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Attentione! International Employment | US Employees in Italy

This Freeman Law Insights blog regards considerations, challenges, and opportunities for a domestic U.S. employer looking to or engaged in the employ a U.S. citizen who resides in the country of Italy. This is not legal advice; just legal information, unless you paid for it. However, the legge information here should be useful for those U.S. employers interested in expanding the now ubiquitous U.S. employee remote work regime into the country of Italy.

Employer of Record. The U.S. employer should first evaluate and consider engaging an employer of record who is active in such services in the country where the U.S. citizen will perform the work. An employer of record is, essentially, a third-party service that operates as an employer on a hiring U.S. company’s behalf. This allows the hiring company to avoid having to establish an entity in the foreign country. The employer of record usually handles the legal requirements for complying with the foreign laws for payroll, contracts, and benefits.

Military Considerations. If the employee is a dependent of a member of the U.S. military, the employee should be aware that the rules of Status of Forces Privileges (SOFA) may or may not jeopardy certain military privileges by virtue of the employee’s employ while stationed overseas. See, for example, SOFA information on work in Italy here (Spouse Employment). However, the SOFA privilege matters were recently (August 30, 2023) modified to mitigate the adverse consequences to those U.S. citizen dependents on military bases in, for example, Italy and who work for a U.S. employer, provided that the U.S. citizen has a missione visa. See Telework to US Employers. And, U.S. employees who qualify for the approved telework as such likely fall under U.S. and not Italian employment laws.

Worker Tax Matters. The wages paid to the U.S. citizen living in Italy and working for a U.S. employer are subject to U.S. federal income tax withholding. Limited exceptions apply. A U.S. citizen living and working in Italy is required to file a U.S. tax return and a similar return in Italy, reporting wages from the U.S. employer-issued Form W2. The employee should be advised to engage independent tax counsel because the confluence of U.S. and Italy personal tax laws is or can be complicated.

Worker Social Security. For example, the U.S. employer is likely not required to pay Italian social security because of the Totalization Agreement in place between the U.S. and Italy. The U.S. employer usually must withhold FICA and Social Security from the wages earned by the U.S. citizen working overseas. The U.S. citizen may be taxed, under Italian law, for the amounts withheld for U.S. employment tax purposes (i.e., for FICA and Social Security), and then the U.S. citizen may later receive a credit pursuant to a foreign tax credit for subsequent U.S. tax returns. An exemption may be established through the Totalization Agreement between the U.S. and Italy, and the recently-issued SOFA Telework changes may have mitigated, if not eliminated, that duplication of social security for the U.S. citizen working under the military Telework regime. The U.S. employer generally must request a Certificate of Coverage to establish the U.S. citizen’s exemption from Italian social security. See also the Certificate of Coverage Request Form for online application for Certificate.

Earned Income Tax Exclusion for the US Worker. The U.S. citizen may also benefit from an exclusion for foreign earned income, if the U.S. citizen meets the requirements applicable for the exclusion. However, the employee may be subject to a double taxation initially, which may then entitle the employee to a refund, based on a foreign tax credit application in later filing years in the U.S.

Written Agreement. In any case, a written contract for remote work between the hiring entity and the U.S. citizen overseas is recommended and advisable (and may be required under Italian law, for example), whether for contract labor or employment. And, an employer of record is recommended, whether the worker is treated as an employee or an independent contractor (the distinction of which has its own set of considerations).

Closing. Italy has a complex system for employment matters, and the international aspects of the potential employer-employee relationship make the arrangement even more cumbersome. But, with attention to detail (and legal and tax requirements), the arrangement is achievable and will not be the first of its kind. Below is a schedule of resources and information on this subject.

Informational Resources for Telework of US Citizens in Italy
Status of Forces Agreement (SOFA) – Italy	https://home.army.mil/italy/my-garrison-Italy/pcsguidevic/living-vicenza/spouse-employement
Telework to U.S. Employers – Italy (missione visa required) (August 30, 2023)	https://home.army.mil/italy/my-garrison-Italy/telework
IRS Guidance – Federal Income Tax Withholding for Persons Employed Abroad by a U.S. Person	https://www.irs.gov/individuals/international-taxpayers/persons-employed-abroad-by-a-us-person
Department of State – U.S. Embassy & Consulate in Italy	https://it.usembassy.gov/u-s-citizen-services/local-resources-of-u-s-citizens/visiting-living/ https://it.usembassy.gov/u-s-citizen-services/irs/
IRS Guidance – Foreign Earned Income Exclusion – What is Foreign Earned Income	https://www.irs.gov/individuals/international-taxpayers/foreign-earned-income-exclusion-what-is-foreign-earned-income
IRS Guidance – Foreign Earned Income Exclusion	https://www.irs.gov/individuals/international-taxpayers/foreign-earned-income-exclusion
IRS Foreign Tax Credit	https://www.irs.gov/individuals/international-taxpayers/foreign-tax-credit
IRS Guidance – FBAR Reporting for Foreign Financial Accounts	https://www.irs.gov/businesses/small-businesses-self-employed/report-of-foreign-bank-and-financial-accounts-fbar
Department of State – Telework Guidance for Overseas Family Members	https://www.state.gov/global-community-liaison-office/family-member-employment/telework
U.S. – Italian Social Security Agreement	https://www.ssa.gov/international/Agreement_Texts/italy.html
Social Security Administration – Totalization Agreement with Italy	https://www.ssa.gov/international/Agreement_Pamphlets/italy.html US International Social Security Agreements
Social Security Administration – Certificate of Coverage for Employee Exemption in Italy	https://www.ssa.gov/international/Agreement_Pamphlets/italy.html#certificate2 https://opts.ssa.gov/s/ (online application for Certificate)

Tax Court In Brief

The Tax Court December 26, 2021 – January 1, 2022

The Tax Court December 13 – 18, 2021

The Tax Court December 6 – December 10, 2021
Tax Court Case: Coggin v. Comm’r, 157 T.C. No. 12 | December 8, 2021 | Weiler, J. | Dkt. No. 21580-19
The Tax Court in Brief November 29 – December 3, 2021

The Tax Court in Brief November 22 – November 26, 2021

901 S. Broadway v. Comm’r, No. 14179-17, T.C. Mom 2021-132 | November 23, 2021 | Halpern
Sand Inv. Co. v. Comm’r; 157 T.C. Memo. 11, 2021 | November 23, 2021 Lauber, J. | Dkt. No. 7307-19

The Tax Court in Brief November 15 – November 19, 2021

The Tax Court in Brief November 8 – November 12, 2021

Peak v. Comm’r, T.C. Memo 2021-128
Knox v. Comm’r, T.C. Memo. 2021-126
Smaldino v. Comm’r, T.C. Memo 2021-127

The Tax Court in Brief October 25 – October 29, 2021

Tribune Media et al. v. Comm’r, Nos. 20940-16 & 20941-16, T.C. Memo 2021-122
Cashaw v. Comm’r, No. 9352-16L, T.C. Memo 2021-123
Albert G. Hill, III v. Comm’r; T.C. Memo. 2021-121

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

Goldberg v. Comm’r, T.C. Memo. 2021-119 | October 19, 2021 | Paris, J. | Dkt. No. 12871-18L

The Tax Court in Brief October 4 – October 8, 2021

Crim v. Comm’r, T.C. Memo. 2021-117
Leyh v. Comm’r, 157 T.C. No. 7
Suzanne Jean McCrory v. Comm’r, T.C. Memorandum 2021-116

The Tax Court in Brief September 27 – October 1, 2021

Whistleblower 14377-16W v. Comm’r, T.C. Memo. 2021-113
Gregory v. Comm’r, T.C. Memo. 2021-115

The Tax Court in Brief September 20 – September 24, 2021

Daniel Omar Parker and Chantrell Antoine Parker v. Comm’r, No. 13231-19, T.C. Memo 2021-111

The Tax Court in Brief September 13 – September 17, 2021

Donna M. Sutherland v. Comm’r, No. 3634-18, T.C. Memo 2021-110

The Tax Court in Brief August 30 – September 3, 2021

Karson C. Kaebel v. Comm’r, No. 16171-18P, T.C. Memo 2021-109

The Tax Court in Brief August 30 – September 3, 2021

Tax Court Case: Sherrie L. Webb v. Comm’r; T.C. Memo. 2021-105
Wai-Cheung Wilson Chow and Deanne Chow v. Comm’r, No. 14249-18W, T.C. Memo 2021-106
Tax Court Case: Gaston v. Comm’r, T.C. Memo. 2021-107

The Tax Court in Brief 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

The Tax Court in Brief August 16 – August 20, 2021

Catlett v. Comm’r, No. 13058-14, T.C. Memo 2021-102
Catherine S. Toulouse v. Comm’r, 157 T.C.
Lissack v. Comm’r, 157 T.C. No. 5
Deborah C. Wood v. Comm’r; T.C. Memo. 2021-103

The Tax Court in Brief August 9 – August 13, 2021

Manuelito B. Rodriguez & Paz Rodriguez v. Comm’r, No. 19122-19
Christian D. Silver v. Comm’r, T.C. Memo 2021-98
Wathen v. Comm’r, No. 4310-18, T.C. Memo 2021-100
Kidz University, Inc. v. Comm’r, T.C. Memo. 2021-101

The Tax Court in Brief August 2 – August 6, 2021

Tax Court Case : Belair v. Comm’r, Bench Opinion
Rogers v. Commissioner, 157 T.C. No. 3
Today’s Health Care II LLC. v. Comm’r, 2021 T.C. Memo 2021-96
Jerry R. Abraham and Debra J. Abraham. v. Comm’r, 2021 T.C. Memo 2021-97

The Tax Court in Brief July 26 – July 31, 2021

Tax Court Case: Harrington v. Comm’r, T.C. Memo. 2021-95
Ononuju v. Commissioner, T.C. Memo. 2021-94
Tax Zuo v. Comm’r, No. 5716-19S, 2021 BL 279235, 2021 Us Tax Ct. Lexis 53

The Tax Court in Brief July 19 – July 23, 2021

Tax Court Case: Morris F. Garcia, Deceased, and Sharon Garcia v. Commissioner
Tax Court Case: New World Infrastructure Organization v. Commissioner, T.C. Memo. 2021-91

The Tax Court in Brief July 12 – July 16, 2021

Tax Court Case: Blossom Day Care Centers, Inc. v. Comm’r, 2021 T.C. Memo 2021-87
Tax Court Case: Berger v. Commissioner, T.C. Memo. 2021-89
Tax Court Case: Morreale v. Commissioner, T.C. Memo. 2021-90

The Tax Court in Brief July 5 – July 9, 2021

Peter Freund v. Commissioner, T.C. Memo. 2021-83
Delgado v. Commissioner, T.C. Memo. 2021-84
Mathews v. Commissioner, T.C. Memo. 2021-85

The Tax Court in Brief June 21 – June 25, 2021

Tax Court Case: Ervin v. Commissioner, T.C. Memo. 2021-75
Hussey v. Commissioner, 156 T.C. No. 12

The Tax Court in Brief June 14 – June 18, 2021
Bell Capital Management, Inc. v. Commissioner, T.C. Memo. 2021-74
The Tax Court in Brief May 31 – June 4, 2021

ES NPA Holding, LLC v. Commissioner, T.C. Memo. 2021-68
Michael Torres v. Commissioner, T.C. Memo. 2021-66
New Capital Fire, Inc. v. Commissioner, T.C. Memo. 2021-67

The Tax Court in Brief May 24 – May 28, 2021

Estate of Grossman v. Comm’r, T.C. Memo. 2021-65

The Tax Court in Brief May 17 – May 21, 2021

Fumo v. Comm’r, T.C. Memo. 2021-31
PEEPLES v. Comm’r, Summary Op
Shitrit v. Commissioner, T.C. Memo. 2021-63
Ginos v. Comm’r, T.C. Memo. 2021-14
Mason v. Comm’r, T.C. Memo. 2021-64

The Tax Court in Brief May 10 – May 14, 2021

Jenkins v. Commissioner, T.C. Memo. 2021-54
Adler v. Commissioner, T.C. Memo. 2021-56
Bailey v. Commissioner, T.C. Memo. 2021-55
Battat v. Commissioner, T.C. Memo. 2021-5
ESTATE OF MORRISSETTE, T.C. Memo. 2021-60

The Tax Court in Brief May 3 – May 7, 2021

Chancellor v. Comm’r, T.C. Memo. 2021-50
Barnes v. Comm’r, T.C. Memo. 2021-49
Jacobs v. Comm’r, T.C. Memo. 2021-51
Berry v. Comm’r, T.C. Memo. 2021-52
Tikar, Inc. v. Comm’r, T.C. Memo. 2021-53

The Tax Court in Brief April 26 – April 30, 2021

Plentywood Drug, Inc.
Ronnie S. Baum and Teresa K. Baum v. Comm’r, T.C. Memo 2021-46
Mylan, Inc. & Subsidiaries v. Commissioner, 156 T.C. No. 10
Aschenbrenner v. Comm’r, Bench Opinion
Stankiewicz v. Comm’r, 2021 BL 156162
Haghnazarzadeh v. Comm’r, T.C. Memo 2021-47
Woll v. Comm’r, Bench Opinion

The Tax Court in Brief April 19 – April 23, 2021

Tax Court Case: Colton v. Comm’r, T.C. Memo 2021-44

The Tax Court in Brief April 11 – April 16, 2021

De Los Santos v. Comm’r, 156 T.C. No. 9
Tax Court Case: Flynn v. Comm’r, T.C. Memo 2021-43

The Tax Court in Brief April 05 – April 09, 2021

Tax Court Case Reston and Elizabeth Olsen
Andrew and Sara Berry

The Tax Court in Brief March 29 – April 2, 2021

Crandall v. Comm’r
Rowen v. Comm’r
Purple Heart Patient Center, Inc. v. Comm’r
Walton v. Comm’r| T.C. Memo. 2021-40
Max v. Comm’r| T.C. Memo. 2021-37
Rowen v. Comm’r| 156 T.C. No. 8

The Tax Court in Brief March 22 – March 26, 2021

American Limousines, Inc. v. Comm’r
Martin v. Comm’r, T.C. Memo. 2021-35

The Tax Court in Brief – March 15 – March 19, 2021
Catania v. Commissioner, T.C. Memo. 2021-33 | March 15, 2021 | Vasquez, J. | Dkt. No. 13332-19
The Tax Court in Brief – March 8 – 12, 2021

Clarence J. Mathews v. Comm’r, T.C. Memo 2021-28 March 9, 2021
Smith v. Comm’r, T.C. Memo. 2021-29
Caylor Land & Development, Inc. v. Commissioner, T.C. Memo. 2021-30
Brian E. Harriss, T.C. Memo. 2021-31

The Tax Court in Brief – March 1-5, 2021

The Tax Court in Brief – February 22 – 26, 2021

The Tax Court in Brief February 15 – February 19, 2021

Tax Court Case: Kramer v. Comm’r, T.C. Memo. 2021-16
Estate of Warne v. Comm’r, T.C. Memo. 2021-17
Blum v. Comm’r, T.C. Memo. 2021-18
San Jose Wellness v. Comm’r, 156 T.C. No. 4

The Tax Court in Brief February 8 – February 12, 2021

BM Construction v. Comm’r, T.C. Memo. 2021-13
Complex Media, Inc. v. Comm’r, T.C. Memo. 2021-14

The Tax Court in Brief – January 25 – 29, 2021

Costello v. Comm’r, T.C. Memo. 2021-9
Grajales v. Comm’r, 156 T.C. No. 3
Reynolds v. Comm’r, T.C. Memo. 2021-10
Whatley v. Comm’r, T.C. Memo. 2021-11
Sells v. Comm’r, T.C. Memo. 2021-12

The Tax Court in Brief 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

The Tax Court in Brief – January 11 – 15, 2021

Kennedy v. Comm’r, T.C. Memo. 2021-3
Ramey v. Comm’r, 156 T.C. No. 1
Filler v. Comm’r, T.C. Memo. 2021-6

Freeman Law’s Top 10 Tax Court Cases of 2020

Frost v. Comm’r, 152 T.C. No. 2 (Jan. 7, 2020)
Laidlaw’s Harley Davidson Sales, Inc. v. Comm’r, 154 T.C. No. 4 (Jan. 16, 2020)
Chadwick v. Comm’r, 154 T.C. No. 5 (Jan. 21, 2020)
Oakbrook Land Holdings, LLC v. Comm’r, 154 T.C. No. 10 (May 12, 2020)
Sage v. Comm’r, 154 T.C. No. 12 (June 2, 2020)
Ruesch v. Comm’r, 154 T.C. No. 13 (June 25, 2020)
Barnhill v. Comm’r, 155 T.C. No. 1 (July 21, 2020)
Bemmelen v. Comm’r, 155 T.C. No. 4 (Aug. 27, 2020)
Thompson v. Comm’r, 155 T.C. No. 5 (Aug. 31, 2020)
Bemmelen v. Comm’r, 155 T.C. No. 4 (Aug. 27, 2020)

The Tax Court in Brief November 14 – November 20, 2020

Bruno v. Comm’r, T.C. Memo. 2020-156
Aghadjanian v. Comm’r, T.C. Memo. 2020-155
Kane v. Comm’r, T.C. Memo. 2020-154

The Tax Court in Brief – November 7 – November 13, 2020

The Tax Court in Brief October 31 – November 6, 2020

Glade Creek Partners, LLC, Sequatchie Holdings, LLC, TMP v. Comm’r, T.C. Memo. 2020-148
Leith v. Comm’r, T.C. Memo. 2020-149

The Tax Court in Brief October 24 – October 30, 2020

Sharma v. Comm’r, T.C. Memo. 2020-147

The Tax Court in Brief October 17 – October 23, 2020

Giambrone v. Comm’r, T.C. Memo. 2020-145
Coleman v. Comm’r, T.C. Memo. 2020-146

The Tax Court in Brief October 10 – October 16, 2020

Jesus R. Oropeza v. Comm’r, 155 T.C. No. 9
Watts v. Comm’r, T.C. Memo. 2020-143
The Morning Star Packing Company, L.P., et al. v. Comm’r, T.C. Memo. 2020-142
Watts v. Comm’r, T.C. Memo. 2020-143

The Tax Court in Brief October 3 – October 9, 2020

Doyle v. Comm’r, T.C. Memo. 2020-139
Spagnoletti v. Comm’r, T.C. Memo. 2020-140
Worthington v. Comm’r, T.C. Memo. 2020-141

The Tax Court in Brief September 28 – October 2, 2020

Lucero v. Comm’r, T.C. Memo. 2020-136

The Tax Court in Brief September 21 – September 25, 2020

Patel v. Comm’r, T.C. Memo. 2020-133
Robinson v. Comm’r, T.C. Memo. 2020-134

The Tax Court in Brief September 12 – 18, 2020

Deckard v. Comm’r, 155 T.C. No. 8
Cindy Damiani v. Comm’r, T.C. Memo. 2020-132
Felix Ewald Friedel v. Comm’r, T.C. Memo. 2020-131

Tax Court in Brief September 5 – 11, 2020

Sutherland v. Comm’r, 155 T.C. No. 6
Fowler v. Comm’r, 155 T.C. No. 7
Robert J. Belanger v. Comm’r, T.C. Memo. 2020-130
Korean-American Senior Mutual Association, Inc., T.C. Memo. 2020-129

The Tax Court in Brief August 29 – September 4, 2020

Savedoff v. Comm’r, T.C. Memo. 2020-125
Daichman v. Comm’r, T.C. Memo. 2020-126
Douglas M. Thompson and Lisa Mae Thompson v. Comm’r, 155 T.C. No. 5
Dickinson v. Commissioner, T.C. Memo. 2020-128
Franklin v. Commissioner, T.C. Memo. 2020-127

The Tax Court in Brief August 22 – August 28, 2020

Swanberg v. Comm’r, T.C. Memo. 2020-123
Rivas v. Comm’r, T.C. Memo. 2020-124
Whistleblower v. Comm’r, 155 T.C. No. 2
TGS-NOPEC Geophysical Company & subsidiaries v. Comm’r, 155 T.C. No. 3.
Van Bemmelen v. Comm’r, 155 T.C. No. 4

The Tax Court in Brief August 15 – August 21, 2020

Emanouil v. Comm’r, T.C. Memo. 2020-120
Nirav B. Babu, T.C. Memo. 2020-121
Brashear v. Comm’r, T.C. Memo. 2020-122

The Tax Court in Brief August 1 – August 7, 2020

Reflectxion Resources, Inc. v. Comm’r, T.C. Memo. 2020-114
Red Oak Estates, LLC v. Commissioner, T.C. Memo. 2020-116
Cottonwood Place, LLC v. Commissioner, T.C. Memo. 2020-115
Schroeder v. Comm’r, T.C. Memo. 2020-117
Stevens v. Comm’r, T.C. Memo. 2020-118

The Tax Court in Brief – July 25 – July 31, 2020
Biggs-Owens v. Comm’r, T.C. Memo. 2020-113 | July 30, 2020 | Urda, J. | Dkt. No. 15274-17L
The Tax Court in Brief – July 19 – July 24, 2020

The Tax Court in Brief July 12 – July 17, 2020

Duffy v. Comm’r, T.C. Memo. 2020-108 Smith Lake, LLC, David Hewitt, TMP v. Comm’r, T.C. Memo. 2020-84
Weiderman v. Comm’r, T.C. Memo. 2020-109
Robert Elkins v. Comm’r, T.C. Memo. 2020-110

The Tax Court in Brief July 6– July 10, 2020

The Tax Court in Brief June 29 – July 3, 2020

The Tax Court in Brief The Week of June 22, 2020

Lloyd v. Comm’r, T.C. Memo. 2020-92 | June 22, 2020 | Halpern, J. | Dkt. No. 12309-17
Plateau Holdings, LLC, Waterfall Development Manager, LLC, TMP v. Comm’r, T.C. Memo. 2020-93
Lumpkin One Five Six, LLC v. Comm’r, T.C. Memo. 2020-94
Vivian Ruesch v. Comm’r, 154 T.C. No. 13 | June 25, 2020 | Lauber, J. | Dkt. No. 6188-19P

The Tax Court in Brief June 15 – 19, 2020

The Tax Court in Brief June 8 – 12, 2020

The Tax Court in Brief June 1-7, 2021

The Tax Court in Brief 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

The Tax Court in Brief May 18 – 22, 2020

Nesbitt v. Comm’r, T.C. Memo. 2020-61
Pope v. Comm’r, T.C. Memo. 2020-62
Richlin v. Comm’r, T.C. Memo. 2020-60
Frantz v. Comm’r, T.C. Memo. 2020-64
Peacock v. Comm’r, T.C. Memo. 2020-63
Joseph v. Comm’r, T.C. Memo. 2020-65
Serrano v. Comm’r, T.C. Summ. Op. 2020-15
\n\n[/cs_content_seo][cs_element_text _id=”20″ ][cs_content_seo]Tax Court January 31 – February 4, 2022

The Tax Court January 9 -15th 2022

The Tax Court December 26, 2021 – January 1, 2022

The Tax Court December 13 – 18, 2021

The Tax Court in Brief December 6 – December 10, 2021

Coggin v. Comm’r, 157 T.C. No. 12 | December 8, 2021 | Weiler, J. | Dkt. No. 21580-19

The Tax Court in Brief November 29 – December 3, 2021

The Tax Court in Brief November 22 – November 26, 2021

901 S. Broadway v. Comm’r, No. 14179-17, T.C. Mom 2021-132 | November 23, 2021 | Halpern
Sand Inv. Co. v. Comm’r; 157 T.C. Memo. 11, 2021 | November 23, 2021 Lauber, J. | Dkt. No. 7307-19

The Tax Court in Brief November 15 – November 19, 2021

The Tax Court in Brief November 8 – November 12, 2021

Peak v. Comm’r, T.C. Memo 2021-128
Knox v. Comm’r, T.C. Memo. 2021-126
Smaldino v. Comm’r, T.C. Memo 2021-127

The Tax Court in Brief October 25 – October 29, 2021

Tribune Media et al. v. Comm’r, Nos. 20940-16 & 20941-16, T.C. Memo 2021-122
Cashaw v. Comm’r, No. 9352-16L, T.C. Memo 2021-123
Albert G. Hill, III v. Comm’r; T.C. Memo. 2021-121

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

Goldberg v. Comm’r, T.C. Memo. 2021-119 | October 19, 2021 | Paris, J. | Dkt. No. 12871-18L

The Tax Court in Brief October 4 – October 8, 2021

Crim v. Comm’r, T.C. Memo. 2021-117
Leyh v. Comm’r, 157 T.C. No. 7
Suzanne Jean McCrory v. Comm’r, T.C. Memorandum 2021-116

The Tax Court in Brief September 27 – October 1, 2021

Whistleblower 14377-16W v. Comm’r, T.C. Memo. 2021-113
Gregory v. Comm’r, T.C. Memo. 2021-115

The Tax Court in Brief September 20 – September 24, 2021

Daniel Omar Parker and Chantrell Antoine Parker v. Comm’r, No. 13231-19, T.C. Memo 2021-111

The Tax Court in Brief September 13 – September 17, 2021

Donna M. Sutherland v. Comm’r, No. 3634-18, T.C. Memo 2021-110

The Tax Court in Brief August 30 – September 3, 2021

Karson C. Kaebel v. Comm’r, No. 16171-18P, T.C. Memo 2021-109

The Tax Court in Brief August 30 – September 3, 2021

The Tax Court in Brief 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

The Tax Court in Brief August 16 – August 20, 2021

Catlett v. Comm’r, No. 13058-14, T.C. Memo 2021-102
Catherine S. Toulouse v. Comm’r, 157 T.C.
Lissack v. Comm’r, 157 T.C. No. 5
Deborah C. Wood v. Comm’r; T.C. Memo. 2021-103

The Tax Court in Brief August 9 – August 13, 2021

The Tax Court in Brief August 2 – August 6, 2021

The Tax Court in Brief July 26 – July 31, 2021

Tax Court Case: Harrington v. Comm’r, T.C. Memo. 2021-95
Ononuju v. Commissioner, T.C. Memo. 2021-94
Tax Zuo v. Comm’r, No. 5716-19S, 2021 BL 279235, 2021 Us Tax Ct. Lexis 53

The Tax Court in Brief July 19 – July 23, 2021

Tax Court Case: Morris F. Garcia, Deceased, and Sharon Garcia v. Commissioner
New World Infrastructure Organization v. Commissioner, T.C. Memo. 2021-91

The Tax Court in Brief July 12 – July 16, 2021

Tax Court Case: Blossom Day Care Centers, Inc. v. Comm’r, 2021 T.C. Memo 2021-87
Tax Court Case: Berger v. Commissioner, T.C. Memo. 2021-89
Morreale v. Commissioner, T.C. Memo. 2021-90

The Tax Court in Brief July 5 – July 9, 2021

Peter Freund v. Commissioner, T.C. Memo. 2021-83
Delgado v. Commissioner, T.C. Memo. 2021-84
Mathews v. Commissioner, T.C. Memo. 2021-85

The Tax Court in Brief June 21 – June 25, 2021

Tax Court Case: Ervin v. Commissioner, T.C. Memo. 2021-75
Hussey v. Commissioner, 156 T.C. No. 12

The Tax Court in Brief June 14 – June 18, 2021

Bell Capital Management, Inc. v. Commissioner, T.C. Memo. 2021-74

The Tax Court in Brief May 31 – June 4, 2021

ES NPA Holding, LLC v. Commissioner, T.C. Memo. 2021-68
Michael Torres v. Commissioner, T.C. Memo. 2021-66
New Capital Fire, Inc. v. Commissioner, T.C. Memo. 2021-67

The Tax Court in Brief May 24 – May 28, 2021

Estate of Grossman v. Comm’r, T.C. Memo. 2021-65

The Tax Court in Brief May 17 – May 21, 2021

Fumo v. Comm’r, T.C. Memo. 2021-31
PEEPLES v. Comm’r, Summary Op
Shitrit v. Commissioner, T.C. Memo. 2021-63
Ginos v. Comm’r, T.C. Memo. 2021-14
Mason v. Comm’r, T.C. Memo. 2021-64

The Tax Court in Brief May 10 – May 14, 2021

The Tax Court in Brief May 3 – May 7, 2021

The Tax Court in Brief April 26 – April 30, 2021

The Tax Court in Brief April 19 – April 23, 2021

Tax Court Case: Colton v. Comm’r, T.C. Memo 2021-44

The Tax Court in Brief April 11 – April 16, 2021

De Los Santos v. Comm’r, 156 T.C. No. 9
Tax Court Case: Flynn v. Comm’r, T.C. Memo 2021-43

The Tax Court in Brief April 05 – April 09, 2021

Tax Court Case Reston and Elizabeth Olsen
Andrew and Sara Berry

The Tax Court in Brief March 29 – April 2, 2021

Crandall v. Comm’r
Rowen v. Comm’r
Purple Heart Patient Center, Inc. v. Comm’r
Walton v. Comm’r| T.C. Memo. 2021-40
Max v. Comm’r| T.C. Memo. 2021-37
Rowen v. Comm’r| 156 T.C. No. 8

The Tax Court in Brief March 22 – March 26, 2021

American Limousines, Inc. v. Comm’r
Martin v. Comm’r, T.C. Memo. 2021-35

The Tax Court in Brief – March 15 – March 19, 2021

Catania v. Commissioner, T.C. Memo. 2021-33 | March 15, 2021 | Vasquez, J. | Dkt. No. 13332-19

The Tax Court in Brief – March 8 – 12, 2021

The Tax Court in Brief – March 1-5, 2021

The Tax Court in Brief – February 22 – 26, 2021

The Tax Court in Brief February 15 – February 19, 2021

Tax Court Case: Kramer v. Comm’r, T.C. Memo. 2021-16
Estate of Warne v. Comm’r, T.C. Memo. 2021-17
Blum v. Comm’r, T.C. Memo. 2021-18
San Jose Wellness v. Comm’r, 156 T.C. No. 4

The Tax Court in Brief February 8 – February 12, 2021

BM Construction v. Comm’r, T.C. Memo. 2021-13
Complex Media, Inc. v. Comm’r, T.C. Memo. 2021-14

The Tax Court in Brief – January 25 – 29, 2021

Costello v. Comm’r, T.C. Memo. 2021-9
Grajales v. Comm’r, 156 T.C. No. 3
Reynolds v. Comm’r, T.C. Memo. 2021-10
Whatley v. Comm’r, T.C. Memo. 2021-11
Sells v. Comm’r, T.C. Memo. 2021-12

The Tax Court in Brief 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

The Tax Court in Brief – January 11 – 15, 2021

Kennedy v. Comm’r, T.C. Memo. 2021-3
Ramey v. Comm’r, 156 T.C. No. 1
Filler v. Comm’r, T.C. Memo. 2021-6

Freeman Law’s Top 10 Tax Court Cases of 2020

The Tax Court in Brief November 14 – November 20, 2020

Bruno v. Comm’r, T.C. Memo. 2020-156
Aghadjanian v. Comm’r, T.C. Memo. 2020-155
Kane v. Comm’r, T.C. Memo. 2020-154

The Tax Court in Brief – November 7 – November 13, 2020

The Tax Court in Brief October 31 – November 6, 2020

Glade Creek Partners, LLC, Sequatchie Holdings, LLC, TMP v. Comm’r, T.C. Memo. 2020-148
Leith v. Comm’r, T.C. Memo. 2020-149

The Tax Court in Brief October 24 – October 30, 2020

Sharma v. Comm’r, T.C. Memo. 2020-147

The Tax Court in Brief October 17 – October 23, 2020

Giambrone v. Comm’r, T.C. Memo. 2020-145
Coleman v. Comm’r, T.C. Memo. 2020-146

The Tax Court in Brief October 10 – October 16, 2020

The Tax Court in Brief October 3 – October 9, 2020

Doyle v. Comm’r, T.C. Memo. 2020-139
Spagnoletti v. Comm’r, T.C. Memo. 2020-140
Worthington v. Comm’r, T.C. Memo. 2020-141

The Tax Court in Brief September 28 – October 2, 2020

Lucero v. Comm’r, T.C. Memo. 2020-136

The Tax Court in Brief September 21 – September 25, 2020

Patel v. Comm’r, T.C. Memo. 2020-133
Robinson v. Comm’r, T.C. Memo. 2020-134

The Tax Court in Brief September 12 – 18, 2020

Deckard v. Comm’r, 155 T.C. No. 8
Cindy Damiani v. Comm’r, T.C. Memo. 2020-132
Felix Ewald Friedel v. Comm’r, T.C. Memo. 2020-131

Tax Court in Brief September 5 – 11, 2020

Sutherland v. Comm’r, 155 T.C. No. 6
Fowler v. Comm’r, 155 T.C. No. 7
Robert J. Belanger v. Comm’r, T.C. Memo. 2020-130
Korean-American Senior Mutual Association, Inc., T.C. Memo. 2020-129

The Tax Court in Brief August 29 – September 4, 2020

The Tax Court in Brief August 22 – August 28, 2020

The Tax Court in Brief August 15 – August 21, 2020

Emanouil v. Comm’r, T.C. Memo. 2020-120
Nirav B. Babu, T.C. Memo. 2020-121
Brashear v. Comm’r, T.C. Memo. 2020-122

The Tax Court in Brief August 1 – August 7, 2020

The Tax Court in Brief – July 25 – July 31, 2020

Biggs-Owens v. Comm’r, T.C. Memo. 2020-113 | July 30, 2020 | Urda, J. | Dkt. No. 15274-17L

The Tax Court in Brief – July 19 – July 24, 2020

The Tax Court in Brief July 12 – July 17, 2020

Duffy v. Comm’r, T.C. Memo. 2020-108 Smith Lake, LLC, David Hewitt, TMP v. Comm’r, T.C. Memo. 2020-84
Weiderman v. Comm’r, T.C. Memo. 2020-109
Robert Elkins v. Comm’r, T.C. Memo. 2020-110

The Tax Court in Brief July 6– July 10, 2020

The Tax Court in Brief June 29 – July 3, 2020

The Tax Court in Brief The Week of June 22, 2020

The Tax Court in Brief June 15 – 19, 2020

The Tax Court in Brief June 8 – 12, 2020

The Tax Court in Brief June 1-7, 2021

Kroner v. Comm’r, T.C. Memo. 2020-73 | June 1, 2020 | Marvel P. L. | Dkt. No. 23983-14

The Tax Court in Brief May 25 – 29, 2020

The Tax Court in Brief May 18 – 22, 2020

Nesbitt v. Comm’r, T.C. Memo. 2020-61
Pope v. Comm’r, T.C. Memo. 2020-62
Richlin v. Comm’r, T.C. Memo. 2020-60
Frantz v. Comm’r, T.C. Memo. 2020-64
Peacock v. Comm’r, T.C. Memo. 2020-63
Joseph v. Comm’r, T.C. Memo. 2020-65
Serrano v. Comm’r, T.C. Summ. Op. 2020-15
\n\n[/cs_content_seo][cs_element_text _id=”21″ ][cs_content_seo]Tax Court January 31 – February 4, 2022

The Tax Court January 9 -15th 2022

The Tax Court December 26, 2021 – January 1, 2022

The Tax Court December 13 – 18, 2021

The Tax Court in Brief December 6 – December 10, 2021
Coggin v. Comm’r, 157 T.C. No. 12 | December 8, 2021 | Weiler, J. | Dkt. No. 21580-19
The Tax Court in Brief November 29 – December 3, 2021

The Tax Court in Brief November 22 – November 26, 2021

901 S. Broadway v. Comm’r, No. 14179-17, T.C. Mom 2021-132 | November 23, 2021 | Halpern
Sand Inv. Co. v. Comm’r; 157 T.C. Memo. 11, 2021 | November 23, 2021 Lauber, J. | Dkt. No. 7307-19

The Tax Court in Brief November 15 – November 19, 2021

The Tax Court in Brief November 8 – November 12, 2021

Peak v. Comm’r, T.C. Memo 2021-128
Knox v. Comm’r, T.C. Memo. 2021-126
Smaldino v. Comm’r, T.C. Memo 2021-127

The Tax Court in Brief October 25 – October 29, 2021

Tribune Media et al. v. Comm’r, Nos. 20940-16 & 20941-16, T.C. Memo 2021-122
Cashaw v. Comm’r, No. 9352-16L, T.C. Memo 2021-123
Albert G. Hill, III v. Comm’r; T.C. Memo. 2021-121

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

Goldberg v. Comm’r, T.C. Memo. 2021-119 | October 19, 2021 | Paris, J. | Dkt. No. 12871-18L

The Tax Court in Brief October 4 – October 8, 2021

Crim v. Comm’r, T.C. Memo. 2021-117
Leyh v. Comm’r, 157 T.C. No. 7
Suzanne Jean McCrory v. Comm’r, T.C. Memorandum 2021-116

The Tax Court in Brief September 27 – October 1, 2021

Whistleblower 14377-16W v. Comm’r, T.C. Memo. 2021-113
Gregory v. Comm’r, T.C. Memo. 2021-115

The Tax Court in Brief September 20 – September 24, 2021

Daniel Omar Parker and Chantrell Antoine Parker v. Comm’r, No. 13231-19, T.C. Memo 2021-111

The Tax Court in Brief September 13 – September 17, 2021

Donna M. Sutherland v. Comm’r, No. 3634-18, T.C. Memo 2021-110

The Tax Court in Brief August 30 – September 3, 2021

Karson C. Kaebel v. Comm’r, No. 16171-18P, T.C. Memo 2021-109

The Tax Court in Brief August 30 – September 3, 2021

The Tax Court in Brief 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

The Tax Court in Brief August 16 – August 20, 2021

Catlett v. Comm’r, No. 13058-14, T.C. Memo 2021-102
Catherine S. Toulouse v. Comm’r, 157 T.C.
Lissack v. Comm’r, 157 T.C. No. 5
Deborah C. Wood v. Comm’r; T.C. Memo. 2021-103

The Tax Court in Brief August 9 – August 13, 2021

The Tax Court in Brief August 2 – August 6, 2021

The Tax Court in Brief July 26 – July 31, 2021

Tax Court Case: Harrington v. Comm’r, T.C. Memo. 2021-95
Ononuju v. Commissioner, T.C. Memo. 2021-94
Tax Zuo v. Comm’r, No. 5716-19S, 2021 BL 279235, 2021 Us Tax Ct. Lexis 53

The Tax Court in Brief July 19 – July 23, 2021

Tax Court Case: Morris F. Garcia, Deceased, and Sharon Garcia v. Commissioner
New World Infrastructure Organization v. Commissioner, T.C. Memo. 2021-91

The Tax Court in Brief July 12 – July 16, 2021

Tax Court Case: Blossom Day Care Centers, Inc. v. Comm’r, 2021 T.C. Memo 2021-87
Tax Court Case: Berger v. Commissioner, T.C. Memo. 2021-89
Morreale v. Commissioner, T.C. Memo. 2021-90

The Tax Court in Brief July 5 – July 9, 2021

Peter Freund v. Commissioner, T.C. Memo. 2021-83
Delgado v. Commissioner, T.C. Memo. 2021-84
Mathews v. Commissioner, T.C. Memo. 2021-85

The Tax Court in Brief June 21 – June 25, 2021

Tax Court Case: Ervin v. Commissioner, T.C. Memo. 2021-75
Hussey v. Commissioner, 156 T.C. No. 12

The Tax Court in Brief June 14 – June 18, 2021
Bell Capital Management, Inc. v. Commissioner, T.C. Memo. 2021-74
The Tax Court in Brief May 31 – June 4, 2021

ES NPA Holding, LLC v. Commissioner, T.C. Memo. 2021-68
Michael Torres v. Commissioner, T.C. Memo. 2021-66
New Capital Fire, Inc. v. Commissioner, T.C. Memo. 2021-67

The Tax Court in Brief May 24 – May 28, 2021

Estate of Grossman v. Comm’r, T.C. Memo. 2021-65

The Tax Court in Brief May 17 – May 21, 2021

Fumo v. Comm’r, T.C. Memo. 2021-31
PEEPLES v. Comm’r, Summary Op
Shitrit v. Commissioner, T.C. Memo. 2021-63
Ginos v. Comm’r, T.C. Memo. 2021-14
Mason v. Comm’r, T.C. Memo. 2021-64

The Tax Court in Brief May 10 – May 14, 2021

The Tax Court in Brief May 3 – May 7, 2021

The Tax Court in Brief April 26 – April 30, 2021

The Tax Court in Brief April 19 – April 23, 2021

Tax Court Case: Colton v. Comm’r, T.C. Memo 2021-44

The Tax Court in Brief April 11 – April 16, 2021

De Los Santos v. Comm’r, 156 T.C. No. 9
Tax Court Case: Flynn v. Comm’r, T.C. Memo 2021-43

The Tax Court in Brief April 05 – April 09, 2021

Tax Court Case Reston and Elizabeth Olsen
Andrew and Sara Berry

The Tax Court in Brief March 29 – April 2, 2021

Crandall v. Comm’r
Rowen v. Comm’r
Purple Heart Patient Center, Inc. v. Comm’r
Walton v. Comm’r| T.C. Memo. 2021-40
Max v. Comm’r| T.C. Memo. 2021-37
Rowen v. Comm’r| 156 T.C. No. 8

The Tax Court in Brief March 22 – March 26, 2021

American Limousines, Inc. v. Comm’r
Martin v. Comm’r, T.C. Memo. 2021-35

The Tax Court in Brief – March 15 – March 19, 2021
Catania v. Commissioner, T.C. Memo. 2021-33 | March 15, 2021 | Vasquez, J. | Dkt. No. 13332-19
The Tax Court in Brief – March 8 – 12, 2021

The Tax Court in Brief – March 1-5, 2021

The Tax Court in Brief – February 22 – 26, 2021

The Tax Court in Brief February 15 – February 19, 2021

Tax Court Case: Kramer v. Comm’r, T.C. Memo. 2021-16
Estate of Warne v. Comm’r, T.C. Memo. 2021-17
Blum v. Comm’r, T.C. Memo. 2021-18
San Jose Wellness v. Comm’r, 156 T.C. No. 4

The Tax Court in Brief February 8 – February 12, 2021

BM Construction v. Comm’r, T.C. Memo. 2021-13
Complex Media, Inc. v. Comm’r, T.C. Memo. 2021-14

The Tax Court in Brief – January 25 – 29, 2021

Costello v. Comm’r, T.C. Memo. 2021-9
Grajales v. Comm’r, 156 T.C. No. 3
Reynolds v. Comm’r, T.C. Memo. 2021-10
Whatley v. Comm’r, T.C. Memo. 2021-11
Sells v. Comm’r, T.C. Memo. 2021-12

The Tax Court in Brief 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

The Tax Court in Brief – January 11 – 15, 2021

Kennedy v. Comm’r, T.C. Memo. 2021-3
Ramey v. Comm’r, 156 T.C. No. 1
Filler v. Comm’r, T.C. Memo. 2021-6

Freeman Law’s Top 10 Tax Court Cases of 2020

The Tax Court in Brief November 14 – November 20, 2020

Bruno v. Comm’r, T.C. Memo. 2020-156
Aghadjanian v. Comm’r, T.C. Memo. 2020-155
Kane v. Comm’r, T.C. Memo. 2020-154

The Tax Court in Brief – November 7 – November 13, 2020

The Tax Court in Brief October 31 – November 6, 2020

Glade Creek Partners, LLC, Sequatchie Holdings, LLC, TMP v. Comm’r, T.C. Memo. 2020-148
Leith v. Comm’r, T.C. Memo. 2020-149

The Tax Court in Brief October 24 – October 30, 2020

Sharma v. Comm’r, T.C. Memo. 2020-147

The Tax Court in Brief October 17 – October 23, 2020

Giambrone v. Comm’r, T.C. Memo. 2020-145
Coleman v. Comm’r, T.C. Memo. 2020-146

The Tax Court in Brief October 10 – October 16, 2020

The Tax Court in Brief October 3 – October 9, 2020

Doyle v. Comm’r, T.C. Memo. 2020-139
Spagnoletti v. Comm’r, T.C. Memo. 2020-140
Worthington v. Comm’r, T.C. Memo. 2020-141

The Tax Court in Brief September 28 – October 2, 2020

Lucero v. Comm’r, T.C. Memo. 2020-136

The Tax Court in Brief September 21 – September 25, 2020

Patel v. Comm’r, T.C. Memo. 2020-133
Robinson v. Comm’r, T.C. Memo. 2020-134

The Tax Court in Brief September 12 – 18, 2020

Deckard v. Comm’r, 155 T.C. No. 8
Cindy Damiani v. Comm’r, T.C. Memo. 2020-132
Felix Ewald Friedel v. Comm’r, T.C. Memo. 2020-131

Tax Court in Brief September 5 – 11, 2020

Sutherland v. Comm’r, 155 T.C. No. 6
Fowler v. Comm’r, 155 T.C. No. 7
Robert J. Belanger v. Comm’r, T.C. Memo. 2020-130
Korean-American Senior Mutual Association, Inc., T.C. Memo. 2020-129

The Tax Court in Brief August 29 – September 4, 2020

The Tax Court in Brief August 22 – August 28, 2020

The Tax Court in Brief August 15 – August 21, 2020

Emanouil v. Comm’r, T.C. Memo. 2020-120
Nirav B. Babu, T.C. Memo. 2020-121
Brashear v. Comm’r, T.C. Memo. 2020-122

The Tax Court in Brief August 1 – August 7, 2020

The Tax Court in Brief – July 25 – July 31, 2020
Biggs-Owens v. Comm’r, T.C. Memo. 2020-113 | July 30, 2020 | Urda, J. | Dkt. No. 15274-17L
The Tax Court in Brief – July 19 – July 24, 2020

