Stephen Olsen

About Stephen Olsen

Stephen J. Olsen’s practice includes tax planning and controversy matters for individuals, businesses and exempt entities for the law firm Gawthrop Greenwood, PC.

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New Estate Tax Lien Discharge Procedures — Give the IRS All the Monies

In early April, the IRS issued updated guidance relating to the processing of the estate tax liens after June of 2016. See SBSE-05-0417-0011.   In June of 2016, various changes were made to the administration of the estate tax, including which groups in SBSE handled requests for the discharge of the estate tax lien.  The changes to the discharge were fairly drastic in some ways, and the Service took a significant amount of time getting around to announcing the changes (which it states is actually just the correct implementation of the law, perhaps implying the prior handling was incorrect).  The new provisions appear to force prepayment of tax, or at least handing over the funds, in exchange for the discharge of the lien in a broader range of situations, potentially creating a significant hardship for estates.  This has caught many estate administration lawyers off guard, altering sales, and angering many in the professional community.

The estate tax lien is somewhat different than other tax liens, and arises in every estate (you just don’t know it most of the time).  Under Section 6324(a), a lien is immediately imposed on all property in the “gross estate” of the decedent.  This includes property passing through the estate, but also most property passing directly to a beneficiary by operation of law, such as property held joint with right of survivorship, and most property passing by beneficiary designation.  As stated in the IRS guidance:

Unlike other tax liens, no assessment, no notice and no demand for payment are necessary to create the estate tax lien. It attaches at the time of the decedent’s death, before the tax is determined, and is security for any estate taxes that may be determined to be due. It is referred to as the “silent lien” and does not have to be recorded to be enforced.

Sneaky stuff, but arguably provides important protection for the Fed.  This lien attaches and remains in place for ten years after the date of death unless discharged.  There are some provisions extending the lien in circumstances where the estate tax is deferred, such as under Section 6166, but otherwise the use-by date is set at ten years.  As a side note, it is possible for a general tax lien to also be imposed under Section 6321, which could be in place longer, so in dealing with a lien estate tax practitioner must determine if one or both are in place.  See IRM 5.5.8.2.  For those looking to learn more about this lien, Keith and Les recently drafted chapter 14A.20 in SaltzBook, which covers the lien in depth, along with the transferee liability, how to request discharge, and various other interesting aspects of the “silent lien.”

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As indicated above, the lien is imposed immediately, while the audit could take months or years to occur, if ever at all.  Various situations would not be audited or do not require returns.  This can create issues, especially for illiquid estates, that need funds for administration costs.  If a fiduciary sought to transfer assets, especially when finicky title insurance and mortgage companies were involved, assurances would be needed that the property could be transferred free and clear.

Under the old rules, release or discharge was handled by different groups depending on whether a return was filed or audit was occurring.  If no return was filed or a return was under audit, Exam reviewed the request. This used to be outlined in IRM 4.25.14.2, which has subsequently been updated to indicate Exam will no longer be handling discharge requests.  Specialty Collection Advisory used to handle all other requests relating to the estate tax lien, which was covered under IRM 5.5.8 and IRM 5.12.10.

The prior procedures would allow the fiduciary to request a discharge of the lien on the property to be sold by filing a Form 4422, Application for Certificate of Discharging Property Subject to the Estate Tax Lien. This was fairly routine in the past and occurred quickly, allowing property to be sold and estates to obtain the proceeds.  This was allowed under Section 6325 if the lien was “fully satisfied or provided for.”  Presumably, the “provided for” language was what was relied upon prior to payment and the issuance of a closely letter.  The regulations added some additional requirements regarding “necessity” of the estate.

In SBSE-05-0417-0011, the Service outlined the new procedures for requesting discharge, and it appears the conditions for obtaining discharge have become a bit more strict.  Beginning in June of 2016, responsibly for all discharge applications of the estate tax lien were shifted to Advisory to be handled by its “Estate Tax Lien Group.”   Information about requesting the discharge, including the address to send such requests, is found on the IRS webpage here.  The directions provide that such requests must be filed “at least 45 days before the transaction date”, which is roughly a month or more longer than such requests used to take.  This is irksome, but not as problematic as some other changes that have been made.

After noting discharge is completely discretionary, the advice indicates considerations that Advisory may take into account, including situations where Advisory does not need to consult with Exam prior to issuing a discharge, stating:

In many instances, decisions concerning the discharge application can be made from the information provided on the Form 706 (if applicable) and the Form 4422 without the need to coordinate with Examination Estate & Gift. For example, if based on the information provided with the Form 4422 and internal account records you are able to determine that the estate tax liability has been paid, or the estate is not subject to a Form 706 filing requirement, or the value of other property disclosed on the Form 4422 that will remain subject to the estate tax lien is more than ample to protect the government’s interest in the payment of the estate tax, coordination with Examination Estate &Gift is not ordinarily necessary (emph. added).

The advice goes on to cover situations where Advisory will need to coordinate with Exam or Chief Counsel when considering discharge.  I emphasized some language in the above quote, because that language would seem to indicate discharge is appropriate where there is clearly more than sufficient other assets to timely pay the estate tax, which historically occurred.  Other language would give the same impression:

In many instances, in determining whether to grant an estate tax lien discharge, the issue you will need to consider is whether the estate tax liability is adequately provided for, meaning that the government’s interest in collecting the estate tax is secured… In determining whether an estate tax liability is adequately provided for, you have discretion and should exercise your judgment in making that decision based on the particular circumstances…[and] you may also consider the criteria in IRC § 6325(b) as a guideline in making your decision as the estate tax liability will generally be adequately provided for when one or more of the IRC § 6325(b) criteria set forth below is satisfied. In addition, there may be other circumstances where you and your manager determine that the estate tax liability has been adequately provided for under the particular circumstance involved.

This again would indicate payment at the time of discharge is not required, although gets a little thornier perhaps by reference to Section 6325(b), which allows for discharge in various circumstances, such as having double the potential liability available, partial payment, substitution of proceeds at sale, substitution of other assets (deposits, bonds, etc.).

The advice then covers some common scenarios.  For instance, if no Form 706 is required to be filed, no discharge is offered, and instead  Letter 1352 is issued indicating no return must be filed.  When a return is required, but no tax is due, the advice indicates escrow may not be needed.  But, if there are questions as to the veracity of the claim, additional research may be needed, and perhaps escrow.

Then  it starts to get problematic, stating:

if the Form 4422 shows an estimated estate tax greater than the net proceeds from the property being sold, and no estimated payment has been made, then the net proceeds should be paid or escrowed before granting the discharge.

For an estate that is illiquid, holding only real property or closely held business interests, this could be very problematic.  And, anecdotally, it appears some estates are running into this issue.  Although the estate tax is a priority claim, there are various other administration costs that can be paid first (my fave, attorneys’ fees).  It could also impact the payment of state death taxes, the timing of which can be more important that federal taxes.  In Pennsylvania, for instance, prepayment of inheritance tax at the three month mark will provide a five percent discount off the tax bill.  At least one tax practitioner has requested some type of hardship request from having to pay over the funds, and been rebuffed.

It also brings into question what will happen for someone who would have requested an extension to pay tax under Section 6161 or Section 6166.  I suppose the funds could be escrowed until the return is filed, but the funds may have been needed to run a closely held company or pay another debt.

I do not necessarily begrudge the IRS attempting to ensure payment, but this seems like an attempt to solve a problem that may not have existed.  I would be interested in seeing whether or not the IRS often gets stiffed on federal estate tax by people who request a discharge and have indicated tax may be due (my suspicion is no, but I could be wrong).  If this is not a problem, it seems like this change that can drastically and negatively impact estate administration (and potentially the value of estate assets) is misguided.  It would also be good if the IRS became a bit more flexible on a case by case basis – there cannot be that many of these per year — which the guidance seems to still allow.  From the anecdotal evidence, it would seem that the factors in Section 6325(b) may have been applicable in having assets worth double the tax debt still under the lien, but funds have still had to be paid or escrowed.

