The Branch Profits Tax

The branch profits tax is imposed on foreign corporations engaged in a U.S. trade or business through a branch, rather than a subsidiary.  The branch profits tax is imposed in addition to any tax on income that is effectively connected[1] to the conduct of the business.

In other words, under the branch profits tax, foreign corporations with U.S. branches are, in theory at least, subject to two levels of tax: (i) At the entity level when the U.S. branch earns income, and (ii) at the shareholder level when the earnings are deemed to be repatriated.

In effect, the branch profits tax treats the U.S. branch of a foreign corporation as if it were a subsidiary—at least for purposes of taxing the repatriation of profits.  This puts the earnings and profits of a foreign corporation’s branch that are deemed to be repatriated to its home office on equal footing with the earnings and profits of a U.S. subsidiary that are paid out as a dividend to its foreign parent.  By treating a branch’s profits as though they were remitted to the foreign corporation, the branch profits tax effectively eliminates the advantage of operating as a U.S. branch rather than a subsidiary with respect to the repatriation of profits.

The Taxation of a Foreign Corporation’s Effectively Connected Income, Generally

Foreign corporations that have a trade or business in the U.S. may be subject to tax on the income that is effectively connected with that U.S. trade or business at normal corporate tax rates. A foreign corporation has effectively connected income if it is engaged in a trade or business within the U.S. and has income connected to that trade or business. For example, a foreign corporation that performs services in the U.S. is engaged in a trade or business in the U.S. and has effectively connected income.

The Branch Profits Tax, Generally

The branch profits tax was enacted under the Tax Reform Act of 1986.  It was intended to put a U.S. branch of a foreign corporation on par with a U.S. subsidiary of a foreign corporation.

The branch profits tax imposes a 30% tax (or lower rate under an applicable treaty) on the after-tax earnings of a foreign corporation’s U.S. trade or business that are not deemed to be reinvested in that U.S. trade or business. The branch profits tax is imposed on the “dividend equivalent amount.” As such, the branch profits tax treats a U.S. branch of a foreign corporation as if it were a subsidiary of a foreign corporation.

The branch profits tax is imposed in addition to the tax imposed by section 882 on effectively connected income.

Note that the termination or incorporation of a U.S. trade or business, or the liquidation or reorganization of a foreign corporation or its domestic subsidiary, may impact the branch profits tax.

The Dividend Equivalent Amount

The term “dividend equivalent amount” is defined as a foreign corporation’s effectively connected earnings and profits, with certain adjustments. The dividend equivalent amount is similar to dividends paid by a subsidiary either out of current E&P not yet invested or out of accumulated E&P invested in subsidiary assets.

To determine the dividend equivalent amount, we start with the effectively connected earnings and profits.  Effectively connected earnings and profits are the earnings and profits (or deficits) determined under section 312 and Treasury Regulations that are attributable to effectively connected income (within the meaning of the Treasury Regulations).[2] Because the phrase effectively connected income includes income treated as effectively connected, income that is effectively connected income under section 842(b) (minimum net investment income of an insurance business) or 864(c)(7) (gain from property formerly held for use in a U.S. trade or business) gives rise to effectively connected earnings and profits. Effectively connected earnings and profits also includes earnings and profits attributable to effectively connected income of a foreign corporation earned through a partnership, and through a trust or estate. For purposes of section 884, gain on the sale of a U.S. real property interest by a foreign corporation that has made an election to be treated as a domestic corporation under section 897(i) will also give rise to effectively connected earnings and profits.

Generally, the effectively connected earnings and profits are adjusted (up or down) to reflect increases or decreases in the branch’s investment in United States assets (i.e., its U.S. net equity).  The dividend equivalent amount is reduced by the increase in a U.S. branch’s U.S. net equity.  It is increased by a U.S. branch’s decrease in U.S. net equity.

U.S. net equity equals U.S. assets minus U.S. liabilities.  The Treasury Regulations provide elaborate rules for the calculation of U.S. net equity.

There are two ways to increase U.S. net equity: use the profits to purchase additional U.S. assets or to reduce U.S. liabilities. Branch income that is reinvested in qualifying branch (U.S.) assets is not considered repatriated to the foreign home office.

On the other hand, if branch income is not reinvested in qualifying U.S. assets, then it is deemed repatriated.

Tax Treaties

The United States is a signatory to more than 60 income tax treaties.  With some exceptions, a qualifying foreign corporation that is a resident of a country with which the United States has an income tax treaty and that has a dividend equivalent amount.

Our Freeman Law interactive tax treaty map provides a link to tax treaty materials for each U.S. treaty partner:

If the foreign corporation satisfies the limitation on benefits provisions of the applicable tax treaty with respect to the dividend equivalent amount, the foreign corporation will not be subject to the branch profits tax on that amount (or will qualify for a reduction in the amount of tax with respect to such amount) if—

(i) The foreign corporation is a qualified resident of such country for the taxable year;[3] or

(ii) The limitation on benefits provision, or an amendment to that provision, entered into force after December 31, 1986.

A foreign corporation that, in any taxable year, is a qualified resident of a country with which the United States has an income tax treaty in effect solely because it meets the requirements of § 1.884–5(b) and (c) (relating, respectively, to stock ownership and base erosion) is exempt from the branch profits tax or subject to a reduced rate of branch profits tax pursuant to a treaty with respect to the portion of its dividend equivalent amount for the taxable year attributable to accumulated effectively connected earnings and profits only if the foreign corporation is a qualified resident of the treaty country under the Treasury Regulations, in whole or in part, in a consecutive 36–month period that includes the taxable year of the dividend equivalent amount. A foreign corporation that fails the 36–month test is exempt from the branch profits tax or subject to the branch profits tax at a reduced rate with respect to accumulated effectively connected earnings and profits (determined on a last-in-first-out basis) accumulated only during prior years in which the foreign corporation was a qualified resident of such country.

Foreign corporations should also analyze whether they have Form 5472 or other reporting obligations.

International and Offshore Tax Compliance Attorneys

Need help with tax issues? Contact us as soon as possible to discuss your rights and the ways we can assist in your defense. We handle all types of cases, including complex international & offshore tax compliance. Schedule a consultation or call (214) 984-3000 to discuss your international tax concerns or questions. 

[1]For purposes of the branch profits tax, under applicable regulations the term “effectively connected income” means income that is effectively connected with the conduct of a trade or business in the United States and income that is treated as effectively connected with the conduct of a trade or business in the United States under any provision of the Code. The term effectively connected income also includes all income that is or is treated as effectively connected with the conduct of a U.S. trade or business whether or not the income is included in gross income (for example, interest income earned with respect to tax-exempt bonds).

[2] The term “ECEP” does not include any earnings and profits attributable to—

(i) Income excluded from gross income under section 883(a)(1) or 883(a)(2) (relating to certain income derived from the operation of ships or aircraft);

(ii) Income that is ECI by reason of section 921(d) or 926(b) (relating to certain income of a FSC and certain dividends paid by a FSC to a foreign corporation or nonresident alien) that is not otherwise ECI;

(iii) Gain on the disposition of a U.S. real property interest described in section 897(c)(1)(A)(ii) (relating to certain interests in a domestic corporation);

(iv) Income that is ECI by reason of section 953(c)(3)(C) (relating to certain income of a captive insurance company that a corporation elects to treat as ECI) that is not otherwise ECI;

(v) Income that is exempt from tax under section 892 (relating to certain income of foreign governments); and

(vi) Income that is ECI by reason of section 882(e) (relating to certain interest income of banks organized under the laws of a possession of the United States) that is not otherwise ECI.

[3] Note that if a foreign corporation is a qualified resident only with respect to one of its trades or businesses in the United States, i.e., the trade or business that is an integral part of its business conducted in its country of residence, and not with respect to another, the treaty exceptions may only apply to that portion of its dividend equivalent amount attributable to the trade or business for which the foreign corporation is a qualified resident.

Unlike FDAP income, the United States taxes effectively connected income (“ECI”) on a net basis.  Effectively connected income is income that is effectively connected with the conduct of a U.S. trade or business.  It also includes gains from the disposition of U.S. real property under FIRPTA, which are treated as ECI.

Generally, when determining whether income constitutes effectively connected income, the IRS employs two tests: (i) the asset-use test; and (ii) the business-activities test.  The asset-use test looks to whether the income or gain is derived from assets used in, or held for use in, the conduct of the trade or business in the United States.  The business-activities test looks to whether the activities of the trade or business were conducted in the United States and were a material factor in the realization of the income or gain at issue.

What is Effectively Connected Income?

Generally, when a foreign person is engaged in a trade or business in the United States, all income from sources within the United States connected with the conduct of that trade or business is considered to be effectively connected income. This applies even if there is no connection between the income and the trade or business being carried on in the United States during the tax year. Among the more common traps, partners in a partnership and beneficiaries of an estate or trust are treated as engaged in a U.S. trade or business if the partnership, estate, or trust is so engaged.

A taxpayer is generally considered to be engaged in a U.S. trade or business when they perform personal services in the United States. Whether the taxpayer is engaged in a trade or business in the United States depends on the nature of the taxpayer’s activities.

What Income is Effectively Connected with a U.S. Trade or Business?

In the case of U.S.-source capital gain and U.S.-source income that would be subject to gross-basis U.S. taxation, whether the income is ECI generally depends upon whether the income is derived from assets used in or held for use in the conduct of the U.S. trade or business and whether the activities of the U.S. trade or business were a material factor in the realization of the amount (the “asset use” and “business activities” tests).  All other U.S.-source non-FDAP income is treated as effectively connected income.

The following categories of income are usually considered to be connected with a trade or business in the United States:

• If the taxpayer is a member of a partnership that at any time during the tax year is engaged in a trade or business in the United States, they are considered to be engaged in a trade or business in the United States.
• A taxpayer is usually engaged in a U.S. trade or business when they perform personal services in the United States.
• A taxpayer is considered to be engaged in a trade or business in the United States if they are temporarily present in the United States as a nonimmigrant on an “F,” “J,” “M,” or “Q” visa. The taxable part of any U.S. source scholarship or fellowship grant received by a nonimmigrant in “F,” “J,” “M,” or “Q” status is treated as effectively connected with a trade or business in the United States.
• If the taxpayer owns and operates a business in the United States selling services, products, or merchandise, the taxpayer is, with certain exceptions, engaged in a trade or business in the United States. For example, profit from the sale in the United States of inventory property purchased either in this country or in a foreign country is effectively connected trade or business income.
• Gains and losses from the sale or exchange of U.S. real property interests (whether or not they are capital assets) are taxed as if the taxpayer was engaged in a trade or business in the United States.
• Income from the rental of real property may be treated as ECI if the taxpayer elects to do so.

A foreign person’s income from foreign sources generally is considered to be ECI only if the person has an office or other fixed place of business within the United States to which the income is attributable and the income is in one of the following categories: (1) rents or royalties for the use of patents, copyrights, secret processes or formulas, good will, trademarks, trade brands, franchises, or other like intangible properties derived in the active conduct of the trade or business; (2) interest or dividends derived in the active conduct of a banking, financing, or similar business within the United States or received by a corporation the principal business of which is trading in stocks or securities for its own account; or (3) income derived from the sale or exchange (outside the United States), through the U.S. office or fixed place of business, of inventory or property held by the foreign person primarily for sale to customers in the ordinary course of the trade or business, unless the sale or exchange is for use, consumption, or disposition outside the United States and an office or other fixed place of business of the foreign person in a foreign country participated materially in the sale or exchange. Foreign-source dividends, interest, and royalties are not treated as effectively connected income if the items are paid by a foreign corporation more than 50 percent (by vote) of which is owned directly, indirectly, or constructively by the recipient of the income.

Prior-Year Activity

Income, gain, deduction, or loss for a particular year generally is not treated as effectively connected income if the foreign person is not engaged in a U.S. trade or business in that year.  If, however, income or gain taken into account for a taxable year is attributable to the sale or exchange of property, the performance of services, or any other transaction that occurred in a prior taxable year, the income or gain is effectively connected income if the income or gain would have been treated as such in the prior year. If any property ceases to be used or held for use in connection with the conduct of a U.S. trade or business and the property is disposed of within 10 years after the cessation of that activity, the income or gain attributable to the disposition of the property is effectively connected income if the income or gain would have been treated as such had the disposition occurred immediately before the property ceased to be used or held for use in connection with the conduct of a U.S. trade or business.         

FIRPTA 

A foreign person’s gain or loss from the disposition of a U.S. real property interest (“USRPI”) is treated as effectively connected income.  Thus, a foreign person subject to tax on such a disposition is required to file a U.S. tax return. In the case of a foreign corporation, the gain from the disposition of a USRPI may also be subject to the branch profits tax at a 30-percent rate (or lower treaty rate).

The payor of income that FIRPTA treats as ECI is generally required to withhold U.S. tax from the payment.  The foreign person can request a refund with its U.S. tax return, if appropriate, based on that person’s overall tax liability for the taxable year.         

Branch Profits Taxes

Under the branch profits tax, the United States imposes a tax of 30 percent on a foreign corporation’s “dividend equivalent amount.”  The dividend equivalent amount is generally equal to the earnings and profits of a U.S. branch of a foreign corporation attributable to its ECI. Limited categories of earnings and profits attributable to a foreign corporation’s ECI are excluded in calculating the dividend equivalent amount.

In arriving at the dividend equivalent amount, a branch’s effectively connected earnings and profits are adjusted to reflect changes in a branch’s U.S. net equity (i.e., the excess of the branch’s assets over its liabilities, taking into account only amounts treated as connected with its U.S. trade or business).

What is a U.S. Trade or Business?

Whether a foreign person is engaged in a U.S. trade or business is a factual question.  Characterization as a U.S. trade or business depends upon whether the activity rises to the level of a trade or business, whether a trade or business has sufficient connections to the United States, and whether the relationship between the foreign person and persons performing activities in the United States for the foreign person is sufficient to attribute those activities to the foreign person. Special rules govern whether trading in stock or securities or commodities constitutes the conduct of a U.S. trade or business.

Tax Treaties 

The United States is a signatory to more than 60 income tax treaties.  For eligible foreign persons, U.S. tax treaties restrict the application of net-basis U.S. taxation. Under each treaty, the United States is permitted to tax business profits only to the extent those profits are attributable to a U.S. permanent establishment of the foreign person. The threshold level of activities that constitute a permanent establishment is generally higher than the threshold level of activities that constitute a U.S. trade or business. For example, a permanent establishment typically requires the maintenance of a fixed place of business over a significant period of time.

Our Freeman Law interactive tax treaty map provides a link to tax treaty materials for each U.S. treaty partner:

Effectively Connected Income is Taxed on a “Net” Basis

The Tax Code allows deductions against effectively connected income and it is taxed at the graduated rates that apply to U.S. citizens and resident aliens or lesser rates under a tax treaty.

Taxable ECI is computed by taking into account deductions associated with the gross ECI. Regulations address the allocation and apportionment of deductions between ECI and other income. Specific rules provide for the allocation and apportionment of certain items, such as research expenditures, legal and accounting fees, income taxes, losses on dispositions of property, and net operating losses.

International and Offshore Tax Compliance Attorneys

Need help with tax issues? Contact us as soon as possible to discuss your rights and the ways we can assist in your defense. We handle all types of cases, including complex international & offshore tax compliance. Schedule a consultation or call (214) 984-3000 to discuss your international tax concerns or questions. 

This Insights blog is Part 2 of a 3-Part series focused on the unrelated business income tax rules for the nonprofit organization that is tax-exempt pursuant to section 501(c)(3) of the Internal Revenue Code (the “Code”).

Part 1—Tax Exemption and Unrelated Business Income Tax (UBIT): The Framework—provided an overview of the organizational and operational tests of section 501(c)(3) of the Code and alluded to the trigger for unrelated business income rules.

This Part 2 dives deeper into the unrelated business income tax rules.

Summary of Unrelated Business Income Tax Laws and Regulations

Generally, a tax-exempt organization must pay income tax on income classified as unrelated business income. 26 U.S.C. § 511(a). An unrelated trade or business is any trade or business, regularly carried on, the conduct of which is not substantially related to the organization’s exempt purpose. 26 U.S.C. § 513(a). Modifications, exclusions, and exceptions exist.

Section 512 of the Code contains several exceptions and about 20 modifications to general rule for taxation of unrelated business taxable income. Section 512 excludes from the definition of unrelated business taxable income from passive investments, royalties, and rent from real property and personal property rented with real property, provided no more than an incidental amount of the rent payment is allocated to the rental of the personal property.

The applicability of a particular exception or modification will depend on the numerous facts and circumstances of the income-driving trade or business in issue, the type of organization that conducts such trade or business, and other factors contained in or required by the Code and related Treasury Regulations.

General Rule of Unrelated Business Taxable Income

If an organization that is exempt from federal income taxes under section 501(a) of the Code produces income from an unrelated trade or business, that income is called unrelated business income and is taxable, unless a modification, exclusion or exception applies. See 26 U.S.C. §§ 511(a)(1), 512-514; see also IRS Unrelated Business Income Tax (providing guidance on the subject).

“Unrelated Trade or Business” and “Unrelated Trade or Business Taxable Income”

Generally, an activity is an unrelated business if the activity meets three requirements: (1) it is a trade or business, (2) it is regularly carried on and (3) it is not substantially related to furthering the exempt purposes of the organization.

Section 513 of the Code defines an unrelated trade or business as “any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under section 501[.]” See 26 U.S.C. § 513(a).

The term “unrelated business taxable income” means the gross income derived by any organization from any “unrelated trade or business” (as defined in section 513) regularly carried on by the organization, less applicable deductions connected with the carrying on of such trade or business, computed with the modifications in subsection 512(b). See 26 U.S.C. § 512(a)(1).

Regularly Carried On

Whether a trade or business for these purposes is “regularly carried on” is determined by evaluation of the frequency and continuity with which the activities productive of the income are conducted and the manner in which those activities are pursued. Specific business activities of an exempt organization will ordinarily be deemed to be “regularly carried on” if, for example, “they manifest a frequency and continuity, and are pursued in a manner, generally similar to comparable commercial activities of nonexempt organizations.” 26 C.F.R. § 1.513-1(c)(1).

What is “regular” from a timing or performance perspective depends on the industry involved, any non-exempt market performance of similar activities, and the type of activity. The Treasury Regulations provide these rules and examples:

Where income producing activities are of a kind normally conducted by nonexempt commercial organizations on a year-round basis, the conduct of such activities by an exempt organization over a period of only a few weeks does not constitute the regular carrying on of trade or business. For example, the operation of a sandwich stand by a hospital auxiliary for only 2 weeks at a state fair would not be the regular conduct of trade or business. However, the conduct of year-round business activities for one day each week would constitute the regular carrying on of trade or business. Thus, the operation of a commercial parking lot on Saturday of each week would be the regular conduct of trade or business. Where income producing activities are of a kind normally undertaken by nonexempt commercial organizations only on a seasonal basis, the conduct of such activities by an exempt organization during a significant portion of the season ordinarily constitutes the regular conduct of trade or business. For example, the operation of a track for horse racing for several weeks of a year would be considered the regular conduct of trade or business because it is usual to carry on such trade or business only during a particular season.

Id. at § 1.513-1(c)(2)(i).

Exceptions to “Unrelated Trade or Business”

Certain activities are expressly excepted from the meaning of “unrelated trade or business.” For the exceptions to apply, the organization and the activity producing the income must be evaluated.

For example, “unrelated trade or business” does not include (1) qualified fair or exposition public entertainment activities of certain organizations which regularly conduct, as one of its substantial exempt purposes, an agricultural and educational fair or exposition; (2) qualified convention and trade show activities that attract persons in an industry generally as well as members of the public for the purpose of displaying industry products or to simulate interest in the particular industry. Qualified hospital services, qualified bingo games, and, of course, certain pole-rental activities are also excluded from the meaning of “unrelated trade or business” for organizations described in these carve outs set forth in section 513. See id. at § 513(d)-(h).

Qualified sponsorship payments are also excepted from the meaning of “unrelated trade or business.” A “qualified sponsorship payment” is any payment made by any person engaged in a trade or business with respect to which there is no arrangement or expectation that such person will receive any substantial return benefit other than the use or acknowledgement of the name or logo of such person’s trade or business in connection with the activities of the organization that receives such payment. Limitations apply, such as conditioning the payment on factors relating to the degree of public exposure to a particular event. See id. at § 513(i)-(i)(3).

Modifications to “Unrelated Business Taxable Income”

“Except as otherwise provided in this subsection, the term “unrelated business taxable income” means the gross income derived by any organization from any unrelated trade or business (as defined in section 513) regularly carried on by it, less the deductions allowed . . . which are directly connected with the carrying on of such trade or business, both computed with the modifications provided in subsection (b).” 26 U.S.C. § 512(a)(1) (emphasis added).  Generally, gross income from an unrelated trade or business, and the applicable deductions related to that income, are computed the same way in which corporate income taxes are calculated. See 26 U.S.C. §§ 511(a) (corporate rates applicable), 162 (trade or business expenses), 167 (depreciation).

There are about 20 modifications contained in subsection 512(b). They include the following:

• Dividends and Interest. Subsection section 512(b)(1) excludes dividends, interest income, and payments with respect to securies loans, amounts received or accrued as consideration for entering into agreements to make loans, and annuities, and all deductions directly connected with such income.
• Royalties. Subsection 512(b)(2) excludes all royalties, and all deductions directly connected with such income.
• Rents Attributable to Real Property. Subsection 512(b)(3)(A)(i) excludes from unrelated business taxable income rents attributable to real property, provided that an exception to the exclusion does not apply, including the debt-financed property exception.
• Rents from Personal Property. Subsection 512(b)(3)(A)(ii) excludes from unrelated business taxable income all rents from personal property leased with such real property, if the rents attributable to such personal property are an incidental amount of the total rents received or accrued under the lease (and provided that an exception to the exclusion does not apply).
• Research. Income from research performed for any federal or state governmental agency, or from research performed by a college, university, or hospital for any person is excluded. id. at § 512(b)(7)-(9).
• $1,000 Deduction. With limited exception, the Code permits a specific deduction of $1,000 of any unrelated business taxable income. And, in the case of a diocese or convention of churches, there is also allowed, with respect to each individual church, a specific deduction equal to the lower of $1,000 or the gross income derived from any unrelated trade or business regularly carried on by such individual church.
• Controlled Entities and Receipts from Foreign Corporations. Subsection 512(b)(13) provides special rules and modifications to unrelated business taxable income for amounts received from controlled entities.

Exceptions to the Modifications Applicable to Real Property and Personal Property

In the case of personal property leased with real property (which is commonly referred to as a “mixed lease”) the rental income is excludable from unrelated business taxable income if the rents that are attributable to the personal property are not more than 10% of the total rents received under the lease. See 26 C.F.R. § 1.512(b)-1(C)(2)(ii)(b). Moreover, the exclusions from unrelated business taxable income for rental income in subsection 512(b)(3)(A) (i.e., rents from real property and personal property) shall not apply: (i) if more than 50 percent of the total rent received or accrued under the lease is attributable to personal property, or (ii) if the determination of the amount of such rent depends in whole or in part on the income or profits derived by any person from the property leased (other than an amount based on a fixed percentage or percentages of receipts or sales). See 26 U.S.C. § 512(b)(3)(B)(i).

Debt-Financed Property Exceptions to the Modifications

As noted above, subsection 512(b)(3)(A)(i) excludes from unrelated business taxable income rents attributable to real property. However, exceptions apply. Section 514 of the Code provides special (and complex) rules for inclusion of income derived from real property that is debt-financed. The term “debt-financed property” means any property which is held to produce income and with respect to which there is an acquisition indebtedness at any time during the taxable year. See id. at § 514(b)(1).

When income is derived through the use of borrowed funds, section 514 is triggered, and the income—while perhaps once excluded or modified for taxation purposes by section 511, 512, or 513—may be brought back into the taxable category. See id. at § 514(a)-(b).

If, for example, a church receives leases debt-financed property to a third party for a purpose that is not substantially related to the exempt purposes of the church, the rent from that activity is likely includable in unrelated business taxable income.

Similarly, if an exempt organization purchases securities with borrowed funds, the dividends or interest earned on those securities is likely subject to the unrelated business taxable income rules. (Exceptions apply, such as in the case of tax-exempt bond issuances or tax-exempt loans, but that is a whole other can of tax worms for another future blog.)

Exceptions to Unrelated Business Income Tax Rules

In addition to the modifications, section 513 of the Code expressly excepts any trade or business—

• in which substantially all the work in carrying on such trade or business is performed for the organization without compensation [e., a volunteer-run business]; or
• which is carried on by the organization primarily for the convenience of its members, students, patients, officers, or employees; or
• which is the selling of merchandise, substantially all of which has been received by the organization as gifts or contributions [e., sale of donated goods].

See id. at § 513(a)-(a)(3).

Closing of Part 2

That is a wrap for this Part 2 – Tax Exemption and Unrelated Business Income Tax (UBIT): Rules, Modifications and Exceptions. Stay tuned for Part 3 of this 3-Part series where we will dive deeper into these unrelated business income rules and what is meant by a trade or business that is “substantially related” to a tax-exempt organization’s exempt purposes. See Continuing Life Communities Thousand Oaks LLC v. Comm’r, T.C. Memo. 2022-31 |April 6, 2022 |Holmes, J. | Dkt. No. 4806-15 (“One way to think about tax law is to view it as a series of general rules qualified by exceptions, and exceptions to those exceptions, and exceptions to those exceptions to those exceptions.”).

Nonprofit and Exempt Organization Attorneys

Every nonprofit is different, that’s why we collaborate with our nonprofit clients to identify and meet their unique needs. Freeman Law represents associations & 501(c)(6) organizations, churches and other religious organizations, foundations, private foundations, 501(c)(3) organizations, and other nonprofit clients. While nonprofits encounter many of the same economic concerns and administrative challenges as any business, they also face many unique challenges. Schedule a consultation or call (214) 984-3000 to discuss your nonprofit concerns or questions. 

Recent developments, such as the Tax Cuts & Jobs Act (TCJA) and the OECD’s Base Erosion and Profits Shifting (BEPS) initiative, have forced multinational businesses to re-evaluate global strategies and the tax impact of doing business abroad.   Navigating the risk of a permanent establishment remains among the most important international tax risks.

While a nonresident alien or foreign corporation engaged in a trade or business in the United States is generally subject to taxation on its net taxable income that is effectively connected with the conduct of the U.S. trade or business, the rules are different (or at least, can be) when a resident of a treaty country conducts the business.  Where a tax treaty is applicable, the concept of a permanent establishment—and whether income is attributable to that permanent establishment—replaces the concept of effectively connected income as the governing standard.

Generally, a business enterprise that is a resident in one treaty country will only be taxed on its business profits by the other country if it carries on its business operations through a permanent establishment.  Where a permanent establishment exists, the business enterprise is potentially subject to tax by the host country to the extent of its profits that are allocable to the permanent establishment.

Whether a permanent establishment exists generally depends upon whether the business conducts activities that are attributable to a fixed place of business in the treaty country.  Some categories of locations and activities give rise to a “per se” permanent establishment.  A business may also have a deemed permanent establishment—regardless of whether it has a fixed place of business in the treaty country—as a result of its contractual activities.

What is a Permanent Establishment?

As used in the U.S. model treaty, a permanent establishment is a fixed place of business through which the taxpayer’s business is wholly or partly carried on.

Generally, the place of business must be “fixed” in the sense of a particular building or physical location through which the enterprise conducts its business. It must, however, be foreseeable that the enterprise’s use of the building or other physical location will be more than temporary.

A permanent establishment includes (though is not at all limited to) the following examples:

• a place of management,
• a branch,
• an office,
• a factory,
• a workshop, and
• a mine, oil or gas well, quarry or other place of extraction of natural resources 

What is a “Branch”?

The Tax Court has addressed the meaning of the term “branch,” at least for purposes of section 954(d)(d), providing that it should be given its customary meaning as a “[d]ivision, office, or other unit of business located at a different location from [the] main office or headquarters” or as an office in a different location than the parent company. If the taxpayer maintains a branch in a treaty county, it has a PE in that county.

Foreign Agents and Permanent Establishments

A foreign enterprise will also be considered to have a U.S. permanent establishment as a result of activities undertaken on its behalf by a dependent agent who has and habitually exercises in the United States an authority to conclude relevant contracts that are binding on the foreign enterprise. A foreign enterprise will not, however, be deemed to have a permanent establishment in the United States merely because it carries on business in the United States through a broker, general commission agent, or any other agent of an independent status, provided that such person is acting in the ordinary course of his business as an independent agent.

Activities that are Generally Not a Permanent Establishment

U.S. tax treaties typically provide that several common categories of activities will generally not be classified as a “permanent establishment.”  Those categories generally include the following:

1. the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise;
2. the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery;
3. the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise;
4. the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or of collecting information, for the enterprise;
5. the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character;
6. the maintenance of a fixed place of business solely for any combination of the activities mentioned in subparagraphs (a) through (e) of this paragraph, provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character.

The Impact of a Permanent Establishment

A foreign enterprise conducting business in the United States through a permanent establishment will, under a tax treaty, be taxed in the United States on its profits attributable to that permanent establishment.

This treatment is consistent across the OECD model treaty, the U.N. model treaty, and the U.S. model treaty:

• The OECD model tax treaty provides that the profits of an enterprise “shall be taxable” only in the country of which the enterprise is a national “unless the enterprise carries on business in [another country] through a permanent establishment situated therein.”[1]
• The UN Model Treaty similarly provides that the profits of an enterprise are taxable in a country only if “the enterprise carries on business in [that country] through a permanent establishment situated therein.” [2]
• The U.S. Model Tax Treaty contains similar provisions barring taxation absent a permanent establishment. [3]

International and Offshore Tax Compliance Attorneys

Need help with tax issues? Contact us as soon as possible to discuss your rights and the ways we can assist in your defense. We handle all types of cases, including complex international & offshore tax compliance. Schedule a consultation or call (214) 984-3000 to discuss your international tax concerns or questions. 

[1] OECD, Model Tax Convention on Income and on Capital: Condensed Version 2017, art. 7(1).

[2] UN, Model Double Taxation Convention Between Developed and Developing Countries, art. 7(1).

[3] Compare United States Model Income Tax Convention, art. 7 (“Profits of an enterprise of a Contracting State shall be taxable only in that Contracting State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein.”) with U.S.-UK Tax Treaty, art. 7 (“The business profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the business profits of the enterprise may be taxed in the other State but only so much of them as are attributable to that permanent establishment.”).

luThe European Commission recently ordered Ireland to recover a record-breaking sum from Apple—over 13 billion euros—for what it believes was illegal state aid.  The Commission, following a years-long state-aid investigation, determined that Ireland provided Apple with improper state aid in the form of tax benefits through tax rulings dating back to 1991 that, it claims, artificially lowered Apple’s taxable profits.  The Commission determined that the tax benefits were illegal under EU state-aid rules, giving Apple an improper advantage over other EU businesses.

The EC’s ruling specifically found that the tax benefits at issue were in breach of Article 107(1) of the Treaty on the Functioning of the European Union (TFEU), which provides that:

any aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favoring certain undertakings or the production of certain goods shall, in so far as it affects trade between Member States, be incompatible with the internal market.

Consolidated Version of the Treaty on the Functioning of the European Union art. 107(1), 2016 O.J. C 202/47. The State aid rules are designed to “ensure that the functioning of [the] internal [EU] market is not distorted by anticompetitive behavior . . . favouring some actors to the detriment of others.” Commission Communication COM/2012/209, EU State Aid Modernisation (SAM), ¶ 2 (May 8, 2012).

According to the Commission, the tax rulings that were issued to Apple have “substantially and artificially lowered the tax paid by Apple in Ireland since 1991.” The Commission, which has the authority to order recovery of illegal state aid going back ten years from the Commission’s first request for information (which took place in 2013), ordered Ireland to recover unpaid taxes from Apple for the years 2003 to 2014.