The Tax Court in Brief July 12 – July 17, 2020

Duffy v. Comm’r, T.C. Memo. 2020-108 Smith Lake, LLC, David Hewitt, TMP v. Comm’r, T.C. Memo. 2020-84
Weiderman v. Comm’r, T.C. Memo. 2020-109
Robert Elkins v. Comm’r, T.C. Memo. 2020-110

The Tax Court in Brief July 6– July 10, 2020

The Tax Court in Brief June 29 – July 3, 2020

The Tax Court in Brief The Week of June 22, 2020

The Tax Court in Brief June 15 – 19, 2020

The Tax Court in Brief June 8 – 12, 2020

The Tax Court in Brief June 1-7, 2021

The Tax Court in Brief May 25 – 29, 2020

The Tax Court in Brief May 18 – 22, 2020

Nesbitt v. Comm’r, T.C. Memo. 2020-61
Pope v. Comm’r, T.C. Memo. 2020-62
Richlin v. Comm’r, T.C. Memo. 2020-60
Frantz v. Comm’r, T.C. Memo. 2020-64
Peacock v. Comm’r, T.C. Memo. 2020-63
Joseph v. Comm’r, T.C. Memo. 2020-65
Serrano v. Comm’r, T.C. Summ. Op. 2020-15
\n\n[/cs_content_seo][cs_element_text _id=”22″ ][cs_content_seo]Tax Court January 31 – February 4, 2022

The Tax Court January 9 -15th 2022

The Tax Court December 26, 2021 – January 1, 2022

The Tax Court December 13 – 18, 2021

The Tax Court in Brief December 6 – December 10, 2021
Coggin v. Comm’r, 157 T.C. No. 12 | December 8, 2021 | Weiler, J. | Dkt. No. 21580-19
The Tax Court in Brief November 29 – December 3, 2021

Plateau Holdings, LLC, Waterfall Development Manager, LLC, TMP v. Comm’r (Plateau II), T.C. Memo. 2021-133 | November 30, 2021 | Lauber, J. | Dkt. No. 12519-16
FAB Holdings, LLC v. Comm’r; Berritto v. Comm’r; T.C. Memo. 2021-135 | November 30, 2021 Copeland, J. | Docket Nos. 21971-17 22152-17
Hong Jun Chan v. Comm’r, No. 21904-19, T.C. Memo. 2021-136 | December 1, 2021 | Lauber
Soni v. Comm’r; T.C. Memo. 2021-137 | December 1, 2021 Lauber, J. | Dkt. No. 15328-15

The Tax Court in Brief November 22 – November 26, 2021

901 S. Broadway v. Comm’r, No. 14179-17, T.C. Mom 2021-132 | November 23, 2021 | Halpern
Sand Inv. Co. v. Comm’r; 157 T.C. Memo. 11, 2021 | November 23, 2021 Lauber, J. | Dkt. No. 7307-19

The Tax Court in Brief November 15 – November 19, 2021

The Tax Court in Brief November 8 – November 12, 2021

Peak v. Comm’r, T.C. Memo 2021-128
Knox v. Comm’r, T.C. Memo. 2021-126
Smaldino v. Comm’r, T.C. Memo 2021-127

The Tax Court in Brief October 25 – October 29, 2021

Tribune Media et al. v. Comm’r, Nos. 20940-16 & 20941-16, T.C. Memo 2021-122
Cashaw v. Comm’r, No. 9352-16L, T.C. Memo 2021-123
Albert G. Hill, III v. Comm’r; T.C. Memo. 2021-121

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

Goldberg v. Comm’r, T.C. Memo. 2021-119 | October 19, 2021 | Paris, J. | Dkt. No. 12871-18L

The Tax Court in Brief October 4 – October 8, 2021

Crim v. Comm’r, T.C. Memo. 2021-117
Leyh v. Comm’r, 157 T.C. No. 7
Suzanne Jean McCrory v. Comm’r, T.C. Memorandum 2021-116

The Tax Court in Brief September 27 – October 1, 2021

Whistleblower 14377-16W v. Comm’r, T.C. Memo. 2021-113
Gregory v. Comm’r, T.C. Memo. 2021-115

The Tax Court in Brief September 20 – September 24, 2021

Daniel Omar Parker and Chantrell Antoine Parker v. Comm’r, No. 13231-19, T.C. Memo 2021-111

The Tax Court in Brief September 13 – September 17, 2021

Donna M. Sutherland v. Comm’r, No. 3634-18, T.C. Memo 2021-110

The Tax Court in Brief August 30 – September 3, 2021

Karson C. Kaebel v. Comm’r, No. 16171-18P, T.C. Memo 2021-109

The Tax Court in Brief August 30 – September 3, 2021

The Tax Court in Brief 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

The Tax Court in Brief August 16 – August 20, 2021

Catlett v. Comm’r, No. 13058-14, T.C. Memo 2021-102
Catherine S. Toulouse v. Comm’r, 157 T.C.
Lissack v. Comm’r, 157 T.C. No. 5
Deborah C. Wood v. Comm’r; T.C. Memo. 2021-103

The Tax Court in Brief August 9 – August 13, 2021

The Tax Court in Brief August 2 – August 6, 2021

The Tax Court in Brief July 26 – July 31, 2021

Tax Court Case: Harrington v. Comm’r, T.C. Memo. 2021-95
Ononuju v. Commissioner, T.C. Memo. 2021-94
Tax Zuo v. Comm’r, No. 5716-19S, 2021 BL 279235, 2021 Us Tax Ct. Lexis 53

The Tax Court in Brief July 19 – July 23, 2021

Tax Court Case: Morris F. Garcia, Deceased, and Sharon Garcia v. Commissioner
New World Infrastructure Organization v. Commissioner, T.C. Memo. 2021-91

The Tax Court in Brief July 12 – July 16, 2021

Tax Court Case: Blossom Day Care Centers, Inc. v. Comm’r, 2021 T.C. Memo 2021-87
Tax Court Case: Berger v. Commissioner, T.C. Memo. 2021-89
Morreale v. Commissioner, T.C. Memo. 2021-90

The Tax Court in Brief July 5 – July 9, 2021

Peter Freund v. Commissioner, T.C. Memo. 2021-83
Delgado v. Commissioner, T.C. Memo. 2021-84
Mathews v. Commissioner, T.C. Memo. 2021-85

The Tax Court in Brief June 21 – June 25, 2021

Tax Court Case: Ervin v. Commissioner, T.C. Memo. 2021-75
Hussey v. Commissioner, 156 T.C. No. 12

The Tax Court in Brief June 14 – June 18, 2021
Bell Capital Management, Inc. v. Commissioner, T.C. Memo. 2021-74
The Tax Court in Brief May 31 – June 4, 2021

ES NPA Holding, LLC v. Commissioner, T.C. Memo. 2021-68
Michael Torres v. Commissioner, T.C. Memo. 2021-66
New Capital Fire, Inc. v. Commissioner, T.C. Memo. 2021-67

The Tax Court in Brief May 24 – May 28, 2021

Estate of Grossman v. Comm’r, T.C. Memo. 2021-65

The Tax Court in Brief May 17 – May 21, 2021

Fumo v. Comm’r, T.C. Memo. 2021-31
PEEPLES v. Comm’r, Summary Op
Shitrit v. Commissioner, T.C. Memo. 2021-63
Ginos v. Comm’r, T.C. Memo. 2021-14
Mason v. Comm’r, T.C. Memo. 2021-64

The Tax Court in Brief May 10 – May 14, 2021

The Tax Court in Brief May 3 – May 7, 2021

The Tax Court in Brief April 26 – April 30, 2021

The Tax Court in Brief April 19 – April 23, 2021

Tax Court Case: Colton v. Comm’r, T.C. Memo 2021-44

The Tax Court in Brief April 11 – April 16, 2021

De Los Santos v. Comm’r, 156 T.C. No. 9
Tax Court Case: Flynn v. Comm’r, T.C. Memo 2021-43

The Tax Court in Brief April 05 – April 09, 2021

Tax Court Case Reston and Elizabeth Olsen
Andrew and Sara Berry

The Tax Court in Brief March 29 – April 2, 2021

Crandall v. Comm’r
Rowen v. Comm’r
Purple Heart Patient Center, Inc. v. Comm’r
Walton v. Comm’r| T.C. Memo. 2021-40
Max v. Comm’r| T.C. Memo. 2021-37
Rowen v. Comm’r| 156 T.C. No. 8

The Tax Court in Brief March 22 – March 26, 2021

American Limousines, Inc. v. Comm’r
Martin v. Comm’r, T.C. Memo. 2021-35

The Tax Court in Brief – March 15 – March 19, 2021
Catania v. Commissioner, T.C. Memo. 2021-33 | March 15, 2021 | Vasquez, J. | Dkt. No. 13332-19
The Tax Court in Brief – March 8 – 12, 2021

The Tax Court in Brief – March 1-5, 2021

The Tax Court in Brief – February 22 – 26, 2021

The Tax Court in Brief February 15 – February 19, 2021

Tax Court Case: Kramer v. Comm’r, T.C. Memo. 2021-16
Estate of Warne v. Comm’r, T.C. Memo. 2021-17
Blum v. Comm’r, T.C. Memo. 2021-18
San Jose Wellness v. Comm’r, 156 T.C. No. 4

The Tax Court in Brief February 8 – February 12, 2021

BM Construction v. Comm’r, T.C. Memo. 2021-13
Complex Media, Inc. v. Comm’r, T.C. Memo. 2021-14

The Tax Court in Brief – January 25 – 29, 2021

Costello v. Comm’r, T.C. Memo. 2021-9
Grajales v. Comm’r, 156 T.C. No. 3
Reynolds v. Comm’r, T.C. Memo. 2021-10
Whatley v. Comm’r, T.C. Memo. 2021-11
Sells v. Comm’r, T.C. Memo. 2021-12

The Tax Court in Brief 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

The Tax Court in Brief – January 11 – 15, 2021

Kennedy v. Comm’r, T.C. Memo. 2021-3
Ramey v. Comm’r, 156 T.C. No. 1
Filler v. Comm’r, T.C. Memo. 2021-6

Freeman Law’s Top 10 Tax Court Cases of 2020

The Tax Court in Brief November 14 – November 20, 2020

Bruno v. Comm’r, T.C. Memo. 2020-156
Aghadjanian v. Comm’r, T.C. Memo. 2020-155
Kane v. Comm’r, T.C. Memo. 2020-154

The Tax Court in Brief – November 7 – November 13, 2020

The Tax Court in Brief October 31 – November 6, 2020

Glade Creek Partners, LLC, Sequatchie Holdings, LLC, TMP v. Comm’r, T.C. Memo. 2020-148
Leith v. Comm’r, T.C. Memo. 2020-149

The Tax Court in Brief October 24 – October 30, 2020

Sharma v. Comm’r, T.C. Memo. 2020-147

The Tax Court in Brief October 17 – October 23, 2020

Giambrone v. Comm’r, T.C. Memo. 2020-145
Coleman v. Comm’r, T.C. Memo. 2020-146

The Tax Court in Brief October 10 – October 16, 2020

The Tax Court in Brief October 3 – October 9, 2020

Doyle v. Comm’r, T.C. Memo. 2020-139
Spagnoletti v. Comm’r, T.C. Memo. 2020-140
Worthington v. Comm’r, T.C. Memo. 2020-141

The Tax Court in Brief September 28 – October 2, 2020

Lucero v. Comm’r, T.C. Memo. 2020-136

The Tax Court in Brief September 21 – September 25, 2020

Patel v. Comm’r, T.C. Memo. 2020-133
Robinson v. Comm’r, T.C. Memo. 2020-134

The Tax Court in Brief September 12 – 18, 2020

Deckard v. Comm’r, 155 T.C. No. 8
Cindy Damiani v. Comm’r, T.C. Memo. 2020-132
Felix Ewald Friedel v. Comm’r, T.C. Memo. 2020-131

Tax Court in Brief September 5 – 11, 2020

Sutherland v. Comm’r, 155 T.C. No. 6
Fowler v. Comm’r, 155 T.C. No. 7
Robert J. Belanger v. Comm’r, T.C. Memo. 2020-130
Korean-American Senior Mutual Association, Inc., T.C. Memo. 2020-129

The Tax Court in Brief August 29 – September 4, 2020

The Tax Court in Brief August 22 – August 28, 2020

The Tax Court in Brief August 15 – August 21, 2020

Emanouil v. Comm’r, T.C. Memo. 2020-120
Nirav B. Babu, T.C. Memo. 2020-121
Brashear v. Comm’r, T.C. Memo. 2020-122

The Tax Court in Brief August 1 – August 7, 2020

The Tax Court in Brief – July 25 – July 31, 2020
Biggs-Owens v. Comm’r, T.C. Memo. 2020-113 | July 30, 2020 | Urda, J. | Dkt. No. 15274-17L
The Tax Court in Brief – July 19 – July 24, 2020

The Tax Court in Brief July 12 – July 17, 2020

Duffy v. Comm’r, T.C. Memo. 2020-108 Smith Lake, LLC, David Hewitt, TMP v. Comm’r, T.C. Memo. 2020-84
Weiderman v. Comm’r, T.C. Memo. 2020-109
Robert Elkins v. Comm’r, T.C. Memo. 2020-110

The Tax Court in Brief July 6– July 10, 2020

The Tax Court in Brief June 29 – July 3, 2020

The Tax Court in Brief The Week of June 22, 2020

The Tax Court in Brief June 15 – 19, 2020

The Tax Court in Brief June 8 – 12, 2020

The Tax Court in Brief June 1-7, 2021

The Tax Court in Brief May 25 – 29, 2020

The Tax Court in Brief May 18 – 22, 2020

Nesbitt v. Comm’r, T.C. Memo. 2020-61
Pope v. Comm’r, T.C. Memo. 2020-62
Richlin v. Comm’r, T.C. Memo. 2020-60
Frantz v. Comm’r, T.C. Memo. 2020-64
Peacock v. Comm’r, T.C. Memo. 2020-63
Joseph v. Comm’r, T.C. Memo. 2020-65
Serrano v. Comm’r, T.C. Summ. Op. 2020-15
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Battling the Counterfeiters: White-Collar Intellectual Property Enforcement

By: Jason B. Freeman, JD, CPA

Contributing Authors: Bryce Couch, Jessica Lee, Alexandra Duncan, and Vrinda Bhuta

This CLE paper explores criminal intellectual property violations. There are a wide range of potentially applicable statutory provisions. Part One broadly discusses criminal copyright infringement, focusing on 17 U.S.C. Section 506 and 18 U.S.C. Section 2319. Part Two explores the Trademark Copyright Act, as well as its relation to its civil law counterpart, the Lanham Act, and its evolution since 1984. Part Three explores the theft of trade secrets, both those illegally obtained for the benefit of a foreign government, instrumentality, or agent and those merely sold for profit. Part Four explores the enactment of the Digital Millennium Copyright Act—a 1998 bill that responded to the increasing prevalence of web-based technology—highlighting the anti-circumvention and anti-trafficking measures necessary to prevent internet piracy. Part Five explores counterfeit and illicit labels, as well as counterfeit documentation and packaging, in the context of certain classes of copyrighted works under 18 U.S.C. § 2318. Part Six explores the sentencing guidelines for copyright claims under U.S.S.G. Section 2B5.3 and EEA claims under US.S.G. Section 2B1.1.

Criminal Copyright Infringement

I. Introduction: History and Purpose

The Constitution gave Congress the power “to promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries.”[1] Under this provision, Congress promulgated a variety of statutes intended to preserve rights associated with copyrights.[2] This body of law grants copyright holders a variety of exclusive rights: (1) reproduction of the work; (2) preparation of derivative works based upon the original copyrighted work; (3) public distribution; (4) public performance of literary, musical, dramatic, choreographic, and mixed audiovisual works; (5) public display of the aforementioned types of works; and (6) performance of sound recordings by means of digital auto transmission.[3] Copyright law also governs the infringement of these rights. Although most of the case law stemming from copyright is civil in nature, the government can and does institute copyright cases.[4] Nonetheless, civil cases often provide informative judicial authority with regard to criminal actions.[5]

This subsection provides an overview of Section 506 and Section 2319, the provisions that establish the basis of criminal copyright infringement. Notably, section 506(a) criminalizes willful copyright infringement while section 2319 imposes penalties for such willful infringement. After analyzing these provisions and the elements of felony copyright infringement, this subsection concludes with a brief discussion of potential defenses in criminal copyright proceedings.

II. Elements of Felony & Misdemeanor Infringement

Criminal copyright law protects the exclusive rights of copyright holders outlined at the beginning of this subsection. A person who willfully infringes upon a copyright may be punished pursuant to Section 2319 when the infringement was committed: (1) for the purpose of commercial advantage or private financial gain;[6] (2) by the reproduction or distribution of a copyrighted work totaling more than $1,000 within a 180-day period; and (3) by making a work prepared for commercial distribution accessible via a computer network when the individual knew or should have known of the intended commercial purpose of said work.[7] The Government may pursue either felony or misdemeanor copyright infringement.[8]

To establish felony copyright infringement, the burden falls on the Government to show that: (1) a valid copyright exists; (2) the defendant infringed the copyright; (3) the defendant acted willfully in doing so; and (4) the infringement entailed reproduction or distribution.[9] With regard to the last requirement, it is a violation to reproduce or distribute at least ten copies of a copyrighted work valued at more than $2,500.[10] It is also a felony to distribute copies prepared for commercial distribution, to make such copies publicly accessible, and to act when one knows or should know that the work is being prepared for commercial distribution.[11]

On the other hand, to establish misdemeanor copyright infringement, the Government must show that: (1) a valid copyright exists; (2) the defendant infringed the copyright; (3) the defendant acted willfully in doing so; and (4) the infringement was committed via reproduction or distribution.[12] A misdemeanor charge is appropriate when a defendant (a) acted with the purpose of commercial advantage or financial gain[13] or (b) reproduced or distributed one or more works valued at more than $1,000 within a 180-day period.[14] Misdemeanor charges also apply to unlawful use of digital audio transmission and infringement on the exclusive performance right.[15]

a. Valid Copyright

A copyright only protects original works fixed in a tangible medium or expression. These works are independently created by the author and possess some minimal degree of creativity.[16] Additionally, copyright protects a particular form of expression rather than an underlying idea itself, so a copyrightable work must be fixed in some tangible medium.[17] Generally, a certificate of registration within five years will constitute prima facie evidence of a copyright, and the production of such registration shifts the burden of proof to the defendant to challenge its validity.[18] It should be noted that the Copyright Act does not expressly require a certificate of registration to merit copyright protection, but a registration typically is a prerequisite to certain statutory remedies, such as criminal actions.[19]

b. Infringed by the Defendant

Criminal enforcement focuses on infringement upon the rights established in Section 106.[20] Most often, however, criminal actions entail infringement upon the reproduction and distribution rights.[21] These violations are often the most serious infringements and give rise to the most significant penalties under criminal law.[22] In assessing whether an infringement occurred, it is important to consider whether the specific act in question falls within the purview of the statutory exceptions to the exclusive rights afforded by a copyright.[23]

c. Willfully

It is insufficient for the Government to demonstrate general intent.[24] Instead, the Government must prove that an individual acted with the intent to violate a known legal duty.[25] To meet this mens rea requirement, it is not necessary for the Government to put forward direct evidence of the mental state. The Government discharges this obligation by proving that the individual acted with a reckless disregard of a copyright holder’s rights.

Notably, there is a split in authority as to whether the willful requirement applies to the act of copying the work or infringing on the copyright.[26] The majority of courts adopt the higher standard, requiring an intention to violate a known duty.[27] However, some courts adopt a lower standard, requiring an intent to conduct the infringing activities without knowledge that the actions constitute infringement.[28]

d. For Purposes of Commercial Advantage or Private Financial Gain

A defendant acts for the purpose of commercial advantage or private financial gain when the defendant seeks a profit, financial or otherwise.[29] The focus of this inquiry is not whether or not a profit is actually obtained but whether a profit is intended.[30]

Historically, the law required proof of an individual’s intent to secure commercial advantage or private financial gain in criminal copyright prosecutions.[31] However, over time, this requirement shifted to promote the intended purpose of copyright law and to respond to substantial changes in the technological landscape.[32] Now, the Government generally demonstrates willful infringement exceeding particular monetary and numerical thresholds.[33] If the Government establishes a purpose of commercial advantage or private financial gain, it increases the maximum statutory sentence, increases the guideline sentencing range, and decreases the viability of the fair use defense.[34]

III. Section 2319 Penalties

If the Government successfully establishes a violation of Section 506, the question becomes, what penalties attach under section 2319? Under this provision, the Government may seek felony or misdemeanor penalties. A felony charge applies when a defendant infringes upon the rights of reproduction or distribution in the quantity and values stated by statute. By contrast, a misdemeanor penalty applies if a defendant fails to meet the numeric and monetary thresholds or if the defendant infringed on rights other than reproduction or distribution.

IV. Defenses

There are a variety of defenses for criminal copyright infringement cases. The Department of Justice’s Prosecuting Intellectual Property Crimes manual recognizes, these potential defenses as follows: Statute of Limitations, Jurisdiction, Venue, The First Sale Doctrine, Fair Use, and “Archival Exception” for Computer Software. This section highlights serval of these defenses.

a. Statute of Limitations

Under Section 507, there is a five-year statute of limitations for criminal copyright.[35] Previously, the limitations period was three years.[36]

b. Jurisdiction

Copyright law has no extraterritorial effect.[37] In other words, U.S. law cannot be invoked nor can U.S. courts provide relief when the infringing act occurs entirely outside the United States.

c. The First Sale Doctrine

Another possible defense is the First Sale Doctrine, embodied in 17 U.S.C. § 109. Once a copyright holder authorizes the use of a specific copy by one person, the copyright holder then cannot control how the copy is subsequently sold or transferred.[38] In other words, the subsequent purchaser may further distribute or dispose of a copy without permission.[39] Notably, this defense only applies to distribution; the first sale doctrine does not grant a subsequent purchaser the right to make additional copies.[40]

Trafficking In Counterfeit Trademarks, Service Marks, and Certification Marks

I. Introduction: History and Purpose

In the United States, trademarks, service marks, certification marks, and collective marks are protected not only by civil law pursuant to the Lanham Act, but also by criminal law pursuant to the Trademark Counterfeiting Act, 18 U.S.C. § 2320.[41] It is intended to protect both businesses and consumers who rely on such marks to buy and sell various goods and services.[42]

On one hand, 18 U.S.C. § 2320 encourages businesses to control the quality of their goods and services and invest in their brands by penalizing those who earn profits by taking advantage of the reputations, research and development, and advertising efforts of other businesses.[43] 18 U.S.C. § 2320 considers it to be a form of corporate identity theft and penalizes those who divert sales from or devalue the reputations of such businesses.[44]

On the other hand, 18 U.S.C. § 2320 also encourages consumers to rely on the marks of business brands by penalizing those who attempt to mislead consumers into purchasing counterfeit goods or services.[45] It also provides consumer protection against the various health or safety risks that may arise as a result of the misrepresentation of genuine goods and services.[46]

18 U.S.C. § 2320 has gone through major changes since its passage in 1984. For example, the Stop Counterfeiting in Manufactured Goods Act and the Protecting American Goods and Services Act of 2005 expanded the definition of “trafficking” under 18 U.S.C. § 2320 to include trafficking in labels and packaging bearing counterfeit marks, even when such labels are not joined to actual goods.[47] Similarly, the Prioritizing Resources and Organization for Intellectual Property Act enhanced penalties under 18 U.S.C. § 2320(b)(2) for knowingly or recklessly causing or attempting to cause serious bodily injury or death.[48] It also prohibits transshipment or exportation of goods or services under 18 U.S.C. § 2320(i) and brings the forfeiture provision in line with the restitution provision under 18 U.S.C. § 2320(c).[49] In addition, the National Defense Authorization Act for Fiscal Year 2012 and the Food and Drug Administration Safety and Innovation Act increased penalties for certain offenses, such as those related to counterfeit military goods, counterfeit drugs, and conspiracy.[50]

II. Elements: 18 U.S.C. § 2320

In order to assert a criminal offense claim under 18 U.S.C. § 2320, the government must prove the following elements:

Defendant intentionally trafficked, attempted, or conspired to traffic in goods, services, labels, patches, stickers, wrappers, badges, emblems, medallions, charms, boxes, containers, cans, cases, hangtags, documentation, or packaging;
Defendant knowingly used or applied a counterfeit mark, which is likely to cause mistake, confusion, or deception, on or in connection with such goods, services, labels, patches, stickers, wrappers, badges, emblems, medallions, charms, boxes, containers, cans, cases, hangtags, documentation, or packaging; and
It is a counterfeit mark pursuant to 18 U.S.C. § 2320(f).[51]

It is a felony to sell even one counterfeit good or service, and there is no corresponding misdemeanor provision.[52]Furthermore, 18 U.S.C. § 2320 is a general intent crime.[53] Pursuant to 18 U.S.C. § 2320(f), a mark may be considered counterfeit if the government can prove the following:

It was not genuine or authentic;
It was identical to or substantially indistinguishable from a genuine mark owned by another; and
It was used in connection with the type of goods or services for which the protected mark was registered.[54]

In addition, the government must be able to prove the following about the genuine mark:

It was registered on the principal register in the United States Patent and Trademark Office; and
It was in use by the holder of the mark or its licensee.[55]

Congress relied heavily on the “concepts and definitions of the Lanham Act” when writing 18 U.S.C. § 2320.[56] In fact, Congress advised on several occasions that 18 U.S.C. § 2320 should be interpreted in light of the Lanham Act, stating, “No conduct will be criminalized by this act that does not constitute trademark infringement under the Lanham Act,” and incorporated the Lanham Act’s various defenses and limitations on remedies into 18 U.S.C. § 2320 as well.[57]For these reasons, courts often refer to civil opinions under the Lanham Act when analyzing criminal cases under 18 U.S.C. § 2320, though the latter is often construed more narrowly.[58]

III. Defenses

However, there are many defenses specific to 18 U.S.C. § 2320 as well, such as the authorized-use defense, the repackaging genuine goods defense, the statute of limitations defense, and the vagueness defense.

a. Authorized-Use Defense

In some cases, an otherwise authorized manufacturer or producer makes and sells “overrun” goods and services on the side without the mark holder or licensor’s knowledge or approval.[59]Such goods and services are not considered counterfeit under 18 U.S.C. § 2320(f)(1)(B), provided that they are produced during the time authorized by the license as well.[60]

In exchange, licensees may not use the authorized-use defense to join genuine or overrun labels to counterfeit goods or services.[61] It is well settled that a genuine or authentic mark immediately becomes counterfeit when it is used in connection with a counterfeit good or service.[62] Similarly, the authorized-use defense is inapplicable if the licensee produces a good or service that she was not authorized to produce.[63]

In other cases, an otherwise authorized manufacturer or producer imports “gray market goods,” or “parallel imports”; that is, “trademarked goods and services legitimately manufactured and sold overseas, and then [illegally] imported into the United States.”[64] Such goods are also not considered counterfeit under 18 U.S.C. § 2320(f)(1)(B).[65]

b. Repackaging Genuine Goods Defense

In more extreme cases, a person or organization may mislead the public or bring harm to the mark holder’s goodwill by repackaging genuine goods.[66] If so, the repackaging is criminal.[67] For example, individuals may be prosecuted under 18 U.S.C. § 2320 for repackaging genuine drugs with reproduced trademarks if they led customers into believing that foreign versions of a drug were domestic and approved by the United States Food and Drug Administration.[68]However, the person or organization may not be prosecuted under 18 U.S.C. § 2320, even if the person or organization repackaged genuine goods with reproduced trademarks, if they did not confuse the public in the process.[69]

c. Statute of Limitations Defense

18 U.S.C. § 2320 has no specified statute of limitations period, so it is subject to the general five-year limitations period for all non-capital federal crimes not expressly provided for by law.[70] However, it has been argued that the limitations period under 18 U.S.C. § 2320 should be limited to the shorter period under the Lanham Act.[71]

d. Vagueness Defense

For the most part, vagueness defenses under the Fifth Amendment have been rejected.[72] For example, in United States v. McEvoy, 820 F.2d 1170 (11th Cir. 1987), the Eleventh Circuit rejected the claim that 18 U.S.C. § 2320 is unconstitutionally vague on its face. Similarly, in United States v. Lam, 677 F.3d 190, 201-03 (4th Cir. 2012), the Fourth Circuit rejected the claim that 18 U.S.C. § 2320 is unconstitutionally vague because of the phrase “substantially indistinguishable.”

IV. Special Issues

a. High-Quality and Low-Quality Counterfeits

It is generally of little relevance to the government under 18 U.S.C. § 2320 that the counterfeit good is of too low or high quality to deceive any consumers.[73] Instead, the purpose of the statute is to give businesses the “right to control the quality of the goods manufactured and sold” under the mark and that the “actual quality of the goods is irrelevant; it is the control of quality that a trademark holder is entitled to maintain.”[74]

b. Scope of 18 U.S.C. § 2320

18 U.S.C. § 2320 also extends to genuine marks applied to genuine products in a manner that misrepresents the genuine product’s quality, as well as to genuine marks applied to counterfeit goods and services.[75] On the other hand, “reverse passing-off,” or selling the good of another business as one’s own, is not a crime under 18 U.S.C. § 2320, since it does not involve the use of a counterfeit mark as defined in 18 U.S.C. § 2320(f).[76]

V. Penalties

a. Fines and Imprisonment

For first offenses, the maximum penalty is up to two million dollars in fines and ten years imprisonment for an individual and up to five million dollars in fines for an organization.[77] For second and subsequent offenses, the maximum penalty is up to five million dollars in fines and twenty years imprisonment for an individual and up to fifteen million dollars in fines for an organization.[78]

Enhanced penalties may be applicable under 18 U.S.C. § 2320(b)(2) for those who knowingly or recklessly cause or attempt to cause serious bodily harm or death.[79] In the case of a serious bodily injury, for example, an individual may be subject to up to five million dollars in fines and twenty years imprisonment for an individual and up to fifteen million dollars in fines for an organization.[80] In the case of death, however, an individual may even be subject to life imprisonment.[81]

Enhanced penalties may also be applicable to those cases involving counterfeit military goods or services, as well as counterfeit drugs.[82] For first offenses, the maximum penalty is up to five million dollars in fines and twenty years imprisonment for individuals and up to fifteen million dollars in fines for organizations.[83] For second and subsequent offenses, the maximum penalty is up to fifteen million dollars in fines and thirty years imprisonment for an individual and up to thirty million dollars in fines for organizations.[84]

b. Restitution

Restitution is calculated by analyzing “the actual amount [of infringing goods] placed into commerce and sold.”[85] In particular, goods that are not actually sold may not be included in the restitution calculation, since the purpose of restitution is to compensate victims for only actual losses.[86] Pursuant to 18 U.S.C. § 2320, mark holders are required to use the ® symbol, or the words, “Registered in U.S. Patent and Trademark Office” or “Re. U.S. Pat. & Tm. Off.,” to give the public actual notice of their proper registration.[87] If not, mark holders may be barred from recovering lost profits or other damages under 15 U.S.C. § 1111, even though the licensee may still be liable under 18 U.S.C. § 2320.[88]

VI. Other Charges to Consider

In the alternative, prosecutors may also consider the following charges as well:

Conspiracy and aiding-and-abetting under 18 U.S.C. §§ 2, 371;
Mail and wire fraud under 18 U.S.C. §§ 1341, 1343;
Copyright infringement under 17 U.S.C. § 506 and 18 U.S.C. § 2319;
Trafficking in counterfeit labels, illicit labels, or counterfeit documentation or packaging under 18 U.S.C. § 2318;
Trafficking in misbranded food, drugs, and cosmetics under 21 U.S.C. §§ 331(a), 333, 343, 352, 362, and 841(a)(2); and
Tampering with consumer products under 18 U.S.C. § 1365.[89]

Theft of Commercial Trade Secrets

I. Generally

The Economic Espionage Act (EEA), codified in 18 U.S.C. § 1831-1839, makes the theft or trafficking in trade secrets for foreign governments, instrumentalities, or agents a criminal act. The act was first introduced following the sudden rise in IP theft after the Cold War.[90] Prior to the passage of the EEA, the only federal statute that directly prohibited economic espionage was the Trade Secrets Act, 18 U.S.C. § 1905, which forbid the unauthorized disclosure of confidential government information, including trade secrets, by a government employee. The Trade Secrets Act, however, does not apply to private sector employees and thus was unsuccessful in addressing or remedying the issue more broadly.[91] The EEA was amended in 2016 by the Defend Trade Secrets Act (DTSA), which created a federal private cause of action for trade secret misappropriation[92] and underscored Congress’s desire to align closely with the Uniform Trade Secrets Act.[93] Though the DTSA was enacted as part of the EEA, many regard it as a separate statute. The main body of the EEA is unchanged by the amendments and establishes two prosecutable offenses regarding the theft of trade secrets.[94]

a. Theft Benefitting a Foreign Government | Section 1831

The first offense is addressed by 18 U.S.C. § 1831. Section 1831 addresses “economic espionage,” which arises when the theft in question benefits a foreign government, foreign instrumentality, or foreign agent.[95] To prove economic espionage under 18 U.S.C. § 1831, the government must prove the defendant knew or intended that the offense would benefit a foreign government, foreign instrumentality, or foreign agent.[96] Economic espionage prosecutions under Section 1831 require express approval from the Attorney General, the Deputy Attorney General, or the Assistant Attorney General of the Criminal Division.[97] If a foreign instrumentality element does not exist or cannot be proved, the government may still establish a violation of 18 U.S.C. § 1832 by proving three additional elements.

b. Theft of Commercial Trade Secrets | Section 1832

Section 1832, the second offense, punishes the commercial theft of trade secrets carried out for economic advantage—whether or not it benefits a foreign government, instrumentality, or agent.[98] This offense is more general, applies to both foreign and domestic trade secret disputes, and carries a ten-year maximum term of imprisonment.[99] Section 1832 contains three additional limitations not found in § 1831.[100] First, a defendant charged under section 1832 must intend to convert a trade secret “to the economic benefit of anyone other than the owner thereof,” which includes the defendant himself.[101] Second, section 1832 states that the defendant must intend or know that the offense will injure an owner of the trade secret—a restriction not found in Section 1831. Finally, unlike section 1831, section 1832 also requires that the trade secret be “related to or included in a product that is produced for or placed in interstate or foreign commerce.”[102]

Sections 1831 and 1832 both require the government to prove beyond a reasonable doubt three elements: (1) the defendant misappropriated information (or conspired or attempted to do so); (2) the defendant knew or believed this information was proprietary and that they had no claim to it; and (3) the information was in fact a trade secret (unless the crime charged is a conspiracy or an attempt).[103]

II. Elements of a Trade Secret

A threshold question under both sections of the EEA is whether the information qualifies as a trade secret. Under 18 U.S.C. § 1839(3) the EEA defines “trade secret” to mean:

All forms and types of financial, business, scientific, technical, economic, or engineering information, including patterns, plans, compilations, program devices, formulas, designs, prototypes, methods, techniques, processes, procedures, programs, or codes, whether tangible or intangible, and whether or how stored, compiled, or memorialized physically, electronically, graphically, photographically, or in writing if—

(A) the owner thereof has taken reasonable measures to keep such information secret; and

(B) the information derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable through proper means by, another person who can obtain economic value from the disclosure or use of the information.

The statute’s legislative history counsels a broad interpretation of this definition.[104] The key attribute of a trade secret is that the information must not be “generally known to,” or “readily ascertainable through proper means by,” the public.[105] To this point, a trade secret’s owner must take reasonable measures under the circumstances to keep the information confidential.[106] A trade secret does not lose its protection under the EEA, however, if it is temporarily, accidentally, or illicitly released to the public, provided it does not become “generally known” or “readily ascertainable through proper means.”[107] After determining if the information is a trade secret, the court then assess whether the owner undertook reasonable measures under the circumstances to keep the information confidential.

a. Standard of Secrecy

The measure of secret keeping is frequently a threshold issue and is also a question of fact. Courts have repeatedly held that the required standard is not one of absolute secrecy.[108] Security measures, such as locked rooms, security guards, and document destruction methods, in addition to confidentiality procedures, such as confidentiality agreements and document labeling, are often considered reasonable measures.[109] In addition, for circumstances where sufficient measures were taken but the secret was leaked by an insider there is a 2-level adjustment for abuse of a position of trust under U.S.S.G. § 3B1.3, which is further explored below.[110]

b. Independent Economic Value

Finally, to qualify as a trade secret, the item must have independent economic value.[111] Although the EEA does not require any specific level of value, it must be proven that the trade secret in question has some independent economic value.[112] Economic value “speaks to the value of the information to either the owner or a competitor; any information which protects the owner’s competitive edge or advantage.”[113] Economic value can be derived from the market, the cost of the item, or even the defendant’s acknowledgement that the secret is valuable.[114]

III. Defenses

The most common defense to EEA charges is that the information does not qualify as a trade secret by failing to meet any one of the elements explored above.[115] Defendants also correctly assert that the government bears the burden of proving, beyond a reasonable doubt, that the trade secret derived economic value from not being generally known to the public through proper means.[116] What counts as disclosure, however, is nuanced and varied and generally requires the assistance of expert witnesses.[117] It should be noted that the defense of legal impossibility has largely been rejected by courts in EEA prosecutions.[118] Likewise, several defendants have challenged the EEA on grounds that it is vague or otherwise unconstitutional and, thus far, all such challenges have been rejected.[119]

The next defense also operates as an essential element of the offense—the defendant’s intent to convert the trade secret.[120] This defense is rooted in Congress’ stated purpose to differentiate between trade secrets, which are the subject matter of the EEA, and a person’s general skills and knowledge.[121] The EEA does not cover reverse engineering, parallel development, or ‘soft skills’ gained while employed.[122] Although legislators eliminated language providing that general knowledge, skills, and experience are not “trade secrets,”[123] it is clear that Congress did not intend the definition of a trade secret to be so broad as to prohibit lawful competition such as the use of general skills or lawful parallel development of a similar product.[124] As such, other common defenses to EEA charges are the parallel development defense (that the defendant independently, through its own effort, developed the same information without access to trade secrets) and the reverse engineering defense (that the defendant legally discovered the information by taking apart something that was legally acquired to determine how it works, or was made or manufactured).[125]

IV. Future of the EEA

A proposal to amend the EEA was introduced in the Senate in late April of 2021. The ‘Safeguarding Educational Institutions, Colleges, Universities, and Research Entities from China’s Attempts to Misappropriate Property of the United States Act of 2021’ (or the ‘SECURE CAMPUS Act of 2021’) proposes to secure the research enterprise of the United States from the Chinese Communist Party, and for other purposes.[126] One of the proposals includes an amendment to Section 1839(1) by:

(1) inserting ‘education, research,’ after ‘commercial,’; and

(2) inserting ‘or otherwise incorporated or substantially located in or composed of citizens of countries subject to compulsory political or governmental representation within corporate leadership’ after ‘foreign government’.”

The bill was read twice and referred to the Committee on Foreign Relations.[127]

Digital Millennium Copyright Act

I. Background & History of the Act

The rise of the Internet posed a series of challenges to existing copyright law. Intending to address substantive copyright issues arising in the virtual landscape, Congress passed the Digital Millennium Copyright Act (DMCA) in 1998.[128] The DMCA served as U.S. implementation of two World Intellectual Property Organization (WIPO) treaties signed in 1996: WIPO Copyright Treaty and the WIPO Performances and Phonograms Treaty.[129] These treaties prohibited breaking the security measures taken by copyright holders to protect digital content from unauthorized uses.[130] By enacting the DMCA, Congress sought to “protect[] copyrighted works from piracy and promot[e] electronic commerce.”[131]

Generally, the DMCA enacted specific prohibitions that regulated the circumvention of copyright protect systems[132] and addressed the integrity of copyright management systems.[133] Under the DMCA, criminal enforcement primarily addresses violations of the anti-circumvention and anti-trafficking component of Section 1201.

II. 17 U.S.C. § 1201: Circumvention of Copyright Protection Systems

Section 1201 is one of the most important provisions of the DMCA. Section 1201(a)(1)(A) notably prohibits the circumvention of access control.[134] So, for example, this provision prohibits the decryption of protective measures on CDs or DVDs so that it can be accessed on other devices.[135] Additionally, Section 1201 prohibits the manufacture or trafficking in devices or technology that enables an individual to circumvent the security measures intended to affect access to a protected a work.[136] Finally, section 1201 prohibits the manufacture or trafficking in devices or technology designed to circumvent the protection of a copyright owner’s rights.[137] Violations of these provisions can result in civil actions under section 1203[138] or criminal prosecution under section 1204,[139] discussed below.