The take away for now is that 1) you have to apply much more in advance from closing and 2) if you need the proceeds from the sale, you probably need to make a compelling argument under Section 6325(b) why the fisc would be lighter for it.

What is a “Record” for FOIA

In today’s post, I am covering a somewhat stale, non-tax holding in American Immigration Lawyers Association v. Executive Office for Immigration Review (“AILA”), a case dealing with a FOIA request “seeking disclosure of records related to complaints about the conduct of immigration judges.”  It will also touch on the DOJ response to the case, which was issued in January.  Perfect for a tax procedure blog that tries to stay somewhat current.  The case, decided by the DC Circuit, is important, however, because the determination of what could be redacted from a record, once it is determined the record was responsive to the FOIA request.  Specifically, whether non-responsive aspects of the record could be redacted (spoiler – Sri Srinivasan says “no”). This has far reaching potential consequences with FOIA requests beyond the narrow scope of the request, including to FOIA requests made in relation to tax cases or requests for information about how the Service administers the laws.

The substance of the case does not matter much for this discussion, although it is interesting that such terrible allegations have repeatedly been made against the immigration judges.  Various complaints included disrespectful and at times racist treatment of defendants, and sometimes fairly reprehensible treatment of counsel.  Unfortunately, this is probably old hat for people who work in this system; makes me somewhat thankful when I do catch a helpful Appeals Officer or Revenue Agent or the quality work usually done by the tax court.  In this case, AILA requested all information relating to complaints about the immigration judges.  Interestingly, I believe some faulty redacting relating to this case may have resulted in the summary of the complaints being released, along with the judges’ names. I just redacted the heck out of about 1500 pages using Adobe, and now I am a little nervous.  I would assume the FOIA folks redact far more frequently than me.

Procedurally, FOIA generally requires the feds to make certain information available to the public, but subject to nine exceptions.  See 5 USC § 552(a).   The pubic is allowed to request the documents, and the agency must provide them, but has the ability to withhold the documents if the entire document is subject to an exemption, or can redact portions that are properly withheld and provide the rest of the document.  The exemptions can be found listed here.  For those of you interested in learning all about the intersection of FOIA and tax practice and procedure, Les recently updated chapter 2 of SaltzBook, which covers this in great detail, including all the exemptions and how to use FOIA requests in your practice.

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In AILA, what is important is that various documents were found that were responsive to the extensive requests made.  Many of those documents contained portions that were responsive to the request, and portions that were responsive but also fit into one of the exemptions.  Aspects of some of the documents were also non-responsive.  Meaning, portions of the documents did not relate to the request that was made.  Agency practice, I believe including the IRS, was to redact all portions of the document that were exempt, and also to redact all the portions of the document that were non-responsive to the request.  When in doubt, keep it out.

This practice had been somewhat sanctioned by various district courts, and was in question in AILA.  The DC Circuit, however, disagreed with the district courts.  In discussing the “ostensibly non-responsive material” (you know this isn’t going to go your way when “ostensibly” is applied to your position), the Court noted that the government’s position was that it was not under any obligation to release information concerning matters unrelated to the FOIA request.  Not a wholly absurd position.  In the Vaughn index, examples were given as to why the portions of the documents were not responsive, such as information relating to the judge needing to clean his/her office, and vacation plans.   That is all interesting, but not germane to the request.

Although the lower court and other district courts had addressed this issue, it was the first time the DC Circuit had taken the matter up.  The Court began by providing some background information, stating FOIA requires “’each agency, upon any request for records which (i) reasonably describes such records and (ii) is made in accordance with published rules stating time, place, fees (if any), and procedures to be followed, shall make the records promptly available to any person.’ 5 USC § 552(a)(3)(A).” Further, in “responsive records” certain portions may be redacted pursuant to the exemptions.  The only provisions, however, related to responsive records, and withholding information, is found within those exemptions.  The court stated, FOIA creates a process for an agency to follow when responding to a FOIA request:

First, identify responsive records; second, identify those responsive records or portions of responsive records that are statutorily exempt from disclosure; and third, if necessary and feasible, redact exempt information from the responsive records. The statute does not provide for…redacting non-exempt information within responsive records.

Relying on a handful of SCOTUS cases that required FOIA exemptions to be narrowly construed, the Court did not see how it could authorize the redacting of aspects of records that were found to be responsive.  As stated above, the manner in which agencies generally redacted was contrary to this holding.

We do not know the exact significance of the holding yet, and the Court somewhat foreshadowed what impact this case may have.  The Court stated:

The practical significance of FOIA’s command to disclose a responsive record as a unit…depends on how one conceives of a “record.”  Here the parties have not addressed the antecedent question of what constitutes a distinct “record” for FOIA purposes…for purposes of this case, we simply take as a given [the government’s] own understanding of what constitutes a responsive “record,” as indicated by its disclosures…

Although FOIA includes a definition section…that sections provides no definition of the term “record.”  Elsewhere, the statute describes the term record as ‘include[ing] any information that would be an agency record…when maintained by an agency in any format, including an electronic format’…but that description provides little help in understanding what is a “record” in the first place.”

In the text of the case, the Court compares the definition of “record” under FOIA to the definition of record under the Privacy Act, which states it is “any item, collection, or grouping of information.” See 44 USC § 2201(2).  Although not completely clear, it is more instructive than no definition at all.

In AILA, the Court’s holding was clearly not going to sit well with the government, but the Court provided the framework for each agency to rethink how it approached FOIA requests in a manner that mitigated what the agencies viewed as a negative holding.  The DOJ somewhat took them up on that offer.  In January of 2017, Office of Information Policy released guidance entitled, “Defining a ‘Record’ Under FOIA” addressing the holding in AILA.  The guidance notes that after AILA, “it is not permissible to redact information within a record as “non-responsive.”  It also highlighted the fact that the Court looked to the “sister statute” of FOIA, The Privacy Act, 5 USC 552a(a)(4) for the potential definition of “record” as “any item, collection, or grouping of information.”

From this, the guidance encouraged the agencies to use the Privacy Act definition and use a “more fine-tuned, content-based approach to the decision,” as to what a record is, and determine if an entire document is the record, or just a page, or just a paragraph.  In AILA, the Court stated it may be impossible to withhold one sentence of a paragraph, and DOJ agreed.  The guidance provided some practical pointers about how an agency must then report the number of records the agency has that is responsive.  It should also clearly identify each record and if it contains multiple subjects so “the requester can readily see why and how the agency divided the document into distinct ‘records’.”

AILA was a substantial departure from how agencies, including Treasury, and the Service, handled FOIA responses.  The case, however, provided a roadmap to mitigate the shift, which the Government apparently will seek to implement.  The practical impact may be less overall pages, but with less redaction.

 

Second Circuit Tosses Penalties Because of IRS Failure To Obtain Supervisor Approval

–Or, Tax Court Burnt by Second Circuit’s Hot Chai

Yesterday the Second Circuit decided a very important decision in favor of the taxpayer pertaining to the Section 6571 requirement that a direct supervisor approve a penalty before it is assessed.  In Chai v. Commissioner, the Second Circuit reversed the Tax Court, holding the Service’s failure to show penalties were approved by the immediate supervisor prior to issuing a notice of deficiency caused the penalty to fail.  In doing so, the Second Circuit explicitly rejected the recent Tax Court holdings on this matter, including Graev v. Commissioner, determining the matter was ripe for decision and that the Service’s failure prevented the imposition of the penalty.  Chai also has interesting issues involving TEFRA and penalty imposition that will not be covered (at least not today), and is important for the Second Circuit’s rejection of the IRS position that the taxpayer was required to raise the Section 6571 issue.   It is lengthy, but worth a read for practitioners focusing on tax controversy work.

