of partnership or LLC interests should check in with their advisers to ensure the BBA’s new structure is addressed in their partnership agreement as they (or their CPAs) begin filling out the new Form 1065. At a minimum, partners should ensure they have addressed the process for selecting, removing, and binding the partnership representative. Further, partners should take time now to agree on how potential audits will be managed if the election out is not possible and contractually bind all current (and future) partners to such plan. Finally, to the extent possible, the partnership representative should make sure the partnership elects out of the BBA’s regime. While it may take years to see how audits ultimately play out under the BBA, taking these prophylactic steps now before any potential audit will minimize the impact of the BBA’s new audit regime on existing partnerships.

Opportunity Zones: Gimmick or a Real Opportunity?

The IRS recently issued draft proposed regulations clarifying rules on deferring gain from investing in the opportunity zone program [click here for location of opportunity zones:
https://eig.org/opportunityzones ]. As a reminder, proposed regulations are not effective until final, but rather provide a glimpse into how the IRS is thinking. These proposed regulations are pro-taxpayer and should increase interest in this relatively new program.

In short, the opportunity zone program allows taxpayers to sell a capital asset and reinvest the gains in a qualifying opportunity fund (QOF), which is generally a traditional investment entity such as an LLC or preferred partnership. The QOF must hold at least 90% of its assets in qualified opportunity zone property, which includes business property within the opportunity zone and even equity interest in a business that qualifies as an opportunity zone business.

The benefits are three-fold, 1) gain on the sale of a capital asset can be deferred until December 31, 2026; 2) of that gain, 15% is excluded from income if the taxpayer keeps the investment in the fund for more than seven years; and 3) taxes on gain from the actual investment in the QOF held for 10 years is forgiven. At this point, to get all three tiers of benefits, the investment in the QOF should be made by December 31, 2019.

But wait, there’s more! The proposed regulations may allow taxpayers to hold their investment thought 2047 without losing the tax benefits.

Here is the kicker. The QOF must make “substantial improvements” to the opportunity zone property. This forced expenditure turned many taxpayers away from this opportunity. However, the proposed regulations provided that substantial improvements for land with a building on it is met if the basis of the building is more than doubled. That is a big deal, if the basis of the land is not included. This clarification alone may move many taxpayers into this program. Further, taxpayers have 31 months to make the substantial improvements, not six months.

Right now, the opportunity zone program has moved into a real opportunity. At risk of stating the obvious, you should consider an investment in its entirety, beyond the tax benefits. However, the tax benefits sure do sweeten the deal.

Post written by:
Stanton P. Geller
Culp Elliott & Carpenter, P.L.L.C.
 

The Gravity of the Graev III Case Concerning IRS Tax Penalties

When the IRS seeks to impose a penalty against a taxpayer in an income tax case in U.S. Tax Court, typically under section 6662 of the Internal Revenue Code, the asserted penalty must meet the conditions and criteria specified under that provision.  However, before any such penalty can be asserted, there must be an internal "approval" of the penalty being asserted.

Section 6751(b) of the Internal Revenue Code specifies that NO tax penalty can be assessed unless the "initial determination of such assessment" is personally approved, in writing, by the immediate supervisor of the IRS individual making such determination or such higher level official as the Secretary may designate"  The timing of the approval is not specified in that Code section.  This has caused a lot of litigation.

In Graev v. Commissioner, 147 16 (2016) (known as "Graev II") the Tax Court held that a taxpayer's argument about the written approval before the fact of assessment (the mere computer entry on the IRS's ledger that the tax or penalty is owed as a fixed liability of the taxpayer, which can occur only after any tax deficiency proceedings such as U.S. Tax Court cases are final and concluded) was not ripe in the Tax Court and could not be raised in a Tax Court case.  (Note:  "Graev I", or Graev v. Commissioner, 140 T.C. 377 (2013) involved the Tax Court's determination of disallowed cash and non-cash charitable contribution deductions as a ruling in the Graev cases on the substantive tax merits).