III. 17 U.S.C. § 1202: Integrity of Copyright Management Information

Unlike Section 1201’s focus on copyright protection systems, section 1202 focuses on copyright management information. This section prohibits knowingly falsifying, removing, or altering copyright management information. Further, it prohibits intentionally facilitating the infringement of management information[140] or facilitating the infringement by distributing copies where the copyright information has been removed.[141] Subsection (c) defines copyright management information to include: the title and other information identifying the work; the name of, and other identifying information about, the author of the work; the name of, and other identifying information about, the copyright owner of the work; terms and conditions of the work; identifying numbers or symbols referring to such information; and more.[142]

IV. Elements of the Key Provisions

a. Circumventing Access Controls: 17 U.S.C. §§ 1201(a)(1), 1204

To establish a violation by circumventing access controls, the Government must show that the defendant (1) willfully (2) circumvented (3) a technological measure that effectively controls access (4) to a copyrighted work (5) for commercial advantage or private financial gain.[143]

b. Trafficking in Access Control Circumvention Tools and Services: 17 U.S.C. §§ 1201(a)(2), 1204

To establish a violation by trafficking access control circumvention tools and services, the Government must show that a defendant willfully manufactured or trafficked in a technology, product, service, or part thereof.[144] This product must either (a) be primarily designed or produced for the purpose of, (b) only have limited commercially significant purposes or use other than, or (c) be marketed with knowledge of the item’s use in circumventing an access control without authorization from the copyright owner for commercial advantage or private financial gain.[145]

c. Trafficking in Tools, Devices, and Services to Circumvent Copy Controls: 17 U.S.C. §§ 1201(b)(1), 1204

To establish a violation by trafficking in tools, devices, and services to aid the circumvention of copy controls, the Government must show that an individual willfully manufactured or tracked in a technology, product, service, or part thereof.[146] Similar to Section 1201(a)(2), the item must either (a) be primarily designed or produced for the purpose of, (b) have limited commercially significant purpose or use other than, or (c) marketed with the knowledge of the item’s use for circumvention.[147] However, for Section 1201(b)(1), the item must be used to circumvent the protection afforded by a technological measure designed to protect the rights of the copyright owner for commercial advantage or private gain.[148]

d. 17 U.S.C. § 1202

Although criminal enforcement of section 1202 is rare, it is possible if the Government demonstrates that the defendant violated the provision willfully and for purposes of commercial advantage or private financial gain.[149]

V. 17 U.S.C. § 1203: Civil Remedies

Under Section 1203, the DMCA allows those suffering an injury because of a Section 1201 or 1202 violation to bring a civil action in an appropriate United States district court.[150] If a civil action is brought, a court may: grant temporary and permanent injunctions; order the impounding of any device that the court has reasonable cause to believe was involved in the violation; award damages; allow the recovery of costs by or against a party other than the United States or an officer thereof; award attorney’s fees; and order remedial modification or destruction of a device involved in the violation.[151] Under Subsection (c), a person liable for a violation is liable for either the actual damages and additional profits of the violator or statutory damages.[152]

VI. 17 U.S.C. § 1204: Criminal Offenses & Penalties

Section 1204 outlines the potential penalties for criminal violations of the DMCA provisions if an individual violates Section 1201 or 1202 willfully and for purposes of commercial advantage or private financial gain.[153] This enforcement excludes nonprofit libraries, archives, educational institutions, and public broadcasting entities, as defined under Section 118(f).[154] Under this section, criminal violation carries a maximum penalty of five years’ imprisonment, a $500,000 fine or twice the monetary gain or loss, or both imprisonment and a fine.[155] These penalties apply for first time criminal violations. For subsequent offenses, the criminal punishment increases: ten years’ imprisonment, a $1 million fine or twice the monetary gain or loss, or both imprisonment and a fine.[156]

VII. Possible Defenses

There are a variety of defenses possible for a DMCA action. The Department of Justice’s Prosecuting Intellectual Property Crimes manual highlights these possible defenses, exceptions, and exemptions. These have included: Statute of Limitations, Librarian of Congress Regulations, Certain Non-Profit Entities, Information Security Exemption, Reverse Engineering and Interoperability of Computer Programs, Encryption Research, Restricting Minors’ Access to the Internet, Protection of Personally Identifying Information, Security Testing, and challenges to the constitutionality of the DMCA.[157] This section highlights a few of these available arguments.

a. Statute of Limitations

Under Section 1204(c), the statute of limitations for the DMCA is five years.[158] A criminal proceeding may not be brought beyond this period.[159]

b. Exemption for Non-Profit Entities

There is an exemption from criminal prosecution for nonprofit libraries, archives, educational institutions, and public broadcasting entities under Section 1204(b).[160] Similarly, there is a more limited exemption under Section 1201(d).[161] This provision, however, omits public broadcasting entities.[162]

c. Exemption for Information Security

Under Section 1201(e), Congress enacted a narrow exemption intended to permit law enforcement to disable technical security measures to ensure that government computer systems are secure from hacking.[163] Section 1201(e) does not prohibit acts of “any lawfully authorized investigative, protective, information security, or intelligence activity of an officer, agent or employee . . . carried out in order to identify and address the vulnerabilities of a government computer, computer system, or computer network.”[164]

Counterfeit and Illicit Labels, Counterfeit Documentation and Packaging

I. Introduction: History and Purpose

Similar to the Copyright Act, 18 U.S.C. § 2318 is a criminal statute that protects creative works ofindividuals and organizations from those who knowingly traffic in counterfeit or illicit labels, or counterfeit documentation and packaging for certain classes of copyrighted works.[165] 18 U.S.C. § 2318, however, is not a pure copyright statute and provides protections that vary from those provided by the Copyright Act, or even 18 U.S.C. § 2320.[166]

For example, even though counterfeit and illicit labels, as well as counterfeit documentation and packaging, commonly exhibit counterfeit trademarks,18 U.S.C. § 2318 gives no attention to the counterfeit trademarks themselves.[167]Similarly, 18 U.S.C. § 2320 penalizes the trafficking of labels and labeling components bearing counterfeit trademarks in connection with any type of good of service, but 18 U.S.C. § 2318 penalizes only counterfeit labels in connection with particular copyrighted works.[168]

Originally, 18 U.S.C. § 2318 covered only counterfeit labels for phonorecords. Later, Congress expanded its scope in 2004 to cover counterfeit labels, documentation, and packaging for movies; music; software; copies of literary, pictorial, graphic, or sculptural works; works of visual arts; and labels designed to be used with documentation and packaging for any of the enumerated classes of copyrighted works.[169] In 2006, Congress again expanded 18 U.S.C. § 2318 to cover “illicit labels,” or “genuine certificate[s], licensing document[s], registration card[s], or similar labeling component[s]” distributed or intended for distribution without the owner’s permission.[170]

II. Elements: 18 U.S.C. § 2318

In order to successfully assert a criminal offense claim under 18 U.S.C. § 2318, the government must prove the following elements:

Defendant knowingly trafficked in labels affixed to, enclosing, or accompanying, or designed to be affixed to, enclose, or accompany a phonorecord; a copy of a computer program; a copy of a motion picture or other audiovisual work; a copy of a literary work; a copy of a pictorial, graphic, or sculptural work; a work of visual art; documentation or packaging; or counterfeit documentation or packaging.
Either the documentation or the packaging was counterfeit, or the labels were counterfeit or illicit; and
Federal jurisdiction is satisfied because one or more of the following is satisfied:
1. Such offense occurred in special maritime territories or other areas of special jurisdiction of the United States;
2. Such offense used or intended to use the mail or a facility of interstate or foreign commerce;
3. Such counterfeit or illicit labels were affixed to, enclosed, or accompanied copyrighted materials, or were designed to; or
4. Such documentation or packaging is copyrighted.[171]

III. Defenses

a. Statute of Limitations Defense

18 U.S.C. § 2318 has no specified statute of limitations period, so it is subject to the general five-year limitations period for all non-capital federal crimes not expressly provided for by law.[172]

b. First-Sale Defense

Even though the first-sale defense is often a valid defense against copyright infringement charges under 17 U.S.C. § 109, it is generally rejected in the context of 18 U.S.C. § 2318.[173]

IV. Special Issues

a. Electronic Copies of Labels, Documentation, or Packaging

18 U.S.C. § 2318 may also be applied in limited circumstances to those cases where either the original or the counterfeit or illicit copies are electronic or digital in form.[174] In particular, the phrase, “in physical form,” as used in 18 U.S.C. § 2318(b)(5), is inapplicable to labels, documentation, and packaging that are only available in electronic or digital form.[175] However, 18 U.S.C. § 2318 is less clear regarding similar electronic or digital labels, documentation, and packaging uploaded onto physical items, such as CD-ROMs.[176]

b. Advantages of Charging a § 2318 Offense

18 U.S.C. § 2318 is generally popular because the mens rea and minimum threshold for illegal conduct are lower than those of the Copyright Act.[177] Likewise, the standard of proof is often lower than other criminal trademark charges that require proof that the marks used on the counterfeit or illicit labels are identical to or substantially indistinguishable from registered marks with the United States Patent and Trademark Office.[178]

Penalties

a. Fines and Imprisonment

For all offenses, the maximum penalty is up to $250,000 in fines and five years imprisonment for an individual and up to $500,000 in fines for an organization.[179] In the alternative, the individual or organization may be fined twice the offense’s pecuniary gain or loss without limit.[180]

b. Restitution

Restitution is calculated by analyzing “the actual amount [of infringing goods] placed into commerce and sold.”[181] In particular, goods that are not actually sold may not be included in the restitution calculation, since the purpose of restitution is to compensate victims for only actual losses.[182]

Other Charges to Consider

In the alternative, prosecutors may also consider the following charges as well:

Copyright infringement under 17 U.S.C. § 506 and 18 U.S.C. § 2319;
Trademark counterfeiting under 18 U.S.C. § 2320;
Mail or wire fraud under 18 U.S.C. §§ 1341, 1343;
Racketeer Influenced and Corrupt Organizations (RICO) under 18 U.S.C. §§ 1961-68; and
Bootleg sound recordings and music videos of live musical performances under 18 U.S.C. § 2319A.[183]

Sentencing Guidelines

I. Offenses Involving: Copyright (Including Bootleg Music, Camcorded Movies, and the Unauthorized Use of Satellite, Radio, and Cable Communications), Trademark, Counterfeit Labeling, and the DMCA.

Most intellectual property offenses are calculated and sentenced under U.S.S.G. Section 2B5.3. Offenses involving; Copyright, Bootleg Music, Camcorded Movies, and the Unauthorized Use of Satellite, Radio, and Cable Communications, Trademark, Counterfeit Labeling, and the DMCA all included. Section 2B5.3 was adopted with the initial set of guidelines in 1987 and largely retained its original form until amended, effective May 1, 2000, in response to the No Electronic Theft Act of 1997.^[184] The May 2000 amendments increased the base offense level and increased the number and type of special offense characteristics to include not only the infringement amount, but also characteristics for manufacturing, uploading, or importing infringing items; for infringement not committed for commercial advantage or private financial gain; and for risk of serious bodily injury or possession of a dangerous weapon in connection with the offense.^[185] The base offense level under the EEA is eight, which, like all base offense levels, is designed to “reflect a minimal, general harm caused by the offense.”^[186] It incorporates the “more than minimal planning” conduct that the Commission determined was present in the majority of offenses sentenced under this guideline.^[187]

a. Calculating the Infringement Amount | General

Under U.S.S.G. § 2B5.3(b)(1), the base offense level is adjusted according to the “infringement amount,” an estimate of the magnitude of infringement. Thus, the infringement amount tends to be the most significant factor in the calculation of a sentence.^[188] The infringement amount is generally calculated by multiplying the retail value of the infringed item by the number of infringing items.^[189] If the court cannot determine the number of infringing items, the court need only make a reasonable estimate of the infringement amount using any relevant information, including financial records.^[190]“Infringed item” means the copyrighted or trademarked item with respect to which the crime against intellectual property was committed.^[191] “Infringing item” means the item that violates the copyright or trademark laws.^[192] The “retail value” of an infringed item or an infringing item is the retail price of that item in the market in which it is sold.^[193] If the infringement amount is $2,500 or less, there is no offense level increase.^[194] If the infringement amount exceeds $2,500 but is less than $6,500 the level increases by one.^[195] In the case that the amount exceeds $6,500 the base level offense is increased by the number of levels from the table in Section.^[196]

b. Infringement Amount | Counterfeit Goods and Labels

For offenses of trafficking in counterfeit goods and labels, the infringement amount should include all items the defendant acquired because the term “traffic” is defined to include obtaining control over an infringing item with the “intent to … transport, transfer, or otherwise dispose of” it.^[197] This applies equally if the defendant is convicted of attempting or conspiring to traffic in counterfeit goods.^[198] In cases which involve counterfeit labels that have not been affixed to, or packaging that does not actually enclose or accompany, a good or service, the infringing items counted should be the labels and packaging which, “had [they] been so used, would appear to a reasonably informed purchaser to be affixed to, enclosing or accompanying an identifiable, genuine good or service.”^[199]

c. Infringement Amount | Bootleg and Camcord

Bootlegging and camcording statutes also criminalize the production of infringing items, regardless of actual distribution.^[200] Distribution of a copyrighted item before it is legally available to the consumer is more serious than the distribution of already available items and, as of October 2005, includes an added two-level enhancement for offenses that involve the display, performance, publication, reproduction, or distribution of a work being prepared for commercial distribution.^[201]

II. Offenses Involving the Economic Espionage Act (EEA)

U.S.S.G. § 2B1.1 is the primary applicable Guideline for the Economic Espionage Act, except for attempts and conspiracies.^[202] The choice of U.S.S.G. § 2B1.1 instead of U.S.S.G. § 2B5.3 likely reflects the idea that EEA offenses are primarily about stolen property rather than infringement.[203] Subsection (b)(14) of U.S.S.G. § 2B1.1 addresses offenses involving the misappropriation of a trade secret when the defendant knew or intended either (A) that the trade secret would be transported or transmitted out of the United States, which results in an increase by two levels,^[204] or (B) that the offense would benefit a foreign government, foreign instrumentality, or foreign agent, which results in an increase by four levels and sets a minimum resulting offense level of fourteen.^[205]

a. Additional Penalties | Abuse of Position of Trust or Use of Special Skill

Trade secret offenses committed by corporate insiders often deserve a two-level adjustment for abuse of a position of trust under U.S.S.G. § 3B1.3. “Public or private trust” refers to a position of public or private trust characterized by professional or managerial discretion (i.e., substantial discretionary judgment that is ordinarily given considerable deference) and the position of trust “contributed in some significant way to facilitating the commission or concealment of the offense.”^[206] A defendant can receive the enhancements for abuse of a position of trust and sophisticated means simultaneously, but adjustment may not be employed if an abuse of trust or skill is included in the base offense level or specific offense characteristic.^[207] If the adjustment is based upon an abuse of a position of trust, it may be employed in addition to an adjustment under § 3B1.1 (Aggravating Role); if the adjustment is based solely on the use of a special skill, it may not be employed in addition to an adjustment under § 3B1.1 (Aggravating Role). “Special skill” refers to a skill not possessed by members of the general public and usually requiring substantial education, training or licensing. Examples would include pilots, lawyers, doctors, accountants, chemists, and demolition experts.^[208]

b. Additional Penalties | Sophisticated Means

If the offense involved sophisticated means, then the offense level is increased by two levels and if the resulting offense is less than twelve, it must be increased to twelve.^[209] “Sophisticated means” is defined as “especially complex or especially intricate offense conduct pertaining to the execution or concealment of an offense,” which includes “hiding assets or transactions,” among other things.^[210] The sophisticated means enhancement often applies to trade secret offenses committed by corporate insiders who have the need and opportunity to take extensive precautions to shield their actions from their employer.^[211] A defendant can receive the adjustment for sophisticated means in addition to the adjustment for use of a special skill under U.S.S.G. § 3B1.3.^[212]

c. EEA | Calculating Loss

The defendant’s sentence in an EEA offense is largely calculated by the value of the lost property. Under U.S.S.G. § 2B1.1(b)(1) the offense level increases according to the amount of the loss. Guideline Section 2B1.1 outlines a number of methods for calculating loss but, regardless of the method chosen, the court “need only make a reasonable estimate of the loss” and not be absolutely certain or precise.^[213] The resulting loss figure is “the greater of actual loss or intended loss.”^[214] “Actual loss” means the reasonably foreseeable pecuniary harm that resulted from the offense.^[215]“Intended loss” means the pecuniary harm that the defendant purposely sought to inflict; and includes intended pecuniary harm that would have been impossible or unlikely to occur.^[216] Many factors complicate forming a reasonable estimate such as whether; the defendant paid anything for the secret, the defendant was paid anything for the secret, the defendant used the secret, the defendant used the secret and made money from its use, the victim’s sales decreased, increased, or increased at a lower rate than if the misappropriation had not occurred, and other such situations.^[217] Loss calculations are often complicated and are only made more so by the fact that, by definition, trade secrets lack an open market price or value for the court to use as a reference or basis. Given the variety of scenarios, evidence available, and broad principles of valuing trade secrets, the DOJ recommends that prosecutors, agents, and courts be pragmatic about choosing which method to use so long as it is equitable, appropriately punitive, and supported by the evidence.^[218]

i. Calculating Loss | Criminal Cases

Most federal criminal decisions calculate loss by using the trade secret’s development costs.^[219] Some, however, have measured loss with respect to trade secrets via pecuniary loss.^[220]

ii. Calculating Loss | Civil Cases

Civil cases often compute the trade secret’s market value with either the victim’s loss or the defendant’s gain.^[221] The focus in civil cases, however, is usually upon the defendant’s gain, with most civil courts noting that if the victim’s loss were the only appropriate measure of damages, a defendant accused of stealing trade secrets could not be punished if they had not yet used the information to the owner’s detriment.^[222] The Uniform Trade Secrets Act also provides that damages may be based on a “reasonable royalty” much like with patent infringement.

[1] U.S. Const. art. 1, § 8, cl. 8.

[2] Office of Legal Educ. Exec. Off. Of U.S. Att’ys., Prosecuting Intellectual Property Crimes 10 (4th ed. 2013).

[3] 17 U.S.C. § 106(1)–(6).

[4] Office of Legal Educ., supra note 2, at 11.

[5] Id. (citing United States v. Wise, 550 F.2d 1180, 1188 n.14 (9th Cir. 1977) (“[T]he general principle in copyright law of looking to civil authority for guidance in criminal cases.”)).

[6] 17 U.S.C. § 101 (defining financial gain as the “receipt, or expectation of receipt, of anything of value, including the receipt of other copyrighted works”).

[7] 17 U.S.C. § 506.

[8] Copyright Law, Dep’t of Just., (last updated January 2020).

[9] Office of Legal Educ., supra note 2, at 16.

[10] 18 U.S.C. § 2319(b)(1).

[11] 17 U.S.C. § 506(a)(1).

[12] Office of Legal Educ., supra note 2, at 59–60.

[13] Id. at 60 (citing 17 U.S.C. § 506(a)(1)(A), 18 U.S.C. § 2319(b)(3)).

[14] Id. (citing 17 U.S.C. § 506(a)(1)(B), 18 U.S.C. 2319(c)(3)).

[15] Id.

[16] Id. at 18.

[17] 17 U.S.C. § 102(b).

[18] 17 U.S.C. § 410(c).

[19] Office of Legal Educ., supra note 2, at 21.

[20] See 17 U.S.C. § 106(1)–(6).

[21] Office of Legal Educ., supra note 2, at 34.

[22] Id.

[23] See, e.g., 17 U.S.C. §§ 107–122.

[24] Office of Legal Educ., supra note 2, at 26 (citing 143 Cong. Rec. 26,420-21 (1997)).

[25] 143 Cong. Rec. 26,420 (1997) (“‘Willful’ ought to mean the intent to violate a known legal duty.’”).

[26] Office of Legal Educ., supra note 2, at 28–29.

[27] See, e.g., United States v. Sherman, 576 F.2d 292, 297 (10th Cir. 1978).

[28] See, e.g., United States v. Backer, 134 F.2d 533, 535 (2d Cir. 1943).

[29] Office of Legal Educ., supra note 2, at 57.

[30] 17 U.S.C. § 101.

[31]Office of Legal Educ., supra note 2, at 55.

[32] Id. At 55–56.

[33] Id. at 56.

[34] Id.

[35] 17 U.S.C. § 507(a).

[36] Office of Legal Educ., supra note 2, at 60.

[37] Id. at 61.

[38] Id. at 63–64.

[39] Id. at 64.

[40] Id.

[41] Office of Legal Educ., supra note 2, at 89.

[42] Id.

[43] Id. at 90.

[44] Id.

[45] Id. at 93.

[46] Id.

[47] The Stop Counterfeiting in Manufactured Goods Act, Pub. L. No. 109-181, § 1, 120 Stat. 285, 285-88 (2006); The Protecting American Goods and Services Act of 2005, Pub. L. No. 109-181, § 2, 120 Stat. 285, 288 (2006).

[48] The Prioritizing Resources and Organization for Intellectual Property (PRO-IP) Act, Pub. L. No. 110-403, 122 Stat. 4256, 4261-63 (2008).

[49] Id.

[50] The National Defense Authorization Act (NDAA) for Fiscal Year 2012, Pub. L. No. 112-81, 125 Stat. 1298 (2011), H.R. 1540, S. 1867; The Food and Drug Administration Safety and Innovation Act (FDASIA), Pub. L. No. 112-144, 126 Stat. 993, S. 3197.

[51] The Trademark Counterfeiting Act, 18 U.S.C. § 2320.

[52] United States v. Foote, 413 F.3d 1240, 1246 (10th Cir. 2005).

[53] United States v. Baker, 807 F.2d 427, 429 (5th Cir. 1986); United States v. Gantos, 817 F.2d 41, 42-43 (8th Cir. 1987).

[54] 18 U.S.C. § 2320(f).

[55] Id.

[56] See H.R. Rep. No. 98-977, at 4-5 (1984).

[57] See Joint Statement on Trademark Counterfeiting Legislation, 130 Cong. Rec. 31,675 (1984).

[58] United States v. Torkington, 812 F.2d 1347, 1352 (11th Cir. 1987); United States v. Giles, 213 F.3d 1247, 1249-50 (10th Cir. 2000).

[59] Office of Legal Educ., supra note 2, at 130.

[60] Id.

[61] Id. at 131.

[62] Id.

[63] Id.

[64] Id. at 133.

[65] Id.

[66] Id. at 134.

[67] Id.

[68] United States v. Milstein, 401 F.3d 53, 62-63 (2d Cir. 2005).

[69] United States v. Hanafy, 302 F.3d 485 (5th Cir. 2002).

[70] The Trademark Counterfeiting Act, 18 U.S.C. § 2320; 18 U.S.C. § 3282(a).

[71] See United States v. Foote, 413 F.3d 1240, 1247 (10th Cir. 2005)

[72] See United States v. Bohai Trading Co., 45 F.3d 577 (1st Cir. 1995); United States v. Hon, 904 F.2d 803 (2d Cir. 1990); United States v. Diallo, 476 F. Supp. 2d 497 (W.D. Pa. 2007), aff’d, 575 F.3d 252 (3d Cir.), cert. denied, 130 S. Ct. 813 (2009).

[73] See United States v. Farmer, 370 F.3d 435 (4th Cir. 2004); United States v. Gonzalez, 630 F. Supp. 894, 896 (S.D. Fla.1986).

[74] Id.

[75] Office of Legal Educ., supra note 2, at 141.

[76] Id.

[77] 18 U.S.C. § 2320(b).

[78] Id.

[79] 18 U.S.C. § 2320(b)(2).

[80] Id.

[81] Id.

[82] 18 U.S.C. § 2320(b)(3).

[83] Id.

[84] Id.

[85] United States v. Beydoun, 469 F.3d 102, 108 (5th Cir. 2006).

[86] Id.

[87] 18 U.S.C. § 2320(f).

[88] United States v. Sung, 51 F.3d 92, 93-94 (7th Cir. 1995).

[89] Office of Legal Educ., supra note 2, at 151–53.

[90] United States v. Hsu, 155 F.3d 189, 194 (3d Cir. 1998) (citing Richard J. Heffernan & Dan T. Swartwood, Trends in Intellectual Property Loss 4, 15 (1996) (Government spies migrated to the private sector following the Cold War and by 1996 it was estimated as much as $24 billion in trade secrets was being stolen and sold each year.)

[91] Hsu, 155 F.3d at 194 n.5 (3d Cir. 1998); see also United States v. Yang, 281 F.3d 534, 543 (6th Cir. 2002) (noting “the purpose of the EEA was to provide a comprehensive tool for law enforcement personnel to use to fight theft of trade secrets”).

[92] Defend Trade Secrets Act § 2(e); 18 U.S.C. § 1833(b)(1).

[93] 18 U.S.C. § 1831-1839; S. Rep. No. 114-220, at 14 (2016) (Prior to the DTSA’s enactment, private causes of action for trade secret misappropriation were solely a matter of state law, which in a vast majority of states was based on the Uniform Trade Secret Act (UTSA)).

[94] 18 U.S.C. § 1831-1832.

[95] 18 U.S.C. § 1832(a) (as amended by the Theft of Trade Secrets Clarification Act, Pub. L. No. 112-236, § 2, 126 Stat. 1627 (2012)) (‘Theft’ is defined to mean “(1) steals, or without authorization appropriates, takes, carries away, or conceals, or by fraud, artifice, or deception obtains such information; (2) without authorization copies, duplicates, sketches, draws, photographs, downloads, uploads, alters, destroys, photocopies, replicates, transmits, delivers, sends, mails, communicates, or conveys such information; (3) receives, buys, or possesses such information, knowing the same to have been stolen or appropriated, obtained, or converted without authorization.”)

[96] 18 U.S.C. § 1832(a).

[97] 18 U.S.C. § 1831; USAM 9-2.400, 9-59.000.

[98] 18 U.S.C. § 1832(a).

[99] Id.

[100] Hsu, 155 F.3d at 195.

[101] Id.

[102] Id. at 196

[103] See 18 U.S.C. §§ 1831(a), 1832(a).

[104] See H.R. Rep. No. 104-788, at 12 (1996), reprinted in 1996 U.S.C.C.A.N. 4021, 4031.

[105] See APPENDIX P2. Economic Espionage Act (18 U.S.C.A. § 1839(3)) (As Amended May 11, 2016 by the Defend Trade Secrets Act of 2016- See Appendix P3, infra), 4 Trade Secrets Law Appendix P2. (Congress passed the Defend Trade Secrets Act (“DTSA”) in 2016 which supplements the EEA by creating a private civil cause of action for trade secret misappropriation.)

[106] 18 U.S.C. § 1839(3).

[107] 18 U.S.C. § 1839(3)(B).

[108] U.S. v. Genovese, 409 F. Supp. 2d 253 (S.D. N.Y. 2005).

[109] United States v. Chung, 659 F.3d 815, 825 (9th Cir. 2011).

[110] See United States v. Ratliff, 376 Fed. Appx. 830, 836-41 (10th Cir. 2010); cf. United States v. Straus, 188 F.3d 520, 1999 WL 565502, at *5 (10th Cir. 1999) (holding that abuse-of-trust and more-than-minimal-planning enhancements, the latter in a predecessor to U.S.S.G. § 2B1.1(b)(10)(C), can be applied to same conduct simultaneously).

[111] 18 U.S.C. § 1839(3)(B).

[112] 18 U.S.C. § 1831.

[113] US West Communications, Inc. v. Office of Consumer Advocate, 498 N.W.2d 711, 714 (Iowa 1993) (citations omitted).

[114] U.S. v. Genovese, 409 F. Supp. 2d 253, 257 (S.D. N.Y. 2005).

[115] United States v. Shiah, SA CR 06-92 DOC, 2008 WL 11230384, at *19 (C.D. Cal. Feb. 19, 2008) (Defendant argued that the trade secret’s owner failed to take reasonable measures to protect the secrecy of the information at issue.)

[116] 18 U.S.C. §§ 1831(a), 1832(a).

[117] Penalty Kick Mgmt. Ltd. v. Coca Cola Co., 318 F.3d 1284, 1291 (11th Cir. 2003); Mixing Equip. Co. v. Philadelphia Gear, Inc., 436 F.2d 1308, 1311 n.2 (3d Cir. 1971) (holding that industrial mixing equipment charts and graphs lost trade secret status through publication in trade journals); DVD Copy Control Ass’n Inc. v. Bunner, 10 Cal. Rptr. 3d 185, 194 (Cal. Ct. App. 2004) (If the Internet posting causes the information to fall into the public domain, a person who republishes the IV. Theft of Commercial Trade Secrets 197 information is not guilty of misappropriating a trade secret, even if he knew that the information was originally acquired by improper means); Hsu, 155 F.3d at 199 (Information does not lose its status as a trade secret if the government discloses it to the defendant as “bait” during a sting operation).

[118] Hsu, 155 F.3d at 195.

[119] Hsu, 155 F.3d at 195; United States v. Yang, 281 F.3d 534, 544 n.2 (6th Cir. 2002); United States v. Kumrei, 258 F.3d 535, 539 (6th Cir. 2001).

[120] Id. at *24.

[121] Hsu, 155 F.3d at 196–97.

[122] Id.

[123] 142 Cong. Rec. S12,213 (daily ed. Oct. 2, 1996) (Managers’ Statement).

[124] See, e.g., Id. at S12,212 (noting that “[t]his legislation does not in any way prohibit companies, manufacturers, or inventors from using their skills, knowledge and experience to solve a problem or invent a product that they know someone else is working on”); see also Lawrence Pedowitz & Carol Miller, Protecting Your Client Under the Economic Espionage Act, BUSINESS CRIMES BULLETIN, available in Lexis-Nexis (Legal News) (“The EEA does not apply to individuals who seek to capitalize on their lawfully developed knowledge, skills or abilities. Employees who change employers or start their own company cannot be prosecuted solely because they were exposed to a trade secret while employed.”).

[125] Kewanee Oil Co. v. Bicron Corp., 416 U.S. 470, 476 (1974).

[126] 117th CONGRESS, 1st Session, 117th CONGRESS, 1st Session.

[127] Id.

[128] The Digital Millennium Copyright Act of 1998, U.S. Copyright Off., (last accessed June 25, 2021).

[129] Id.

[130] Office of Legal Educ., supra note 2, at 233.

[131] Id. at 234.

[132] 17 U.S.C. § 1201.

[133] 17 U.S.C. § 1202.

[134] 17 U.S.C. § 1201(a)(1)(A).

[135] Legal Overview of Section 1201, U.S. Copyright Off., (last accessed June 25, 2021).

[136] 17 U.S.C. § 1201(a)(2).

[137] 17 U.S.C. § 1201(b).

[138] 17 U.S.C. § 1203.

[139] 17 U.S.C. § 1204.

[140] 17 U.S.C. §§ 1202(a)(2), (b)(2).

[141] 17 U.S.C. § 1202(b)(3).

[142] 17 U.S.C. § 1202(c).

[143] Office of Legal Educ., supra note 2, at 241.

[144] Id. at 253.

[145] Id.

[146] Id. at 258.

[147] Id.

[148] Id.

[149] Id. at 263.

[150] 17 U.S.C. § 1203.

[151] 17 U.S.C. § 1703(b)(1)–(6).

[152] 17 U.S.C. § 1703(c).

[153] 17 U.S.C. § 1204(a).

[154] 17 U.S.C. § 1204(b).

[155] 17 U.S.C. § 1204(a)(1).

[156] 17 U.S.C. § 1205(a)(2).

[157] Id. at 263–79 (2013).

[158] 17 U.S.C. § 1204(c).

[159] Id.

[160] 17 U.S.C. § 1204(b).

[161] Office of Legal Educ., supra note 2, at 264. See 17 U.S.C. § 1201(d).

[162] Office of Legal Educ., supra note 2, at 264.

[163] Id.

[164] 17 U.S.C. § 1201(e).

[165] Office of Legal Educ., supra note 2, at 281.

[166] Id.

[167] Id.

[168] Id.

[169] Id. at 281–82.

[170] Id.

[171] 18 U.S.C. § 2318.

[172] The Trademark Counterfeiting Act, 18 U.S.C. § 2318; 18 U.S.C. § 3282(a).

[173] See United States v. Harrison, 534 F.3d 1371, 1373 (11th Cir. 2008).

[174] Office of Legal Educ., supra note 2, at 290-91.

[175] Id.

[176] Id.

[177] Office of Legal Educ., supra note 2, at 291-92.

[178] Id.

[179] 18 U.S.C. § 2318(a).

[180] 18 U.S.C. § 3571(a)-(d).

[181] Beydoun, 469 F.3d at 108.

[182] Id.

[183] Office of Legal Educ., supra note 2, at 295-96.

[184] Pub. L. No. 105–147, 111 Stat. 2678; USSG App C, amend. 590 (effective May 1, 2000).

[185] See U.S.S.G. App. C (Amendments 590, 593).

[186] Id. (if prior is deleted this is referencing: U.S.S.G. App. C (Amendments 590, 593).

[187] Id. at 593.

[188] See § 2B5.3(b)(1).

[189] See U.S.S.G. § 2B5.3 cmt. n.2(A),(B).

[190] U.S.S.G. 2B5.3 (n.2(E))

[191] U.S.S.G. 2B5.3(n. 1).

[192] Id.

[193] U.S.S.G. 2B5.3 (n.2(C)).

[194] Id. * § 2B5.3(b)(1).

[195]U.S.S.G. § 2B5.3(b)(1)(A).

[196] U.S.S.G. 2B5.3(b)(1)(B).

[197] 18 U.S.C. §§ 2320(f)(5), 2318(b)(2).

[198] See 18 U.S.C. § 2320(a).

[199] U.S.S.G. § 2B5.3, cmt. n.2(A)(vii); 18 U.S.C. § 2318; 18 U.S.C. § 2320.

[200] See 18 U.S.C. §§ 2319A(a)(1), 2319B(a).

[201] U.S.S.G. App. C (Amendment 675, 687).

[202] An EEA attempt or conspiracy is sentenced under U.S.S.G. Section 2X1.1. 2B1.1 which uses 2B1.1’s basic calculation and then decreases the base offense level by three.

[203] Office of Legal Educ., supra note 2, at 333.

[204] U.S.S.G. 2B1.1(b)(14)(A)

[205] U.S.S.G. 2B1.1(b)(14)(B)

[206] U.S.S.G. 3B1.3

[207] Id.; See United States v. Ratliff, 376 Fed. Appx. 830, 836-41 (10th Cir. 2010).

[208] U.S.S.G. 3B1.3.

[209] U.S.S.G. § 2B1(b)(10)(C).

[210] Id. at n.8(B).

[211] See United States v. Ojemon, 465 Fed. Appx. 69, 71- 72 (2d Cir. 2012); United States v. Rice, 52 F.3d 843, 851 (10th Cir. 1995); United States v. Minneman, 143 F.3d 274, 283 (7th Cir. 1998).

[212] See Ojemon, 465 Fed. Appx. at 71- 72.

[213] U.S.S.G. § 2B1.1 at n.3(C).

[214] U.S.S.G. 2B1.1 at n.3(A).

[215] Id. at cmt. n.3(A)(i); See also United States v. Wilkinson, 590 F.3d 259 at 268 (4th Cir. 2010).

[216] U.S.S.G. 2B1.1 at n.3(A)(ii).

[217] Office of Legal Educ., supra note 2, at 333–35.

[218]Id.

[219] Salsbury Labs., Inc. v. Merieux Labs., Inc., 908 F.2d 706, 714-15 (11th Cir. 1990) (holding that research and development costs for misappropriated vaccine were a proper factor to determine damages); University Computing Co. v. Lykes–Youngstown Corp., 504 F.2d 518, 536 (5th Cir.1974) (damages for misappropriation of trade secrets are measured by the value of the secret to the defendant “where the secret has not been destroyed and where the plaintiff is unable to prove specific injury”); United States v. Ameri, 412 F.3d 893 (8th Cir. 2005) (the Eighth Circuit affirmed the trial court’s loss estimate, which appears to be the development costs times the number of copies the defendant made);

[220] Wilkinson, 590 F.3d at 268. (Based on the plain language of the Guidelines’ definition of ‘Actual Loss’ in USSG § 2B1.1, comment. (n.3(A)(i))).

[221] Vermont Microsystems, Inc. v. Autodesk Inc., 138 F.3d 449, 452 (2d Cir. 1998) (base the trade secret’s market value on the victim’s loss or the defendant’s gain, depending on which measure appears to be more reliable or greater given the particular circumstances of the theft.)

[222] University Computing, 504 F.2d at 536 (holding that damages for misappropriation of trade secrets are measured by the value of the secret to the defendant “where the [trade] secret has not been destroyed and where the plaintiff is unable to prove specific injury”); Salisbury Labs., 908 F.2d at 714 (ruling that under Georgia’s UTSA, damages for misappropriation of trade secrets should be based on the defendant’s gain).

The Research & Development Credit | Section 41

Taxpayers are always interested in whether certain expenditures qualify as tax deductions. But many taxpayers often forget that expenditures may alternatively qualify for various tax credits, such as the research and development credit. And all things being equal, taxpayers should generally prefer tax credits over tax deductions as the former are more valuable monetarily than the latter.

Regrettably, many taxpayers are unaware that they qualify for certain tax credits. For this reason, thousands of taxpayers each year fail to file the necessary forms with their tax returns, rendering the credits unclaimed. After a number of years, these credits are gone forever due to the statute of limitations for refund claims.

This article explains one of the more commonly missed tax credits: the research and development credit under Section 41.[i] This article also discusses the IRS’s renewed interest in this credit and its new refund claim procedures applicable to taxpayers who seek to claim the credit after January 10, 2022.

The Research & Development Credit

Section 38 houses many permissible tax credits. Among these is the “qualified research activities credit,” the requirements of which are found in Section 41. Section 41 is not an easy read. Rather, it is full of super-technical statutory definitions (often within other statutory definitions) and various formulas and computations. Indeed, the IRS recently commented on Section 41 as follows:

The research credit (as provided by I.R.C. § 41) is a complex area of law involving the application of a four-part test, numerous exclusions, and significant computation and calculation elements to each research activity claimed by a taxpayer in any given tax year.[ii]

And the Tax Court has further commented on Section 41: “The research credit is one of the most complicated provisions in the Code. Its complexity is evidenced by the fact that it was the most commonly reported uncertain tax position on Schedule UTP, Uncertain Tax Position Statement, for 2010, 2011, and 2012.”[iii]

Credit Amount

Generally, the amount of the qualified research activities credit can be determined through the following formula:

Research Credit Amount = 20 % x [Qualified Research Expenses for Year – Base Amount]

For these purposes, the term “qualified research expenses” means the sum of all amounts paid or incurred during the tax year by the taxpayer in carrying on a trade or business for “in-house research expenses” and “contract research expenses.”[iv]

In-House Research Expenses

“In-house research expenses” is defined by statute to mean all expenses for: (1) wages paid or incurred to an employee for qualified services performed by the employee; (2) any amount paid or incurred for supplies used in the conduct of qualified research; and (3) certain amounts paid or incurred to another person for the right to use computers in the conduct of qualified research.[v]

Qualifying Wages

For purposes of Section 41, the term “wages” has the same meaning as that term is used throughout the Code.[vi] Generally, wages must be separated between those allocable to qualified services and those allocable to other services.[vii] However, there is a taxpayer-friendly rule in the regulations—if substantially all of the services performed by the employee for the taxpayer during the tax year consists of qualified services (i.e., 80% or more), the taxpayer may claim all of the employee’s wages as qualified services.[viii]

“Qualified services” means engaging in either: (1) qualified research; or (2) the direct supervision or direct support of research activities which constitute qualified research.[ix] “Qualified research” is discussed more extensively below. For purposes of (2), however, “direct supervision” means the immediate supervision (i.e., first-line management) of qualified research and not higher-level managers, and “direct support” means services in the support of persons engaging in actual conduct of qualified research, or persons who are directly supervising persons engaging in the actual conduct of qualified research.[x]

Supplies

Section 41 defines “supplies” broadly to mean any tangible property other than land or land improvements and property subject to depreciation.[xi]

Contract Research Expenses

“Contract research expenses” is defined to mean 65% of any amount paid or incurred by the taxpayer to any person (other than an employee of the taxpayer) for qualified research.[xii]

What is Qualified Research?

As shown above, the term “qualified research” is ubiquitous throughout Section 41 and its various statutory definitions. Thus, the heart of Section 41—and a taxpayer’s eligibility for the tax credit—often hinges on whether the activity at issue constitutes a qualified research activity.

Generally, to constitute qualified research, the activity must meet all of the following requirements: (1) the expenditures associated with the activity must be Section 174 expenditures; (2) the activity must be undertaken for the purpose of discovering information which is technological in nature, and the application of which is intended to be useful in the development of a new or improved business component of the taxpayer; and (3) substantially all of the activities must constitute elements of a process of experimentation for purposes of Section 41(d)(3).[xiii] Under Section 41(d)(3), research qualifies if it is conducted for a purpose that relates to a new or improved function, performance, or reliability or quality, unless it also relates to style, taste, cosmetic, or seasonal design factors.

The Section 174 Test

The first requirement to constitute “qualified research” is that the expenditures from the activity must represent Section 174 expenditures. Under the Section 174 regulations, Section 174 expenditures are “expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.”[xiv] Generally, this definition hinges on uncertainty—the expenditures for the activity must be intended to discover information that would eliminate uncertainty concerning the development or improvement of a new product.[xv] In turn, uncertainty is present if the information available to the taxpayer does not establish the capability or method in developing or improving the product or the appropriate design of the product.[xvi] Examples in the Regulations provide some additional color on Section 174 expenditures and the uncertainty component.

Example. Company is engaged in the manufacture and sale of custom machines. Company contracts to design and produce a machine to meet a customer’s specifications. Because Company has never designed a machine with these specifications, Company is uncertain regarding the appropriate design of the machine, and particularly whether features desired by the customer can be designed and integrated into a functional machine. Company incurs a total of $31,000 on the project. Of the $31,000, Company incurs $10,000 of costs on materials and labor to produce a model that is used to evaluate and resolve the uncertainty concerning the appropriate design. Company also incurs $1,000 of costs using the model to test whether certain features can be integrated into the design of the machine. This $11,000 of costs represents research and development costs in the experimental or laboratory sense.

After uncertainty is eliminated, Company incurs $20,000 to produce the machine for sale to the customer based on the appropriate design. The model produced and used to evaluate and resolve uncertainty is a pilot model. Therefore, the $10,000 incurred to produce the model and the $1,000 incurred on design testing activities qualifies as research or experimental expenditures under Section 174. However, Section 174 does not apply to the $20,000 that Company incurred to produce the machine for sale to the customer based on the appropriate design.[xvii]

Example: Company is a wine producer. Company is researching and developing a new wine production process that involves the use of a different method of crushing the wine grapes. In order to test the effectiveness of the new method of crushing wine grapes, Company incurs $2,000 in labor and materials to conduct the test on this part of the new manufacturing process. The $2,000 of costs represents research and development costs in the experimental or laboratory sense. Therefore, the $2,000 incurred qualifies as research or experimental expenditures under Section 174 because it is a cost incident to the development or improvement of a component of a process.[xviii]

The Technological Information Test

To be “qualified research,” an activity must be undertaken for the purpose of discovering information that is technological in nature. Information is technological in nature if the process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science.[xix]

The Business Component Test

The business component test requires that research undertaken to discover information must be intended to be used to develop a new or improved business component of the taxpayer. For these purposes, a business component is “any product, process, computer software, technique, formula, or invention which is . . . held for sale, lease, or license, or . . . used by the taxpayer in . . . [its trade or business.”[xx]

The Process of Experimentation Test

To be “qualified research,” the activity must also meet the process of experimentation test. For these purposes, a process of experimentation is a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities.[xxi] Generally, federal courts and the IRS break the process of experimentation test down further into three separate elements: (1) the “substantially all” element; (2) the “process of experimentation” element; and (3) the “qualified purpose” element.[xxii] Each of these elements is tested for each separate business component.

To meet the “substantially all” element, at least 80% of the taxpayer’s research activities for each business component, measured on a cost or other reasonable basis, must constitute a process of experimentation for a qualified purpose.[xxiii]

To meet the “process of experimentation” element, the taxpayer must engage in “a process designed to evaluate one or more alternatives to achieve a result” where the taxpayer is uncertain at the beginning of its research activities regarding the capability or method of achieving the result or an appropriate design.[xxiv] The Section 41 regulations further provide:

A process of experimentation must fundamentally rely on the principles of the physical or biological sciences, engineering, or computer sciences and involves the identification of uncertainty concerning the development or improvement of a business component, the identification of one or more alternatives intended to eliminate that uncertainty, and the identification and the conduct of a process of evaluating the alternatives (through, for example, modeling, simulation, or a systematic trial and error methodology). A process of experimentation must be an evaluative process and generally should be capable of evaluating more than one alternative.[xxv]

To meet the “qualified purpose” element, the research process must relate to a new or improved function, performance, reliability or qualify of the business component.[xxvi] Research activities for style, taste, cosmetic, or seasonal design factors do not qualify. And qualified research specifically does not include the following activities:

Research after Commercial Production. Any research conducted after the beginning of commercial production of a business component.
Adaptation of Existing Business Components. Any research related to the adaptation of an existing business component to a particular customer’s requirement or need.
Duplication of Existing Business Component. Any research related to the reproduction of an existing business component (in whole or in part) from a physical examination of the business component itself or from plans, blueprints, detailed specifications, or publicly available information with respect to such business component.
Surveys, Studies, etc.. Any of the following: (i) efficiency survey; (ii) activity relating to management function or technique; (iii) market research, testing, or development (including advertising or promotions); (iv) routine data collection; or (v) routine or ordinary testing or inspection for quality control.
Computer Software. Unless otherwise exempted by regulations, any research with respect to computer software which is developed by (or for the benefit of) the taxpayer primarily for internal use by the taxpayer, other than for use in: (i) an activity which constitutes qualified research, or (ii) a production process with respect to which the requirements of (i) are met.
Foreign Research. Any research conducted outside the United States, the Commonwealth of Puerto Rico, or any possession of the United States.
Social Sciences, Etc. Any research in the social sciences, arts, or humanities.
Funded Research. Any research to the extent funded by any grant, contract, or otherwise by another person (or government entity).[xxvii]

Examples under the Section 41 regulations are helpful in determining whether an activity meets the qualified purpose element:

Example: Company is engaged in the business of developing and manufacturing blue vehicles. Company wants to change the color of its blue vehicles to green. Company obtains from various suppliers several different shades of green paint. Company paints several sample vehicles, and surveys its customers to determine which shade of green the Company’s customers prefer. In this case, the Company’s activities to change the color of its blue vehicles to green are not qualified research because substantially all of Company’s activities are not undertaken for a qualified purpose. All of Company’s research activities are related to style, taste, cosmetic, or seasonal design factors.[xxviii]

Example: Same example as above, except that Company chooses one of the green paints. Company obtains samples of the green paint from a supplier and determines that Company must modify its painting process to accommodate the green paint because the green paint has different characteristics from other paints that Company has used. Company obtains detailed data on the green paint from Company’s paint supplier. Company also consults with the manufacturer of Company’s paint spraying machines. The manufacturer informs Company that Company must acquire a new nozzle that operates with the green paint Company wants to use. Company tests the nozzles to ensure that they work as specified by the manufacturer of the paint spraying machines. Under these new facts, Company’s activities to modify its painting process are a separate business component, and Company’s activities to modify its painting process to change the color of its blue vehicles to green are not qualified research. Company did not conduct a process of evaluating alternatives in order to eliminate uncertainty regarding the modification of its painting process. Rather, the manufacturer of the paint machine eliminated Company’s uncertainty regarding the modification of its painting process. Company’s activities to test the nozzles to determine if the nozzles work as specified by the manufacturer of the paint spraying machines are in the nature of routine or ordinary testing or inspection for quality control.[xxix]

Base Amount

If a taxpayer has qualified research and otherwise meets the requirements of Section 41, the taxpayer must then compute the “base amount”. For these purposes, the “base amount” is defined as the product of (i) the “fixed-base percentage,” and (ii) the average annual gross receipts of the taxpayer for the four tax years preceding the tax year for which the credit is being claimed (i.e., the “credit year.”).[xxx]

Section 41(c)(3)(A) generally defines the “fixed-base percentage” as the percentage of aggregate qualified research expenses of the taxpayer for the taxable year beginning after December 31, 1983, and before January 1, 1989, to the aggregate gross receipts of the taxpayer for such tax years. If the taxpayer had both gross receipts and qualified research expenses after December 31, 1983, the fixed-based percentage is set by statute, starting with 3% for each of the taxpayer’s first five taxable years beginning after December 31, 1993.[xxxi]

Due in part to the complexity of the “base amount” computations, the Code also permits taxpayers to elect an “alternative simplified method.”[xxxii] Under this method, the credit is equal to 14% of so much of the qualified research expenses for the tax year as exceeds 50% of the average qualified research expenses for the three tax years preceding the tax year for which the credit is being determined.

Claiming the R&D Credit

The Section 41 credit has historically been claimed on IRS Form 6765, Credit for Increasing Research Activities. More recently, however, the IRS has indicated that it intends to make it more difficult for taxpayers to claim the credit, particularly for claims made after January 10, 2022. The IRS’s justification for imposing these new requirements is due to its difficulty in ascertaining whether the taxpayer qualifies and a regulation that provides that taxpayers must generally provide sufficient facts to apprise of the IRS of any refund or claim for credit.

Specifically, by regulation, the IRS is not required to issue a refund or credit unless it receives a claim that sets forth in detail each ground upon which the refund or credit is claimed and facts sufficient to apprise the IRS of the exact basis of the refund or credit.[xxxiii] On October 15, 2021, the IRS issued a Field Attorney Advice (“FAA”) that provided additional requirements taxpayers must meet under this regulation to make a valid claim for credit or refund under Section 41.[xxxiv] If the taxpayer fails to meet the requirements, the IRS has indicated that it will deny the refund or credit claim in its entirety as invalid.

Under the FAA, the taxpayer’s refund claim for a research activity credit is valid if, at a minimum, the taxpayer:

Identifies all the business components to which the Section 41 research credit claim relates for that year;
For each business component, the taxpayer identifies all research activities performed; identifies all individuals who performed each research activity; and identifies all the information each individual sought to discover;
Provides the total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year (which may be done through using Form 6765);
Must provide a declaration signed under penalties of perjury verifying that the facts provided in the claim are accurate.