PT regulars know that we have covered this topic on the blog in the past, including the recent taxpayer loss in the very divided Tax Court decision in Graev v. Commissioner.  Keith’s post on Graev from December can be found here.  For readers interested in a full review of that case and the history of this matter, Keith’s blog is a great starting point, and has links to prior posts written by him, Carlton Smith, and Frank Agostino (whose firm handled Graev and also the Chai case). Graev was actually only recently entered, and is appealable to the Second Circuit, so I wouldn’t be surprised if the taxpayer in that case files a motion to vacate based on the Second Circuit’s rejection of the Tax Court’s approach in Greav.

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Before discussing the  Second Circuit holding, I will crib some content from Keith, to indicate the status of the law before yesterday.  Here is Keith’s summary of the holding in Graev:

The Court split pretty sharply in its opinion with nine judges in the majority deciding that the IRC 6751(b) argument premature since the IRS had not yet assessed the liability, three judges concurring because the failure to obtain managerial approval did not prejudice the taxpayers and five judges dissenting because the failure to obtain managerial approval prior to the issuance of the notice of deficiency prevented the IRS from asserting this penalty (or the Court from determining that the taxpayer owed the penalty.)

That paragraph from Keith’s post regarding the holding doesn’t cover the lengthy and nuanced discussion, but his full post does for those who are interested.  The Second Circuit essentially rejected every position taken by the majority and concurrence in Graev, and almost completely agreed with the dissenting Tax Court judges (with a  few minor differences in rationale).

For its Section 6751(b) review, the Second Circuit began by reviewing the language of the statute.  It highlighted the fact that the Tax Court did the same, and found the language of the statute unambiguous, a conclusion with which the Second Circuit disagreed.

Section 6751(b)(1) states, in pertinent part:

No penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination…[emph. added]

The Tax Court found the lack of specification as to when the approval of the immediate supervisor was required allowed the immediate supervisor to approve the determination at any point, even after the statutory notice of deficiency was issued or the Tax Court reviewed the matter.

The Second Circuit, however, found the language ambiguous, and the lack of specification as to when the approval was required problematic.  The Second Circuit stated “[u]understanding § 6751 and appreciating its ambiguity requires proficiency with the deficiency process,” and then went through a primer on the issue.  To paraphrase the Second Circuit, the assessment occurs when the liability is recorded by the Secretary, which is “essentially a bookkeeping notation.”  It is the last step before the IRS can collect a deficiency.  The Second Circuit stated the deficiency is announced to the taxpayer in a SNOD, along with its intention to assess.  The taxpayer then has 90 days to petition the Tax Court for review.  If there is a petition to the Court, it then becomes the Court’s job to determine the amount outstanding.  As it is the Court’s job to determine the amount of the assessment, the immediate supervisor no longer has the ability to approve or not approve the penalty.  The Second Circuit agreed with the Graev dissent that “[i]n light of the historical meaning of ‘assessment,’” the phrase “initial determination of such assessment” did not make sense.  A deficiency can be determined, as can the decision to make an assessment, but you cannot determine an assessment.

The Second Circuit then looked to the legislative history, and found the requirement was meant to force the supervisor to approve the penalty before it was issued to the taxpayer, not simply before the bookkeeping function was finalized.  The Court further stated, as I noted above, if the supervisor is to give approval, it must be done at a time when the supervisor actually has authority.  As the Court noted, [t]hat discretion is lost once the Tax Court decision becomes final: at that point, § 6215(a) provides that ‘the entire amount redetermined as the deficiency…shall be assessed.”  The supervisor (and the IRS generally) can no longer approve or deny the imposition of the penalty.  The Court further noted, the authority to approve really vanishes upon a taxpayer filing with the Tax Court, as the statute provides approval of “the initial determination of such assessment,” and once the Court is involved it would no longer be the initial determination.  Continuing this line of thought, the Second Circuit stated that the taxpayer can file with the Tax Court immediately after the issuance of the notice of deficiency, so it is really the issuance of the notice of deficiency that is the last time where an initial determination could be approved.

This aspect of the holding is important for two reasons.  First, the Second Circuit is requiring the approval at the time of the NOD, and not allowing it to be done at some later point.  Second, this takes care of the ripeness issue.  If the time is set for approval, and it has passed, then the Court must consider the issue.

Of potentially equal importance in the holding is the fact that the Second Circuit stated unequivocally that the Service had the burden of production on this matter under Section 7491(c) and was responsible for showing the approval. It is fairly clear law that the Service has the burden of production and proof on penalties once a taxpayer challenges the penalties, with taxpayers bearing the burden on affirmative defenses.   The case law on whether the burden of production exists when a taxpayer doesn’t directly contest the penalties is a little more murky (thanks to Carlton Smith for my education on this matter).  The Second Circuit made clear its holding that the burden of production was solely on the Service, and the taxpayer had no obligation to raise the matter nor the burden of proof to show the approval was not given.  The Service had argued the taxpayer waived this issue by not bringing it up earlier in the proceeding, which the Second Circuit found non-persuasive.

As to the substance of the matter, the Second Circuit held the government never once indicated there was any evidence of compliance with Section 6751.  Since the Commissioner failed to meet is burden of production and proof, the penalty could not be assessed and the taxpayer was not responsible for paying it.  A very good holding for taxpayers, and we would expect a handful of other case to come through soon.  Given the division within the Tax Court, and the various rationales, it would not be surprising to see other Circuits hold differently.

One Hake of a Taxpayer Friendly Reasonable Cause Holding

And, could this be heading to SCOTUS?

The District Court for the Middle District of Pennsylvania just issued a holding in Hake v. United States regarding the reasonable cause exception for the failure to file penalties for executors who failed to file due to bad advice from their lawyer.  This was a fairly taxpayer friendly opinion, following somewhat closely on the heels of the Thouron case in the Third Circuit, which we covered heavily here.  While Thouron could have been limited, somewhat, to its facts, the Hake opinion applied the case broadly, allowing taxpayer reliance on an advisor to eliminate penalties.  Longtime PT readers will know that I dislike the framework from Boyle regarding reasonable cause for reliance on an expert in this area (but other practitioners disagree, including other PT authors).  Our readers will also likely recall that I was fairly heated in my harsh words against the Eastern District’s decision in Thouron before it was reversed by the Third Circuit.  Although I think allowing reasonable cause is the right thing to do for the Hakes, the case isn’t nearly as strong for reasonable cause as Thouron was, at least in my mind.  So, why do I think the Hakes got lucky (or more specifically their lawyer)?

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Mrs. Hake died in October of 2011 after a period of incapacitation, holding substantial assets including a closely held grocery store chain.  Her five children apparently did not agree on much, and that included the administration of her estate and the value of the assets.  Two of her five children, Ricky and Randy, were named executors, and hired the family lawyer to act as estate and tax counsel.  Normally, the estate tax return, Form 706, would have been due nine months following the date of death, in July of 2012. See Section 6075(a).  Due to the disagreements between the family, it was believed that they would not know the actual values of the estate assets at the filing deadline.

The attorney suggested filing a Form 4768 to obtain an extension of time to file the return and pay the tax due.  In June of 2012, the request for extension was filed.  An associate in the office was tasked with determining the extension, and informed the primary attorney, who in turn informed the client, that the filing deadline and the payment deadline had both been extended by a year.

But, that isn’t really a thing.  The estate had received a six month automatic filing extension, and a one year discretionary extension for payment.  This fact didn’t make it to the executors, who thought they were doing substantial good by prepaying the tax in February of 2013 ( about a month after the return was due) and in July the return was filed.  In August of 2013, the Service notified the estate that about $198k of penalties were due for failure to file a timely return under Section 6651, along with $17k in interest.  The estate took administrative steps to seek abatement, but eventually had to pay the tax due.  It then filed a refund suit in the District Court.

