FinCEN Moves To Include Convertible Virtual Currency On FBAR Form

We welcome back guest blogger James Creech, who describes an interesting development in the government’s efforts to track and tax virtual currency. Christine

Recently FinCEN has declared its intention to require convertible virtual currency (aka Bitcoin) to be reported on the FBAR. In order to begin the formal rulemaking process FinCEN published Notice 2020-2 stating that it intends to modify 31 C.F.R. 1010.350.

While not a formally a tax provision, filing delinquent FBAR’s and the IRS counterpart FATCA reporting were a main stay of the tax practice during the heyday of the offshore voluntary account disclosure program in the early to mid 2010s. As a result many practitioners would be well served by taking a second look at these proposed changes as more details become available.

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One issue that has always appeared to be a challenge for reporting virtual currency on both the FBAR and the 8938 is identifying where the asset is held. The blockchain that stores the data on virtual currency is hosted on a decentralized network stored upon tens of thousands of computers all across the globe. The keys (analogous to a password) that control the underlying virtual currency could be anywhere as well. While it was generally accepted that keys stored on a desktop in the United States were not held in a foreign account, there were a number of edge cases that became much tricker to administer. For example how do you report a UK based exchange that might hold custodial assets in a server in Iceland? Or if bitcoin is stored locally on a phone does it become a foreign account if the taxpayer travels (with their phone) to Portugal for 9 months?

In recent days FinCEN has been laying the groundwork for a potentially wide application of FBAR reporting requirements.  On December 23, 2020 FinCEN published a notice of proposed rule making that would require virtual currency transactions from self custodial or unhosted wallets (wallets that do not use a financial institution to store the virtual currency) to be reported on Currency Transaction Reports (CTR) if the amount transferred to or from a financial institution was more that $3,000. Part of this proposed rule making was to expand the definition of unhosted wallets as having a high risk of money laundering similar to bank accounts held in Iran or North Korea. And while this is even further removed from tax, administrative law devotees will be interested in the fact that FinCEN’s comment period for these proposed rules was only 14 days which included Christmas and New Years. (If you would like to read comments I submitted they can be found here and they expand on the risk of loss concerns contained below)

Based upon how aggressive FinCEN has been towards unhosted wallets and CTR reports it will be interesting to watch how they treat unhosted wallets for purposes of FBAR reporting, and if the IRS follows suit by amended the requirements for FATCA reporting via Form 8938. It may be that FinCEN takes a hard line and definitionally declares that all unhosted wallets are foreign assets and as such need to be reported on a taxpayer’s FBAR. Those that fail to do so may be subject to the same draconian penalties of $10,000 (non willful) or 50% of the highest account balance (willful) as those who fail to report a Swiss bank account.

A Word of Caution

While FinCEN does have legitimate reasons for potentially using the broadest definition of unhosted wallets possible, such a mandate may cause security and liability issues for tax practitioners. Beyond the technological aspects, the biggest difference between virtual currencies and traditional assets is that virtual currencies users have a 100% risk of loss if the private keys used to transfer the underlying virtual currency are lost or stolen. There is no way for a user to recover compromised keys after a hack or to undo a fraudulent transfer that is a result of a phishing attack. For those reasons, high value virtual currency users have relied on a combination of robust data security using an unhosted wallets, coupled with personal anonymity to protect their assets. The logic behind anonymity is simple. Unless a thief knows that a particular user has enough virtual currency to steal they are not a target. Sophisticated attacks are costly and security developers can quickly fix exploits once they become known or widely used. As such criminals chose there targets carefully.

Why this matters to tax practitioners is that the information required to file the FBAR would also provide a roadmap for bad actors to target and steal virtual currency from your clients. Hacking a law firms internal system would mean that bad actors would have access to a list of clients along with where they lived, their contact information, what their net worth was, and in the case of any voluntary disclosures a narrative of their dealings in virtual currency. Such information could be used to then target the end user directly.

This informational burden would exponentially raise the stakes on tax practitioner data security. Having virtual currency information stored on a firm’s computer would be the digital equivalent of having large amounts of cash stored in the office in perpetuity. It would also significantly raise the need for specialized malpractice insurance because filing a FBAR for someone with $50 million in virtual currency is completely unlike filing an FBAR with someone with $50 million in a Swiss bank account. If the bank account information gets hacked there are still several layers of institutional security that might prevent the attacker from successfully gaining access to the assets, not to mention bank deposit insurance that would compensate for lost funds. If the firm’s virtual currency FBAR client list was hacked, and the information was used to successfully target the client, then the firm would be responsible for an uncompensated $50 million loss.

Given how anonymity is synonymous with criminality in the eyes of law enforcement it is likely that FinCEN will seek to require significant information when drafting the virtual currency FBAR rules. If this does happen tax practitioners need to be aware that simply going back to the old FBAR playbook will not be sufficient, and that there are very real second order consequences for both legitimate virtual currency users and the professionals that they use to comply with the law.

A Brief Look At Section 7805(b)

We welcome back Monte Jackel, Of Counsel at Leo Berwick, who returns to discuss regulations that are made public but that are not published in the federal register prior to the end of a presidential administration. Les

Section 7805 was amended as part of the second Taxpayer Bill of Rights in 1996, P.L. 104-68, JCS-12-96, p. 44. Subsection (b), headed “Retroactivity of regulations”, describes the circumstances where retroactivity, that is where a “taxable period”, an undefined term, cannot be subject to a regulation filed or issued before certain dates, is permitted. Section 7805(b)(1)(A) references the date the regulation is filed with the Federal Register. The date of filing is a clearly known term given that the Office of the Federal Register uses that term as the date the document is available for public inspection before it is published there. Section 7805(b)(1)(B) also uses the filing date with the Federal Register to set the retroactivity that is permitted. However, section 7805(b)(1)(C) uses the term “issued” to the public when referencing the permitted retroactivity. That term is not defined although 5 USC 552(a)(1) (the APA) requires federal agencies to publish their regulations in the Federal Register. The term “issued” is not used there. Section 7805(b)(2), relating to promptly issued regulations, references the term “filed or issued” but defines neither. The legislative history does not add anything to this either. However, it is probably safe to assume that “issued” means “published”. 

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There has been some commentary recently about the upcoming change in administrations and what happens to regulations that are made available to the public before they are filed with the Federal Register but are not published there by the time a new incoming administration orders that all regulations not yet published (and maybe even those that are) be returned to the issuing agency. Attached at the end of this post is the text of a letter to the editor that I recently published in Tax Notes describing some of these issues. 

The practice of the IRS and Treasury releasing to the public a copy of a regulation with a disclaimer at the top of the first page saying that only the copy published in the Federal Register is the legal copy, should be discouraged. I can find no provision in either the Internal Revenue Code or the APA that authorizes this practice or gives any legal significance to it. And while this is not the first time in our history that presidential orders of a new administration put a “freeze” on the publication of regulations to evaluate them first, this practice only adds to the natural confusion created when a new administration takes power. The situation is exasperated when the text of the regulations are made available to the public but those regulations do not apply to any taxable period beginning before the regulations are published. What positions do taxpayers take in the interim. 