The FAA indicates that if the taxpayer fails to meet these requirements, the IRS will reject the claim as deficient.[xxxv]

Conclusion

Every year, taxpayers who qualify for the Section 41 credit fail to claim it. This is somewhat understandable, particularly in light of the difficulties taxpayers face in determining whether they meet each of Section 41’s various statutory and regulatory requirements. However, business owners who engage in new processes and products should consult with a tax professional to determine whether they are leaving money on the table each year in not claiming the tax credit.

Freeman Law Tax Attorneys

Freeman Law aggressively represents clients in tax litigation at both the state and federal levels. When the stakes are high, clients rely on our experience, knowledge, and talent to help them navigate all levels of the tax dispute lifecycle—from audits and examinations to the courtroom and all levels of appeals. Schedule a consultation or call (214) 984-3000 to discuss your tax needs.

[i] All section references are to the Internal Revenue Code of 1986, as amended (the “Code”).

[ii] IRS FAA 20214101F.

[iii] Suder v. Comm’r, T.C. Memo. 2014-201.

[iv] See I.R.C. § 41(b)(1).

[v] I.R.C. § 41(b)(2).

[vi] I.R.C. § 41(b)(2)(D).

[vii] Treas. Reg. § 1.41-2(d)(1).

[viii] Id. at (d)(2).

[ix] I.R.C. § 41(b)(2)(B).

[x] Id. at (c)(3).

[xi] I.R.C. § 41(b)(2)(C).

[xii] I.R.C. § 41(b)(3).

[xiii] I.R.C. § 41(d).

[xiv] Treas. Reg. § 1.174-2(a)(1).

[xv] Id.

[xvi] Id.

[xvii] Treas. Reg. § 1.174-2(a)(11), Ex. 4.

[xviii] Id., Ex. 10.

[xix] Treas. Reg. § 1.41-4(a)(4); see also Max v. Comm’r, T.C. Memo. 2021-37 (quoting legislative history).

[xx] Sec. 41(d)(2)(B).

[xxi] Treas. Reg. § 1.41-4(a)(5).

[xxii] Union Carbide Corp. & Subs. v. Comm’r, T.C. Memo. 2009-50.

[xxiii] Treas. Reg. § 1.41-4(a)(6).

[xxiv] Treas. Reg. § 1.41-4(a)(5).

[xxv] Id.

[xxvi] Id.

[xxvii] I.R.C. § 41(d)(4).

[xxviii] Treas. Reg. § 1.41-4(a)(8), Ex. 1.

[xxix] Id., Ex. 2.

[xxx] I.R.C. § 41(c)(1).

[xxxi] I.R.C. § 41(c)(3).

[xxxii] I.R.C. § 41(c)(4).

[xxxiii] See Treas. Reg. § 301.6402-2(b)(1).

[xxxiv] See FAA 20214101F.

[xxxv] The AICPA has provided comments and concerns to the IRS regarding its implementation of the change in requirements for a valid refund claim for the R&D credit.

Facebook Under IRS Audit: Facing IRS Transfer Pricing Challenges, Facebook Refuses to Comply with Summonses

Facebook, Inc. is under an IRS audit that could result in Facebook owing an estimated $3-5 billion, according to disclosures made by the company in its recent quarterly report filed with the Securities and Exchange Commission. The IRS is challenging the company’s transfer pricing arrangement with its foreign subsidiaries. Facebook, whose 2008 through 2013 tax years are currently under audit, recently refused to comply with several IRS summonses that were issued in connection with that audit. When Facebook initially refused to comply with the government-issued summonses, the Department of Justice stepped in and sued Facebook, requesting that a district judge order the company to comply. On August 10^th, a district judge for the U.S. District Court for the Northern District of California issued an order taking the first steps in that process, requiring Facebook to appear in court and demonstrate why the court should not compel it to comply with the summonses. The pending case is captioned United States v. Facebook Inc. and Subsidiaries (No. 3:16-cv-03777).

The IRS is challenging Facebook’s transfer pricing arrangement with its foreign subsidiaries. Particularly, the IRS is challenging the value of intellectual property transferred by Facebook in 2010 to its Irish subsidiary, alleging that Facebook undervalued the intangible property by billions, allowing it to shift income away from the U.S. (a high-tax jurisdiction) to Ireland (a low-tax jurisdiction).

According to Facebook’s most recent quarterly report (available here), if the IRS prevails in its tax position, it could cost Facebook an estimated $3–5 billion. Facebook provided the following excerpted note in its quarterly report filed with the SEC:

We are subject to taxation in the United States and various other state and foreign jurisdictions. The material jurisdictions in which we are subject to potential examination include the United States and Ireland. We are under examination by the Internal Revenue Service (IRS) for our 2008 through 2013 tax years. . . . On July 27, 2016, we received a Statutory Notice of Deficiency (Notice) from the IRS relating to transfer pricing with our foreign subsidiaries in conjunction with the examination of the 2010 tax year. While the Notice applies only to the 2010 tax year, the IRS states that it will also apply its position for tax years subsequent to 2010, which, if the IRS prevails in its position, could result in an additional federal tax liability of an estimated aggregate amount of approximately $3.0 – $5.0 billion, plus interest and any penalties asserted. We do not agree with the position of the IRS and will file a petition in the United States Tax Court challenging the Notice. If the IRS prevails in the assessment of additional tax due based on its position, the assessed tax, interest and penalties, if any, could have a material adverse impact on our financial position, results of operations or cash flows.

Facebook, a U.S. company, established its international headquarters in Dublin, Ireland. The company is not alone in moving its international headquarters overseas—many large companies have taken similar steps and have substantial financial and tax incentives for doing so. Ireland boasts a much lower corporate tax rate than the United States: 12.5% versus 35%. The general idea is that companies that are able to move tax-generating income to countries like Ireland are able to save substantial amounts of tax by sourcing that income in the low-tax country.

Some of the summonses issued by the IRS seek to find out information about Facebook’s decision to make Dublin its international headquarters and its valuation of intellectual property transferred to its Irish subsidiary. The tax litigation could have a major impact—to the tune of billions of dollars—on Facebook’s future cash flows and financial reporting.

Expert Tax Defense Attorneys

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Everything That You Need to Know About Federal Tax Liens

When an IRS Tax Lien Arises

The Internal Revenue Code (IRC) governs when and how a federal tax lien arises. The federal tax lien—sometimes referred to as a “statutory lien” or “silent lien”—is often confused with the notice of the lien’s existence, which is generally filed by the IRS at a later date (i.e. a Notice of Federal Tax Lien or NFTL).

A Notice of Federal Tax Lien is a document that is publicly filed with state and local jurisdictions in order to put other creditors on notice of the IRS’s lien interest. As a result, the NFTL itself does not actually create the lien—it merely informs others of a lien that already exists by statute. However, the date of the NFTL filing is important for determining the IRS’s priority against other creditors.

Tax liens are one of the primary tools that the IRS uses to collect outstanding taxes. The IRS also uses the levy process or seizures to collect taxes where available. See our separate post on IRS Seizures: The Good, the Bad, and The Ugly for more on topics related to levies and seizures.

What is a Tax Lien?

The law generally defines a lien as a charge or encumbrance on the property of another as security for a debt or obligation. A lien does not change the ownership of the property; it merely identifies the property as having a claim against it.

Liens can be divided into three general categories: common-law liens, consensual liens, and statutory liens. The tax lien created under the Internal Revenue Code is a statutory lien.

The primary federal tax lien is the “general” tax lien, sometimes referred to as the “secret” or “silent” lien. The federal tax lien arises automatically—that is, by operation of law—when a taxpayer fails or refuses to pay tax after notice and demand. I.R.C. § 6321.

The general tax lien under Section 6321 is broad; it generally encompasses all of the taxpayer’s property or rights to property to secure payment of tax liability. Section 6321 provides that if any person liable to pay any tax neglects or refuses to pay the tax after demand, the amount (including any interest, additional amount, addition to tax, or assessable penalty, together with any costs that may accrue in addition thereto) shall be a lien in favor of the United States upon all property and rights to property belonging to such person. However, the Government’s lien under §6321 cannot extend beyond the property interests held by the delinquent taxpayer.

Under I.R.C. section 6321, a federal tax lien attaches to all of a taxpayer’s property or rights to property. The Supreme Court has held that state law controls the determination of the existence of any legal interest that a taxpayer has in a property. Aquilino v. United States, 363 U.S. 509 (1960). However, whether the state-created interest constitutes property or rights to property to which the federal tax lien attaches is a matter of federal law. United States v. Bess, 357 U.S. 51 (1958).

In addition to the general federal tax lien, there are also special liens for estate and gift taxes that arise at the date of death or the date of the gift, respectively. These liens are provided for by IRC § 6324. IRC § 6324A and IRC § 6324B also provides for special estate tax liens applicable to certain closely held business or farm or qualified family-owned business property.

How the Tax Lien Arises

A federal tax lien arises when any “person” liable for any federal tax fails to pay the tax after a demand by the Government for payment. IRC § 6321. For federal tax law purposes, a “person” includes individuals, trusts, estates, partnerships, associations, companies, and corporations. IRC § 7701(a)(1).

The lien is effective from the date that the Government assesses the tax. Thus, if the taxpayer neglects or refuses to pay the assessed tax, then the lien is deemed to “relate back” to the assessment date. IRC § 6322. The IRS is not required to file a Notice of Federal Tax Lien (“NFTL”) in order for the tax lien to attach. However, filing a NFTL may be necessary for the IRS to have priority over other creditors.

The Span of a Federal Tax Lien

The federal tax lien continues until the assessed tax liability is satisfied or becomes unenforceable by reason of lapse of time, i.e., passing of the collection statute expiration date (“CSED”). IRC § 6322. Generally, after assessment, the IRS has ten years to collect the tax liability. IRC § 6502. However, there are some circumstances that may extend or suspend the ten-year collection period.

IRC § 6502 provides for an extension of the collection period in two situations:

The statute of limitations was extended at the same time an installment agreement was entered into. In this case, collection action may be taken until the 89th day after expiration of the installment agreement. IRC § 6502(a)(2)(A).[1]
Release of a levy under IRC § 6343 is accompanied by an agreement to extend the statute of limitations to a specific date and that date has not yet passed. IRC § 6502(a)(2)(B); Treas. Reg. § 301.6343-1(b)(2)(ii)(D).

Moreover, IRC § 6503 provides for the suspension of the collection period in several situations. The most common situations are the following:

Issuance of a statutory notice of deficiency, IRC § 6503(a).
Assets of the taxpayer in control or custody of a court, IRC § 6503(b).
Taxpayer is outside of the United States for a continuous period of at least 6 months, IRC § 6503(c).
An extension exists for the payment of an estate tax, IRC § 6503(d).
A wrongful seizure of property or a wrongful lien on property, IRC § 6503(f).
A taxpayer bankruptcy filing triggering the automatic stay, IRC § 6503(h).

Taxpayers should note that there are other IRC sections whose provisions extend the Collection Statute Expiration Date (CSED), including, but not limited to, IRC §§ 6015(e)(2), 6330(e)(1), 6331(i)(5), 6331(k)(3)(B) and 6672(c)(4).

If the United States government files suit and reduces a tax claim to judgment, the collection period generally does not expire until the judgment has been satisfied or other law so provides. United States v. Overman, 424 F.2d 1142 (9th Cir. 1970); United States v. Hodes, 355 F.2d 746 (2nd Cir. 1966).

Taxpayers should be aware that state statutes of limitations do not affect the length or existence of the federal tax lien. Overman, 424 F.2d at 1147.

The Transfer of Property Subject to Lien

After the federal tax lien attaches to property, it remains attached to that property until the lien expires, is released, or the property has been discharged from the lien. The transfer of property after attachment does not affect the lien. United States v. Bess, 357 U.S. 51, 57 (1958). If property is sold by the taxpayer, the lien attaches to whatever is substituted for it, as it reaches all of the taxpayer’s property and rights to property. Phelps v. United States, 421 U.S. 330, 334-35 (1975) (lien attached to the cash proceeds of a sale). However, as a practical matter, it may be difficult for the IRS to enforce a tax lien against certain assets, such as cash sale proceeds.

The Notice of Federal Tax Lien (NFTL)

The federal tax lien arises by law when the IRS satisfies the prerequisites of IRC § 6321: (i) an assessment and (ii) a notice and demand for payment. However, for the federal tax lien to have priority against certain competing lien interests, the IRS must also file a NFTL pursuant to IRC § 6323.

Purpose and Effect of Filing Notice

The filing of a NFTL is not required in order to perfect the IRS’s lien against the taxpayer. Rather, filing a NFTL protects the government’s priority vis. a vis. third parties, such as a purchaser, security interest holder, mechanic’s lienor, or judgment lien creditor. IRC § 6323(a). Generally speaking, unless the IRS properly files a notice of its federal tax lien first, a purchaser will have priority over the federal tax lien. Similarly, unless the IRS files a NFTL first, the holder of a security interest, mechanic’s lienor, and judgment lien creditor will have priority over the federal tax lien.

IRC § 6323(f)(4) requires that in some states a NFTL filed with respect to real property must be indexed in order to be treated as filed. Indexing is required in a state where a deed must be indexed to be valid against a subsequent bona fide purchaser. See Hanafy v. United States, 991 F. Supp. 794 (N.D. Tex. 1998).

Place of Filing

IRC § 6323(f) and state law ultimately determine the correct place to file a NFTL. If the Service files the NFTL in the wrong office, then the lien will not have priority over a later purchaser, holder of a security interest, mechanic’s lienor, or judgment lien creditor.

Note that different filing rules apply for real property and personal property. IRC § 6323(f) provides that states may designate one office for filing the NFTL for real and personal property.

For real property, the NFTL is filed in the one office designated by the State where the property is physically located. That office is generally the county recorder or clerk of the county in which the real property is located.

With respect to personal property, the “situs” of both tangible and intangible property is the residence of the taxpayer at the time the notice of lien is filed. Again, most states generally provide that the one office for filing the NFTL for an individual’s personal property is the county clerk’s office in the county in which the individual resides.

The residence of a corporation or partnership is deemed to be the place at which the principal executive office is located, which is the office at which the major executive decisions are made. S. D’Antoni, Inc. v. Great Atlantic & Pacific Tea Co., Inc., 496 F. 2d 1378 (5th Cir. 1974). For employment tax and certain excise tax purposes, a single-owner unincorporated business entity is classified as a corporation under Treas. Reg. § 301.7701-2(c)(2)(iv) and (v).

For purposes of filing a notice of federal tax lien, a taxpayer who resides abroad is deemed to reside in Washington, D.C. Thus, a notice of federal tax lien filed against personal property is to be filed with the Recorder of Deeds for the District of Columbia.

If a state fails to provide an office or designates more than one office for filing a NFTL, then IRC § 6323(f) provides that the NFTL is to be filed in the office of the clerk of the United States District Court for the judicial district in which the property subject to the lien is situated.

IRC § 6323(f)(5) provides that the filing of a NFTL is governed solely by the Internal Revenue Code and is not subject to any other Federal law establishing a place or places for the filing of liens or encumbrances under a national filing system. For purposes of determining whether a state has designated more than one office for filing a NFTL, state law that merely adopts or reenacts a Federal law establishing a national filing system is not counted. IRC § 6323(f)(1)(A)(ii). See also Treas. Reg. § 301.6323(f)-1(a)(2).

The Revised Uniform Federal Tax Lien Registration Act (1966), which has been adopted by many states, provides, among other things, a clear rule for the personal property of corporations and partnerships: NFTLs should be filed in the Office of the Secretary of State. This rule applies in states that have adopted the Act.

Refiling of Notice

All NFTLs must be refiled within the required refiling period to retain priority as of the initial filing date. If the period expires and the NFTL has not been refiled, most NFTLs will self release thirty days after the date that is ten years after the assessment, regardless of any extension or suspension of the collection statute of limitations.

The NFTL may be refiled during the one-year period ending 30 days after the expiration of ten years after the assessment date of the tax. IRC § 6323(g)(3)(A).

If the collection period continues to be suspended or extended after the initial refiling, the Service may have to refile again. This second refiling must be made in the one-year period ending with the expiration of 10 years after the close of the preceding required refiling period. IRC § 6323(g)(3)(B).

Often, the IRS files the NFTL in multiple offices. When the Service refiles, it must refile in each of the offices in which the prior NFTLs were filed. See IRC § 6323(g)(2)(A) and Treas. Reg. § 301.6323(g)-1(a)(1). If a taxpayer properly notifies the Service of a change of residence, the Service must not only refile in the original offices, but must also file a NFTL in the recording office covering the new residence.

If a self-releasing NFTL is filed in multiple offices with respect to a particular tax assessment, and the Service fails to timely refile in each of those offices, the assessment lien releases and the refiling of any other NFTL is rendered ineffective. Treas. Reg. § 301.6323(g)-1(a)(1). In other words, even if the NFTL is properly refiled in every office except for one, failure to refile in one office causes the underlying assessment lien to be extinguished and the refiled NFTLs to be ineffective.

However, neither the failure to refile before the expiration of the refiling period, nor the release of the lien, alters or impairs any right of the United States to property or its proceeds that is the subject of a levy or judicial proceeding commenced prior to the end of the refiling period or the release of the lien, except to the extent that a person acquires an interest in the property for adequate consideration after the commencement of the proceeding and does not have notice of, and is not bound by, the outcome of the proceeding. Treas. Reg. § 301.6323(g)-1(a)(3).

Contents of Notice of Federal Tax Lien

The Secretary of Treasury prescribes the form and content of the NFTL and the NFTL is valid notwithstanding any other provisions of law regarding the form or content. IRC § 6323(f)(3). State law may not require that the NFTL be in any particular form or contain any particular items to be recordable. United States v. Union Central Life Ins., 368 U.S. 291 (1961).

The NFTL can be either a paper form (the Service uses Form 668(Y)(c)), or a form transmitted electronically, including by fax or e-mail. Regardless of the method used to file the NFTL, it must identify the taxpayer, the tax liability giving rise to the lien, and the date the assessment arose. Treas. Reg. § 301.6323(f)-1(d)(2).

Effect of Errors in Notice of Federal Tax Lien

Errors appearing on the face of the Service’s filed NFTL often create problems not only in evaluating the validity of the NFTL, but also in determining relative priorities between the Service’s claim and other competing lien claimants.

A number of controversies concern errors in the name of the taxpayer as it appears on the NFTL. The general rule is that if the name on the notice is not identical to the correct name of the taxpayer, then the NFTL is still valid if the NFTL is sufficient to put a third party on notice of a lien outstanding against the taxpayer. This is known as the substantial compliance test. United States v. Sirico, 247 F. Supp. 421 (S.D.N.Y. 1965).

In applying the substantial compliance test, some courts have upheld NFTLs even when there was an error in the taxpayer’s name. SeeQuist v. Wiesener, 327 F.Supp.2d 890 (E.D. Tenn. 2004) (“Joint Effort” rather than “Joint Effort Productions, Inc.” ); Whiting-Turner v. P.D.H. Dev. Inc., 184 F.Supp.2d 1368 (M.D.Ga. 2000) (“PDH Development, Inc.” rather than PD Hill Development, Inc.”); Kivel v. United States, 878 F.2d 301 (9th Cir. 1989) (“Bobbie Morgan” rather than “Bobbie Morgan Lane” ); United States v. Polk, 822 F.2d 871 (9th Cir. 1987) (“Roy Bruce Polk” rather than “Bruce Polk” ); Tony Thornton Auction Service, Inc. v. United States, 791 F.2d 635 (8th Cir. 1986) (notice filed against “Davis’s Restaurant,” a partnership, and one partner, “Joe Davis,” was sufficient as notice against the other partner, “Mary Davis” ); Richter’s Loan Co. v. United States , 235 F.2d 753 (5th Cir. 1956) (“Freidlander” rather than “Friedlander”); Brightwell v. United States, 805 F. Supp. 1464 (S.D. Ind. 1992) (“William S. Van Horn” rather than “William B. Van Horn”); and United States v. Sirico, 247 F. Supp. 421 (S.D.N.Y. 1965) (“Sirico, George” and “Sirico, A.” rather than “Assunta Sirico”). ButseeFritschler, Pellino, Schrank & Rosen, S.C. v. United States, 716 F. Supp. 1157 (E.D.Wis. 1988) (“Alan G. Casey” rather than “Alan J. Casey”); Haye v. United States, 461 F. Supp. 1168 (C.D.Cal. 1978) (“Castello” rather than “Castillo”); United States v. Ruby Luggage Corp., 142 F. Supp. 701 (S.D.N.Y. 1954) (“Ruby Luggage Corp.” rather than “S. Ruby Luggage Corp.”); and Continental Invs. v. United States, 142 F. Supp. 542 (W.D. Tenn. 1953) (“W.B. Clark, Sr.” rather than “W.R. Clark, Sr.”).

In re Spearing Tool and Manufacturing Co., Inc., 412 F.3d 653 (6th Cir. 2005), cert. denied sub nom. Crestmark Bank v. United States, 549 U.S. 810 (2006), is the lead case for upholding a NFTL when lien filing records are electronically searched. In Spearing Tool, the Sixth Circuit held that the Service’s identification of a taxpayer in a NFTL was sufficient where the name of the corporation appeared in an abbreviated form of the corporate name registered with the Michigan Secretary of State. A lien search by a secured creditor did not disclose the NFTLs that had been filed against “Spearing Tool & Mfg. Company, Inc.” The proper name under UCC filing rules was “Spearing Tool and Manufacturing Co.”

The 6th Circuit found that the secured creditor challenging the validity of the NFTL had failed to conduct a reasonable and diligent electronic search because its search did not take into consideration the following three factors:

The use of the abbreviation “Mfg.” and the use of an ampersand are common.
The secured creditor knew that Spearing Tool sometimes used these abbreviations.
The Michigan Secretary of State’s office recommended to the secured creditor that it undertake a search using the abbreviations.

The 6th Circuit limited its holding to the facts and specifically expressed no opinion about whether creditors have a general obligation to search name variations.

In summary, when searching for a NFTL in public records, either in a book format or electronic format, the searcher must act reasonably and diligently. The NFTL identifies the taxpayer when it is sufficient to put a third party on notice of a lien outstanding against the taxpayer. Since this is essentially a factual question, however, it is especially important to pay attention to the “details.” Thus, for example, if the IRS suspects that a person uses any aliases or owns property held for him/her by a nominee, agent or trustee, it may prepare an individual NFTL for filing in all such names.

Collection Due Process

IRC § 6320 gives the taxpayer the right to challenge a NFTL filing, request a Collection Due Process (CDP) hearing with Appeals, and seek judicial review of Appeals’ determination with the Tax Court. The Service must generally notify the taxpayer within 5 business days after the date of filing the first NFTL for a tax period. The notice of lien must be given in person, left at the taxpayer’s home or place of business, or sent by certified or registered mail to the person’s last known address. The notice must also inform the taxpayer of the amount of the unpaid tax, the taxpayer’s right to request a hearing, the available administrative appeals procedures, and applicable procedures for releasing the lien. IRC § 6320(a).

Property to Which the Tax Lien Attaches

The federal tax lien attaches to all property and rights to property of the taxpayer. This is a very broad concept and includes not only items which are typically thought of as property, e.g., tangible items and “things,” but also intangible items and “rights” which a taxpayer may have but are not necessarily marketable. The only exception is that the lien does not attach to any interest of a Native American in restricted land held by the United States. Treas. Reg. § 301.6321-1.

The courts have interpreted this very broad language to include property of greatly varying natures, as well as future interests, contingent interests, and executory contracts.

Future interests. The fact that a taxpayer’s enjoyment of a “right to property” may be postponed does not prevent attachment. If a taxpayer has an unqualified fixed right, under trust or a contract, to receive periodic payments or distributions of property, a lien attaches to the taxpayer’s entire right regardless of when the payments or distributions will be made. Rev. Rul. 55-210, 1955-1 C.B. 544.
Contingent interests. These are interests which a party will receive only if certain circumstances or events occur.See Fouts v. United States, 107 F.Supp.2d 815, 817 (W.D. Mich. 2000) (under state law an expectant beneficiary of an inter vivos trust has a present interest in property that is attachable). Butsee Dominion Trust Co. of Tennessee v. United States, 7 F.3d 233 (unpublished table decision) (6th Cir. 1993) (under state law a contingent remainder person did not have an interest in property). An inter vivos trust is sometimes referred to as a “living trust.”
Executory contracts. A lien may attach before performance under a contract.See Seaboard Surety Co. v. United States, 306 F.2d 855, 859 (9th Cir.1962) (a lien attached to the taxpayer’s rights under an executory contract which the taxpayer had assigned and, when the taxpayer performed under the contract, the government had a lien on the proceeds). See also Randall, Sr. v. H. Nakashima & Co., 542 F.2d 270, 274 (5th Cir. 1976) (contract rights under a partially executed contract constituted a right to property because they had a realizable value).

Once the lien has come into existence, it attaches immediately to any property acquired by the taxpayer during the existence of the lien. In other words, unlike a typical mortgage, the federal tax lien attaches to a taxpayer’s after-acquired property.

If the Service files a NFTL, the tax lien will generally have priority to a taxpayer’s after-acquired property. In United States v. McDermott, 507 U.S. 447 (1993), the Supreme Court held that the federal tax lien had priority over a judgment lien on the taxpayer’s after-acquired property, to which the judgment lien and the federal tax lien attached simultaneously, even though the judgment lien was filed ahead of the NFTL.

State Law

State law is very significant when considering the property and rights to property to which the federal tax lien attaches. The Government looks to state law to determine a taxpayer’s rights in a particular piece of property, but federal law determines whether such interests qualify as property or rights to property. “[One] look[s] to state law to determine what rights the taxpayer has in the property the Government seeks to reach, then to federal law to determine whether the taxpayer’s state-delineated rights qualify as ‘property’ or ‘rights to property’ within the compass of federal tax lien legislation.” United States v. Craft , 535 U.S. 274 (2002); Drye v. United States, 528 U.S. 49, 58 (1999).

State law does not determine whether something is property under the Internal Revenue Code. For example, in many states a liquor license is not property. Under the Internal Revenue Code, however, the question is whether the taxpayer has rights under state law. Because the taxpayer does have rights under state law, the liquor license is property under the Internal Revenue Code. SeeDrye, 528 U.S. at 58-59.

The Government must look to state law to determine whether a taxpayer has rights in property by virtue of a civil union, domestic partnership, or similar relationship.

Real Property

Federal tax lien questions relating to the joint ownership of property generally arise when other parties claim an interest in real property otherwise subject to the federal tax lien. This issue typically arises when the Service asserts a tax lien against only one of the parties having an interest in real property which, depending on state law, is held in one of the following forms:

Community property,
Joint tenancy,
Tenancy in common, or
Tenancy by the entirety.

Community Property

The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Puerto Rico is also a community property jurisdiction. Spouses in Alaska may elect to have statutory community property rules apply to some or all of their property. Alaska St. § 34.77.010 et seq. Community property includes both real and personal property.

In most community property states, only married couples may own property as part of a community. See Obergefell v. Hodges , 135 S. Ct. 2584 (2015). The community property rules also apply in some states to state-created, formal relationships between non-married couples. For example, California, Nevada and Washington permit domestic partnerships to which each state applies its community property laws.

Community property law presents special problems concerning the force and effect of the federal tax lien.

Joint Tenancy

A joint tenancy may be created when the following conditions are met:

Two or more persons become the owners of property in equal and undivided shares.

The interest of each tenant is created in the same conveyance at the same time and the interests must be equal.

Joint tenants generally have a right of survivorship. Under the right of survivorship, when a joint tenant dies, the surviving joint tenants automatically own a greater portion of the property.

By statute, some states have abolished the survivorship feature of joint tenancy.

Generally, where only one of the joint tenants owes taxes, the lien attaches to the taxpayer’s property interest and the entire property may be sold pursuant to judicial sale under IRC § 7403, although the non-liable joint tenant must be compensated from the sale proceeds. If the Service enforces the tax lien against a taxpayer’s interest in a joint tenancy and sells it, the purchaser acquires the taxpayer’s partial interest in property, but most states then treat the joint tenancy as having been converted to a tenancy in common (discussed below). See generally, United States v. Rodgers, 461 U.S. 677 (1983).

In most states, if the individual, against whose property a federal tax lien attaches, dies before any of the other joint tenants, then the lien ceases to attach to the property. However, if the same individual is the last survivor of the joint tenants, the tax lien then attaches to the entire property. In a few states, however, this is not the rule. Wisconsin is an exception to the general rule: if the federal tax lien has attached to the interest of one joint tenant who then dies, the surviving joint tenant takes the property encumbered with the federal tax lien. United States v. Librizzi , 108 F.3d 136 (7th Cir. 1997). Connecticut is also an exception to the general rule. Conn. Gen. Stat. 47-14f. See also Paternoster v. United States, 640 F.Supp.2d 983 (S.D. Ohio 2009). Accordingly, state law should always be consulted to determine whether there is an exception to the general rule.

Tenancy in Common

A tenancy in common is like a joint tenancy in that it creates an undivided interest in property. However, it is different from a joint tenancy in two important aspects:

First, the interest of a tenant in common may be transferred to a third party without destroying the tenancy in common.
Second, there is no right of survivorship in a tenancy in common.

Applying the above rules to collection, the Service may levy and sell a taxpayer’s interest in a tenancy in common. Alternatively, the Service may ask a court to foreclose the federal tax lien and sell the entire property, although the non-liable tenant in common must be compensated from the sale proceeds. Also, if a tax lien attaches to one tenant’s interest, it will survive the taxpayer’s death and continue to encumber the property in the hands of heirs or legatees.

Tenancy by the Entirety

Only spouses can hold property in a tenancy by the entirety. A tenancy by the entirety is similar to a joint tenancy in having a right of survivorship. But the tenancy by the entirety has a restriction not found with a joint tenancy: one spouse cannot transfer his or her interest without the consent of the other spouse. See Obergefell v. Hodges , 135 S. Ct. 2584 (2015). Some states permit real and personal property to be held as a tenancy by the entirety while others only permit real property to be held in such manner.

For many years there was uncertainty as to whether a federal tax lien could attach to the interest of only one tenant. (If both spouses were liable, the general rule was that a federal tax lien could attach to the tenancy by the entirety.) In United States v. Craft, 535 U.S. 274 (2002), the Supreme Court provided a clear answer, holding that the federal tax lien may attach to the tenancy by the entirety when only one spouse had a federal tax liability. Notice 2003-60, 2003-39 I.R.B. 643 addressed the application of Craft to different situations. In summary, the Notice stated the following:

The federal tax lien attaches to all the property and rights to property of the taxpayer. The Court’s decision confirms that a taxpayer’s property and rights to property have always included any rights that the taxpayer may have in entireties property under state law. The Court’s decision, therefore, does not represent new law and does not affect other law applicable to federal tax liens and federal tax collection. For example, theCraft decision does not change any limitation on the ability of the Service to rescind an accepted offer in compromise or terminate an accepted installment agreement.
As a matter of administrative policy, the Service will, under certain circumstances, not applyCraft, with respect to certain interests created before Craft, to the detriment of third parties who may have reasonably relied on the belief that state law prevents the attachment of the federal tax lien.
The administrative sale of entireties property subject to the federal tax lien presents practical problems that limit the usefulness of the Service’s seizure and sale procedures. Levying on cash and cash equivalents held as entireties property is considerably less problematic and will be used by the Service in appropriate cases.
Because of the potential adverse consequences to the non-liable spouse of the taxpayer, the use of lien foreclosure for entireties property subject to the federal tax lien will be determined on a case-by-case basis.See United States v. Rodgers, 461 U.S. 677 (1983) (IRC § 7403 authorizes foreclosure sale of entire jointly-owned property for separate tax liability of one spouse, but non-liable spouse is entitled to compensation from sale proceeds for loss of her share of the property).
As a general rule, the value of the taxpayer’s interest in entireties property will be deemed to be one-half.Accord Popky v. United States, 419 F.3d 242, 245 (3d Cir. 2005); United States v. Barr, 617 F.3d 370, 373 (6th Cir. 2010), denied, 131 S. Ct. 1678 (2011). Butsee Pletz v. United States, 221 F.3d 1114, 1117-18 (9th Cir. 2000) (using actuarial tables). Craft declined to address the valuation of each spouse’s individual interest in the property. 535 U.S. at 289.
Where there has been a sale or other transfer of entireties property subject to the federal tax lien that does not provide for the discharge of the lien, whether the transfer is to the non-liable spouse or a third party, the lien thereafter encumbers a one-half interest in the property held by the transferee.

Equitable Conversion

Some states recognize the doctrine of equitable conversion, which provides that a purchaser acquires equitable title to property when the unrecorded contract for sale is executed. Although the seller retains bare legal title to the property, the seller’s equity interest is in the right to the balance of the purchase money. The seller holds legal title in trust for the purchaser.

Some states extend the doctrine of equitable conversion to a lender who secures the interest with a mortgage or deed of trust.

Personal Property

Personal property is defined generally as everything that can be owned that is not real property. Tangible property is defined generally as personal property that has physical form and is moveable.

The Service takes collection action against a variety of types of personal property, including automobiles, trucks, boats, goods, bank accounts, wages and benefits, interests in trusts, and partnership interests.

Cash and Rights to Cash

The federal tax lien attaches to a taxpayer’s interest in a bank account, even when the bank account is in the joint names of the taxpayer and others. United States v. National Bank of Commerce, 472 U.S. 713 (1985). This means that the lien reaches a taxpayer’s unqualified right to withdraw all of the money in the account without the consent of the other account holder. However, the right of a taxpayer joint depositor to withdraw funds from a joint bank account is provisional and subject to a later claim by a co-depositor that the money in fact belongs to him or her.

The federal tax lien attaches to a taxpayer’s wages as the wages become his property and rights to property. State laws shielding some portion of a debtor’s wages from collection do not apply to the Service, as the collection of federal taxes is a matter of federal supremacy.

In many situations, the Service loses its federal tax lien on money when a third party acquires the money in exchange for fair value. This occurs under IRC § 6323(b)(1)(A), which provides a superpriority for a purchaser of a security if the purchaser has no actual knowledge of the federal tax lien. Treas. Reg. § 301.6323(h)-1(d) defines a security to include negotiable instruments and money.

Partnership and Other Joint Interests

It is often difficult to determine a partner-taxpayer’s interest in a partnership or other joint interest to which a federal tax lien has attached. Generally speaking, a partner-taxpayer’s interest in either a partnership or a joint venture is only a share in the equity in the assets; that is, the excess of assets over liabilities. United States v. Kaufman, 267 U.S. 408 (1925). Note that a partnership may own both real and personal property in the name of the partnership. If a federal tax lien exists on the partner-taxpayer’s property, the federal tax lien would not attach to the partnership’s property. See Rev. Rul. 73-24, 1973-1 C.B. 602 (addressing whether partnership account is subject to levy to satisfy tax liability of individual partner).

Frequent and regular partnership “draws” which are advances or loans on annual profits are subject to a lien (and may be levied as salary or wages). United States v. Moskowitz, Passman & Edelman, 603 F.3d 162 (2d Cir 2010).

Another issue that arises with respect to partnerships is whether the federal tax lien attaches to a general partner’s individual property in connection with an assessment made against the partnership for a partnership tax liability. In United States v. Galletti, 541 U.S. 114 (2004), the Supreme Court held that a timely assessment of a partnership’s employment tax liability permits the Service to collect the liability from the individual partners. Because the partners are derivatively liable for the taxes under state law, the assessment and notice and demand upon the partnership gave rise to the federal lien both on partnership and partner property.

Trusts and Beneficial Interests

A trust is a state-law created entity where one party holds property for the benefit of another. The following are terms generally used in connection with trusts:

The creator of the trust is referred to as the “grantor” or “settlor.”
The property held by the trust is called the “res,” “corpus,” “principal” or “remainder.” Income generated by the corpus is called income.
The person holding the property for the benefit of the other person is called the “trustee” or “fiduciary.”
The person benefitting from the trust is called the “beneficiary.” A beneficiary may only be entitled to income, principal or both, depending on the provisions of the trust.
A “revocable” trust is one where under the terms of the trust, the grantor/settlor reserves the right to dissolve the trust and take the property back.
An “irrevocable” trust is one that the grantor/settlor cannot dissolve and cannot take the property back.

If the taxpayer is the grantor or settlor of a trust, the validity of the trust must be determined under applicable state law. If the grantor reserves a substantial interest or unrestricted control over the management of the operations that is not for the benefit of the purported beneficiary, the grantor remains the owner of the property and the trust will be ignored. For example, property in a family trust that is a sham – the grantors attempt to reduce their taxes by putting the property in trust, while retaining the use and benefits of the property – is subject to collection action to satisfy the grantors‘ liability. Whitesel Family Estate v. United States, 84-2 U.S. Tax Cas. (CCH) ¶ 9890 (S.D. Ohio 1984); Edwards Family Trust v. United States, 572 F. Supp. 22 (D. N.M. 1983).

If the taxpayer is the beneficiary of a trust, a federal tax lien will attach to the taxpayer’s beneficial interest in the trust. This determination is made by reference to the trust instrument itself, with the appropriate state law governing construction of the terms of the instrument or the resolution of any ambiguities in the instrument. In some cases the lien will attach to the corpus of the trust and the income payable to the beneficiary. In other cases the lien will attach only to the income as it becomes payable to the beneficiary, and in a few cases it may not attach to either the income or the corpus. The latter situation may arise where the trustee has the unrestricted power of disposition of the trust income; i.e., where he/she may legally refuse to make any further distribution to the taxpayer-beneficiary and instead make the distribution to other beneficiaries or simply accumulate the income.

The trust instrument can only determine the property right of the beneficiary (e.g., the taxpayer) in the trust corpus and income; the trust instrument itself cannot determine the effect of the federal tax lien upon that right. Thus, a so-called “spendthrift” trust may by its terms confer certain specific benefits upon a beneficiary and then purport to restrict the rights of creditors to reach those benefits. Such restrictions are not effective to remove those benefits from the reach of the federal tax lien, regardless of whether under the appropriate state law a “spendthrift” trust is regarded as valid in all respects. Bank One Ohio Trust Co. v. United States, 80 F.3d 173 (6th Cir. 1996).

Because the validity of a trust and the taxpayer’s rights to trust property are highly dependent upon the particular facts of the case, the terms of the trust agreement, and applicable state law, Area Counsel should be consulted whenever these issues arise.

Intangible Property

Intangible property is personal property which lacks a physical existence but is represented by physical evidence. Items in this category include certificates of stock, bonds, promissory notes, licenses, goodwill, debts owed to the taxpayer, patents, copyrights, trademarks, franchises and “choses in action.”

A chose in action is a personal right not reduced to possession and recoverable by a suit at law. A plaintiff’s cause of action in tort or contract against a defendant is an example of a chose in action. United States v. Stonehill, 83 F.3d 1156 (9th Cir. 1996), cert. denied, 519 U.S. 992 (1996).

Exempt Property

State laws exempting a debtor’s property from creditors do not affect the reach of the federal tax lien. United States v. Bess, 357 U.S. 51 (1958); Commissioner v. Stern, 357 U.S. 39 (1958). Similarly, while state law may prevent a beneficiary of a spendthrift trust from transferring his or her interest to third parties, the beneficiary’s interest remains property subject to the federal tax lien.

Terminable Interests

Terminable interests are interests that a taxpayer may have that, by definition, terminate upon the death of the party holding the interest. These may include a life estate in property, or a contract right that will terminate at some time ( e.g., an option).

The federal tax lien may attach to such an interest before it terminates. However, once the interest terminates, the federal tax lien on that interest also terminates. United States v. Swan, 467 F.3d 655 (7th Cir. 2006); Rev. Rul. 54-154, 1954-1 C.B. 277.

Similarly, in the case of a life estate, the federal tax lien clearly attaches to the life tenant’s interest and may be enforced against that interest so long as the life tenant lives. However, upon the death of the life tenant, the lien ceases to attach to the property since the Government’s tax lien rights do not exceed the taxpayer’s right to the property.

Property in the Custody of a Court

When a taxpayer’s property is within the jurisdiction of and under the control of a state or federal court, such property is referred to as being in “custodia legis.” This is a judicial doctrine. In most situations, courts recognize that a lien may attach to property held in the court’s custody. See Dragstrem v. Obermeyer 549 F.2d 20 (7th Cir. 1977).

There may be situations, however, when the federal tax lien will not attach to property held in the court’s custody. For example, if an assessment has not been made prior to the transfer of the taxpayer’s property to a state court receiver and the taxpayer has no property interest or rights to property after the transfer, then the federal tax lien will not attach to the property held by the receiver.

Each state decides whether the taxpayer is divested of his interest upon the transfer.

The fact that the Government may not have a lien on property in custodia legis does not prevent the Government from collecting the tax liability in the judicial proceeding that administers the property. The tax lien will attach to any property of the taxpayer not in the custody of the court and will attach to any property returned to the taxpayer upon termination of the court proceedings, such property being in the nature of after-acquired property.

In bankruptcy cases, the discharge of the debtor-taxpayer from a tax liability may prevent the tax lien from attaching to after-acquired property.

Property Held By Third Parties

Attempting to avoid the imminent attachment of the federal tax lien, taxpayers have transferred their assets to legal entities that they or their friends or relatives control. However, the federal tax lien extends to property held by a third party if that third party is either the alter ego or the nominee of the taxpayer. Attempts to improperly use an alter ego or nominee may be factors that increase the risk of criminal exposure. The factors that are relevant in determining whether such a situation exists are similar to the factors which are used in deciding whether a taxpayer has fraudulently conveyed property to keep it from the reach of creditors.

This section outlines some of the most significant elements in determining whether the federal tax lien attaches to property held by a taxpayer’s alter ego or nominee. Note that these two doctrines are legally distinct. Oxford Capital Corp. v. United States, 211 F.3d 280 (5th Cir. 2000).

“Alter egos” connote legally distinct entities which are so intermixed that their affairs (and assets) are not readily separable.
“Nominees” connote readily separable persons or entities, with one holding certain specific property for the exclusive use and enjoyment of the other.

The terms often interchange or overlap, but “alter egos” are usually corporate and business entities controlled by the taxpayer, whereas “nominees” are usually individuals who clearly have a separate physical identity.

Alter Ego

Alter ego essentially means a “second self.” It is a doctrine that allows the law to disregard an entity’s separate legal identity in order to extend liability and prevent abuse. Using an alter ego theory, if an individual is the alter ego of a corporate taxpayer or other legally distinct entity, then that individual’s assets may be used to satisfy the debts of the corporate taxpayer. This is sometimes called “piercing the corporate veil.”

Similarly, if a corporation or other legally distinct entity is the alter ego of a taxpayer, then the assets of that entity may be used to satisfy the debts of the individual taxpayer. This is sometimes called “reverse piercing of the corporate veil.”

An alter ego generally involves a sham corporation used to avoid legal obligations. To establish an alter ego, such that an alter ego Notice of Federal Tax Lien may be filed, it must be shown that the shareholders disregarded the corporate entity and made it an instrumentality for the transactions of their own affairs.

The IRS’s position is that federal common law, rather than state law, governs alter ego status. See Chief Counsel Notice CC-2012-002 (Dec. 2, 2011).

No one factor determines whether an alter ego situation is present, but a number of factors taken together may. The following list is neither exhaustive nor exclusive, but alter ego situations typically involve one or more of the following:

Commingling of corporate and personal finances and use of corporate funds to pay personal expenses.
Unsecured interest-free loans between the corporation and the shareholder.
The taxpayer is a shareholder, director, or officer of the corporation, or otherwise exerts substantial control over the corporation.
The corporation is undercapitalized relative to its reasonable anticipated risks of business.
A failure to observe corporate formalities, e.g. issuance of stock, payment of dividends, director and shareholder meetings, or the maintenance of corporate records.
A failure to disregard the corporate fiction presents an element of injustice or “fundamental unfairness.”

In an alter ego case, a special condition NFTL is used, identifying, in the name line of the NFTL before the taxpayer’s name, the third party as the alter ego. For example, if the taxpayer is TP, and ABC Inc. is TP’s alter ego, then the NFTL name line would read “ABC, Inc., as Alter Ego of TP.”

Generally, the IRS will not assert an alter ego in transactions involving only individuals.

Nominee

A “nominee” is someone designated to act for another. As used in the federal tax lien context, a nominee is generally a third-party individual who holds legal title to property of a taxpayer while the taxpayer enjoys full use and benefit of that property. In other words, the federal tax lien extends to property “actually” owned by the taxpayer even though a third party holds “legal” title to the property as nominee. Generally speaking, the third party in a nominee situation will be either another individual or a trust.

A nominee situation generally involves a fraudulent conveyance or transfer of a taxpayer’s property to avoid legal obligations. To establish a nominee lien situation, it must be shown that while a third party may have legal title to the property, it is really the taxpayer that owns the property and who enjoys its full use and benefit.

No one factor determines whether a nominee situation is present, but a number of factors taken together may. The following list is neither exhaustive nor exclusive, but nominee situations typically involve one or more of the following:

The taxpayer previously owned the property.
The nominee paid little or no consideration for the property.
The taxpayer retains possession or control of the property.
The taxpayer continues to use and enjoy the property conveyed just as the taxpayer had before such conveyance.
The taxpayer pays all or most of the expenses of the property.
The conveyance was for tax avoidance purposes.

The Service’s NFTL in a nominee situation is identical to the standard NFTL, except that the nominee is identified as the name of the taxpayer. For example, if the taxpayer is TP, and My Brother-In-Law or My Trust is TP’s nominee, then the name of the taxpayer on the nominee NFTL would be “My Brother-In-Law or My Trust, Nominee of TP.”

Unlike the alter ego situation, nominee situations usually involve specific pieces of a taxpayer’s property that were conveyed to the nominee. Since the federal tax lien only attaches to property actually “owned” by the taxpayer, it may not reach all property that is, in fact, actually owned by the nominee. Therefore, the NFTL in a nominee situation will usually contain a notation on its face that the lien is filed to attach specifically to certain identified property. This property must be specifically identified and described in the NFTL.