As the court stated, the issue was narrowly defined:

When an executor relies upon inaccurate advice from legal and tax counsel regarding the extended deadline for filing an estate tax return, in a factual context where determination of filing and payment deadlines are governed by a series of mandatory and discretionary rules which may vary depending upon the residence status of the taxpayer, does that reliance upon professional advice constitute reasonable cause to avoid the assessment of late filing penalties and interest?

The Court found that yes, it did constitute reasonable cause, which I applaud, and, as I have said repeatedly in the past, in this particular situation I do not think penalties should be imposed on the estate.  However, this is not in line with most of the case law.  The holding does follow the Third Circuit opinion in Thouron, as discussed below, but this fact pattern pushes the boundaries of the Supreme Court’s holding in Boyle further than Thouron did.

To begin the legal analysis, the court covered the general law, including that a six month extension is allowed under Reg. 20.6075-1 for filing, and that an extension to pay is allowed for up to a year under Reg. 20.6081-1(b).  Pursuant to Section 6081(a), however, the IRS is limited in allowing extensions beyond six months for failure to file (unless the taxpayer is outside of the country).

The Court characterizes this extension in an interesting way, stating:

 thus, with respect to payment and filing deadlines, the legal terrain requires subtle multi-faceted analysis. First, one must determine the initial filing and payment deadlines.  Next one must negotiate a series of deadline extensions rules.  Some of these extensions are automatic; others are discretionary.  Further, one must be alert to the fact that the application of these differing rules can lead to different deadlines for payment and filing.  Finally, one must remain mindful of the fact that the filing rules themselves change depending upon residency status of the executors.

The language is clearly framing this as a difficult issue that lay persons generally would not be capable of figuring out, which is not always how the discussions begin in cases following Boyle.    As our readers know, the failure to file penalty has an exception when such failure was due to reasonable cause and not willful neglect. Section 6651(a)(1).  SCOTUS outlined the general test for executors seeking to show reasonable cause in United States v. Boyle when relying on a tax professional.

The District Court discussed Boyle, but largely through the context of Thouron v. United States, the 2014 Third Circuit failure to pay case, which found the executor had reasonable cause for failing to timely pay estate tax because of his reliance on a tax professional regarding the extended deadline.

At the outset, it is important to note that most courts, practitioners, and commentators believe the failure to pay case law and the failure to file case law is largely interchangeable in this area, which I agree with.

The District Court noted the Third Circuit stated Boyle:

identified three distinct categories of late-filing cases. In the first category consists of 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…[SCOTUS] held…such…reliance…was not reasonable cause…The second category…is 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…lawyer or accountant advised the taxpayer was available.  Finally, in the third category are those cases where “an accountant or attorney advises a taxpayer on a matter of tax law.”

The District Court believed that Thouron had instructed it to construe Boyle narrowly, only clearly applying to the first set of failure above.  As to the second set, it believed Boyle did not hold on the issue leaving the lower courts to make their own determinations, and that under the third set of cases, Boyle would not apply.

The government’s contention is that the requirement for timely filing is non-delegable, and reasonable cause based on misunderstanding the deadline is never sufficient.  Such a failure is, in its mind (I am assuming), a malpractice claim between the taxpayer and its advisor.  The Service would never allow reasonable cause in the second set of cases, and would likely argue against it in most of the third set of cases.

The District Court in Hake, in the remainder of the opinion, somewhat appeared to begrudgingly agree with the Third Circuit’s analysis that reasonable cause could, and perhaps should, apply in all second and third category cases.  Towards the end, the Court stated the following not-so-ringing endorsement of its holding:

In reaching this conclusion, however, we wish to emphasize the very narrow scope of our ruling. We do not purport to stake out new or novel legal theories in this decision.  Rather, we attempt to simply and faithfully apply the law of this circuit to the facts of this case.  Moreover, our decision regarding the reasonableness of the executor’s reliance upon legal advice is strictly limited to, and bound up in the facts of this case.

The Court did then note, as a positive, the fact that the executors had overpaid the amount of tax due before the deadline for doing so (making the imposition of the penalty seem a little boorish on the part of the Service).  Finally, in foot note 6, the Court invited the government to consider taking this case up through various appeals to clarify the disparity in case law on this matter that is found in the other Circuits compared to the Third.

I have no specific knowledge of the case, but the opinion seemed to indicate that the district court judge in Hake 1)  doesn’t agree with Thouron completely, 2)  appreciated the fact that taxes were timely (over) paid, and 3)  didn’t want to be overruled on the opinion.

Thouron, however, in my mind left the door potentially open for the judge in Hake  to hold the other way, had it wanted to.  Hake doesn’t clearly state whether it falls within the second or third group of Boyle cases indicated above.  The language of the case would indicate the judge in Hake was analyzing the case under the second group, where the taxpayer files within the time frame erroneously indicated by a practitioner, not where there was clear reliance on legal advice (although the discussion of the complexity of the filing dates does drift into what I would view as a discussion more related to reliance on legal advice).

Thouron, likewise, didn’t specify whether it was a second or third group case.  It stated that Boyle only held on clerical oversight in an agent failing to file by the deadline.  “It 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”.

Thouron certainly indicates a willingness of the Third Circuit to allow a reliance case in either a second (advice regarding deadline) or third (reliance on expert for tax law advice), but it does not flesh out the issue any further.

One key distinction between Thouron and Hake, in my opinion, is that Thouron seems more like reliance on an expert regarding tax advice, which happened to impact the filing deadline.  In Thouron, the estate failed to timely pay tax because the estate erroneously believed it qualified for deferral of payment under Section 6166.  That Section allows deferrals on certain closely held business interests, and is incredibly complicated, including substantial regulations, rulings, etc.  Section 6166 itself, which only deals with the extension to pay, is about 4,000 words long.  Determining whether or not an estate qualifies is clearly an expert’s job, and to attempt to penalize an estate for such reliance when the expert is wrong in the analysis is antithetical to the statutes and regulations regarding the reasonable cause exception.  Hake, instead, was just a normal extension request.

While I agree the automatic extension provisions and the discretionary extension for payment can be confusing, and arguably could be expert advice, I think the case is less clear that it would fall within group three.   Again, the holding in Thouron lumps groups two and three together, but it does not state whether Thouron was in one or both groups.  It also does not state that all cases involving an accountant or lawyer advice regarding a deadline would qualify under group two (for instance, it would be interesting to see a court have that type of holding with the same automatic extension to pay income taxes and an extension to pay income tax).  I suspect the Third Circuit would affirm Hake, and probably would have reversed it had the holding been for the government.  Its statements in Thouron were somewhat clear in stating it would find reasonable cause for reliance on determining an extension or on legal advice.

I do not believe Hake has been appealed to the Third Circuit yet, and may not be.  If it or other similar cases should continue to be affirmed by the Third Circuit, it would result in a sufficient split to allow SCOTUS to weigh in on how Boyle should be applied, or more accurately, how the underlying law should be applied in groups two and three.  I think cases in group three have to remain reasonable cause, but it would be really interesting to see what happens with group two.

Procedure Round Up(date):   Regulations, Mount Up! & State Law SOL Issue When Suing Promoters.

This will be a short post that touches on some temporary and final regulations that were issued in the last quarter of last year that impact tax procedure, specifically information reporting and the preparer due diligence rules, which we have previously covered.  The second portion of the post will deal with a state law statute of limitations issue from a tax shelter participant suing the promoter.

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Regulation Update

What is Keno?

Back in March of 2015, I wrote about the temporary regulations dealing with reporting of winnings from bingo, keno, and slot machines.  The Service has finalized those regulations, which can be found here.  I believe the final regulations are similar to the temporary regulations (although aspects regarding electronic slot machines were not included in the final regs). These rules peg the required reported winnings at $1,200 for bingo and slot machines (but $1,500 for keno).  Anyone have any idea why those amounts are different (or what keno is, I don’t go to casinos much)?  The information on the information reporting must include the name, address, and EIN of the payee, along with a description of the two types of ID used to verify the payee’s address.