I think there should be a new federal statute that prohibits the issuance of regulations within 60 to 90 days before a new administration comes on board absent “extreme need” or other such standard, which is subject to review later. Alternatively, a new statute could describe the legal impact of these regulatory freezes. I much prefer the former. What do others think?

Text of Letter to the Editor, “Potential Danger of Making Public Pre-Release Versions of Regulations”
170 Tax Notes Federal 299, Jan. 11, 2021

To the Editor:

The Office of Information and Regulatory Affairs website says that the final section 163(j) regulations were released from OIRA on December 30, 2020. These regulations were, based on past IRS practice, posted on IRS.gov on January 5, 2021. Under the Congressional Review Act, the final regulations state that they will be effective on the date filed with the Federal Register. That date was either yesterday or today or will be shortly thereafter. But those regulations may not make it to be published in the Federal Register by January 20. That day, or the next day or so by the latest, a presidential executive order will be issued by the new administration ordering the Federal Register to return regulations not yet published there.
Emily L. Foster addressed the issue in her story last week [in Tax Notes] titled “Final Interest Regs Provide Clarifications for Taxpayers” but the story is a bit misleading when it discusses what happens if the regulations are pulled back by a new administration before they’re published in the Federal Register. It’s true that the regulations are effective on the date filed with the Federal Register under the CRA (assuming that the explanation given for the expedited effective date by the IRS stands up to challenge if it comes to it). That date was either January 5 or 6, or will be shortly thereafter.

But that only means that the regulations are legal documents upon filing with the Federal Register. However, the applicability date of the regulations is for tax years beginning on or after 60 days from the date of publication in the Federal Register. If the regulations are never published or publication is delayed for months, the regulations will not be mandatorily applicable to taxpayers and neither will the proposed regulations.

However, the final regulations state that taxpayers can elect to apply the final regulations to periods before they are applicable. Also, the final regulation preamble (but not the text of the regulation) says that prior to the applicability date, taxpayers can apply the proposed regulations instead. In addition, the final regulation preamble (but not the text of the regulation) states that if there is a rule from the proposed regulations that is not in the final regulations, taxpayers can nevertheless apply the proposed regulation rule until final regulations are published at a later date that deal with the omitted items. It is unclear what happens if the final regulations are never published in the Federal Register. In other words, can taxpayers rely on the proposed omitted items forever like they have for the proposed section 465 regulations (since the late 1970s)?

Eric Yauch wrote about the omitted items and other partnership rules in the final regulations in a story titled “Trading Partnership Approach Remains in Final Interest Regs”. The omitted rules from the proposed regulations were, principally, the creation of inside tax basis “out of thin air” upon a complete redemption of a partner and the application of section 734(b), and all the tiered partnership rules.
The latter rules were incoherent and difficult to follow and apply, even for partnership experts. But the final regulation preamble (but not the regulation text) says if a rule is omitted from the final regulations that was in the proposed regulations, a taxpayer can apply the proposed rules anyway.

That action could end up with the omitted rules being like the proposed section 465 regulations, which, as noted, have been proposed and not finalized since the late 1970s. This “can rely on the omitted rules” rule will literally be the case even if the final regulations are never published in the Federal Register or are published months from now. In the interim period before the omitted rules are addressed and finalized in one form or another, taxpayers are not obligated to apply the missing omitted rules from the proposed regulations, but they will have to apply a reasonable approach based on the statute and its legislative history.

Since the IRS does not explain why the omitted rules were not finalized, what other approach would be considered reasonable? Would a pure aggregate approach to tiered partnerships suffice? Can there be a situation when the “create basis out of thin air rule” applies without relying on how the proposed regulations handle that rule? How long will it be until these issues are resolved, if ever? The final regulation preamble states only that the partnership rules continue to be studied. Although that explanation sounds good, it’s probably truer to say that the omitted rules had technical and other issues and that the IRS could not figure out what changes should be made. They then ran out of time because the IRS powers that be wanted the final regulations pushed out the door before the new administration comes into power.

Is this course of behavior by the current IRS and Treasury advisable? The other regulations now pending at OIRA may also get posted to IRS.gov by January 20, but it is unlikely that those regulations will make it out as published in the Federal Register by that date. The section 1061 carried interest regulations come to mind. [Those regulations ended up being released to the public after this letter was submitted to Tax Notes]. That means that all those pre-publication regulations will most likely not be mandatorily applicable to taxpayers for months, if ever. Taxpayers can elect to apply those unpublished rules in the interim, but they don’t have to. Why do this?

In other words, if the OIRA-reviewed regulations have already been returned to the IRS, they may end up being a set of pre-publication regulations posted on IRS.gov which has, as a matter of law, absolutely no legal effect unless taxpayers elect that they apply. But what if they don’t so elect?

Such is the case with the section 163(j) final regulations. And it will be a race for other federal agencies to get their regulations filed and then published in the Federal Register by no later than the close of business on January 19, the day before inauguration day. If not, the same mess as with section 163(j) applies.

If pre-publication regulations that have been publicly released don’t make the January 19 Federal Register publication date, there will, as noted, be an executive order by the new administration shortly thereafter sending all unfiled and/or unpublished regulations back to the agency issuing them. At this point, it will likely be months before activity occurs on those regulations.

In the interim, how many taxpayers will gamble on the “new rules” that would apply to them once the regulations are resubmitted to the Federal Register by the new administration, and how many taxpayers will just apply the proposed regulations? Is it even safe to assume that the statements made by the current administration in the final section 163(j) regulations (that taxpayers can rely on those rules today) will not be changed by the new administration?
That latter action would be the height of unfairness but what stops a new administration from doing so? At that point, the Administrative Procedure Act would come into play in terms of how to render uneffective those regulations deemed effective by the good cause exception under the CRA? Would it be revocation and reissuance, or would it just be revocation under the CRA?
Is this good or bad tax policy for the current administration? To me, the answer is that it is resoundingly bad. What do others think?

DAWSON is Awesome

We welcome back guest blogger Steve Milgrom.  Steve is the litigation coordinator at the low income taxpayer clinic located at the Legal Aid Society of San Diego.  He provides a thoughtful voice on tax procedure issues facing low income taxpayers.  Today, he provides an initial and very positive reaction to the Tax Court’s new electronic case filing system, DAWSON.  We have written about DAWSON before here, here and here.

Because I was waiting for DAWSON to go live in order to file some documents, I experienced it on the first day it opened.  I found it to be easy to use.  I echo Steve’s remarks about the positive feature of filing petitions electronically.  While the high number of pro se taxpayers coming to the Tax Court almost certainly means it will continue to receive paper petitions for some time, the prospect of filing a petition electronically and knowing it is timely filed provides a wonderful improvement over the myriad of situations in which something can go wrong when filing a paper return.  This is not to say that nothing can go wrong when filing electronically as we have seen with the electronic filing of returns but the ability to manage the problem seems much greater.  Keith

DAWSON!  As a tax lawyer who already talks in Code, I’ve added a new word to my lexicon.  DAWSON!  What a fabulous word it is!  And it didn’t even take an act of Congress.