According to the EC’s order:

The Commission’s investigation into Ireland and Apple is not a new phenomenon.  It has been actively investigating the tax ruling practices of its member states since June 2013.  In October 2015, for instance, the Commission found that Luxembourg and the Netherlands had improperly granted selective tax advantages to Fiat and Starbucks.  And in January 2016, it announced that Belgium had improperly granted selective tax benefits to least 35 multinationals, mainly from the EU, under its “excess profit” tax scheme. The Commission also has two ongoing investigations into tax rulings by Luxembourg with respect to Amazon and McDonald’s.

The Commission has received some pushback and criticism from U.S. parties, including the U.S. Treasury Department, for its ruling.  For instance, a report from the Tax Foundation cited the following collection of statements from Congressmen, mostly critical of the EC’s ruling:

Lunch Links: European Commission Slammed by Congress Over Apple/Ireland Tax Decision—available here.

What is particularly interesting, though, is that the Commission’s investigation into Apple appears to have actually been triggered by U.S. Senate investigations/hearings.  Indeed, the European Competition Commissioner, in a statement last week, said that the “story of the Apple investigation began in the United States”—not in Europe.  “[I]t was their [the U.S. Senate’s] investigation into Apple — and U.S. transparency rules — that tipped us off that the company might have received state aid.”

Back in the early part of 2013, the Senate’s Permanent Subcommittee on Investigations held hearings to examine how Apple was shifting profits away from the United States and into Ireland.  An excerpt from the Permanent Subcommittee on Investigation’s report gives some background on the investigation and the Subcommittee’s findings:

Senate Permanent Subcommittee on Investigations Memorandum, Offshore Profit Shifting and the U.S. Tax Code – Part 2 (Apple Inc.).  Apparently this U.S. senate investigation triggered the probe by the European Commission, which began a few months later.

At any rate, both Apple and Ireland intend to appeal the Commission’s ruling.  Stay tuned for more to come—on this case and on several others that will impact U.S.-based companies.

Expert Tax Defense Attorneys

Need help with tax issues?  Contact us as soon as possible to discuss your rights and the ways we can assist in your defense. We handle all types of cases, including complex international & offshore tax compliance.  Schedule a Consultation Today!

Why is the Concept of a Permanent Establishment Important?

Tax treaties typically provide that the business profits of a foreign business or taxpayer are taxable in the host state only to the extent that the enterprise/taxpayer has a permanent establishment in the host state to which the profits are attributable.

What is a Permanent Establishment?

In general, under a treaty, a permanent establishment is a fixed place of business through which the business of an enterprise is carried on in whole or in part. A permanent establishment generally includes a place of management, a branch, an office, a factory, a workshop, a mine, an oil or gas well, a quarry, or other places of extraction of natural resources.

Thus, if a person, other than an independent agent, is acting on behalf of an enterprise and has and habitually exercises the authority in a country to conclude contracts in the name of an enterprise of the other country, the enterprise generally will be deemed to have a permanent establishment in the first country in respect of any activities that person undertakes for the enterprise. Under the U.S. model and the OECD model, this rule does not apply where the contracting authority is limited to those activities described above, such as storage, display, or delivery of merchandise which are excluded from the definition of a permanent establishment.  A foreign enterprise will not be deemed to have a permanent establishment in the United States merely because it carries on business in the United States through a broker, general commission agent, or any other agent of an independent status, provided that such person is acting in the ordinary course of his business as an independent agent.

What about a subsidiary?

It is generally accepted that the existence of a subsidiary company does not, in and of itself, constitute a permanent establishment of its parent company.

However, any space or premises belonging to the subsidiary that is at the disposal of the parent company and that constitutes a fixed place of business through which the parent carries on its own business may constitute a permanent establishment of the parent.

An example is that of an employee of a company who, for a long period of time, is allowed to use an office in the headquarters of another company (e.g., a newly acquired subsidiary) in order to ensure that the latter company complies with its obligations under contracts concluded with the former company. In that case, the employee is carrying on activities related to the business of the former company and the office that is at his disposal at the headquarters of the other company may constitute a permanent establishment of his employer, provided that the office is at his disposal for a sufficiently long period of time so as to constitute a “fixed place of business.

Must the Place of Business be Fixed?

A place of business must be a “fixed” one.  That is, there must be a link between the place of business and a specific geographical point. (Geographically Fixed).

In addition, a permanent establishment will generally only be deemed to exist the place of business has a certain degree of permanency, i.e., if it is not of a purely temporary nature. (Temporally Fixed)

A place of business may, however, constitute a permanent establishment even though it exists, in practice, only for a very short period of time. Permanent establishments normally have not been considered to exist where a business had been carried on in a country through a place of business that was maintained for less than six months (conversely, there are a number of cases where a permanent establishment has been considered to exist where the place of business was maintained for a period longer than six months).

Temporary interruptions of activities do not cause a permanent establishment to cease to exist.

A nonresident alien individual or a foreign corporation is not considered to have an office or other fixed place of business merely because such alien individual or foreign corporation uses another person’s office or other fixed places of business, whether or not the office or place of business of a related person, through which to transact a trade or business, if the trade or business activities of the alien individual or foreign corporation in that office or other fixed place of business are relatively sporadic or infrequent, taking into account the overall needs and conduct of the trade or business.

See Commentary on Article 5(1) of the OECD Model; CIR v. Consolidated Premium Iron Ores, Limited, 265 F.2d 320 (6th Cir. 1959); Treas. Reg. Section 1.864-7(b)(2).

What are Recent Developments in the Concept of a Permanent Establishment?

The OECD’s Action Plan on Base Erosion and Profit Shifting (BEPS Action Plan) calls for a review of the PE definition to prevent the use of common tax avoidance strategies that are used to circumvent the existing PE definition.  Included among the targeted arrangements are arrangements through which taxpayers replace subsidiaries that traditionally acted as distributors by commissionaire arrangements.  The OECD believes that changes to the PE definition are necessary to prevent the exploitation of certain exceptions to the PE definition provided under Art. 5(4) of the OECD Model Tax Convention (2014), particularly in the digital economy.

Business Divorce Litigation

Our trial attorneys represent clients in complex business divorce litigation, including majority and minority owners and investors in private companies across Texas.

• We are a sophisticated boutique trial firm hyper-focused on advancing our clients’ litigation interests in business divorces.
• Our trial attorneys have been recognized nationally and internationally, including being named to U.S. News and World Report’s Best Lawyers in America list, Super Lawyers, and recognized by Chambers & Partners as among the leading attorneys in the United States, as well as recognized as the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas.
• Our litigation attorneys include former government trial attorneys, former law clerks, federal judges, law professors, and dual-credentialed CPAs with deep experience in complex financial reporting, accounting, and fraud. Nearly one-third of our attorneys serve as law professors at tier-one law schools.

Business Litigation is Our Business

Freeman is a “go-to” business divorce litigation firm—trial counsel for the cases that count. Our trial attorneys bring significant experience in complex business relationships and agreements, as well as breach-of-fiduciary-duty matters, representing owners and investors in private companies. Well-versed in high-stakes litigation, our attorneys are trial-ready and battle-tested; we’re ready when you are.

Business Divorce Litigation

Business divorces present unique and complex considerations. They may be influenced by an array of business entities, complex agreements and provisions, and conflicts. Our attorneys bring a wealth of business and accounting experience, combined with extensive experience litigating complex disputes.

Unique Litigation Insights

Our attorneys bring a wealth of tax litigation and white-collar dispute experience, providing a uniquely insightful perspective in business divorce disputes. Our attorneys often forensically evaluate tax returns, uncovering analytical insights and following the money. Our unique and in-depth understanding of partnership and company agreements, capital accounts, and partnership accounting positions us to forensically analyze business divorce disputes with clinical insight, seeing issues that others miss.

We Try Cases. We Win Cases

Freeman is a sophisticated trial boutique, hyper focused on advancing our clients’ litigation interests. We are committed to delivering world-class counsel in the courtroom using bold, tactical, state-of-the-art approaches to litigation. Our attorneys bring big-firm talent, think-tank intellect, and analytical precision.

Clients need a winning strategy. Our experienced litigators employ creative, trial-tested strategies that position clients for courtroom success. We craft detailed strategies and trial plans designed to convey the most impactful, psychologically moving themes and storylines—moving juries to action.

Our attorneys are not just litigators—they are trial attorneys. We instill and cultivate a difference, creating a focus on the end-game from the beginning.

Clear and Focused

We are client-focused problem solvers. Tireless advocates that work best under pressure, we are committed for the long haul, and relentless in our pursuit of justice.

Our award-winning attorneys make the complex clear, bringing the issues and facts into focus with perspective and clarity.

Strategic

The right move at the right time can mean the difference between the right outcome and the wrong one. Strategic victories are no accident. We begin thinking through the end game from day one. And we have tactical trial experience built on strategic approaches that keep the big picture in mind.

Comprehensive Business Divorce Representation

Freeman’s skilled trial counsel regularly resolves sophisticated business disputes, representing clients in courthouses and arbitration throughout Texas and across the country. We are business-minded and client-centric. Our client’s objectives drive our strategy. We offer skilled and practical insight to vindicate and defend our clients and their causes during high-stakes disputes.

We represent clients in complex business divorces, offering practical, innovative solutions to complex issues. Our business divorce representations include:

• Closely-held business disputes
• “Buy-sell” agreement disputes
• Breaches of partnership fiduciary duties
• Embezzlement
• Books-and-records requests
• Business valuation disputes

The Right Litigation Model

We were built to take on anything—from the largest law firms to the Department of Justice. And we are rewriting the odds in complex, high-stakes litigation one case at a time. We leverage technological advances; eschew wasteful staffing; and employ collaborative, end-result-driven litigation systems that avoid knowledge segregation and enhance ideation.

We represent a paradigm shift—a change in the historic litigation model. We believe that the trial boutique model simply outperforms the large-firm approach. The ability to scale trial preparation has never been greater. Intelligently designed law firm models can not only go up against the largest firms and parties, they can—and should—win. Indeed, the boutique model offers advantages that larger firm models simply can’t match.

Authentic

We pledge transparency and authenticity, bringing candid, pull-no-punches trial strategies that home-in on the issues that matter. Though often overlooked, authenticity is the single most impactful virtue in a trial lawyer. Without it, the best-laid plans and preparations are lost. When the issues are make-or-break, trust our attorneys to see them through.

Legal acumen

Our attorneys bring big-firm talent and backgrounds, think-tank intellect, and analytical precision. Our trial attorneys are not only skilled advocates, they are steeped in substantive expertise gained from years of experience in the trenches. We provide sophisticated representation and penetrating legal acumen.

Driven

Our firm’s founding principles and vision of exceptionalism permeate throughout our litigation and trial practice. We are driven by uncompromising attention to detail and a desire to exceed expectations.

Ready for the Moments that Matter

Every Freeman attorney participates in the firm’s Trial College, a rigorous training program focused on trial advocacy and procedure. Our attorneys are experienced, trial-honed, and ready for the moments that matter.

Any Time, Any Place

We eschew a siloed-specialist focus; rather, we employ a cross-functional, integrated multi-disciplinary and team approach to the practice of law and litigation. Siloed, narrowly focused attorneys inevitably view client’s disputes through an every-problem-is-a-nail framework, missing the forest for the trees. We cultivate judgment and an appreciation for the bigger picture. After all, litigation, though at times necessary, is a means to an end.

Bet-The-Company Business Divorces

Litigation can represent an existential threat. When business divorces threaten mission-critical interests, jeopardizing years of work and investment, clients turn to our trial attorneys and our insightful counsel. When everything is on the line, Freeman steps up to it for you.

In an evolving and increasingly complex environment, businesses face unprecedented challenges and risks. Freeman represents clients in complex business disputes, including fraud, breach-of-contract, fiduciary duty, and other disputes. With our historic background in white-collar litigation—both civil and criminal—we are uniquely positioned to represent clients in matters involving embezzlement, fraudulent transfers, fiduciary breaches, and other complex financial disputes.

Our skilled trial counsel regularly resolve sophisticated business disputes, representing clients in courthouses and arbitration throughout Texas and across the country. Many matters entrusted to us require managing outside factors and mitigating collateral consequences, such as parallel regulatory investigations. We offer skilled and practical insight to navigate our clients and their causes during high-stakes disputes.

Even successful long-term business relationships can break down and suffer from “irreconcilable differences.” When this occurs between co-owners of business entities, they may desire to undertake a unilateral or mutually agreed “business divorce.” There are complex legal, tax, accounting and other issues at play in these situations, and success requires a team that understands these multi-disciplinary issues.

Co-owners desiring to separate their investment from a going concern may not always be able to withdraw or separate their capital from the business. A threshold consideration for owners of a minority stake is whether the owner has a withdrawal right, a right to sell the minority interest to a third party, or a right to force a dissolution, redemption, or a buyout. Alternatively, a majority owner might prefer to continue to manage and control a business without being encumbered by a bothersome minority interest owner. Preserving value can require ensuring that offers and other conduct in connection with a buyout (or a “squeeze-out” attempt) are consistent with any fiduciary duties that apply because of an owner’s position in the company, or as a result of special circumstances.

Just like with a marriage, a business divorce may be brought on by a number of issues, including: disputes regarding personal or business issues; inactive or unproductive business partners, and the financial or personal problems of an owner. These situations can impact a company’s ability to operate and its owners’ futures and livelihoods. In a business divorce, the goal should be to reach the best resolution as possible.

Even when owners of a business agree in principle that they desire to separate subject to finalization of detailed agreements, a solid understanding of background law, negotiation dynamics, and a client’s business and personal interests are key to achieving the best price or distribution of assets possible. Freeman Law’s well-rounded team of litigators, tax, and transactional lawyers, including dual credential attorney-CPAs understand these concerns. Common issues to address when seeking to split up a business involve the following, for example: (1) the value of the business and whether to hire expert appraisers; (2) employee relationships, contracts, and whether any necessary confidentiality agreements are in place, (3) whether to conduct a forensic investigation into key or all aspects of the business; (4) tax issues and planning; (5) ownership of intellectual property; (5) any terms and conditions governing future collaboration or business competition; and (6) determining how to deal with unresolved issues such as outstanding contracts or unresolved liabilities or litigation.

Our firm stands ready to litigate business divorce issues, and when appropriate, to negotiate resolutions and business divorce agreements (or vice versa). Our skilled trial counsel regularly resolve sophisticated business disputes, representing clients in courthouses and arbitration throughout Texas and across the country.

We are trial boutique, positioned to represent clients in business divorce litigation.  We are:

• Recognized and Sophisticated.We are a sophisticated boutique trial firm, hyper focused on advancing our clients’ litigation interests in litigation between business owners.  Our trial attorneys have been recognized nationally and internationally, including being named to U.S. News and World Report’s Best Lawyers in America list, Super Lawyers, and recognized by Chambers & Partners as among the leading attorneys in the United States, as well as recognized as the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas.
• Multi-Disciplinary and Qualified.Our litigation attorneys include former government trial attorneys, former law clerks to federal judges, law professors, and dual-credentialed CPAs with deep experience in complex financial reporting, accounting, and fraud.  Nearly one-third of our attorneys serve as law professors at tier-one law schools.
• Freeman is a “Go-To” Litigation Firm—Trial Counsel for the Cases that Count. Our business divorce attorneys are versed in business litigation and disputes between co-owners. Well-versed in high-stakes litigation, our attorneys are trial-ready and battle tested; we’re ready when you are.
• We Try Cases.  We Win Cases. We are committed to delivering world-class counsel in the courtroom using bold, tactical, state-of-the-art approaches to litigation.  Our attorneys bring big-firm talent, think-tank intellect, and analytical precision.
• Strategic. Our experienced litigators employ creative, trial-tested strategies that position clients for courtroom success.  We craft detailed strategies and trial plans designed to convey the most impactful, psychologically moving themes and storylines—moving juries to action.
• Clear and Focused. We are client-focused problem solvers. Tireless advocates that work best under pressure, we are committed for the long haul, and relentless in our pursuit of justice. Our award-winning attorneys make the complex clear, bringing the issues and facts into focus with perspective and clarity.
• Legal acumen. Our attorneys bring big-firm talent and backgrounds, think-tank intellect, and analytical precision.  Our trial attorneys are not only skilled advocates, they are steeped in substantive expertise gained from years of experience in the trenches.  We provide sophisticated representation and penetrating legal acumen.
• Driven. Our firm’s founding principles and vision of exceptionalism permeate throughout our litigation and trial practice.  We are driven by uncompromising attention to detail and a desire to exceed expectations.
• Ready for the Moments that Matter. Every Freeman attorney participates in the firm’s Trial College, a rigorous training program focused on trial advocacy and procedure.  Our attorneys are experienced, trial-honed, and ready for the moments that matter.

U.S. taxpayers are generally taxed on their worldwide income.  But what happens when that income is also taxed by another country?  The Internal Revenue Code’s primary mechanism to alleviate this double taxation of income is the foreign tax credit.  The foreign tax credit provides U.S. taxpayers who owe taxes to a foreign country with a credit against their U.S. tax equal to the amount of qualifying foreign taxes paid or accrued.

Generally, U.S. taxpayers are entitled to a credit for income, war profits, and excess profits taxes paid or accrued during a tax year to any foreign country or U.S. possession, or any political subdivision of the country or possession. U.S. taxpayers living in certain treaty countries may be able to take an additional foreign tax credit for the foreign tax imposed on certain items of income.  In addition, note that taxpayers making an election under section 962—to be taxed at corporate rates on certain income from a controlled foreign corporation (CFC)—are required to include that income in gross income under sections 951(a) and 951A(a) and may be entitled to claim the credit based on their share of foreign taxes paid or accrued by the CFC.

Foreign Tax Credit Basics

The foreign tax credit was first introduced in 1918. Its purpose is and was to alleviate the double taxation that occurs when a U.S. person’s income is subject to taxation by the United States and a foreign country.  The United States cedes its own taxing rights, however, only where the foreign country has the primary right to tax income. See Bowring v. Comm’r, 27 B.T.A. 449, 459 (1932) (“In the case of the citizen and resident alien, the United States recognizes the primary right of the foreign government to tax income from sources therein . . . and accordingly, grants a credit.”).

Not all foreign taxes qualify for foreign tax credit treatment.  Section 901 allows a credit only for income, war profits, and excess profits taxes.  In other words, not all foreign taxes that may be imposed by a foreign jurisdiction—such as value-added taxes or sales taxes, or for other levies such as tariffs—will qualify for the foreign tax credit.  Other taxes, such as foreign real and personal property taxes, do not qualify, although a taxpayer may be entitled to deduct these taxes.

The foreign tax credit applies only to foreign-source income.  That is, the foreign tax credit can only reduce U.S. taxes on foreign source income; it cannot reduce U.S. taxes paid on U.S. source income.

U.S. taxpayers can generally elect whether to utilize the amount of any qualified foreign taxes paid or accrued during the year as a foreign tax credit or as a deduction.  With some exceptions, the treatment elected applies to all qualified foreign taxes.

What Taxes Qualify for the Foreign Tax Credit?

Foreign taxes must satisfy the following criteria to qualify for the foreign tax credit:

1. The taxpayer must have paid or accrued the tax.
2. The tax must be an income tax or in lieu of an income tax.
3. The tax must be the legal amount owed in foreign tax liability.
4. The tax must be imposed on the taxpayer, and the taxpayer must be legally obligated to pay it.

The following taxes generally do not qualify for a foreign tax credit:

• Taxes on excluded income (such as the foreign earned income exclusion),
• Taxes that can only be taken as an itemized deduction,
• Taxes on foreign mineral income,
• Taxes from international boycott operations,
• Taxes paid to certain foreign countries,[1]
• A portion of taxes on combined foreign oil and gas income,[2]
• Taxes of U.S. persons controlling foreign corporations and partnerships who fail to file required information returns,
• Taxes related to a foreign tax splitting event,
• The disqualified portion of any foreign tax paid or accrued in connection with a covered asset acquisition,[3] and
• Social security taxes paid or accrued to a foreign country with which the United States has a social security agreement.

Taxes Paid or Accrued

Section 901 allows a credit for foreign income taxes in either the year the taxes are paid or the year the taxes accrue, in accordance with the taxpayer’s method of accounting for such taxes.

Taxpayers who use an accrual method of accounting can, therefore, claim the credit only in the year in which they accrue the tax.  Generally, foreign taxes accrue when all the events have taken place that fix the amount of the tax and your liability to pay it.[4]

Thus, if a taxpayer is contesting the foreign tax liability, the taxpayer generally cannot accrue the liability and take a credit until the amount of foreign tax due is finally determined. However, if a taxpayer chooses to pay the tax liability being contested, if other criteria are satisfied, they may take a credit for the amount paid before a final determination of foreign tax liability is made.

Taxpayers reporting under the cash method of accounting can take the credit either in the year paid or accrued.

Note that the amount of tax withheld by a foreign country is often not entirely creditable.

The Tax Must be an Income Tax (or a Tax in Lieu of Income Tax)

In general, only income, war profits, and excess profits taxes (income taxes) qualify for the foreign tax credit. Foreign taxes on wages, dividends, interest, and royalties qualify for the credit in most cases. Furthermore, foreign taxes on income can qualify even though they are not imposed under an income tax law if the tax is in lieu of an income, war profits, or excess profits tax.

In order to constitute an income tax for U.S. tax purposes, the base of a foreign tax must conform in essential respects to the determination of taxable income for Federal income tax purposes. See, for example, Keasbey & Mattison Co. v. Rothensies, 133 F.2d 894, 895 (3d Cir. 1943) (holding that the criteria prescribed by U.S. revenue laws are determinative of the meaning of the term “income taxes” in applying the former version of section 901); and Comm’r v. American Metal Co., 221 F.2d 134, 137 (2d Cir. 1955) (providing that “the determinative question is ‘whether the foreign tax is the substantial equivalent of an ‘income tax’ as that term is understood in the United States’”).

A foreign levy is an income tax only if it meets both of the following requirements:

• It is a tax; that is, the taxpayer is required to pay it and receives no specific economic benefit from paying it.
• The predominant character of the tax is that of an income tax in the U.S. sense.

A foreign levy is a tax in lieu of an income tax only if it meets both of the following requirements.

• It is not payment for a specific economic benefit.
• The tax is imposed in place of, and not in addition to, an income tax otherwise generally imposed.

The Tax Must Be the Legal and Actual Foreign Tax Liability

The amount of foreign tax that qualifies is not necessarily the amount of tax withheld by the foreign country. Only the legal and actual foreign tax liability that is paid or accrued during the year qualifies for the credit.  Thus, a taxpayer cannot take a foreign tax credit for income taxes paid to a foreign country if it is reasonably certain the amount will be refunded, credited, rebated, abated, or forgiven if a claim is made.  Likewise, if a tax payment to a foreign country gives rise to a subsidy, the tax does not qualify for the foreign tax credit.

Taxpayers Eligible for the Foreign Tax Credit

US persons and tax residents are generally eligible for the foreign tax credit. Nonresident aliens and foreign corporations are only eligible for the foreign tax credit if they conduct business or trade within the U.S. and owe tax on effectively connected income (“ECI”).

Limitations on the Foreign Tax Credit

The tax laws impose limitations on the amount of foreign tax credit allowed. The foreign tax credit is, for example, limited to the amount of tax liability owed.

In addition, a foreign tax credit cannot be used to reduce U.S. taxes on income that is unrelated to the foreign income. Thus, separate income limitations are calculated for each of the following categories:

• Passive Income[5]
• General Income
• Foreign Branch Income[6]
• Global Intangible Low Taxed Income[7]
• Foreign Sourced Income from Sanctioned Countries
• Income resourced by tax treaties[8]
• Lump-sum distributions

Under IRC 904(a), taxes that are paid or deemed paid in a given year, but that are not utilized because they exceed the limitation of §904(a), can be carried back one year and carried forward 10 years. Taxes that are carried back or forward to another taxable year must be credited and cannot be deducted in the carryback or carryover year.  Other limitations may also apply.  The carry forward treatment is performed on a category-by-category basis to the extent that there is foreign tax credit limitation equal to or greater than the foreign tax credits paid or accrued in the carryover or carryback year or carried over from earlier taxable years.

How to Claim the Foreign Tax Credit

Individuals, estates, and trusts can claim a credit by filing Form 1116 if they paid or accrued foreign taxes. Corporations must file a separate Form 1118 to claim their foreign tax credit.

Alternatively, individual taxpayers may elect to deduct the foreign taxes.

The IRS allows for an extended period to amend previous tax returns and file a claim for a refund of taxes paid if the taxpayer did not initially claim a foreign tax credit.

International and Offshore Tax Compliance Attorneys

Need help with tax issues? Contact us as soon as possible to discuss your rights and the ways we can assist in your defense. We handle all types of cases, including complex international & offshore tax compliance. Schedule a consultation or call (214) 984-3000 to discuss your international tax concerns or questions. 

[1] These countries are those designated by the Secretary of State as countries that repeatedly provide support for acts of international terrorism, countries with which the United States doesn’t have or doesn’t conduct diplomatic relations, or countries whose governments aren’t recognized by the United States and aren’t otherwise eligible to purchase defense articles or services under the Arms Export Control Act.

[2] This includes taxes paid or accrued to a foreign country in connection with the purchase or sale of oil or gas extracted in that country if the taxpayer doesn’t have an economic interest in the oil or gas, and the purchase price or sales price is different from the fair market value of the oil or gas at the time of the purchase or sale.

[3] Covered asset acquisitions include certain acquisitions that result in a stepped-up basis for U.S. tax purposes.

[4] Regardless of the year in which the credit is allowed, the taxpayer must both owe and actually remit the foreign income tax to be entitled to a foreign tax credit for such tax. The taxpayer’s liability for the tax may become fixed and determinable in a different taxable year than that in which the tax is remitted, so that the taxpayer’s entitlement to the credit may be perfected in a taxable year after the taxable year in which the credit is allowed.

[5] Passive income generally includes dividends, interest, royalties, rents, annuities, excess of gains over losses from the sale of property that produces such income or of non-income-producing investment property, and excess of gains over losses from foreign currency or commodities transactions. Capital gains not related to the active conduct of a trade or business are also generally passive income.

Passive income doesn’t include export financing interest, active business rents and royalties, or high-taxed income. High-taxed income is income if the foreign taxes you paid on the income (after allocation of expenses) exceed the highest U.S. tax that can be imposed on the income.

Specified passive category income.  Dividends from a domestic international sales corporation (DISC) or former DISC to the extent they are treated as foreign source income, and certain distributions from a former foreign sales corporation (FSC) are specified passive category income.

[6] Foreign branch category income consists of the business profits of U.S. persons that are attributable to one or more qualified business units (QBUs) in one or more foreign countries. Foreign branch category income doesn’t include any passive category income.

[7] Section 951A category income includes any amount included in gross income under section 951A (other than passive category income). Section 951A category income is otherwise referred to as global intangible low-taxed income (GILTI) and is included by U.S. shareholders of certain CFCs.

[8] See sections 865(h), 904(d)(6), and 904(h)(10) and the regulations under those sections (including 1.904-4(k)) for any grouping rules and other exceptions.

Just before the turn of the new year, Congress passed—and the president signed—the Tax Cuts and Jobs Act of 2017 (“TCJA”).  The TCJA represents the most extensive rewrite of the U.S. tax code in over 30 years.  The new act contains a number of important provisions that will impact business tax planning for years to come.  Below are some highlights from the business-related provisions that practitioners need to know.

21% Corporate Rate. The new act eliminates the progressive corporate tax rate system, which imposed a 35-percent maximum tax rate.  In its place, it provides a flat 21-percent corporate rate.  This change, which is not set to phase out, will play a significant role in choice-of-entity decisions.

Corporate Alternative Minimum Tax.  The new law repeals the corporate Alternative Minimum Tax for tax years beginning after December 31, 2017.

Dividend Received Deduction. The TCJA reduces the general corporate dividends received deduction rates.  Existing law generally provides corporate taxpayers with a dividend received deduction equal to 70 percent of dividends received from another corporation; 80 percent of dividends received from a 20-percent owned corporation; and 100 percent of dividends received from a corporation that is a member of the same affiliated group.  The new act reduces the general corporate dividends received deduction to 50 percent, and reduces the deduction applicable to 20-percent owned corporations to 65 percent.

Cost Recovery.  The new act allows for first-year “bonus” depreciation of 100 percent of the cost of qualifying property.  The 100-percent bonus depreciation rate is phased down to 80 percent beginning in 2023 and is ultimately phased out by 2027.  Notably, under the new act, used property that was not previously used by the taxpayer and that is not acquired from a related party may be eligible for bonus depreciation.

The new act also expands the availability of section 179 expensing, increasing the maximum amount that can be deducted under section 179 to $1 million and raising the dollar-for-dollar phase-out threshold to $2,500,000.

Net Operating Losses. The new law limits future net operating loss deductions to 80 percent of taxable income with respect to losses arising in tax years that begin after December 31, 2017.  Existing law generally provides for a two-year carryback and 20-year carryforward for NOLs.  The new law, however, does not allow for carrybacks with respect to losses arising after December 31, 2017.  Instead, it allows for an indefinite carryforward period.  Thus, taxpayers will be required to separately track NOLs from prior periods.

Section 174 Research and Experimentation.  The new act provides that research and experimental expenditures incurred in tax years beginning after December 31, 2021 must be capitalized and amortized over a five-year period.  These changes mark a significant break from current law, which permits taxpayers to immediately expense, amortize, or capitalize such expenditures.  In addition, under the new law, certain research and experimental expenditures that are attributable to research conducted outside the United States are required to be capitalized and amortized over a 15-year period.

Accounting Methods. The act expands the availability of the cash method of accounting for corporations with average gross receipts over a three-year period that do not exceed $25 million.  It also eliminates the requirement to comply with the inventory tracking rules and the Section 263A Uniform Capitalization rules for producers and resellers that meet the $25 million test.

Limitation on Net Interest Deduction.  The new act replaces the “Earnings Stripping Rules” under section 163(j).  In their place, it provides a new limitation on deductible interest.  The new limitation disallows a deduction for net business interest expense in excess of 30 percent of adjusted taxable income plus floor plan financing interest. However, the new limitation does not apply to taxpayers that have average annual gross receipts of less than $25 million. Notably, certain taxpayers, such as certain real estate businesses and farming businesses, may elect out of the interest expense limitation.  Such electing businesses are required to use the alternative depreciation system with respect to certain property.

Excessive Employee Remuneration.   The TCJA expands and strengthens the section 162(m) limitation on the deduction of compensation paid by publicly traded corporate employers to covered employees. The act expands the definition of “covered employee” to include both the principal executive officer and principal financial officer, as well as the three most highly compensated officers for the tax year required to be reported on the company’s proxy statement. It also adopts a new once-a-covered-employee, always-a-covered-employee rule.  Perhaps most notably, the act eliminates the exception for commissions and performance-based compensation.

20% Deduction for Combined Qualified Business Income.  The TCJA provides for a deduction, under new Code section 199A, of up to 20 percent of certain pass-through income.  The deduction is designed to provide relief to owners of pass-through businesses, which include partnerships, S-corporations, and sole proprietorships.  Notably, the deduction phases out after 2025, a consideration that may factor into the choice-of-entity calculus.

The deduction is generally equal to the taxpayer’s “combined qualified business income.” (Technically, there is fine print, and for some taxpayers the calculation is slightly more complicated.)  The deduction, however, cannot exceed the taxpayer’s taxable income (reduced by net capital gain) for the year.  It is not taken into account to compute adjusted gross income, and is available to both itemizing and non-itemizing taxpayers.