In the nominee lien context, courts have recognized that the language of section 6321 “is broad and reveals on its face that Congress meant to reach every interest in property that a taxpayer might have.” United States v. Natl. Bank of Commerce, 472 U.S. 713, 719-720 [56 AFTR 2d 85-5210] (1985); see also Drye v. United States, 528 U.S. 49, 56 [84 AFTR 2d 99-7160] (1999). Among the property interests reached by section 6321 is an equitable interest owned by or for the benefit of a taxpayer in property titled in the name of a nominee. G.M. Leasing Corp. v. United States, 429 U.S. 338, 350-351 [39 AFTR 2d 77-475] (1977); United States v. Miller Bros. Constr. Co., 505 F.2d 1031 [34 AFTR 2d 74- 6241] (10th Cir. 1974). Section 6321 authorizes the Government, among other things, to file a nominee NFTL against property of a taxpayer in the hands of an alter ego or nominee. G.M. Leasing Corp. v. United States, supra at 351.

A nominee NFTL lien may be used whenever legal title to property is held by a third party but equitable ownership, in whole or in part, resides with the taxpayer. G.M. Leasing Corp. v. United States, supra. It enables the Commissioner to perfect a lien under section 6323 on property in which a taxpayer has an interest that is titled in the name of a third party. Id.; see also Drye v. United States, 528 U.S. 49 [84 AFTR 2d 99-7160] (1999) (holding that a disclaimer by the sole heir of an intestate decedent did not prevent a Federal tax lien with regard to the heir’s unpaid tax liabilities from attaching to his inheritance); Wilkinson v. United States, 770 F. Supp. 1085 (W.D.N.C. 1991); United States v. Drexler, 60 AFTR 2d 87-5091 [60 AFTR 2d 87- 5091], 87-2 USTC par. 9493 [60 AFTR 2d 87-5091] (E.D. Okla. 1985).

Disclaimers and Renunciations

State laws generally provide that a recipient does not have to accept a gift or transfer. Such transfers are generally inheritances, devises, bequests, gifts, and marital interests upon divorce or death of a spouse. To avoid the transfer, state law allows the recipient to “disclaim” or “disavow” or “renounce” such transfers. Typically, the operation of state law can create a legal fiction that the recipient of such transfers never received the property in question by retroactively treating the disclaimer as having occurred prior to the receipt of the property.

The issue is whether a taxpayer-recipient’s disclaimer will prevent the federal tax lien from attaching to the property. In Drye v. United States, 528 U.S. 49 (1999), the Supreme Court held that such a disclaimer will not prevent a federal tax lien from attaching to the property. Similarly, even though a spouse’s renunciation of a marital interest may be treated as retroactive under state law, that state-law disclaimer does not determine the spouse’s liability for federal tax on her share of community income realized before the renunciation. United States v. Mitchell, 403 U.S. 190 (1971).

“Retroactive” or “relation-back” state laws also do not prevent a federal tax lien from attaching to property. Treas. Reg. § 301.6323(h)-1(a)(2)(B); Brent v. Commissioner, 630 F.2d 356 (5th Cir. 1980); Daine v. Commissioner, 168 F.2d 449 (2nd Cir. 1948); Eisenberg v. Commissioner, 161 F.2d 506 (3d Cir. 1947), cert. denied, 332 U.S. 767 (1947).

Same-sex Marriage and Legally-Recognized Relationships

The recognition of same-sex marriage and the creation of formal relationships other than marriage may give taxpayers property rights they previously did not have. Federal tax liens will attach to these property rights and the Service will be able to levy on these rights. Some states allow opposite and same-sex couples to enter into other formal, legal relationships that confer rights and benefits similar to those provided by marriage. These relationships include civil unions, registered domestic partnerships, reciprocal beneficiaries, and designated beneficiaries. Among the rights conferred on members of the state-created legal relationships are:

1.	Inheritance rights. Upon the death of one spouse or member of a legally-recognized relationship, the survivor may be entitled to inherit certain property under the state’s intestacy law. Alternatively, the surviving member may have a right to property as a beneficiary under the decedent’s will. Instead of taking under a will, or in the event of unjustifiable disinheritance or omission from the will, the survivor may be entitled to claim an elective share.
2.	Community property rights.
3.	Tenancy by the entirety.
4.	Tort claims. A member of a legally-recognized relationship may have the right to bring a cause of action in connection with the death or injury of the other member of the legally-recognized relationship. A federal tax lien attaches to tort claims. United States v. Hubbell, 323 F.2d 197 (5th Cir. 1963).
5.	Insurable interest. A member of a legally-recognized relationship may have an insurable interest in the life of the other member of the legally-recognized relationship. A delinquent taxpayer in one of these legally-recognized relationships may be the beneficiary under an insurance policy upon the death or disability of the other member.
6.	Retirement plans. A liable taxpayer may be entitled to receive survivor benefits or the balance of a retirement account from a retirement plan in which his or her deceased spouse or member of a legally-recognized relationship was a participant. If a liable taxpayer has been divorced, he or she may be entitled to benefits or the account balance from a retirement plan in which his or her divorced spouse or member of a legally-recognized relationship is or was a participant.
	a.	ERISA-qualified plans. The Employment Retirement Income Security Act (ERISA) governs most retirement plans and if ERISA-qualified, state law rules do not apply. For a defined benefit plan (plan funded by an employer that pays participants a specific monthly benefit at retirement), the surviving spouse of participant is eligible for a monthly benefit unless the participant and spouse elect against it. For a defined contribution plan (e.g., 401(k), IRA, profit-sharing plan), a spouse is entitled to the balance of the account unless the participant and spouse elect against it. In the absence of a spouse, the named beneficiary may be a registered domestic partner or member of another legally-recognized relationship.
	b.	Non-ERISA plans. Governmental plans, many church plans and section 403(b) plans are not covered by ERISA. These plans may provide for survivor benefits for a spouse or member of a legally-recognized relationship upon the death of the participant.

Priority of Tax Liens: Specially Protected Competing Interests

After notice and demand for payment, the federal tax lien arises and relates back to the assessment date. Congress recognized that it was difficult to conduct business when creditors were unaware of the Service’s assessment lien. Consequently, Congress enacted the forerunner of IRC § 6323(a) to provide that a NFTL must be filed in order to have priority over certain creditors. Today, IRC § 6323(a) provides, in part, that “[the] lien imposed by section 6321 shall not be valid as against any purchaser, holder of a security interest, mechanic’s lienor, or judgment lien creditor until notice thereof … has been filed …”

IRC § 6323(a) applies to the Service in a variety of situations including interpleaders and lien foreclosures. In lien priority disputes, the Service must determine which claims against the taxpayer’s property will be satisfied first, which second, and so on down the order of priority until the value of the property is exhausted. If a purchaser, holder of a security interest, mechanic’s lienor, or judgment lien creditor with a claim to the taxpayer’s property perfects its claim prior to the filing of a NFTL, then that claim is entitled to priority over the tax lien.

The parties listed in IRC § 6323(a) are protected against unfiled NFTLs, notwithstanding actual knowledge of the statutory assessment lien. Rev. Rul. 2003-108, 2003-2 C.B. 963.

Purchasers

If a NFTL has not been filed prior to the sale of a taxpayer’s property, a purchaser takes the property free of the federal tax lien. IRC § 6323(a).

A purchaser is a person who, for adequate and full consideration in money or money’s worth, acquires an interest (other than a lien or security interest) in property which is valid under local law as against subsequent purchasers without actual notice. IRC § 6323(h)(6).

A purchaser must acquire the property pursuant to a sale. The amount paid must bear some reasonable relationship to the value of the property acquired. However, this requirement of full and adequate consideration does not preclude a bona fide bargain purchase or a purchaser who has not completed performance of his/her obligation, such as the completion of installment payments.

A purchaser is also one who has acquired a lease of property, an executory contract to purchase or lease property, one who has an option to purchase or lease property or an interest in it, or one who has an option to renew or extend a lease on property, if the interest acquired is not a lien or security interest.

Some states recognize the doctrine of equitable conversion, which provides that a purchaser acquires equitable title to property when the unrecorded contract for sale is executed. Equitable conversion is only relevant where the contract for sale is executed before the NFTL is filed but recordation occurs after the NFTL is filed or not at all. Even in states that recognize equitable conversion, the purchaser will not take the property free of the federal tax lien unless they qualify as a “purchaser” under IRC 6323(h)(6). Ruggerio v. United States, 2005-2 USTC ¶ 50,645 (4th Cir. 2005), cert. denied, 549 U.S. 811 (2006). In Ruggerio, which is a Maryland case, an assessment lien attached to the taxpayer-seller’s real property. Subsequently, the taxpayer-seller contracted to convey the real property to buyer. The Service filed a NFTL before the closing date on the real property. The Fourth Circuit held that buyer took the real property with the federal tax lien attached to it, because the Service filed a NFTL before the buyer qualified as a purchaser under IRC § 6323(a).

State Law Guides contain information on equitable conversion and its impact on the priority of the federal tax lien in relation to purchasers.

Judgment Lien Creditor

If a NFTL has not been filed prior to a creditor perfecting a judgment lien, the judgment lien has priority over the federal tax lien. In order to be a judgment lien creditor, the creditor must obtain a valid judgment in a court of record and of competent jurisdiction for the recovery of specifically designated property or for a certain sum of money. Treas. Reg. § 301.6323(h)-1(g).

In the case of a judgment for the recovery of a certain sum of money, a claimant must have a perfected lien on the property involved. This requires:

the identity of the lienor,
the property subject to the lien, and
the amount of the lien be established.

If state law requires a recording of the judgment before there is a lien on the real property good against third parties, the creditor does not qualify as a judgment lien creditor until that recordation date. If state law requires a levy or seizure of personal property before there is a lien on the personal property that is good against third parties, then there must be a levy or seizure of the personal property before the notice of federal tax lien is filed in order for a judgment lien creditor to have priority.

Mechanic’s Lienor

If a NFTL has not been filed prior to a creditor perfecting a mechanic’s lien, the mechanic’s lien has priority over the federal tax lien.

IRC § 6323(h)(2) defines a mechanic’s lienor as a person who, under local law, has a lien on real property (or on the proceeds of a contract relating to real property) for services, labor or materials furnished in connection with the construction or improvement of the property.

For priority purposes, the lien arises on the earliest date such lien becomes valid under local law against subsequent purchasers of the property without actual notice of the tax lien but not before the mechanic begins to furnish the services, labor or materials. Thus a mechanic’s lienor, who takes all of the requisite action under local law to perfect and enforce such lien, has a mechanic’s lien from a date no earlier than the day on which the mechanic began to furnish the services, labor or materials on the job to which the lien relates.

Holder of a Security Interest

If a NFTL has not been filed prior to a creditor perfecting a security interest, the security interest has a priority over the federal tax lien. IRC § 6323(h)(1) defines a security interest as any interest acquired by written contract for the purpose of security (payment, performance, indemnity) in existing property for which the holder paid money or money’s worth and which has priority under local law over subsequent judgment liens arising out of unsecured obligations.

If a federal tax lien is invalid against an initial holder of a security interest, it is also invalid against another party that acquires the security interest, whether by purchase or otherwise.

A security interest must be in existence to prime a federal tax lien. A security interest exists at any time –

if, at such time the property is in existence and the security interest has become protected under local law against a subsequent judgment lien and
to the extent that, at such time, the holder has parted with money or money’s worth. See Treas. Reg. § 301.6323(h)-1(a)(1).

Thus, where a creditor fails to perfect its security interest as required by the Uniform Commercial Code, the federal tax lien will attach to the property and will be entitled to priority over the creditor. United States v. Trigg, 465 F. 2d 1264 (8th Cir. 1972), cert. denied sub nom. First State Bank of Crossett, Arkansas v. United States, 410 U.S. 909 (1973).

Local law distinguishes real property from personal property. This is important because the actions required under local law to establish the priority of the security interest against a subsequent judgment lien may differ depending on whether the property involved is real or personal property.

State law permitting relation back to perfect a state lien cannot affect the priority of the lien. Treas. Reg. § 301.6323(h)-1(a)(2)(B).

In some states, equitable conversion provides a lender priority over a NFTL filed before the lender records. Equitable conversion is only relevant where the mortgage instrument or deed of trust is executed before the NFTL is filed, but recordation occurs after the NFTL is filed or not at all. Equitable conversion provides that a lender acquires equitable title when an unrecorded mortgage or deed of trust is executed. In some states, priority is established when the mortgage or deed of trust is executed because the lender’s equitable interest is protected under local law against a subsequent judgment lien arising out of an unsecured obligation. IRC 6323(h)(1); Susquehanna Bank v. United States, 2014-2 USTC ¶ 50492 (4th Cir. 2014). In Susquehanna Bank, the NFTL was filed after the deed of trust securing the loan was executed, but before the deed of trust was recorded. The Fourth Circuit found that the lender’s unrecorded security interests had priority over the federal tax lien, even though the NFTL had been filed, because an equitable security interest is protected under Maryland law against subsequent judgment-lien creditors.

State Law Guides contain information on equitable conversion and its impact on the priority of the federal tax lien in relation to holders of a security interest.

Superpriorities

The Internal Revenue Code provides special protection for limited interests by giving them priority over the federal tax lien even though the interests come into existence after the filing of a NFTL. IRC § 6323(b). These special interests are called “superpriorities.”

There may be some overlapping among categories of “superpriorities” in which event federal law provides protection if any category applies even though another may also be relevant. Should two categories of “superpriorities” apply to an interest, then the Service should use that category which gives the greatest protection to the private interest.

Securities

This “superpriority” protects the purchaser or the holder of a security interest in a “security” who at the time of purchase or at the time the security interest came into existence did not have actual notice or knowledge of the existence of the federal tax lien. IRC § 6323(b)(1). The Code defines securities to include money, stock, bonds, debentures, notes, negotiable instruments, and various other types of interests. IRC § 6323(h)(4).

A subsequent holder of a security interest is also protected if the prior holder did not have actual notice or knowledge at the time the security interest came into existence.

Motor Vehicles

This “superpriority” protects the purchaser of a motor vehicle if, at the time of purchase—

the purchaser did not have actual notice or knowledge of the existence of the federal tax lien; and
before the purchaser has actual notice or knowledge, the purchaser has actual possession of the motor vehicle and has not thereafter relinquished actual possession to the seller or his/her agent. IRC § 6323(b)(2).

Personal Property Purchased at Retail

This “superpriority” protects the purchaser of tangible personal property purchased at a retail sale unless at the time of purchase the purchaser intends the purchase to (or knows the purchase will) hinder, evade or defeat the collection of the federal tax. IRC § 6323(b)(3).

“Retail sale” means a sale made in the ordinary course of the seller’s trade or business of tangible personal property of which the seller is the owner. It includes a sale in the customary retail quantities by a seller who is going out of business but not a bulk sale or an auction sale in which goods are offered in quantities substantially greater than are customary in the ordinary course of the seller’s trade or business or an auction sale where the owner is not in the business of selling such goods. Treas. Reg. § 301.6323(b)-1(c)(2).

Personal Property Purchased in Casual Sale

This “superpriority” protects a purchaser of household goods, personal effects or other tangible personal property exempt from levy under IRC § 6334(a). It encompasses items purchased (other than for resale) in a casual sale for less than $1,590 (as of January 1, 2019). IRC § 6323(b)(4). This amount is adjusted annually for inflation. See Rev. Proc. 2018-57, 2018-49 I.R.B. 827. Rev. Proc. 2018-57, 2018-49 I.R.B. 827. These sales include “garage sales” or “tag sales.”

A casual sale is a sale not made in the ordinary course of the seller’s trade or business. Protection is afforded only if the purchaser does not have actual notice or knowledge of the existence of the federal tax lien or that the sale is one of a series of sales which means that the seller plans to dispose of, in separate transactions, substantially all of his/her household goods, personal effects and other tangible personal property. See Treas. Reg. §301.6323(b)-1(d)(2). This exception applies only to tangible personal property (e.g. household goods, personal effects, wearing apparel, firearms, furniture, etc.) as defined in Treas. Reg. § 301.6334-1.

Personal Property Subject to Possessory Lien

This “superpriority” protects someone in possession of tangible personal property subject to a lien under local law securing the reasonable price of the repair or improvement of that property. IRC § 6323(b)(5).

Thus, for example, if state law gives an automobile mechanic a lien for the repair bill and the right to retain possession of the repaired automobile as security for payment of the repair bill, and the mechanic retains continuous possession of the automobile, a federal tax lien which has attached to the automobile will not be valid to the extent of the repair bill.

Real Property Tax and Special Assessment Liens

This “superpriority” protects certain specified state and local tax liens against real property. IRC § 6323(b)(6) applies if state or local law entitles such liens to priority over security interests in such property which are prior in time, and such lien secures payment of one of the following three types of taxes or charges:

A tax of general application levied by any taxing authority based upon the value of such property. For example, real estate tax.
A special assessment imposed directly upon such property by any taxing authority, if such assessment is imposed for the purpose of defraying the cost of any public improvement. For example, sewers, streets, or sidewalks.
A charge for utilities or public services furnished to such property by the United States, a state or political subdivision thereof, or an instrumentality of any one or more of the foregoing.

If real estate taxes (whenever they accrue) are ahead of mortgages under local law, they will also be ahead of federal tax liens. The result will be the same if a special assessment lien arises after the federal tax lien is in existence. The same priorities apply in the case of charges for utilities or public services.

This superpriority category does not include other state and local tax liens arising for personal property taxes, state or local income taxes, franchise taxes, etc.

Residential Property Subject to a Mechanic’s Lien for Certain Repairs and Improvements

This “superpriority” protects lienors whose liens arise from the repair or improvement of certain real property. IRC § 6323(b)(7).

The property must be a personal residence containing not more than four dwelling units with the owner occupying one of the units and the total contract price being $7,970 or less (as of January 1, 2019). This amount is adjusted annually for inflation See Rev. Proc. 2018-57, 2018-49 I.R.B. 827. Rev. Proc. 2018-57, 2018-49 I.R.B. 827.

Attorney’s Liens

This “superpriority” protects an attorney who, under local law, holds a lien upon, or a contract enforceable with respect to, a judgment or other amount in settlement of a claim or cause of action, to the extent of reasonable compensation for obtaining the judgment or procuring the settlement, even if the attorney has actual notice or knowledge of the filing of the notice of lien. IRC § 6323(b)(8). There is a limitation upon this absolute priority that arises with respect to a judgment or amount in settlement of a claim or a cause of action against the United States, to the extent that the United States sets off such judgment or amount against any liability of the taxpayer to the United States.

Even in those cases where the attorney’s lien enjoys the priority over the federal tax lien, it is limited to reasonable compensation. Generally, reasonable compensation means the amount customarily allowed under local law for an attorney’s services for litigating or settling a similar case or administrative claim. SeeNorth Carolina Joint Underwriting Assn. v. Long, et al., 2008-1 USTC ¶ 50,183 (E.D.N.C. 2008). Nevertheless reasonable compensation shall be determined on the basis of the facts and circumstances of each individual case. The priority does not apply to an attorney’s lien which may arise from the defense of a claim or cause of action against a taxpayer, except to the extent such a lien is held upon a judgment or other amount arising from the adjudication or settlement of a counterclaim in favor of the taxpayer. See Treas. Reg. § 301-6323(b)-1(h)(1).

Certain Insurance Contracts

This “superpriority” protects an insurer in a life insurance, endowment or annuity contract with a taxpayer. IRC § 6323(b)(9).

This “superpriority” applies under the following situations:

If an insurer makes a policy loan on a life insurance policy after a notice of lien has been filed with respect to the property of the insured, the insurer is protected as against the tax lien if such insurer did not have actual notice or knowledge of the existence of the tax lien at the time the policy loan was made.
The insurer, after actual notice or knowledge of a federal tax lien, will still have priority but only with respect to advances (including contractual interest) required to be made under an agreement entered into prior to such actual notice or knowledge.
Thus, although an insurer will not have priority for policy loans made after the insurer has actual notice or knowledge that the policy is subject to a tax lien, the insurer may nevertheless continue to make automatic premium loans to maintain the contract in force and have priority over the federal tax lien with respect to such loans, if the agreement to make the automatic premium loans was entered into before the insurer had actual notice or knowledge.

Deposit Secured Loans

This “superpriority” protects certain institutions, including banks and building and loan associations with regard to a loan, if the loan is secured by an account with the bank. IRC 6323(b)(10). The following requirements apply:

The provisions of IRC § 6323(b)(10) apply to financial institutions described in IRC §§ 581 and 591.

The bank must make the loan without any actual notice or knowledge of the existence of the tax lien.
IRC § 6323(b)(10) requires that the security interest be valid under state law. Under the Uniform Commercial Code (UCC) adopted in all 50 states, a bank cannot obtain a security interest in an account if the loan is made for a consumer transaction, i.e., it is not a business loan. UCC § 9-109(d)(13) (excluding consumer loans from the scope of Article 9).

A superpriority is not a defense to a levy. Therefore, if a bank does qualify for an IRC § 6323(b)(10) superpriority, it should either:

honor the levy and seek a timely return of wrongfully levied property under IRC § 6343(b), or
the bank may promptly request the Service to release the levy.

If the bank timely proves that it has a IRC § 6323(b)(10) superpriority, the Service will generally release the levy. See Rev. Rul. 2006-42, 2006-2 C.B. 337.

Purchase Money Security Interest (PMSI)

A purchase money mortgage or security interest is defined under state law as a mortgage or security device taken to secure the performance of an obligation incurred in the purchase of real or personal property.

While the Internal Revenue Code does not give a PMSI priority status, pursuant to Rev. Rul. 68-57, 1968-1 C.B. 553, the Service recognizes that a PMSI will have priority over the Service’s NFTL if the PMSI is valid under local law.

With respect to personal property, Revised Article 9 of the Uniform Commercial Code defines the creation and perfection of a PMSI.

Creating the PMSI–Pursuant to a security agreement under UCC § 9-103, a PMSI arises when a creditor advances money or credit to enable the debtor-taxpayer to purchase goods (new tangible personal property), and the money loaned is actually used to acquire these specific goods. The newly purchased goods will serve as collateral for the loan. Generally, the PMSI arises in one of the following situations.

Seller advances credit—Buyer obtains possession of the goods, giving seller a security interest in the goods pursuant to a security agreement. Seller has not received full payment.
Bank/finance company advances money—Bank/finance company loans money to purchase goods after debtor-taxpayer signs security agreement with bank/finance company. Seller is fully paid. The burden is on the bank/finance company to prove that the money was actually used to purchase the goods.First Interstate Bank v. IRS, 930 F.2d 1521, 1526 (10th Cir. 1991). Typically, a bank/finance company meets this burden by drafting a check payable to the seller of the goods. If the bank/finance company cannot carry its burden, then it has a regular security interest, not a PMSI.

Perfecting the PMSI – In order to prime a NFTL, a creditor must perfect its PMSI. First National Bank v. Coxson, 76-1 USTC 9450 (D.N.J. 1976). This is generally not a burden for a PMSI in consumer goods: the PMSI is automatically perfected by the security agreement. There is no filing requirement. It’s an entirely different situation for a PMSI in business goods, which must be perfected within a short period from the date that the debtor-taxpayer obtains the collateral. See UCC §§ 9-317(e), 9-324(a) and (b).

Losing a PMSI in consumer goods – Some states have adopted a transformation rule for consumer goods, i.e., a creditor may lose its PMSI in consumer goods if it allows the debtor-taxpayer to refinance or consolidate its debts. The reasoning behind the rule is that the debt restructuring transforms the “old” loan to a “new” loan with a security interest encumbering the debtor-taxpayer’s old assets. The debtor-taxpayer does not acquire any new goods with the new loan. Thus, the new loan could not create a PMSI, because, by definition, a PMSI exists only if the debtor-taxpayer acquires new goods.

Example of transformation rule: Assume NFTL filed on January 2, 2006. Also assume finance company loans debtor-taxpayer funds to purchase a television for his personal use on February 2, 2006, and pursuant to the security agreement, finance company acquires a PMSI in the television. On April 1, 2006, because of debtor-taxpayer’s financial problems, finance company restructures the loan agreement, reducing monthly payments but extending the payment period. In some states, under the transformation rule, this would be a new loan agreement. The debtor-taxpayer did not use the new loan to acquire new consumer goods. Consequently, the creditor’s security interest under the new loan is only a regular security interest, not a PMSI. The PMSI from February 2, 2006 has been extinguished by the new agreement. Accordingly, in a lien priority dispute on June 1, 2006, the NFTL primes the finance company’s regular security agreement on the television.

The transformation rule does not apply to a PMSI in nonconsumer goods under UCC § 9-103(b). Instead, a different rule, the dual status rule, applies. The dual status rule preserves the original PMSI in a restructuring or refinancing for the original PMSI goods. After the restructuring or refinancing, the creditor has both a PMSI in the original goods and a regular security interest in other existing goods.

Example of dual status rule: Using the preceding example with some changes, assume that debtor-taxpayer purchases the television to entertain customers at his restaurant. In this situation, the television is not a consumer good; instead, it is business equipment. When the debtor-taxpayer restructures his loan agreement on April 1, 2006, the new security agreement gives creditor a security interest in the television as well as existing tables and chairs. In a lien priority dispute on June 1, 2006, under the dual status rule, the creditor has a PMSI in the television that primes the NFTL, but the creditor has only a general security interest in the chairs and tables. The NFTL primes the general security interest in the chairs and tables.

Identifying the PMSI property – Even if a creditor establishes that a PMSI was created, in a lien priority fight the creditor must be able to identify the original property encumbered with the PMSI or traceable to the original property. E.g., Citizens Savings Bank v. Miller, 515 N.W.2d 7 (Iowa 1994).

Protected Interests Arising from Certain Financing Agreements

In limited situations, IRC § 6323(c) and (d) provide that certain claims may prime an earlier filed NFTL and act substantially in the same manner as superpriorities.

IRC § 6323(c) has three different subsections that deal with different transactions. There are, however, prerequisites that apply to all three subsections. In order for any creditor to qualify for any of the protections in section 6323(c), the creditor must show the following:

The security interest is in “qualified property.” The definition of qualified property differs in each of the three subsections.
There is a written agreement entered into before tax lien filing, which constitutes a commercial transactions financing agreement, a real property construction or improvement financing agreement, or an obligatory disbursement agreement.
The security interest is protected under local law against a judgment lien arising, as of the time of the tax lien filing, out of an unsecured obligation.

Commercial Transactions Financing Agreements

IRC § 6323(c)(2) provides protection for commercial transactions financing agreements. Generally, these are loans to a taxpayer to operate a business. The creditor and the taxpayer, in the course of trade or business, agree that loans to the taxpayer will be secured by taxpayer’s commercial financing security. Security can include, but is not limited to, accounts receivable, mortgages on real property, and inventory. The agreement must be entered into before the NFTL is filed; however, priority will extend to commercial financing security acquired before the 46th day after the NFTL is filed and to advances made within 45 days of filing (or sooner if the creditor gains knowledge of the NFTL).

Alternatively, a commercial transactions financing agreement could be the purchase of commercial financing security, other than inventory, acquired by the taxpayer in the ordinary course of the taxpayer’s trade or business. Note that both the lender/purchaser and the debtor-taxpayer must have entered into the loan/sale within the ordinary course of business. This protection exists, however, for a limited time period. To be protected, the creditor must loan the funds or purchase the property from the taxpayer within 45 days of the filing of the NFTL, or (if earlier) before the lender or purchaser had actual notice or knowledge of the notice of lien filing.

The term “commercial financing security” is defined as (i) paper of a kind ordinarily arising in commercial transactions, (ii) accounts receivable, (iii) mortgages on real property, and (iv) inventory. General intangibles, such as patents or copyrights, are not included. IRC § 6323(c)(2)(C) . In the case of loans to the taxpayer, commercial financing security also includes inventory. Inventory consists of raw material and goods in process, as well as property held by the taxpayer primarily for sale to customers in the ordinary course of business. Treas. Reg § 301.6323(c)-1(c)(1).

Real Property Construction or Improvement Financing Agreement

IRC § 6323(c)(3) provides protection for interests arising from written real property construction or improvement financing agreements entered into before a NFTL is filed and which interests are given priority under state law against a judgment lien creditor as of the time of the filing of the NFTL. This protection applies to 3 different situations:

the owner’s construction or improvement (including demolition) of real property;
a contractor obtains financing, usually a bank loan, to construct or improve real property; or
the raising or harvesting of a farm crop or the raising of livestock or other animals.

The first subsection addresses a taxpayer’s financing and lien for construction or improvement of the taxpayer’s home or business. IRC § 6323(c)(3)(A)(i). Pursuant to such a financing agreement, the lender takes a mortgage/lien on the taxpayer’s property undergoing construction and agrees to make distributions in the future to finance the construction.

There is no 45-day rule, i.e., disbursements can be made more than 45 days after the filing of the NFTL and the lender’s lien will still prime the NFTL.

Actual knowledge of the NFTL will not disqualify the lender, provided the written agreement predated the filing of the NFTL.

The second subsection addresses a contractor’s financing for a construction project. IRC § 6323(c)(3)(A)(ii).

There is no 45-day rule, i.e., disbursements can be made more than 45 days after the filing of the NFTL and the lender’s lien will still prime the NFTL.

Actual knowledge of the NFTL will not disqualify the lender, provided the written agreement predated the filing of the NFTL. In return for financing on the construction project, the lender acquires a security interest in the contract proceeds, not the real estate.

There is a difference between section 6323(c)(3)(A)(i), a financing agreement for construction on real property, and section 6323(c)(3)(A)(ii), an agreement to finance a construction contract. In the former situation, the lender’s lien is on the real property undergoing construction. In the latter situation, the lender’s lien is on the proceeds of the construction contract only.

The third subsection addresses a farmer’s financing to raise or harvest a crop/livestock. There is no 45-day rule, i.e., disbursements can be made more than 45 days after the filing of the NFTL and the lender’s lien will still prime the NFTL.

Actual knowledge of the NFTL will not disqualify the lender, provided the written agreement predated the filing of the NFTL.

This subsection is relatively generous to the lender because it protects the lender’s interest in not only the crop or livestock raised, but also in any of the taxpayer’s property existing as of the filing date of the NFTL, assuming that property was listed in the security agreement.

Obligatory Disbursement Agreement

IRC § 6323(c)(4) provides protections for interests arising from an obligatory disbursement agreement, which generally requires a lender to make a payment because someone other than a taxpayer has relied on that obligation. The lender must have entered into the obligatory disbursement agreement in the course of his trade or business. A general obligatory disbursement agreement requires that on the filing date of the NFTL, the lender’s security interest must be protected against a hypothetical judgment lien creditor. Also, the taxpayer and the lender’s written agreement must provide that the lender’s duty to pay is triggered by the claim of a third party. In other words, the lender is typically paying a third party for property/services provided to the taxpayer. Under a general obligatory disbursement agreement, the protected security interest covers only two categories:

all of the taxpayer’s property as of the filing date of the NFTL and
after the filing date, any property traceable to the lender’s payment.

A letter of credit is a classic example of an obligatory disbursement agreement. A bank issues a letter of credit (a promise to pay the holder of the letter of credit) to Taxpayer. The Service then files a NFTL. Taxpayer later purchases property by giving the seller the letter of credit. The seller later presents letter of credit to the bank to obtain payment. The bank will have priority over the FTL with respect to all of Taxpayer’s property existing as of the date of the filing of the NFTL and the property purchased with the letter of credit after the filing of the NFTL.

Section 6323(c)(4) provides extra protection to surety agreements. A surety agreement is a special type of obligatory disbursement agreement: The surety agrees to perform a contract if the taxpayer fails to perform. The taxpayer and the surety must meet all of the procedural requirements imposed on a general obligatory disbursement agreement. For example, there must be a written contract; the duty to perform must be triggered by the claim of a third party; and prior to the filing of a NFTL, the security interest must be perfected against the claim of a hypothetical judgment lien creditor.

Sureties receive extra protection because section 6323(c)(4) expands the categories of collateral. Unlike a general obligatory disbursement that creates only two categories of collateral, a surety can look to four categories for collateral:

All of the taxpayer’s property as of the filing of the NFTL (similar category for general obligatory payment).
After the filing date, any of taxpayer’s property traceable to the surety’s payment (similar category for general obligatory payment).
The proceeds of the contract for which performance was insured (an additional category).
If the contract is to construct or improve real property, to produce goods, or to furnish services, any tangible personal property used by the taxpayer in performing the insured contract (an additional category).

IRC § 6323(d)

IRC § 6323(d) protects a creditor’s security interest for disbursements made within 45 days after the filing of the NFTL or before the lender acquires knowledge of the NFTL, if before the 45th day. As discussed below, section 6323(d) is similar to section 6323(c)(2) in some ways, but is different in other ways.

The section 6323(d) and section 6323(c)(2) commercial transaction financing protections are similar in that they both require the following:

Prior to the filing of the NFTL, the taxpayer and the lender must sign a written agreement that creates a security interest in the encumbered property.
As of the filing date of the NFTL, the lender’s security interest must prime a hypothetical judgment lien creditor.
After the filing of the NFTL, the lender must not have any actual knowledge of the NFTL when it makes the loan.
Such loan must be made within 45 days of the filing of the NFTL. If, within the 45 day period, the lender acquires knowledge of the NFTL before making the loan, then the 45 days is shortened to the day on which the knowledge is acquired.

Section 6323(d) and section 6323(c)(2) differ as to the types of property and the time when the taxpayer acquired the property. Specifically, section 6323(d) applies to all of the taxpayer’s property as of the date of the filing of the NFTL. In contrast, section 6323(c)(2) applies to specific property acquired by the taxpayer before the 46th day after the filing of the NFTL. Section 6323(d) applies to a larger pool of property; section 6323(c)(2) may apply to property acquired after the NFTL is filed.

Priority of Interest and Expenses

Interest and certain expenses may enjoy the same priority as the lien or security interest to which they relate. This is the case if under local law they are added to and become a part of the lien or security interest. The types of interest listed in IRC § 6323(e) are the following:

Interest or carrying charges (including finance and service charges) on the obligation secured by a lien or security interest.
Reasonable expenses of an indenture trustee (such as a trustee under a deed of trust) or agent holding a security interest.
Reasonable expenses incurred in collecting by foreclosure and enforcing a secured obligation (including reasonable attorney’s fees).
Reasonable costs of insuring, (fire and casualty insurance for instance) and preserving or repairing the property subject to the lien or security interest.
Reasonable costs of insuring payment of the obligation secured (such as mortgage insurance).
Amounts paid by the holder of a lien or security interest to satisfy another lien on the property where this other lien has priority over the federal tax lien.

An example of this last situation would be if both a security interest and a statutory lien for state sales taxes have priority over a federal tax lien. In that situation, the holder of the protected security interest may discharge the sales tax lien and increase the amount so expended, even though under local law he/she is not subrogated to the rights of the holder of the sales tax lien. However, if the holder of the security interest is, under local law, subrogated to the rights of the holder of the sales tax lien, he/she may also be entitled to any additional protection afforded by IRC § 6323(i)(2). Treas. Reg. § 301.6323(e)-1(d).

Priority of Tax Liens: The Competing Choate Lien

IRC § 6323 does not cover all of the competing lien interests that could attach to a taxpayer’s property, e.g., a state tax lien. To resolve the competing priority claims of these other interests, a court will use the choateness test, which was developed by Supreme Court case law. This test arises under federal law and applies federal rules to determine lien priority, not state rules.

The choateness test follows the general rule for resolving lien priorities: the lien that is “first in time” is “first in right.” The federal tax lien is choate as of the assessment date. (The filing of the NFTL is irrelevant under the choateness test.) However, to be considered first in time, the nonfederal lien must be “choate,” that is, sufficiently specific, when the federal lien arises. A state-created lien is not choate until the following three elements are all established:

the identity of the lienor,
the property subject to the lien, and
the amount of the lien.

United States v. City of New Britain, 347 U.S. 81 (1954). Failure to meet any one of these conditions forecloses priority over the federal lien, even if under state law the nonfederal lien was enforceable for all purposes when the federal lien arose.

In cases involving state and local tax liens, the Supreme Court has indicated that a state or local tax lien that attaches to “all property and rights to property” may be sufficiently choate so as to obtain priority over a later arising federal tax lien. United States v. State of Vermont, 377 U.S. 351 (1964). Therefore, state, county and municipal tax liens may be regarded as choate when: the identity of the lienor is known; the amount of the lien has been finally fixed; and the lien has attached to the taxpayer’s property by virtue of statute or ordinance so as to authorize enforcement by the state or local taxing authority without substantial further administrative remedy being available to the taxpayer. If the state or local tax lien meets these criteria, the rule of first in time, first in right, should then be applied to determine priorities.

Most choateness litigation arises in lien priority disputes with states. In this context, choateness is a federal law test, not a state law test. In re Priest, 712 F.2d 1326 (9th Cir. 1983), mod. 725 F.2d 477 (1984) (holding a state law ineffective which stated that a tax lien arose when the tax return was “due and payable,” or on the date the return was required to be filed). A state-created lien arises when the state takes administrative steps to fix the taxpayer’s liability – mere receipt of a tax return does not make the state tax lien choate. Minnesota v. United States, 184 F.3d 725 (8th Cir. 1999), cert. denied, 528 U.S. 1075 (2000).

Lien Priority Disputes Arranged by Topic

Assignments

An assignment is a transfer of intangible property, frequently an account receivable. An assignee, the party receiving the assigned rights, may meet the requirements of the definition of a purchaser under IRC § 6323(h)(6). Whether an assignee is a purchaser within the meaning of the above subsection is a federal question. SeeUnited States v. Gilbert Associates, 345 U.S. 361 (1953). An assignee who fails to qualify as a purchaser may try to argue that it has a security interest under IRC § 6323(h)(1).

Attachment Liens

An attachment lien, provided for under most state statutes, may arise upon the filing of a creditor’s suit and, under state law, will be taken as of the time the attaching creditor acquired a lien on the debtor’s property. This is done by the doctrine of “relation-back” which relates the subsequently acquired judgment lien back to the date of the attachment lien. This relation back doctrine does not apply to priority disputes with the federal tax lien. United States v. Security Trust and Savings Bank, 340 U.S. 47 (1950).

In cases involving the determination of priority between a federal tax lien and such an attachment lien, the attachment lien is deemed inchoate until perfected by a final judgment.

Circular Priority

Circular priority describes a situation where A’s lien is senior to the federal tax lien; the federal tax lien is senior to B’s lien; but state law makes B’s lien senior to A’s lien.

In United States v. City of New Britain, 347 U.S. 81(1954), the Supreme Court resolved the circular priority problem by providing:

first, that the portion of the fund for which federal law creates a lien superior to that of the Government’s tax lien is set aside;
second, the federal tax claim is paid; and
third, the reserved portion of the fund is distributed among competing claimants according to state law.

Today, circular priority situations generally arise in lien priority disputes with secured creditors under the UCC. Most potential circular priority issues were eliminated when the IRC § 6323(b) superpriority provisions were enacted.

Dower and Curtesy

The wife’s right of dower and the husband’s right of curtesy are limited estates in the real property of the respective spouses which some states still recognize at common law.

Many states have abolished the common law dower and curtesy in favor of a statutory right of dower in either surviving spouse as to both real and personal property.

Some states treat dower and curtesy as creating a property right as of the marriage: a spouse’s dower or curtesy interest or statutory rights cannot be defeated by the other spouse’s conveyances or alienations after the marriage or by a lien in favor of the other spouse’s creditors that becomes effective after the marriage. In these states, if the marriage occurred before the Service assesses the tax liability of one spouse, then the federal tax lien is junior to the non-liable spouse’s dower/curtesy interest. Rev. Rul. 79-399, 1979-2 C.B. 398.

Foreclosure Costs

As discussed in IRM 5.17.2.6.7, if the holder of a security interest or lien has priority over a federal tax lien, then certain expenses also will have priority, provided such expenses are “reasonable” and also would have priority under local law. IRC § 6323(e).

In effect, both direct expenses of sale, such as advertising, auctioneer’s expenses and any other necessary expenses of the sale and items of cost which are included in IRC § 6323(e), which are not normally direct expenses, will have priority over the federal tax lien if the original obligation is a lien or security interest and has priority over the tax lien.

Forfeited Property

Most states have laws providing that property used in connection with the commission of a crime shall be seized; and if the accused is convicted of the criminal charge, the property is to be forfeited. IRC § 6323(i)(3) provides that a forfeiture under local law of property seized by a law enforcement agency of a state, county, or other local governmental subdivision shall relate back to the time of the seizure, except that this paragraph shall not apply to the extent that under local law the holder of an intervening claim or interest would have priority over the interest of the state, county, or other local governmental subdivision in the property.

For example, assume that a state seizes taxpayer’s car in January 2013; the Service makes an assessment against taxpayer in February 2013, and the state obtains an order of forfeiture in August 2013. Also assume that under local law the holder of an intervening claim or interest would not have priority over the state’s interest in the car. In this situation, the forfeiture relates back to the seizure, so essentially the state owned the car as of January 2013 and the car would no longer be property of the taxpayer to which the federal tax lien would attach as of February 2013.

Home Equity Line of Credit or Open-end Mortgage

An “open-end” mortgage or home equity line of credit is different from a typical mortgage. Frequently, these mortgages provide for an initial loan at the time that the parties sign the mortgage, and the borrower has the discretion to request future advances after the mortgage is recorded.

If the Service files a NFTL and the lender makes a future advance within 45 days of the filing of the NFTL, the lender may be entitled to protection under IRC § 6323(d). Bank of America v. Fletcher, 342 F.Supp.2d 1009 (N.D. Okl. 2004).

Insurance and Insurance Loans

Section 6322 of the Code provides that the lien imposed by section 6321 of the Code upon all the property and rights to property of any person liable to pay any tax arises at the time assessment is made.

In UNITED STATES V. BESS, 357 U.S. 51 (1958), the Supreme Court held that the cash surrender value of an insurance policy was property to which a lien attached and that the lien followed the property into the hands of the beneficiary.

In the discussion of superpriorities, it was stated that a lien is not valid against life insurance, endowment or annuity contracts as against the insurer at any time before the insurer had actual notice or knowledge of the lien. Even if the company had such notice or knowledge, it could still make advances for automatic premium loans to maintain the contract if the agreement to make the advances was entered into before the insurer had actual notice or knowledge of the lien. In addition, if a levy had been served on the insurer and the levy was satisfied, the insurer would have priority for subsequent policy loans until a new notice of levy was served on the insurer.

Policy loans are those loans made to an insured by an insurance company without causing the policy to be terminated. Automatic premium loans are loans for the payment of premiums made against the cash surrender value of the insured’s policy, but which the company is required to make by the terms of the contract of insurance itself by reason of the insured’s default in premium payments.

Policy loans will prime the federal tax lien if they are made by the insurance company before the insurer has actual notice or knowledge of the existence of the federal tax lien. IRC § 6323(b)(9)(A).

Automatic premium loans will prime the federal tax lien if the agreement to make advances was entered into before the insurer had actual notice or knowledge of the lien. IRC § 6323(b)(9)(B).

If the Service serves a notice of levy on the insurer and that levy is satisfied by the insurer, then that notice of levy will not constitute a notice of a lien until the Service delivers a new notification of the lien to the insurance company. IRC § 6323(b)(9)(C). The notification may take any form but delivery will only be effective from the time the insurer actually receives the notification.

Landlord’s Liens

State law generally gives landlords and lessors a statutory lien for unpaid rents against their tenant’s or lessee’s property located on the leased premises. When a landlord’s lien competes with a federal tax lien for priority, IRC § 6323(a) generally does not apply. Instead, the priority dispute is resolved under the “choateness test.”

In the case of United States v. Scovil, 348 U.S. 218 (1955), the Supreme Court held that the landlord did not have a choate lien until the landlord recovered a judgment. Prior to obtaining a judgment, the landlord’s lien was inchoate because the amount of the secured debt was not certain, i.e., the secured debt could increase as time progressed and the secured debt could be reduced by the landlord’s breach of contract. To have priority over a federal tax lien, a landlord would have to recover a judgment and then perfect the judgment lien on the personal property prior to the NFTL filing.

Limited Liability Companies (LLCs)

An LLC is a form of business created under state law. LLCs may be either multi-member or single member. Treas. Reg. § 301.7701-3 explains the federal taxation of LLCs. If an LLC is a multi-member, the members may elect to have the LLC taxed as a corporation. If the members do not make the election, then the LLC is treated as a partnership by default. Note, however, that if under state law the members of an LLC are not liable for the debts of the LLC, generally the IRS may not collect the LLC’s federal tax liabilities from the members. Rev. Rul. 2004-41, 2004-1 C.B. 845. A single-member LLC may also elect to be taxed as an association. If the election is not made, then by default the single member LLC will be disregarded, i.e., the single-member owner is the taxpayer.

Treasury regulations affect the treatment of single-owner disregarded LLCs. See Treas. Reg. § 301.7701-3. The single-owner disregarded LLC is liable for excise taxes as of January 1, 2008; the single-owner disregarded LLC is liable for employment taxes as of January 1, 2009. Treas. Reg. §7701-2(c)(2)(iv) and (v).

Maritime Liens

The Federal Maritime Lien Act provides that any person furnishing repairs, supplies, towage or other necessaries for a vessel shall have a lien upon the vessel for payment. Maritime liens arise under 46 USC § 31342. Although the Internal Revenue Code does not provide a priority for maritime liens, courts have generally given maritime liens priority over the federal tax lien.