Discharge Reporting- Buy Now, Three Years, No Payments!

I thought I had written up the proposed regulations from 2014 relating to the rules on discharge of indebtedness reporting when a borrower had not paid for more than three years, but I cannot find the post (very possible I just read about it and found it interesting).  Under Section 6050P, prior regulations treated nonpayment of debt for 36 months as an “identifiable event”, which indicated formal discharge of indebtedness and required the issuance of a Form 1099-C.  This caused many borrowers to believe the debt had been discharged, but it was simply an IRS reporting requirement.  Tax professionals, lenders and borrowers did not like the rule.  The final regulations can be found here.  The regulations eliminate the passage of that time frame as a reportable event, which is a good result.  This change may have come from discussions started in the ABA Tax Section, Low Income Taxpayer Committee.

Preparer Due Diligence Regs Updated.

The Government has issued temporary/proposed regulations regarding the preparer due diligence rules, which can be found here.  We’ve talked about preparer due diligence repeatedly on the blog, including one of our first posts (and most popular), where Les extensively discussed peeing in pools.  That was re-posted earlier this year, and can be found here.  In both 2014 and 2015, Section 6695 dealing with preparer due diligence was amended.  The penalty was indexed for inflation, and the due diligence requirements were expanded to include the Child Tax Credit, the Additional Child Tax Credit, and the American Opportunity Tax Credit.  The proposed regulations update the provisions to take into account these changes.

Information(less) Returns

In late December 2016, the Service issued guidance (Notice 2017-9) regarding the new de minimis safe harbor provisions enacted under the PATH act.  In general, failure to include all required information on an information return or payee statement will result in a penalty being imposed on the issuer.  The penalty is dependent on various factors, including the amount incorrectly reported, when it was not reported, how quickly it is rectified, and potentially other factors.

The penalty under Section 6721 can be reduced or eliminated in certain circumstances.  There is a de minimis exception to Section 6721, which allows the penalties to be waived if the error is corrected on or before August 1st in the year it is filed.  This is limited to the greater of ten returns or .5 percent of the information returns filed.  For returns required to be filed after December 31, 2016, there is a safe harbor that applies, where, if the information return has an error of $100 or less, or involves less than $25 of withholding, then the safe harbor applies, and no corrected return is required.  The notice is clear that this does not apply for intentional acts or intentional disregard.  It also indicates that regulations will be forthcoming regarding the safe harbor.

The de minimis safe harbor will not apply, however, if the payee elects out of the safe harbor.  Under Section 6721(c)(3)(B) and Section 6722(c)(3)(B), the payee can make an election and the payor has thirty days to furnish a corrected payee statement to the payee and the IRS.  If it is not done within thirty days the penalties will apply (it is possible for additional time in limited circumstances).

The payor must provide the manner for making such an election, which can be any reasonable manner including by writing, electronically or by telephone.  The payee must be told in writing the fashion in which the election can be made.  The notice goes on to indicate the timing of when the election must be made, and indicates the election must: 1) clearly state the election is being made; 2) the payee’s name, address, and TIN; 3) the type of statements and account numbers; and 4) the years in which the election should apply.

So, if you are super angry that Gigantor Bank and Lack of Trust Company misstated your 1099 by $4.37, you now have your avenue for redress.

Shelter Participant SOL Against Promotor Runs From Final Tax Court Ruling, Not Notice of Tax Deficiency

I initially saw this suit, and thought some aspect pertained to federal law claims against the tax shelter promoter, but the claims were state law based.  It is, however, still an interesting statute of limitations issue, that could impact future rulings based on state law.

In Kipnis v. Bayerische Hypo-Und Vereinsbank, AG, the Eleventh Circuit, following direction from the Florida Supreme Court, has reversed the district court in holding the statute of limitation on state based claims against a tax shelter promoter by a participant were not time barred.

The particular holding is for a relatively straightforward issue.  After the defendant admitted fault, the IRS issued a notice of deficiency to the plaintiff for his involvement in the shelter.  This occurred in October of 2007.  On November 1, 2012, there was a final tax court order disposing of the case (90 days thereafter appeal rights expired).  On November 4, 2013, plaintiff filed suit against the defendant alleging various state law claims including fraud from the promoting and selling of the transaction.

The defendants moved to have the case thrown out as being outside of Florida’s four and five year statute of limitations for the claims made.  The issue was appealed to the Eleventh Circuit, which sought guidance from the Florida Supreme Court on the issue, specifically:

Under Florida law and the facts in this case, do the claims of the plaintiff taxpayers relating to the CARDS tax shelter accrue at the time the IRS issues a notice of deficiency or when the taxpayer’s underlying dispute with the IRS is concluded or final.

The Florida Supreme Court, which the Eleventh Circuit followed, determined that the claims accrued at the time the tax court order became final, which was ninety days after the order was issued when the appeals period had passed. See Kipnis v. Bayerische Hypo-Und Vereinsbank, AG 202 So. 3d 859 (Fla. 2016).  I think this is inline generally with what the federal law would be in most analogous situations, but would invite others to comment on this aspect if they have thoughts.

What Does Mnuchin Think of the Whistleblower Program

And, “collected proceeds” Tax Court case is finally final…now will there be an appeal?

In early August 2016, I wrote a second post on Whistleblower 21276-13W v. CIR, where the Petitioner was successful arguing that criminal fines and civil forfeitures were included in “collected proceeds” for whistleblower awards.  The decision can be found here, and my lyrical yet learned post can be found here.  The issue, as I wrote it up back then was:

Under Section 7623(b), certain whistleblowers are entitled to mandatory awards if certain requirements are met.  That amount can be between 15% and 30% of the “collected proceeds” under (b)(1), which has a parenthetical indicating that is “(including penalties, interest, additions to tax, and additional amounts),” and the sentence further states these amounts can be “resulting from the action (including any related actions) or from any settlement in response to such action.”

…[T]he Service took the position collected proceeds did not include criminal penalties and civil forfeitures.  The Service based this on the claim that Section 7623 should only apply to proceeds assessed and collected under the federal tax laws found in Title 26 of the United States Code.  As the fines and forfeitures here were imposed under Chapter 18, they could then not be “collected proceeds” subject to the statute; unlike the restitution, which as per 2010 law can be assessed and collected in the same manner as tax.

The Court concluded the statute was clear on its face, and the penalties and forfeitures were included.  I would highly recommend reading the post if you are interested in this area.  Although I heaped self-praise on myself, the post is really strong because of the input from Jack Townsend on the case and Les Book.  It also links back to our initial post on this case, which Dean Zerbe wrote, and which is also an important but different holding.  Dean, who was lead counsel on the case, also provided some comments on the second holding, which we included in a separate post, found here.

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The Service had sought a motion for reconsideration, but it was denied on January 28th in apparently a one sentence order (I could not track that down).  It will be interesting to see if anything happens in the next 90 days.

This case has, somewhat directly, come up in the recent testimony of Treasury Secretary nominee Steve Mnuchin.  Much of the remainder of this post will be borrowed from a press release by Kohn, Kohn, and Colapinto, co-counsel on the above case, which can be found here, and from Senator Grassley’s webpage.

Dean provided a recent quote on the case, arguing against the failed “kitchen sink” approach taken by Counsel, and highlighting that the Tax Court wasn’t picking up what the Service was putting down, stating:

The IRS Chief Counsel’s office emptied the in basket in making arguments for the Motion for Reconsideration – including the availability of funds for award payments.  To no avail.  While I appreciate that Counsel wanted to defend its corner, at the end of the day the Tax Court wasn’t buying what IRS Counsel was selling.  This decision gives Treasury Secretary nominee Mnuchin and the new administration an opportunity to embrace the Tax Court’s final ruling and show that it supports the IRS whistleblower program and is serious about going after big time tax cheats.