“Combined qualified business income” is generally equal to 20 percent of the taxpayer’s qualified business income (“QBI”) with respect to each qualified trade or business.  QBI is defined as the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer.  The amount of QBI for each qualified trade or business that is taken into account, however, is limited to the greater of (a) 50 percent of the W-2 wages paid with respect to the qualified trade or business or (b) the sum of 25 percent of the W-2 wages paid with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property.  (These limitations do not apply for taxpayers with taxable income below certain thresholds—$157,500 for single taxpayers and $315,000 for married filing joint taxpayers—and are “phased-in” for taxpayers with taxable income exceeding such thresholds.)  The allowable amount must be calculated and added together for each qualified trade or business to determine the taxpayer’s “combined qualified business income.”

Notably, the section 199A deduction is not available with respect to income from a “specified service trade or business” for taxpayers with taxable income over certain thresholds ($207,500 for single and $415,000 for married filing joint taxpayers).  A specified service trade or business generally includes any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.  The deduction for such income—income from a “specified service trade or business”—begins to be phased out for single taxpayers with taxable income over $157,500 and married filing joint taxpayers with taxable income over $315,000; it is completely phased out (i.e., unavailable) when such taxpayers reach the thresholds mentioned above ($207,500 for single and $415,000 for married filing joint taxpayers).

Loss Limit.  The new law disallows “excess business losses” for non-corporate taxpayers.  An “excess business loss” is defined as the amount by which the taxpayer’s total deductions attributable to the taxpayer’s trades or businesses exceed the total gross income from those trades or business plus $250,000 (or $500,000 for married filing joint taxpayers).

Section 1031.  The new law scales back the scope of like-kind exchanges under section 1031.  It eliminates 1031 deferral for exchanges of tangible personal property and intangible property.  Thus, like-kind deferral is limited to exchanges of real property, and is not allowed for exchanges of real property held primarily for sale.

Carried Interest.  The new law provides for an extended, three-year holding period in order to qualify for long-term capital gain treatment on the sale of certain partnership interests.  More particularly, it provides that the sale of certain profits interests in a partnership that were received in exchange for the performance of services constitutes short-term capital gain unless held for three years or longer. The rule applies to interests in partnerships engaged in raising or returning capital, and (1) either investing in (or disposing of) certain assets (or identifying certain assets for investing or disposition), or (2) developing certain assets.

International Tax Provisions.  The new law fundamentally changes the international tax landscape, marking a shift toward a quasi-territorial system of taxation.  The new rules feature a deemed repatriation, which treats “United States shareholders” (as defined in section 951) of specified foreign corporations as receiving a dividend (taxed at special effective rates) equal to their pro rata share of certain unrepatriated and untaxed existing earnings and profits of the foreign corporation, whether they actually receive such funds or not. The TCJA also provides domestic corporations with a new 100-percent deduction for the foreign-source portion of dividends received from specified 10-percent owned foreign corporations when the domestic corporation is a United States shareholder of such foreign corporation. The deemed repatriation and dividends received deduction are designed to remove the “lockout” effect that inhibits the investment of foreign subsidiary earnings back into the United States.

The new law retains the current subpart F regime with some tweaks.  It also provides for a new class of income known as global intangible low taxed income (“GILTI”), requiring United States shareholders of controlled foreign corporations (“CFCs”) to include their share of the CFC’s GILTI in current income in a manner similar to subpart F income. Corporate shareholders, however, are allowed to deduct 50 percent of such income (37.5 percent beginning in 2026). The new law also provides domestic corporations with a reduced effective tax rate (13.125 percent) on foreign derived intangible income (“FDII”), which is defined as a portion of the statutorily-defined “intangible” income earned directly by U.S. corporations from serving foreign markets.  In addition, the new law contains a number of base erosion and anti-hybrid measures.  As a result, taxpayers with international operations will be required to navigate a new and complex array of tax provisions and, for some, to rethink existing structures.

As published by Jason B. Freeman in Today’s CPA Magazine.

For other tax reform resources, try: Choice of Entity After Tax Reform, A Practical Roadmap Through Section 199A.

Business Tax Planning Lawyer

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The Tax Court in Brief August 23 – August 27, 2021

Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.

For a link to our podcast covering the Tax Court, in Brief, download here or check out other episodes of The Freeman Law Project.

Tax Litigation: The Week of August 23 – August 27, 2021

• Estate of Charles P. Morgan, Deceased, Roxanna L. Morgan, Personal Representative and Roxanna L. Morgan v. Comm’r, T.C. Memo 2021-104
• Vera v. Comm’r, 157 T.C. No. 6 

Estate of Charles P. Morgan, Deceased, Roxanna L. Morgan, Personal Representative and Roxanna L. Morgan v. Comm’r, T.C. Memo 2021-104

August 23, 2021 | Pugh, J. | Dkt. No. 592-18

Tax Dispute Short Summary:  The case analyzed whether activities carried to acquire a business rise to the level of a trade or business, and thus, whether related expenses are deductible. Additionally, the case discusses the framework applicable to establish reasonable cause based on reliance on a tax professional.

Mr. Morgan (the petitioner) was a real estate developer. During the 1983-2009 period he actively owned and was involved in various real estate companies. During the 2009 financial crisis, his real estate companies were severely impacted because of lack of liquidity and eventually, his creditors requested the appointment of a receiver. Upon the appointment, the receiver was in sole control of the petitioner’s companies, and he was prohibited from incurring expenses on behalf of the companies that were under the receiver’s control.

As a consequence of the above, the petitioner spent vacation time and later decided to start a new business, through a single-member LLC, Legacy. The purpose of his new venture was to acquire a business. Petitioner recorded his time spent working as “business search” and deducted various expenses related to the search of a possible target acquisition. Aside from Legacy, petitioner also owned another entity, Falcon, that was used to hold and operate an aircraft. Legacy paid consulting fees to Falcon, and Falcon’s expenses were related to the use and maintenance of the aircraft. Legacy deducted the consulting fee paid to Falcon. Finally, petitioner claimed Net Operating Losses (NOL) for both Legacy and Falcon, derived from previous years. The IRS disallowed the expenses and issued a notice of deficiency and imposed a penalty under section 6662 (underpayment due to negligence or substantial understatement of income tax).

The Tax Court determined that petitioner business of searching for target acquisition did not constitute a trade or business because no business had been started yet. Therefore the expenses were rejected. However, the Court rejected the imposition of the 6662 penalty because the petitioner showed reasonable cause based on reliance on a tax professional.

Tax Litigation Key Issues: Whether the acquisition of a business constitutes itself a trade or business?

Primary Holdings: The search of an active or existing trade or business is not a trade or business. Related expenses fall within Section 195(c)(1)(A)(i) as start-up expenses rather than expenses related to a trade or business.

Key Points of the Tax Laws:

Section 162 allows taxpayers to deduct expenses paid or incurred on any trade or business. To determine the existence of a trade or business, three main factors are relevant: carrying the activity for profit, that the taxpayer is regularly and actively involved in the activity and that the activity has actually commenced. See Weaver v. Commissioner, T.C. Memo. 2004-108 , 2004 WL 938293 , at *6 ; McManus v. Commissioner, T.C. Memo 1987-457 , 1987 Tax Ct. [54 T.C.M. (CCH) 475], Memo LEXIS 454, at *20. To properly commence a business, the taxpayer must engage in such business. See Cabintaxi Corp. v. Commissioner, 63 F. 3d 614 , 620-621 (7th Cir. 1995), aff’g in part, rev’g in part, and remanding T.C. Memo. 1994-316.

If there is no business yet, Section 195(a) provides that no deduction is allowed for start-up expenses. Legislative history includes as start-up expenses those incurred in the study and choose of potential business, and those to prepare to begin that business. See H. Rept. 96-1278 , at 10-11 (1980), 1980- 2 C.B. 709, 712; S. Rept. 96-1036, at 11-12 (1980), 1980 U.S.C. C.A.N. 7293, 7301. If taxpayer has yet not decided to enter into a business or which business to enter, any expenses is considered as an investigatory cost under Section 195(c). Once the business is chosen, and the business starts functioning as a going concern and performs the activities for which it was organized, any expense incurred falls within Section 162, because there is an existing trade or business.

In this particular case, petitioner argued that his expenses were deductible under Section 162 under two theories. First, petitioner argued that his homebuilding activities never ceased. The Court determined that this argument was without merit because the taxpayer considered himself as no longer carrying a homebuilding business (based on his testimony) and also, because the receivership terms clearly stated that the taxpayer could not be engaged in his previous business.

Second, taxpayer argued that the search for a new trade or business to acquire was itself an active trade or business. The Court rejected this argument for both entities, Legacy and Falcon. For Legacy, the Court ruled that the business investigation expenses that were claimed, fell within the start-up expenditures of Section 195(c)(1)(A)(i) as “amounts paid or incurred in connection with investigating the creation or acquisition of an active trade or business”. These included paid employees and outside consultants. This argument was supported by the fact that no business was acquired by petitioner. For Falcon, the Court concluded that such entity did not lease the aircraft and only income came from petitioner and Legacy, thereby no trade or business existed.

In sum, the Court concluded that no trade or business was carried by both Legacy and Falcon and rejected the related expenses.

The Court also ruled on NOLs related to the trade or business which were rejected based on the same conclusion that there was no trade or business for both Legacy and Falcon. A determination for partnership was also made and followed the same conclusion as above (no existence of trade or business).

Finally, as for the Section 6662(a) penalty, the Court determined that reasonable cause existed in this case because the taxpayer relied on professional advice, and the adviser was a competent professional with sufficient expertise to justify reliance, the taxpayer provided all necessary and accurate information to the adviser and the taxpayer actually relied in good faith on the adviser’s judgment. See Alt. Health Care Advocates v. Commissioner, 151 T.C. 225 , 246 (2018); Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43 , 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002). In this case, the tax preparer, a CPA, was professionally licensed and knew the petitioners’ personal and business affairs. Secondly, petitioner provided necessary and accurate information to his tax adviser and third, petitioner relied on his tax adviser, because he had been preparing his returns for over a decade.

Tax Court Motion:  This case is relevant especially in certain business ventures, for example, SPACs (Special Purpose Acquisition Ventures), whose main purpose is to acquire an existing venture. Special consideration must be given to the determination as to whether a trade or business exists in those cases and if not, determine the most appropriate manner on how to characterize the expenses related.

This case is also relevant to understand the general framework of establishing reasonable cause, which usually applies in multiple settings around the Code.

Vera v. Comm’r, 157 T.C. No. 6 

August 23, 2021 | Buch, J. | Dkt. No. 9921-19

Tax Dispute Short Summary:

• For 2010 and 2013, the years at issue, Petitioner Vera filed joint returns with her (then) spouse. For 2010, the Commissioner determined a deficiency that was assessed as a joint liability. For 2013, the tax shown on the return was not paid in full, resulting in an underpayment of tax. The Commissioner assessed the tax liability and associated penalties.
• In early 2015, Petitioner filed a request for innocent spouse relief relating solely to the 2013 underpayment. She submitted Form 8857, Request for Innocent Spouse Relief, setting forth her grounds for relief. In March 2016, the Commissioner issued a final determination denying relief to Petitioner, writing that she did not meet the requirements for relief.
• Petitioner challenged the Commissioner’s determination in Court, and that determination was ultimately dismissed for lack of jurisdiction.
• Several months later, Petitioner submitted a request for relief for 2010, but in that request, she also re-raised her 2013 liability. The Commissioner denied the request for relief in a Final Appeals Determination Letter (dated March 14, 2019). The header of that letter specified only 2010 as the tax year, but the substance of the letter denied the request for relief as to both the 2010 and 2013 tax years. It read:
  • For tax year 2010, the information we have shows that you didn’t meet the requirements for relief.
  • For tax year 2010, you didn’t have a reasonable expectation that the person you filed the joint return with would or could pay the tax.
  • For tax year 2013, you didn’t comply with all income tax laws for the tax years that followed the years that are the subject of your claim.
• Petitioner filed a timely petition challenging the Commissioner’s determination. She used the Tax Court’s petition form (T.C. Form 2 as revised in November 2018). Line 3 of the form requests: “Provide the year(s) or period(s) for which the NOTICE(S) was/were issued.” Petitioner wrote “Tax Year 2010, Tax Year 2013.”
• Petitioner included in her petition a copy of the Commissioner’s notice, as well as a statement of facts that also mentioned both 2010 and 2013.
• The Commissioner filed a motion to dismiss for lack of jurisdiction as to tax year 2013. He averred the following in his motion:
  • that the March 14, 2019, determination is not a second determination for 2013,
  • that a second request for innocent spouse relief is available only when seeking to allocate a deficiency, and
  • that because the 2013 liability is an underpayment, it cannot be subject to a second election for relief

Tax Litigation Key Issue:

• Whether the Court has jurisdiction to determine the appropriate relief available to a Petitioner who has received the Commissioner’s final determination denying innocent spouse relief on the merits.

Primary Holding: 

When the Commissioner issues a final determination denying innocent spouse relief on the merits, the Tax Court has jurisdiction to determine the appropriate relief available, even if the Commissioner had previously denied relief. The Court’s jurisdiction extends to both the 2010 and 2013 tax years, as the substance of the Commissioner’s final determination unambiguously denied innocent spouse relief as to both years.

Key Points of the Laws:

• R.C. § 6015(e) grants tax courts the jurisdiction to determine the appropriate relief with regard to a taxpayer’s petition for innocent spouse relief.
• Final determination letters issued under § 6015 are not subject to any statutory or regulatory form or content requirements.
• A predicate to the Court’s jurisdiction pursuant to § 6015(e) is the mailing of a final determination.
• Although § 6015(e)(1)(A)(i)(I) refers to a final determination, nothing in that provision prohibits the Commissioner from issuing more than one final determination as to a given tax year.
• The regulations clarifying § 6015 limit claimants to a single qualified request for a given year. Income Tax Regs § 1.6015-1(a)(2) , (h)(5).
  • A qualified request is defined as the “first timely claim for relief.” para. (h)(5).
  • Moreover, the “requesting spouse is entitled to only one final administrative determination of relief.” Income Tax Regs § 1.6015-5 (c)(1).
• But these regulations leave open the possibility for the Commissioner to issue a second final determination. See Income Tax Regs Secs. 1.6015-1(h)(5) , 1.6015-5(c)(1) , 1.6015-3 (stating that if a requesting spouse changes marital status, the regulations permit a second claim, resulting in a second final determination); see also Internal Revenue Manual (IRM) pt. 25.15.17.7(1) (Mar. 5, 2019) (allowing for a second claim when a “delay or error” imposes an “unfair burden” on the requesting spouse and the Commissioner exercises his discretion to issue a second final determination).
• The Internal Revenue Manual provides following instructions with respect to final determinations:
  • A second determination issued under these limited circumstances grants the requesting spouse the right to petition the Tax Court. I.R.M. 25.15.17.7.
  • Upon request, the Commissioner also may reconsider previous requests. pt. 25.15.17.5(1).
  • If he determines relief is appropriate, the Commissioner may change his final determination as to the previous requests. pt. 25.15.17.5(3). However, I.R.M. pt. 25.15.17.5 specifically cautions agents that reconsideration decisions should not be issued through final determination letters.
  • While the I.R.M. does not carry the force of law, but courts have considered it when understanding the Commissioner’s procedures
  • The I.R.M. instructs the Commissioner to issue a Letter 3657C (No Consideration Innocent Spouse) to taxpayer petitioners when taxpayers submit a second request for relief concerning the same tax year. IRM pt. 25.15.17.4(4) (Mar. 5, 2019).
• However, where, as here, the Commissioner issues a second final determination as to any tax year, then the requesting spouse has the right to petition the Tax Court for a determination of relief. See IRM pt. 25.15.17.7.
  • This is all the more true when the Final Determination Letter unambiguously relates solely to the merits of relief for the prior tax years, and does not describe a rejection on the basis of an improper second request.
• Moreover, courts have jurisdiction to review final determinations issued in error. This rule applies in the context of final determination letters pertaining to: (1) innocent spouse relief, (2) whistleblower awards, (3) deficiencies, and (4) collections.
• If the Petitioner taxpayer timely files a petition and the notice of final determination serves as the predicate for the court’s jurisdiction, then the court will first look to the face of the notice. Courts will only look beyond the face of the notice if it is ambiguous or inconsistent.

Tax Court Motion:

• When a taxpayer submits a second request for innocent spouse relief concerning the same tax year, the I.R.M. instructs the Commissioner to issue a Letter 3657C (No Consideration Innocent Spouse).
• If instead, the Commissioner issues a second final determination as to any tax year, then the requesting spouse has the right to petition the Tax Court, and the Tax Court has jurisdiction to determine, the appropriate relief.

Tax Court Litigation Attorneys

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Section 280E of the Internal Revenue Code prohibits taxpayers who are engaged in the business of trafficking certain controlled substances (including, most notably, marijuana) from deducting typical business expenses associated those activities.  Section 280E, which was enacted in 1982 during the so-called War on Drugs, has become increasingly relevant for cannabis (marijuana) businesses. The marijuana industry has grown substantially in recent years and is projected to take in more than $25 billion annually by 2025.  This revenue growth has been driven by an increasing number of states opting to legalize marijuana.  But despite this trend towards legalization at the state level, marijuana remains illegal under federal law—it is classified as a Schedule I controlled substance under the Comprehensive Drug Abuse Prevention and Control Act of 1970, 21 U.S.C. §801–971 (1970), (“Controlled Substances Act” or “CSA”), raising the specter of section 280E.

By enacting section 280E, Congress sought to reverse a then-recent Tax Court decision: The 1981 landmark case of Edmondson v. Commissioner.  In that case, the Tax Court allowed a trafficker of amphetamines, cocaine, and cannabis to deduct ordinary and necessary business expenses related to an illicit drug business.[1] The expenses included rent, packaging, telephone, automobile expenses and the purchase of a small scale.[2] In response,[3] Congress enacted Section 280E,[4] preventing businesses engaged in certain illegal activities from recovering costs related to controlled substances or claiming associated business deductions[5]—that is, disallowing deductions that would otherwise be available under Section 162.

Generally, Section 162(a) allows a taxpayer to deduct ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business.[6] Deductions under Section 162, however, are, as the adage goes, “matters of legislative grace” and “Congress [may generally] condition, limit, or deny deductions from gross income in arriving at the net which is to be taxed.”[7] Section 280E provides that:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.[8]

Marijuana is classified as a Schedule I controlled substance under the Controlled Substances Act, rendering marijuana businesses subject to section 280E.  The Senate Report accompanying the enactment of Section 280E elaborated on the legislative intent behind the provision:

All deductions and credits for amounts paid or incurred in the illegal trafficking in drugs listed in the Controlled Substances Act are disallowed. To preclude possible challenges on constitutional grounds, the adjustment to gross receipts with respect to effective costs of goods sold is not affected by this provision of the bill.

REP. NO. 97-494 (Vol. I), at 309 (1982).

In short, Section 280E prohibits a taxpayer who is engaged in trafficking a Schedule I or II controlled substance (such as cannabis, i.e., ‘marijuana,’ which is listed as ‘marihuana’ on Schedule I)[9] from taking tax deductions or credits—except for the adjustment to offset gross receipts by the cost of goods sold (COGS)—when determining gross income.[10]Notably, Section 280E disallows deductions for expenses that are not illegal per se (such as: rent, salaries, and telephone expenses).[11]

THE THREE ELEMENTS OF 280E

Section 280E applies where three elements are present: (1) a controlled substance; (2) trafficking; and (3) a trade or business.[12]

I. Controlled Substance

Section 280E denies deductions and credits for amounts paid or incurred in carrying on the trade or business of trafficking controlled substances (within the meaning of Schedules I and II of the CSA), in violation of federal or state law.[13] Despite legalization in at least 31 states (and the District of Columbia) and approval for medical use in nine states, federal law continues to classify cannabis as a “controlled substance” under schedule I of the CSA.[14]  Section 280E, therefore, prohibits tax deductions and credits attributable to the trade or business of trafficking in cannabis.

II. Trafficking

The Tax Court has defined “trafficking” by reference to the verb “traffic,” taking the definition from Webster’s Third New International Dictionary to mean “to engage in commercial activity: buy and sell regularly.”[15] Thus, the purchase and sale of cannabis constitutes trafficking even when permitted by state law.[16] By defining “trafficking” in this manner, the court has cast a wide net.  Indeed, most, if not all, commercial activity with respect to cannabis would appear to fall under section 280E’s definition of trafficking.

III. Trade or Business

Whether a taxpayer’s activities constitute a trade or business is an issue that draws upon a host of case law precedents and generally looks to the level of activity, continuity of that activity, and period over which the taxpayer has engaged in that activity.  Although a cannabis business is illegal under federal law,[17] a taxpayer is nonetheless required to pay federal income tax on the taxable income derived from a cannabis trade or business.  Section 61(a), in other words, does not differentiate between income derived from legal sources and income derived from illegal sources. [18]

TWO LANDMARK CASES

Californians Helping to Alleviate Medical Problems, Inc., v. C.I.R. (2007) (“CHAMP”)

A California public benefit corporation that provided medical cannabis to patients with debilitating diseases, pursuant to state statute, and provided non-cannabis-related counseling and caregiving services to its members, challenged the IRS’s disallowance of all of its ordinary and necessary business expenses.[19] While the tax court held that the taxpayer’s provision of medical cannabis constituted “trafficking”[20] within the meaning of section 280E, the court held that the taxpayer’s caregiving services were a separate trade or business sufficient for the purposes of business expense deductions.[21] The court reached this holding based on legislative history expressing that Section 280E was not intended to preclude taxpayers from deducting expenses attributable to a trade or business other than that of illegal trafficking in controlled substances simply because the taxpayer was also involved in trafficking a controlled substance.[22] Notably, the government conceded that §280E does not prohibit a taxpayer from claiming COGS related to the trafficked substance.[23]

Canna Care, Inc. v. C.I.R. (2015)

Canna Care (“Canna”) was a mutual benefit corporation and pursuant to California law, was prohibited from distributing cannabis for profit. The IRS determined deficiencies in Canna’s federal income tax and Canna challenged the IRS’s disallowance of deductions for operating expenses that it incurred in operating a medical cannabis dispensary that was permitted by California law.[24] The tax court held that Canna, unlike CHAMP, was a single-business venture and that it was engaged in the trade or business of trafficking in controlled substances (here, medical cannabis).[25] Thus, Canna’s operating expenses were held not to be deductible.[26]

Canna reaffirmed two key aspects of 280E in relation to cannabis businesses. First, despite legalization across the country, cannabis is still a controlled substance under federal law and, as such, the Tax Court will continue to characterize taxpayers engaged in cannabis-related business activities as being engaged in trafficking within the meaning of section 280A. Second, a taxpayer engaged in the trade or business of selling cannabis falls under Section 280E and cannot claim business deductions other than the cost of goods sold with respect to that trade or business.

Takeaways

Section 280E is a federal statute that bars any business, or portion of its business, engaged in trafficking a Schedule I or II controlled substance (such as cannabis) from deducting non-COGS related deductions or credits for federal tax purposes. Case law, however, provides businesses that have separate and distinct cannabis and non-cannabis operations with an opportunity to structure their operations in a manner that mitigates the impact of section 280A.  Such taxpayers should consult an experienced tax attorney to ensure that they structure operations in an optimal manner and comply with the latest case law interpreting section 280E.

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[1] See Edmondson v. C.I.R., 42 T.C.M. (CCH) 1533 (T.C. 1981), acq. in part and nonacq. in part recommended by I.R.S. AOD- 1982-82 (IRS AOD Oct. 15, 1982)

[2] Id.

[3] S. REP. NO. 97-494 (Vol. I), supra at 309 (1982) (“There is a sharply defined public policy against drug dealing. To allow drug dealers the benefit of business expense deductions at the same time that the U.S. and its citizens are losing billions of dollars per year to such persons…”)

[4] 26 U.S.C.A. § 280E

[5] 26 U.S.C.A. § 280E

[6] 26 U.S.C. § 162(a) (emphasis added).

[7] See Alpenglow Botanicals, LLC v. United States, 894 F.3d 1187, 1199 (10th Cir. 2018) (citations omitted) (internal quotation marks omitted).

[8] In the Comprehensive Drug Abuse Prevention and Control Act of 1970, 21 U.S.C. §801–971 (1970), (“Controlled Substances Act” or “CSA”), Congress created a regime to curtail the unlawful manufacture, distribution, and abuse of dangerous drugs (“controlled substances”). Congress assigned each controlled substance to one of five lists (Schedule I through Schedule V). See §812 of the CSA. Schedule I includes: (a) opiates; (b) opium derivatives (e.g., heroin; morphine); and (c) hallucinogenic substances (e.g., LSD; marihuana (a/k/a marijuana); mescaline; peyote).

[9] 21 U.S.C.A. § 812, Schedule I (c)(10) (West).

[10] S. REP. NO. 97-494 (Vol. I), at 309 (1982).

[11] 26 U.S.C. § 162(c); 26 U.S.C.A. § 280E.

[12] See Canna Care, Inc. v. Comm’r of Internal Revenue, 694 Fed. Appx. 570 (9th Cir. 2017).

[13] See §812 of the CSA.

[14] See “2019 FEDERAL TAX UPDATE FOR BUSINESS RETURNS”, Sharon Kreider and Vern Hoven, Spring Business 2019.pdf.

[15] Californians Helping to Alleviate Med. Problems, Inc. v. C.I.R., 128 T.C. 173, 182 (2007).

[16] Id. See also, Alpenglow, at 1206; Beck v. Comm’r, 110 T.C.M. (CCH) 141, *5–6 (2015); Olive v. Comm’r, 792 F.3d 1146, 1149 (9th Cir. 2015).

[17] 21 U.S.C.A. § 841(D) (detailing penalties in dealing in less than 50kg (about 100lbs) of cannabis (‘marihuana’) or 50 or more plants.).

[18] See James v. United States, 366 U.S. 213, 218 (1961).

[19] Californians Helping to Alleviate Med. Problems, Inc. v. C.I.R., 128 T.C. 173, 174 (2007) (“CHAMP”).

[20] Id. at 182 (The tax court chose to utilize Webster’s Dictionary and apply the gerund “trafficking” by reference to the verb “traffic”, which as relevant herein denotes “to engage in commercial activity: buy and sell regularly”.)

[21] Id. at 178. (The court distinguished and allocated the company’s expenses into two primary businesses; one that focused on providing ‘caregiving services’ and a second that was tied directly to cannabis distribution. The ordinary and necessary business expenses associated with the caregiving portion (about 18/25 of the expenses including: salaries, wages, employee benefits, employee training, meals and entertainment, parking and tolls, rent, and laundry and cleaning) were held to be legally deductible. Id. at 185. The remaining expenses (about 7/25^t of the expenses) associated with the cannabis distribution were disallowed entirely).

[22] Id. at 182.

[23] Id. at 178 (n. 4).

[24] Canna Care, Inc. v. C.I.R., 110 T.C.M. (CCH) 408 (T.C. 2015), aff’d sub nom. Canna Care, Inc. v. Comm’r of Internal Revenue, 694 Fed. Appx. 570 (9th Cir. 2017).

[25] Id. at *5.

[26] Id.

The Tax Court in Brief January 18 – January 22, 2021

Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.

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The Week of January 18 – January 22, 2021

• Adams Challenge (UK) Limited v. Comm’r, 156 T.C. No. 2
• Aspro, Inc. v. Comm’r, T.C. Memo. 2021-8

Adams Challenge (UK) Limited v. Comm’r, 156 T.C. No. 2

January 21, 2021 | Lauber, J. | Dkt. No. 4816-15

Short Summary:  The case discusses whether under Section 882(c)(2) of the Code, a foreign corporation is entitled to the benefits of deductions or credits after the IRS has prepared returns for such corporation. The case also discusses whether the application of Section 882(c)(2) violates provisions of the tax treaty between the U.S. and the U.K., specifically those related to business profits and nondiscrimination.

During 2009 through 2011, Adams Challenge, a UK corporation (the taxpayer) owned a multipurpose support vessel. In 2009, the taxpayer entered into a contract with a U.S. company, allowing the U.S. company to use the vessel for various oil projects within the Outer Continental Shelf in the Gulf of Mexico.

In 2013, the IRS issued a Notice of Jeopardy Assessment to the taxpayer in the amount of $23,780,625 for the 2009-2011 period. At that time, the taxpayer had not filed a U.S. income tax return.

In 2014, the IRS issued a notice of deficiency where it determined that the taxpayer had effectively connected income adding that the taxpayer was not entitled to deductions or credits because it had failed to submit a tax return. The taxpayer submitted a petition with the Court. In 2017, the taxpayer filed protective returns for 2009 and 2010.

The IRS argued that under Section 882(c)(2) the taxpayer had failed to submit a true and accurate return before the IRS issued the notice of deficiency, consequently the taxpayer was not entitled to receive the benefits of the deductions and credits allowed by the Code.

The taxpayer argued that such regulation did not provide such a requirement. Additionally, it argued that Section 882(c)(2) was overridden by the provisions of the UK-U.S. tax treaty (the Treaty) specifically those related to business profits (which allow foreign corporations to the deductions and credits related to the business of a foreign corporation) and the nondiscrimination article.

After analyzing the statutory and case law development behind Section 882(c)(2), and the applicability of the UK-US tax treaty, the Court agreed with the IRS.

Key Issues: Whether Section 882(c)(2) provides a specific terminal date for a foreign corporation to submit a tax return and be entitled to the benefits of deductions and credits under the Code.  Whether Section 882(c)(2) violates the business profits article or the nondiscrimination article of the Treaty.

Primary Holdings: Based on the statutory and the applicable case law, Section 882(c)(2) establishes that a foreign corporation must file a true and accurate tax return before the IRS prepares a return on behalf of the foreign corporation. Moreover, Section 882(c)(2) does not contradict the provisions of the Treaty, specifically the business profits and nondiscrimination articles.

Key Points of Law:

• Section 882(c)(2) was introduced in 1928 (as Section 233) to prevent foreign corporations from not reporting income effectively connected with a U.S. trade or business, by allowing such corporations to receive the benefits of deductions and credits conditioned to the filing of a U.S. income tax return. Because Section 882(c)(2) is not clear in relevant aspects, caselaw has mostly defined the reach and limits of the statute.
• In Anglo-American Direct Tea Trading Co. v. Comm’r 38 BT.A. 711 (1938), the Court ruled determined that the mere fact that a tax return was not timely filed by a foreign corporation did not preclude the allowance of the deductions claimed.
• In Taylor Securities, Inc. v. Commissioner, 40 B.T.A. 696 (1939), the Court determined that under Section 233, the foreign corporation loses its right to deductions and credits if it does not file a return until after the IRS has prepared a return for it and has notified the taxpayer of the deficiency determination.
• In Ardbern Co. v. Commissioner, 41 B.T.A. 910 (1940), modified and remanded, 120 F.2d 424 (4^th 1941), the Court established that if the taxpayer “attempted in good faith” to file a return before the IRS prepared returns for it, but it ultimately filed the return after the IRS has prepared the return, the taxpayer was entitled to deductions because of “elementary justice”.
• In Blenheim Co. v. Commissioner, 42 B.T.A. 1248, the Court determined that although Section 233 did not provide a “time element” to submit the tax return, the statute required the foreign corporation to file the return before a “terminal date” which, under Taylor, is defined as the date on which the IRS prepares a return for the foreign corporation.
• In the 1954 Code, Section 233 was recodified as Section 882(c)(2). Such provision was in substance, identical to its predecessor, according to the Senate Finance Committee. In a new case, Brittingham v. Commissioner, 66 T.C. 373 (1976), aff’d per curiam, 598 F.2d 1375 (5th Cir. 1979), the Court reaffirmed the previously developed caselaw to now Section 882(c)(2) coupled with the 1957 regulations. Finally, the Court analyzed that under Espinosa v. Commissioner, 107 T.C. 146 (1996), a nonresident alien forfeits his rights for deductions and credits if he fails to file a return before the IRS prepares a return for him.
• Under the previous case law and the statutory language of Section 882(c)(2), the Court reasoned that the taxpayer did not file a return before the IRS prepared a return for the taxpayer. Consequently, under Taylor, the taxpayer is not entitled to deductions or credits for the year. The Court also added that the taxpayer in this case could use the “good faith” defense established by Ardbern Co., because the taxpayer failed to offer a plausible excuse for failing to file a return until the IRS had prepared the return.
• The Court also analyzed the taxpayer under the Regulations, which were revised in 1990 and 2003. Under the Regulations, a foreign corporation has a fixed deadline to submit a return within 18 months of the due date (which for foreign corporations is within 5 ½ months after the close of the tax year). This allows foreign corporations a total period of 23 ½ months to submit a tax return before Section 882(c)(2) applies. And although such a deadline can be waived if requested, the taxpayer did not show that it requested a waiver. Considering such elements, the Court argued that under the Regulations and the relevant case law, the taxpayer was not entitled to deductions or credits for the relevant years.
• As for the applicability of the Treaty provisions, the Court determined that under the intent of the contracting States, the UK did not express any intention that the Treaty should override Section 882(c)(2). Additionally, the business profits article of the Treaty does not conflict with Section 882(c)(2), because the latter provides only administrative and procedural conditions that limit the deductibility of business expenses.
• As for the nondiscrimination argument, the Court ruled that foreign corporations are not in the same circumstances as domestic corporations with respect to the filing of tax returns. Under the view of the Treasury, to which the Court deferred, the nondiscrimination article is not violated if a foreign corporation is subject to different requirements than those applicable to a domestic corporation. Accordingly, the Court held that Section 882(c)(2) did not violate the Treaty.