Dawson is the name given to the Tax Court’s new case management system.  If this is the wonkiest thing I’ve ever celebrated I don’t know what is.  Why the celebration?  With the role out of Dawson on December 26th the Tax Court now permits Petitions to be e-filed.  And yes, December 26th was a Sunday.  Someone was actually working the weekend to get it going.

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Those of us who read Tax Court opinions for fun know the havoc that a snowstorm in D.C. can play with Taxpayer Rights.  For some unknown reason many taxpayers, and even some practitioners, want to spend more than the cost of a first class stamp to send their Petitions to the Tax Court.  If one chose the wrong delivery service and the Petition didn’t arrive by the 90th day following the mailing of a Notice of Deficiency, the taxpayer lost their right to engage in a pre-assessment challenge to the IRS’s determination that they owed the government more money.  See Guralnik v. Commissioner, 146 T.C. 230 (2016).  That’s a big loss and a big black eye for any practitioner who missed the filing deadline due to hiring someone other than the U.S. Post Office to deliver a Petition.  But what an inequitable result due to an act of God!  Well, Keith and Carl Smith fought this battle in many different venues with little success.  One wonders if this is what pushed Carl into full retirement?

Wherefore Dawson?  The Tax Court decided to honor the late Judge Howard A. Dawson, Jr., who was first appointed to the Tax Court by President Kennedy in 1962, was reappointed by President Nixon, and went on Senior status in 1985.  According to the Tax Court’s web site he was known as a meticulous record keeper, which is probably what inspired the naming of a case management system in his honor.

I propose a plaque be placed on the Tax Court building in his honor, designating him as the founder of the 21st Century Tax Court.  We all owe Judge Dawson a hurrah for his contribution to the court’s recognition of the importance of e-filing to Taxpayer Rights.  Each step that simplifies our dealings with the government is to be celebrated.  If someone from the Court wants to contact me, I will personally pay for the plaque.

Now if we could just get the Tax Court to give us equal access to court filings.  While Chief Judge Foley recently wrote that the pandemic has revealed that geography is not a barrier to connection, it sure is a barrier to Taxpayer Rights.  Just like other Federal courts, the Tax Court’s records should be available for remote viewing so we can all have the benefit of learning from what others do in their cases.  I never met Judge Dawson but I hope he would support additional access to the Court for the millions of taxpayers and practitioners who don’t live in D.C.

Phantom Regulations Under The APA

Today’s guest post by Monte A. Jackel explores whether courts can and should fill the gap when Treasury fails to exercise discretionary regulatory authority. Les

Introduction 

In recently finalized small business accounting regulations (T.D. 9942, Dec. 23, 2020), the IRS and Treasury refused to promulgate regulations dealing with providing an exception to the syndicate tax shelter rule for small business taxpayers. The grant of regulatory authority was discretionary in this case (Congress used the words “if the Secretary determines”) and, ordinarily, that would mean that the taxpayer and the courts are and were powerless to compel such promulgation and for the courts to fill in the gap. 

However, in today’s environment where the Administrative Procedure Act (APA) is taking more prominence in tax rulemaking, the question has become whether, if the IRS and Treasury take it upon themselves to address the reasons why they are not exercising their discretionary regulation authority and the explanation does not “jive with reality”, meaning that it is arbitrary and not grounded in sound reasoning, can the courts fill in the gaps if a taxpayer litigates the issue and, in effect, force the government to in substance issue the very same regulations it refused to issue? See my prior PT post, Conservation Easement Donation and the Validity of Tax Regulations  I think the answer is or should be yes. 

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Analysis

In the seminal article dealing with the issue of the courts filling in the gaps for missing tax regulations (See Philip Gall,  Phantom Tax Regulations: The Case Of Spurned Delegations, 56 Tax Law 413 (2002-2003)), the author correctly described the case law at that time as precluding the courts from filling in the gaps with phantom regulations where the regulatory delegation was what is called a “policy delegation”, that is, a delegation where it is discretionary with the IRS whether to issue regulations or not. 

I am not disputing the correctness of that assertion in the article generally but, rather, I am questioning the correctness of that statement today in cases where the IRS offers a reason(s) for its refusal to issue regulations in response to public comments asking for the regulatory grant to be exercised and that explanation(s) is not sufficiently well reasoned and responsive to the intent of the Congressional grant as to pass muster. In those cases, I believe that the courts should be free to promulgate phantom regulations on the issue. 

The key question for a future court is did the IRS provide an adequate answer (see below) to taxpayer comments asking it to exercise its regulatory authority? I think not because the grant of authority in section 1256(e)(3)(C)(v) (“if the Secretary determines (by regulations or otherwise) that such interest [in an entity] should be treated as held by an individual who actively participates in the management of such entity, and that such entity and such interest are not used (or to be used) for tax avoidance purposes”) was added in the tax act of 1981 to allow certain passively held interests to be treated as active and thus not a syndicate under section 1256 and thereby eligible for the hedging exception to mark to market treatment under section 1256. 

The fact that the TCJA in 2017 did not say anything about providing an exception for certain syndicates as tax shelters, as the IRS asserted as an explanation in the final regulation preamble for not issuing regulations, should not lead to any inference one way or the other. The Congress merely provided statutory cross references in the TCJA to other statutes in providing an exception to the small business carve-out for tax shelters, and the grant of regulatory authority should be viewed in that light. (For background and analysis of this tax shelter carve-out generally, see Monte Jackel, Small Business Tax Shelters Under the Business Interest Expense Limitation, 165 Tax Notes Federal 607, Oct. 28, 2019). 

The principal defect in the government’s position on the syndicate issue is that the explanation(s) given for the refusal to issue regulations would lead to the conclusion that all passive investments are established or maintained for tax avoidance purposes. Without the government explaining why that is the case, I believe that the failure to issue regulations in at least some cases involving passive investment is contrary to the Congressional intent that there could be cases where passive investment should be deemed active and, thus, not a tax shelter. The government’s statement in the final regulation preamble that allowing a passive investment exception would be “overbroad” and lead to the conclusion that no syndicates are tax shelters is and was just plain wrong. It is the failure of the government to either state (1) that all passive investment syndicates are tax shelters per se and explain why that is so, or (2) that it is not administratively possible to provide for any passive investments to not be syndicates, that results in an arbitrary application of the tax law that a court should not allow to stand. What do you think?

FROM THE FINAL SMALL BUSINESS ACCOUNTING REG PREAMBLE

“Several comments were received concerning issues related to tax shelters, including the definition of “syndicate,” under proposed §1.448-2(b)(2)(i)(B). Some commenters recommend using the authority granted under section 1256(e)(3)(C)(v) to provide a deemed active participation rule to disregard certain interests held by limited entrepreneurs or limited partners for applying the Section 448(c) Gross Receipts Test if certain conditions were met. For example, conditions of the rule could include that the entity had not been classified as a syndicate within the last three taxable years, and that the average taxable income of the entity for that period was greater than zero.