Senator Grassley, who has been instrumental in the implementation of the whistleblower program and often a harsh critic of how it has been rolled out by the Service, questioned Mr. Mnuchin on the program, and specifically how the Service would handle this issue.  The response was somewhat positive as to the Whistleblower program, although not exactly a guarantee on the collected proceeds issue.  The Senator asked:

The IRS has chosen to interpret the whistleblower law narrowly to the detriment of whistleblowers and several instances, the IRS has interpreted the terms ‘collected proceeds’ which is the base for determining the amount of award to exclude criminal penalties and certain other proceeds suggest penalties assessed for undisclosed foreign bank accounts.  Two questions, and I will say that both – should you be confirmed, can I count on you to be support of the whistleblower program and work to ensure its success and would you be willing to review the IRS’s administration program including its very narrow interpretation of the words ‘collected proceeds?

Mr. Mnuchin’s response was favorable to the program overall, but not terribly specific as to the “collected proceeds” issue, stating:

We are aware there is tax fraud.  There is tax fraud as you said, and we need to be diligent and I believe that the whistleblower laws are very important part of that.  I will work very hard with you on that.

He also gave assurances he would look into the collected proceeds matter.  Giving assurances to look into something seems a little like government (and lawyer) speak for one of three things: “nope”; “I have no idea”; or, “we’ll actually consider it…someday”.    It would have been nice to get more specifics out of this aspect of the Q&A, as Mr. Mnuchin knew this was going to be a topic.  Here is a quote about Senator Grassely and Mr. Mnuchin meeting prior to the hearings to discuss Senator Grassely’s concerns.  From the Senator:

It was our first time meeting, so Mr. Mnuchin and I spent a few minutes getting acquainted.  We then discussed a series of issues.  We covered the importance of comprehensive tax reform on both the corporate and individual levels and how tax fairness is critical to economic growth and job creation.  I’ve often said that a major undertaking like tax reform requires the President’s use of his bully pulpit to rally support behind a plan from Congress and the American people.  There’s an opportunity to do that with a new administration.  I emphasized the importance of listening to whistleblowers within the Treasury Department and those who come to the IRS with allegations of major tax fraud.  The provisions improving the IRS whistleblower office that I drafted are working, but it’s required a lot of oversight to maintain the momentum, and I’d like to see a Treasury secretary who will build on the progress.  Enforcing tax fraud is a matter of fairness for the majority of the taxpayers who pay what they owe.  Mr. Mnuchin and I discussed the burden of the estate tax on family farms and businesses.   I emphasized the need to treat alternative energy tax incentives fairly, including keeping the current phase-out for the wind energy production tax incentive as is.  Alternative energy drives job creation in Iowa and nationwide.  We discussed currency manipulation as well as the need to broaden the scope of the Committee on Foreign Investment in the United States to cover food security.  Mr. Mnuchin seemed to appreciate the need for the review process to become broader than it is now to help protect U.S. interests.  I look forward to covering these issues and more in Mr. Mnuchin’s nomination hearing.

You can find the full exchange during the hearings here on YouTube.  The Senator endorsed Mnuchin following the hearing, stating the following on the whistleblower program:

Having a Treasury secretary who understands the whistleblower role in enforcing tax fraud is important.  Whistleblowers have helped the IRS recover $3.4 billion that otherwise would have been lost to fraud.  Cracking down on big dollar tax fraud is a matter of fairness to the vast majority of taxpayers who pay what they owe.  The IRS has made progress in working with whistleblowers, but there’s more work to be done.  Mr. Mnuchin gave his assurance that he’ll work with me if confirmed to support tax fraud whistleblowers.

I also asked Mr. Mnuchin about the importance of supporting the congressionally established phase-out of the wind energy production tax credit.  A smooth transition and the certainty of the phase-out are necessary for a fast-growing industry that supports numerous jobs in Iowa and elsewhere around the country.  The industry needs to be able to maintain its successful growth even as its tax credit phases out.  Mr. Mnuchin said he supported the smooth phase-out.  And I asked Mr. Mnuchin about the role of private contractors in collecting tax debt that the IRS hasn’t tried to collect.  He agreed that it makes sense to use outside help in closing the tax gap.

I’ve expressed my personal views on the whistleblower program in the past.  I am fully in favor of having a whistleblower program, but my perception of the IRS handling of the program has not been favorable.  I recognize the financial and other constraints, but it does seem like other aspects of the agency may not be favorably inclined towards it, that the roll out had significant issues, and that internally there have been some efforts to thwart what seem like straightforward requirements of payment.  I hope the program continues to grow under Mr. Mnuchin or anyone else who may take over as Secretary of Treasury.

For more on this case, the testimony, and the recent report on whistleblower awards, check out Dean’s post on Forbes here.

USVI – Residing or Vacationing (and What if You Pay Income Tax While only Vacationing)

I am sitting in my dining room writing, and there is freezing rain outside, I’ve got a terrible cold, and my wife is cleaning up some child’s vomit.  I can’t help but think how nice it would be to live somewhere much warmer, that wasn’t as affected by these seasonal illnesses ….  And, wouldn’t it be all the better if I paid far less in taxes?  Maybe I should trade Love Park for Love City (nickname of St. John’s, USVI—which is apparently giving people money to come visit)?

The United States Virgin Islands have shown up in a lot of tax procedure cases over the last decade (like a ton!, there are only around 100,000 residents, and it seems like there is an important case every week).  So why is that the case?

Well, it is, for some, a legal tax shelter.  Normally, a US Citizen must file his or her return with the Service on a specified date, and the Service must assess tax within three years of filing a return, but if no return is filed the period of limitations remains open indefinitely.  See Section 6501.  To be filed, “the returns must be delivered…to the specific individual…identified in the Code or Regulations.” See Allnut v. Comm’r.  This normally means somewhere with the Service.  The USVI however operates a “separate but interrelated tax system.” Huff v. Comm’r.  Bona fide USVI residents are required to only file tax returns with the USVI Bureau of Internal Revenue (“VIBIR”).  See Section 932(c)(2).  If the taxpayer is not a bona fide resident, but has USVI source income, the taxpayer must file with the VIBIR and the Service.  In an effort to bring businesses to the USVI, an economic development program was implemented in USVI, which allows for a reduction of USVI tax on certain USVI residents up to 90% of their income tax.  Not sure how much economic development it has spurred, but a lot of rich people began trying to be bona fide USVI residents (or at least claimed they were), and the IRS took exception.

Below is a discussion of a few cases relating to claims of USVI residency.  One will review the requirements of residency, and why parking a boat may not be enough. It also highlights the interesting SOL issue of whether a USVI return starts the limitations period when the taxpayer is not a USVI resident.  The final case below investigates what happens if a non-resident pays tax to USVI (claiming to be a resident) and the refund statute of limitations has passed after there has been a determination that the person was not a resident.

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Parking Your Yacht and Staying at Ritz–Not Residency

In Commissioner v. Estate of Travis L. Sanders, the Eleventh Circuit reversed the Tax Court and remanded for additional fact findings regarding whether or not the decedent had ever been a resident of the USVI (and from the tone of the case, the Court gave fairly clear indication that the Tax Court should find he was not a resident).    The Tax Court opinion in Sanders can be found here.  The issue in the case was whether the filing of a USVI return started the statute of limitations, which the Court decided hinges on whether he was a resident of USVI.  As stated above, this has been a hot topic over the last few years, which we have not covered much on PT.