Insight: This case provides great insight for foreign corporations that may be subject to ECI rules, specifically as for the filing of a tax return. Careful analysis is required to determine whether a protective tax return must be filed, to comply with Section 882(c)(2). Moreover, the case is relevant to determine the interpretation of tax treaties entered by the U.S. Multiple provisions of tax treaties are usually deemed to override he provisions of the Code, but this case clearly shows that if the provision of the Code does not directly contradict the provisions of a treaty, then the requirements of the Code may be applicable. This case clearly opens the door for the IRS to subject transactions that are “covered” by a treaty to U.S. requirements which could lead to denial of treaty benefits in a variety of cases.

Aspro, Inc. v. Comm’r, T.C. Memo. 2021-8

January 21, 2021 | Pugh, J. | Dkt. No. 17494-17

Short Summary:  Aspro, Inc. (Aspro) paid management fees to its three shareholders:  Milton Dakovich, Jackson Enterprises, Corp., and Manatt’s Enterprises, Ltd. for the tax years ending November 30, 2012, November 30, 2013, and November 30, 2014.  The IRS disallowed the deductions as disguised dividends.  Aspro filed a timely petition with the United States Tax Court challenging the IRS’ determinations.

Key Issues: Whether Aspro is entitled to deductions for fees it paid to Milton Dakovich, Jackson Enterprises, Corp., and Manatt’s Enterprises, Ltd.?

Primary Holdings: Aspro is not entitled to deductions for fees it paid to Milton Dakovich, Jackson Enterprises, Corp. and Manatt’s Enterprises, Ltd. because most of the evidence shows that Aspro paid the fees to its three shareholders as disguised distributions.  This evidence includes:  (1) Aspro made no distributions to its three shareholders during the years at issue or its entire corporate history but paid management fees each year; (2) the two large shareholders always got equal amounts and the percentages of management fees all three shareholders received roughly correspond to their respective ownership interests; (3) Aspro paid the management fees as lump sums at the end of each tax year to its shareholders; (4) Aspro had relatively little taxable income after deducting the management fees each year; and (5) Aspro’s process of setting management fees was unstructured and had little, if any, relation to the services being provided.  Moreover, any payments to the three shareholders were not reasonable in amount.

Key Points of Law:

• The taxpayer generally bears the burden of proving that the Commissioner’s determinations in a notice of deficiency are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).  The taxpayer also bears the burden of proving entitlement to any deductions claimed. INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).  The Code and the regulations, therefore, require the taxpayer to maintain records sufficient to establish the amount of any deduction claimed.  See 6001; Treas. Reg. § 1.6001-1(a).
• A subchapter C corporation is subject to Federal income tax on its taxable income, which is its gross income less allowable deductions. 11(a), 61(a)(1) and (2), 63(a).  A corporation may deduct all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered.   Sec. 162(a)(1); Treas. Reg. § 1.162-7(a).
• An expense is ordinary if it is customary or usual within a particular trade, business, or industry or relates to a transaction “of common or frequent occurrence in the type of business involved.” Deputy v. du Pont, 308 U.S. 488, 495 (1940).  An expense is necessary if it is appropriate and helpful for the development of the business.  See Comm’r v. Heininger, 320 U.S. 467, 471 (1943).  Whether an expense is ordinary and necessary is generally a question of fact.  at 475.
• In testing whether compensation is deductible we consider whether the payments “are in fact payments purely for services.” Reg. § 1.162-7(a).  This is a question of fact to be determined from all the facts and circumstances.  Am. Sav. Bank v. Comm’r, 56 T.C. 828 (1971).  However, distributions to shareholders disguised as compensation are not deductible.  Treas. Reg. § 1.162-7(b)(1).
• Courts closely scrutinize compensation paid by a corporation to its shareholders to ensure the payments are not disguised distributions. Charles Schneider & Co. v. Comm’r, 500 F.2d 148, 152 (8^th 1974); Heil Beauty Supplies, Inc. v. Comm’r, 199 F.2d 193, 194 (8^th Cir. 1952).  In the Eighth Circuit, where an appeal would lie in this case, the issue of whether or to what extent compensation paid by a corporation to its shareholders represents compensation for services or constitutes a distribution of profits is a determination of “matter purely of fact.”  Heil Beauty Supplies, Inc. v. Comm’r, 199 F.2d at 195.
• In determining whether the compensation paid to a corporation’s shareholders is instead a distribution of profit, the Tax Court considers all the facts and circumstances.   And the Tax Court is not “compelled to accept at face value the naked, interested testimony of the corporation or the stockholder[s], merely because that testimony is without direct contradiction by other witnesses.”  Id.
• In addition to being for services, the amount allowed as compensation may not exceed what is reasonable under all the circumstances. Home Interiors & Gifts, Inc. v. Comm’r, 73 T.C. 1142, 1155 (1980); Treas. Reg. § 1.162-7(b)(3).  The regulations state that generally, reasonable and true compensation is only such an amount as would ordinarily be paid for like services by like enterprises under like circumstances.  Reg. § 1.162-7(b)(3).  The reasonableness of the amount is also a question of fact to be determined from the record in each case.  Charles Schneider & Co. v. Comm’r, 500 F.2d at 152; Estate of Wallace v. Comm’r, 95 T.C. 525 (1990).  Finally, the test of reasonableness is not applied to the shareholders as a group but rather to each shareholder’s compensation in the light of the individual services performed.  L. Schepp Co. v. Comm’r, 25 B.T.A. 419 (1932).
• In the case of shareholder-employee compensation, courts have considered the following factors: the employee’s qualification; the nature, extent, and scope of the employee’s work; the size and complexities of the business; a comparison of salaries paid with the gross income and the net income; the prevailing general economic conditions; a comparison of salaries with distributions to stockholders; the prevailing rates of compensation for comparable positions in comparable concerns; the taxpayer’s salary policy for all employees; and in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years.  Charles Schneider & Co. v. Comm’r, 500 F.2d at 152; Mayson Mfg. Co. v. Comm’r, 178 F.2d 115, 119 (6^th 1949); Home Interiors & Gifts, Inc. v. Comm’r, 73 T.C. at 1155-1156.  No single factor is dispositive of the issue; instead, the Court’s decision must be based on a careful consideration of applicable factors in the light of the relevant facts.  See Mayson Mfg. Co. v. Comm’r, 178 F.2d at 119.
• Some courts have supplemented or completely replaced the multifactor approach for analyzing shareholder-employee compensation with the independent investor test. See Mulcahy, Pauritsch, Salvador & Co. v. Comm’r, 680 F.3d 867 (7^th 2012).  The Court of Appeals for the Eighth Circuit has not opined on this test yet.  But in cases appealable to that Court of Appeals, we have applied the independent investor test as a way to view each factor.  See Wagner Constr., Inc. v. Comm’r, T.C. Memo. 2001-160.

The Aspro case shows the difficulties corporate taxpayers can face in attempting to prove that compensation paid to shareholders is reasonable and, in fact, true compensation.  For corporate taxpayers who pay their shareholders compensation, it may be advisable to have a tax attorney document the compensation to protect against any challenge and future IRS examination.

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The Tax Court in Brief – August 15th – August 19th, 2022

Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.

For a link to our podcast covering the Tax Court in Brief, download here or check out other episodes of The Freeman Law Project.

Tax Litigation:  The Week of August 15th, 2022, through August 19th, 2022

Medtronic, Inc. v. Comm’r, T.C. Memo. 2022-84 | August 18, 2022 | Kerrigan, J. | Dkt. No. 6944-11.

Short Summary: This opinion regards a transfer pricing, comparable uncontrolled transaction (“CUT”), comparable profits method (“CMP”), and deficiencies in tax totaling approximately $548,180,115 for 2005 and $810,301,695 for 2006 against taxpayer Medtronic, Inc. and its consolidated affiliates. The underlying transactions—being the transactions for which deficiencies were determined—stemmed from a long history of third-party settlement agreements in medical device patent litigation, assignments of patent royalty rights, related-company agreements and licenses and valuation of consideration exchanged in those agreements for, but not limited to, patents, royalties, litigation settlements, product liability risk assumptions, self-insurance risks, and other.

Procedurally, the case regards a remand from the U.S. Court of Appeals for the Eighth Circuit for further consideration of prior Tax Court opinion in Medtronic, Inc. v. Commissioner (Medtronic I), T.C. Memo. 2016-112, vacated and remanded Medtronic, Inc. v. Commissioner (Medtronic II), 900 F.3d 610 (8^th Cir. 2018). Basically, the Circuit Court concluded that the factual findings from the previous Tax Court opinion were insufficient to enable the Circuit Court to conduct an evaluation of the Tax Court’s determination about the CUT in issue, so the Circuit Court remanded to the Tax Court for further factual development.

In turn, the Tax Court provided this 75-page memorandum opinion heavily focused on facts and evidence, including testimony from 10 expert witnesses, and complex evaluation of 26 U.S.C. § 482 and related Treasury Regulations, 26 C.F.R. § 1.482-1, et. seq., to horizontal and vertical transactions involving transfer pricing, CUTs, and CMP permitted by the Internal Revenue Code and Treasury Regulations.

This Tax Court in Brief provides a succinct summation of the tax laws in issue. For more detailed application of the law to the facts in issue, please see the opinion itself.

Key Issue:

Under section 482 and related Treasury Regulations, what is the proper method for determining the arm’s-length rate to be applied to the transactions in issue, including for royalty payments and other consideration exchanged between Medtronic and its related companies?

Primary Holdings:

Medtronic did not meet its burden to show that its proposed allocation under the CUT method and its proposed “unspecified method” satisfy the arm’s-length standard. The Tax Court determined that, of the five general comparability factors applied to the agreements presented for comparison by Medtronic, the functions, economic conditions, and property or services were not comparable, and thus, the proposed comparable agreement was not a CUT. The comparison required too many adjustments.

Also, the IRS’s modified CPM resulted in an abuse of discretion. The CPM proposed by the IRS resulted in skewed comparison of medical devices, an unrealistic profit split and too high a royalty rate, and the IRS’s adjustment for product liability was deemed inadequate based on the evidence presented. Thus, the IRS’s determination based on the modified CPM presented constituted an abuse of discretion.

If neither party has proposed a method that constitutes “the best method,” the Tax Court must determine from the record the proper allocation of income. Therefore, pursuant to section 482 of the Internal Revenue Code and related Treasury Regulations, the Tax Court—taking somewhat of a blend of the available methods and evidence presented— applied what it believed was the “best method” for arriving at appropriate allocation and royalty rate to be applied to the related-party intellectual property agreements and royalty rates made the basis thereof. By this approach, the Tax Court sought to bridge the gap between the section 482 methods presented by Medtronic and the IRS.

Key Points of Law:

26 U.S.C. § 482—Allocation of income and deductions among taxpayers. “In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. In the case of any transfer (or license) of intangible property (within the meaning of section 367(d)(4)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible. For purposes of this section, the Secretary shall require the valuation of transfers of intangible property (including intangible property transferred with other property or services) on an aggregate basis or the valuation of such a transfer on the basis of the realistic alternatives to such a transfer, if the Secretary determines that such basis is the most reliable means of valuation of such transfers.” (emphasis added).

Section 482 was enacted to prevent tax evasion and to ensure that taxpayers clearly reflect income relating to transactions between controlled entities. Veritas Software Corp. & Subs. v. Commissioner, 133 T.C. 297, 316 (2009). Section 482 gives the IRS broad authority to allocate gross income, deductions, credits, or allowances between two related corporations if the allocations are necessary either to prevent evasion of tax or to reflect clearly the income of the corporations. See Seagate Tech., Inc. & Consol. Subs. v. Commissioner, 102 T.C. 149, 163 (1994).

Standard of Review. When the IRS has determined deficiencies based on section 482, the taxpayer bears the burden of showing that the allocations assigned by the IRS are arbitrary, capricious, or unreasonable. See Sundstrand Corp. & Subs. v. Commissioner, 96 T.C. 226, 353 (1991). The IRS’s section 482 determination must be sustained absent a showing of abuse of discretion. See Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525, 582 (1989), aff’d, 933 F.2d 1084 (2d Cir. 1991). “Whether respondent [IRS Commissioner] has exceeded his discretion is a question of fact. . . . In reviewing the reasonableness of respondent’s determination, the Court focuses on the reasonableness of the result, not on the details of the methodology used.” Sundstrand Corp., 96 T.C. at 353–54; see also Terrazzo Strip Co. v. Commissioner, 56 T.C. 961, 971 (1971). The regulations provide that when determining which method provides the most reliable measure of an arm’s-length result, the two primary factors to take into account are (1) the degree of comparability between the controlled transaction (taxpayer) and any uncontrolled comparables and (2) the quality of the data and assumptions used in the analysis. Treas. Reg. § 1.482-1(c)(2).

IRS Evaluation of a Section 482 Transaction. The IRS will evaluate the results of a transaction as actually structured by the taxpayer unless it lacks economic substance. Reg. § 1.482-1(f)(2)(ii)(A). Treasury Regulation § 1.482-1(d)(4)(iii)(A)(1) provides that transactions “ordinarily will not constitute reliable measures of an arm’s length result” if they are “not made in the ordinary course of business.” However, the IRS may consider the alternatives available to the taxpayer in determining whether the terms of the controlled transaction would be acceptable to an uncontrolled taxpayer faced with the same alternatives and operating under similar circumstances. Id. Thus, the IRS may adjust the consideration charged in the controlled transaction according to the cost or profit of an alternative, but the IRS will not restructure the transaction as if the taxpayer had used the alternative. See id. To determine “true taxable income,” the standard to be applied is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer. Id. para. (b)(1).

As in effect during 2005 through 2006, the Treasury Regulations provided four methods to determine the arm’s-length amount to be charged in a controlled transfer of intangible property: the CUT method, the CPM, the profit split method, and unspecified methods as described in Treasury Regulation § 1.482-4(d). See id. 1.482-4(a).

The best method rule provides that the arm’s-length result of a controlled transaction must be determined using the method that, under the facts and circumstances, provides the most reliable measure of an arm’s-length result. Id. § 1.482-1(c)(1). There is no strict priority of methods, and no method will invariably be considered more reliable than another. Id. In determining which of two or more available methods provides the most reliable measure of an arm’s-length result, the two primary factors to take into account are the degree of comparability between the controlled transaction (or taxpayer) and any uncontrolled comparables, and the quality of data and assumptions used in the analysis. Id. subpara. (2); see also Reg. §§ 1.482– 1(c)(1), 1.482-4(a); Coca-Cola Co. & Subs. v. Commissioner, 155 T.C. 145, 211-12 (2020).

If neither party has proposed a method that constitutes “the best method,” the Tax Court must determine from the record the proper allocation of income. Sundstrand Corp. & Subs., 96 T.C. at 393. In transfer pricing cases it is not unique for the Tax Court to be required to determine the proper transfer pricing method. See Perkin-Elmer Corp. & Subs. v. Commissioner, T.C. Memo. 1993-414.

The CPM evaluates whether the amount charged in a controlled transaction is arm’s length according to objective measures of profitability (profit level indicators) derived from transactions of uncontrolled taxpayers that engage in similar business activities under similar circumstances. 26 C.F.R. § 1.482-5(a) (comparable profits method). Profit level indicators are ratios that measure relationships between profits and costs incurred or resources employed. Id. para. (b)(4). The profit level indicator depends upon a number of factors, including the nature of the activities of the tested party, the reliability of available data with respect to uncontrolled comparables, and the extent to which the profit level indicator is likely to produce a reliable measurement of the income that the tested party would have earned had it dealt with controlled taxpayers at arm’s length, taking into account all facts and circumstances. Id.; see also Coca-Cola Co. & Subs., 155 T.C. at 210–13, 221–37.

An additional CPM method is a cost-plus method, which is used for cases involving the manufacture, assembly, or other production of goods sold solely to related parties. See Reg. § 1.482-3(d)(1).

The CPM benchmarks the arm’s-length level of operating profits earned by the tested party with reference to the level of operating profits earned by comparable companies. See Reg. § 1.482-5(b)(1).

CUT Method. The CUT method evaluates whether the amount charged for a controlled transfer of intangible property was arm’s length by reference to the amount charged in a comparable uncontrolled transaction. Reg. § 1.482-4(c)(1). If an uncontrolled transaction involves the transfer of the same intangible under the same or substantially the same circumstances as the controlled transaction, the results derived generally will be the most direct and reliable measure of the arm’s-length result for the controlled transfer of an intangible. Id. subpara. (2)(ii). The CUT method requires that the controlled and uncontrolled transactions involve the same intangible property or comparable intangible property as defined in the Treasury Regulations. Id. subdiv. (iii)(A). To be considered comparable, both intangibles must (i) be used in connection with similar products or processes within the same general industry or market and (ii) have similar profit potential. Id. subdiv. (iii)(B)(1). The profit potential of an intangible is most reliably measured by directly calculating the net present value of the benefits to be realized (on the basis of prospective profits to be realized or costs to be saved) through the use or subsequent transfer of the intangible, considering the capital investment and startup expenses required, the risks to be assumed, and other relevant considerations. Id. subdiv. (iii)(B)(1)(ii).

A comparable with different royalty rate may serve “as a base from which to determine the arm’s-length consideration for the intangible property involved in this case.” Sundstrand Corp., 96 T.C. at 393.

Controlled and uncontrolled transactions must involve the same or comparable intangible property, and differences in contractual terms and economic conditions should be considered. See Reg. § 1.482-4(c)(2)(iii). The Treasury Regulations provide contractual and economic factors to assess the comparability of circumstances between a controlled and an uncontrolled transaction for the CUT method. See id. subdiv. (iii)(B)(2).

The degree of comparability between controlled and uncontrolled transactions is determined by applying the comparability provisions of Treasury Regulation § 1.482-1(d). Specified factors are particularly relevant to the CUT method. Treas. Reg. § 1.482-4(c)(2)(iii). Those factors are (1) functions, (2) contractual terms, (3) risks, (4) economic conditions, and (5) property or services. The application of the CUT method specifies that the controlled and uncontrolled transactions need not be identical but must be sufficiently similar that they provide an arm’s-length result. Id. subpara. (2). If there are material differences between the controlled and uncontrolled transactions, adjustments must be made if they can be made with sufficient accuracy to improve the reliability of the results. Id. If adjustments for material differences cannot be made, the reliability of the analysis will be reduced. Id.

For intangible property to be considered comparable, the intangibles must be used in connection with similar products or processes within the same general industry or market and have similar profit potential. Id. § 1.482-4(c)(2)(iii)(B)(1). In evaluating the comparability of the circumstances of the controlled and uncontrolled transactions the following factors “may be particularly relevant”: (1) the terms of the transfer; (2) the stage of development of the intangible; (3) rights to receive updates, revisions, or modifications of the intangible; (4) the uniqueness of the property; (5) the duration of the license; (6) any economic and product liability risks; (7) the existence and extent of any collateral transactions or ongoing business relationships; (8) the functions to be performed by the transferor and transferee; and (9) the accuracy of the data and the reliability of assumptions used. Id. subdivs. (iii)(B)(2), (iv).

Profit Split Method. The profit split method evaluates whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is arm’s length by reference to the relative value of each controlled taxpayer’s contribution to that combined operating profit or loss. Id. § 1.482-6(a). Allocation under the profit split method must be made in accordance with either the comparable profit split method or the residual profit split method. Id. para. (c)(1). The comparable profit split method is derived from the combined operating profit of uncontrolled taxpayers whose transactions and activities are similar to those of the controlled taxpayers in the relevant business. Id. subpara. (2).

Unspecified Method. Methods not specified in paragraphs (a)(1), (2), and (3) of Treasury Regulation § 1.482-4 may be used to evaluate whether the amount charged in a controlled transaction is arm’s length. Any method used must be applied in accordance with the provisions of Treasury Regulation § 1.482-1. See Reg. § 1.482-4(d)(1). An unspecified method should take into account the general principle that uncontrolled taxpayers evaluate the terms of a transaction by considering the realistic alternatives to that transaction, and only enter into a particular transaction if none of the alternatives is preferable to it. Id. An unspecified method should provide information on the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction. Id. An unspecified method will not be applied unless it provides the most reliable measure of an arm’s-length result under the principles of the best method rule. Id.

“Commensurate with Income” – Difficulty in determining whether the arm’s length transfers of intellectual property between unrelated parties are comparable. Where taxpayers transfer intangibles with a high profit potential, the compensation for the intangibles should be greater than industry averages or norms. All facts and circumstances are considered in determining what pricing methods are appropriate in cases involving intangible property, including the extent to which the transferee bears real risks with respect to its ability to make a profit from the intangible or, instead, sells products produced with the intangible largely to related parties and has a market essentially dependent on, or assured by, such related parties’ marketing efforts. The profit or income stream generated by or associated with intangible property is to be given primary weight. The “commensurate with income” standard should be applied to work consistently with the arm’s-length standard.

For comparing two separate royalty-producing transactions for tax purposes under section 482, there must be enough similarities that the agreements can, at a minimum, be used as a starting point for determining a proper royalty rate. For example, if the terms of the payments are comparable, and if the compared agreements have similar royalty rates, the Tax Court may deem them appropriately comparable for evaluation under section 482. See Reg. § 1.482-4(c)(2)(iii); id. § 1.482-1(d)(3)(ii)(A)(1).

Generally, intangible property is considered comparable if it is used in connection with similar products. Treas. Reg. § 1.482– 4(c)(2)(iii)(B)(1)(i).

Allocation of Risks and Liabilities. Pursuant to the regulations “the consequent allocation of risks . . . that are agreed to in writing before the transactions are entered into will be respected if such terms are consistent with the economic substance of the underlying transactions.” Treas. Reg. § 1.482-1(d)(3)(ii)(B)(1). The regulations specify that risks in this respect include product liability risks. Id. subdiv. (iii)(A)(5).

Best Method. An unspecified method will not be applied unless it provides the most reliable measure of an arm’s-length result under the principles of the best method rule. Treas. Reg. § 1.482– 4(d). Under the best method rule, the arm’s-length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable method of getting an arm’s-length result. Id. § 1.482-1(c)(1).

Insight: This third iteration of Medtronic (Medtronic III, if you will) provides a comprehensive and fact-intensive example of how the Tax Court will evaluate a transaction for which allocations must be made under section 482 and related Treasury Regulations. The Tax Court here appeared to be extremely thorough and intellectually honest, noting that, after further trial and presentation of evidence following remand by the Eighth Circuit, some of the Tax Court’s findings in Medtronic I should be adjusted. And, the Tax Court appears confident in its leverage of the Treasury Regulations that permit the Tax Court to arrive at the best method when, as here, neither the taxpayer nor the IRS presented a method that was properly sustainable under section 482 and the related Treasury Regulations. In this remand proceeding, only Medtronic suggested a new method from what had been presented in earlier proceeding. While the Tax Court did not wholesale approve Medtronic’ new method, the Tax Court used that method, with adjustments, to arrive at an arm’s length allocation for federal income tax purposes. I suspect (or hope) the Court of Appeals for the Eighth Circuit will be satisfied with the Tax Court’s further development of facts and analysis of section 482 and its application to the transactions in issue.

This article discusses Business Disparagement under Texas law. This article does not discuss the tort of defamation or slander of title. Although similar to defamation or slander of title, the false assertion in a business disparagement case instead harms the economic interests of the business.[1] Texas law refers to this type of action as “business disparagement”[2] while the Restatement refers to it as “injurious falsehood.”[3]

The Elements of Business Disparagement in Texas

To prove an action for business disparagement under Texas law, the plaintiff must establish five elements: (1) that the defendant published disparaging words, (2) the words were false, (3) the defendant published the words with malice, (4) without privilege, and (5) the plaintiff must prove special damages.[4] These elements are more stringent than those of defamation because disparagement protects against pecuniary loss.[5]

Disparaging Words

A plaintiff must first prove that the defendant published disparaging words to a third party about the plaintiff’s economic interests.[6]  The Restatement Second of Torts asserts that words are disparaging (1) if they cast doubt upon the quality or ownership of another’s land, chattels or intangible things, or upon the existence or extent of his property in them, and (2) that the defendant intended the words to cast doubt, or a third party reasonably understood the words to cast doubt.[7] Moreover, the Restatement rule notes that the disparagement may be by an expression of opinion or a statement of fact.[8]

Falsity

To prove an action for business disparagement, a plaintiff must plead and prove that the published words were false.[9] In a business disparagement case, there is no presumption of falsity; instead, the plaintiff has the burden of proving the falsity of the publication as part of its cause of action and, likewise, the defendant has no such burden to prove the publication is true.[10] However, a showing by the defendant of the substantial truth of a publication negates the essential element of falsity, and thus entitles the defendant to summary judgment.[11]

Malice

To prove an action for business disparagement, the plaintiff must prove that the defendant published the disparagement with actual malice. Proof of actual malice can be put forward in several different ways, but requires sufficient evidence to permit the conclusion that, at the time of publication, the defendant either: knew the statement was false, “acted with ill will or intended to interfere in the economic interest of the plaintiff,” entertained serious doubts as to the truth of the publication, or “acted with reckless disregard” for the truth.[12]

Actual malice, in this context, “is a term of art.” In the words of the Forbes court, it is not ill will, spite, or evil motive.[13] When the plaintiff in a business disparagement cause of action is a public official or figure, that plaintiff has the burden of proving by clear and convincing evidence that the disparaging words were published with knowledge that they were false or with reckless disregard as to whether or not they were true.[14]

A public figure, however, cannot satisfy the malice requirement merely by demonstrating the defendant’s ill will or intent to interfere with its economic interests.[15] In contrast, a private individual may demonstrate malice merely through the defendant’s “negligence.”[16] Note, however, that a media defendant’s poor choice of words or content, without evidence of deliberate falsity, does not amount to actual malice under Texas law.[17]

Privilege

In the context of business disparagement, privilege means that the defendant has some form of recognized legal immunity that protects them, even from the consequences of making a defamatory statement with malice.[18] In general, privilege may be absolute or conditional.[19] However, because conditional or qualified privilege would be defeated by a finding of malice, and malice is a necessary element of a business disparagement cause of action, such privileges are irrelevant in the context of business disparagement.[20] An absolute privilege, however, is applicable and may more properly be thought of as an immunity because it is based on the personal position or status of the actor.[21]

Special Damages

Texas law requires proof that the disparagement caused a direct pecuniary loss.[22] Proof of special damages is perhaps the most essential element in a business-disparagement claim—as without proof of special damages, there is no claim.[23]  Special damages are pecuniary losses that the plaintiff has suffered that have been realized or liquidated (e.g., loss of specific sales).[24] Furthermore, the disparaging communication in question must play a substantial part in inducing others not to deal with the plaintiff with the result that special damage, in the form of the loss of trade or other dealings, is established.[25] Finally, Texas courts have held that the pecuniary loss must be greater than the attorney fees incurred to bring the business-disparagement claim.[26]

Remedies

A plaintiff in an action for business disparagement can recover actual damages representing commercial harm or pecuniary loss to the plaintiff’s economic interests.[27] Actual damages in a business-disparagement action are “special damages” and must be specifically pleaded.[28] Other remedies include expense of counteracting publication, exemplary damages, equitable relief, interest, court costs, but notably not attorney fees or damages for personal injury.[29] Plaintiffs can also recover damages for the loss of a specific sale, loss of credit, or even loss of business if its business was completely destroyed.[30] The measure of damages for the loss of business is the market value of the business on the date of the loss rather than the loss of expected profits.[31]

Defenses

Defenses against a business disparagement action include limitations, proportionate responsibility, immunity and privilege.

Limitations

The limitations period for an action for business disparagement is two years.[32]  But when the sole basis of a business-disparagement claim is a defamatory injury to reputation and there is no evidence of special damages, the one-year statute of limitations for defamation applies.[33]

Proportionate Responsibility

The defendant can assert the defense that the plaintiff’s own acts or omissions caused or contributed to the plaintiff’s injury.[34]

Immunity & Privilege

Privilege as a defense to a business-disparagement claim, is supported by the Restatement which states that “the defendant has the burden of proving … the publication was absolutely or conditionally privileged.”[35] A defendant in a business-disparagement action can assert any absolute privileges that would be available in a defamation action.When the privilege is absolute, the actor’s motivation is irrelevant.[36] Such immunity, however, attaches only to a limited and select number of situations which involve the administration of the functions of the branches of government, and thus is only applicable in the business-disparagement claim when the defendant is a public official or figure.[37] The absolute privileges in defamation and business disparagement are “in all respects the same.”[38] This is not the case, however, for conditional or qualified privilege. Because conditional or qualified privilege would be defeated by a finding of malice, and malice is a necessary element of a business disparagement cause of action, a defendant cannot assert the defense of a common-law qualified privilege.[39]

Business Litigation Attorney

Need assistance in managing the business tax audit process? Freeman Law’s representations include disputes involving a variety of claims, such as breaches of fiduciary duty, business torts and other commercial disputes, partnership disputes, misrepresentation, deceptive trade practices act (“DTPA”) violations, tortious interference, extortion, Texas Theft Statute violations, civil conspiracy, and cyber and computer violations. We offer value-driven services and provide practical solutions to complex tax issues. Schedule a consultation or call (214) 984-300 to discuss our business litigation services. 

[1] Hurlbut v. Gulf Atl. Life Ins., 749 S.W.2d 762, 766 (Tex.1987); Waste Mgmt. of Tex., Inc. v. Tex. Disposal Sys. Landfill, Inc., 434 S.W.3d 142, 152 (Tex. 2014) (defining pecuniary and non-pecuniary harm).

[2] Id.

[3] Restatement (Second) of Torts § 623A, comment a (1977).

[4] Hurlbut, 749 S.W.2d at 766; Innovative Block v. Valley Builders Sup., 603 S.W.3d 409, 417 (Tex.2020); San Angelo Cmty. Med. Ctr., LLC v. Leon, 03-19-00229-CV, 2021 WL 1680194, at *8 (Tex. App.—Austin Apr. 29, 2021, no pet. h.).

[5] Hurlbut, 749 S.W.2d at 766.

[6] Id.