“The final regulations do not adopt this recommendation. The Treasury Department and the IRS have determined that it would be inappropriate to provide an exception to the active participation rules in section 1256(e)(3)(C)(v) by “deeming” active participation for small business taxpayers. The Treasury Department and the IRS believe that the deeming of active participation in this context would be overbroad and would run counter to Congressional intent. Sections 448(b)(3) and (d)(3), 461(i)(3) and 1256(e)(3)(C) were not modified by the TCJA, and the legislative history to section 13012 of the TCJA does not indicate any Congressional intent to modify the definition of “tax shelter” or “syndicate.” By not modifying those provisions, Congress presumably meant to exclude tax shelters, including syndicates, from being eligible to use the cash method of accounting and the small business taxpayer exemptions in section 13102 of the TCJA, even while otherwise expanding eligibility to meet the Section 448(c) Gross Receipts Test.”

PROPOSED REGULATION PREAMBLE

“One commenter expressed concern that the definition of syndicate is difficult to administer because many small business taxpayers may fluctuate between taxable income and loss between taxable years, thus their status as tax shelters may change each tax year. The commenter suggested that the Treasury Department and the IRS exercise regulatory authority under section 1256(e)(3)(C)(v) to provide that all the interests held in entities that meet the definition of a syndicate but otherwise meet the Section 448(c) gross receipts test be deemed as held by individuals who actively participate in the management of the entity, so long as the entities do not qualify to make an election as an electing real property business or electing farm business under section 163(j)(7)(B) or (C), respectively. The Treasury Department and the IRS decline to adopt this recommendation. The recommendation would allow a taxpayer that meets the Section 448(c) gross receipts test to completely bypass the “syndicate” portion of the tax shelter definition under section 448(d)(3). Neither the statutory language of section 448 nor the legislative history of the TCJA support limiting the application of the existing definition of tax shelter in section 448(d)(3) in this manner.”  

Revisiting the IRS’s Erroneous EIP Guidance for Nonresident Aliens

We welcome first-time guest blogger Justin Schwegel. Justin is a Sarasota, Florida-based attorney. His academic interests include international economic justice, agricultural policy, and government integrity. Today Justin offers thoughts regarding economic impact payments to nonresident aliens. This issue and related administrative law considerations will be addressed in more depth in an article to be published in the CUNY Law Review’s Footnote Forum. When the link becomes available it will be linked here. Christine

On March 27, in response to the economic crisis caused by Covid-19, Congress passed bipartisan stimulus legislation that included enhanced unemployment benefits, relief for small businesses, financial support for state, local, and tribal governments, and a one-time stimulus payment for eligible individuals. On May 6, the IRS issued guidance on its Economic Impact Payment Information Center website instructing incarcerated individuals, nonresident aliens (even if they were resident aliens in 2019), and the family members of the deceased taxpayers that they should return economic impact payments they received from the IRS. This guidance is wrong, and has the potential to harm vulnerable migrant workers, some of whom will see a tax residency status change as a result of the global pandemic.

Following the recent success of incarcerated individuals in getting a permanent injunction enjoining the IRS from withholding their CARES Act Economic Impact Payments, it is worth revisiting similar erroneous guidance the IRS provided to another class of individuals, nonresident aliens. Nina Olson has already explained why the guidance is wrong with respect to the families of deceased taxpayers, and Patrick Thomas explored this topic briefly in May, but the issue warrants a deeper dive.

Most nonresident aliens who received economic impact payments in 2020 did so because based on 2018 or 2019 tax filings they were resident aliens, and consequently, “eligible individuals.” H-2A (nonimmigrant agricultural guest workers) and H-2B (nonimmigrant unskilled guest workers) visa holders who returned to their country of origin could be particularly impacted by the guidance. In 2019, there were almost 258,000 H-2A workers, while the H-2B program is capped at 66,000 annually.

Many H-2A employees list their labor camp as their address on their tax filings, while many H-2B employees list the residence they have while working in the United States. Both visa categories have many people who are unbanked. Consequently, for many H-2A and H-2B workers who were resident aliens in 2019, but not in 2020, payments were likely sent in the form of physical checks to either labor camps where the workers no longer live or to other housing that is no longer current and would have been returned as undeliverable. Requesting a new physical check from an administrative agency that believes you are not entitled to a payment, and asking that it be delivered to a different address is probably an insurmountable barrier for most aliens who have undergone a tax residency change.

IRS Guidance

The IRS guidance is inconsistent with past guidance and inconsistent with the statutory language of the CARES Act. On April 17, the IRS issued several Q and A responses on its Economic Impact Payment Information Center. Most interesting for the purpose of this post:

Q17. I received an additional $500 payment in 2020 for my qualifying child.  However, he just turned 17.  Will I have to pay back the $500 next year when I file my 2020 tax return?

A17. No, there is no provision in the law requiring repayment of a Payment…

This guidance was renumbered several times, but remained largely unchanged until August. On May 6, the IRS published guidance stating that incarcerated individuals, nonresident aliens, and relatives of deceased taxpayers should make repayment of a payment. This means that for months, the IRS had guidance on its Economic Impact Payment Information Center stating both that there “is no provision in the law requiring repayment of a payment” and advising three different categories of individuals that they should repay a payment.

On August 3, the IRS issued new guidance on repaying economic impact payments.

Q J3. I received an Economic Impact Payment. Do I need to pay back all or some of the Payment if, based on the information reported on my 2020 tax return, I don’t qualify for the amount that I already received??

A J3. No, there is no provision in the law that would require individuals who qualify for a Payment based on their 2018 or 2019 tax returns, to pay back all or part of the payment, if based on the information reported on their 2020 tax returns, they no longer qualify for that amount or would qualify for a lesser amount…

This modification seems aimed at allowing the IRS to distinguish between an individual who changes from an “eligible individual” to an “ineligible individual” between 2019 and 2020 and a filer who remains an “eligible individual” but no longer qualifies for a payment. The eligibility criteria are written negatively such that any individual who is not 1) a nonresident alien, 2) an individual who could be claimed as a dependent by another taxpayer or 3) an estate or trust, is an eligible individual so long as they also provide the requisite Social Security Numbers on their taxes. One can shift from being an eligible individual because they have died, changed tax residency status, or become a dependent. Not all eligible individuals qualify for payment. If an eligible individual (filing single) has an AGI that exceeds $99,000, they are an eligible individual, but do not qualify for the payment. Likewise an individual who has a dependent who turns 17 in 2020 no longer qualifies for the additional $500 payment they received as an advance payment in 2020. Answer J3 is couched exclusively in terms of qualifying for payment rather than status as an eligible individual. The IRS assures these individuals who simply no longer qualify for a payment that they need not worry about making repayment.

The new guidance would allow the IRS to maintain consistency when it seeks to require repayment from the families of deceased taxpayers and 2019 resident aliens who undergo a tax residency status change in 2020. This distinction cannot be supported by statutory text that clearly delineates the time at which eligibility criteria must be met, i.e. in 2019.