Then, however, in Chai v. Commissioner, 851 F. 3d 190 (2d Cir. 2017), decided on March 20, 2017, the Second Circuit Court of Appeals reversed the Tax Court's ruling that the taxpayer's raising of the written approval requirement for tax penalties for the first time on post trial briefing was untimely, and held that the requirement under section 6751(b) for the IRS to obtain a written supervisory approval of the tax penalty kicks in NO LATER THAN the date the IRS issues a statutory notice of defeciency, or files an Answer or Amended Answer asserting the penalty in conjunction with the written approval.  Essentially the Second Circuit held the Tax Court does have jurisdiction to review the written supervisory approval issue if made timely, being no later than the above "trigger" dates.  The Court in Chai FURTHER held that the IRS bears the burden of production and proof to show the supervisory written approval was obtained timely pursuant to section 7491(c) of the Internal Revenue Code.

All of this has set the stage for last December's nationwide ruling in Graev v.Commissioner, ("Graev III"), 149 T.C.No. 23 (12-20-17).  In an 81 page opinion, the Tax Court found the taxpayer's argument that the IRS failed to comply with Section 6751(b) was INDEED properly subject to the Tax Court's pre-assessment jurisdiction and subject to a hearing on the matter.  Moreover, Graev III also held that the Commissioner had the burden of production under section 7491(c) of the Internal Revenue Code to show compliance. Under the specific facts of Graev III, the Tax Court found compliance because the penalty was tied to the IRS officer who "initially proposed" the penalty, being the IRS docket attorney who first proposed an alternative 20% penalty on non-cash charitable contributions as first raised in the statutory notice of deficiency, which had supervisory written approval, as well as a new 40% penalty first raised in the IRS's Amended Answer in that Tax Court case. 

How about a penalty FIRST asserted by an examining revenue agent?  The outside time limit of the Stat. Notice expressed by Chai does not seem to be enough.  In his concurrence in Graev III. Judge Lauber stressed that while written supervisory approval could occur NOT LATER than the time of the statutory notice of deficiency or Tax Court Answer or Amended Answer, the supervisory written approval would be timely only if it were issued no later than the time the FIRST IRS officer FIRST asserts the penalty .  Judge Lauber stated, ..."And by requiring [written] supervisory approval the first time an IRS official introduces the penalty into the conversation, the Court's interpretation is faithful to Congress's purpose by affording maximum protection to taxpayers against the improper wielding of penalties as a bargaining chip."

Since the Graev III decision, there have been numerous motions by the IRS to open the trial record post trial in some cases to introduce written penalty approvals, some of which have been granted and some of which have been denied.  And post trial briefing on this issue has been intensive. 

STAY TUNED!

Sixth Circuit Limits Scope of Substance Over Form Doctrine

The U.S. Court of Appeals for the Sixth Circuit recently dealt a significant taxpayer victory in Summa Holdings, Inc. v. Commissioner, No. 16-1712 (Decided February 16, 2017), and limited the government's ability to assert the substance over form doctrine to dismantle the taxpayer's combination plan of providing estate planning wealth shifting benefits to younger generation family members using a domestic international sales corporation (DISC) shelter in tandem with Roth IRA's.

In Summa, the taxpayer father operated an exporting business, and his two sons established their own Roth IRA's, with initial contributions of $3,500 each.  Shortly thereafter, the Roth IRAs as sole shareholders invested $1,500 of capital each in newly formed JC Export, which was established as DISC.  Under the tax law, DISCs can receive up to 10% of an affiliated company's export sales revenue as "sales commissions" as so designated by Congress, which commissions are deductible by the affiliated export company and tax exempt to the DISC.  However, DISC dividends to shareholders are subject to up to 33% income taxes to the DISC as unrelated business taxable income, which was paid by JC Export.  However then the DISC paid the remaining funds to the son's Roth IRA accounts. Over a period of years and by 2008, each Roth IRA had accumulated over $3 million under this plan.