[7] Restatement (Second) of Torts § 629 (1977).

[8] Restatement (Second) of Torts § 629, comment a (1977); but see First Amendment of the United States Constitution and Art. I, § 8 of the Texas Constitution (note that statements of opinion are not actionable under the Lanham Act because opinions are protected.)

[9] Hurlbut, 749 S.W.2d at 766.

[10] Astoria Indus. of Iowa, Inc. v. SNF, Inc., 223 S.W.3d 616, 625 (Tex. App.—Fort Worth 2007, pet. denied), abrogated by Dallas Symphony Ass’n, Inc. v. Reyes, 571 S.W.3d 753 (Tex. 2019).

[11] See Granada Biosciences, Inc. v. Forbes, Inc., 49 S.W.3d 610 (Tex. App. Houston 14th Dist. 2001), order withdrawn, (Sept. 26, 2002) and judgment rev’d on other grounds, 124 S.W.3d 167 (Tex. 2003).

[12] Granada, 49 S.W.3d at 617; Bentley v. Bunton, 94 S.W.3d 561, 591 (Tex.2002).

[13] Forbes Inc. v. Granada Biosciences, Inc., 124 S.W.3d 167, 171 (Tex. 2003) (internal citations omitted).

[14] Forbes, 124 S.W.3d at 170.

[15] Id.

[16] Id.

[17] Bose Corp. v. Consumers Union of U.S., Inc., 466 U.S. 485, 490, 104 S. Ct. 1949, 1954, 80 L. Ed. 2d 502 (1984).

[18] Hurlbut, 749 S.W.2d at 768.

[19] Id.

[20] Granada, 49 S.W.3d at 619.

[21] Id.

[22] Johnson v. Hosp. Corp. of Am., 95 F.3d 383, 391 (5th Cir. 1996) (citing Hurlbut, 749 S.W.2d at 767).

[23] Waste Mgmt., 434 S.W.3d at 155; Hurlbut, 749 S.W.2d at 767.

[24] Hurlbut, 749 S.W.2d at 767.

[25] Id.

[26] C.P. Interests, Inc. v. California Pools, Inc., 238 F.3d 690, 696 (5th Cir.2001).

[27] Hurlbut, 749 S.W.2d at 767.

[28]Id.

[29] Hurlbut, 749 S.W.2d at 767; Dallas Symphony, 571 S.W.3d at 753; Dwyer v. Sabine Mining Co., 890 S.W.2d 140, 143 (Tex.App.—Texarkana 1994, writ denied) (damages for mental distress and injury to reputation are not recoverable in action for business disparagement).

[30] Hurlbut, 749 S.W.2d at 767.

[31] Id.

[32] Glassdoor, Inc. v. Andra Grp., 575 S.W.3d 523, 527 (Tex.2019).

[33] Nath v. Texas Children’s Hosp., 446 S.W.3d 355, 370 (Tex.2014).

[34] Tex. Civ. Prac. & Rem. Code Ann. § 33.000-4.

[35] Restatement Second, Torts § 651(2).

[36] Hurlbut, 749 S.W.2d at 768.

[37] Id.

[38] Restatement Second, Torts § 635, comment a.

[39] Granada 49 S.W.3d at 619, citing Hurlbut, 749 S.W.2d at 768.

All About IRS Offers in Compromise

An economic downturn increases the ability for thousands of Americans to settle their outstanding tax debt with the IRS.  That means that for many, now may be the time to take advantage of the economic uncertainty and to position themselves for a successful tax settlement—and a fresh start.

An offer in compromise (OIC) is an agreement between a taxpayer and the Internal Revenue Service (IRS) to settle a tax liability for less than the full amount owed.[1]  For many taxpayers, the IRS’s Offer in Compromise program is a path toward a fresh start. To qualify, a taxpayer must submit an offer package (including all required documentation and forms) that meets IRS criteria.  Taxpayers should take care to comply with all applicable IRS criteria—submitting a non-compliant or rejected offer may harm the taxpayer’s position or ability to submit a subsequent offer with success.

Section 7122 of the Code provides broad authority to the Secretary to compromise any case arising under the internal revenue laws, as long as the case has not been referred to the Department of Justice for prosecution or defense.

The IRS will accept an offer in compromise when it is unlikely that the tax liability can be collected in full and the amount offered reasonably reflects the taxpayer’s “collection potential,” a term of art that is defined in IRS regulations. The goal of an offer in compromise is to collect such amounts as early and efficiently as possible.  Taxpayers with significant tax debts can potentially take advantage of the IRS’s Offer in Compromise Program and a skilled tax attorney can help navigate the regulatory complexities and position a taxpayer for the best possible settlement with the IRS.

Official IRS policies provide that an Offer in Compromise is a tool for providing taxpayers with a “fresh start” and reaching a resolution that is in the best interest of both the taxpayer and the IRS:

The ultimate goal [of the Offer in Compromise Program] is a compromise which is in the best interest of both the taxpayer and the Service.   Acceptance of an adequate offer will also result in creating for the taxpayer an expectation of and a fresh start toward compliance with all future filing and payment requirements.

Thus, acceptance of an offer in compromise conclusively settles the liability of the taxpayer, absent fraud or mutual mistake.[2] Compromise with one taxpayer, however, does not extinguish the liability of any person not named in the offer who is also liable for the tax to which the offer relates. The Service may therefore continue to take action to collect from any person not named in the offer.

An offer to compromise a tax liability must be submitted in writing on the IRS’s Form 656, Offer in Compromise.  None of the standard terms can be removed or altered, and the form must be signed under penalty of perjury. The offer should include the legal grounds for compromise, the amount the taxpayer proposes to pay, and the payment terms.  Payment terms include the amounts and due dates of the payments. The offer should also contain any other information required by Form 656 or IRS regulations.

An offer to compromise a tax liability should set forth the legal grounds for compromise and should provide enough information for the Service to determine whether the offer fits within its acceptance policies.  There are three categories for OIC relief: (1) Doubt as to liability; (2) Doubt as to collectability; and (3) Promotion of effective tax administration.

(1) Doubt as to liability

Doubt as to liability exists where there is a genuine dispute as to the existence or amount of the correct tax liability under the law. Doubt as to liability does not exist where the liability has been established by a final court decision or judgment concerning the existence of the liability.

An offer to compromise based on doubt as to liability generally will be considered acceptable if it reasonably reflects the amount the Service would expect to collect through litigation. This analysis includes consideration of the hazards of litigation that would be involved if the liability were litigated. The evaluation of the hazards of litigation is not an exact science and is within the discretion of the Service.

(2) Doubt as to collectability

Doubt as to collectability exists in any case where the taxpayer’s assets and income cannot satisfy the full amount of the liability.

An offer to compromise based on doubt as to collectability generally will be considered acceptable if it is unlikely that the tax can be collected in full and the offer reasonably reflects the amount the Service could collect through other means, including administrative and judicial collection remedies. See Policy Statement P-5-100. This amount is the reasonable collection potential of a case. In determining the reasonable collection potential of a case, the Service will take into account the taxpayer’s reasonable basic living expenses. In some cases, the Service may accept an offer of less than the total reasonable collection potential of a case if there are special circumstances.

(3) Promotion of effective tax administration

The Service may compromise to promote effective tax administration where it determines that, although collection in full could be achieved, collection of the full liability would cause the taxpayer economic hardship. Economic hardship is defined as the inability to pay reasonable basic living expenses. See § 301.6343-1(d). No compromise may be entered into on this basis if the compromise of the liability would undermine compliance by taxpayers with the tax laws.

An offer to compromise based on economic hardship generally will be considered acceptable when, even though the tax could be collected in full, the amount offered reflects the amount the Service can collect without causing the taxpayer economic hardship. The determination to accept a particular amount will be based on the taxpayer’s individual facts and circumstances.

If there are no other grounds for compromise, the Service may compromise to promote effective tax administration where a compelling public policy or equity considerations identified by the taxpayer provide a sufficient basis for compromising the liability. Compromise will be justified only where, due to exceptional circumstances, collection of the full liability would undermine public confidence that the tax laws are being administered in a fair and equitable manner. The taxpayer will be expected to demonstrate circumstances that justify compromise even though a similarly situated taxpayer may have paid his liability in full. No compromise may be entered into on this basis if compromise of the liability would undermine compliance by taxpayers with the tax laws.

An offer to compromise based on compelling public policy or equity considerations generally will be considered acceptable if it reflects what is fair and equitable under the particular facts and circumstances of the case.

Under §7122(c) factors such as equity, hardship, and public policy will be considered in certain circumstances where granting an offer in compromise will promote effective tax administration. The legislative history of this provision (H. Conf. Rep. 599, 105th Cong., 2d Sess. 289 (1998)) states that:

the conferees expect that the present regulations will be expanded so as to permit the IRS, in certain circumstances, to consider additional factors (i.e., factors other than doubt as to liability or collectibility) in determining whether to compromise the income tax liabilities of individual taxpayers. For example, the conferees anticipate that the IRS will take into account factors such as equity, hardship, and public policy where a compromise of an individual taxpayer’s income tax liability would promote effective tax administration. The conferees anticipate that, among other situations, the IRS may utilize this new authority, to resolve longstanding cases by forgoing penalties and interest which have accumulated as a result of delay in determining the taxpayer’s liability. The conferees believe that the ability to compromise tax liability and to make payments of tax liability by installment enhances taxpayer compliance. In addition, the conferees believe that the IRS should be flexible in finding ways to work with taxpayers who are sincerely trying to meet their obligations and remain in the tax system. Accordingly, the conferees believe that the IRS should make it easier for taxpayers to enter into offer-in-compromise agreements, and should do more to educate the taxpaying public about the availability of such agreements.

The IRS will generally take into account a number of circumstances bearing on potential economic hardship, including:

• The taxpayer’s age, employment status and history, ability to earn, number of dependents, and status as a dependent of someone else;
• The amount reasonably necessary for food, clothing, housing (including utilities, home-owner insurance, home-owner dues, and the like), medical expenses (including health insurance), transportation, current tax payments (including federal, state, and local), alimony, child support, or other court-ordered payments, and expenses necessary to the taxpayer’s production of income (such as dues for a trade union or professional organization, or child care payments which allow the taxpayer to be gainfully employed);
• The cost of living in the geographic area in which the taxpayer resides;
• The amount of property exempt from levy which is available to pay the taxpayer’s expenses;
• Any extraordinary circumstances such as special education expenses, a medical catastrophe, or natural disaster; and
• Any other factor that the taxpayer claims bears on economic hardship and brings to the attention of the director.

The following non-exclusive list of factors support (but are not conclusive of) a determination that collection would cause economic hardship:

• Taxpayer is incapable of earning a living because of a long term illness, medical condition, or disability, and it is reasonably foreseeable that taxpayer’s financial resources will be exhausted providing for care and support during the course of the condition;
• Although taxpayer has certain monthly income, that income is exhausted each month in providing for the care of dependents with no other means of support; and
• Although taxpayer has certain assets, the taxpayer is unable to borrow against the equity in those assets and liquidation of those assets to pay outstanding tax liabilities would render the taxpayer unable to meet basic living expenses.

Making the Offer

The offer should include all information necessary to verify the grounds for compromise. Except for offers to compromise based solely on doubt as to liability, this includes financial information provided in a manner approved by the Service. Individual or self-employed taxpayers must submit a Form 433-A, Collection Information Statement for Wage Earners and Self-Employed Individuals, together with any attachments or other documentation required by the Service. Corporate or other business taxpayers must submit a Form 433-B, Collection Information Statement for Businesses, together with any attachments or other documentation required by the Service. The Service may require the corporate officers or individual partners of a business taxpayer to complete a Form 433-A.

A Pending Offer

Section 6331(k)(1) generally prohibits the IRS from making a levy on a taxpayer’s property or rights to property while an offer to compromise a liability is pending with the Service, for 30 days after the rejection of an offer to compromise, or while an appeal of a rejection is pending. The statute of limitations on collection is suspended while levy is prohibited. An offer to compromise becomes pending when it is accepted for processing. The Service accepts an offer to compromise for processing when it determines that: the offer is submitted on the proper version of Form 656 and Form 433-A or B, as appropriate; the taxpayer is not in bankruptcy; the taxpayer has complied with all filing and payment requirements listed in the instructions to Form 656; the taxpayer has enclosed the application fee, if required; and the offer meets any other minimum requirements established by the Service. A determination that the offer meets these minimum requirements means that the offer is processable.

Returned Offers

If an offer to compromise accepted for processing does not contain sufficient information to permit the Service to evaluate whether the offer should be accepted, the Service will request that the taxpayer provide the needed additional information.  If the taxpayer does not submit the additional information that the Service has requested within a reasonable time period after such a request, the Service may return the offer to the taxpayer. The Service also may return the offer after it has been accepted for processing if:

1. The Service determines that the offer was submitted solely to delay collection;
2. The taxpayer fails to file a return or pay a liability;
3. The taxpayer files for bankruptcy;
4. The offer is no longer processable; or
5. The offer was accepted for processing in error. 

The Taxpayer’s Ability to Pay

Courts have held that the “[t]he IRS may reject an offer-in-compromise because the taxpayer’s ability to pay exceeds the compromise proposal.”[3]  Under IRS procedures, the agency will not accept a compromise that is less than the reasonable collection value of the case, absent a showing of special circumstances. See Rev. Proc. 2003–71(2). The IRS considers the reasonable collection value of a case to be the funds available after the taxpayer meets basic living expenses. Id.

The IRS determines the taxpayer’s ability to pay based on the tax liabilities (assessed and unassessed) due at the time the offer is submitted.

When the IRS receives an offer in compromise submission, the IRS will generally complete an initial calculation to determine if the taxpayer can fully pay the tax debt through an installment agreement based on the IRS’s applicable guidelines.  If the initial calculation indicates that the taxpayer cannot full pay the tax through an installment agreement, the IRS will continue its OIC investigation to determine the taxpayer’s reasonable collection potential (RCP).

In determining whether an offer reasonably reflects collection potential, the IRS takes into consideration amounts that might be collected from (1) the taxpayer’s assets, (2) the taxpayer’s present and projected future income, and (3) third parties (e.g., persons to whom the taxpayer had transferred assets). Although most doubt as to collectability offers only involve consideration of the taxpayer’s equity in assets and future disposable income over a fixed period of time, the IRS on occasion also will consider whether the taxpayer should be expected to raise additional amounts from assets in which the taxpayer’s interest is beyond the reach of enforced collection (e.g., interests in property located in foreign jurisdictions or held in tenancies by the entirety).

Taxpayer Documents

If during the IRS’s OIC investigation, the financial information provided by the taxpayer becomes older than 12 months and it appears significant changes have occurred, the IRS will generally request updated information.  If the taxpayer’s circumstances have significantly changed since the submission of the OIC (for example, a change of employment, loss of job, etc.), the IRS will generally seek updated information.

Equity in Assets

The IRS will seek to determine the taxpayer’s equity in his or her assets.  In doing so, the IRS may, among other steps, review the following documents to determine whether there are undisclosed assets or income and to assist in valuing the property:

1. Divorce decrees or separation agreements to determine the disposition of assets in the property settlements;
2. Homeowners or renters insurance policies and riders to identify high value personal items such as jewelry, antiques, or artwork;
3. Financial statements recently provided to lending institutions or others to identify assets or income that may not have been revealed on the CIS.

Ongoing Businesses

For an ongoing business, the IRS may make field calls to validate the existence and value of business assets and inventory.  The IRS may follow other special procedures related to an on-going business, and in some situations, the IRS may accept offers for less than the business’s RCP.

Net Realizable Equity

For offer in compromise purposes, a taxpayer’s assets are valued at net realizable equity (NRE).

Net realizable equity is defined as the quick sale value (QSV) less amounts owed to secured lien holders with priority over the federal tax lien, if applicable, and applicable exemption amounts

The QSV is defined as an estimate of the price a seller could get for the asset in a situation where financial pressures motivate the owner to sell in a short period of time, usually 90 calendar days or less. Generally, the QSV is less than the fair market value (FMV) of the asset.

Generally, QSV is calculated at 80% of FMV.  IRS guidance provides that a higher or lower percentage may be applied in determining QSV when appropriate, depending on the type of asset and current market conditions. If, based on the current market and area economic conditions, it is believed that the property would quickly sell at full FMV, then the IRS may consider QSV to be the same as FMV. This is occasionally found to be true in real estate markets where real estate is selling quickly at or above the listing price. If the IRS believes that the value chosen represents a fair estimate of the price a seller could get for the asset in a situation where the asset must be sold quickly (usually 90 calendar days or less) then the IRS may use a percentage other than 80%. Generally, it is the policy of the IRS to apply QSV in valuing property for offer purposes.

When a particular asset has been sold (or a sale is pending) in order to fund the offer, the IRS will not provide for a reduction for QSV. Instead, it will verify the actual sale price, ensuring that the sale is an arms-length transaction, and use that amount as the QSV. The IRS may allow for a reduction for the costs of the sale and the expected current-year tax consequence to arrive at the NRE of the asset.

Jointly Held Assets

When taxpayers submit separate offers but have jointly-owned assets, the IRS will generally allocate equity in the assets equally between the owners. However, the IRS will allocate the equity in a different manner under certain circumstances: If the joint owners demonstrate that their interest in the property is not equally divided, the IRS will allocate the equity based on each owner’s contribution to the value of the asset.

If the joint owners have joint and individual tax liabilities included in the offer in compromise, the IRS will generally apply the equity in assets first to the joint liability and then to the individual liability.

For property held as tenancies by the entirety when the tax is owed by only one spouse, the taxpayer’s portion is usually considered to be 50% of the property’s NRE.   However, applicable state law, such as community property and registered domestic partnership laws, may impact property ownership rights and may change the taxpayer’s interest in assets that should be included in RCP for offer in compromise purposes.

Assets Held By Others as Transferees, Nominees, or Alter Egos

The IRS will also conduct an investigation to determine what degree of control the taxpayer has over assets and income that are in the possession of others, particularly when the offer will be funded by a third party.

The IRS will seek to determine whether there are any transferee, nominee, or alter ego issues present.   If the IRS determines that the taxpayer has a beneficial interest in assets or income streams that are held by a transferee, nominee, or alter ego, the IRS will reflect the value of such assets or interest in the RCP.

Cash

When determining an individual taxpayer’s RCP, the IRS will generally utilize the amount of cash listed on the taxpayer’s Form 433-A (OIC) for the amount of cash in the taxpayer’s bank accounts, though it will reduces such amount by $1,000.

When determining a business taxpayer’s RCP, the IRS will generally utilize the amount listed on the Form 433-B(OIC) for the amount of cash in the taxpayer’s bank account.  The $1,000 reduction applicable to individual bank accounts is not applicable with respect to business taxpayers.

The IRS will review the taxpayer’s checking account statements over a reasonable period of time, generally three months for wage earners and six months for taxpayers who are non-wage earners. The IRS will seek to ascertain whether there is unusual activity, such as deposits in excess of reported income, withdrawals, transfers, or checks for expenses not reflected on the CIS.

If a taxpayer offers the balances of certain accounts—for example, certificate of deposit, savings bonds, etc.—to fund the proposed offer, the IRS may allow for any penalty for early withdrawal and allow for expected current year tax consequences with respect to the account withdrawal.

Securities and Stocks of Closely Held Entities

Financial securities are considered an asset and the IRS includes their value in its determination of the taxpayer’s the RCP.

If the taxpayer proposes to liquidate an investment in order to fund the proposed offer in compromise, the IRS will allow for the associated fees in addition to any penalty imposed on the taxpayer for early withdrawal, as well as the expected current year tax consequences.

In order to determine the value of “closely held” stock that is not traded publicly or for which there is no established market, the IRS may consider the following methods to value the stock:

• a recent annual report to stockholders.
• recent corporate income tax returns.
• an appraisal of the business as a going concern by a qualified and impartial appraiser.

IRS standards provide that when a taxpayer holds only a negligible or token interest in the stock, or has made no investment and exercises no control over the corporate affairs, it is permissible to assign no value to the stock.

The IRS may be skeptical when a taxpayer claims that they have no interest in a closely held corporation or family owned business but the facts indicate that their interest may have been transferred or assigned.  Under such circumstances, the IRS will generally conduct additional investigative measures.

There are additional considerations when it comes to offers involving closely held entities:

• Compensation to Corporate Officers – The IRS may not allow wages and/or other compensation, (i.e., draws) paid to corporate officers in excess of applicable expenses allowable per National and Local standards as business expenses. The officer’s ownership interest in the business and any control over the compensation received is generally a consideration in the IRS’s determination of whether the officer compensation is deemed excessive.
• Stock Holder Distributions and Repayment of Loans to Officers – Because these expenses are discretionary in nature, the IRS may evaluate distributions of this nature made after the incurrence of the outstanding tax liability under the “dissipated asset” provisions. Loans to officers are generally considered an account receivable and valued according to their collectability. If the IRS believes that the taxpayer may be receiving income from loans and that their wages are not reasonable, the IRS may consider a referral to the Examination Division.
• Stock Held by Beneficial Owner – The value of stock ownership in a closely held corporation/LLC is generally included in the RCP of a taxpayer submitting an offer to compromise their individual liabilities.

Virtual Currency.  The taxpayer may have in interest or ownership in virtual currency (e.g. bitcoin). A virtual currency is an electronic currency that isn’t legal tender and isn’t issued by a government. For tax purposes, the transactions are treated as an exchange of property. The IRS will generally include the value of virtual currency in the taxpayer’s RCP. The value will generally be determined in the same manner as a publicly traded stock.

Life Insurance

The IRS will may treat life insurance differently depending upon the type and nature of the insurance policy.  The IRS will seek to identify the type of insurance, the conditions for borrowing or cancellation, and the current loan and cash values on the policy.

Under IRS guidance, life insurance as an investment (e.g., whole life) is generally not considered “necessary.”

When determining the value in a taxpayer’s insurance policy, consider:

• If the taxpayer will retain the insurance policy then the equity is considered to be the cash surrender value
• If the taxpayer will sell the policy to help fund the proposed offer, then the taxpayer’s “equity” is considered to be the amount that the taxpayer will receive from the sale of the policy. Documentation from a broker may be required to verify the selling price and related expenses.
• If the taxpayer will borrow on the policy to help fund the proposed offer, then the taxpayer’s “equity” is considered to be the cash loan value less any prior policy loans or automatic premium loans required to keep the contract in force.

The IRS will generally allow reasonable premiums for term life insurance policies as a necessary expense.

If the taxpayer has a whole life policy, the IRS will generally allow a reasonable amount of the premiums that is attributable to the death benefit under the policy.

Retirement or Profit-Sharing Plans

Funds held in a retirement or profit-sharing plan are considered an asset and must be valued for purposes of the offer in compromise.

The IRS considers does not consider contributions to voluntary retirement plans to be a necessary expense.  The IRS provides for a number of rules based upon the type of account at issue:

Furniture, Fixtures, and Personal Effects

The IRS will generally accept the taxpayer’s declared value of household goods unless there are articles of extraordinary value, such as antiques, artwork, jewelry, or collector’s items.  In such cases, the IRS may even personally inspect the assets.

There is a statutory exemption from IRS levies that applies to a number of items, including the taxpayer’s furniture and personal effects. This exemption amount is updated on an annual basis.  This exemption applies only to individual taxpayers.

The property is owned jointly with any person who is not liable for the tax, the IRS will determine the value of the taxpayer’s proportionate share of property before allowing the levy exemption.

While the furniture or fixtures used in a business may not qualify for the personal effects exemption, they may qualify for the levy exemption as tools of a trade.

If the property has a valid encumbrance with priority over the NFTL, the IRS will allow the encumbrance in addition to the statutory exemption.

Motor Vehicles, Airplanes, and Boats

Equity in motor vehicles, airplanes, and boats is included in the taxpayer’s RCP. The general rule for determining Net Realizable Equity applies when determining equity in these assets. However, unusual assets such as airplanes and boats may require an appraisal to determine FMV.

In most cases, the IRS will discounted at 80% of FMV to arrive at the QSV for a vehicle.

The IRS will exclude $3,450 per car from the QSV of vehicles owned by the taxpayer and used for work, the production of income, and/or the welfare of the taxpayer’s family (up to two cars for joint taxpayers and one vehicle for a single taxpayer).

Note that when assets in this category are used for business purposes, they may be considered income producing assets.

Real Estate

The IRS will seek to verify the FMV of real property. FMV is defined as the price at which a willing seller will sell, and a willing buyer will pay, for the property, given time to obtain the best and highest possible price. The IRS will seek to verify the type of ownership through warranty and mortgage deeds, and may seek to verify or determine the FMV of the property through various sources, including:

• The value listed on real estate tax assessment statements.
• Market comparables.
• Recent purchase prices.
• An existing contract to sell.
• Recent appraisals.
• A homeowner’s insurance policy.

The equity in real estate is included when calculating the taxpayer’s RCP to determine an acceptable offer amount.

Note, however, that there may be circumstances in which an offer under ETA or Doubt as to Collectibility with Special Circumstances (DATCSC) may be appropriate for an amount which does not include some or all of the real property equity.

For real estate and other related property held as tenancies by the entirety when the tax is owed by only one spouse, the IRS usually treats the taxpayer’s portion as 50% of the property’s NRE.

Accounts and Notes Receivable

Accounts and notes receivable are considered assets unless the IRS makes a determination to treat them as part of the taxpayer’s income stream when they are required for the production of income. When the IRS determins that liquidation of a receivable would be detrimental to the continued operation of an otherwise profitable business, the receivable may be treated as future income.

Accounts Receivable – The value of accounts receivable to be included in the taxpayer’s RCP may be adjusted based on the age of the account.  Accounts receivable that are current (i.e. less than or equal to 90 days past due is generally considered current for these purposes) generally may be discounted at Quick Sale Value (QSV), if the taxpayer presents accounting or industry rules or other substantiation providing for devaluation of such accounts. If the account is determined to be delinquent it may be discounted appropriately based on the age of the receivable and the potential for collection.

When the receivables have been sold at a discount or pledged as collateral on a loan, the IRS will apply the provisions of IRC 6323(c) to determine the lien priority of commercial transactions and financing agreements.

The IRS may closely examine accounts of significant value that the taxpayer is not attempting to collect, or that are receivable from officers, stockholders, or relatives.

In order to determine the value of a note receivable, the IRS may consider, among other things, the following:

• Whether it is secured and if so by what asset(s),
• What is collectible from the borrower, and
• If it could be successfully levied upon.

Income-Producing Assets

When an offer includes business assets, the IRS conducts an analysis to determine if certain assets are essential for the production of income. When it has been identified that an asset or a portion of an asset is necessary for the production of income, the IRS will adjust the income or expense calculation for the taxpayer to account for the loss of income stream if the asset was either liquidated or used as collateral to secure a loan to fund the offer.

The IRS will generally use the following procedures when valuing income-producing assets:

As a general rule, equity in income-producing assets will not be added to the taxpayer’s RCP of a viable, ongoing business, unless the IRS determines that the assets are not critical to business operations.  However, the IRS will include equity in real property in the calculation of RCP.

Moreover, even though rental property, owned by the taxpayer, may produce income, the IRS will generally include the equity in the taxpayer’s RCP.  However, an adjustment to the taxpayer’s future income value may be appropriate if the taxpayer will be borrowing against or selling the property to fund the proposed offer.

The following examples provides some guidance with respect to the treatment of equity and income produced by assets:

Example:

(1) A business depends on a machine to manufacture parts and cannot operate without this machine. The equity is $100,000. The machine produces net income of $5,000 monthly. The RCP should include the income produced by the machine, but not the equity. Equity in this machine will generally not be included in the RCP because the machine is needed to produce the income, and is essential to the ability of the business to continue to operate.

The IRS considers it to be in the government’s best interests to work with taxpayer in this situation to maintain business operations.

Based on a taxpayer’s specific circumstances, there may instances where the IRS will treat the income producing assets in a Subchapter S corporation in a similar manner to assets owned by a taxpayer’s sole proprietorship business.  Factors that are considered in this analysis include:

• Type of business activity
• Taxpayer’s occupation
• Current income received from the corporation as salary and the amount of future income that the taxpayer will receive
• Current income received from corporation as dividend
• Ability of the taxpayer to sell their interest in the corporation

Inventory, Machinery, Equipment, and Tools of the Trade

Inventory, machinery, and equipment may be considered income-producing assets.  In order to determine the value of business assets, the IRS may use the following:

• For assets commonly used in many businesses, such as automobiles and trucks, the value may be determined by consulting trade association guides.
• For specialized machinery and equipment suitable for only certain applications, the IRS may consult a trade association guide, secure an appraisal from a knowledgeable and impartial dealer, or contact the manufacturer.
• When the property is unique or difficult to value and no other resource will meet the need, the IRS may utilize the services of an IRS valuation engineer.
• The IRS may ask the taxpayer to secure an appraisal from a qualified business appraiser.

There is a statutory exemption from levy that applies to an individual taxpayer’s tools used in a trade or business, which the IRS will allow in addition to any encumbrance that has priority over the NFTL. Whether an automobile is a tool of the trade depends on the taxpayer’s trade. The levy exemption amount is updated on an annual basis.

Business as a Going Concern

The IRS may evaluate a business as a going concern when determining the RCP of an operating business that is owned individually or by a corporation, partnership, or LLC. The IRS recognizes that a business may be worth more than the sum of its parts when sold as a going concern.

To determine the value of a business as a going concern, the IRS will consider the value of its assets, future income, and intangible assets such as:

• Ability or reputation of a professional.
• Established customer base.
• Prominent location.
• Well known trade name, trademark, or telephone number.
• Possession of government licenses, copyrights, or patents.

Generally, the difference between what an ongoing business would realize if sold on the open market as a going concern and the traditional RCP analysis is attributable to the value of these intangibles.

Dissipation of Assets

The inclusion of dissipated assets in the calculation of the reasonable collection potential (RCP) is no longer applicable, except where it can be shown that the taxpayer sold, transferred, encumbered or otherwise disposed of assets in an attempt to avoid the payment of the tax liability or used the assets or proceeds (other than wages, salary, or other income) for other than the payment of items necessary for the production of income or the health and welfare of the taxpayer or their family, after the tax has been assessed or during a period of up to six months prior to or after the tax assessment.

The evaluation of a taxpayer’s interest in property held as a nominee, transferee, or alter ego is evaluated separately from the determination of whether the taxpayer may have dissipated an asset in an attempt to avoid the payment of tax.

Generally, the IRS uses a three-year time frame to determine if it is appropriate to include a dissipated asset in the taxpayer’s RCP.

Even if the transfer and/or sale took place more than three years prior to the offer submission, the IRS may deem it appropriate to include an asset in the calculation of RCP if the asset transfer and/or sale occurred during a period of up to six months prior to or after the assessment of the tax liability. If the asset transfer took place upon notice of or during an examination, the IRS may not apply these time frames based on the circumstances of the case. Where the IRS is considering the inclusion of a dissipated asset, it may also look at whether the funds were used for health/welfare of the family or production of income.

Note that if the tax liability at issue did not exist prior to the transfer or the transfer occurred prior to the taxable event giving rise to the tax liability, generally, a taxpayer cannot be said to have dissipated the assets in disregard of the outstanding tax liability.

If a taxpayer withdraws funds from an IRA to invest in a business opportunity but does not have any tax liability prior to the withdrawal, the IRS will not consider the funds to have been dissipated.

Any tax paid as a result of the sale of dissipated assets may be allowed as a reduction to the value placed on the dissipated asset.

Retired Debt

Retired debt is considered an expected change in necessary or allowable expenses. The necessary/allowable expenses may decrease after the retirement of the debt, which would change the taxpayer’s ability to pay. 

For example, required child support payments may stop before the future income period ends. Under IRS standards, these retired payments would generally increase the taxpayer’s ability to pay.