The IRS has not sought repayment from all individuals who have changed from eligible to ineligible between 2019 and 2020. Specifically, individuals who filed taxes independently in 2019, but can be claimed as a dependent in 2020 have not been instructed to return the 2019 payments. This predominantly includes elderly individuals who were eligible individuals based on 2018 or 2019 tax filings, but who can now be claimed as a dependent by e.g. their child. It also includes children between the ages of 19 and 24 who return to school in 2020.

This seems conspicuous, because the IRS is aware of this situation and addresses some questions regarding newly dependent adults on its Economic Impact Information Center. If the IRS’s position is that individuals who received advance refunds because they were eligible in 2019 must return them if they become ineligible in 2020, for consistency it must require adults who become dependents in 2020 to do so as well. Perhaps the IRS overlooked this category of individuals in instructions to return economic impact payments. It seems more likely that the Trump Administration was aware that such a move would be politically toxic.

Statutory text

IRS guidance notwithstanding, the plain language of the CARES Act makes it clear that if a person was a resident alien in 2019, they need not return payment just because their tax residency status changed in 2020.

Section 2101 of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) added a new section to the tax code at 26 U.S.C. 6428 governing EIPs. This section created a refundable tax credit for the 2020 tax year called a “recovery rebate” and defined the eligibility criteria. Eligibility criteria were defined negatively, i.e. all classes of ineligible individuals were listed. An ineligible individual is any individual who in 2020 is a nonresident alien, an individual who could be claimed as a dependent, and an estate or trust. Individuals must also file their taxes with a social security number, their spouse’s social security number if filing jointly, and their child’s social security number if claiming a dependent child.

26 U.S.C. 6428 also created an “advance refund” with eligibility criteria identical to the eligibility criteria for the 2020 recovery rebate in all ways except timing. If an individual was an eligible individual in 2019 the individual is eligible for an an advance refund so long as they are not excluded by the limitation based on adjusted gross income. Those who were eligible individuals in 2019 are treated as having made an income tax payment “in an amount equal to the advance refund amount for such taxable year.” Consequently, the advance refund functions as a refund of an overpayment of 2019 taxes. 26 U.S.C. 6428(e) coordinates the advance refund with the 2020 recovery rebate so that the 2020 rebate is reduced, but not below zero, by the amount of the advance refund.

Most H-2A and H-2B guest workers are required to file taxes as resident aliens under the arcane substantial presence test outlined in publication 519, though the terms of relevant bilateral tax treaties control and can be difficult for workers to navigate.  These workers are also eligible to receive social security numbers. These workers are eligible to receive social security numbers and many do have them. It is risible that the IRS asked 2019 resident aliens who received an economic impact payment to guess at the beginning of May, during an unprecedented global pandemic, whether over the next eight months they would meet the complicated substantial presence test, and return the payment if not.

With the exception of a few foreign nationals who filed their income taxes incorrectly, economic impact payments made to aliens were made because they were eligible based on 2018 or 2019 tax filings. There is no provision in the CARES Act that requires an individual to repay an economic impact payment made under the CARES Act. Indeed, the advance refunds function as a reimbursement of overpayment of 2019 taxes. It is bizarre that the IRS has asked individuals who, in effect, received a refund for overpayment of 2019 taxes to return the refund with no rational explanation why.

IRS erred in CDP hearing, but taxpayers have no chance to recover administrative costs… absent help from Congress

We welcome first-time guest blogger Maria Dooner to Procedurally Taxing. Maria is the Director of Tax Controversy Services at TaxFirm.com. She chairs the Board of Directors of Community Tax Aid in Washington D.C. and she is a co-author of the chapter, “Recovering Fees and Costs When a Taxpayer Prevails” in the forthcoming edition of Effectively Representing Your Client Before the IRS. Today Maria examines a recent Tax Court opinion denying costs to taxpayers who successfully appealed their CDP determination. Bryan Camp also wrote an excellent post on the case which you can find here. Christine

An award of reasonable administrative and litigation costs under section 7430 was designed to promote effective tax administration by preventing abusive actions and overreaching by the Internal Revenue Service (IRS). But to be effective, a taxpayer must actually recover costs when the government’s position was not substantially justified. A recent Tax Court decision not only continues to expose the challenges faced by taxpayers in recovering reasonable administrative and litigation costs from the IRS, but it also spotlights the need for potential Congressional action.

In Tung Dang and Hieu Pham Dang v. Commissioner, T.C. Memo. 2020-150 (Nov. 9, 2020), the Tax Court held that 1) the petitioners did not incur any reasonable administrative costs as defined by section 7430, and 2) the petitioners were not entitled to an award of reasonable litigation costs since the United States’ litigation position was substantially justified. The court focused almost exclusively on timing — it evaluated when the government’s position was or was not substantially justified and when costs were incurred. Previous PT blog posts have highlighted the difficulties in proving that the government’s position was not substantially justified (see here and here). This post primarily focuses on the challenges with recovering administrative costs due to the timeframe in which they are incurred.

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Facts of Dang

Dang involved a tax collection case where a Revenue Officer denied the taxpayers’ request to levy their individual retirement account (IRA) to pay their outstanding tax liability – a request that would avoid the additional tax on early distributions and the potential sale of other assets. When declining the request, the Revenue Officer stated that the taxpayers had access to alternative sources of funds and she subsequently issued a notice of federal tax lien and notice of intent to levy. In response, the Dangs filed a request for a Collection Due Process (CDP) hearing, but the Settlement Officer sustained the IRS collection actions, stating that a levy is not a collection alternative considered by Appeals. (As an aside, the irony of this case cannot be overlooked – while the taxpayer is contesting the notice of intent to levy, the Appeals Office says “no” to the taxpayer’s specific levy request.)

After receiving an unfavorable notice of determination, the Dangs filed a petition to Tax Court where IRS Counsel conceded the issue in his answer, stating that a substitution of assets (via a levy) is a valid collection alternative, and the Appeals Office abused its discretion. Against the desires of the Dangs who wanted an order to levy their IRA, Special Trial Judge Armen remanded the case back to the Appeals Office to promptly hold another administrative hearing, correct its flawed reasoning and reconsider the taxpayers’ request to levy the IRA. Keith blogged about the remand order on PT here (the taxpayers unsuccessfully argued a remand was unnecessary).

After the Appeals Office concluded that the levy on the IRA was appropriate, and settlement was reached in Tax Court, the taxpayers filed a motion for approximately $13,000 in reasonable administrative costs and approximately $70,000 in litigation costs. The administrative costs claimed by the Dangs included the time spent preparing and participating in the CDP hearing. The litigation costs claimed by the Dangs included all the work that was performed after receiving the Notice of Determination from the Appeals Office. This included time spent preparing the Tax Court petition and work performed while the taxpayers were in Tax Court, including the time spent on the case during the supplemental CDP hearing when it was remanded back to the Appeals Office.

Was the government’s position substantially justified, and when were costs incurred?