Maritime liens have, throughout history, enjoyed a peculiar sort of priority because of the very nature of a ship, its usage and needs, and the needs of its crew. For example, taking on provisions in a foreign port will give rise to a lien against the ship, generally entitled to seniority over any non-maritime lien against the ship, whether arising prior to or subsequent to the maritime lien.

The source of problems in this area is that federal law has created both maritime liens and the federal tax liens. Currently, the courts have generally taken the view that the maritime lien should prevail over both prior and subsequent federal tax liens, regardless of whether the Service has filed a NFTL. National Bank of North America v. S.S. Oceanic Ondine, 335 F. Supp. 71 (S.D. Tex. 1971), aff’d, 452 F.2d 1014 (5th Cir.1972); United States v. Flood, 247 F.2d 209 (1st Cir. 1957).

Mechanics’ Liens

All state statutes provide liens for laborers (mechanics) and material suppliers (materialmen) for work performed or materials supplied with respect to real property. Local law governs the method by which such liens are perfected and their duration. Generally, a mechanic’s lien must be enforced within a certain specified time or it will be lost. Generally, a mechanic’s lien attaches to the real property under construction and the proceeds of the construction contract. In determining lien priority disputes under IRC § 6323(a), one must look to the definition of mechanic’s liens in IRC § 6323(h)(2), which limits the relief provided to persons who have a lien on real property under local law for services, labor, or material furnished in construction of the real property. IRC § 6323(h)(2) also provides that a mechanic’s lien arises on the later of –

The date on which the mechanic’s lien first becomes valid under local law against subsequent purchasers of the real property without actual notice, or
The date on which the mechanic’s lienor begins to furnish the services, labor, or materials.

In addition to the above, issues may arise as to whether a payment is the taxpayer’s property. In many cases a subcontractor asserts a mechanic’s lien on construction payments in the main contractor’s possession. A main contractor may fail to pay both his federal tax liability and the subcontractors on a construction project. If the Service and the subcontractors make claims on construction payments, the first step in resolving this priority dispute is determining whether the funds in the general contractor’s possession are the general contractor’s property or rights to property. In many situations the funds will not be the property or rights to property of the general contractor because state law does not give the general contractor any interest in the funds when subcontractors have not been paid.

In two landmark cases, the United States Supreme Court annunciated the now famous “no property” rule. Aquilino v. United States, 363 U.S. 509 (1960), and United States v. Durham Lumber Company, 363 U.S. 522 (1960). The “no property” rule means that in approaching any priority determination, the first question must be: “Does the taxpayer have any property to which the lien will attach?” The fundamental thrust of this inquiry is that if there is no property interest to which the federal tax lien attaches, then there is no need to even consider the question of priorities.

In Aquilino, the Supreme Court remanded the case for a determination of whether the taxpayer-prime contractor, by virtue of a New York statute, held the funds against which the federal tax lien was asserted in trust for the payment of laborers and material suppliers.

In Durham Lumber Company, the prime contractor-taxpayer, by virtue of the law of North Carolina, was held to have no property interest in funds due from the owner except in any surplus that might remain after the payment of the subcontractors.

Miller Act Cases and Sureties

Subcontractors and suppliers who agree to provide labor and materials to a prime contractor take the risk that they will not be paid by the contractor. To protect these subcontractors and suppliers, Congress enacted the Miller Act, codified at 40 USC §§ 3131-3132 in 1935. Specifically, the Miller Act requires that the prime contractor on all federal construction projects purchase both a performance and a payment bond.

The Miller Act, however, does not set forth the priorities as between any claim of the surety and any government claim. In United States v. Munsey Trust Co, 332 U.S. 234, 239 (1947), the Court first held that the government, like any creditor, has the right to setoff amounts owed to a debtor against amounts the debtor owes to the government.

The Court also stated that if the surety completed the job, the surety would be entitled to the “retained moneys in addition to progress payments,” as otherwise a surety would rarely agree to complete a job if it knew that, by doing so, it would lose more money than if it had allowed the government to proceed. Munsey Trust, 332 U.S. at 244.

Subsequently, lower courts have cited Munsey Trust to contrast a surety’s payments made pursuant to a payment bond with payments made pursuant to a performance bond. If the surety makes a payment pursuant to a payment bond, then the government has the right to setoff. Dependable Ins. Co., Inc. v. United States, 846 F.2d 65, 67 (Fed. Cir. 1988); United States Fid. & Guar. Co. v. United States, 475 F.2d 1377, 1383 (Ct. Cl. 1973); Barrett v. United States , 367 F.2d 834 (Ct. Cl. 1966). If a surety makes a payment pursuant to a performance bond, then the government does not have the right to setoff. See Aetna Cas. & Surety Co. v. United States, 845 F.2d 971, 976 (Fed. Cir. 1988); Aetna Cas. & Surety Co. v. United States, 435 F.2d 1082 (5th Cir. 1970); Trinity Universal Ins. Co., v. United States, 382 F.2d 317, 321 (5th Cir. 1967), cert. denied, 390 U.S. 906 (1968).

Receivers

A “receiver” is a disinterested third party (similar to a trustee) appointed by a court to receive and preserve property funds in litigation. In general, in determining the priority of the federal tax lien over court appointed receivers, the threshold consideration is determining the nature of the receiver’s interest in the insolvent’s property. Of course, if the taxpayer is divested of title prior to the time the federal tax lien arises, there is no property belonging to the taxpayer in the hands of the receiver to which a federal tax lien will attach. SEC v. Levine, 881 F.2d 1165 (2d Cir. 1989). If, however, the lien arises prior to the passing of title to the receiver, the property will pass burdened with the lien.

Right of Setoff

Setoff may be defined as the discharge or reduction of one demand by an opposite one. Practically speaking, this question usually arises in the case where a bank has loaned money to a taxpayer who also is the bank’s customer. If the customer/borrower fails to meet the required loan repayments, the bank will often assert a right of setoff against any funds the customer has on deposit.

If the federal tax lien attaches to a taxpayer’s property prior to setoff, then the bank takes funds encumbered with a federal tax lien. The Government may levy on the bank to obtain the encumbered funds. United States v. Donahue Industries, Inc., 905 F.2d 1325 (9th Cir. 1990). Alternatively, the Government may file suit under IRC § 7403 to foreclose the tax lien on the property. United States v. Cache Valley Bank, 866 F.2d 1242 (10th Cir. 1989).

If the bank setoff occurs prior to creation of the assessment lien, then the tax lien will not attach to the funds because the money no longer belongs to the taxpayer.

State and Local Tax Liens

Unlike the property tax, which has a superpriority status under IRC § 6323(b)(6), a state, county, or municipal lien for taxes (e.g., sales taxes, income taxes, franchise taxes, etc.) can achieve priority over the federal tax lien only on the basis that such lien is a choate lien prior in time to the federal tax lien arising, which occurs when the federal tax liability is assessed. Then the doctrine of “first in time, first in right” is applicable. United States v. City of New Britain, 347 U.S. 81 (1954).

State and local liens may not achieve priority over a federal tax lien by being characterized by the local law as some interest in addition to a lien. Thus, the U.S. Supreme Court rejected the characterization by the New Hampshire Supreme Court of a municipal tax lien as constituting a judgment lien, thus bringing the lienor within the protection of IRC § 6323. United States v. Gilbert Associates, Inc., 345 U.S. 361 (1953).

Similarly, a state’s characterization of its lien for taxes as an expense of sale in a mortgage foreclosure action was unavailing and the federal tax lien was held entitled to priority over the subsequent liens of the state on a first in time, first in right basis. United States v. Buffalo Savings Bank, 371 U.S. 228 (1963). Also, in determining the relative priorities of federal tax liens and state and local liens for taxes, the state’s characterization of its liens as choate is not conclusive for federal tax purposes. Illinois v. Campbell, 329 U.S. 362 (1946).

The question of what constitutes “perfection” is particularly significant in this area. States vary in terms of how local tax liens are perfected. Generally speaking, state and local tax liens arise either at the time notice and demand is issued (similar to federal tax liens), or after administrative appeal procedures to contest the lien are exhausted. See Minnesota v. United States, 184 F.3d 725 (8th Cir. 1999) (holding that a state-created lien arises when the state takes administrative steps to fix the taxpayer’s liability); Monica Fuel, Inc. v. IRS, 56 F.3d 508 (3d Cir. 1995), cert. denied, 528 U.S. 1075 (2000) (holding state tax liens to be choate when the time period to administratively appeal the lien expires).

In any event, the principal inquiry in these cases is that of “perfection” of the competing state or local tax lien. If there is “nothing more to be done” in order for the state to enforce its tax lien prior to the attachment of the federal tax lien, which occurs when the federal tax liability is assessed, then the state or local tax lien will have priority. However, if the state must still take administrative action to establish a taxpayer’s liability after the federal tax lien arises, then the federal tax lien will have priority. This means that the state/local lien must be “choate” or “perfected” with respect to the property at issue prior to the time the federal tax liability is assessed.

Subrogation

The doctrine of subrogation involves the substitution of one person in the place of another with respect to a lawful claim or right. IRC § 6323(i)(2) allows creditors to argue subrogation in federal tax lien priority disputes. Specifically, IRC § 6323(i)(2) provides that where, under local law, one person is subrogated to the rights of another with respect to a lien or interest, such person shall be subrogated to such rights for purposes of any lien imposed by IRC § 6321 (relating to lien for taxes) or IRC § 6324 (relating to special liens for estate and gift taxes). In lien priority disputes, subrogation issues arise when a lien that is junior to the federal tax lien pays off a lien that is senior to the federal tax lien.

There is no universal definition of subrogation under state law. Whenever a lienor claims the right of subrogation, state law must be carefully examined to determine if such a claim meets the state definition of subrogation. Consult with Area Counsel on questions regarding applicable state law. State definitions of subrogation may differ. For example, under California law, courts (e.g., United States v. Han, 944 F.2d 526 (9th Cir. 1991)) apply a five-factor guideline for determining equitable subrogation:

Payment was made by the subrogee to protect his own interest.
The subrogee has not acted as a volunteer.
The debt paid was one for which the subrogee was not primarily liable.
The entire debt has been paid.
Subrogation would not work any injustice to the rights of others.

Note: Subordination is the act or process by which one person’s rights or claims are moved voluntarily to a position ranked below those of other claimants. This differs from the principal of subrogation, in which a creditor moves ahead of another claimant by operation of law.

Uniform Commercial Code (UCC) Security Interest

Many lien priority disputes arise between the lien as secured by the NFTL filing and UCC security interest holders. In order to determine priority, you need to understand the creation and perfection of a security interest under Revised Article 9 of the UCC.

Creation of a security interest — Under state law, attachment is the term used to describe the creation of a security interest in the debtor’s collateral. Under UCC § 9-203, attachment generally requires the following three elements:

creditor has given value to the debtor,
the debtor has rights in the collateral, and
an agreement.

The above three elements may occur in any order. Note, however, that a security interest does not exist under the UCC until all three elements have been met. The definition of a security interest in IRC § 6323(h)(1) includes similar requirements to the above three elements. In short, if a debtor fails the state definition of attachment, the creditor will also fail the IRC § 6323(h)(1) definition of a security interest.

Perfection of a financing statement — Under state law, in order to have priority against other lienors, the security interest not only must attach to the collateral but also must be perfected. UCC § 9-301 and the following sections provide that, depending on the facts and type of collateral, steps for perfection may occur under four different methods:

filing a financing statement,
taking possession of the collateral,
for some types of collateral, particularly bank accounts, exercising control over the collateral,
in limited situations, usually a purchase money security interest in consumer goods, automatic perfection exists, i.e., attachment of the security interest automatically perfects it. An example is when a store sells a television for personal use, taking a security interest in the television.

A UCC security interest must have attached and must have been perfected in order to have priority over the Service’s later filed NFTL. Do not assume, however, that a creditor’s security interest is perfected just because a financing statement has been filed. The UCC allows a creditor to file a financing statement before the security interest has attached (come into existence), and creditors frequently do so. UCC § 9-308. The Official Comments to UCC § 9-308, number 2, explain that “If the steps for perfection have been taken in advance, as when the secured party files a financing statement before giving value or before the debtor acquires rights in the collateral, then the security interest is perfected when it attaches.”

For corporations, limited liability companies, and other business entities created under state law (registered organizations) do not assume that a UCC security interest is filed at the same location where the NFTL is filed. IRC § 6323(f)(2)(B) states that the location of personal property is the taxpayer’s residence, and the residence of a corporation is the principal executive office of the business. In contrast, a UCC security interest for a debtor-corporation is filed in the state of incorporation. For example, a UCC security interest on the inventory of a corporation with a principal executive office in California, which was incorporated in Delaware, would be filed in Delaware.

Unrecorded Conveyances

Unrecorded conveyances can interact with the federal tax lien at differing points in time. The interaction could be:

After the accrual of the tax but before the tax is assessed;
After the tax is assessed and the statutory lien arises, but before a Notice of Federal Tax Lien has been filed; or
After a Notice of Federal Tax Lien has been filed.

Prior to assessment, a tax lien does not attach to property the taxpayer has conveyed to a third party through a bona fide conveyance which divests the taxpayer’s interest in the property at issue.

Even where state law provides creditors with certain rights to property if there is an unrecorded conveyance, but all of the taxpayer’s interest in the property was conveyed prior to assessment (i.e. the taxpayer retains no post-conveyance interest), the federal tax lien generally will not attach even if the conveyance is recorded after the lien arises. Filicetti v. United States, 2012-1 USTC ¶ 50,214 (D.Idaho 2012).

In cases involving the determination of priority between a federal tax lien arising after an unrecorded conveyance that extinguishes all of the taxpayer’s interest in the property at issue, generally the federal tax lien does not attach and the lien has no priority position.

The Service’s position on unrecorded conveyances is limited to any bona fide conveyance prior to the assessment and the statutory lien arising that extinguishes all of the taxpayer’s interest in the property at issue. A conveyance is not considered bona fide by the IRS if the taxpayer retains control over the property or enjoys full use and benefit. Thus, the position on unrecorded conveyances does not apply to a transfer to a nominee or alter ego prior to assessment.

Relief from the Federal Tax Lien

The law provides various mechanisms for relief from the federal tax lien.

The most common types of relief from the federal tax lien are a discharge of property from the effect of the tax lien issued by the Service, a foreclosure by a senior competing lienor, and the Service’s release of the tax lien itself.
The less common types of relief from the federal tax lien are a certificate of non-attachment, a certificate of erroneous lien, the subordination of the lien, and withdrawal of the NFTL.

The above types of relief are separate and distinct, as discussed below.

Discharge of Property From the Effect of the Tax Lien

A discharge of the property means that the federal tax lien is removed from a particular piece of property. This occurs only in limited situations listed in IRC § 6325(b). A discharge of the property should not be confused with a release of the federal tax lien. When the Service releases the federal tax lien, the underlying tax lien is extinguished on all of the taxpayer’s property.

The Internal Revenue Code provides that the Service may issue a certificate of discharge of property from the federal tax lien if one of the following conditions is met:

If the fair market value of the taxpayer’s property remaining subject to the lien after the discharge is at least double the sum of the tax liability plus all other encumbrances on that property entitled to priority over the Government’s lien. IRC § 6325(b)(1).
If the Service receives payment of an amount equal to the value of the Government’s interest in the property. IRC § 6325(b)(2)(A).
If the Service’s interest in the property has no value. IRC § 6325(b)(2)(B) .

Note: If there is a short sale, meaning the senior lienholder agrees to accept less than the full amount of its lien, the government’s lien has no value and the Service cannot require payment of a sum that would have been applied to junior real estate taxes as a condition of discharge.

4. If all or part of the taxpayer’s property is sold, and, pursuant to a written agreement with the Service, the proceeds of such sale are to be held as a fund subject to the liens and claims of the United States, in the same manner and with the same priority that such liens and claims had with respect to the discharged property. IRC § 6325(b)(3). This provision often assists in facilitating the sale of property whenever a dispute exists among competing lienors, including the Government, concerning their respective rights in the property.

5. Under IRC § 6325(b)(4), the third-party owner of this property (previously owned by the taxpayer, against which the Service has a lien and has filed an NFTL) may obtain a certificate of discharge with respect to the lien on that property. The Service shall issue such a certificate of discharge of property from the federal tax lien if the third-party owner (but, not the taxpayer) either deposits the amount of the Service’s lien interest in the property (as determined by the Service) or posts an acceptable bond for that amount. IRC § 6325(b)(4). The third party then has 120 days to file a court action to determine the value of the Service’s lien interest in the property. IRC § 7426(a)(4). If the Service determines that the taxpayer’s liability can be satisfied by other sources, or the value of the property is less than the deposit or bond, then the Service will refund the deposit (with interest) and/or release the bond. IRC § 6325(b)(4)(B). If a Court determines the value of property is less than the Service’s determination, it will order the same. IRC § 7426(b)(5). If the third party does not institute proper court proceedings within the 120 days after the Service issues the Certificate of Discharge, then the Service has 60 days within which to apply the amount deposited (or collect on the posted bond) to the amount the Service determined was secured by the lien, and refund (with interest) any remainder to the third party. IRC § 6325(b)(4)(C). See also Treas. Reg. § 301.6325-1(b)(4), for further procedures. Note that any person who co-owned the property with the taxpayer can also avail themselves of this remedy.

In all of the above situations, value means either fair market value or forced sale value in appropriate cases and includes the situation where the interest of the Government in the property sought to be discharged has no monetary value, as in the case of property subject to prior encumbrances in a greater amount than the value of the property.

A certificate of discharge is conclusive that the property covered by the certificate is discharged from the lien. IRC § 6325(f)(1)(B). However, if the taxpayer reacquires the property that has been discharged, the tax lien will again attach. IRC § 6325(f)(3).

Foreclosure by Senior Competing Lienor

When a senior lienholder sells a taxpayer’s property to enforce its lien, this “foreclosure sale” may discharge a federal tax lien in certain situations. Such foreclosure sales can be either a judicial sale (i.e., pursuant to a judicial proceeding) or a nonjudicial sale.

Discharge of Tax Lien in Nonjudicial Sale

Most controversies involving the priority of the federal tax lien involve nonjudicial sales, which are sales made pursuant to one of the following:

An instrument creating a lien on the property sold;
A confession of judgment on the obligation secured by an instrument creating a lien on the property sold; or
A statutory lien on the property sold.

Nonjudicial sales include the divestment of a taxpayer’s interest in property by operation of law, by public or private sale, by forfeiture, or by termination under provisions contained in a contract for deed, land sale contract, or conditional sales contract. Treas. Reg. § 301.7425-2(a). The key point is that a court action is not needed to enforce the creditor’s interest and to sell the property.

The first step in analyzing a nonjudicial sale is determining whether the Service filed a NFTL more than 30 days before the sale. If the Service filed more than 30 days before the sale, then notice of the proposed sale must be given to the Service by the foreclosing party in order for the sale to discharge the federal tax lien. If proper notice is not given to the Service, then the federal tax lien will remain on the property. If the Service filed a NFTL less than 30 days before the sale, then the Service is not entitled to notice of the nonjudicial sale, which will generally discharge the property from the federal tax lien. IRC § 7425(b).

If a senior lienor finds a NFTL and wishes to give notice to the Service of a pending nonjudicial sale, the Internal Revenue Code and regulations provide that notice of a nonjudicial sale shall be given in writing by registered or certified mail or by personal service, not less than 25 days prior to the date of sale, to the IRS official, office and address specified in IRS Publication 786, “Instructions for Preparing a Notice of Nonjudicial Sale of Property and Application for Consent to Sale,” or its successor publication. Treas. Reg. § 301.7425-3(a)(1)). The 25-day period is measured from the time of mailing of the notice and applies to the sale of all real and personal property except perishable goods.

When a scheduled sale for which notice has been given is postponed to a later date, the seller of the property must give notice of the postponement to the appropriate Service official in the same manner as is necessary under local law with respect to other secured creditors. Treas. Reg. § 301.7425-3(a)(2).

The date of the sale is significant in order to compute the requisite notice period that the seller has to provide the Service of any anticipated nonjudicial sale of property encumbered by the federal tax lien. Under Treas. Reg. § 301.7425-2(b), the “date of sale” for purposes of notice to the Service arises in one of the following three situations:

In the case of a public sale which divests junior liens on property, the date of the public sale is controlling.
In the case of a private sale which divests junior liens on property, the date that title to the property is transferred is controlling.
In all other cases (i.e., where there is a divestment of title or interest not resulting from a private or public sale), the date of sale is deemed to be the date on which junior liens in the property are divested under local law.

The Service has authority to consent to a sale of property free and clear of the tax lien or title of the United States in a nonjudicial sale which does not meet the standard notice requirements for such sales. If the Service consents in the manner prescribed by the regulations, then the sale will discharge or divest the property from the federal tax lien notwithstanding a defect in the original notice of sale. Treas. Reg. § 301.7425-3(b).

Special rules apply for the notice of sale requirements for perishable goods. These are set forth in Treas. Reg. § 301.7425-3(c).

Discharge of Tax Lien in Judicial Sale

A judicial sale may discharge property from a federal tax lien. 28 USC § 2410(c). Under IRC §7425(a), if the Service files a NFTL prior to commencement of the suit or civil action, the United States must be named as a party in the suit in order to discharge property from the federal tax lien. If the United States is not named as a party, the judicial sale will not discharge property from the federal tax lien. There may be situations in which the United States is not named as a party in the suit because a NFTL has not been filed prior to the filing of the suit, or the filing of a notice of lien is not provided by the IRC, such as in the case of estate or gift tax liens. In these situations, the judicial sale will discharge the federal tax lien as to the property sold.

Redemption

If either a nonjudicial sale or a judicial sale discharges real property from the federal tax lien, the Service has the right of redemption. This right enables the Service to redeem the real property from the party who purchased it at the foreclosure sale, and then sell it. For both judicial and nonjudicial sales, the Service may redeem the real property within 120 days of the date of sale or the redemption period under state law, whichever is longer. 28 USC § 2410(c) (redemption after judicial sales) and IRC § 7425(d)(1) (redemption after nonjudicial sales).

Release of Lien

There is a fundamental legal distinction between the “release” of a federal tax lien provided for by IRC § 6325(a) and the “discharge” of property from the tax lien provided for by IRC § 6325(b). The release of a lien extinguishes the federal tax lien itself. In other words, a release goes to the very existence of the federal tax lien. In contrast, a discharge will leave only a particular piece of property unencumbered by the federal tax lien.

Before the Service can issue a certificate of release, certain specified conditions must be met. IRC § 6325(a); Treas. Reg. § 301.6325-1. A certificate of release of the federal tax lien is authorized under each of the following conditions:

The amount assessed (plus interest) is paid.
The amount assessed becomes legally unenforceable.
A bond is furnished that is satisfactory in terms and sufficient in amount to secure the payment of the outstanding assessments plus interest.

If either of the first two conditions is met and a Notice of Federal Tax Lien has been filed, a certificate of release must be issued by the IRS. Pursuant to the regulations, a tax lien must be released as soon as practicable, but not later than 30 days, after the IRS Area Director has:

determined that the liability has been fully satisfied,
determined that the liability has become legally unenforceable, or
agreed to accept a bond for the release.

All NFTLs filed since December 1982 contain a self-releasing clause stating that the federal tax lien will automatically be released unless the NFTL is timely refiled. Also, the Service may file a certificate of release prior to the time a NFTL will self-release. In both situations, the release is conclusive that the tax lien referred to in the certificate is extinguished. IRC § 6325(f)(1)(A). To prevent the lien from self-releasing, the Service must refile the NFTL in every office in which a NFTL was originally filed.

If the underlying tax liability has not been satisfied or is not legally unenforceable, the taxpayer is not entitled to release of the lien. See IRC §§ 6322, 6325(a).

The effect of a release is extinguishment of the underlying statutory assessment lien. IRC § 6325(f). The release, in itself, does not extinguish the underlying liability. For example, if a release occurs due to acceptance of a bond or expiration of the collection statute, the liability remains while the assessment lien is extinguished.

Certificate of Nonattachment

The Service may issue a certificate of nonattachment of the federal tax lien if it determines that a person (other than the taxpayer) may be injured by the appearance of the Service’s NFTL. IRC § 6325(e). This situation typically arises when the name of the taxpayer is similar (or identical) to that of a taxpayer identified on a NFTL. The Service files this certificate in the same office where the Service filed the NFTL. It is conclusive that the lien of the Government does not attach to the property of the person referred to in the certificate. The Service may also revoke the certificate in the same manner as a certificate of release of lien. IRC § 6325(f)(2).

The certificate of nonattachment is not related to the discharge of property or the release of a federal tax lien. The certificate of nonattachment is used only when, as a matter of fact and law, the federal tax lien never attached to the property involved because the taxpayer did not own it. The owner of certain property may be subjected to unnecessary hardship because of a lien against a taxpayer with a similar name, thus, perhaps, constituting a cloud on the former’s title to his/her property.

Erroneously Filed NFTL

Treas. Reg. sec. 301.6326-1(b) defines an erroneously filed NFTL as one which is filed during the presence of one of the following conditions:

The tax liability was satisfied prior to the NFTL filing,
The tax liability was assessed in violation of deficiency procedures in IRC sec. 6213,
The tax liability was assessed in violation of the Bankruptcy Code, or
The statute of limitations for collection expired prior to the filing of the NFTL.

In situations where it has been determined that a NFTL was erroneously filed, a specially-worded Form 668(Z), Certificate of Release of Federal Tax Lien, and Letter 544, Letter of Apology – Erroneous Filing of Notice of Federal Tax Lien, will be issued. Pursuant to IRC sec. 6326, the release and letter should be issued within 14 days of the determination, when practical.

Subordination of the Tax Lien

Subordination is the act or process by which one person’s rights or claims are moved voluntarily to a position ranked below those of other claimants. This differs from the principle of subrogation, in which a creditor moves ahead of another claimant by operation of law. Under IRC § 6325(d), the Service may issue certificates subordinating a tax lien to another interest if:

payment is received in an amount equal to the amount with respect to which the tax lien is subordinated , or
the Service believes that the subordination of the tax lien to another interest will ultimately result in an increase in the amount realized by the United States from the property subject to the lien and will aid in the collection of the tax liability.

Subordination provides the Service with flexibility. In subordination by payment, the tax lien is being subordinated only to the extent the United States receives, on a dollar-for-dollar basis, an equivalent amount. The Government’s interest cannot be injured and a new procedure for collecting taxes is made available.

In subordination to ultimately aid in the collection of the tax, there is a risk that the subordination will decrease collection. For example, the federal tax lien could be subordinated to a mortgage that would provide funds to repair a dilapidated building. The assumption is that the real estate market will not go down and that the increased value of the building would both satisfy the mortgage and increase the overall payment of the tax liability. The assumption may be incorrect; the real estate market may go down. After the mortgage is paid, the Service may receive less revenue because of its decision to subordinate.

The Service must exercise good judgment in weighing the risks and deciding whether to subordinate the federal tax lien. The Service’s judgment is similar to the decision that an ordinarily prudent business person would make in deciding whether to subordinate his/her rights in a debtor’s property in order to secure additional long run benefits.

Withdrawal of Notice of Federal Tax Lien

There is an important distinction between “releasing” a federal tax lien and “withdrawing” a filed notice of that lien. The release of a federal tax lien extinguishes the underlying statutory assessment lien. IRC § 6325(f). Not all releases occur after the liability has been satisfied. For example, unless an NFTL is timely refiled, the federal tax lien will self-release because all NFTLs filed since December 1982 contain a self-release clause. The release does not, in itself, extinguish the underlying liability.

The Service has authority to “withdraw” a notice of federal tax lien, in certain circumstances. IRC § 6323(j)(1). The withdrawal of the NFTL only withdraws public notice of the lien; it does not extinguish the underlying liability, nor does it release the underlying federal tax lien.

The Service may withdraw a notice of federal tax lien if the appropriate official determines that one of the following four conditions is met:

The Service’s filing of the NFTL was premature or otherwise not in accordance with administrative procedures.
The taxpayer has entered into an installment agreement to satisfy the tax liability, unless the agreement provides otherwise.
The withdrawal of the NFTL will facilitate collection of the tax liability underlying the NFTL.
The withdrawal of the NFTL would be in the best interest of the taxpayer, as determined by the National Taxpayer Advocate (NTA), and in the best interest of the United States, as determined by the appropriate official.

Note: The Service needs the consent of the taxpayer or the NTA to withdraw a notice of federal tax lien as in the best interests of the United States. A withdrawal for one of the other reasons does not require consent. IRC § 6323(j)(1).

The Service must file its notice of withdrawal of the NFTL at the same office as the withdrawn notice, and must provide a copy of the withdrawal to the taxpayer. Treas. Reg. 301.6323(j)-1. In addition, if requested in writing by the taxpayer, the Service must make reasonable efforts to give notice of withdrawal of the NFTL to creditors, credit reporting agencies, and financial institutions specified by the taxpayer. IRC § 6323(j)(2).

Withdrawal of Notice of Federal Tax Lien after Lien Release

IRC 6323(j) is primarily for situations in which the federal tax lien is still in effect; however, the Service is not legally prohibited from withdrawing the lien’s notice (NFTL) after the lien has been released pursuant to IRC 6325(a). The IRS does not have general authority to withdraw a NFTL outside of the conditions of IRC 6323(j) but whether or not to grant a post-release withdrawal becomes a matter of policy.

Written requests submitted under IRC § 6323(j)(1)(A) (the Service’s filing of the NFTL was premature or otherwise not in accordance with administrative procedures) will generally be granted after lien release if the taxpayer demonstrates the original NFTL filing was improper or not otherwise in accordance with IRS procedures. A withdrawal under this provision may be issued whether a certificate of release was issued or the lien self-released.

Post-release NFTL withdrawals under IRC 6323(j)(1)(D) (best interest test) will generally be granted if the following conditions apply:

The taxpayer requests the withdrawal in writing, and
The taxpayer fully satisfied the liabilities on the NFTL.
The taxpayer is in compliance with filing requirements.

The taxpayer will be considered to be in compliance if the return was, or can be, closed for one of the following reasons:

a. Not liable for the tax period;

b. Income below the filing requirement;

c. Little or no tax due or due a refund;

d. No longer liable for filing.

Liens that self-released in error when the releases are subject to revocation do not qualify for withdrawal under these procedures.

Withdrawal of Notice of Federal Tax Lien When Direct Debit Installment Agreement (DDIA) is in Effect

A request for lien withdrawal under IRC § 6323(j)(1)(B), related to an active DDIA, will generally be approved for certain types of taxpayers if the following conditions are met:

Aggregate unpaid balances of assessment and pre-assessed taxes are $25,000 or less.
Liability will be full paid in 60 months, or prior to collection statute expiration, whichever comes first.
The withdrawal request is in writing.
The taxpayer is in compliance with all other filing and payment requirements.
At least three consecutive payments have been made and there have been no defaults in payment.
The taxpayer has no previous lien withdrawals, excluding withdrawals relating to improper NFTL filing.
If a taxpayer defaults on making payment after the NFTL is withdrawn, a new NFTL may be filed if appropriate.

Note: If a taxpayer does not meet these criteria for withdrawal, the Service must still consider the withdrawal request under the general rule allowing for withdrawal if the taxpayer enters into an installment agreement set forth at IRC 6323(j)(1)(B).

Revocation of Release of Lien and Nonattachment of Lien

If the Service made an error in releasing the federal tax lien or filing a nonattachment of tax lien, that error may be corrected if the collection period is still open. A lien may be found to have been released erroneously or improvidently when the lien self-releases because it was not timely refiled or not timely refiled in all locations where the original NFTL was filed, the Service erroneously files a certificate of release, or when an offer in compromise has been breached. The Service may correct such errors by revoking the certificate of release or nonattachment. IRC § 6325(f)(2).

Because a released lien or a lien released pursuant to self-release language in an NFTL releases the underlying statutory lien, a release in one location invalidates any notice of that statutory lien (NFTL) filed elsewhere. There is only one statutory lien but there can be multiple notices filed for that one statutory lien. The revocation reinstates the statutory lien.

The Service effects the revocation by mailing a notice of the revocation to the taxpayer’s last known address and by filing notice of the revocation in the same office(s) in which the notice of lien to which it relates was filed. If NFTLs or refiled NFTLs were filed in multiple offices, the notices of revocation must also be filed in each of those offices. Any release not cancelled by a revocation filing remains a release of the statutory lien and continues to invalidate any lien notice (NFTL) filed elsewhere.

The effective date of reinstatement will be the date by which the Service has both mailed the notice of revocation to the taxpayer and properly filed the notice of revocation. Revocation does not restore the continuity of the original tax lien from the date of assessment, and there is a gap period between the original release and the revocation of that release within which other liens may arise. Other liens arising during the gap period may have priority over the “reinstated” federal tax lien.

The reinstated lien will have the same force and effect as a general tax lien which arises upon assessment of the tax. IRC § 6321. The reinstated lien will not be in existence for a period longer than the period of limitation on collection after assessment of the tax liability to which it relates. The reinstated lien will not be valid against any holder of a lien or interest described in IRC § 6323(a) that perfected their lien or interest prior to the filing of the reinstated lien. Treas. Reg. § 301.6325-1(f)(2)(iii)(b). The Service must file a new NFTL pursuant to IRC § 6323(a) in every office where it wishes to establish priority.

If the Service seeks to issue a notice of revocation of the certificate of release during a taxpayer’s bankruptcy, it should seek relief from the automatic stay of Bankruptcy Code § 362 to avoid the question of whether the revocation of a certificate of release constitutes a prohibited creation of a new lien interest while the debtor is subject to the automatic stay.

Special Tax Liens Applicable to Estates and Gifts

The Internal Revenue Code provides for a special estate tax lien and a gift tax lien, both of which are separate and independent of the general tax lien. IRC § 6324. The estate tax lien and the gift tax lien may exist simultaneously with the general lien provided for by IRC § 6321 or they may exist independently of the general lien under IRC § 6321. The estate and gift tax liens arise automatically, unlike the general tax lien.

The Estate Tax Lien

When an individual dies, the estate tax lien automatically arises upon death for the estate tax liability. The Government does not have to take any action to create the estate tax lien. This means that the estate tax lien is in existence before the amount of the tax liability it secures is even ascertained. Detroit Bank v. United States, 317 U.S. 329 (1943).

The estate tax lien is a function of the amount of the estate tax a decedent’s estate ultimately owes. The lien attaches to the decedent’s entire “gross estate,” exclusive of property used to pay charges against the estate and administration expenses, for a period of ten years from the date of the decedent’s death. IRC § 6324(a)(1). The majority of courts have held that the ten-year estate tax lien is of absolute duration and thus, lien foreclosure must be completed before expiration of ten years. SeeUnited States v. Davis, 52 F.3d 781 (8th Cir. 1995); United States v. Cleavenger, 517 F.2d 230 (7th Cir. 1975). The Service follows this majority rule. On the other hand, an administrative levy is completed once the notice of levy is served or in the case of tangible property, when the notice of seizure is given. Thus, any suit outside the ten-year period to enforce a levy would not be barred.

The estate tax lien attaches to the “gross estate” of the decedent. The gross estate, arising under federal law, includes certain types of property not included in the probate estate. For example, property held by trusts established by the decedent many years before death may be includible in the gross estate by reason of the trust instrument reserving to the decedent certain “powers,” such as the power to revoke the trust, change beneficiaries, etc.

Under IRC § 6324(a)(2), special rules exist for property included in the “gross estate” but not passing through probate. For nonprobate property, if the estate tax is not paid when due, then the spouse, transferee, trustee, surviving tenant, person in possession, or beneficiary of the estate is generally liable for the payment of the estate tax to the extent of the value of the estate’s property held by, or passing to, such person. IRC § 6324(a)(2). This means that the estate tax lien will encumber such property in the hands of persons within the above classes without regard to any filing of notice of lien or the need for a separate assessment of tax.

If a spouse, transferee, trustee, surviving tenant, person in possession, or beneficiary of the estate transfers nonprobate property to a purchaser or holder of a security interest, then that property is divested from the estate tax lien. IRC § 6324(a)(2). The Service, however, may still collect from the spouse, transferee, trustee, surviving tenant, person in possession, or beneficiary of the estate. IRC § 6324(a)(2) provides that if a transfer of nonprobate property to a purchaser or holder of a security interest removes the estate tax lien, then a “like lien” shall attach to the transferor’s property.

The statute of limitations applicable to the personal liability established by IRC § 6324(a)(2) is not the 10-year period from the date of death set forth in IRC § 6324(a)(1); rather it is 10 years from the date the assessment is made against the estate upon the filing of the estate tax return, in accordance with IRC § 6502(a). The section 6324(a)(2) personal liability arises independently of the estate tax lien; accordingly, it may be collected within the ordinary collection period of 10 years from the date of assessment. A separate assessment against the transferees is not required. SeeEstate of Mangiardi v. Commissioner, T.C.M. 2011-24 aff’d, 442 Fed. Appx. 526 (11th Cir., October 12, 2011); United States v. Bevan, 2008 WL 5179099 (E.D. Cal. 2008); United States v. Degroft, 539 F.Supp.42 (D.Md. 1981).

If property is included in the estate under IRC § 2033 (probate assets), it is divested of the lien upon transfer to a purchaser or holder of a security interest only if the estate’s executor has been discharged from personal liability under IRC § 2204. See IRC § 6324(a)(3); United States v. Vohland, 675 F.2d 1071, 1075 (9th Cir. 1982); United States v. Estate of Young, 592 F.Supp. 1478, 1486 (E.D. Pa. 1984). See also Rev. Rul. 69-23, 1969-1 C.B. 302

As with the general tax lien, there are some exceptions to the special lien for estate taxes. IRC § 6324(c). Thus, the estate tax lien will not be valid as against a mechanic’s lienor and against the superpriorities listed under IRC § 6323(b) if the conditions set forth in that section are satisfied. In addition, if a lien or security interest has priority over the estate tax lien, interest and allowable expenses based on the lien or security interest will have priority based on state or local law. Thus, for example, if A has a valid mortgage on B’s real property, A’s priority over the special lien will include not only the amount of the mortgage debt owed but also the amount of interest and allowable expenses.

IRC § 6324A creates a special lien for estate taxes deferred under IRC § 6166. The executor of the estate makes an election under IRC § 6166 to defer payment of the estate tax for a period of up to 14 years. This period can be extended if the estate requests an extension to make a payment under the deferral election pursuant to IRC § 6161(a)(2)(B). If an estate qualifies and elects to defer the payment of estate tax pursuant to IRC § 6166, the Service must evaluate whether a bond should be required as security for deferral or whether it will require any security at all based on the facts and circumstances of each case. See IRC § 6165; Estate of Roski v. Commissioner, 128 T.C. 113 (2007); IRM 5.5.5.5. The Service’s decision to require a bond can be appealed to the Tax Court. See IRC § 7479(a). See Notice 2007-90, 2007-46 I.R.B. 1003 regarding the factors the Service will consider in deciding to require security. If the Service does require security, the estate may elect to provide an IRC § 6324A special lien in lieu of the bond.

IRC § 6324B creates a special lien for the pending additional estate tax attributable to the estate’s election to use a “special use value” for certain “qualified” property for estate tax calculations. See IRC § 2032A (valuation of farm real property and certain real property used in family business).

The Gift Tax Lien

Under IRC §6324(b), the gift tax lien comes into existence upon the making of a gift by a donor, if the donor is, in fact, liable for a tax in respect to such gift, or any other in the same taxable year. The gift tax lien, like the estate tax lien, arises automatically, and requires no action by the Service. Unless the donor files a gift tax return, there is no statute of limitations on the gift and the Service may examine the gift at any time.

The gift tax lien attaches only to the property which is the subject of the gift. It does not attach to any of the donor’s property. It may attach to the other property of the recipient of the gift in a manner similar to the way an estate tax lien may attach to other property of a decedent’s distributees or transferees. See IRM 5.17.2.9.1. This is because the recipient is made personally liable for any gift tax incurred by the donor on a gift, made during the calendar year, to the extent of the value of the property received if the tax is not paid when due.

A separate assessment against the donee is not required to make the gift tax lien enforceable against the donee’s property. Any part of the property which was the subject of the gift that is transferred by the recipient to a purchaser or holder of a security interest will be divested of the lien and, to the extent of the value of such transfer, the lien will attach to the property of the donee, including after-acquired property.

As was pointed out above, property that comprises the gift or a portion of the gift in issue, which is transferred by the recipient to a purchaser or holder of a security interest is divested of the lien. Likewise the recipient’s own property to which the lien shifts, as explained above, is in turn divested of the lien if it is transferred to a purchaser or holder of a security interest. The exceptions for superpriorities applicable to estate tax liens also apply to gift tax liens.

Note. The following provision govern tax liens:

#	Code Section	Regulation	Description
1	26 USC § 6321:	§301.6321-1	Lien for taxes
2	26 USC § 6322:	no regulation	Period of lien
3	26 USC § 6323:	§301.6323(a)-1, §301.6323(b)-1, §301.6323(c)-1, §301.6323(c)-2, §301.6323(c)-3, §301.6323(d)-1, §301.6323(e)-1, §301.6323(f)-1, §301.6323(g)-1, §301.6323(h)-0, §301.6323(h)-1, §301.6323(i)-1, §301.6323(j)-1	Validity and priority against certain persons
4	26 USC § 6320:	§301.6320-1	Notice and opportunity for hearing upon filing of notice of lien
5	26 USC § 6324:	§301.6324-1	Special liens for estate and gift taxes
6	26 USC § 6324A:	§301.6324A-1	Special lien for estate tax deferred under section 6166
7	26 USC § 6324B:	no regulation	Special lien for additional estate tax attributable to farm, etc., valuation
8	26 USC § 6325	§301.6325-1	Release of lien or discharge of property
9	26 USC § 6326:	§301.6326-1	Administrative appeal of liens
10	26 USC § 6327:	no regulation	Cross References
11	26 USC § 7425:	§301.7425-1, §301.7425-2, §301.7425-3, §301.7425-4	Discharge of Liens
12	26 USC § 7426:	§301.7426-1, §301.7426-2	Civil actions by persons other than taxpayers
13	26 USC § 7432:	§301.7432-1	Civil damages for failure to release lien
14	28 USC § 2410:		Actions affecting property on which United States has lien

The following Policy Statements and Delegation Orders regulate NFTL filing.

#	IRM	Description
1	IRM 1.2.14.1.2	Policy Statement 5-2 – Collecting Principles
2	IRM 1.2.14.1.13	Policy Statement 5-47 – (1) Notices of lien generally filed only after taxpayer is contacted in person, by telephone or by notice; (2) Notice of lien filing in jeopardy assessment cases; (4) Other notice of lien filing requirements
3	IRM 1.2.44.5	Delegation Order 5-4 (Rev 3) – Federal Tax Lien Certificates
4	IRM 1.2.65.3.2 or Functional Delegation Order including authority to foreclose the federal tax lien	Delegation Order SBSE- 1-23-9, Approval of Form 4477, Civil Suit Recommendation

[1] Note that the IRS only secures extensions on partial payment installment agreements and only in limited situations.

Representation in Tax Audits & Appeals

Need assistance in managing the audit process? Freeman Law’s team of attorneys and dual-credentialed attorney-CPAs regularly represents taxpayers before the IRS and Texas Comptroller. Our team also provides tax return-related representations and helps taxpayers navigate state tax laws. Our Firm offers value-driven services and provides practical solutions to complex issues. Schedule a consultation or call (214) 984-3000 to discuss our tax representation services.

A Picture, A Painting, and A Prince: The Supreme Court Addresses the ‘Fair Use’ Doctrine

On May 18, 2023, the U.S. Supreme Court issued its 43-page majority opinion in the case of Andy Warhol Foundation for the Visual Arts, Inc. v. Goldsmith, No. 21-869, 598 U.S. __ (May 18, 2023) (slip opinion linked here).

Facts. The facts of the case center around artistic creations of Andy Warhol and Lynn Goldsmith.

In the 1980s, Goldsmith, a photographer extraordinaire, captured images of many rock-n-roll stars, including Prince. In 1984, Goldsmith licensed to Vanity Fair magazine one of her photos of Prince for “one time” use as an “artist reference.” Vanity Fair wanted to use the photo for the creation of illustrations to be included in an article about Prince. Vanity Fair engaged renowned artist, Andy Warhol, to prepare the illustrations. Goldsmith was credited for the source and was paid $400. But, Warhol went on to create additional works using Goldsmith’s photo or the illustrations he created from it. In 2016, the Andy Warhol Foundation for the Visual Arts, Inc. (AWF) licensed one of those works to magazine publisher, Condé Nast, for illustrating another story about Prince. AWF received $10,000 for the license. Goldsmith received nothing.

Shown below are the three creative works in issue in the case:

A Black and White Portrait Photograph of Prince taken in 1981 by Lynn Goldsmith

Goldsmith, 598 U.S. __ (May 18, 2023) at pg. 4 (slip opinion)

A purple silkscreen portrait of Prince created in 1984 by Andy Warhol to illustrate an article in Vanity Fair

Id. at pg. 5.

An orange silkscreen portrait of Prince on the cover of a special edition magazine published in 2016 by Conde´ Nast

Id. at pg. 6.

Goldsmith informed AWF that the use of the photo in the Condé Nast magazine infringed her copyright in the photo she provided to Vanity Fair in 1984. In response, AWF sued her, claiming that AWF’s use was “fair use” and thus, pursuant to 17 U.S.C. § 107, was not an infringement on Goldsmith’s copyright. Goldsmith counterclaimed for infringement.