The IRS argued that in substance, Summa Holdings paid a non-deductible dividend to it's shareholders, who were Mr. Benenson and a trust for the benefit of his sons.  The U.S. Tax Court agreed and decided the case in favor of the IRS.

On appeal, the 6th Circuit reversed the Tax Court and held that the substance over form doctrine did not and could not apply to circumstances where the substance of a tax statute enacted by Congress was defined by the IRS through re-characterizing transactions which adhered to the form prescribed by Congress.  The 6th Circuit reasoned that while the substance over form doctrine could be used to prevent a taxpayer from distorting a transaction's true substance by adopting a masquerading transactional form inconsistent with economic reality, here Congress expressly sanctioned using a shell DISC and/or a Roth IRA in form only to achieve an artificial but Congressional permitted tax benefit, as a matter of "congressional design."

The 6th Circuit referred to this type of transaction as "Code compliant" form of tax advantaged transaction that did not follow a devious path in its form but straightforward steps as authorized by Congress.  And quoting Judge Hand in Helverling v. Gregory, 69 F. 2d 809 (2d Cir. 1934), the 6th Circuit reiterated that "Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury, " and added that if Congress by design and through the Code authorizes a set of "formal" transactions the taxpayer entered into, "it is of no consequence that it  was all an elaborate scheme to get rid of income taxes."  Consequently, the 6th Circuit refused to adopt the alternative two step narrative of the Commissioner re-characterizing the DISC commissions as constructive dividends follow by excessive Roth IRA contribution.

Our Firm predicts that a huge amount of discussion and debate in the tax scholarship and in the tax press will ensue from this decision.  Stay tuned.

STATE TAX RESIDENCY CASE WON BY SELLING BUSINESS OWNERS

The North Carolina Court of Appeals recently decided in Fowler v. North Carolina Department of Revenue, No. COA-14-1302 (August 8, 2015) that the owners of a construction company in Raleigh owed none of the $10.4 million capital gains tax from the sale of their business claimed by the NCDOR, because they changed tax residency to Florida a few weeks before the sale closing.  This has been a very highly contested case and the taxpayers have won for the third time, first at trial before an administrative law judge, then before the NC Superior Court, then before the Court of Appeals.

The Fowler case is significant because of the complex nature of the facts and the trial court's findings that they intended to change their domicile to Florida right before selling their business due to the steps they took to achieve the change (including buying a larger new home in Florida, starting a Florida business, changing their address) even though their steps were less than perfect and even though they had continuing contacts with North Carolina by keeping their old home, and continuing to work for the company's buyer after the sale for a temporary period of time.

Our Firm was handled the taxpayer's administrative appeal in the case and served as co-counsel at trial.  Our view is that the Court of Appeals decision was a just one when all the change of domicile factors are analyzed, and that it is not necessary for a taxpayer to sever every single tie with the prior state of domicile to change to another state, which is consistent with tax residency decisions in other states, most notably of which is the Allen Page case in Minnesota.

For more information, contact Curtis Elliott at 704-372-6322 or wce@ceclaw.com

Crummey Trusts Continue to Be Approved By Tax Court

The U.S. Tax Court recently held in Mikel v. Commissioner, T.C. Memo 2015-64 that so called "Crummey" gifts of $12,000 each to 60 trust beneficiaries qualified for the annual gift tax exclusion as present interest gifts.  The IRS argued that although the trust beneficiaries had legally enforceable rights of withdrawal over those funds, they were unlikely to assert those rights under the trust's no-contest clause.  The Tax Court disagreed, and found the withdrawal demands could not be legally resisted by the Trustee of the trust and that the in terrorem provisions would not necessarily deter the beneficiaries from pursuing judicial relief as a practical matter.

This favorable view of the trust's Crummey provisions provides further solace to estate planners and their clients that the use of Crummey trust gifts to multiple trust beneficiaries will be accorded present interest status per gift to enable the donor to make larger annual exclusion gifts to family trusts.  This case is a major positive case law development for practitioners and their clients.