Future Income

Future income is defined by IRS guidance as an estimate of the taxpayer’s ability to pay based on an analysis of gross income, less necessary living expenses, for a specific number of months into the future.

As a general rule, the IRS uses the taxpayer’s current income in the analysis of the taxpayer’s future ability to pay.  This may include situations where the taxpayer’s income has been recently reduced based on a change in occupation or employment status.

The IRS will also consider the taxpayer’s overall general circumstances, including age, health, marital status, number and age of dependents, level of education or occupational training, and work experience.

Depending on the circumstances, the IRS may place a different value on future income than current or past income indicates.  The IRS may also seek to secure a future income collateral agreement based on the taxpayer’s earnings potential.

Allowable Expenses

Allowable expenses consist of necessary and conditional expenses.  Allowable expenses are discussed below.

Necessary Expenses

A necessary expense is one that is necessary for the production of income or for the health and welfare of the taxpayer’s family.  The national and local expense standards serve as guidelines in determining a taxpayer’s basic living expenses.

Taxpayers are allowed the National Standard Expense amount for their family size, without a need to substantiate the amount actually spent.[4]  However, if the total amount claimed is more than the total allowed by the National Standards, the taxpayer is required to provide documentation to substantiate and justify that the allowed expenses are inadequate to provide basic living expenses.

National Standards

The IRS’s Offer in Compromise Program was impacted by a 1995 IRS initiative designed to ensure uniform treatment of similarly situated taxpayers. In administering its collection operations, including both the installment agreement program and the compromise program, the IRS has always permitted taxpayers to retain funds to pay reasonable living expenses.

In 1995, the IRS adopted and published national and local standards for determining allowable expenses, which were designed to apply to all collection actions, including offers to compromise. National expense standards were derived from the Bureau of Labor Statistics Consumer Expenditure Survey and were promulgated for expense categories such as food, clothing, personal care items, and housekeeping supplies. Local expense standards derived from Census Bureau data were promulgated for housing, utilities, and transportation.

The IRS allowable expense criteria play an important role in determining whether taxpayers are candidates for an offer in compromise.

Housing and Utilities

When determining a taxpayer’s housing and utility expense, the IRS seeks to use an amount that provides for basic living expenses. The IRS requires that deviations from the expense standards be verified, reasonable, and documented.

Transportation Expenses

Transportation expenses are considered necessary when they are used by taxpayers and their families to provide for their health and welfare and/or the production of income.

The transportation standards are designed to account for loan or lease payments—referred to as ownership costs—and additional amounts for operating costs broken down by Census Region and Metropolitan Statistical Area. Operating costs include maintenance, repairs, insurance, fuel, registrations, licenses, inspections, parking and tolls.

Ownership Expenses – Expenses are allowed for the purchase or lease of a vehicle. Taxpayers are generally allowed the local standard or the amount actually paid, whichever is less, unless the taxpayer provides documentation to verify and substantiate that the higher expenses are necessary.

Operating Expenses – The IRS will generally allow the full operating costs portion of the local transportation standard, or the amount actually claimed by the taxpayer, whichever is less. Substantiation for this allowance is generally not required unless the amount claimed is more than the total allowed by any of the transportation standards.

A taxpayer who commutes long distances to reach his place of employment, he may be allowed greater than the standard operating expenses, as the additional operating expense would generally meet the production of income test.

If the taxpayer has a vehicle that is over eight years old or has reported mileage of 100,000 miles or more, an additional monthly operating expense of $200 will generally be allowed per vehicle (up to two vehicles when a joint offer is submitted).

Other Expenses

Other expenses may be allowed in determining the value of future income for IRS offer purposes. The expense, however, generally must meet the necessary expense test by providing for the health and welfare of the taxpayer and/or his or her family or must be for the production of income. This is determined based on the facts and circumstances of each case.

Generally, the repayment of loans incurred to fund the offer and secured by the taxpayer’s assets will be allowed, if the asset is necessary for the health and welfare of the taxpayer and/or their family, i.e. taxpayer’s residence, and the repayment amount is reasonable. The same rule applies whether the equity is paid to the IRS before the offer is submitted or will be paid upon acceptance of the offer.

Minimum payments on student loans guaranteed by the federal government are allowed for the taxpayer’s post-high school education. Proof of payment, however, must generally be provided. If student loans are owed, but no payments are being made, the IRS may not allow them, unless the non-payment is due to circumstances of financial hardship, e.g. unemployment, medical expenses, etc.

Education expenses are generally allowed only for the taxpayer and only if it they are required as a condition of present employment. Expenses for dependents to attend colleges, universities, or private schools may not be allowed by the IRS unless the dependents have special needs that cannot be met by public schools.

Child support payments for natural children or legally adopted dependents may generally be allowed based on the taxpayer’s situation. A copy of the court order and proof of payments should be provided as part of the offer submission. If no payments are being made, the IRS may not allow the expense, unless the nonpayment was due to temporary job loss or illness.

The IRS will generally not allow payments for expenses, such as college tuition or life insurance for children, made pursuant to a court order. The IRS’s position is that the fact that the taxpayer may be under court order to make payments with respect to such expenses does not change the character of the expense. Therefore, the fact that a taxpayer is under court order to provide a payment may not elevate that expense to allowable status as an offer expense, if the Service would not otherwise allow it.

Generally, charitable contributions are not allowed in the RCP calculation. However, charitable contributions may be an allowable expense if they are a condition of employment or meet the necessary expense test.

Payments being made to fund or repay loans from voluntary retirement plans will generally not be allowed by the IRS. Taxpayers who cannot repay these loans will have a tax consequence in the year that the loan is declared in default and that consequence should be estimated and allowed as an additional tax expense on the IET for the required number of months necessary to cover the additional tax consequence.

Current taxes are allowed regardless of whether the taxpayer made them in the past or not. If an adjustment to the taxpayer’s income is made, an adjustment of the tax liability must also be made. Current taxes include federal, state, and local taxes. In a wage earner situation, allow the amount shown on the pay stub. If the current withholding amount is insufficient or was recently adjusted to substantially over-withhold, the tax expenses should be based on the actual tax expense.

Shared Expenses

Generally, the IRS will only a taxpayer the expenses that the taxpayer is required to pay. Consideration must be given to situations where the taxpayer shares expenses with another. Shared expenses may exist in one of two situations:

• An offer is submitted by a taxpayer who shares living expenses with another individual who is not liable for the tax.
• Separate offers are submitted by two or more persons who owe joint liabilities and/or separate liabilities and who share the same household.

Generally, the assets and income of a non-liable person are excluded from the computation of the taxpayer’s ability to pay. Treasury Reg. 301.7122-1 (c) (2) (ii) (A) only applies in non-liable situations.

Calculation of Future Income

Future income is defined as an estimate of the taxpayer’s ability to pay based on an analysis of gross income, less necessary living expenses, for a specific number of months into the future. The number of months used depends on the payment terms of the offer.

Note:

Generally, the amount to be collected from future income is calculated by taking the projected gross monthly income, less allowable expenses, and multiplying the difference by the number of months applicable to the terms of offer.

For lump sum cash and periodic payment offers, when there are less than 12 or 24 months remaining on the statutory period for collection, the IRS will use the number of months remaining on the statutory period for collection.

Calculation of Future Income – Cultivation and Sale of Marijuana in Accordance with State Laws

The value of future income when a taxpayer is involved in the cultivation and sale of marijuana, in accordance with applicable state laws, should be based on the following guidance:

1. The IRS will determine the taxpayer’s gross income over a specific time period (normally annually);
2. The IRS will limit allowable expenses consistent with Internal Revenue Code Section 280E, where a taxpayer may not deduct any amount for a trade or business where the trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances;

Since only expenses that are allowable based on current federal law will be included in determining future income value, the taxpayer’s most recent income tax return is generally the most appropriate document to use when completing the income/expense table.

Limited Liability Companies (LLC) Issues

Offers in compromise from a LLC involve unique issues, especially when the liabilities include employment or excise taxes.

The classification of the LLC for federal tax purposes is important.  Yet, classification of the LLC for federal tax purposes does not negate state law provisions concerning the legal status of the LLC. For example:

• Classification of an LLC as a partnership does not mean the member/owners have liability for LLC debts as would be the case in a state law partnership.
• Under certain circumstances, an LLC may be disregarded as an entity separate from its owner. This classification does not mean that an LLC owned by an individual is the equivalent of a sole proprietorship.

Financial Analysis of an LLC

As with any entity, the IRS will require sufficient information to make an informed decision on the acceptability of the taxpayer’s compromise proposal.  This requires a financial statement from the LLC, as well as employment tax liabilities for wages paid prior to January 1, 2009, where the classification of the LLC is a disregarded entity even though the LLC is not the liable taxpayer.

The IRS will generally also seek financial information of all member owners, except when a member owner holds only a negligible or token interest, has made no or minimal investment and exercises no control over the corporate affairs unless other factors are present to indicate the information is necessary to determine the acceptability of the taxpayer’s offer.

Financial Analysis of a Partnership Interest

Since the taxpayer’s interest in any asset should be included in RCP, if the taxpayer has any interest in a partnership, the IRS will make a determination of the appropriate value to include in an acceptable offer amount. The taxpayer’s interest in a partnership may be as a general or limited partner.

Generally, the value of the taxpayer’s interest would either be the taxpayer’s share of the underlying assets or the value of the transferable interest. The determination of the correct valuation may also be based on other factors, including whether the taxpayer is a general partner, how the taxpayer’s interest was acquired, how the assets of the partnership were acquired, the taxpayer’s relationship to the other partners, and the liquidity of the transferable interest.

Offer in Compromise Submitted on Cases Involving Collection Statute Expiration Date Extensions

Taxpayers that previously extended the CSED in connection with an installment agreement may request approval of an OIC.

Payment Terms

Payment terms are negotiable, but the IRS will request that they provide for payment of the offered amount in the least time possible. If a taxpayer is planning to sell asset(s) to fund all or a portion of the offer, the payment terms for the offer may need to provide for immediate payment of the amounts received from the sale. If the taxpayer is planning to borrow a portion of the money, the payment terms of the offer may need to provide for payment of the borrowed portion at the time the funds are received.

For those taxpayers who agree to shorter payment terms, fewer months of future income are required:

While a periodic payment offer is being evaluated by the Service, the taxpayer is required to make subsequent proposed periodic payments as they become due. Even though there is no requirement that the payments be made monthly or in equal amounts, the IRS will base offer payments on the taxpayer’s specific situation and ability to pay. While the calculation of RCP and consideration of any special circumstances will ultimately assist the IRS in determining an acceptable offer amount, the IRS is not bound by the offer amount or the terms proposed by the taxpayer.

The Law

Offers in Compromise are generally and primarily governed by I.R.C. section 7122 and the regulations thereunder.  We have provided the current versions of those most relevant authorities below:

 I.R.C. Sec. 7122

(a)Authorization.  The Secretary may compromise any civil or criminal case arising under the internal revenue laws prior to reference to the Department of Justice for prosecution or defense; and the Attorney General or his delegate may compromise any such case after reference to the Department of Justice for prosecution or defense.

(b)Record.  Whenever a compromise is made by the Secretary in any case, there shall be placed on file in the office of the Secretary the opinion of the General Counsel for the Department of the Treasury or his delegate, with his reasons therefor, with a statement of—

(1) The amount of tax assessed,

(2) The amount of interest, additional amount, addition to the tax, or assessable penalty, imposed by law on the person against whom the tax is assessed, and

(3) The amount actually paid in accordance with the terms of the compromise.

Notwithstanding the foregoing provisions of this subsection, no such opinion shall be required with respect to the compromise of any civil case in which the unpaid amount of tax assessed (including any interest, additional amount, addition to the tax, or assessable penalty) is less than $50,000. However, such compromise shall be subject to continuing quality review by the Secretary.

(c)Rules for submission of offers-in-compromise

(1)Partial payment required with submission

(A)Lump-sum offers

(i)In general

The submission of any lump-sum offer-in-compromise shall be accompanied by the payment of 20 percent of the amount of such offer.

(ii)Lump-sum offer-in-compromise

For purposes of this section, the term “lump-sum offer-in-compromise” means any offer of payments made in 5 or fewer installments.

(B)Periodic payment offers

(i)In general

The submission of any periodic payment offer-in-compromise shall be accompanied by the payment of the amount of the first proposed installment.

(ii)Failure to make installment during pendency of offer

Any failure to make an installment (other than the first installment) due under such offer-in-compromise during the period such offer is being evaluated by the Secretary may be treated by the Secretary as a withdrawal of such offer-in-compromise.

(2)Rules of application

(A)Use of payment

The application of any payment made under this subsection to the assessed tax or other amounts imposed under this title with respect to such tax may be specified by the taxpayer.

(B)Application of user fee

In the case of any assessed tax or other amounts imposed under this title with respect to such tax which is the subject of an offer-in-compromise to which this subsection applies, such tax or other amounts shall be reduced by any user fee imposed under this title with respect to such offer-in-compromise.

(C)Waiver authority

The Secretary may issue regulations waiving any payment required under paragraph (1) in a manner consistent with the practices established in accordance with the requirements under subsection (d)(3).

(3)Exception for low-income taxpayers

Paragraph (1), and any user fee otherwise required in connection with the submission of an offer-in-compromise, shall not apply to any offer-in-compromise with respect to a taxpayer who is an individual with adjusted gross income, as determined for the most recent taxable year for which such information is available, which does not exceed 250 percent of the applicable poverty level (as determined by the Secretary).

(d)Standards for evaluation of offers

(1)In general

The Secretary shall prescribe guidelines for officers and employees of the Internal Revenue Service to determine whether an offer-in-compromise is adequate and should be accepted to resolve a dispute.

(2)Allowances for basic living expenses

(A)In general

In prescribing guidelines under paragraph (1), the Secretary shall develop and publish schedules of national and local allowances designed to provide that taxpayers entering into a compromise have an adequate means to provide for basic living expenses.

(B)Use of schedules

The guidelines shall provide that officers and employees of the Internal Revenue Service shall determine, on the basis of the facts and circumstances of each taxpayer, whether the use of the schedules published under subparagraph (A) is appropriate and shall not use the schedules to the extent such use would result in the taxpayer not having adequate means to provide for basic living expenses.

(3)Special rules relating to treatment of offersThe guidelines under paragraph (1) shall provide that—

(A) an officer or employee of the Internal Revenue Service shall not reject an offer-in-compromise from a low-income taxpayer solely on the basis of the amount of the offer,

(B)in the case of an offer-in-compromise which relates only to issues of liability of the taxpayer—

(i) such offer shall not be rejected solely because the Secretary is unable to locate the taxpayer’s return or return information for verification of such liability; and

(ii) the taxpayer shall not be required to provide a financial statement, and

(C) any offer-in-compromise which does not meet the requirements of subparagraph (A)(i) or (B)(i), as the case may be, of subsection (c)(1) may be returned to the taxpayer as unprocessable.

(e)Administrative review.  The Secretary shall establish procedures—

(1) for an independent administrative review of any rejection of a proposed offer-in-compromise or installment agreement made by a taxpayer under this section or section 6159 before such rejection is communicated to the taxpayer; and

(2) which allow a taxpayer to appeal any rejection of such offer or agreement to the Internal Revenue Service Independent Office of Appeals.

(f)Deemed acceptance of offer not rejected within certain period.  Any offer-in-compromise submitted under this section shall be deemed to be accepted by the Secretary if such offer is not rejected by the Secretary before the date which is 24 months after the date of the submission of such offer. For purposes of the preceding sentence, any period during which any tax liability which is the subject of such offer-in-compromise is in dispute in any judicial proceeding shall not be taken into account in determining the expiration of the 24-month period.

(g)Frivolous submissions, etc.  Notwithstanding any other provision of this section, if the Secretary determines that any portion of an application for an offer-in-compromise or installment agreement submitted under this section or section 6159 meets the requirement of clause (i) or (ii) of section 6702(b)(2)(A), then the Secretary may treat such portion as if it were never submitted and such portion shall not be subject to any further administrative or judicial review.

(Aug. 16, 1954, ch. 736, 68A Stat. 849; Pub. L. 94–455, title XIX, § 1906(b)(13)(A), Oct. 4, 1976, 90 Stat. 1834; Pub. L. 104–168, title V, § 503(a), July 30, 1996, 110 Stat. 1461; Pub. L. 105–206, title III, § 3462(a), (c)(1), July 22, 1998, 112 Stat. 764, 766; Pub. L. 109–222, title V, § 509(a), (b), May 17, 2006, 120 Stat. 362, 363; Pub. L. 109–432, div. A, title IV, § 407(d), Dec. 20, 2006, 120 Stat. 2962; Pub. L. 113–295, div. A, title II, § 220(y), Dec. 19, 2014, 128 Stat. 4036; Pub. L. 116–25, title I, §§ 1001(b)(1)(F), 1102(a), July 1, 2019, 133 Stat. 985, 986.)

Treas. Reg. Sec. 301.7122-1 Compromises.

(a) In general

(1) If the Secretary determines that there are grounds for compromise under this section, the Secretary may, at the Secretary’s discretion, compromise any civil or criminal liability arising under the internal revenue laws prior to reference of a case involving such a liability to the Department of Justice for prosecution or defense.

(2) An agreement to compromise may relate to a civil or criminal liability for taxes, interest, or penalties. Unless the terms of the offer and acceptance expressly provide otherwise, acceptance of an offer to compromise a civil liability does not remit a criminal liability, nor does acceptance of an offer to compromise a criminal liability remit a civil liability.

(b) Grounds for compromise –

(1) Doubt as to liability. Doubt as to liability exists where there is a genuine dispute as to the existence or amount of the correct tax liability under the law. Doubt as to liability does not exist where the liability has been established by a final court decision or judgment concerning the existence or amount of the liability. See paragraph (f)(4) of this section for  special rulesapplicable to rejection of offers in cases where the Internal Revenue Service (IRS) is unable to locate the taxpayer‘s return or return information to verify the liability.

(2) Doubt as to collectibility. Doubt as to collectibility exists in any case where the taxpayer‘s assets and income are less than the full amount of the liability.

(3) Promote effective tax administration.

(i) A compromise may be entered into to promote effective tax administration when the Secretary determines that, although collection in full could be achieved, collection of the full liability would cause the  taxpayer economic hardship within the meaning of § 301.6343-1.

(ii) If there are no grounds for compromise under paragraphs (b)(1), (2), or (3)(i) of this section, the IRS may compromise to promote effective tax administration where compelling public policy or equity considerations identified by the  taxpayer provide a sufficient basis for compromising the liability. Compromise will be justified only where, due to exceptional circumstances, collection of the full liability would undermine public confidence that the  tax laws are being administered in a fair and equitable manner. A  taxpayer proposing compromise under this paragraph (b)(3)(ii) will be expected to demonstrate circumstances that justify compromise even though a similarly situated  taxpayer may have paid his liability in full.

(iii) No compromise to promote effective tax administration may be entered into if compromise of the liability would undermine compliance by  taxpayers with the  tax laws.

(c) Special rules for evaluating offers to compromise –

(1) In general. Once a basis for compromise under paragraph (b) of this section has been identified, the decision to accept or reject an offer to compromise, as well as the terms and conditions agreed to, is left to the discretion of the Secretary. The determination whether to accept or reject an offer to compromise will be based upon consideration of all the facts and circumstances, including whether the circumstances of a particular case warrant acceptance of an amount that might not otherwise be acceptable under the Secretary’s policies and procedures.

(2) Doubt as to collectibility –

(i) Allowable expenses. A determination of doubt as to collectibility will include a  determination of ability to pay. In determining ability to pay, the Secretary will permit  taxpayers to retain sufficient funds to pay basic living expenses. The determination of the amount of such basic living expenses will be founded upon an evaluation of the individual facts and circumstances presented by the  taxpayer‘s case. To guide this  determination, guidelines published by the Secretary on national and local living expense standards will be taken into  account.

(ii) Nonliable spouses –

(A) In general. Where a taxpayer is offering to compromise a liability for which the  taxpayer‘s spouse has no liability, the assets and income of the nonliable spouse will not be considered in determining the amount of an adequate offer. The assets and income of a nonliable spouse may be considered, however, to the extent property has been transferred by the  taxpayer to the nonliable spouse under circumstances that would permit the IRS to effect collection of the taxpayer‘s liability from such property (e.g., property that was conveyed in fraud of creditors), property has been transferred by the  taxpayer to the nonliable spouse for the  purpose of removing the property from consideration by the IRS in evaluating the compromise, or as provided in paragraph (c)(2)(ii)(B) of this section. The IRS also may  requestinformation regarding the assets and income of the nonliable spouse for the  purpose of verifying the amount of and responsibility for expenses claimed by the  taxpayer.

(B) Exception. Where collection of the taxpayer‘s liability from the assets and income of the nonliable spouse is permitted by applicable  state law (e.g., under  state community property laws), the assets and income of the nonliable spouse will be considered in determining the amount of an adequate offer except to the extent that the  taxpayer and the nonliable spouse demonstrate that collection of such assets and income would have a material and adverse impact on the standard of living of the  taxpayer, the nonliable spouse, and their dependents.

(3) Compromises to promote effective tax administration –

(i)  Factors supporting (but not conclusive of) a determination that collection would cause economic hardship within the meaning of paragraph (b)(3)(i) of this section include, but are not limited to –

(A) Taxpayer is incapable of earning a living because of a long term illness, medical condition, or disability, and it is reasonably foreseeable that  taxpayer‘s financial resources will be exhausted providing for care and support during the course of the condition;

(B) Although taxpayer has certain monthly income, that income is exhausted each month in providing for the care of dependents with no other means of support; and

(C) Although taxpayer has certain assets, the  taxpayer is unable to borrow against the equity in those assets and liquidation of those assets to pay outstanding  tax liabilities would render the  taxpayer unable to meet basic living expenses.

(ii) Factors supporting (but not conclusive of) a determination that compromise would undermine compliance within the meaning of paragraph (b)(3)(iii) of this section include, but are not limited to –

(A) Taxpayer has a history of noncompliance with the filing and  payment requirements of the Internal Revenue Code;

(B) Taxpayer has taken deliberate  actions to avoid the  payment of taxes; and

(C) Taxpayer has encouraged others to refuse to comply with the  tax laws.

(iii) The following examples illustrate the types of cases that may be compromised by the Secretary, at the Secretary’s discretion, under the economic hardship provisions of paragraph (b)(3)(i) of this section:

Example 1.

The taxpayer has assets sufficient to satisfy the tax liability. The taxpayer provides full time care and assistance to her dependent child, who has a serious long-term illness. It is expected that the taxpayer will need to use the equity in his assets to provide for adequate basic living expenses and medical care for his child. The taxpayer’s overall compliance history does not weigh against compromise.

Example 2.

The taxpayer is retired and his only income is from a pension. The taxpayer’s only asset is a retirement account, and the funds in the account are sufficient to satisfy the liability. Liquidation of the retirement account would leave the taxpayer without an adequate means to provide for basic living expenses. The taxpayer’s overall compliance history does not weigh against compromise.

Example 3.

The taxpayer is disabled and lives on a fixed income that will not, after allowance of basic living expenses, permit full payment of his liability under an installment agreement. The taxpayer also owns a modest house that has been specially equipped to accommodate his disability. The taxpayer’s equity in the house is sufficient to permit payment of the liability he owes. However, because of his disability and limited earning potential, the taxpayer is unable to obtain a mortgage or otherwise borrow against this equity. In addition, because the taxpayer’s home has been specially equipped to accommodate his disability, forced sale of the taxpayer’s residence would create severe adverse consequences for the taxpayer. The taxpayer’s overall compliance history does not weigh against compromise.

(iv) The following examples illustrate the types of cases that may be compromised by the Secretary, at the Secretary’s discretion, under the public policy and equity provisions of paragraph (b)(3)(ii) of this section:

Example 1.

In October of 1986, the taxpayer developed a serious illness that resulted in almost continuous hospitalizations for a number of years. The taxpayer’s medical condition was such that during this period the taxpayer was unable to manage any of his financial affairs. The taxpayer has not filed tax returns since that time. The taxpayer’s health has now improved and he has promptly begun to attend to his tax affairs. He discovers that the IRS prepared a substitute for return for the 1986 tax year on the basis of information returns it had received and had assessed a tax deficiency. When the taxpayer discovered the liability, with penalties and interest, the tax bill is more than three times the original tax liability. The taxpayer’s overall compliance history does not weigh against compromise.

Example 2.

The taxpayer is a salaried sales manager at a department store who has been able to place $2,000 in a tax-deductible IRA account for each of the last two years. The taxpayer learns that he can earn a higher rate of interest on his IRA savings by moving those savings from a money management account to a certificate of deposit at a different financial institution. Prior to transferring his savings, the taxpayer submits an e-mail inquiry to the IRS at its Web Page, requesting information about the steps he must take to preserve the tax benefits he has enjoyed and to avoid penalties. The IRS responds in an answering e-mail that the taxpayer may withdraw his IRA savings from his neighborhood bank, but he must redeposit those savings in a new IRA account within 90 days. The taxpayer withdraws the funds and redeposits them in a new IRA account 63 days later. Upon audit, the taxpayer learns that he has been misinformed about the required rollover period and that he is liable for additional taxes, penalties and additions to tax for not having redeposited the amount within 60 days. Had it not been for the erroneous advice that is reflected in the taxpayer’s retained copy of the IRS e-mail response to his inquiry, the taxpayer would have redeposited the amount within the required 60-day period. The taxpayer’s overall compliance history does not weigh against compromise.

(d) Procedures for submission and consideration of offers –

(1) In general. An offer to compromise a tax liability pursuant to section 7122 must be submitted according to the procedures, and in the form and manner, prescribed by the Secretary. An offer to compromise a  tax liability must be made in writing, must be signed by the  taxpayer under  penalty of perjury, and must contain all of the information prescribed or requested by the Secretary. However,  taxpayers submitting offers to compromise liabilities solely on the basis of doubt as to liability will not be required to provide financial statements.

(2) When offers become pending and return of offers. An offer to compromise becomes pending when it is accepted for processing. The IRS may not accept for processing any offer to compromise a liability following reference of a case involving such liability to the Department of Justice for prosecution or defense. If an offer accepted for processing does not contain sufficient information to permit the IRS to evaluate whether the offer should be accepted, the IRS will request that the  taxpayer provide the needed additional information. If the  taxpayer does not submit the additional information that the IRS has  requested within a reasonable time period after such a  request, the IRS may return the offer to the  taxpayer. The IRS may also return an offer to compromise a  tax liability if it determines that the offer was submitted solely to delay collection or was otherwise nonprocessable. An offer returned following acceptance for processing is deemed pending only for the period between the date the offer is accepted for processing and the date the IRS returns the offer to the  taxpayer. See paragraphs (f)(5)(ii) and (g)(4) of this section for rules regarding the effect of such returns of offers.

(3) Withdrawal. An offer to compromise a tax liability may be withdrawn by the  taxpayer or the  taxpayer‘s representative at any time prior to the IRS’ acceptance of the offer to compromise. An offer will be considered withdrawn upon the IRS’ receipt of written notification of the withdrawal of the offer either by personal delivery or certified mail, or upon  issuance of a letter by the IRS confirming the  taxpayer‘s intent to withdraw the offer.

(e) Acceptance of an offer to compromise a tax liability.

(1) An offer to compromise has not been accepted until the IRS issues a written notification of acceptance to the taxpayeror the  taxpayer‘s representative.

(2) As additional consideration for the acceptance of an offer to compromise, the IRS may request that  taxpayer enter into any collateral agreement or post any  security which is deemed necessary for the protection of the  interests of the United States.

(3) Offers may be accepted when they provide for payment of compromised amounts in one or more equal or unequal installments.

(4) If the final payment on an accepted offer to compromise is contingent upon the immediate and simultaneous release of a  tax lien in whole or in part, such  payment must be made in accordance with the forms, instructions, or procedures prescribed by the Secretary.

(5) Acceptance of an offer to compromise will conclusively settle the liability of the taxpayer specified in the offer. Compromise with one  taxpayer does not extinguish the liability of, nor prevent the IRS from taking  action to collect from, any  person not named in the offer who is also liable for the  tax to which the compromise relates. Neither the  taxpayer nor the Government will, following acceptance of an offer to compromise, be permitted to reopen the case except in instances where –

(i) False information or documents are supplied in conjunction with the offer;

(ii) The ability to pay or the assets of the taxpayer are concealed; or

(iii) A mutual mistake of material fact sufficient to cause the offer agreement to be reformed or set aside is discovered.

(6) Opinion of Chief Counsel. Except as otherwise provided in this paragraph (e)(6), if an offer to compromise is accepted, there will be placed on file the opinion of the Chief Counsel for the IRS with respect to such compromise, along with the reasons therefor. However, no such opinion will be required with respect to the compromise of any civil case in which the unpaid amount of tax assessed (including any  interest, additional amount, addition to the  tax, or assessable penalty) is less than $50,000. Also placed on file will be a statement of –

(i) The amount of tax assessed;

(ii) The amount of interest, additional amount, addition to the  tax, or assessable  penalty, imposed by law on the  personagainst whom the  tax is assessed; and

(iii) The amount actually paid in accordance with the terms of the compromise.

(f) Rejection of an offer to compromise.

(1) An offer to compromise has not been rejected until the IRS issues a written notice to the  taxpayer or his representative, advising of the rejection, the reason(s) for rejection, and the right to an appeal.

(2) The IRS may not notify a taxpayer or  taxpayer‘s representative of the rejection of an offer to compromise until an independent  administrative review of the proposed rejection is completed.

(3) No offer to compromise may be rejected solely on the basis of the amount of the offer without evaluating that offer under the provisions of this section and the Secretary’s policies and procedures regarding the compromise of cases.

(4) Offers based upon doubt as to liability. Offers submitted on the basis of doubt as to liability cannot be rejected solely because the IRS is unable to locate the taxpayer‘s return or return information for verification of the liability.

(5) Appeal of rejection of an offer to compromise –

(i) In general. The taxpayer may administratively appeal a rejection of an offer to compromise to the IRS Office of Appeals (Appeals) if, within the 30-day period commencing the day after the date on the letter of rejection, the  taxpayerrequests such an  administrative review in the manner provided by the Secretary.

(ii) Offer to compromise returned following a determination that the offer was nonprocessable, a failure by the taxpayer to provide requested information, or a determination that the offer was submitted for purposes of delay. Where a determination is made to return offer documents because the offer to compromise was nonprocessable, because the  taxpayer failed to provide  requested information, or because the IRS determined that the offer to compromise was submitted solely for  purposes of delay under paragraph (d)(2) of this section, the return of the offer does not constitute a rejection of the offer for  purposes of this provision and does not entitle the  taxpayer to appeal the matter to Appeals under the provisions of this paragraph (f)(5). However, if the offer is returned because the  taxpayer failed to provide  requested financial information, the offer will not be returned until a managerial review of the proposed return is completed.

(g) Effect of offer to compromise on collection activity –

(1) In general. The IRS will not levy against the property or rights to property of a taxpayer who submits an offer to compromise, to collect the liability that is the subject of the offer, during the period the offer is pending, for 30 days immediately following the rejection of the offer, and for any period when a timely filed appeal from the rejection is being considered by Appeals.

(2) Revised offers submitted following rejection. If, following the rejection of an offer to compromise, the taxpayermakes a good faith revision of that offer and submits the revised offer within 30 days after the date of rejection, the IRS will not levy to collect from the  taxpayer the liability that is the subject of the revised offer to compromise while that revised offer is pending.

(3) Jeopardy. The IRS may levy to collect the liability that is the subject of an offer to compromise during the period the IRS is evaluating whether that offer will be accepted if it determines that collection of the liability is in jeopardy.