In Sanders, the taxpayer made his money on surge protectors (I think high end, not the consumer ones your computer is plugged into).  The more protectors he sold, the more his balance sheet surged.  In 2002, Mr. Sanders began spending some (but not much) time in the USVI.  From ’02 to ’04, the years in question, Mr. Sanders stayed at the Ritz, and then parked his yacht on the islands and stayed on the boat.  He spent somewhere between 8 and 18 days on the islands in ’02, between 49 and 78 days in ’03, and between 74 and 109 days in ’04.  He kept his FL home, never established a personal mailing address in the USVI, his girlfriend (eventually wife) remained in FL, his minor child lived in FL, and he spent considerable time at the company HQ in FL.

As to his work at the surge company, he became a limited partner in a USVI company, which employed him, and then contracted his services to the company he had created.  Mr. Sanders took the position that this was USVI source income, and that he was a USVI resident.  He then claimed the income was exempt from United States taxes (and it was potentially entitled to a 90 percent tax credit under USVI tax laws – hence the set up).

The IRS said this Caribbean dream was a little too dreamy, and in 2010 issued a notice of deficiency, alleging Mr. Sanders was not a bona fide USVI resident and that the set up was, as Jack Townsend would say, a b@!! $&!1 tax shelter.  Unfortunately, our Captain Sanders died in 2012, and did not get to see if his scheming worked.  In August, the Eleventh Circuit didn’t weigh in on the BS’iness of the tax shelter, but did overturn the Tax Court as to whether the statute of limitations prohibited the assessment.  Why did the courts disagree?

How to qualify as a USVI resident has changed somewhat over recent years, and, the discussion to follow regarding the statute of limitations on filing with VIBIR may no longer apply, as the Service and VIBIR entered into an information sharing agreement in ’07, and following that the Service agreed to treat certain returns filed with VIBIR as starting the statute of limitations regardless of whether the person was actually resident of USVI.

This was prior to ’07, and the Service took the position that Mr. Sanders was not a bona fide resident of the USVI in the years in question, and therefore the return he filed with VIBIR did not start the running of the statute of limitations in the United States.  Mr. Sanders (and the USVI government) argued he was a bona fide resident, and the statute had run.

The Court did not determine whether Mr. Sanders was or was not a bona fide resident, and remanded for further fact finding.  It was clear from the tenor of the opinion that based on the facts before the Court it strongly (very, very, very strongly) disagreed with the Tax Court conclusion that Mr. Sanders was a resident.

The more important holding, although not new law, was that the statute of limitations for filing his US Federal tax return would only run due to the VIBIR filing if Mr. Sanders was a bona fide resident (requiring a substantive finding of fact), and there was no good faith exception to this requirement implied in the statute.

In discussing the good faith exception, the Eleventh Circuit reviewed the meaning and use of the term bona fide and found it required objective proof.  The Court did note there are some fairness concerns in not having such an exception, but said that was not sufficient to read such an exception into the statute.  In addition, it noted that “entwining of the merits of a case with the statute of limitations is not uncommon in tax cases.”  The Eleventh Circuit rejected the good faith exception, holding filing with VIBIR only triggers the statute if the taxpayer is a bona fide resident (not merely that the taxpayer believes he is).

As to the bona fide residency, as mentioned above, the Eleventh Circuit gave a pretty heavy indication as to its feelings as to residency.  The Court stated that “[b]ecause the Tax Court never decided the nature and extent of Sanders’s physical presence, it cannot have properly weighed this factor.”  Further, “[e]ven Sanders’s own estimate that he spent 18 days in the USVI…places him on the island for only a small portion of time,” and “he had no personal home on the islands for any part of [the years in question].”  And, “[l]iving in a condominium partially owned by one’s employer (and which is not even available for every visit) does little to evidence an intention to reside there indefinitely…”, but the Court did note that moving the boat to the island and connecting it to utilities was slightly more indicative of residence; although, noted this was less strong evidence than a fixed home.  There were various other similar quotes, making it fairly clear the Court did not think Sanders was a bona fide resident.

Although I’ve discussed this type of planning in the past with clients for both USVI and PR (and other more exotic jurisdictions), this type of planning has a more common analogous state level planning topic; which is selecting a state level income tax residence (in my practice, it is usually someone in NY, NJ, MA, and less often PA, considering a move to FL).  Obviously, the analysis is different, but the advice is the same; you can’t just say you think you are a resident, you have to take meaningful steps that can prove you are.

Also, interesting to note, at least to me, that the Chief Justice of the Eleventh Circuit was appointed by George H. W. Bush, who once claimed residency in Texas while staying a limited number of days per year in the Houstonian, which Texas accepted and Maine, DC, and other states never questioned.  Perhaps the Houstonian is more homey than the Ritz.

Where Does My Entity Reside?

The Third Circuit had an interesting, albeit unsurprising, holding in the end of October relating to USVI residency of entities.  In VI Derivatives, LLC v. United States, the Third Circuit affirmed the district court’s denial of the taxpayer’s motion to dismiss for lack of subject matter jurisdiction, holding that res judicata barred the challenge to subject matter jurisdiction.  In VI Derivatives, various LLCs were challenging their residency, but the lower court had previously already determined the residency of the entity owners (the Ventos, more on them in a minute).  In that holding, the Court indicated there was no separate determination to be made regarding the entities, “Because those partnerships are pass-through entities…, they do not have residencies separate from their owners.”  When the entities filed a motion to dismiss for lack of subject matter jurisdiction based on residency, the District Court denied the motions, holding res judicata barred the challenge because the residency decision on the owners constituted a final judgement on the merits, which was not appealed.  The Third Circuit agreed.

For those of you who follow tax procedure closely, especially offshore matters, the Ventos are turning into a familiar family.  Cases pertaining to the capital gains ($180MM) generated from the sale of Richard’s Vento’s business have generated interesting holdings regarding USVI residency, summons enforcement, and FOIA (and probably others that I am forgetting).

And…

VI Non-Residents Cannot Claim FTC For VI Income Paid

Not a shocking holding either.  In Vento v. Comm’r, the Tax Court reviewed the case of Renee Vento (daughter of Richard), who claimed foreign tax credits on her United States return for tax she paid in the USVI.  In the year the tax arose, Renee lived in the US.  For the tax year, she filed her income tax return with VIBIR including the payment of tax claiming to be a USVI resident, and the IRS transferred her estimated US payments to VIBIR.  Later, the IRS and Courts determined she was not a USVI resident, and a notice of deficiency was issued.  An agreed assessment was determined, with Renee treated as a US resident.  Renee apparently sought a refund on the VIBIR return, but this was likely denied due to the passing of the statute of limitations.  Renee then attempted to seek credits on her US return under Section 901 for payments she made to VIBIR (and the IRS payments that were converted to VIBIR payments) for the tax year in question.  Renee also claimed that for the IRS or the Court to hold otherwise would unfairly subject her to double taxation in the US and USVI.

The IRS responded by arguing that Renee was not a USVI resident, and therefore the payments were not compulsory, so no credits could be issued.

The Tax Court agreed with the Service.  It found that Renee had no USVI source income, and therefore there was no obligation to pay tax, so the payments to VIBIR were not “taxes paid”.  Section 901(b)(1) allows a credit for “the amount of any income…tax paid or accrued during the taxable year to any…possession of the United States.”  The Court found that the holdings regarding residency did not appear to give much credence to Renee’s position, which it found undercut her argument that she had a reasonable basis for paying VIBIR.  The Court also found that Renee had not exhausted all of her potential remedies to reduce her liability to USVI.  As such, the Tax Court found Renee did not meet her burden of showing that she had validly paid tax to USVI.

Before getting to the equity argument, the Court did note that Congress did not intend that taxes paid to USVI be eligible for the foreign tax credit.  The Court viewed the coordination rules under Section 932(c) as eliminating the potential for double taxation that the FTC usually solved.  Further, the Regulations specifically state that for FTC purposes, USVI income of a Section 932(a) taxpayer is treated as income from sources within the United States.  See Reg. 1.932-1(g)(1)(ii)(B).  The Court did also note that Renee’s situation may allow her to “slip through the crack in the statutory framework,” as under the literal terms she did not earn any USVI income, but it did not believe Congress would have intended that result.  The Court did not, however, hold on this rationale, as the “taxes paid” reasoning was sufficient.