The federal district court in New York ruled in favor of AWF. The Court of Appeals for the Second Circuit reversed, finding that all factors of the fair use doctrine favored Goldsmith. AWF petitioned the matter to the U.S. Supreme Court, focusing primarily on the first factor of the fair use doctrine, being “the purpose and character of the use.” See 17 U.S.C. § 107(1). AWF contended that the purpose and character of its use of Goldsmith’s photograph weighed in favor of fair use because Warhol’s silkscreen image of the photograph has a new meaning or message than the original photograph created by Goldsmith, i.e., AWF claimed that its use was “transformative” and thus protected fair use.

Issue. Whether the fair use factor – “the purpose and character of the use, including whether such use is of a commercial nature or is for nonprofit educational purposes,” 17 U.S.C. § 107(1)—weighed in favor of AWF’s later commercial licensing.

Holding. No, AWF’s use of Goldsmith’s photograph was not fair use. Fair use, under section 107(1) of the Copyright Act, does not protect all use of a copyrighted work that might add some new expression, meaning, or message. Otherwise, “transformative use” would swallow the copyright owner’s exclusive right to prepare derivative works from an original. The Court stated as follows:

Although the purpose could be more specifically described as illustrating a magazine about Prince with a portrait of Prince, one that portrays Prince somewhat differently from Goldsmith’s photograph (yet has no critical bearing on her photograph), that degree of difference is not enough for the first factor to favor AWF, given the specific context of the use. To hold otherwise would potentially authorize a range of commercial copying of photographs, to be used for purposes that are substantially the same as those of the originals. As long as the user somehow portrays the subject of the photograph differently, he could make modest alterations to the original, sell it to an outlet to accompany a story about the subject, and claim transformative use. Many photographs will be open to various interpretations. A subject as open to interpretation as the human face, for example, reasonably can be perceived as conveying several possible meanings. The application of an artist’s characteristic style to bring out a particular meaning that was available in the photograph is less likely to constitute a “further purpose” as Campbell [v. Acuff-Rose Music, Inc., 510 U.S. 569 (1994)] used the term.

Goldsmith, 598 U.S. __ (May 18, 2023) at pg. 32 (slip opinion).

Key Points of Law.

Constitutional Authority for Copyright Protection. The U.S. Constitution empowers Congress to enact copyright laws “[t]o promote the Progress of Science and useful Arts.” U.S. Const. art. I, § 8, cl. 8. Congress has exercised this delegated authority continuously, beginning with the Copyright Act of 1790 and, more recently, through the Copyright Act of 1976. See Andy Warhol Foundation for the Visual Arts, Inc. v. Goldsmith, 11 F. 4th 26, 36 (2^nd Cir. 2021), aff’d by Goldsmith, No. 21-869, 598 U.S. __ (May 18, 2023) (opinion of the Second Circuit linked here). Like other property rights, there is a “bundle of rights” associated with copyrights, including the right to reproduce a copyrighted work, to prepare derivative works, and, in the case of photographs or graphic works, to display the work publicly. Goldsmith, 598 U.S. __ (May 18, 2023) at pg. 13 (slip opinion).

Protection of Original Works and Derivative Works. Under the 1976 Act, copyright protection extends to the original creative work and to derivative works, which the Act defines as follows:

a work based upon one or more preexisting works, such as a translation, musical arrangement, dramatization, fictionalization, motion picture version, sound recording, art reproduction, abridgment, condensation, or any other form in which a work may be recast, transformed, or adapted. A work consisting of editorial revisions, annotations, elaborations, or other modifications which, as a whole, represent an original work of authorship, is a “derivative work”.

17 U.S.C. § 101.

Exclusive Rights in Copyrighted Works. Section 106 of the Copyright Act provides as follows:

Subject to sections 107 through 122, the owner of copyright under this title has the exclusive rights to do and to authorize any of the following:

to reproduce the copyrighted work in copies or phonorecords;
to prepare derivative works based upon the copyrighted work;
to distribute copies or phonorecords of the copyrighted work to the public by sale or other transfer of ownership, or by rental, lease, or lending;
in the case of literary, musical, dramatic, and choreographic works, pantomimes, and motion pictures and other audiovisual works, to perform the copyrighted work publicly;
in the case of literary, musical, dramatic, and choreographic works, pantomimes, and pictorial, graphic, or sculptural works, including the individual images of a motion picture or other audiovisual work, to display the copyrighted work publicly; and
in the case of sound recordings, to perform the copyrighted work publicly by means of a digital audio transmission.

17 U.S.C. § 106(1)-(6) (emphasis added).

Rights of Authors to Attribution and Integrity. Section 106A of the Copyright Act provides that, subject to section 107 and independent of the exclusive rights provided in section 106, the author of a work of visual art shall have certain additional rights, such as to claim authorship and to prevent the use of the author’s name as the author of any work of visual art which the author did not create. 17 U.S.C. § 106A. Those authors also have the right to prevent the use of the author’s name as the author of the work of visual art in the event of a distortion, mutilation, or other modification of the work which would be prejudicial to the author’s honor or reputation. Authors within the meaning of section 106A may seek to prevent any intentional distortion, mutilation, or other modification of the particular work that may violate the rights vested in the author by section 106A. Id. at § 106A(a)-(a)(3)(B).

Limitation on Exclusive Rights: Fair Use, Section 107. Pursuant to the Copyright Act, the fair use of a copyright work is not an infringement of copyright. The fair use doctrine reflects a balance of competing claims upon the public interest—“‘Creative work is to be encouraged and rewarded, but private motivation must ultimately serve the cause of promoting broad public availability of literature, music, and the other arts.’” Goldsmith, 598 U.S. __ (May 18, 2023) at pg. 13 (slip opinion) (quoting Twentieth Century Music Corp. v. Aiken, 422 U.S. 151, 156 (1975)). Codified in 1976, the fair use statute provides as follows:

Notwithstanding the provisions of sections 106 and 106A, the fair use of a copyrighted work, including such use by reproduction in copies or phonorecords or by any other means specified by that section, for purposes such as criticism, comment, news reporting, teaching (including multiple copies for classroom use), scholarship, or research, is not an infringement of copyright. In determining whether the use made of a work in any particular case is a fair use the factors to be considered shall include—

1. the purpose and character of the use, including whether such use is of a commercial nature or is for nonprofit educational purposes;
2. the nature of the copyrighted work;
3. the amount and substantiality of the portion used in relation to the copyrighted work as a whole; and
4. the effect of the use upon the potential market for or value of the copyrighted work.

17 U.S.C. § 107(1).

The fair use provision of the Copyright Act calls for a holistic, context-sensitive inquiry “not to be simplified with bright-line rules[.] . . . All [four statutory factors] are to be explored, and the results weighed together, in light of the purposes of copyright.” Campbell v. Acuff-Rose Music, Inc., 510 U.S. 569, 577-78 (1994). The courts “apply [fair use] in light of the sometimes conflicting aims of copyright law,” and a copyright protection may be stronger where the work serves an artistic rather than a utilitarian function. Google LLC v. Oracle Am., Inc., __ U.S. __, 141 S. Ct. 1183, 1197, 209 L.Ed.2d 311 (2021).

Factor 1 – Purpose and Character. The first factor “focuses on whether an allegedly infringing use has a further purpose or different character, which is a matter of degree, and the degree of difference must be weighted against other considerations, like commercialism.” Goldsmith, 598 U.S. __ (May 18, 2023) at pg. 12 (slip opinion). The first factor considers the reasons for, and nature of, the copier’s use of an original work. The ‘central’ question it asks is ‘whether the new work merely ‘supersede[s] the objects’ of the original creation . . . (‘supplanting’ the original), or instead adds something new, with a further purpose or different character.’” Goldsmith, 598 U.S. __ (May 18, 2023) at pg. 15 (slip opinion) (quoting Campbell, 510 U.S. at 579).

Whether the purpose and character of a use weighs in favor of fair use is an objective inquiry into what use was made, i.e., what the user does with the original work.

Indeed, whether a work is transformative does not turn on the stated or perceived intent of the creator or the meaning or impression that a critic or judge draws from the work. The courts evaluate the degree to which the use is “transformative,” meaning “whether the new work merely supersedes the objects of the original creation, or instead adds something new, with a further purpose or different character, altering the first with new expression, meaning, or message.” Campbell, 510 U.S. at 579. Whether a work is “transformative” involves an evaluation of how the work may be “reasonably be perceived,” and examples of transformative uses include criticism, comment, news reporting, teaching, scholarship, and research. See 17 U.S.C. § 107. Another example is parody, which mimics an original work to make its point and is usually protected under the fair use doctrine.

Factor 1 – Commercial Use. The first factor in the fair use statute also directs courts to consider whether the use is of a commercial nature or is for nonprofit educational purposes. 17 U.S.C. § 107(1). Commercial use tends to weigh against finding that the use is “fair,” but that seemingly bright-line approach is applied with reluctance since essentially all uses of a work, even use by a nonprofit organization, are generally conducted for some type of monetary gain or exploitation. See Campbell, 510 U.S. at 584-85. The commercial nature of a secondary use is of decreased importance when the use is sufficiently transformative such that the primary author should not reasonably expect to be compensated.

Factor 2 – The Nature of the Copyrighted Work. This factor requires evaluation of (1) whether the work is expressive or creative or more factual, and (2) whether the work is published or unpublished, with the scope of fair use involving unpublished works being considerably narrower. See Goldsmith, 11 F. 4th at 45; Blanch v. Koons, 467 F.3d 244, 256 (2d Cir. 2006). That a creator might make a work available for a single use on limited terms does not change its status as an unpublished work nor diminish the law’s protection of the creator’s choice of when to make a work public and whether to withhold a work to shore up demand. Goldsmith, 11 F. 4th at 45.

Factor 3 – The Amount and Substantiality of the Use. This factor requires an evaluation of the quantity of the materials used as well as the quality and importance in relation to the original work. “The ultimate question under this factor is whether ‘the quantity and value of the materials used are reasonable in relation to the purpose of the copying.’” See Goldsmith, 11 F. 4th at 46 (quoting Campbell, 510 U.S. at 586). But, there is no bright line separating a permissible amount of borrowing from an impermissible one. See Google LLC, 593 U. S., at __ (slip op., at 24–25) (noting that “[a]n ‘artistic painting’ might, for example, fall within the scope of fair use even though it precisely replicates a copyrighted ‘advertising logo to make a comment about consumerism.’”); Rogers v. Koons, 960 F.2d 301, 309-11 (2d Cir. 1992) (noting that “Sometimes wholesale copying may be permitted, while in other cases taking even a small percentage of the original work has been held unfair use.”).

Factor 4 – The Effect of the Use on the Market for the Original. For this factor, the courts evaluate whether, if the challenged use becomes widespread, it will adversely affect the potential market for the copyrighted work. Thus, the courts consider the benefit the public will derive if the use is permitted and the personal gain the copyright owner will receive if the use is denied. This is a market-usurpation analysis that considers the primary market for the work and any derivative markets that exist or that its creator might reasonably license others to develop, regardless of whether the creator claiming infringement has elected to develop such markets. See Goldsmith, 11 F. 4th at 48.

Insights. The U.S. Supreme Court’s opinion in Goldsmith adds context to and consideration for the first factor of the Fair Use Doctrine. The holding could have a significant impact on the copyrights of artists, musicians, singers, photographers, and others whose works are used—fairly or unfairly—with or through artificial intelligence to create what are (or are arguably) derivative works that infringe on the creator’s rights. The boundaries of fair use remain extremely grey, and the case-by-case and context-sensitive evaluation lends itself to much subjective speculation about how a court of law, i.e., a judge or a panel of judges, may apply an objective analysis in determining whether a use of a copyrighted work is fair and thus non-infringing.

Fairly stated:

Not every instance will be clear cut, however. Whether a use shares the purpose or character of an original work, or instead has a further purpose or different character, is a matter of degree. Most copying has some further purpose, in the sense that copying is socially useful ex post. Many secondary works add something new. That alone does not render such uses fair. Rather, the first factor (which is just one factor in a larger analysis) asks “whether and to what extent” the use at issue has a purpose or character different from the original. The larger the difference, the more likely the first factor weighs in favor of fair use. The smaller the difference, the less likely.

Goldsmith, 598 U.S. __ (May 18, 2023) at pg. 15 (slip opinion) (internal citations omitted).

Tax Court in Brief | Moore v. Comm’r | Research Credit and Computation of Research Expenses under Section 41(a)

The Tax Court in Brief – February 20th – February 24th, 2023

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 February 20th, 2022, through February 24th, 2023

Moore v. Comm’r, T.C. Memo. 2023-20| February 23, 2023 |Colvin, J. | Dkt. No. 18632-19

Summary: Petitioner Gayla Moore was the sole owner of Nevco, Inc. (Nevco), a subchapter S corporation, during the tax years in issue (2014 and 2015). Nevco claimed the section 411 credit for increasing research activities (research credit) on its 2014 and 2015 Forms 1120S, U.S. Income Tax Return for an S Corporation. The credit flowed through to Gayla Moore and Scott Moore’s individual income tax returns. Nevco manufactured scoreboards and other types of equipment for sports venues. Mr. Moore was the vice president of Nevco. From 2004 to 2006 an outside consultant advised on Nevco’s personnel and inventory requirements. The consultant was hired as chief operating officer from 2006 to 2016 and served as president and COO during 2014 and 2015. He focused a majority of his time on new product development. He had a base compensation $85,092 in 2014 and $178,956 in 2015, and he received various bonuses during those years. Nevco also employed engineers, and the president and COO was the direct supervisor of a few. The engineers engaged in qualified research during 2014 and 2015. They developed a number of new sports-venue-related products for Nevco, and the president and COO made various executive decisions regarding the design and development. The Tax Court describes, at length, five of the products – Scoreboard Truss, Scorbitz, New Caney Ribbon Board, MPCX–2, and a Slim Shot Clock.

The Moores filed their 2014 and 2015 joint income tax returns on Forms 1040, U.S. Individual Income Tax Return. Nevco filed its 2014 and 2015 income tax returns on Forms 1120S. Nevco claimed research credits on those returns, which flowed through to the Moores individual income tax returns for 2014 and 2015. Nevco used the base period 1984 to 1988 to calculate the fixed-base percentage for its 2014 regular research credit. Nevco used the alternative simplified credit method to calculate its 2015 research credit. An accounting firm prepared the Moores’ Forms 1040 and Nevco’s Forms 1120S for both 2014 and 2015. The IRS determined deficiencies in the Moores’ income tax of $68,263 for 2014 and $141,945 for 2015.

Key Issue: Whether (and if so to what extent) Nevco is entitled to a research credit under section 41 for compensation paid to the president and COO during 2014 and 2015?

Primary Holdings: The president and COO did not engage in direct supervision or direct support (as provided by section 41(b)(2)(B)(ii)) of persons who performed qualified services during 2014 and 2015. And, even though he was extensively involved in new product development, the record did not show the portion of his work on new product development which meets the requirements of “qualified research” under section 41(b)(2)(B)(i). Thus, Nevco cannot consider the president/COO’s wages in computing the research credit for 2014 and 2015.

Key Points of Law:

Research Credit. Section 41(a) establishes the method for computing the research credit. See 26 U.S.C. § 38(b)(4). A taxpayer’s qualified research expenses include “inhouse research expenses” “which are paid or incurred by the taxpayer during the taxable year in carrying on any trade or business of the taxpayer.” Id. at § 41(b)(1)(A). A taxpayer’s “in-house research expenses” include “any wages paid or incurred to an employee for qualified services performed by such employee.” Id. at § 41(b)(2)(A)(i). Section 41(b)(2)(A) includes as wages “all remuneration . . . for services performed by an employee for his employer, including the cash value of all remuneration (including benefits) paid in any medium other than cash.” See id. at §§ 41(b)(2)(D)(i), 3401(a). An employee performs “qualified services” by either “(i) engaging in qualified research, or (ii) engaging in the direct supervision or direct support of research activities which constitute qualified research.” Id. at § 41(b)(2)(B).

Qualified Research. Under section 41(d), four requirements must be met in order for an activity to be “qualified research.”

(1) The research expenditures must be eligible to be treated as expenses under section 174. 26 U.S.C. § 41(d)(1)(A). Under section 174(a)(1), “[a] taxpayer may treat research or experimental expenditures which are paid or incurred by him during the taxable year in connection with his trade or business as expenses which are not chargeable to capital account.” Those “expenditures so treated shall be allowed as a deduction.” Id. at § 174(a)(1). Treasury Regulation § 1.174-2(a)(1) defines “research or experimental expenditures” as “expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.”

(2) The research must be undertaken to discover information which is “technological in nature.” Id. at § 41(d)(1)(B)(i).

(3) The application of that research must be “intended to be useful in the development of a new or improved business component of the taxpayer.” Id. at § 41(d)(1)(B)(ii).

(4) “Substantially all of the activities of” the research must “constitute elements of a process of experimentation for a purpose” related to “a new or improved function,” “performance,” or “reliability or quality.” Id. at § 41(d)(1)(C), (3)(A).

Excluded Activities. Section 41(d)(4) provides a list of activities that are specifically excluded from the definition of qualified research. Treasury Regulation § 1.41-4(a)(5)(i) defines “process of experimentation” as “a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer’s research activities.” Treasury Regulation § 1.41-4(a)(5)(i) also provides that a process of experimentation

involves the identification of uncertainty concerning the development or improvement of a business component, the identification of one or more alternatives intended to eliminate that uncertainty, and the identification and the conduct of a process of evaluating the alternatives (through, for example, modeling, simulation, or a systematic trial and error methodology).

Treasury Regulation § 1.41-4(a)(4) provides as follows regarding the use of technology in the process of experimentation:

For purposes of section 41(d) and this section, information is technological in nature if the process of experimentation 10 used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science. A taxpayer may employ existing technologies and may rely on existing principles of the physical or biological sciences, engineering, or computer science to satisfy this requirement.

Direct Supervision and Direct Support. Section 41(b)(2)(B)(ii) considers applicable credit for qualified research and “engaging in the direct supervision or direct support of research activities which constitute qualified research”. Under Treasury Regulation § 1.41-2(c)(2):

The term “direct supervision” as used in section 41(b)(2)(B) means the immediate supervision (first-line management) of qualified research (as in the case of a research scientist who directly supervises laboratory experiments, but who may not actually perform experiments). “Direct supervision” does not include supervision by a higher-level manager to whom first-line managers report, even if that manager is a qualified research scientist.

Treasury Regulation § 1.41-2(c)(2) specifically excludes from the definition of direct supervision “supervision by a higher-level manager to whom first-line managers report.”

The regulations under section 41(b)(2)(B)(ii) provide that the term “direct support” includes services in the direct support of either “[p]ersons engaging in actual conduct of qualified research” or “[p]ersons who are directly supervising persons engaging in the actual conduct of qualified research.” Treas. Reg. § 1.41-2(c)(3). Treasury Regulation § 1.41- 2(c)(3)(ii) provides as examples of direct support a secretary “typing reports describing laboratory results derived from qualified research,” a laboratory worker “cleaning equipment used in qualified research,” and a machinist “machining a part of an experimental model used in qualified research.”

Insights: This opinion illustrates the careful attention a taxpayer should take when desiring to allocate compensation of an executive-level employee to a research credit for qualified research performed by others. The Tax Court appears to have wanted the Moores to more thoroughly allocate the portion (i.e., the number of hours) of the president and COO’s work on new product development which was qualified research. The Court was careful to distinguish between qualified research and new product development with respect to Nevco’s operations. And, the Moores did not present estimates of the amount of time the executive spent on qualified research as distinguished from the broader category of new product development. The Tax Court analyzed the matter on a product-by-product basis.

BBA Audits

The Role of the Partnership Representative in an Audit.

The partnership representative has sole authority to act on behalf of the partnership. Partners are bound by the decisions made by the partnership representative. Direct and indirect partners have no participation rights during the examination.

Mathematical Adjustments.

The BBA regime also provides that if an adjustment is identified on account of a mathematical or clerical error appearing on the partnership return, the IRS may make an adjustment to correct the error and may assess the partnership an imputed underpayment resulting from that adjustment. The notice to the partnership of the adjustment on the basis of correcting the error is not considered a notice of final partnership adjustment under section 6231(a)(3). Math error correction also applies to an adjustment to any inconsistently reported partnership-related item on a partner’s return when notice of such inconsistency is not provided.

Determinations at the Partnership Level.

Any partnership adjustment and the applicability of any penalty, addition to tax, or additional amount (plus interest as provided by law) that relates to such adjustment are generally determined and assessed at the partnership level.

Treatment of Payment of Imputed Underpayments.

The payment relating to any imputed underpayment, interest or penalties that is made by the partnership is non-deductible and must be treated as an expenditure described in section 705(a)(2)(B).

BBA Audit Phases.

After a case is disposed from the field to Technical Services and a notice of any proposed partnership adjustment (NOPPA) has been issued, the next phase of the examination is modification which will be handled by the BBA Unit in Ogden.

Delinquent Return and Substitute for Return (SFR)

Delinquent returns and substitute for returns are subject to the BBA regime. Election out of the BBA can only be made on an original timely filed return. Therefore, if a delinquent return includes such an election out, it is deemed invalid and will generally be denied under IRS protocol.

The IRS will generally issue Letter 3798, Non-Filer Appointment, in non-filer cases where return solicitation language is unwarranted. Letter 3798 is not a notice for selection for exam.

Once the IRS makes a determination has been made to conduct an examination of the non-filed/late filed return, it will issue Letter 2205-D and follow the BBA procedures.

Partnerships in Bankruptcy and Ceasing to Exist

The IRS may audit a BBA partnership return if deemed warranted or complete an examination even if the BBA partnership is in bankruptcy or ceases to exist. In general, the running of any period of limitations for making a partnership adjustment and assessment or collection of the imputed underpayment is suspended during the period the IRS is prohibited from making the adjustment, assessment or collection in a Title 11 case. However, the filing of a petition under Title 11 (in a BBA examination) does not prohibit the following actions:

A BBA examination,
The mailing of any notice with respect to a BBA examination,
The issuance of a NAP, NOPPA, and FPA,
A demand for tax returns,
The assessment of any tax and imputed underpayment, or
The issuance of notice and demand for payment.

Whether a partnership ceases to exist, partnership adjustments may be taken into account by the former partners of the partnership. A partnership ceases to exist if the IRS makes a determination that such partnership (including partnership-partner): 1) Terminates within the meaning of § 708(b)(1), or 2) Does not have the ability to pay, in full, any amount due (not collectible)

BBA Scope – Adjustments at the Partnership Level

A partnership adjustment and the applicability of any penalty, addition to tax, or additional amount that relates to such adjustment is determined at the partnership level. Any legal or factual determinations underlying any partnership adjustment or determination are also determined at the partnership level.

A partnership adjustment is any adjustment to a partnership-related item (PRI) and includes any portion of an adjustment to a PRI. The term PRI means:

Any item or amount with respect to the partnership which is relevant in determining the tax liability of any person under chapter 1 of subtitle A of the Code;
Any partner’s distributive share of any such item or amount; and
Any imputed underpayment determined under the BBA regime.

An item or amount is treated as being “with respect to the partnership” if it is:

Shown or reflected, or required to be shown or reflected, on a return of the partnership under section 6031, the regulations thereunder, or the forms and instructions prescribed by the IRS for the partnership’s taxable year or is required to be maintained in the partnership’s books or records, or
Relating to any transaction with, liability of, or basis in the partnership but only if it’s described in the preceding sentence.

Note: An item or amount shown or required to be shown on a return of a person other than the partnership (or in that person’s books and records) that results after application of the Code to a PRI based upon the person’s specific facts and circumstances, including an incorrect application of the Code or taking into account erroneous facts and circumstances of the partner, is not with respect to the partnership.

Examples. Adjustments that constitute adjustments to partnership-related items include:

The character, timing, source, and amount of the partnership’s income, gain, loss, deductions, and credits;
The character, timing, and source of the partnership’s activities;
The character, timing, source, value, and amount of any contributions to, and distributions from, the partnership;
The partnership’s basis in its assets, the character and type of the assets, and the value (or revaluation) of the assets;
The amount and character of partnership liabilities and any changes to those liabilities from the preceding tax year;
The category, timing, and amount of the partnership’s creditable expenditures;
Any item or amount resulting from a partnership termination;
Any item or amount relating to an election under section 754; and
Partnership allocations and any special allocations.

Examples of items that are NOT PRIs include:

A deduction shown on the return of a partner that results after applying(correctly or incorrectly) a limitation under the Code (such as section 170(b)) at the partner level to a partnership-related item based on the partner’s facts and circumstances, and
A partner’s adjusted basis in his/her partnership interest (outside basis).

Non-chapter 1 tax

The BBA regime applies to Subtitle A, Chapter 1 Income Tax only and will not apply to other taxes as shown below.

Chapter 2 (Tax on Self-Employment Income – “SECA”)
Chapter 2A (Unearned Income Medicare Contribution – “NIIT”)
Chapter 3 (Withholding of Tax on Nonresident Aliens and ForeignCorporations)
Chapter 4 (Taxes to Enforce Reporting on Certain Foreign Accounts)Note: No guidance exists for coordination of the BBA with Chapter 6 Consolidated Returns or any other Subtitle of the IRC at the time this interim guidance was released.

However, if the IRS makes adjustments to PRIs or determinations about PRIs in a BBA audit, those adjustments or determinations must be taken into account when determining a tax under chapters 2, 2A, 3 & 4.

Section 6501(c)(12) provides in the case of any partnership adjustment determined under the BBA regime, the period for assessment of any tax imposed under chapter 2 or 2A which is attributable to such adjustment shall not expire before the date that is one year after one of two events.

In the case of an adjustment pursuant to the decision of a court in a proceeding brought under section 6234, the period for assessment shall not expire before the date that is one year after the decision becomes final.
In any other case, the period for assessment shall not expire before the date that is one year after 90 days after the date on which the FPA is mailed under section 6231.

Foreign Partners. If a partnership adjustment subjects the partnership to withholding requirements under chapter 3 or 4, the partnership can either pay the chapter 1 tax (imputed underpayment under section 6225) allocable to the foreign partner’s distributive share of the adjustment or, if electing to push out the adjustments, remit chapter 3 or 4 withholding tax on the foreign partner’s distributive share of the adjustment.

Income Subject to SECA or NIIT. All Partnerships are required to determine whether a partner’s distributive share of income is subject to SECA or NIIT. Partnerships report information about SECA on Schedules K and K-1, line 14 and about NIIT on Schedules K and K-1, line 20. (Line references to 2018 version)

If a partnership correctly classifies income as subject to SECA or NIIT on its originally filed return, section 6501(c)(12) applies to allow assessment of SECA or NIIT at the partner level related to adjustments to PRIs made at the BBA Partnership level. Example – an increase to ordinary income on line 1 of Schedule K-1 will correspondingly increase net earnings from self-employment on line 14 of Schedule K-1 by the same amount.

If a partnership improperly classifies income, or does not classify income at all, as subject to SECA or NIIT on its originally filed return, it is possible that section 6501(c)(12) will not apply to the assessment of any tax imposed under chapter 2 or 2A which is attributable to partnership adjustments determined under the BBA regime. In this case, the IRS may seek to protect partners’ section 6501(a) statutes to assess SECA or NIIT related to both their originally reported distributive share and/or to their distributive share of adjustments to PRIs that are made at the BBA partnership level. Example – a sole adjustment to increase net earnings from self- employment on line 14 of Schedule K-1 from zero to equal to ordinary income on line 1 of Schedule K-1.

Examples.

An adjustment to SECA on line 14 of Schedule K-1 is a PRI whereas an adjustment to NIIT on line 20 of Schedule K-1 is not a PRI.

SECA reported on line 14 of Schedule K-1 is a PRI because it’s an item reported on the BBA partnership’s Schedule K/K-1 and affects the chapter 1 liability of any person because an individual is entitled to an adjustment to income for their deductible part of self-employment tax, which reduces their chapter 1 liability.

NIIT reported on line 20 of Schedule K-1 is not a PRI because there are no adjustments related to NIIT that affect a taxpayer’s chapter 1 liability.

Although whether partnership income is subject to SECA has been determined by the IRS to be a PRI, its auditors will follow dual procedures. Adjustments to whether partnership income is subject to SECA are primarily treated as a PRI but may be alternatively treated as not a PRI.

Dual Procedures means, with respect to a SECA issue, IRS revenue agents auditing both a BBA partnership and its partner(s) will protect both the BBA partnership’s section 6235 statute(s) and the partner(s) section 6501(a) statute(s) and make an adjustment at the BBA partnership level treating the partnership’s income as subject to SECA as a PRI and make an adjustment at the partner level treating it as not a PRI.

Adjusting ordinary income that will impact both lines 1 and 14 of Schedule K will be presented as an adjustment to a PRI at the partnership level and may result in an imputed underpayment. The IRS Revenue Agent may seek involvement from Technical Services (TS) or Campus Pass-Through Function (CPF) to prepare and issue partners’ SNDs to assess SECA at the partner level for their distributive share of line 14 (the adjustment at the BBA partnership level). The SNDs may state that they result from a SECA adjustment related to a partnership adjustment made in an audit of a BBA partnership and section 6501(c)(12) will apply.

Adjusting line 14 to correspond in full or part with line 1 of Schedule K generally involve dual procedures.

The IRS will present the adjustment as an adjustment to a PRI at the partnership level and compute an imputed underpayment. This PRI adjustment is generally the IRS’s primary argument.

The IRS will also prepare Form 4605A and work papers for the SECA issue to assess SECA at the partner level for their distributive share of line 14 (the adjustment at the BBA partnership level). The reports will generally state that the partner is subject to SECA on their distributive share of income from the BBA partnership (e.g., Because the IRS has determined that the partner’s interest in the BBA partnership is not a limited partnership interest for purposes of Chapter 2 SECA).

The IRS will seek to protect the partners’ section 6501(a) statute. This will involve special language in the SND (Letter 531 Notice of Deficiency).

Auditing chapters 2 & 2A – Form 1040 is the key case

Assessments of chapters 2 and 2A taxes are made at the partner (direct and indirect) level in proceedings outside of the BBA regime. In other words, The BBA regime doesn’t apply to taxes under chapter 2A.

The IRS will issue a Form 4605A to a BBA partnership for adjustments to SECA and NIIT that are to be treated as non-PRIs. The IRS will issue Forms 886-A and 886-Ss for each partner receiving an allocable share of your Non-PRI adjustments.

Examples of partner-level audits

An examiner is auditing the Form 1040 of an individual taxpayer. Taxpayer is a partner in a partnership that is subject to the BBA regime. The partnership issued a Schedule K-1 to the partner reporting $100,000 of ordinary income on line 1 and $100,000 of income subject to SECA on line 14 of Schedule K. The partner did not report the income as subject to SECA. The examiner determines, as part of the individual’s audit, a chapter 2 deficiency of $3,800 ($100,000 X 3.8% maximum Medicare rate). BBA doesn’t apply to taxes under chapter 2 and the inconsistent reporting rules under section 6222 can’t be used to assess non-chapter 1 taxes. The examiner is not required to open an audit of the BBA partnership because there’s no adjustments to PRI.
An examiner is auditing the Form 1040 of an individual taxpayer. That taxpayer is a partner in a partnership that is subject to the BBA. The partnership issued a Schedule K-1 to the partner reporting $100,000 of section 1231 gain on line 10 of schedule K from the sale of assets used in one of its trade or business activities. The partner did not report the income as subject to NIIT. The examiner determines, as part of the individual’s audit, that the partner was a passive investor in the BBA partnership and its activities. As such the examiner determines a chapter 2A deficiency of $3,800. This adjustment and assessment is made in a proceeding outside of the BBA regime; the examiner is not required to open an audit of the partnership under the BBA regime because the partner’s failure to include this income as NIIT is exclusively a partner level issue.
An examiner is auditing the Form 1040 of an individual taxpayer. That taxpayer is a partner in a partnership that is subject to the BBA. The partnership issued a Schedule K-1 to the partner reporting $100,000 of ordinary income on line 1 and $0 of income subject to SECA on line 14 of Schedule K. The partner did not report the income as subject to SECA. Examiner reviews the partnership’s other partners and notes that all its partners took similar positions with respect to SECA that they, as partners, were not subject to SECA. The examiner may open the partnership for examination and follow dual procedures. Primarily the examiner will make a $100,000 PRI adjustment to line 14 of Schedule K-1 and compute an IU of $37,000. The examiner is required to utilize BBA PCS linking procedures to have the CPF issue substantially similar SNDs for SECA tax to all the partnerships’ partners and protect the partners’ 6501(a) statutes; these SNDs will state that the partner is subject to SECA on their distributive share of income from the BBA partnership because (state reason; i.e., The IRS has determined that your interest in the BBA partnership is not a limited partnership interest for purposes of Chapter 2 SECA) and this $3,800 ($100,000 X 3.8% maximum Medicare rate) assessment of SECA will be made at the partner level.

Examples of partnership-level audits

1. An examiner is auditing the Form 1065 of a partnership subject to the BBA. The partnership has 10 equal individual partners. The partnership reported $1,000,000 of ordinary income on schedule K, line 1 and reported that $0 of that income as subject to SECA on schedule K, line 14. The examiner determines that the partnership should have reported the entire $1,000,000 on line 14 of Schedule K as subject to SECA. There is no other adjustments to a PRI. Under dual procedures, primarily, this PRI adjustment will result in an IU. Secondarily, the $1,000,000 adjustment to line 14 must be taken into account for purposes of determining the partners’ SECA tax obligations. The IRS may adjust and assess each partners’ SECA tax liabilities on their individual returns. Since each partner is an equal partner, each partners’ income subject to SECA will be increased by $100,000 or 10% of the increase to line 14 of Schedule K-1. The IRS will issue a SND stating that the partner is subject to SECA on their distributive share of income from the BBA partnership and assess $3,800 ($100,000 X 3.8% maximum Medicare rate) to each partner for their SECA tax related to an adjustment made to the BBA partnership. The examiner must follow the BBA linkage procedures and protect the partners’ section 6501(a) statutes.

Auditing chapters 3 & 4

A partnership (domestic or foreign) is subject to the U.S. withholding tax rules that apply to payments of U.S. source income to foreign partners.

Assessing chapters 3 and 4 taxes are generally in proceedings outside of the BBA regime. If foreign withholding is the only issue, the examination is not subject to the BBA regime and you do not have to follow these procedures.

Rate adjustments and failure to file or withhold are determinations that must be made under a chapter 3 or 4 audit; such as:
1. Applying an incorrect withholding rate on Form 8804 or 1042 on partner level income.
2. A partnership’s failure to withhold any tax on FDAP income to third parties.
3. A partnership’s failure to withhold on a disposition of U.S. real property interests (FIRPTA withholding).
4. A failure to file Forms 1042 and/or 8804 but no disagreement of amount ofFDAP or ECI.

Base adjustments may be made under either a chapter 1 BBA audit or a chapter 3 or 4 audit which include items identified by Form 1042 or Form 8804 audit; such as:

Income omissions by the partnership.
Determination that partnership is engaged (or treated as engaged) in aU.S. trade or business and has effectively connected income.
Determination that a partnership has U.S. or foreign source income.
Any other changes to the character or source of the partnership’s income.

A base adjustment to increase the partnership’s income is an adjustment to a PRI and will result in an IU. The tax imposed on the partnership for its failure to withhold on that income, however, is not a tax imposed by chapter 1; rather, it is a tax imposed by chapter 3.

A partnership paying the IU will satisfy its chapters 3 and 4 withholding obligations.
For partnerships that elect to push out the chapter 1 adjustments, the partnership must pay the amount of tax required to be withheld under chapters 3 and 4 on any adjustment. If the chapter 3 or 4 audit is completed first, then any partnership adjustments for which chapter 3 or 4 withholding has been paid are removed from the calculation of the IU.

Examples of chapter 3 or 4 audits.

An examiner is auditing Form 1042 filed by a partnership subject to theBBA regime. The partnership has 2 equal partners, one is a US citizen and one is a non-resident alien who is a resident of another country. The partnership earned $200 of US source royalty income and reported $100 on each partner’s Schedule K-1. The partnership withheld $15 from the foreign partner. The examiner proposes a rate adjustment and determines that the partnership should have withheld $30 from the foreign partner. As such the examiner determines a chapter 3 deficiency of $15. This adjustment and assessment is made in a proceeding outside of the BBA because the tax imposed on the partnership for its failure to withhold on that income, however, is not a tax imposed by chapter 1. Rather, it is a tax imposed by chapter 3, which is not covered by the BBA. Even though the examiner is auditing the partnership’s Form 1042, the examiner is not required to open an audit of the BBA partnership’s Form 1065.
An examiner is auditing Form 1065 filed by a partnership subject to the BBA. The partnership has 2 equal partners, one is a US citizen and one is a nonresident alien who is a resident of another country. The partnership earned $200,000 of US source royalty income and reported $100,000 on each partner’s Schedule K-1. The examiner notes that the partnership properly withheld $30,000 from the foreign partner. The examiner determines, as part of the Form 1065 audit, that the partnership should have reported $400,000 of US source royalty income and proposes a base adjustment. The imputed underpayment is $74,000, calculated as the $200,000 adjustment to royalty income subject to chapter 1 income tax times the maximum individual rate of 37%. The examiner notes that the partnership should have withheld an additional $30,000 from the foreign partner. In this instance, the $37,000 imputed underpayment attributable to the foreign partner’s $100,000 allocable share of the adjustment satisfies the partnership’s requirement to withhold chapter 3 tax; if the partnership elects to push out the partnership adjustment, the partnership must remit $30,000 of chapter 3 withholding on behalf of the foreign partner’s $100,000 allocable share of the adjustment to the foreign partner’s $100,000 allocable share of the adjustment satisfies the partnership’s requirement to withhold chapter 3 tax; if the partnership elects to push out the partnership adjustment, the partnership must remit $30,000 of chapter 3 withholding on behalf of the foreign partner’s $100,000 allocable share of the adjustment.

Planning the Examination

The IRS will perform a risk assessment prior to preparing and executing an audit. This process includes determining whether the examination is subject to the BBA regime and identifying the partnership representative.

The IRS generally will not initiate an examination with less than 12 months remaining on the statute of limitations to make adjustments under 6235(a)(1) without prior managerial approval.

Determining if a partnership is subject to the BBA regime.

The centralized partnership audit regime applies to all partnerships required to file information returns under section 6031(a) whose tax years begin on or after January 1, 2018, except:

Partnerships electing out of the BBA; and
Partnerships electing out of partnership status pursuant to section 761(a).

Section 1101(g)(4) of the BBA also provides that partnerships may “elect” to have the centralized partnership audit regime apply to partnership returns filed for tax periods beginning after November 2, 2015 and before January 1, 2018. This election may only be made within 30 days of the date the IRS first notifies a partnership in writing that its return has been selected for examination (via Letter 2205-D) or by filing an Administrative Adjustment Request under section 6227.

If the partnership is not subject to the BBA regime, the examination is subject to deficiency procedures at the partner level.

Election out of the BBA – tax periods beginning on or after 1/1/2018

An election out is deemed valid until the IRS determines it is invalid.

Eligible partnerships may make the election under section 6221(b) to elect out of the centralized partnership audit regime on their timely filed Form 1065/1066, Schedule B, question 25 (including extensions).

In addition, eligible partnerships must attach Schedule B-2 to provide information concerning their partners as required by section 6221(b)(1)(D) to include each partner’s name, correct TIN, and federal tax classification.

Determining if an election was made timely

Non-filers cannot elect out because no return was filed. The election cannot be made on a substitute for return (SFR). The SFR will be subject to the centralized partnership audit regime.

Similarly, the IRS takes the position that a constructive or de facto partnership would be subject to the centralized partnership audit regime because it would not have made a timely election.

The IRS will generally utilize the TC 150 date for determining timeliness of the election out of the BBA. If the TC 150 date reflects a late filing, you may use the partnership’s proof of timely filing, such as eFile receipts or certified mailing slips.

If the election is not made on a timely filed return (including extensions), the IRS maintains that the election out is invalid.

Eligibility to elect out of the BBA

There are two criteria that a partnership must meet to be eligible to elect out of the BBA:

The partnership may only have partners each of whom is an individual, a C corporation, an estate of a deceased partner, or an S Corporation, and
The partnership is required to furnish 100 or fewer Schedule K-1s.

If either one of these requirements is not met, the partnership is not eligible to elect out and is subject to the BBA regime.

As noted, a partnership may only have direct partners each of whom is an individual, a C corporation, an estate of a deceased partner, or an S Corporation.

A partner that is a foreign entity generally will be considered an eligible partner if the foreign entity would be treated as a C corporation if it were a domestic entity.

S Corporations may have shareholders (such as QSSTs and/or ESBTs) that would otherwise be ineligible if they were direct partners. The type of shareholders doesn’t factor into the determination of eligible partners. Note: Partnerships that have Q-Sub(s) as a partner are not permitted to elect out.

An estate of a deceased partner filing Form 1041 may issue Schedule K-1s to its beneficiaries. Similar to S Corporations, an estate may have beneficiaries that would otherwise be ineligible if they were direct partners. The type of beneficiaries doesn’t factor into the determination of eligible partners.

If any of the following entities or persons are direct partners, the partnership is ineligible to elect out of the BBA and is subject to centralized partnership audit regime:

A partnership or limited liability company
Any type of trust, even a grantor trust
A foreign entity that is not treated as a C Corporation if it were a domestic entity
A disregarded entity for federal tax purposes
An estate of an individual other than a deceased partner
A nominee

The IRS will review and perform analysis with respect to the partnership’s Schedule B-2 in order to determine whether the partnership is eligible.

Partnerships required to furnish 100 or fewer schedule K-1s

If more than 100 Schedule K-1s are required to be furnished, the partnership is not eligible to elect out.

In the determination of whether the 100 or fewer Schedule K-1 threshold is met, the standard is based upon the number of Schedule K-1s required to be furnished, not the actual number of Schedule K-1s furnished. Therefore, if the taxpayer fails to furnish one or more Schedule K-1s, those not furnished but required to be furnished will be included in the total count.

Because S corporations are allowable partners and issue Schedule K-1s to their shareholders, in the determination of whether the partnership has furnished 100 or fewer Schedule K-1s, the Schedule K-1 furnished to the S corporation partner counts as one Schedule K-1 while all of the Schedule K-1s required to be furnished to the shareholders of the S corporation partner count as additional Schedule K-1s.

With regard to a partner that is an estate of a deceased partner, the estate may file Form 1041 and furnish Schedule K-1s to its beneficiaries. For purposes of determining the number of Schedule K-1s required to be furnished by the partnership, any Schedule K-1s furnish by the estate are NOT taken into account for purposes of determining whether the partnership has furnished 100 or fewer K-1 statements.

Determining the number of schedule K-1s required to be furnished

If a statement (Schedule K-1) is required to be furnished (whether issued or not) under section 6031(b) with respect to each of its partner, then each such statement is included in the calculation of the number of schedule K-1s and should be disclosed on Schedule B-2, Part III, Line 3.

Page 1 of the Form 1065 requires an entry for the number of Schedules K-1 attached to the return. This entry will provide you a preliminary assessment as to whether the partnership is close to or has exceeded the maximum 100 threshold, notwithstanding whether any partners are S corporations or whether certain Schedule K-1s were actually issued.

If an S Corporation partner is listed, you should ensure that Schedule K-1 issued to the S Corporation is counted as well as the number of Schedule K-1s the S Corporation is required to furnish to its shareholders under section 6037(b) are also accounted for.

Determination that an election out of the BBA is invalid

The IRS does not provide a procedure to appeal a determination that an election out is invalid.

If The IRS determines that an election out is invalid, it will issue Letter 6062, Notice of Invalid Election Out of the BBA, to notify a partnership of the IRS’ determination. The IRS will generally issue this letter no earlier than the issuance of Letter 2205-D.

Revocation of the election out

Once an election is made by the partnership to elect out of the BBA regime, it cannot be revoked without the consent of the IRS.

A request to revoke the election out of the BBA regime must be made within the first 30 days after the partnership has received notification from the IRS that an examination will take place (via Letter 2205-D).

An election to revoke must be done on a year by year basis.

Partnership must mail or submit the revocation statement to the person whose name appears on Letter 2205-D. The revocation statement must have the following:

A statement that this is an election to revoke section 6221(b) election and identify the taxable year for which the election to revoke is being made.
Sign and date by any person who is authorized to sign the Form 1065. Any partner or LLC member is an authorized person.
The partnership must also designate a partnership representative and submit Form 8979.

The revocation statement

The revocation statement must be submitted timely, signed by an authorized person and include the required information.

Upon acceptance of accept the revocation, the partnership examination will be subject to the BBA regime

Partnership Representative (PR)

The partnership must designate a PR on each return filed for taxable years beginning after December 31, 2017. The designation is effective on the date the return is filed.

Page 3 of Form 1065 should reflect the designation of the PR. Generally, this is the initial designation of record.

If there is no designation of the PR, there is no PR designation in effect.

The partnership representative has a key role in a BBA proceeding. Under section 6223, it is the PR that has the sole authority to act on behalf of the partnership. All partners and the partnership are bound by the PR’s actions and the PR’s final decision in a BBA proceeding. There may be only one PR for a partnership taxable year at any time. Therefore, it is critical that the PR is clearly identified.

A PR can be any person, including the partnership itself. The PR is not required to be a partner, an employee, or have any other relation to the partnership. This allows the partnership to select the person best situated to represent the partnership. The only requirement is that the PR must have a substantial presence in the United States.A. If a partnership designates an entity (including the partnership itself) to be the PR, it must also appoint a designated individual (DI) to act on behalf of the EPR. The DI can be anybody but must also have substantial presence in the United States.

The IRS is not bound by any limitations, restrictions or agreements placed upon the PR by the partnership in the partnership agreement, any side agreements or any other document to which it is not a party.