(4) Offers to compromise determined by IRS to be nonprocessable or submitted solely for purposes of delay. If the IRS determines, under paragraph (d)(2) of this section, that a pending offer did not contain sufficient information to permit evaluation of whether the offer should be accepted, that the offer was submitted solely to delay collection, or that the offer was otherwise nonprocessable, then the IRS may levy to collect the liability that is the subject of that offer at any time after it returns the offer to the  taxpayer.

(5) Offsets under section 6402. Notwithstanding the evaluation and processing of an offer to compromise, the IRS may, in accordance with section 6402, credit any overpayments made by the taxpayer against a liability that is the subject of an offer to compromise and may offset such overpayments against other liabilities owed by the  taxpayer to the extent authorized by section 6402.

(6) Proceedings in court. Except as otherwise provided in this paragraph (g)(6), the IRS will not refer a case to the Department of Justice for the commencement of a proceeding in court, against a person named in a pending offer to compromise, if levy to collect the liability is prohibited by paragraph (g)(1) of this section. Without regard to whether a person is named in a pending offer to compromise, however, the IRS may authorize the Department of Justice to file a counterclaim or third-party complaint in a refund action or to join that  person in any other proceeding in which liability for the  tax that is the subject of the pending offer to compromise may be established or disputed, including a suit against the United  States under 28 U.S.C. 2410. In addition, the United  States may file a claim in any bankruptcy proceeding or insolvency  action brought by or against such  person.

(h) Deposits. Sums submitted with an offer to compromise a liability or during the pendency of an offer to compromise are considered deposits and will not be applied to the liability until the offer is accepted unless the taxpayer provides written authorization for application of the payments. If an offer to compromise is withdrawn, is determined to be nonprocessable, or is submitted solely for  purposes of delay and returned to the  taxpayer, any amount tendered with the offer, including all installments paid on the offer, will be refunded without  interest. If an offer is rejected, any amount tendered with the offer, including all installments paid on the offer, will be refunded, without  interest, after the conclusion of any review sought by the taxpayer with Appeals. Refund will not be required if the  taxpayer has agreed in writing that amounts tendered pursuant to the offer may be applied to the liability for which the offer was submitted.

(i) Statute of limitations –

(1) Suspension of the statute of limitations on collection. The statute of limitations on collection will be suspended while levy is prohibited under paragraph (g)(1) of this section.

(2) Extension of the statute of limitations on assessment. For any offer to compromise, the IRS may require, where appropriate, the extension of the statute of limitations on assessment. However, in any case where waiver of the running of the statutory period of  limitations on assessment is sought, the  taxpayer must be notified of the right to refuse to extend the period of  limitations or to limit the extension to particular issues or particular periods of time.

(j) Inspection with respect to accepted offers to compromise. For provisions relating to the inspection of returns and accepted offers to compromise, see section 6103(k)(1).

(k) Effective date. This section applies to offers to compromise pending on or submitted on or after July 18, 2002.

[T.D. 9007, 67 FR 48029, July 23, 2002; 67 FR 53879, Aug. 20, 2002]

[1] An accepted offer in compromise is properly analyzed as a contract between the parties. United States v. Donovan, 348 F.3d 509, 512-13 (6th Cir. 2003); Roberts v. United States , 242 F.3d 1065 (Fed. Cir. 2001); Timms v. United States, supra at 833-36; United States v. Lane, 303 F.2d 1,4 (5th Cir. 1962); Robbins Tire & Rubber Co. Inc. v. Commissioner,  52 T.C. 420, 436 (1969). Consequently, an OIC, like certain other agreements between the Commissioner and taxpayers, is governed by general principles of contract law. Cf. Duncan v. Commissioner , 121 T.C. 293, 296, (2003) (contract law applied to stipulated arbitration agreement); Bankamerica Corp. v. Commissioner, 109 T.C. 1, 12 (1997) (contract law applied to stipulations of fact); Dorchester Indus., Inc. v. Commissioner, 108 T.C. 320, 330 (1997) (contract law applied to settlement agreement), aff’d without published opinion, 208 F.3d 205 (3d Cir. 2000); Woods v. Commissioner,  92 T.C. 776,780 (1989) (contract law applied to agreement to extend the period for making assessments). Courts have routinely held that OICs are valid and binding contracts. See Timms v. United States, supra at 492; Waller v. United States, 767 F. Supp. 1042, 1044-45 (E.D. Cal. 1991); Seattle-First Nat’l Bank v. United States, 44 F.Supp. 603, 610 (E.D. Wash. 1942), aff’d , 136 F.2d 676 (9th Cir. 1943), aff’d, 321 U.S. 583 (1944); Lang-Kidde Co. v. United States, 2 F. Supp 768,769 (Ct. CI. 1933).

[2] Generally, an acceptance of an OIC will conclusively settle the liability of the taxpayer specified in the OIC, absent fraud or mutual mistake. Dutton v. Commissioner, 122 T.C. 133, 138 (2004); Treas. Reg.  § 301-7122-1(e)(5). See also Estate of Jones v. Commissioner, 795 F.2d 566, 573-74 (6th Cir. 1986), aff’g, T.C. Memo. 1984-53; Timms v. United States, 678 F.2d 831,833 (9th Cir. 1982).  CCA LEG-142031-08, 11/17/2008

[3] Murphy v. Comm’r of Internal Revenue, 469 F.3d 27, 33 (1st Cir. 2006)

[4] Generally, the total number of persons allowed for national standard expenses should be the same as those allowed as dependents on the taxpayer’s current year income tax return. There may be reasonable exceptions.

Tax Litigation Attorneys 

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Hedge Funds and Taxes

Hedge funds provide a vehicle to pool private capital for investment in stocks, securities and financial derivatives.  While hedge funds take on many different structures—including master-feeder, parallel, or fund-of-funds structures—they share many similar tax considerations.

Hedge fund tax issues include entity classification, tax allocations, the taxation of carried interests, swap taxation, withholding, and numerous other issues.  In this Insight post, we discuss the typical hedge fund structure and usual players, as well as several common tax issues.

Typical Hedge Fund Structures

Most hedge funds use one of the following organizational structures: 1) a single entity fund, 2) a master-feeder fund, 3) a parallel fund, or 4) a fund of funds.

A typical hedge fund structure involves an entity formed as a partnership for U.S. federal tax purposes acting as an investment manager with a separate entity functioning as a general partner.  The investment or fund manager is generally compensated through a management fee, typically tied to a percentage of the fund’s net asset value.  In addition, the general partner generally receives an allocation of partnership profits (net of prior losses and management fees) that is based on the master fund’s performance.  This is known as a carried interest.

Hedge Funds vs. Private Equity

Hedge funds share some similarities with private equity.  Both, for instance, involve partnerships raising capital through unregistered offerings.  Unlike private equity, however, hedge funds function more like an open-ended mutual fund, investing in public securities, rather than private-held operating companies.  Many leverage investments using debt in order to enhance returns or employ investment vehicles such as straddles and short positions.

Hedge funds are privately owned, with investments that are generally more liquid than those of private equity funds.

Hedge Fund Regulatory Environment

Unlike mutual funds, hedge funds operate in a largely unregulated environment.  Sponsors generally raise capital through unregistered Reg. D offerings to “accredited investors” and take measures to avoid registration under the Investment Company Act of 1940, thereby avoiding certain diversification and borrowing restrictions under the act.

The Hedge Fund Players

Master Fund: The Master Fund, often a foreign entity or U.S. LP or LLC, is typically treated as a partnership for U.S. tax purposes.  The Master Fund invests capital from any foreign feeder and domestic feeder.

Investment Manager:  The Investment Manager manages the master fund’s portfolio for the investors.  The Master Fund typically enters into an agreement to pay the Investment Manager a management fee.

General Partner: The General Partner usually holds a small interest in the Master Fund and/or feeder funds.  The general partner participates in the master fund’s economic performance through a “carried interest”—a profits interest.

Domestic Feeder: The domestic feeder is generally a U.S. pass-through entity whose income that is allocated from the Master Fund to DF would be subject to US taxation at the partner level.

Foreign Feeder: The foreign feeder is typically a foreign corporation formed in a low or no-tax jurisdiction. For US tax purposes, the FF is treated as a corporation.  US tax-exempt investors (pension funds, 401k funds, governmental entities, etc.) and foreign investors (foreign corporations, non-resident aliens, etc.) make their investments in the Master Fund through the FF. Any distributions from the FF to its foreign investors are treated as dividends for US tax purposes.[1]

Carried Interests

Internal Revenue Code section 1061, which was enacted by the Tax Cuts and Jobs Act of 2017, affects certain carried interest arrangements.  Generally, under section 1061, certain carried interest arrangements (known as “applicable partnership interests”) must be held for more than three years for the related capital gains to qualify for long-term capital gain treatment.

An applicable partnership interest is an interest in a partnership that is transferred to or held by a taxpayer, directly or indirectly, in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business.

Many private equity (PE) funds, hedge funds, and other asset management funds are subject to section 1061’s treatment of carried interests.  Where it applies, section 1061 recharacterizes certain net long-term capital gains of a partner that holds one or more applicable partnership interests as short-term capital gains.

Engaging in a US Trade or Business

The hedge fund’s master fund will generally seek to avoid its activities being deemed to be a U.S. trade or business.  For example, it will seek to avoid U.S. trade or business status due to the impact on most tax-exempt and foreign investors, as well as avoidance of the net-basis tax regime imposed upon effectively connected income.

Foreign corporations that are deemed to be “engaged in a trade or business” in the United States are, generally speaking, subject to U.S.tax on income that is “effectively connected” with that trade or business, as well as a “branch profits” tax on certain income.  The code, however, provides a safe harbor, exempting a foreign corporation that trades in stocks, securities, and derivatives for its own account from being treated as engaged in a U.S. trade or business–an exemption that many states also apply.

A foreign person who invests in a partnership that is engaged in a U.S. trade or business is deemed to be engaged in a U.S. trade or business itself, regardless of the number of partnership tiers between the initial partnership and the foreign partner.

Effectively Connected Income

If a master fund is engaged in a US trade or business, certain foreign-source income earned by the master fund may be effectively connected income (ECI).  Certain income, gain, or loss from foreign sources is treated as effectively connected with the conduct of a U.S. trade or business if the nonresident alien individual or foreign corporation has an office or other fixed place of business within the United States to which such income, gain, or loss is attributable and such income, gain, or loss.^[2]

Similar results may arise if the master fund is investing in U.S. real estate.  Under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), a foreign person’s gain or loss from the disposition of a United States real property interest is treated as if it is effectively connected with a U.S. trade or business.  A United States real property interest includes a) an interest in real property (including an interest in a mine, well, or other natural deposit) located in the United States or the Virgin Islands, and b) any interest (other than an interest solely as a creditor) in any domestic corporation unless the taxpayer establishes that such corporation was at no time a United States real property holding corporation.

What is a Trade or Business? 

The Internal Revenue Code does not define the phrase “trade or business within the United States.” However, the Code provides that the term “trade or business within the United States” includes the performance of personal services within the United States at any time within the taxable year, but does not include” certain personal service activity, and does not generally include “trading in stocks or securities” or trading in commodities.  The IRS has adopted a facts-and-circumstances test to determine whether a foreign person’s activities result in a trade or business within the United States.

Trading Safe Harbors

The Trading Safe Harbors provides two statutory safe harbors under which certain trading activities conducted by or for a foreign person that might otherwise constitute a trade or business within the United States are deemed not to give rise to a trade or business within the United States.

The first trading safe harbor provides that the term “trade or business within the United States” does not include “[t]rading in stocks or securities^[3] through a resident broker, commission agent, custodian, or other independent agent.” § 864(b)(2)(A)(i).^[4]  The trading safe harbor does not apply, however, if the foreign person maintains an office or other fixed place of business in the United States at any time during the taxable year through which the transactions in stocks or securities are effected.

The second Trading Safe Harbor provides that the term “trade or business within the United States” does not include “[t]rading in stocks or securities for the taxpayer’s own account, whether by the taxpayer or his employees or through a resident broker, commission agent, custodian, or other agent, and whether or not any such employee or agent has discretionary authority to make decisions in effecting the transactions.^[5]” This safe harbor is not available to a dealer in stocks, securities, or commodities.  On the other hand, it may apply to a foreign person who has an office or other fixed place of business in the United States.

Investment Fund Counsel

Freeman Law represents investment advisors, funds and institutional investors, providing strategic legal guidance and sophisticated tax counsel. Our attorneys counsel registered and exempt investment advisers, such as private equity, hedge fund, venture capital, and mutual fund managers—from fund formations and structures, to acquisitions and dispositions, to regulatory compliance. Schedule a consultation or call (214) 984-3000 to discuss your investment fund concerns or questions. 

[1] The choice of the corporate form may also lead to the FF being classified as a passive foreign investment company” (“PFIC”) under IRC §1297. A foreign corporation is a PFIC if either a) 75 percent or more of its gross income for the tax year is passive income (passive income test), or b) on average 50 percent or more of its assets produce passive income or are held for the production of passive income (passive asset test). An asset is generally characterized as passive if it generates, or is reasonably expected to generate in the reasonably foreseeable future, passive income as defined in IRC §1297(b). The FF is commonly referred to as a blocker entity because it prevents income flow through treatment to the investors in the FF.

[2] The term “securities” means any note, bond, debenture, or other evidence of indebtedness, or any evidence of an interest in or right to subscribe to or purchase any of the foregoing; and the effecting of transactions in stocks or securities including buying, selling (whether or not by entering into short sales), or trading in stocks, securities, or contracts or options to buy or sell stocks or securities, on margin or otherwise, for the account and risk of the taxpayer.

[3] If a foreign person is not a dealer, the term engaged in trade or business within the United States does not include effecting transactions in derivatives for the taxpayer’s own account, including hedging transactions.

[4] The phrase “effecting of transactions in stocks or securities” includes buying, selling, shorting or trading stocks, securities, or options or contracts to buy or sell stocks or securities for the account and risk of the taxpayer, and any other activities closely related to those activities, such as obtaining credit.

The Tax Court in Brief May 25 – 29, 2020

Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.

For a link to our podcast covering the Tax Court in Brief, download here or check out other episodes of The Freeman Law Project.

The Week of May 25 – 29, 2020

• Gluck v. Comm’r, T.C. Memo. 2020-66
• Amanda Iris Gluck Irrevocable Trust v. Comm’r, T.C. Memo. 154 T.C. No. 11 
• Thoma v. Comm’r, T.C. Memo. 2020-67 
• Novoselsky v. Comm’r, T.C. Memo. 2020-68 
• Engle v. Comm’r, T.C. Memo. 2020-69
• Larkin v. Comm’r, T.C. Memo. 2020-70

Gluck v. Comm’r, T.C. Memo. 2020-66

May 19, 2020 | Lauber, J. | Dkt. No. 2020-66

• Opinion

Short Summary:  The IRS determined that the petitioners were not permitted to defer capital gain as part of a like-kind exchange and asserted a tax deficiency and penalties, prompting the taxpayers to file a petition with the Tax Court.  The IRS moved to dismiss the case for lack of jurisdiction with respect to the tax deficiency.  The taxpayers, in turn, moved for summary judgment, arguing that they were substantively entitled to like-kind exchange treatment under section 1031.

On June 30, 2012, the taxpayer sold a condominium unit for $10,214,000.  He deposited the proceeds from the sale of the condominium unit into a “qualified escrow account.”  See sec. 1.1031(k)-1(g)(3).  The taxpayer designated as the “replacement property” a purported 25% interest in an apartment building. The IRS, however, determined that the replacement property that the taxpayer acquired was in fact an interest in a partnership, rather than a direct interest in the real estate.  The partnership was subject to the unified audit and litigation procedures of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). See secs. 6221- 6234 (as in effect for years before 2018).

The taxpayer did not report the property in a manner consistent with the reporting that the IRS received from the partnership, Greenberg & Portnoy (G&P).  G&P’s returns reported that it owned the Property and that Gluck LLC (an entity established by the taxpayer) in 2012 acquired a partnership interest in G&P, as opposed to a direct ownership interest in the apartment building.

Although the taxpayer acknowledged receipt of a Schedule K-1 reporting as such, he did not report the distributive share of G&P’s income on their 2012 Form 1040. Nor did he file with the IRS Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR). (Taxpayers are instructed to file Form 8082 if they “believe an item was not properly reported on the Schedule K-1 you received from the partnership.” IRS, Instructions for Form 8082, at 1 (rev. Dec. 2011).)

The IRS argued that its adjustment disallowing like-kind exchange treatment was necessary to conform the taxpayer’s tax treatment to the treatment shown on the partnership’s return and was thus a “computational adjustment” within the meaning of section 6231(a)(6).

Key Issue:  Whether the Tax Court has jurisdiction to address the deficiency resulting from the IRS’s adjustments, denying section 1031 treatment on the ground that the taxpayer did not comply with section 1031 because the taxpayer’s “replacement property” was actually an interest in a partnership, which is not “like-kind” property.

Primary Holdings: 

• The Tax Court lacks jurisdiction to redetermine the deficiency but has jurisdiction with respect to the penalty.
• Whether G&P was a valid partnership, whether Gluck LLC was a partner in G&P, and what percentage interest Gluck LLC held in G&P are all “partnership items.” The question of G&P’s ownership vel non of the building is a “partnership item.” Such “partnership items” must be determined in a partnership-level proceeding, as opposed to a deficiency case. The Tax Court has no jurisdiction to consider partnership items in a partner-level deficiency proceeding.
• Although petitioners dispute the true ownership of the Property and Gluck LLC’s status as a partner, the Tax Court has no jurisdiction to consider such partnership items in a deficiency case.
• Because Gluck LLC’s interest in G&P was a partnership item, the IRS’ disallowance of deferral under section 1031 was a change in petitioners’ tax liability that properly reflected G&P’s treatment of a partnership item.
• Petitioners’ entitlement to section 1031 treatment is not a “factual affected item” but rather is a “computational affected item” exempt from deficiency procedures. “If an adjustment to an affected item * * * can be made without making additional partner level determinations, the IRS can directly assess the tax due without having to follow the usual deficiency procedures.”
• The accuracy-related penalty, however, is within the Tax Court’s deficiency jurisdiction. Liability for the penalty is not a “computational affected item,” because the taxpayer’s liability hinges on factual determinations peculiar to them, e.g., their good-faith effort to determine their Federal income tax liability correctly, including any honest misunderstanding of fact or law. See id. at 377; sec. 1.6664-4, Income Tax Regs; sec. 301.6231(a)(6)-1(a)(3), Proced. & Admin. Regs.

Key Points of Law:

• The 2012 version of the Tax Code provided that like-kind exchange treatment does not apply “to any exchange of * * * interests in a partnership.” Sec. 1031(a)(2)(D).
• Deficiency procedures generally do not apply “to the assessment or collection of any computational adjustment.” Sec. 6230(a)(1).
• The Tax Court is a court of limited jurisdiction, and may exercise jurisdiction only to the extent expressly authorized by Congress.
• The Tax Court normally has jurisdiction to redetermine a deficiency if a taxpayer receives a notice of deficiency and timely petitions the Court.
• The Code restricts deficiency jurisdiction in several respects where a TEFRA partnership is concerned.
• The provisions of chapter 63, subchapter B, which govern deficiency jurisdiction, generally do not apply “to the assessment or collection of any computational adjustment” made with respect to a partner in a TEFRA partnership. Sec. 6230(a)(1).
• Section 6231(a)(6) defines a computational adjustment as “the change in the tax liability of a partner which properly reflects the treatment under * * * [TEFRA] of a partnership item.”
• The proper treatment of “partnership items” (as well as penalties and additions to tax relating to adjustments to partnership items) is determined in a TEFRA partnership-level proceeding. The proper treatment of “affected items which require partner level determinations” is generally determined in deficiency proceedings involving the relevant partner(s). Sec. 6230(a)(2)(A)(i); see sec. 301.6231(a)(6)-1(a)(3), Proced. & Admin. Regs. However, “[i]f an adjustment to an affected item is merely computational and can be made without making additional partner-level determinations, the IRS can directly assess the tax due without having to follow the usual deficiency procedures.”  See sec. 301.6231(a)(6)-1(a)(2), Proced. & Admin. Regs.
• A partnership item is “any item required to be taken into account for the partnership’s taxable year * * * to the extent regulations prescribed by the Secretary provide that * * * such item is more appropriately determined at the partnership level than at the partner level.” Sec. 6231(a)(3)
• Whether a person is a partner in a partnership is generally a “partnership item.”
• The existence of a valid partnership is itself a “partnership item.” Tigers Eye Trading, LLC v. Commissioner, 138 T.C. 67, 98- 99 (2012), aff’d in part, rev’d in part, and remanded sub nom. Logan Trust v. Commissioner, 616 F. App’x 426 (D.C. Cir. 2015).
• The term “partnership item” includes “the legal and factual determinations that underlie the determination of the amount, timing, and characterization of items of income, credit, gain, loss, deduction, etc.” Sec. 301.6231(a)(3)-1(b), Proced. & Admin. Regs.
• Section 6225(a) generally prohibits the IRS from assessing “a deficiency attributable to any partnership item” until TEFRA partnership-level proceedings have concluded. However, if a partner who adopts an inconsistent treatment fails to notify the IRS as required by section 6222(b), “section 6225 shall not apply to any part of a deficiency attributable to any computational adjustment required to make the treatment * * * by such partner consistent with the treatment of the items on the partnership return.” Sec. 6222(c).
• The Code denies like-kind exchange treatment where a real property interest is exchanged for a partnership interest. See sec. 1031(a)(2)(D).
• The provisions governing this Court’s deficiency jurisdiction generally do not apply “to the assessment or collection of any computational adjustment.” Sec. 6230(a)(1). The only exception to this rule (as relevant here) arises in the case of a “deficiency attributable to * * * affected items which require partner level determinations.” Id. para. (2)(A)(i).
• Petitioners’ entitlement to like-kind exchange treatment is properly viewed as an “affected item” because it is “affected by a partnership item.” Sec. 6231(a)(5).
• An affected item may be a “computational affected item” or a “factual affected item.” Computational affected items (e.g., a partner’s medical expense deduction) can be determined automatically once the relevant partnership item (e.g., that partner’s distributive share of partnership income) has been determined. See, e.g., Bedrosian v. Commissioner, 144 T.C. 152, 158 (2015). A factual affected item is one that “requires further factual determination at the partner level.”
• “Computational affected items are not subject to deficiency procedures,” whereas “affected items that require partner level factual determinations are subject to deficiency procedures.”
• Deficiency procedures do not apply to “penalties, additions to tax, and additional amounts that relate to adjustments to partnership items.” Sec. 6230(a)(2)(A)(i). Penalties determined under section 6662(a), however, are non-partnership items. As a rule, therefore, such penalties are subject to deficiency proceedings unless they are “computational affected items.”

Insight:  Good riddance to TEFRA.  So much judicial ink has been spilled fleshing out the sometimes-metaphysical nuances of this procedural regime that has been on the books since 1982.  With the enactment of the Bipartisan Budget Act of 2015, a new regime (the “BBA”) governing partnership audits and litigation generally went into effect in 2018.  While we will continue to see TEFRA litigation making its way through the system for the better part of a decade, partnership tax disputes will now be subject to a new regime.

Amanda Iris Gluck Irrevocable Trust v. Comm’r, T.C. Memo. 154 T.C. No. 11 

May 26, 2020 | Lauber, J. | Dkt. No. 5760-19L

• Opinion

Short Summary:   The case involved a collection due process (CDP) proceeding under which the taxpayer sought review pursuant to section 6330(d)(1) of a determination by the Internal Revenue Service (IRS or respondent) to sustain collection action for tax years 2013, 2014, and 2015.

The taxpayer was a direct and indirect partner in partnerships subject to the unified audit and litigation procedures of the Tax Equity and Fiscal Responsibility Act of 1982. See I.R.C. secs. 6221-6234 (as in effect for years before 2018). In 2012 one of the partnerships in which the taxpayer held an indirect interest sold property and realized a large capital gain.  The taxpayer allegedly failed to report its entire distributive share of that gain.

For 2012, the taxpayer filed a return on Form 1041, U.S. Income Tax Return for Estates and Trusts. On this return it allegedly failed to report its distributive share of the gain that had been allocated to a partnership holding.

The IRS adjusted the taxpayer’s 2012-2015 returns via “computational adjustments.” See I.R.C. sec. 6231(a)(6). These adjustments eliminated the net operating loss (NOL) it had claimed for 2012 and disallowed the NOL carryforward deductions the taxpayer had claimed for 2013-2015, creating balances due for those years. The IRS immediately assessed the resulting tax. See I.R.C. secs. 6222(c), 6230(a)(1).

On June 15, 2017, the IRS sent the taxpayer two Letters 4735, Notice of Computational Adjustment. In the first letter the IRS adjusted upward, by $6,543,748, the taxpayer’s distributive share of the partnership’s capital gain for 2012, eliminating the NOL that the taxpayer had reported for that year. In the second letter the IRS disallowed the NOL carryforwards from 2012 that the taxpayer had claimed as deductions for 2013, 2014, and 2015, creating a balance due for each year. Each Letter 4735 explained that “[t]he adjustment is due to your inconsistent treatment of a partnership item related to the section 1231 gain reported by a partnership in which you have an indirect ownership.”

Subsequently, the IRS mailed a levy notice in an effort to collect the taxpayers 2013-2015 tax, and the taxpayer timely requested a collection due process (CDP) hearing. The settlement officer sustained the levy notice. The taxpayer timely petitioned for review, seeking to challenge its underlying liabilities for 2012-2015. The IRS moved to dismiss as to 2012 and 2013, noting that the 2012 tax year was never before the Court and that the taxpayer’s 2013 liability had been fully satisfied by application of credits from other years. The IRS moved for summary judgment as to 2014 and 2015.

The IRS thereafter assessed petitioner’s liabilities for 2013-2015. When the taxpayer did not pay these liabilities upon notice and demand, the IRS issued, on January 11, 2018, a Letter 1058, Final Notice of Intent to Levy and Notice of Your Right to a Hearing (levy notice). As of the date of the levy notice, the taxpayer’s outstanding liabilities for 2013-2015 exceeded $180,000.

Key Issue:  Whether the Tax Court had jurisdiction to review the taxpayer’s tax liability through a CDP challenge.

Primary Holdings: 

• The Court lacks jurisdiction with respect to the taxpayer’s 2012 tax year.
• The taxpayer properly invoked the Court’s jurisdiction under I.R.C. sec. 6330(d)(1) to review its tax liabilities for 2013- 2015. Although the Court generally lacks jurisdiction in a deficiency case to review computational adjustments, see I.R.C. sec. 6230(a)(1), its jurisdiction in a CDP case is not so limited.
• The taxpayer’s 2013 liability has been paid in full, so the taxpayer’s challenge to the collection action for that year is moot.
• The Tax Court may, in a CDP case, review underlying liabilities arising from adjustments to partnership items of TEFRA partnerships, even though such items would not have been subject to review in a deficiency setting.
• The taxpayer is permitted to challenge its underlying liabilities for 2014 and 2015 because it had had no prior opportunity to do so. See I.R.C. sec. 6330(c)(2)(B). The taxpayer properly raised an underlying liability challenge during the CDP hearing by contending that the IRS had improperly disallowed its NOL carryforward deductions for 2014 and 2015. Because genuine disputes of material fact exist as to the taxpayer’s correct tax liabilities for those years, the IRS’s motion for summary judgment will be denied.

Key Points of Law:

• Section 6330(a) requires the IRS, before making a levy, to send a written notice to the taxpayer notifying him of his right to a CDP hearing. The Tax Court has jurisdiction to review a notice of determination issued to a taxpayer following completion of that hearing if a timely petition is filed. Sec. 6330(d).
• Section 6330(d)(1) does not prescribe the standard of review that the Court should apply in reviewing an IRS administrative determination in a CDP case. But its case law provides that where the taxpayer’s underlying tax liability is properly before the court, it reviews the SO’s determination de novo. Goza v. Commissioner, 114 T.C. 176, 181-182 (2000). In other respects, the court reviews the IRS action for abuse of discretion. Abuse of discretion exists when a determination is “arbitrary, capricious, or without sound basis in fact or law.”
• A taxpayer may challenge the existence or amount of its underlying liability in a CDP proceeding only if it “did not receive any statutory notice of deficiency for such tax liability or did not otherwise have an opportunity to dispute such tax liability.” Sec. 6330(c)(2)(B).
• In CDP cases involving assessable penalties (viz., penalties not subject to deficiency procedures), the court has jurisdiction to review a taxpayer’s underlying liability for the penalty provided that he raised during the CDP hearing a proper challenge thereto.
• A taxpayer entitled to dispute its underlying liability must nevertheless present a proper challenge before the SO in order to preserve that challenge for judicial review.
• The Court may determine the correct amount of net operating loss for a year not in issue as a preliminary step in determining the correct amount of a net operating loss carryover to a taxable year in issue.
• In determining the allowability of an NOL carryforward or carryback deduction, the Court may consider facts from the original loss year even though the period of limitations for that year is closed.

Insight:  Where deficiencies result from a partnership proceeding or adjustment, an affected taxpayer needs to carefully vet their procedural avenues where that partnership is subject to the TEFRA statutory regime.  A taxpayer should also take precautions to preserve challenges to substantive tax liabilities in CDP hearings in order to utilize a more favorable standard of review on petition to the Tax Court.

Thoma v. Comm’r, T.C. Memo. 2020-67 

May 27, 2020 | Morrison, J. | Dkt. No. 21922-15

• Opinion

Short Summary:  On October 1, 1976, Mr. Thoma purchased a partial ownership interest in an accounting firm for $40,000. He worked as an accountant at the accounting firm. At some point after that, but before August 2005, Mr. Thoma became the sole owner of the accounting firm, and he began operating the firm as a sole proprietorship under the name “Thoma & Associates, CPAs”.

Around January 1, 2006, Mr. Thoma went into business with Eric Hjerpe, another accountant. Their accounting business appears to have absorbed Mr. Thoma’s sole proprietorship. Their business also appears to have initially operated under the name of Mr. Thoma’s former sole proprietorship, Thoma & Associates, CPAs, but by 2007, it was operating under the name Thoma & Hjerpe, CPAs.  During the period at issue, it was disputed whether the taxpayer (Mr. Thoma) was a partner of the firm or an employee.

Around November 3, 2011, the U.S. Department of Justice sent a letter to Thoma & Hjerpe. At trial Mr. Thoma described the letter as a civil investigative demand, issued personally to him, that requested the records of one or more of his clients. Mr. Thoma responded to the letter but never informed Mr. Hjerpe about it. Mr. Hjerpe eventually learned about the letter. A few weeks later, on November 20, 2011, Mr. Thoma arrived at the offices of Thoma & Hjerpe and found that the locks had been changed. He also discovered he no longer had access to the network, client files, and email accounts. That same day Mr. Thoma received a letter from Mr. Hjerpe informing him that he was being placed on administrative leave for his “gross mishandling” of the U.S. Department of Justice letter and asking him to “refrain from contacting any of our clients” until Mr. Hjerpe had “a better handle on what is going on”. Mr. Thoma did not provide any accounting services to his clients at Thoma & Hjerpe after receiving Mr. Hjerpe’s letter. His professional and business association with Thoma & Hjerpe ended on November 20, 2011, the day Mr. Hjerpe placed him on administrative leave.

On their tax returns for 2010 and 2011 Mr. and Ms. Thoma took the position that Mr. Thoma was self-employed and that the biweekly payments constituted self-employment income for each year, such that Mr. Thoma was liable for self-employment tax. They also claimed an income-tax deduction for one-half of the self-employment tax they reported for Mr. Thoma for each year. The IRS’s notice of deficiency determined that Mr. Thoma was not self employed, but rather an employee. The notice of deficiency recharacterized the reported self-employment income as wages.