To successfully recover costs, the taxpayer must have exhausted administrative remedies with the IRS, have not unreasonably protracted the proceedings, have claimed reasonable costs, and have ultimately prevailed (as well as have satisfied a net worth requirement). Under section 7430(c)(4)(B)(i), a taxpayer cannot be a prevailing party if the United States was substantially justified in their position. When determining whether the government was substantially justified in its position in Dang, Judge Marvel applied a bifurcated analysis.  This involved determining whether the government’s position was substantially justified in 1) its notice of determination in the administrative proceeding, and 2) its answer in the judicial proceeding.  However, before the first question was evaluated, Judge Marvel questioned whether any permissible costs were in fact incurred during the administrative proceeding.

Pursuant to section 7430(c)(2), administrative costs are those incurred by the taxpayer on or after the earliest of: (1) the date of the receipt by the taxpayer of the notice of decision by the IRS Independent Office of Appeals, (2) the date of the notice of deficiency, or (3) the date of the first letter of proposed deficiency that allows the taxpayer to appeal to the IRS Independent Office of Appeals. Because Dang involved a CDP hearing, the only relevant date was the date the taxpayers received the Notice of Determination, which is essentially the notice of decision referenced in the law. So, on or after the notice of determination, the taxpayers could recover any costs incurred from that point forward within an administrative proceeding.

Unfortunately, the notice of determination is probably the worst date to start accruing administrative costs as it concludes a collection case at the administrative level. (The ideal date from a taxpayer’s perspective would be the date the Dangs received a right to a CDP hearing.) But upon receipt of the notice of determination, the Dangs have no move to make in which they could possibly recover any administrative costs. Their only task at hand is to prepare for litigation by reviewing the notice of determination and filing a petition to the Tax Court — time that the Dangs appropriately classified as litigation costs.

Since there were no “administrative costs” (within the scope of the statute) to be awarded, the Tax Court solely evaluated whether the government’s position was substantially justified in the litigation proceeding, relying on Huffman v. Commissioner, 978 F.2d 1148 (1992). Because the IRS promptly conceded its error and moved to remand the case back to the Appeals Office, Judge Marvel found that the IRS’s position was substantially justified. Therefore, no litigation costs could be awarded to the Dangs.

Did the decision to remand create additional administrative costs that could be awarded?

While this case is exceptional in more ways than one, additional costs associated with a supplemental CDP hearing (via a remand) add another twist. Bryan Camp suggests in his post that these costs were incurred after the notice of determination and as part of an administrative proceeding, so there could be an argument that there are administrative costs to be awarded.

This is an interesting point that was not addressed by the Tax Court, which was likely due to the fact these costs were classified as litigation costs by the Dangs. In the Dang case, the supplemental CDP Hearing was held at the direction of the Tax Court, and the hearing was very much connected to the court proceeding, which ultimately concluded the case. (In his order to remand the case back to the Appeals Office, Special Trial Judge Armen still retained jurisdiction over the case.) Thus, it appears that the time spent preparing, traveling, and participating in the remanded appeals hearing was appropriately classified as litigation costs under section 7430(c)(1)(b)(iii).

Why does the definition of “administrative costs” in section 7430 fail to encompass most costs incurred within administrative collection due process proceedings?

Judge Marvel did not analyze whether the government’s position was or was not substantially justified in the administrative proceeding, but we can assume that the position was not substantially justified. (The IRS went against published guidance (i.e. Treas. Reg. 301.6330-1(e)(3)), and this was recognized by IRS Counsel who immediately conceded the issue as well as Special Trial Judge Armen who remanded the case back to the Appeals Office for a do-over.)The question then becomes: why should the Dangs be unable to recover costs for time spent preparing and participating in the original CDP Hearing, which clearly went wrong and did not serve its intended purpose?

As explained above, Judge Marvel’s decision hinges on the definition of “administrative costs” in section 7430(c)(2), which incorporates a timing rule that effectively excludes CDP hearings from consideration. But Regulation § 301.7430-3(a)(4)  appears to go even further, providing that a CDP hearing is not an administrative proceeding for which reasonable administrative costs can be recovered. In their brief, the Dangs argued that this regulation should be disregarded as inconsistent with the statute. The Dangs note, “there is simply no statutory authority for eliminating CDP hearings from the cost recovery regimen.” In their brief, the Dangs emphasize the very first sentence of section 7430, which states that the prevailing party may be awarded reasonable administrative costs in any administrative proceeding in connection with the collection of any tax. They also explain how Regulation § 301.7430-3(a)(4), which precludes most collection actions, particularly a CDP hearing (“the quintessential collection administrative hearing”), from the definition of an administrative proceeding for purposes of section 7430, does not align with the first sentence of section 7430. But despite this being true, it does not change the outcome of the case. Unfortunately, it is the dates that triggered these costs, listed in section 7430(c)(2), that preclude and will continue to preclude the award of administrative costs in most CDP hearings. The dispute over the regulation is a red herring.

Why then did Congress enact a seemingly contradictory statute? An interesting explanation for these dates lies within a small footnote in the Tax Court opinion, indicating that it was Congressional intent to preclude an award for administrative costs arising from a collection action:

In 1988, when Congress amended sec. 7430 to include recovery for administrative costs in addition to litigation costs, the legislative history of the amendment acknowledged that the dates triggering costs precluded an award for administrative costs arising from a collection action. See H.R. Conf. Rept. No. 100-1104, at 226 (1988), 1988-3 C.B. 473, 716 (“Thus, with respect to a collection action, only reasonable litigation costs are recoverable under * * * [sec. 7430].”).

Ironically, a deeper dive into the Technical and Miscellaneous Revenue Act of 1988 shows that its amendment to section 7430 did not even facilitate the recovery of administrative costs for most taxpayers in deficiency proceedings. As passed, this law classified administrative costs as those incurred on or after the earlier of the date of receipt of the notice of the decision of the Appeals Office or the date of the notice of deficiency. Though the Senate bill included a third date, the date of notice of proposed deficiency (often known as the “30-day letter” into the Appeals Office), this was not incorporated into the 1988 Act. Therefore, the 1988 Act added the words “administrative costs” to section 7430, but it failed to provide meaningful impact to taxpayers pursuing administrative costs in deficiency proceedings. By not providing for the effective recovery of administrative costs in proceedings involving both the assessment and collection of tax, the inclusion of “administrative costs” was in many ways meaningless. 

It was not until the passage of the Internal Revenue Service Restructuring and Reform Act of 1998 that Congress approved the award of administrative costs incurred on or after the date of a notice of proposed deficiency. After that, taxpayers were able to recover administrative costs from the moment they received the notice of proposed deficiency and onward. Simultaneously, the 1998 Act created taxpayers’ rights to a CDP hearing — an independent review of a notice of intent to levy and notice of federal tax lien, culminating in a notice of determination and the right to judicial review.

Although we do not know the exact intent of Congress regarding the award of administrative costs in CDP hearings, the legislative history suggests that Congress either lacked an understanding of when these costs were incurred or was not fully committed to awarding them. For example, the fact that Congress did not facilitate the recovery of administrative costs associated with a collection proceeding in the 1998 law could have been an oversight when they were simultaneously creating a collection hearing that did not yet exist. Or maybe more likely, Congress did not understand the dates that triggered these costs. Remember, it took them approximately 10 years, after the law was amended to award administrative costs, to finally incorporate a provision that facilitated the recovery of these costs in deficiency proceedings.