The holding ends with some statements pertaining to the equity argument:

Whatever sympathy we might have for petitioners, however, does not compel us to allow them a credit against their U.S. tax liabilities to which they are not legally entitled.16 To the extent that petitioners pay tax on the same income to both the United States and the Virgin Islands, they must seek a remedy elsewhere; they cannot find it in section 901.

Foot note 16 states:

Our sympathy for petitioners would be tempered to the extent that tax avoidance motives prompted their claims to Virgin Islands residence. While the limited record before us is silent regarding petitioners’ motivations, our agreement to base our decision on the parties’ stipulations and admissions under Rule 122 does not require us to ignore the District Court’s observation in VI Derivatives, LLC v. United States…, aff’d in part, rev’d in part sub nom. Vento v. Dir. of V.I. Bureau of Internal Revenue… that “the timing of the [Vento] family’s decision to ‘move’ to the Virgin Islands is suspicious.” According to that court, Vento family members realized a significant gain as a result of a transaction that occurred at the beginning of 2001. Becoming Virgin Islands residents for that year held out the prospect of more than $9 million in tax savings to the family.

Sounds a bit like unclean hands.  Don’t argue equity after your tax fraud-ish behavior.  A bit harsher than the original taxpayer friendly Sanders holding before the Tax Court.

While reading the case, I wondered if the taxpayer could have made an argument about the amounts paid to the US that were “covered into” USVI (payments) pursuant to Section 7654.  That is the provision that makes the US pay over any tax collections it has to the possession.  I believe USVI intervened in this case (although I could be confusing my USVI residency cases), and the US was clearly a party.  It would seem both were on notice that their transfer of funds was potentially incorrect.  I have done no research on this, so the notion could be completely off base, but it was my initial thought while reading.

Additional Courts Hold Promoter Penalties Not Divisible For Refund Claim

So Flora is not an option.

In the below post, we will discuss the somewhat recent holdings in Diversified Group v. United States and Larson v. United States, two cases dealing with whether or not promoter penalties under Section 6707 are divisible for refund claim purposes.  An interesting issue, and one that may require a tweak to the law from Congress.

In September of 2015, Keith wrote about Diversified Group Inc. v United States, where the Court of Federal Claims held that shelter promoter penalties imposed under Section 6707 were not divisible, and therefore the promoter could not pay the penalty imposed on just one investor (this case was decided based on prior versions of Section 6111 and 6707, but the underlying concepts are still valid).  In November, the Court of Appeals for the Federal Circuit affirmed the Court of Federal Claims; the opinion can be found here.

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As explained by Keith and in the opinion, in general, a taxpayer can only sue for a refund in a district court after the amount of tax has been paid in full.  SCOTUS created an important exception to this rule in Flora v. US, where it indicated an excise tax may be divisible based on each taxable transaction or event, allowing full payment to occur with a small amount of tax.  Under Section 6707, certain promoters who fail to file required returns, or do so with a false or incomplete return, regarding reportable transactions are subject to penalties.  The penalty then imposed was 1% of the aggregate investment amount (now the penalty is $50,000 for each transaction, or, if relating to a listed transaction, it is the greater of $200k or 50% of the gross income derived by the advisor (increased to 75% if the failure is intentional)).  The promoter paid a portion related to one transaction and sued for refund, and the IRS objected.  The lower court determined the penalty was not divisible, and was related to the singular act of failing to report the promoting of the tax shelter (and not the imposition of the amount on the 192 clients separate transactions).

The appellate court affirmed that the singular act of failing to report the shelter was what occurred to impose the penalty.  Further, it reviewed the applicable language, finding the Code viewed the shelters in the aggregate (not individually) for determining if the penalty was applied,  and Section 6111 required disclosure the day on which the shelter was initially offered, and did not relate to each investor  buying in.  Providing more evidence it was the initial failure and not each purchase of the shelter.

I quote briefly from Keith’s post regarding the direct impact of this case:

While feeling sorry for someone who promotes an egregious tax shelter scheme requires a great deal of effort, I think parties should have the opportunity to litigate the imposition of a tax or penalty without full payment.  The Court of Federal Claims decision rests on firm ground, yet barring someone against whom the IRS assesses a penalty, any penalty, from disputing that penalty in court without paying over $24 million seems inappropriate.  Maybe tax shelter promoters have access to that kind of money but most parties do not.

Keith’s post also discusses the potential for CDP as an avenue for a merit review by the courts, which is not without issues.  If readers have not previously reviewed that aspect of Keith’s prior post, I would encourage them to do so.

The Diversified holding was followed by Larson v. United States, which was decided by the District Court for the Southern District of New York on December 28th.  Larson is continued fallout from the KPMG tax shelter case from the mid-2000s.  Mr. Larson paid a fraction of the $63.4MM Section 6707 penalty related to one transaction (the overall penalty was initially a $160.2MM penalty, but others paid portions of it).  He argued that the partial payment was valid under Flora.  The Southern District came to the same conclusion as the Federal Circuit.

Jack Townsend wrote up the case on his Federal Tax Crimes Blog here, where he summarizes the holding and quotes the salient aspects of the case.  At the end of the post, Jack highlights his takeaways from the case, which include similar contents to Keith’s thoughts on Diversified.  Jack thinks, given the huge dollar amounts that can be involved, that there needs to be some prepayment or partial payment review, otherwise taxpayers could be inappropriately precluded from litigating the merits.  Mr. Larson attempted to make similar arguments in his case, based on the APA and the Constitution, which the Southern District did not agree with.  These are discussed below.

Jack also highlights an APA challenge raised by Mr. Larson.  Larson argued for judicial review under the APA claiming the denial of his refund claim was arbitrary, capricious, and an abuse of the IRS discretion.  The Court found this argument lacking, stating “an existing review procedure will…bar a duplicative APA claim so long as it provides adequate redress. Clark City Bancorp. v. US Dept. of Treasury, 2014 WL 5140004 (DDC Sept. 19, 2014)”.   The “existing review procedure” here was the full payment of  the claimed amount due, and the request for review of a refund denial in the district court.  Jack’s post highlights other language summarizing this holding.

There are various other interesting arguments made in this case.  For instance, Mr. Larson argued the fines under Section 6707 violate the 8th Amendment of the Constitution (excessive fine, not cruel and unusual punishment, although if I told my wife I owed a fine of that amount I am certain it would result in cruel and unusual punishment).  The Court questioned whether it had jurisdiction to review the matter, but eventually determined that didn’t matter, as Larson failed to state a claim.

Sticking with long shot Constitutional challenges, Mr. Larson also argued that his due process rights under the Fifth Amendment would be violated by the penalty under Section 6707 if it was not divisible because the imposition of the full payment rule would preclude him from being able to pay and therefore from being able to have a review.  The Court rejected this argument, stating courts have consistently held that the inability to pay penalties has never been determined to be a due process violation (citing to various cases, including the recent case of his one-time co-defendant, Robert Pfaff, 117 AFTR2d 2016-981 (D. Colo. 2016)).  I understand if this was not the rule, everyone would claim inability to pay, and it is possible that much lower fine amounts would clog the courts.  Here, however, the fine was $63MM!  I think less than .1% of the population would ever be able to pay that.

I have no further insight beyond what Jack and Keith stated.  For the most part, the people arguing these cases have violated the tax law, and done so knowing full well that the areas they were flirting with had substantial penalties.  They did this for significant financial gain.  But, the penalties can easily be many times more than the assets of the individual, making it impossible for full payment, and there should be some way for the merits to be litigated.  This will likely require a legislative change, although I am uncertain who is going to advocate for the tax shelter promoters.