Self-employed business-expense deductions. On their tax returns for 2010 and 2011 Mr. and Ms. Thoma claimed deductions of $7,396 and $20,867, respectively, for business expenses Mr. Thoma paid in rendering accounting services for Thoma & Hjerpe. They reported these deductions as affecting adjusted gross income (“AGI”), which is consistent with the deductions being categorized under section 62(a)(1) as attributable to a taxpayer’s business other than the business of providing services as an employee. The notice of deficiency determined that Mr. Thoma was an employee of Thoma & Hjerpe in 2010 and 2011, such that the expenses were not governed by section 62(a)(1) and not deductible in arriving at AGI. The notice of deficiency determined that Mr. Thoma’s expenses of working for Thoma & Hjerpe were deductible only as unreimbursed-employee-business expenses under section 67(b). That deduction is a subset of the miscellaneous itemized deductions allowed under section 67(b). Under section 67(a), total miscellaneous itemized deductions are allowed only to the extent they exceed 2% of AGI.

Self-employed health insurance expense deductions. On their tax returns for 2010 and 2011 Mr. and Ms. Thoma claimed self-employed health insurance expense deductions under section 162(l). Section 162(l) allows self-employed taxpayers a deduction for the cost of “insurance which constitutes medical care”, i.e., the cost of health insurance. Mr. and Ms. Thoma reported that Mr. Thoma paid health insurance expenses of $4,648 for 2010 and $5,580 for 2011. The notice of deficiency determined that Mr. Thoma was an employee of Thoma & Hjerpe and that the health insurance expenses were not properly deductible under section 162(l), but only as deductions for medical expenses under section 213(a). Section 213(a) allows a deduction for medical expenses, including health insurance expenses, but subject to a 7.5% of AGI floor.

Self-employed SIMPLE IRA contribution deductions. Mr. Thoma directly contributed $15,711 to his SIMPLE IRA in 2010 and $14,000 in 2011. Mr. and Ms. Thoma claimed deductions for those contributions. The notice of deficiency determined that the contributions were not deductible because Mr. Thoma was an employee of Thoma & Hjerpe.

Recovery of basis and character of 2011 installment sale payments. In 2008 Mr. Thoma sold his interest in Thoma & Hjerpe to Mr. Hjerpe. In 2011 he received installment sale payments from Mr. Hjerpe totaling $160,000. On their 2011 tax return Mr. and Ms. Thoma reported that the $160,000 installment sale payments were composed of $131,637 in long-term capital gain, $3,921 in taxable interest, and $24,442 in tax-free recovery of basis. The notice of deficiency determined that the installment sale payments were instead composed of $134,001 in long-term capital gain, $19,700 in taxable interest, and $6,299 in tax-free recovery of basis.

Accuracy-related penalties. The notice of deficiency determined that Mr. and Ms. Thoma were liable for accuracy-related penalties under section 6662(a) for 2010 and 2011.

Key Issue:  Whether the taxpayer was an employee or self-employed.

Primary Holdings: 

• Thoma was an employee. The court therefore sustains the self-employment tax and one-half of self-employment tax deduction adjustments in the notice of deficiency.
• The court sustains the determination that the business expenses are deductible only as unreimbursed-employee-business expenses
• The court sustains the determination regarding the tax treatment of Mr. Thoma’s health insurance expenses.
• The court sustains the determination that Mr. Thoma was an employee and sustains the disallowance of the SIMPLE IRA contribution deductions.
• The court sustains the determination regarding the recovery of basis and character of the 2011 installment sale payments.
• The court sustains penalties.

Key Points of Law:

• The taxpayer generally bears the burden of proving that the determinations in the notice of deficiency are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).
• The burden of proof is satisfied by a preponderance of the evidence.
• If the taxpayer shows that the requirements of section 7491(a)(1) and (2) are satisfied for a particular factual issue, then the burden of proof is imposed on the IRS as to that issue. Higbee v. Commissioner, 116 T.C. 438, 442 (2001).
• Gross income is defined as all income from whatever source derived. Sec. 61(a).
• Taxpayers are subject to self-employment tax on their self-employment income during a taxable year, sec. 1401(a), (b)(2), and are allowed to deduct as an above-the-line income-tax deduction (i.e., a deduction in arriving at AGI) an amount equal to one-half of the self-employment tax, sec. 164(f). Self-employment income is generally defined as “the net earnings from self employment derived by an individual”. Sec. 1402(b). “Net earnings from self-employment” are defined as “the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business.” Sec. 1402(a). The term “trade or business”, for purposes of the definition of net earnings from self-employment, has the same meaning as when used in section 162, except that the performance of services by an individual as an employee is not included in the term “trade or business”. Sec. 1402(c)(2). The term “employee” for purposes of self-employment tax has the same meaning as under the Federal Insurance Contributions Act. Sec. 1402(d). Under the Federal Insurance Contributions Act, an “employee” (as relevant here) is “any individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of an employee”. Sec. 3121(d)(2).
• An individual who is a limited partner generally excludes from net earnings from self-employment his or her share of partnership income or loss, with the exception of guaranteed payments for services actually rendered to or on behalf of the partnership to the extent that the guaranteed payments are established to be in the nature of remuneration for those services. Sec. 1402(a)(13).
• Section 761(b) defines a “partner” as a member of a partnership. Section 761(a) defines a “partnership” as a “syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not * * * a corporation or a trust or estate.”
• Federal law controls the question of whether an entity is classified as a partnership for federal tax purposes. Luna v. Commissioner, 42 T.C. 1067, 1077 (1964).
• A bona fide partnership exists under the Code if the putative partners “really and truly intended to join together for the purpose of carrying on business and sharing in the profits or losses or both.” Commissioner v. Tower, 327 U.S. 280, 287 (1946). The following factors are relevant in evaluating whether the putative partners intended to create a partnership for federal-income-tax purposes:
  • [1] The agreement of the parties and their conduct in executing its terms; [2] the contributions, if any, which each party has made to the venture; [3] the parties’ control over income and capital and the right of each to make withdrawals; [4] whether each party was a principal and coproprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income; [5] whether business was conducted in the joint names of the parties; [6] whether the parties filed Federal partnership returns or otherwise represented to respondent [i.e., the IRS] or to persons with whom they dealt that they were joint venturers; [7] whether separate books of account were maintained for the venture; and [8] whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise.
• The Court applies common law rules to determine whether a worker is an employee under section 1402(d). See sec. 3121(d)(2); Prof’l & Exec. Leasing, Inc. v. Commissioner, 89 T.C. 225, 231 (1987), aff’d, 862 F.2d 751 (9th Cir. 1988); Simpson v. Commissioner, 64 T.C. at 984. Whether a worker is an employee is a factual question. Weber v. Commissioner, 103 T.C. 378, 386 (1994), aff’d per curiam, 60 F.3d 1104 (4th Cir. 1995). The court generally considers several factors in making this determination: (1) whether the relationship between the worker and the one to whom the worker provides services (i.e., the principal) was permanent; (2) whether the worker had an opportunity for profit or loss; (3) whether the principal had the right to discharge the worker; (4) whether the principal or the worker invested in the facilities the worker used; (5) whether the work was part of the principal’s regular business; (6) whether the principal could exercise control over the details of the work; and (7) whether the worker and the principal believed that they were creating an employment relationship. Id. at 387. No one factor is determinative; the court looks at all relevant facts. Id.
• In general, the term “installment sale” means “a disposition of property where at least 1 payment is to be received after the close of the taxable year in which the disposition occurs.” Sec. 453(b)(1). “[I]ncome from an installment sale shall be taken into account for purposes of this title under the installment method.” Sec. 453(a). The term “installment method” means “a method under which the income recognized for any taxable year from a disposition is that proportion of the payments received in that year which the gross profit (realized or to be realized when payment is completed) bears to the total contract price.” Sec. 453(c). The gross profit is equal to the contract price less adjusted basis. Sec. 15A.453-1(b)(2)(v), Temporary Income Tax Regs., 46 Fed. Reg. 10710 (Feb. 4, 1981). Interest is not part of the gross profit, and it is excluded from the selling price, the contract price, and the installment sale payment. Id. subdiv. (ii), 46 Fed. Reg. 10709. The gross profit (realized or to be realized when payment is completed) divided by the total contract price is also referred to as the gross profit percentage. The income for the year is equal to the payments received in that year multiplied by the gross profit percentage. Sec. 453(c); sec. 15A.453-1(b)(2)(i), Temporary Income Tax Regs., supra.
• Section 6662(a) imposes a 20% penalty on the portion of an underpayment of tax that is attributable to negligence, or to a substantial understatement of income tax, or to various other causes. Sec. 6662(b).
• Negligence includes any failure to make a reasonable attempt to comply with the tax laws. Sec. 6662(c); sec. 1.6662-3(b), Income Tax Regs. Negligence is strongly indicated where a taxpayer fails to make a reasonable attempt to determine the correctness of a deduction, credit, or exclusion that would seem to a reasonable person to be “too good to be true”. Sec. 1.6662-3(b)(1)(ii), Income Tax Regs. Negligence also includes a failure to maintain accurate records or to substantiate items properly. Sec. 1.6662-3(b)(1), Income Tax Regs. An understatement is substantial if it exceeds the greater of “(i) 10 percent of the tax required to be shown on the return for the taxable year, or (ii) $5,000.” Sec. 6662(d)(1)(A)
• A SIMPLE IRA plan is a small-employer-sponsored individual retirement plan that is funded by employee compensation deferrals and employer matching contributions.8 See sec. 408(p)(1) and (2).

Insight:  The case was a complete loss for the taxpayers.  In 104 pages of IRS-deferential findings, the court sifted through a convoluted business relationship and unique factual setting to determine whether the taxpayer was a partner or an employee of the business.  The case demonstrates the multi-factor test for determining partnership status, and underscores that such an analysis is a matter of federal law (insofar as the question is, as here, whether a partnership exists for federal tax purposes).

Novoselsky v. Comm’r, T.C. Memo. 2020-68 

May 28, 2020 | Lauber, J. | Dkt. No. 22400-13

• Opinion

Short Summary: During 2009 through 2011, Mr. Novoselsky, an attorney, practiced law with a focus on class action litigation.  In those years, he executed “litigation support agreements” with various individuals and entities.  Under those agreements, the individuals and entities made upfront payments to support the costs of litigation.  If the litigation was successful, Mr. Novoselsky was obligated to pay the counter-party, from his award of attorney’s fees and costs, the initial payment advanced to Mr. Novoselsky plus a premium.  However, if the litigation was not successful, Mr. Novoselsky had no obligation to return any funds to the counter-party.

Mr. Novoselsky and his wife filed joint returns with a Schedule C, Profit or Loss From Business, to report the business activities of Mr. Novoselsky’s law firm.  On the Schedule C, Mr. Novoselsky did not report any of the funds advanced to him pursuant to the litigation support agreements in which he had no obligation to repay the counter-party.  The IRS examined the returns and issued a notice of deficiency to Mr. and Mrs. Novoselsky.  In the notice of deficiency, the IRS determined that the advanced funds for which there was no repayment obligation should be reported as gross income to Mr. Novoselsky.  In addition, the IRS asserted accuracy-related penalties with respect to these items.

Key Issue:  Whether the funds advanced to Mr. Novoselsky constitute a loan or gross income and whether Mr. and Mrs. Novoselsky are liable for accuracy-related penalties.

Primary Holdings:

• The payments Mr. Novoselsky received from third parties constituted gross income to Mr. Novoselsky and not loans. Specifically, the payments were not loans because any obligation for Mr. Novoselsky to repay was contingent on future events and therefore did not constitute valid debt for federal income tax purposes.
• In addition, the payments under the litigation agreements do not represent bona fide loans under factors used by federal courts to distinguish between debt and other payments because: (1) Mr. Novoselsky did not execute a formal promissory note; (2) no fixed schedule for repayments was established; (3) Mr. Novoselsky provided no collateral or security; and (4) no payments of principal or interest were ever made.
• Mr. and Mrs. Novoselsky are liable for accuracy-related penalties because: (1) they have put forth no evidence showing reasonable cause; and (2) Mr. Novoselsky is an attorney who had knowledge and education required to determine his tax obligations correctly.  

Key Points of Law:

• The Commissioner’s determination of tax liability is generally presumed correct. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).  In order for this presumption to attach in unreported income cases, the IRS must show a “rational foundation” for the IRS’ determination that the taxpayer received such income.  Pittman v. Comm’r, 100 F.3d 1308, 1313 (7th Cir. 1996), aff’g, T.C. Memo. 1995-243.  Once the Commissioner makes the required threshold showing, the burden shifts to the taxpayer to prove by a preponderance of the evidence that the Commissioner’s determinations are arbitrary or erroneous.  Walquist v. Comm’r, 152 T.C. 61, 67-68 (2019).
• I. R.C. § 61(a) defines gross income as “all income from whatever source derived,” including income derived from business. If a taxpayer is a cash method taxpayer, the taxpayer must include cash sums received in the tax year unless the receipts are nontaxable.  Treas. Reg. § 1.451-1(a).
• Because a genuine loan is accompanied by an obligation to repay, loan proceeds do not constitute income to the taxpayer. Comm’r v. Tufts, 461 U.S. 300, 307 (1983).  For this rule to apply, however, the obligation to repay “must be unconditional and not contingent upon some future event.”  Frierdich v. Comm’r, 925 F.2d 180, 185 (7th Cir. 1991).  “Perhaps the most important underlying principle is that no valid debt exists unless there is an unconditional obligation of another to pay * * * a definite sum of money.”  Henderson, 375 F.2d at 39.
• Where an obligation to pay arises only upon the occurrence of a future event, the Tax Court has consistently held that a valid debt does not exist for federal tax purpose. Taylor v. Comm’r, 27 T.C. 361 (1956), aff’d, 258 F.2d 89 (2d Cir. 1958); Clark v. Comm’r, 18 T.C. 780, aff’d, 205 F.2d 353 (2d Cir. 1953).  The same analysis applies to payment obligations conditioned on the outcome of litigation.  See Bercaw v. Comm’r, 165 F.2d 521, 525 (4th Cir. 1948); Estate of Paine v. Comm’r, T.C. Memo. 1963-275.
• Courts have used a variety of tests to guide the determination of whether particular types of advances should be treated as “loans” for federal tax purposes. See Busch v. Comm’r, 728 F.2d 945, 948 (7th Cir. 1984), aff’gC. Memo. 1983-98; Ill. Tool Works Inc. Comm’r, T.C. Memo. 2018-121.
• A gift, for federal income tax purposes, is one made out of a “detached and disinterested generosity” or “out of affection, respect, admiration, charity or like impulses.” Comm’r v. Duberstein, 363 U.S. 278, 285 (1960).
• As a general rule, funds that a taxpayer receives in trust for another person are not includable in the taxpayer’s gross income. Canatella v. Comm’r, T.C. Memo. 2017-124.
• For individual taxpayers, the substantial understatement penalty applies if the understatement of income tax for a particular year “exceeds the greater of—(i) 10 percent of the tax required to be shown on the return * * *, or (ii) $5,000.” R.C. § 6662(d)(1)(A).  The section 6662 penalty does not apply to any portion of an underpayment “if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to * * * [it].”  I.R.C. § 6664(c)(1). The decision as to whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances.  Treas. Reg. § 1.6664-4(b)(1).  Circumstances that may signal reasonable cause and good faith “include an honest misunderstanding of fact or law that is reasonable in light of all the facts and circumstances, including the experience, knowledge, and education of the taxpayer.  Id.

Insight:  The Novoselsky decision shows the breadth of I.R.C. § 61 and its statutory language that gross income includes all income from whatever source derived.  Because the taxpayer received advances from third parties in which there was no obligation to repay, the Tax Court determined the payments represented gross income.  Notably, if Mr. Novoselsky used the payments for deductible business expenses, he would be entitled to a deduction to offset the gross income, but the decision does not address this issue.

Engle v. Comm’r, T.C. Memo. 2020-69 

May 28, 2020 | Cohen, J. | Dkt. No. 15791-17L

• Opinion

Short Summary:  In 2004, the U.S. Attorney’s Office (USAO) filed an information in federal court charging Mr. Engle with a single count of violation I.R.C. § 7201 by attempting to evade or defeat tax for 1998.  Mr. Engle pled guilty to the information in 2004.

Later, the federal court sentenced Mr. Engle to four years of probation including 18 months of home detention.  The district court did not make a finding of the exact amount of the tax loss involved in the case and did not order full restitution in that amount.  Rather, the federal court ordered that the exact amount of restitution would be determined by the IRS.  Moreover, the federal court directed Mr. Engle pay $25,000 immediately to the IRS and $100,000 within 90 days of the sentence hearing.  On April 4, 2008, the federal court issued a written judgment that stated the exact amount of restitution would “be determined by the IRS.”

The USAO appealed the federal court’s decision, and on January 13, 2010, the Fourth Circuit Court of Appeals vacated the federal court’s decision and remanded the case for resentencing.  Specifically, the Fourth Circuit indicated that it was unable to determine whether Mr. Engle’s sentence was reasonable, particularly where the federal sentencing guidelines recommended a term of imprisonment.  In addition, the Fourth Circuit provided that the federal court was required to reconsider its refusal to order full restitution, particularly because of the significant benefits the Government would have with regard to collection and enforcement.

The federal court resentenced Mr. Engle to 60 months of incarceration and 14 months of supervised release.  The court also ordered him to make restitution to the IRS of $620,549.

On May 26, 2014, the IRS made restitution-based assessments against Mr. Engle for 1984, 1986-1993, and 1995-2001, which totaled the restitution ordered by the federal court in its 2011 amended judgment.  That same day, the IRS mailed Mr. Engle a notice and demand for payment and thereafter issued a notice of federal tax lien.  Mr. Engle filed for a Collection Due Process (CDP) hearing challenging the amount of the restitution-based assessments.  The IRS issued a Notice of Determination to sustain the notice of tax lien filing, concluding:  (1) a taxpayer cannot challenge the amount of court-ordered restitution in a CDP hearing; (2) because the Court of Appeals vacated the federal court’s sentencing order the 2008 restitution order was rendered void, meaning the ultimate restitution order was the amended 2011 judgment; (3) interest was properly assessed on the restitution-based assessments; (4) a lien withdrawal was not appropriate; and (5) the proper legal and procedural requirements had been met in the assessment and collection of the restitution.

Key Issue:  Whether the IRS Settlement Officer abused his discretion in sustaining the notice of federal tax lien filing.

Primary Holdings: 

• The IRS Settlement Officer did not abuse his discretion in sustaining the filing of the notice of tax lien. Specifically, I.R.C. § 6201(a)(4) applies because the Court of Appeals expressly intended to include the 2008 restitution order in its decision to vacate and remand Mr. Engle’s sentence.  Thus, the 2008 order was null and void but the new restitution order in May 2011 was effective.

Key Points of Law:

• I.R.C. § 6321 imposes a lien in favor of the United States on all property and property rights of a taxpayer liable for tax after a demand for the payment of the tax has been made and the taxpayer fails to pay. This lien arises when the assessment is made.  I.R.C. § 6322.  The IRS files a notice of federal tax lien to preserve priority and put other creditors on notice.  I.R.C. § 6323.  Under I.R.C. § 6320(a), the IRS must send written notice to the taxpayer of the filing of a notice of lien and of the taxpayer’s right to an administrative hearing on the matter.
• A taxpayer is strictly prohibited from challenging the existence or amount of an underlying liability that is related to an order of criminal restitution. Carpenter v. Comm’r, 152 T.C. 202, 219 (2019), aff’d, 788 App’x 187 (4th Cir. 2019).
• Where a determination by Appeals is predicated upon an error of law, that determination constitutes an abuse of discretion. Alessio Azzari, Inc. v. Comm’r, 136 T.C. 178, 191 (2011); Swanson v. Comm’r, 121 T.C. 111, 119 (2003).
• The IRS can make a restitution-based assessment only to the extent authorized by I.R.C. § 6201(a)(4)(A). That section provides that the IRS “shall assess and collect the amount of restitution under an order pursuant to section 3556 of title 18, United States Code, for failure to pay any tax imposed under this title [title 26] in the same manner as if such amount were such tax.”  The IRS’ collection authority under I.R.C. § 6201(a)(4) applies only to criminal restitution ordered after August 16, 2010.
• It is well settled that the mandate of a higher court is “controlling as to matters within its compass.” Sprague v. Ticonic Nat’l Bank, 307 U.S. 161, 168 (1939).  “[I]t is indisputable that a lower court generally is ‘bound to carry the mandate of the upper court into execution.’”  S. v. Bell, 5 F.3d 64, 66 (4^th Cir. 1993).  “[W]hen * * * [a higher] court remands for further proceedings, a district court must, except in rare circumstances, “implement both the letter and spirit of the . . . mandate, taking into account [our] opinion and the circumstances it embraces.’”  Id. at 66.

Insight:  The Engle decision stands for the proposition that criminal restitution orders may be difficult for taxpayers to challenge in CDP hearings and that such taxpayers should consider arguing more towards a collection alternative.

Larkin v. Comm’r, T.C. Memo. 2020-70 

May 28, 2020 | Gustafson, J. | Dkt. No. 6345-14

• Opinion

Short Summary:  Mr. and Mrs. Larkin were U.S. nonresident citizens for 2008 through 2010.  Mr. Larkin is an attorney, and Mrs. Larkin is a homemaker.  They owned interests in various entities and real properties in the United States and Europe and claimed deductions on Schedule A and Schedule E related to these activities.  They also claimed foreign tax credits.

The IRS examined the Larkins’ 2008 through 2010 returns and disallowed many of the Schedule A and Schedule E expenses, as well as the foreign tax credits.  Moreover, the IRS issued a notice of deficiency on these issues and also asserted the Larkins were liable for accuracy-related penalties and additions-to-tax for late filing of the returns.

At the Tax Court, the Larkins failed to properly address certain issues and failed to raise those issues in their post-trial briefings.

Key Issue:  Whether the Larkins are entitled to deductions for Schedule A and Schedule E expenses, self-employed health insurance deductions, foreign tax credits, and whether the Larkins are liable for additions-to-tax for late filings and accuracy-related penalties.

Primary Holdings:

• The Tax Court held that the Larkins: (1) failed to substantiate their Schedule A deductions beyond the amounts permitted by the IRS; (2) do not qualify as real estate professionals and are therefore precluded from deducting their Schedule E rental real estate losses after the passive activity loss limitations; (3) are not entitled to the additional self-employed health insurance deductions beyond the amounts permitted by the IRS; (4) are not entitled to a foreign tax credit carryover to 2009; and (5) are liable for the accuracy-related penalties for 2009 and 2010 and liable for additions-to-tax under I.R.C. § 6651(a)(1) for 2008 through 2010.

Key Points of Law:

• Any issue or argument not advanced in a post-trial brief is deemed abandoned. See Mendes v. Comm’r, 121 T.C. 308, 312-13 (2003); Nicklaus v. Comm’r, 117 T.C. 117, 120 n.4 (2001).  Thus, the Tax Court will generally only decide issues that the parties plead, address on brief, and do not concede.
• Under the Tax Court’s Rules of Practice and Procedure, a petition must contain clear and concise assignments of each and every error which the petitioner alleges to have been committed by the IRS in the determination of the deficiency. In addition, any issue not raised in the assignments of error shall be deemed conceded.  Rule 34(b)(4); Foley Mach. Co. v. Comm’r, 91 T.C. 434, 441 (1988).
• In certain circumstances, an issue not raised by the pleadings may be “tried by express or implied consent of the parties, * * * [and] treated in all respects as if they had been raised in the pleadings.” Rule 41(b)(1).  But when a party is not aware of an issue at trial, he cannot be held to have expressly or impliedly consented to the trial of that issue, as required for application of Rule 41(b).  See Markwardt v. Comm’r, 64 T.C. 989, 998 (1975). A taxpayer must carry his burden of proof with evidence offered at trial, to which his brief should refer. Rule 151(e)(3); Adeyemo v. Comm’r, T.C. Memo. 2014-1; D’Errico v. Comm’r, T.C. Memo. 2012-149. 
• I.R.C. § 6001 requires every person liable for any tax, or for the collection thereof, to keep records, and comply with the rules and regulations as the IRS may from time to time prescribe. Thus, a taxpayer is required to keep sufficient records to substantiate his gross income, deductions, credits, and other tax attributes.  See also Treas. Reg. § 1.6001-1(a).
• When a taxpayer adequately establishes that a deductible expense was paid or incurred but does not establish the precise amount, the Court may in some instances estimate the allowable deduction, bearing heavily against the taxpayer whose inexactitude is of his own making. Cohan v. Comm’r, 39 F.2d 50, 543-44 (2d Cir. 1930).  There must, however, be sufficient evidence in the record to provide a basis upon which an estimate may be made and to permit the Court to conclude that a deductible expense, rather than a nondeductible personal expense, was incurred in at least the amount allowed.  Vanicek v. Comm’r, 85 T.C. 731, 743 (1985).  The Tax Court must have some basis on which an estimate may be made.
• The Tax Court will not accept the testimony of a witness at face value to the extent it is implausible or not credible in view of the totality of the surrounding circumstances. Neonatology Assocs., P.A. v. Comm’r, 115 T.C. 43, 84 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).
• Whether to open the record to receive additional evidence is a matter within the discretion of the trial court. Zenith Radio Corp. v. Hazeltine Research, Inc., 401 U.S. 321, 331 (1971).  A motion to reopen the record will not be granted unless, among other requirements, the evidence relied on:  is not merely cumulative or impeaching, is material to the issues involved, and probably would change the outcome of the case.  Butler v. Comm’r, 114 T.C. at 287.  The Tax Court will also take into account other factors, such as “the character of the additional * * * [evidence] and the effect of granting the motion.”  See Purvis v. Comm’r, T.C. Memo. 2020-13.
• I.R.C. § 163(h)(3) provides that interest on a qualified residence is deductible by a non-corporate taxpayer. Qualified residence interest encompasses interest payments on two types of debt:  acquisition indebtedness and home equity indebtedness.  I.R.C. § 163(h)(3)(A).  “Acquisition indebtedness” generally means debt incurred in, or that results from the refinancing of debt incurred in, “acquiring, constructing, or substantially improving” a qualified residence.  I.R.C. § 163(h)(3)(B)(i).  “Home equity indebtedness” generally means indebtedness, other than acquisition indebtedness, that is secured by a qualified residence and that does not exceed the difference between the home’s fair market value and the amount of acquisition indebtedness.  I.R.C. § 163(h)(3)(C)(i).
• Personal interest is nondeductible unless it falls under one of the exceptions enumerated in I.R.C. § 163(h)(2), which allows for the deduction of “investment interest.” Investment interest is defined as interest which is paid or accrued on indebtedness properly allocable to property held for investment.  R.C. § 163(d)(3).  An individuals’ deduction for investment interest expenses cannot exceed his net investment income.  I.R.C. § 163(d)(1).
• I.R.C. § 164(a)(1) allows a deduction for “State and local, and foreign, real property taxes” paid within the taxable year; and I.R.C. § 164(a)(3) allows a deduction for “State and local, and foreign, income * * * taxes.”
• I.R.C. §§ 162 and 212 generally permit taxpayers to deduct ordinary and necessary expenses paid or incurred in carrying on a trade or business or for the production of income. However, in the case of an individual or entity listed in I.R.C. § 469(a)(2), I.R.C. § 469 disallows any current deduction for a passive activity loss.  I.R.C. § 469(a)(1), (b).  A passive activity loss is equal to the aggregate losses from all of the taxpayer’s passive activities minus the aggregate income from all passive activities.  I.R.C. § 469(d)(1).  Generally, a passive activity is any trade or business in which the taxpayer does not materially participate, see I.R.C. § 469(a)(1), (c)(1).  Rental activity (i.e., any activity where payments are principally for the use of tangible personal property are generally a per se passive activity.  See I.R.C. § 469(c)(2).
• An exception to the passive activity loss rules for rental activities exists if: (1) more than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year is performed in real property trades or businesses in which she materially participates; and (2) the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.  R.C. § 469(c)(7)(B).  A taxpayer materially participates in an activity “only if the taxpayer is involved in the operations of the activity on a basis which is—(A) regular, (B) continuous, and (C) substantial.”  I.R.C. § 469(h)(1).
• The regulations indicate that the extent of an individual’s participation in an activity may be established “by any reasonable means.” Reg. § 1.469-5T(f)(4).  Contemporaneous daily time reports, logs, or similar documents are not required, but a party may not rely on a post-event “ballpark guesstimate” or unverified, undocumented testimony.  See Moss v. Comm’r, 135 T.C. 365, 369 (2010); Lum v. Comm’r, T.C. Memo. 2012-103.
• A self-employed taxpayer may deduct health insurance costs paid for medical care for himself and his family, subject to special rules. The deduction may not exceed the “taxpayer’s earned income (within the meaning of section 401(c)) derived by the taxpayer from the trade or business with respect to which the plan providing the medical care coverage is established.  R.C. § 162(l).
• I.R.C. § 901(a) generally allows a taxpayer foreign tax credits for foreign income taxes paid, subject to the limitation imposed by I.R.C. § 904, which in turn limits the credit to the amount of U.S. tax on foreign income. A foreign tax credit is allowed only to the extent that the taxpayer can prove it was “paid or accrued” with respect to income from sources without the United States.  I.R.C. § 905(b)(1) and (2).  Even if a taxpayer proves payment of foreign tax, the credit for a particular year may be limited under I.R.C. § 904(a).  However, a taxpayer may carry back to the first preceding tax year or carry forward to any of the first 10 succeeding tax years any excess foreign tax paid or accrued for the year at issue.  I.R.C. § 904(c).
• A taxpayer claiming a foreign tax credit carryover must establish both the existence of the credit and the amount of any credit that remains (after application to previous years) to be carried over to the year at issue. Segel v. Comm’r, 89 T.C. 816, 842 (1987).
• Each tax year stands on its own and must be separately considered, and the IRS is not bound for any given year to allow a deduction permitted for a prior year. S. v. Skelly Oil Co., 394 U.S. 678, 684 (1969).
• I.R.C. § 6651(a)(1) imposes an addition to tax for late filing a return unless the taxpayer can show reasonable cause. Reasonable cause is not established simply due to the IRS having an open examination of a taxpayer’s prior year returns.  Denenburg v. U.S., 920 F.2d 301, 306 n.10 (5^th Cir. 1991).
• I.R.C. § 6664(b) provides that the accuracy-related penalty and fraud penalty only apply in cases where a return has been filed. If a taxpayer fails to file a return, the accuracy-related penalties do not apply.
• Negligence can be either the lack of due care or the failure to act reasonably under the circumstances. Neely v. Comm’r, 85 T.C. 934, 947 (1985).  Negligence “includes any failure to make a reasonable attempt to comply with * * * [the internal revenue laws],” sec. 6662(c), including any failure by the taxpayer to keep adequate books and records or to substantiate items properly, Treas. Reg. § 1.6662-3(b)(1).
• Under I.R.C. § 6751(b)(1), the IRS must show whether the supervisor in fact approved the penalty and therefore not “the propriety of the Commissioner’s administrative policy or procedure underlying his penalty determinations”, Raifman v. Comm’r, T.C. Memo. 2018-101, nor whether the supervisor “adequately contemplated [a] reasonable cause defense,” see id.
• Whether a taxpayer acted with reasonable cause and good faith is a facts-and-circumstances decision, and the most important factor is the extent of the taxpayer’s efforts to assess his proper tax liability. Reg. § 1.664-4(b)(1).  Also important is the taxpayer’s knowledge and experience.  Id.

Insight: The Larkin decision shows the dangers of not complying with the Tax Court’s Rules of Practice and Procedure.  Taxpayers should bear in mind that every assignment of error should be identified in the petition and should be addressed throughout the trial and post-trial briefing period.  In the event the taxpayer fails to do so, the Tax Court may consider the issues waived.

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