This leads to what may be the main significance of Dang… a successful recovery of administrative costs by taxpayers requires a better understanding of when these costs are actually incurred and a more serious commitment to award them by Congress. The resources exerted in the Dang case where volunteer attorneys spent hours providing financial information, preparing for a CDP hearing, filing motions and briefs, preparing for a second CDP hearing, etc. (all to get back to an answer originally granted by the first Revenue Officer who approved the levy but was replaced by a second Revenue Officer who did not) show the importance of passing a law that allows for the effective recovery of costs and fees when the administrative process goes wrong. 

As a start, Congress could incorporate “costs incurred on or after the date of receipt by the taxpayer of a right to a CDP hearing” into section 7430(c)(2) for the sake of theDangs and thousands of taxpayers in collection cases. By making section 7430 more meaningful, Congress will make it more important for the IRS to follow published guidance in administrative collection due process hearings and will help the IRS achieve its mission in providing top quality service. Ultimately, the purpose of these awards is not to penalize but rather enhance effective tax administration, and to do this, more taxpayers must actually recover costs when the IRS errs.

Treasury and IRS Release New Round of BBA Partnership Audit Proposed Regulations

Today we welcome back guest blogger Rochelle Hodes, a Principal with Crowe LLP and a former Associate Tax Legislative Counsel in Treasury’s Office of Tax Policy.  Rochelle discusses the new proposed regulations under the BBA partnership audit rules that were released just before Thanksgiving.  While the proposed rules primarily address special enforcement matters, the proposed rules would also amend the final BBA regulations in significant and consequential ways that practitioners and taxpayers ought to be attune to.  Rochelle would like to thank her former government colleague Greg Armstrong, a Director with KPMG LLP, for his helpful review and comments.  Rochelle and Greg worked together on, and continue to update, Chapter 8A in Saltzman Book IRS Practice and Procedure regarding the BBA partnership audit rules. Les

On November 24, 2020, Treasury and the IRS published proposed regulations under the centralized partnership audit regime enacted by the Bipartisan Budget Act of 2015 (BBA).  The BBA regime generally applies to partnership tax years beginning in 2018.  This post addresses proposed §301.6221(b)-1(b)(3)(ii)(G) regarding eligibility to elect out of BBA if a partner is a qualified S corporation subsidiary (QSub), proposed §301.6241-3 regarding treatment of partnerships that cease to exist, and proposed §301.6241-7 regarding treatment of special enforcement matters. In general, the proposed applicability date for these rules is November 20, 2020.

These proposed regulations are being released at the end of a presidential administration.  It is unclear how finalizing these proposed regulations will fit into the new administration’s priorities and whether policy decisions embedded in the proposed regulations will be reconsidered.  However, even with this uncertainty, the proposed regulations are important because they give taxpayers and practitioners a window into the IRS’s thinking on the BBA rules at a time when it is increasing its focus on partnership reporting and compliance.

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QSubs

All partnerships required to file Form 1065 are subject to the BBA regime unless the partnership is eligible to elect out of the regime and does so on its timely filed original return.  The election out of BBA is an annual election.  

A partnership is eligible to elect out of BBA if the partnership has 100 or fewer eligible partners.  Partnerships, trusts (including grantor trusts), disregarded entities, and nominees are not eligible partners and therefore partnerships with these types of partners cannot elect out of BBA. 

Section 6221(b) specifically provides that an S corporation is an eligible partner.  However, in the case of an S corporation a special rule applies for purposes of determining whether the partnership has 100 or fewer partners.  Under the special rule, all shareholders to whom the S corporation is required to furnish a Schedules K-1, plus the S corporation itself, are counted as a partner to determine whether the number of partners exceeds 100.  

Under the proposed regulations, a QSub is not an eligible partner, and therefore, a partnership with a QSub cannot elect out of BBA.  This is a reversal of the position taken by the IRS and Treasury in Notice 2019-06.  In Notice 2019-06, the IRS identified partnerships that are owned by a QSub as a special enforcement issue because such partnerships could have more than 100 owners when looking through the QSub to the S corporation and its shareholders. Accordingly, Notice 2019-06 stated that generally a partnership with a QSub as a partner would not be eligible to elect out of BBA, but that Treasury and the IRS intended to publish proposed regulations to allow partnerships with QSub partners to elect out of BBA under rules similar to S corporations.   But why did Treasury and the IRS reverse its position in Notice 2019-06?  It appears that a long simmering debate among practitioners about the nature of a QSub may be the cause.  The preamble includes a discussion of two comments addressing a rationale not to prohibit partnerships held directly by a QSub from electing out of BBA: one that relies on the fact that a QSub is a C corporation and the other that relies on the fact that for partnership reporting the S corporation, not the QSub, is treated as the partner.  The preamble then describes the reason for changing the government’s position in Notice 2019-6 as follows:

“Although Notice 2019-06 states that the proposed regulations would have applied a rule similar to the rules for S corporations under section 6221(b)(2)(A) to partnerships with a QSub as a partner, the Treasury Department and the IRS have reconsidered that approach.  Under § 301.6221(b)-1(b)(3)(ii), partnerships that have disregarded entities as partners may not elect out of the centralized partnership audit regime.  QSubs are treated similarly to disregarded entities for most purposes under the Code in that both QSubs and disregarded entities do not file income tax returns but instead report their items of income and loss on the returns of the person who wholly owns the entity.”  

85 FR 74943 (November 24, 2020).

Treatment Where a Partnership Ceases to Exist

Section 6241(7) provides that if a partnership ceases to exist before a BBA partnership adjustment takes effect, such adjustment shall be taken into account by the former partners of such partnership under regulations prescribed by the Secretary.

The current regulations under §301.6241-3 generally provide that partnership adjustments take effect when all amounts due under BBA resulting from the adjustment are fully paid.  The current regulations also provide that the former partners are the partners for the adjustment year with respect to the reviewed year to which the adjustments relate, but if there are no partners in that year, the former partners are the partners during the last taxable year for which the partnership filed a return.

The proposed regulations would modify several parts of the cease-to-exist regulations, but the two most consequential are the rules for when an adjustment takes effect and who are former partners.  The proposed regulations provide that the partnership adjustments take effect when the adjustment becomes finally determined, when there is a settlement, or if the adjustment relates to an item on an administrative adjustment request (AAR), when the AAR is filed. 

Under the proposed regulations, former partners would be 1) the partners during the last taxable year for which the partnership filed a return or an AAR or 2) “the most recent persons determined to be partners of the partnership in a final determination (for example, a defaulted notice of final partnership adjustment, final court decision, or settlement agreement) binding on the partnership.”  The proposed regulations do not set up an order of priority of which condition would take precedence.

The preamble to the proposed regulations states that these changes are necessary to coordinate section 6241(7) with section 6232(f), which was enacted by the Tax Technical Corrections Act of 2018.  Section 6232(f) provides that the IRS can assess tax upon the adjustment year partners if the partnership fails to pay the imputed underpayment within 10 days of notice and demand.  Section 6232(f) includes a rule allowing assessment against former partners determined under section 6241(7) if the partnership has ceased to exist.  Though section 6232(f) has been on the Treasury and IRS Priority Guidance Plan for a while now, no guidance under this section has been issued to date.  

Special Enforcement 

Section 6241(11) generally provides that in the case of partnership-related items which involve special enforcement matters, the Secretary may prescribe regulations to provide that BBA does not apply to the items and that the items are subject to special rules necessary for the effective and efficient enforcement of the Code.  The statute lists certain special enforcement areas, including termination and jeopardy assessments, criminal investigations, and indirect methods of proof of income.  The IRS had similar statutory authority with respect to special enforcement matters under TEFRA.

In addition to the special enforcement areas described above, the proposed regulations identify other special enforcement matters:

  • Partnership-related items underlying non-partnership-related items.  This provision would allow the IRS to determine that the BBA rules do not apply to adjustments of partnership-related items if all of the following apply:
    • An examination is being conducted of a person other than the partnership,
    • A partnership-related item is adjusted, or a determination regarding a partnership-related item is made, as part of, or underlying an adjustment to a non-partnership-related item of the person whose return is being examined, and 
    • The treatment of the partnership-related item on the Schedule K-1 or the partnership’s books and records is based in whole or in part on information provided by the person whose return is being examined.  
  • Controlled partnerships and extensions of the partner’s period of limitations.  This provision would allow the IRS to adjust partnership-related items outside of BBA if the period of limitations to make partnership adjustments under section 6235 has expired but the partner’s period of limitations on assessment for chapter 1 tax has not expired.  This provision applies to direct or indirect partners that are related to the partnership under section 267(b) or section 707(b) or direct or indirect partners that consent to extend the period of limitations to adjust and assess any tax attributable to partnership-related items. 
  • Penalties and taxes imposed on the partnership under chapter 1.  This provision would allow the IRS to adjust any tax or penalty imposed on, and which is the liability of the partnership, under chapter 1 of the Code without regard to BBA.  It would also allow the IRS to “adjust any partnership-related item, without regard to [BBA], as part of any determination made to determine the amount and applicability of the tax, penalty, addition to tax, or additional amount being determined without regard to [BBA].  Any determinations under this [provision] will be treated as a determination under a chapter of the Code other than chapter 1 for purposes of § 301.6241-6 [coordination with other chapters of the Internal Revenue Code].”

Coinbase Switches From 1099-K to 1099-MISC: A Better Mousetrap or Prelude to Litigation?

Welcome back to guest blogger James Creech. Today James looks into a recent announcement by Coinbase that they are changing their method of tax reporting. When I saw this (in a Law360 article by Joshua Rosenberg) I wondered how such a dramatic shift was possible under the tax laws. We are fortunate that James agreed to investigate the matter and illuminate us. Christine

Former Netscape CEO Jim Barksdale once said, “There are only two ways to make money in business: one is to bundle; the other is unbundle.”   Of the two options, virtual currency exchange Coinbase has chosen to go the bundling route.  At its beginning in 2012 Coinbase supported only a small number of virtual currencies and has steadily expanding its offerings over the last eight years.  Recently Coinbase has dramatically expanded its offerings to include tokens such as the stable coin DAI (don’t worry the technical side does not make a difference to this article) which offers rewards to its holders that functionally resemble interest.

These expanded offerings have caused Coinbase to rethink its third party tax reporting.  Prior to 2020 Coinbase reported transactions to the IRS using Form 1099-K.  The issuance of a 1099-K was due in large part to litigation between Coinbase and the IRS over the issuance of a John Doe Summons that asked for all information Coinbase had regarding US Taxpayers. (Les wrote about the litigation for PT, most recently here.) While the matter was decided in favor of the Government, Coinbase was able to limit the request to information that mirrored the 1099-K and has stuck with that reporting standard since 2017. 

For tax year 2020 that is all changing.  Coinbase is no longer going to issue 1099-K’s and will instead only issue 1099-MISC forms.

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The switch from a 1099-K to a 1099-MISC could be dramatic for a large number of Coinbase users.  Form 1099-K reports gross transactions to the IRS if the taxpayer exceeds 200 transactions or a $20,000 threshold.  The standards for Form 1099-MISC reporting are much lower.  A 1099-MISC is required to be issued if a taxpayer receives more than $600 in payments during the year.  This switch could potentially provide the IRS the names of tens of thousands of taxpayers who thought that they could avoid paying tax on virtual currency gains because they fell under the $20,000 reporting threshold.

Coinbase’s decision to switch from Form 1099-K to Form 1099-MISC could be for a number of reasons.  First is that 1099-MISC is a more appropriate form to report payments akin to interest and that Coinbase decided it was more efficient only to issue one type of 1099.  The second could be that Coinbase made an internal decision that the shortcomings of the 1099-K were too great to ignore.  Since the 1099-K only reports gross transactions and not basis, many taxpayers who actively traded virtual currencies would have a very high dollar amount of transactions reported on the 1099-K but may only have small gains or could potentially have losses.  The responsibility of tracking basis and reporting gains and losses still falls on the taxpayer but now that the IRS is issuing CP2000’s based upon virtual currency exchange third party reporting they might have to spend time, effort, and resources rebutting an incorrect 1099.

The bigger unanswered question after this switch is does Coinbase even intend to report sales or other transactions to the IRS in 2020 and beyond?  The webpage announcing the switch to a 1099-MISC reporting standard states: “1099-MISC Eligibility To be eligible for a 1099-MISC, you must: 1. Be a Coinbase customer, 2. Have received $600 or more in cryptocurrency from Coinbase Earn, USDC Rewards, and/or Staking in 2020 and 3. Be subject to US taxes.”  Nowhere in this announcement are transactions such as sales or purchases mentioned. 

One reading of this press release is that Coinbase is beginning a taxpayer revolt against virtual currency third party reporting.  Recently Coinbase has acquired a reputation of being one of the more conservative technology companies.  For example, the company reaction to the Black Lives Matter protest over the summer was to simply ban its employees from speaking out on the matter or using BLM emblems as part of their internal communications.  This reaction was starkly different from most companies that put out a politely worded statement offering some sort of recognition of the importance of the events.  A further shift into libertarianism vis a vis refusing to provide information to the IRS might play well with the virtual currency community which tends to have an aversion towards any sort of government interaction.  Not to mention it would seem to offer a business advantage for any frustrated virtual currency user who had to spend significant time resolving issues based upon 1099-K’s lack of basis reporting.

If Coinbase does stop reporting transactions to the IRS it sets the stage for a reprise of the John Doe Summons litigation from a few years ago.  The IRS has made tax compliance in the virtual currency space a priority.  It has significantly upgraded its technical understanding of virtual currencies and dedicated significant resources to cracking down on unreported virtual currency income.  A resistant firm like Coinbase, and its users, would be the ideal target for the IRS to showcase their significant ability to identify virtual currency tax noncompliance just as it was in the original litigation.  Only time will tell what will happen, but the only sure thing at the moment is that there is not an ideal form for virtual currency third party reporting.