The designation of a PR remains in effect until the designation is terminated by a valid revocation, a valid resignation, or a determination by the IRS that the designation is not in effect. If there is a change to the PR or DI, any actions of the old PR or DI prior to the change will remain valid.

A partnership, through an authorized person, may designate or change the PR or DI by submitting Form 8979 to an IRS point of contact (i.e., examiner, Appeals Officer, or Counsel attorney). An authorized person is a person who was a partner at any time during the partnership tax year to which the designation or change relates.

Form 8979 may also be submitted in conjunction with the partnership’s filing of an administrative adjustment request. If so, the change in designation (or appointment) is treated as occurring prior to the filing of the administrative adjustment request.

Substantial presence in the United States

Both the PR and DI must have a substantial presence in the United States. All the following requirements must be met:

Make themselves available to meet in person with the IRS in the United States at a reasonable time and place as determined by the IRS in accordance with Regulations section 301.7605-1;
Have a United States street address and a telephone number with a United States area code; and
Have a United States taxpayer identification number (TIN).

If the PR is an entity (including if the PR is the partnership itself), it must be in legal existence to have substantial presence. For example, if the PR is an Entity Partnership Representative (EPR) it must be in legal existence and both the PR and DI must have a United States street address, a telephone number with a United States area code, and a taxpayer identification number.

Form 8979

Form 8979 is the sole mean to revoke a PR or DI, resign as a PR or DI, or designate a PR where no PR designation is in effect. Form F8979 is submitted for a single taxable year.

The following table presents possible actions and who can submit Form 8979.

ACTION:	FORM 8979 COMPLETED BY:
Revocation of a partnership representative (entity or individual PR). Must include the designation of a successor partnership representative (entity or individual). If a successor entity partnership representative is made, the simultaneous appointment of a designated individual is also required.	Partnership (through an authorized person)
Revocation of a designated individual. Must include an appointment of a successor designated individual.	Partnership (through an authorized person)

Designation of an entity partnership representative and appointment of a designated individual.	Partnership (through an authorized person)
Designation of an individual partnership representative.	Partnership (through an authorized person)

Partnerships can submit Form 8979 with an administrative adjustment request (AAR) or any time after the issuance of a notice of selection for examination (Letter 2205-D) to the partnership.

A PR or DI may submit Form 8979 any time after the issuance of a notice of administrative proceeding (NAP) to resign. If an EPR is resigning, the DI signs the form on behalf of the EPR. However, a DI can separately resign as well. In either case, the resignation will result in no PR designation being in effect.

Multiple revocations by the partnership within the 90-day period

Current IRS procedures provide that if two revocations the the PR are received within a 90-day period, the examining agent may (but is not required to) determine that the second revocation (the “current” revocation) results in no PR designation in effect.

The IRS will not send out Letter 6053 responding to the current revocation if it determines that no PR designation in effect.

If, however, the examining agent and his/her manager determine that the facts and circumstances so warrant, the agent may accept the current revocation (if valid) and confirm the latest PR of record. In such case, The IRS will send Letters 6053, 6007 and 6008.

If the IRS determines that there is no PR designation in effect, IRS protocol requires the agent to provide notice within 90 days of receiving the current revocation to indicate that there is no designation in effect. Otherwise, the agent is instructed not to determine that no designation is in effect because of multiple revocations. In such case, the agent will send Letters 6053 and 6007 only.

If The IRS has declared that there is no designation in effect, the examining agent must select a new PR with reasonable due diligence while balancing the need to continue the examination in an efficient and effective manner.

Once the examining agent has selected a PR, the partnership cannot revoke the PR without the permission of the IRS. Permission is granted if the partnership submits a Form 8979 and the IRS accepts the submittal as valid.

Form 8979 and examiner responsibilities

When the IRS receives Form 8979, after determining that the form is valid, within 30 days of receipt, the IRS will issue the appropriate set of letters to inform the appropriate parties about your determination.

Form 8979 is deemed valid until the IRS determines it is invalid.

There may be various reasons for submitting a Form 8979, such as:

The partnership is revoking the current entity or individual PR;
The partnership is revoking the current DI;
The PR is resigning;
The DI is resigning; or
The partnership is designating a PR because there’s no PR in effect.

Generally, the most recent Form 8979 supersedes all prior Form 8979 submissions. However, it is possible that the partnership did not properly revoke the PR or DI by erroneously listing the wrong person. In such a case, that revocation and designation are invalid. The PR or DI before the invalid revocation remains as the PR or DI of record.

Regulations require that the PR and DI must have substantial presence in the United States.

The IRS will prepare and issue notices upon receiving a Form 8979, such as:

Letter 6053, Notice to Partnership of Partnership Representative Status,
Letter 6007, Notice to [Existing or Old] Partnership Representative ofStatus, and
Letter 6008, Notice to [New] Partnership Representative of Status.

Note: The above-listed letters are not required to be mailed when the Form 8979 is received with an AAR prior to issuance of a NAP.

The IRS will mail Letter 6053 to the partnership. Letters 6007 and 6008 should be mailed to the old PR and the new PR (if applicable), respectively. If the PR is an entity, The IRS will mail the letter to the PR at the attention of the DI and use the PR address.

If the IRS made a designation of a PR, the partnership can request permission from the IRS to revoke that designated PR by submitting a valid revocation Form 8979.

Some circumstances under which the IRS can determine that no PR designation exists include:

No substantial presence in the United States. See section “Substantial Presence in the United States” above.
The partnership failed to appoint a DI if the PR is an EPR.
The partnership failed to make a valid designation of a partnership representative.
There was a valid resignation of PR or DI, but no subsequent designation by the partnership.
There are multiple revocations within the 90-day period and the IRS determines that there is no designation in effect.
The PR is no longer in effect for any other reason as determined by other published guidance.

IRS’s selection of a PR

If the IRS must select a PR, there is no specific prescribed timeframe to do so. However, the IRS must select a new PR with reasonable due diligence while balancing the need to continue the examination in an efficient and effective manner.

The IRS can select any person to be the partnership representative (except for an IRS employee, agent, or contractor unless they are a partner in the partnership); however, the person designated by the IRS should have sufficient knowledge of the partnership tax return and business operations to participate in the examination.

If the IRS seeks to designate a PR, IRS rules provide that it should consider the following factors:

The intention of the partnership based on a late or untimely filed Form8979,
The views of majority interest partners,
The partner’s or other person’s general knowledge of tax matters and administrative matters,
The partner’s or other person’s access to the books and records of the partnership,
The profits interest held by the partner,
Whether there is a partner from the year under examination or a partner at the time the partnership representative selection is made,
Whether the person is a United States person, and
The person’s ability to meet with the IRS to participate in the examination.

Inquiries to determine the above items, may requires seeking information and discussing the matter with partners, employees, and other prospective candidates to assess the person’s depth of knowledge. These inquiries are not considered by the IRS to be disclosures or third-party contacts under sections 6103 and 7602. However, the IRS should not address or inquire about tax issues during such preliminary discussions.

Administrative Adjustment Request (AAR)

A partnership may file an AAR under section 6227 with respect to any PRI and correct errors on a previously filed partnership return. However, a partnership may not file an AAR solely for the purpose of changing the designation of a PR.

The filing of an AAR will extend the section 6235(a)(1) statute date which is 3 years from the date the AAR was filed.

Only the PR (or DI, if applicable) may sign and file an AAR on behalf of the partnership.

A partner may not make a request for an administrative adjustment of a PRI unless the partner is a PR (or DI, if applicable) and is doing so on behalf of the partnership.

The AAR is filed with the IRS service center where the original return was filed.

A partnership may not file an AAR more than 3 years after the later of the date the partnership return for such taxable year was filed or the last day for filing such partnership return (without regard to extension); or after a notice of administrative proceeding (NAP) has been issued with respect to such taxable year.

A partnership must determine whether the adjustments requested in the AAR result in an imputed underpayment. If so, the partnership must take the adjustments into account and make payment unless the partnership makes a valid election for the adjustments to be taken into account by the reviewed year partners.

In general, the partnership must pay the imputed underpayment on the date the partnership files the AAR. A partnership may apply modifications to the amount of the imputed underpayment if a notification (Form 8980) is attached to the AAR and includes the following:

Notification to the IRS of the presence of any modification,
A description of the effect that each modification had on the calculation of the imputed underpayment,
An explanation of the basis for the modification made, and
Documentation to support the partnership’s eligibility for the modification.

If the partnership makes a valid election to have adjustments resulting in an imputed underpayment be taken into account by reviewed year partners, the partnership is not required to pay the imputed underpayment.

If the adjustments requested in the AAR do not result in an imputed underpayment, such adjustments must be taken into account by the reviewed year partners.

If a reviewed year partner is required to take into account the adjustments requested in the AAR, the partnership must furnish a statement to the reviewed year partner and file such statement with the IRS on the date the AAR is filed. Each statement must include correct information as follows:

The name and TIN of the reviewed year partner;
The current or last address of the partner that is known to the partnership;
The reviewed year partner’s share of items as originally reported or previously reported;
The reviewed year partner’s share of the adjustments in the underlyingAAR;
The date the statement is furnished to the partner; and
The partnership taxable year to which the adjustments relate.

If a partner of the partnership that filed an AAR is a pass-through entity, the pass-through partners must issue statements to its partner and include the following (in addition to the above).

The name and TIN of the partnership that filed the AAR;
The adjustment year of the partnership that filed the AAR; and
The extended due date for the adjustment year return of the partnership that filed the AAR.

Note: The above list doesn’t have all the items required for pass-through partners.

Each reviewed year partner must take into account their share of all the adjustments requested in the AAR as shown on such statements.

Each reviewed year partner’s share of the adjustment requested in the AAR is determined in the same manner as each adjusted PRI was originally allocated on the partnership return for the reviewed year.

If the partnership pays an imputed underpayment with respect to the adjustments requested in the AAR, the reviewed year partner’s share of the adjustments requested in the AAR only includes adjustments that did not result in the imputed underpayment.

If the adjusted PRI was not reported on the partnership’s return for the reviewed year, each reviewed year partner’s share of the adjustments will be based on how such items would have been allocated per the partnership agreement.

If an adjustment involves a reallocation of an item, the reviewed year partner’s share of the adjustment requested in the AAR is determined in accordance with the AAR.

AAR exam scope

The IRS may determine that an AAR is not valid or readjust any items that were adjusted on the AAR. Also, the amount of an imputed underpayment determined by the partnership, including any modifications, may be re-determined by the IRS.

The partnership audit plan should include any PRI that you do not agree with, including the following:

Any substantial issue relating to the adjustments requested in the AAR,
Discrepancies in the imputed underpayment as determined in the AAR, including modifications, and
The allocation of the adjustments to the reviewed year partners as reported in the filed statements.

Initiating taxpayer contact (Letter 2205-D)

All initial taxpayer contacts are required to be made by mail. The IRS will mail Letter 2205-D to all partnerships regardless of the tax year.

Letter 2205-D is used to:

Provide notice of selection for examination to any partnership, whether subject to the unified rules under TEFRA (Tax Equity and Fiscal Responsibility Act of 1982), the centralized partnership audit regime (Bipartisan Budget Act of 2015), or separate deficiency proceedings;
Confirm certain information of record; and
Request that the taxpayer call-back to schedule an initial appointment for the examination of partnership income tax returns.

BBA partnership Form 2848, Power of Attorney (POA)

Form 2848, Power of Attorney and Declaration of Representative, is used to authorize an individual to represent a PR who is acting on behalf of the partnership under the centralized partnership audit regime.

A power of attorney (including a Form 2848, Power of Attorney) may not be used to designate a partnership representative.

The PR or DI (for an EPR) of record must sign the Form 2848 and the authorized individual must be eligible to practice before the IRS.

For matters unrelated to the centralized partnership audit regime, a separate Form 2848 must be signed by a partner that has authority to do so under state law. For dissolved partnerships, see 26 CFR 601.503(c)(6).

Note: Any statute extension (Form 872-M) should be signed by the PR or DI (for an EPR).

Notice of Administrative Proceeding (NAP)

The IRS must mail to the partnership and PR a NAP when initiating an examination of the partnership for a taxable year, including an examination following an AAR filed by the partnership. The IRS should issue the NAP no earlier than 30 days but no later than 60 days from the issuance of Letter 2205-D.

The NAP will generally be mailed by certified mail. Letter 5893 will be mailed to the partnership’s last known address. Letter 5893-A will be mailed to the PR’s last known address that is reflected in the IRS records as of the date the letter is mailed.

If there is no PR in effect, the IRS will generally mail the NAP to “PARTNERSHIP REPRESENTATIVE” at the last known address of the partnership

If the PR NAP is mailed to an address other than the address shown on the Form 1065 and it is returned as undeliverable, the IRS must mail the PR NAP by certified mail to the address reflected on the partnership return.

A partnership cannot file an AAR and its partners cannot amend their returns to file inconsistently from the partnership after the NAP has been mailed with respect to the taxable year.

A separate NAP will be sent for each year under examination since each year stands on its own. Not that different audit regimes could apply to the different years.

Withdrawal of the NAP

The IRS may, without consent of the partnership, withdraw a NAP within 60 days from the issuance of the NAP if it is determined an AAR had been filed before the issuance of the NAP and no exam is warranted, or for other reasons.

Consistency principle

In general, a partner’s return must be consistent with the partnership return in all respects, including:

Items reported on the partnership return filed with the IRS (including amendments or supplements thereto),
Any AAR filed by the partnership under section 6227 and the regulations thereunder, and
Any statement, schedule or list (including amendments or supplements thereto) filed by the partnership with the IRS pursuant to section 6226 and the regulations thereunder.

A partner is also bound by any action taken by the partnership and any final decision in a proceeding with respect to the partnership under the BBA regime.

For example, a partnership subject to the BBA regime elects to push out the adjustments to its reviewed year partners. Each partner must take into account the adjustments consistently with how the adjustments are reflected on the statement issued by the partnership. Otherwise, it is considered a failure to treat a PRI in a manner which is consistent with the partnership return.

If the treatment of an item on the partner’s return is consistent with how the item was treated on a schedule (e.g., Schedule K-1) or other information furnished to the partner by the partnership but inconsistent with the treatment of the item on the partnership return that is filed with the IRS, the partner’s reporting is considered inconsistent with the partnership return. Upon notice of such inconsistency, a partner may file an election under section 6222(c)(2)(B) to be treated as providing notice to the IRS of the inconsistent treatment.

A partner’s treatment of a PRI attributable to a partnership that did not file a return is per se inconsistent.

For example, a foreign partnership is required to file a return under section 6031 but failed to file one for calendar year 2018. A domestic partner claimed losses arising from the foreign partnership in calendar year 2018. The domestic partner’s reporting of the loss is inconsistent with the partnership return.

For a partner that is a partnership (partnership-partner), the consistency principle applies regardless if the partnership-partner is subject to the centralized partnership audit regime or has made an election out pursuant to section 6221(b).

Partner fails to report a PRI consistently

When a partner fails to report an item on its return consistent with the partnership, whether intentional or not, there are two treatment streams depending on whether the partner has provided notice of the inconsistently reported PRI to the IRS.

Generally, if the partner files inconsistently and does not provide notice, math error will apply, and the IRS may assess any resulting tax to make the partner consistent. Deficiency procedures will not apply to such assessment.
If the partner files inconsistently but provides notice of the inconsistency (via Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request), math error correction will not apply.

The notice provision only applies to items reported on the partnership return filed with the IRS (including amendments or supplements thereto) and PRI reported on an AAR filed by the partnership under section 6227 and the regulations thereunder.

Math error correction

The IRS may adjust the inconsistently reported item on the partner’s return to make it consistent and assess the underpayment of tax that results from that adjustment to correct the mathematical or clerical error when:

A partner filed inconsistently with the partnership return and did not provide notice to the IRS of such inconsistent treatment.
A partner filed inconsistently with items reported from an AAR under section 6227 and the regulations thereunder and did not provide notice to the IRS of such inconsistent treatment.
A partner filed inconsistently with any statement, schedule or list (including amendments or supplements thereto) filed by the partnership with the IRS pursuant to section 6226 and the regulations thereunder regardless if notice was provided.
A partner filed inconsistently with any final decision in a proceeding with respect to the partnership under the BBA regime regardless if notice was provided.

The procedures under section 6213(b)(2) for requesting abatement of an assessment made on the basis of math error do not apply.

The underpayment of tax is the amount by which the correct tax, as determined by making the partner’s return consistent with the partnership return, exceeds the tax shown on the partner’s return.

For any partnership-partner that is subject to the BBA regime, the underpayment of tax is determined in accordance with §301.6225-1 (an imputed underpayment) and may be assessed at the partnership-partner level.

The math error correction is not considered an FPA under section 6231(a)(3) and a petition for readjustment under section 6234 is not applicable.

For any partners that are nonBBA partnerships or S-Corporations, the math error correction must be assessed to the reviewed year partners (or indirect partners) and shareholders, respectively.

Notifying the partner of an assessment on account of mathematical error

The IRS will provide a Letter 6202, Notice of Partner’s Inconsistency, which identifies the adjustment(s) with respect to inconsistent treatment and the underpayment of tax on account of math or clerical error, including any penalty and interest as provided by law. The letter is mailed to the partner’s last known address. If the partner corrects the inconsistency or qualifies and makes a valid election to be treated as having provided notice, then a math error correction will not apply.

Only a partnership-partner may correct the inconsistency by filing an AAR (for partnership-partner subject to the BBA) under section 6227 or an amended partnership return (for partnership-partner not subject to the BBA) prior to assessment.

If correction (via filing of AAR or amended return) for the inconsistency is made within 60 days from the issuance of Letter 6062, the partnership- partner has complied with the requirements.
If no correction is made or can be made within the 60-day period, an assessment due to math error will be made. Contact the BBA POC.

If the inconsistency is due to the partner filing consistently with a statement, schedule or other form prescribed by the IRS and furnished to the partner by the partnership (e.g., Schedule K-1) but differs from what the partnership actually filed with the IRS, then the partner has 60 days from the issuance of Letter 6062 to file a written election under section 6222(c)(2)(B).

The written election must demonstrate that the treatment of such item on the partner’s return is consistent with the treatment of that item on the statement, schedule, or other form prescribed by the IRS as furnished by the partnership.

The written election must have the following contents:

Clearly identify as an election under section 6222(c)(2)(B),
Signed by the partner making the election,
Accompanied by a copy of the statement, schedule, or other form furnished to the partner by the partnership and a copy of the IRS notice that notified the partner of the inconsistency, and
Include any other information required in forms, instructions, or other guidance prescribed by the IRS.

If a valid election is filed timely, the election will be treated as having provided notification of the inconsistent treatment and the assessment based on math error will not apply (instead deficiency proceedings will apply)

A partner files inconsistently with the partnership return and provides notice of the inconsistent treatment

When a partner reports a PRI inconsistent with the treatment of such item on the partnership return and provides notice to the IRS (via Form 8082), assessment based on math error does not apply.A. Form 8082 must be attached to the partner’s return on which the PRI is treated inconsistently. Otherwise, the adjustment and corresponding assessment are considered as based on math error.

The partner is protected only to the extent of the items identified as inconsistent treatment. Assessments to the unidentified, inconsistent PRI on the partner’s return are treated as being based on math error.

If the IRS disagrees with the identified inconsistent treatment, the IRS may adjust the identified, inconsistently reported item in a deficiency proceeding with respect to the partner as follows:

To make the item consistent with the treatment of that item on the partnership return, or
To determine the correct treatment of such item, notwithstanding the treatment of that item on the partnership return.

Any final decision with respect to an inconsistent position in a proceeding to which a partnership is not a party is not binding on the partnership.

Informal claims (LB&I Taxpayers)

As discussed above, after a NAP is issued, an AAR cannot be filed. However, for LB&I taxpayers, the partnership may submit informal claims within 30 days from the opening conference which is consistent with the LB&I Examination Process (LEP). An informal claim is a request to change any PRI that may result in a negative adjustment.

Note: LB&I examiners are required to address the informal claim procedures with the partnership at the opening conference.

Informal claims timely submitted by a BBA partnership must meet the standards of Treasury Regulation Section 301.6402-2, which provides that a valid claim must:

Set forth in detail each ground upon which credit or refund is claimed;
Present facts sufficient to apprise the IRS of the exact basis for the claim; and
Contain a written declaration that it is made under penalties of perjury.

A BBA partnership must submit or mail the informal claim to the person whose name appears on Letter 2205-D within 30 days from the initial conference.

The adjustment will reflect on the applicable grouping and subgrouping per purposes of Forms 14791 and 14792.

The adjustment will reflect in the “Other Information” section of Forms 14791 and 14792.

The IRS will not accept any informal claim after the 30-day window has lapsed unless certain exceptions are met as provided under the LEP.

Statute of limitations (SOL) on making adjustments

The statute of limitations under section 6235 is applicable to the time allowed to make partnership adjustments instead of time to assess. The general rule is that no partnership adjustment for any partnership taxable year may be made after the later of three specified dates:

6235(a)(1) date,
6235(a)(2) date, or
6235(a)(3) date.

The notice of proposed partnership adjustment must be issued prior to the expiration of the 6235(a)(1) date.

The 6235(a)(1) date is the later of:

3 years after the date the return was due;
3 years after the date the return was filed; or
3 years after an Administrative Adjustment Request (AAR) is filed.

The following chart sets out several relevant statutes of limitations provisions:

IRC 6235(c)(2): Substantial omission of income in excess of 25 percent of the amount of gross income per 6501(e)(1)(A) [or omission from gross income of amounts properly includible under IRC 951(a) per 6501(e)(1)(C).]	6 years
IRC 6235(c)(3): Failure to file a partnership return.Note: Under IRC 6235(c)(4), a return executed by the Secretary under IRC 6020(b) on behalf of the partnership shall not be treated as a return of the partnership.	Adjustments can be made at any time
IRC 6235(c)(5): Reportable foreign transactions – failed to report information described in section 6501(c)(8).	Date that is determined under IRC 6501(c)(8)
IRC 6235(c)(6): Listed Transactions – failed to include any information with respect to a listed transaction as described in IRC 6501(c)(10).	Date that is determined under IRC 6501(c)(10)

The IRS will generally request an extension if the 6235(a)(1) date will expire within 14 months if the case is not a no-change. If the partnership refuses to extend the 6235(a)(1) date, The IRS will generally begin the process of closing the examination.

A partnership may request to go to Appeals and protest an adjustment on a substantive issue, any penalty associated with such adjustment, and the imputed underpayment amount.

No change exam

If the examination results in a no-change he partnership agrees with the no-change, Technical Services will prepare and CCP will issue the no-change letters to the partnership (Letter 6099) and PR (Letter 6099-A).

Partnership adjustments and imputed underpayment (IU)

A partnership does not compute and pay an income tax upon filing Form 1065 but instead passes through any profits and losses to its partners. However, when a partnership is examined under the BBA regime, any partnership adjustment resulting in an imputed underpayment and the applicability of any penalty, addition to tax, or additional amount (plus interest as provided by law) that relates to such adjustment are determined, assessed and collected at the partnership level.

In general, Form 886-A, Explanation of Items, is used to convey each adjustment. In addition to preparing a Form 886-A for each substantive issue, you will prepare a Form 886-A for the imputed underpayment.

An imputed underpayment may reflect an amount that is larger than the cumulative amount of tax the partners would have paid as a result of the partnership adjustments. Disregarding adjustments that would otherwise reduce the imputed underpayment and using the highest tax rate permit a streamlined audit process in which the IRS and the partnership generally do not account for particular partners’ facts and circumstances. The imputed underpayment determination allows the partnership to pay an amount of tax that generally eliminates the need for the IRS to proceed against and collect from the partnership’s partners.

There are two types of imputed underpayments: a general imputed underpayment and a specific imputed underpayment. Each type of imputed underpayment is based solely on partnership adjustments with respect to a single taxable year.

Imputed underpayment (IU)

The formula for computing the imputed underpayment (IU) is as follows:

Highest rate in effect for the reviewed year under section 1 or 11

Sum of Net positive adjustments to creditable expenditure and credit groupings (and net negative adjustment to credit grouping if appropriate)

+/-

Total netted partnership adjustments (TNPA)

Imputed Underpayment (IU)

The process of taking the proposed audit adjustments and inputting those adjustments into the above formula requires an understanding of the unique BBA concepts of grouping, subgrouping and netting.

Grouping involves placing each proposed audit adjustment into one of four groupings: reallocation, credit, creditable expenditure and residual. Each of these groupings will be explained in more detail below.

After an adjustment is placed into a grouping, subgrouping is the process of further defining that adjustment into a subgrouping, generally in accordance with how that adjustment would be required to be taken into account separately under section 702(a) or any other provision of the Code. This is necessary to keep adjustments that are similar in nature together while keeping adjustment that are different apart. These subgroups generally follow the line items on Schedule K/K-1 or other separate and distinct line items on Form 1065 and schedules. However, subgrouping is only necessary when any proposed adjustment within a grouping is a negative adjustment.

A negative adjustment is any adjustment that is a decrease in an item of gain or income, an increase in item of loss or deduction, or an increase in an item of credit or creditable expenditure.

A positive adjustment is any adjustment that is not a negative adjustment.

Generally, netting is the process of summing all adjustments together within each grouping or subgrouping, as appropriate. The specific rules and limitations of netting will be discussed later.

Once all adjustments have been grouped, subgrouped (if applicable) and netted, the total netted partnership adjustment (TNPA) can be determined and entered into the above formula. The TNPA is the sum of all net positive adjustments in the reallocation grouping and the residual grouping. If, after netting, either the reallocation or residual grouping summed total is less than or equal to zero, it is not taken into account in calculating the TNPA.

A net positive adjustment means an amount that is greater than zero which results from netting adjustments within a grouping or subgrouping. A net positive adjustment includes a positive adjustment that was not netted with any other adjustment.

A net negative adjustment means any amount which results from netting adjustments within a grouping or subgrouping that is not a net positive adjustment. A net negative adjustment includes a negative adjustment that was not netted with any other adjustment.

Multiply the TNPA by the highest rate of Federal income tax in effect for the reviewed year under section 1 or 11 and increase or decrease the product by: The net positive adjustments from the creditable expenditure grouping.

Note: A net decrease to creditable expenditures is treated as a net positive adjustment to credits and increases the product of the TNPA times the highest tax rate in effect.

Note: A net increase to creditable expenditures is treated as a net negative adjustment that is excluded from the calculation of the TNPA and is an adjustment that does not result in an IU.

The net positive adjustments from the credit grouping.

The net negative adjustment from the credit grouping if the examination team determines that it is appropriate to allow the net negative adjustments to be taken into account in calculating the IU.

Only the net positive adjustment in each grouping will be used to compute the IU, except for credit grouping.

A net negative adjustment does not result in an IU; thus, such adjustment must be taken into account by the partnership in the adjustment year. That is, the adjustment is included on the partnership’s tax return for the year in which such adjustment becomes final.

The adjustment year is the taxable year in which:

The notice of final partnership adjustment (FPA) is mailed or when a waiver of the FPA is executed by the IRS, or
If a petition under section 6234 is filed, the date when the court’s decision becomes final.

Steps in computing the imputed underpayment (IU)

Computing the IU requires approximately 7 steps:

Step 1

The first step in computing an IU involves the placing of each proposed adjustment into one of four groupings: reallocation, credit, creditable expenditure and residual groupings. Each of the four groupings is explained below:

Reallocation grouping – In general, any adjustment that allocates or reallocates a PRI to and from a particular partner or partners is a reallocation adjustment, except for an adjustment to a credit or to a creditable expenditure. Each reallocation adjustment generally results in at least two separate adjustments, each of which become a separate subgrouping. See step 2 which discusses the concept of “subgrouping.”
One leg of the reallocation adjustment reverses the effect of the improper allocation of a PRI that will result in a negative adjustment. This adjustment must be taken into account by the partnership in the adjustment year and cannot generally be netted against other adjustments. See step 3 which discusses the concept of “netting.”
The other leg of the adjustment makes the proper allocation of the PRI and will result in a positive adjustment.
These reallocations are theoretical to the actual partners impacted, that is, they will not impact the partner themselves.

Credit grouping – Any adjustment to a PRI that is reported or could be reported by a partnership as a credit on the partnership’s return, including a reallocation adjustment to such PRI, is placed in the credit grouping.

Generally, a decrease in credits is treated as a positive adjustment, and an increase in credits is treated as a negative adjustment.
A reallocation adjustment relating to the credit grouping is placed into two separate subgroupings and will not be netted together nor will they be netted with other credit adjustments (except for other credit reallocation adjustments allocable to that partner or group of partners).
1. A decrease in credits allocable to one partner or group of partners is treated as a positive adjustment generally in its own subgrouping.
2. An increase in credits allocable to another partner or group of partners is treated as a negative adjustment generally in its own subgrouping and does not result in an IU and must be taken into account by the partnership in the adjustment year.

expenditure grouping – Any adjustment to a PRI where any person could take the item that is adjusted (or item as adjusted if the item was not originally reported by the partnership) as a credit (i.e., creditable foreign tax expenditure or qualified research expense), including a reallocation adjustment to a creditable expenditure, is placed in the creditable expenditure grouping.

Generally, a decrease in creditable expenditures is treated as a positive adjustment to credits, and an increase in creditable expenditures is treated as a negative adjustment.

A reallocation adjustment relating to creditable expenditure grouping is placed into two separate subgroupings and will not be netted together.

A decrease in creditable expenditures allocable to one partner or group of partners is treated as a positive adjustment to credits.

An increase in creditable expenditures allocable to another partner or group of partners is treated as a negative adjustment and does not result in an IU and must be taken into account by the partnership in the adjustment year.

Example: if the adjustment is a reduction of qualified research expenses, the adjustment is to a creditable expenditure grouping because any person allocated the qualified research expenses by the partnership could claim a credit with respect to their allocable portion of such expenses under section 41, rather than a deduction under section 174.

Residual grouping – Any adjustment to a PRI that doesn’t belong in the reallocation, credit, or creditable expenditure grouping is placed in the residual grouping. Also includes any adjustment to a PRI that derives from an item that would not have been required to be allocated by the partnership to a reviewed year partner under section 704(b), such as an adjustment to a liability amount on the balance sheet.

Creditable expenditure grouping – Any adjustment to a PRI where any person could take the item that is adjusted (or item as adjusted if the item was not originally reported by the partnership) as a credit (i.e., creditable foreign tax expenditure or qualified research expense), including a reallocation adjustment to a creditable expenditure, is placed in the creditable expenditure grouping.

Generally, a decrease in creditable expenditures is treated as a positive adjustment to credits, and an increase in creditable expenditures is treated as a negative adjustment.
A reallocation adjustment relating to creditable expenditure grouping is placed into two separate subgroupings and will not be netted together.
1. A decrease in creditable expenditures allocable to one partner or group of partners is treated as a positive adjustment to credits.
2. An increase in creditable expenditures allocable to another partner or group of partners is treated as a negative adjustment and does not result in an IU and must be taken into account by the partnership in the adjustment year.
3. Example: if the adjustment is a reduction of qualified research expenses, the adjustment is to a creditable expenditure grouping because any person allocated the qualified research expenses by the partnership could claim a credit with respect to their allocable portion of such expenses under section 41, rather than a deduction under section 174.

Any adjustment that changes the character of a PRI is a re-characterization adjustment. A re-characterization adjustment will generally result in at least two separate adjustments in the appropriate grouping (reallocation, credit, creditable expenditure, or residual).

One adjustment reverses the improper characterization of the PRI that will result in a negative adjustment.
The other adjustment makes the proper characterization of the PRI and will result in a positive adjustment.
The adjustments that result from a re-characterization are generally placed into separate subgroupings.

If the effect of a partnership adjustment is reflected and taken into account in one or more other partnership adjustments, you may treat the adjustment amount as zero solely for purposes of computing the IU.

Step 2.

The second step in computing an IU is to determine if any proposed adjustment, within one of the four groupings, needs to be subgrouped. If all the proposed adjustments within any grouping are positive adjustments only, then subgrouping is not required for such grouping, and you can determine the IU at this point by plugging in the positive numbers to the above formula. If any of the proposed adjustments within a grouping is a negative adjustment, then subgrouping for that grouping is required. Each of the proposed adjustments will need to be subgrouped according to the following rules.

Each adjustment is subgrouped according to how the adjustment would be required to be taken into account separately under section 702(a) or any other provision of the Code, regulations, forms, instructions, or other guidance prescribed by the IRS applicable to the adjusted PRI. For purposes of creating subgroupings, if any adjustment could be subject to any preference, limitation, or restriction under the Code (or not allowed, in whole or in part, against ordinary income) if taken into account by any person, the adjustment is placed in a separate subgrouping from all other adjustments within the grouping.
Generally, each separate line item of Schedule K/K-1 or return schedule (i.e., Schedule L, etc.), represents a separate and distinct subgrouping. The format for Schedule K/K-1 generally follows the requirement of section 702(a) that each partner is required to take into account separately their distributive share of each class or item of partnership income, gain, loss, deduction or credit. Thus, adjustments to ordinary income must be placed in a different subgroup as capital gain income or interest income since each of those items is required to be separately stated under section 702(a).
Separate line items on Schedule K/K-1 (or other schedules onForm 1065) may include multiple components making up the total shown. If any line item on Schedule K/K-1 or other schedules consists of multiple items and the components are required to be taken into account separately under the Code, regulations, forms, instructions, or other guidance prescribed by the IRS, then such line item must be further subgrouped. For example, if there is more than one type of income to be included on Schedule K/K-1, line 11, Other Income/(loss), the partnership is required to attach a statement to Form 1065 that separately identifies each type and amount of income for each distinct category and each of those would constitute a separate subgroup. As another example, if the Schedule K/K-1, line 1 ordinary income/(loss) entry includes income/loss from more than one trade or business activity, the partnership must identify on an attached statement to Schedule K/ K-1 the amount from each separate activity. Accordingly, the income/(loss) from each separate activity from Schedule K/K-1, line 1 would constitute a separate subgroup.
The ordinary income/(loss) amount reflected on line 1 of Schedule K/K-1, is sourced from Form 1065, page 1 and is a net amount consisting of various page 1 line items of income and expenses. Although those separate page 1 line items are distinct items of income and expense, if they are appropriately netted and included on line 1, Schedule K/K-1, the net amount will be considered a single subgroup, unless such amount is required to be separately delineated, such as when the partnership has more than one trade or business as previously noted.
If you have a negative adjustment along with a positive adjustment in the same line item of Schedule K/K-1, you must consider whether they may be properly netted at the partnership level and whether they are required to be taken into account separately by any partner because it may be subject to a limitation or preference under the Code before you can place them in the same subgroup.
A negative adjustment that is not otherwise required to be placed in its own subgrouping must be placed in the same subgrouping as another adjustment if the negative adjustment and the other adjustment would have been properly netted at the partnership level and such netted amount would have been required to be allocated to the partners of the partnership as a single item for purposes of section 702(a) or other provision of the Code and regulations.

A partnership may request to subgroup adjustments in a manner other than the manner described above, such request is generally done in modification under §301.6225-2 after the issuance of the NOPPA. With that being said, you have discretion to review and grant such request based on the facts and circumstances and you must contact the BBA POC before agreeing to the request.

iAny request must be supported by the facts and circumstances, such as partner-level information that a negative adjustment is not subject to a presumed preference, limitation, or restriction under the Code, or in fact allowed in full against ordinary income.

Step 3.

The third step in computing the imputed underpayment is to appropriately net all the proposed adjustments within each of the groupings and subgroupings.

Netting means summing all adjustments together within each grouping or subgrouping, as appropriate.

Positive adjustments and negative adjustments may only be netted against each other if they are in the same grouping or subgrouping. An adjustment in one grouping or subgrouping may not be netted against an adjustment in any other grouping or subgrouping. Adjustments from one taxable year may not be netted against adjustments from another taxable year.
If any grouping only includes positive adjustments (i.e., there are no subgroupings for that grouping), all adjustments in that grouping are added together to come up with a sum of all net positive adjustments.
All adjustments within a subgrouping are netted to determine whether there is a net positive adjustment or net negative adjustment for that subgrouping.
1. A net positive adjustment means an amount that is greater than zero which results from netting adjustments within a grouping or subgrouping. A net positive adjustment includes a positive adjustment that was not netted with any other adjustment. A net positive adjustment includes a net decrease in an item of credit.
2. A net negative adjustment means any amount which results from netting adjustments within a grouping or subgrouping that is not a net positive adjustment. A net negative adjustment includes a negative adjustment that was not netted with any other adjustment.

Step 4.

The fourth step is to compute the TNPA. The TNPA is the sum of all net positive adjustments in the reallocation grouping and the residual groupings.Each net positive adjustment with respect to a particular grouping or subgrouping in the residual or reallocation grouping that results after netting the adjustments is included in the calculation of the TNPA.

Each net negative adjustment with respect to a residual or reallocation grouping or subgrouping that results after netting the adjustments is excluded from the calculation of the TNPA because those adjustments do not result in an imputed underpayment.

Step 5.

The fifth step is to determine the highest rate in effect for the reviewed year under section 1 or 11.

Step 6.

The sixth step is to determine the sum of net positive adjustments to creditable expenditure and credit groupings that will increase or decrease the product of the TNPA times the highest rate in effect.
A net decrease to creditable expenditures is treated as a net positive adjustment to credits and increases the product of the TNPA times the highest tax rate in effect. A net increase to creditable expenditures is treated as a net negative adjustment that is excluded from the calculation of the TNPA and is an adjustment that does not result in an imputed underpayment.
For the credit grouping, a net positive adjustment will increase the product of the TNPA times the highest tax rate in effect. A net negative adjustment, including net negative adjustments resulting from a credit reallocation adjustment, will be treated as an adjustment that does not result in an imputed underpayment, unless the examination team determines that it is appropriate to allow the net negative adjustment to credit to reduce the product of the TNPA times the highest tax rate in effect.

Step 7.

The seventh and final step is to compute the IU based on the results of steps 4 through 6 and insert those results into the IU formula identified above.

Examples

1. The AB Partnership’s 2019 return is under examination. Form 1065, page 1 consists of gross receipts of $1,000 and COGS of $250 for a net ordinary business income of $750 from a single activity. The $750 of net ordinary business income was included on Schedule K, line 1. The revenue agent proposes to increase gross receipts by $100 and increase COGS by $30. The $100 increase in gross receipts represents a positive adjustment while the increase in COGS represents a negative adjustment. Both of these adjustments are placed in the residual grouping since neither is properly classified as a reallocation, credit or creditable expenditure grouping. Since one of the adjustments is negative, subgrouping is required. The agent verified that AB Partnership netted the gross receipts and COGS as a single partnership-related item on Schedule K, line 1, and therefore, the negative adjustment for COGS will be subgrouped with the positive gross receipts adjustment. After netting these adjustments, the result is a net positive adjustment of $70 in the Schedule K, line 1 subgroup as well as a net positive adjustment in the residual grouping. The $70 will be included in the total netted partnership adjustment for purposes of computing the imputed underpayment.

2. The facts are the same as example 1 above, except the partnership’s operations included two distinct activities (“Activity A” and “Activity B”). The net income from each activity were separately stated on a statement attached to Form 1065. The audit adjustment to gross receipts of $100 (increase) was identified as being related to Activity “A” while the adjustment to COGS of $30 (increase) was identified as being related to Activity “B.” Again, both the positive adjustment to gross receipts of $100 and the negative adjustment of $30 to COGS are placed in the residual grouping. Since the separate net income from each activity are required to be separately stated on line 1 of Schedules K/K-1 (via an attached schedule), those amounts were not treated as a single partnership-related item for purposes of section 702(a) and were not allocated as a single item on the filed tax return as was proper. Therefore, each adjustment must be placed into a separate subgroup within the residual grouping. The two subgroups (within the residual grouping) could be identified as “Schedule K, line 1, Activity A” and “Schedule K, line 1, Activity B” or similar. Under the netting rules, netting adjustments across subgroups is not permitted and the positive $100 adjustment and the negative $30 adjustment may not be netted. Thus, the residual grouping contains a net positive adjustment of $100 (netting rules only allow positive adjustments to be added together in each grouping to arrive at a net positive adjustment). This amount will be included in the total net partnership adjustment for purposes of computing the imputed underpayment. The net negative adjustment of $30 is an adjustment that does not result in an imputed underpayment and must be included on the partnership’s tax return for the year in which such adjustment becomes final.

For any reallocation adjustment, the IRS will include the name and TIN of the impacted partner and whether the allocation is “to” or “from” such partner.

Interest and Penalties

Under the centralized partnership audit regime, the partnership is liable for any interest and penalties associated with any imputed underpayment (unless they elect the alternative to payment of imputed underpayment under section 6226).

IRS protocol requires the examining agreement to compute the applicable penalties and consider reasonable cause and good faith defenses.

For purposes of computing the penalty, the partnership is treated as an individual subject to tax under chapter 1 of subtitle A of the Code.
A partner-level defense may not be raised at the partnership level.

Managers must review and approve whether any penalties should be imposed as part of the examination.

30-day letter package

A partnership may protest and seek to go to Appeals for any un-agreed partnership adjustment, including the substantive issues, imputed underpayment amount and penalty.

If the partnership requests to go to Appeals, the IRS generally requires at least 18 months remaining on the 6235(a)(1) date when the case is transferred to Technical Services.

The 30-day letter package includes the following:

Letter 5891, 30-Day Letter,
Form 14791, Preliminary Partnership Examination Changes, Imputed Underpayment Computation and Partnership Level Determinations as to Penalties, Additions to Tax and Additional Amounts, and
Form 886-A, Explanation of Adjustments for both substantive issues and imputed underpayment of tax.

Notice of proposed partnership adjustment (NOPPA) package

The NOPPA package is required in any administrative proceeding (examination) under the BBA regime, including an administrative proceeding with respect to an administrative adjustment request (AAR) filed by a partnership under section 6227. A NOPPA package is prepared for each partnership taxable year unless it is a no-change.

A NOPPA package is prepared for each partnership taxable year unless it is a no-change.

The NOPPA package includes the following:

Form 14792, Partnership Examination Changes, Imputed UnderpaymentComputation and Partnership Level Determinations as to Penalties,Additions to Tax and Additional Amounts,
Letter 5892, Notice of Proposed Partnership Adjustments- Partnership,
Letter 5892-A, Notice of Partnership Adjustments-PartnershipRepresentative, and
Forms 886-A, Explanation of Adjustments for both substantive issues and imputed underpayment amount.

Federal Income Tax Characterization of Transactions Involving Computer Programs

The sale of a computer program—it seems simple. But, as illustrated by the Treasury Regulations’ computer program characterization rules, the issue of just what a sale of computer program is can become confusing fast.

The Computer Program Characterization Regulations

Treasury Regulation § 1.861-18 provides rules for characterizing primarily cross-border transactions involving computer programs.[1] For these purposes, a “computer program” means “a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result.”[2] The term also includes certain items incidental to the operation of a computer program.[3]

In characterizing a transaction involving a computer program, neither general principles of copyright law nor the parties’ characterization of the transaction are determinative.[4] For instance, it doesn’t matter if the parties label a transaction a license or payments as royalties if factors present in the transaction warrant a different treatment.[5] The means by which the computer program is transferred also is irrelevant.[6]

Ultimately, there are six possible results from the application of the computer program characterization rules: 1) the sale or exchange of copyright in a computer program, 2) the license of a copyright in a computer program (generating royalties income), 3) the sale or exchange of a copy of a computer program, 4) the lease of a copy of a computer program, 5) the provision of services for the development/modification of a computer program; or 6) the provision of know-how relating to computer programming techniques.[7]

To get to these results, the regulations first require that we distinguish between the transfer of the copyright in a computer program versus the transfer of a copy of a computer program.[8]

A transaction is the transfer of a copyright right if the purchaser acquires any one of the following rights:

the right to make copies of the computer program for purposes of public distribution;
the right to prepare derivative computer programs based on the copyrighted computer program;
the right to make a public performance of the computer program;
the right to publicly display the computer program.[9]

If there’s a transfer of all substantial rights in a copyright, then the transaction is sourced as the sale or exchange of the copyright (i.e., the sale or exchange of personal property).[10] If the transaction doesn’t result in the transfer of all substantial rights in copyright, the transaction is characterized as a license with the resulting income being royalties.[11]

On the other hand, if the purchaser acquires a copy of a computer program but none of the copyright rights mentioned above, then the transaction usually is characterized as the sale of a copyrighted article.[12] If the benefits and burdens of ownership of the copyrighted article are transferred to the purchaser, then the transaction is characterized as the sale or exchange of the copyrighted article.[13] But, if the benefits and burdens of ownership of a copyrighted article don’t transfer to the purchaser, then the transaction is characterized as the lease of the copyrighted article, giving rise to rental income.[14]

The computer program characterization regulations give relatively short shrift to determining when a transaction is best characterized as the provision of development or modification services or the provision of know-how. We’re told that determining whether a transaction involving a new or modified computer program should be characterized as the provision of services is based on all the facts and circumstances.[15] These include which party was intended to own the copyright rights in the computer program and how the parties allocated risks of loss.[16] The provision of information relating to a computer program is to be characterized as the provision of know-how only if the information relates to computer programming techniques, is furnished under specifically contracted for conditions preventing unauthorized disclosure, and is considered property subject to trade secret protection.[17]

Recent Developments in Computer Program Taxation

The computer program characterization regulations were finalized in 1998.[18] In 2019, the issued proposed regulations that would update the computer program characterization regulations to account for transfers of digital content more generally and to add a new set of rules dealing with the characterization of cloud transactions.[19]

Under the proposed regulations, the term “computer programs” in the current computer program characterization regulations would largely be replaced by the term “digital content,” which would be defined as “a computer program or any other content in digital format that is either protected by copyright law or no longer protected by copyright law solely due to the passage of time.”[20] The right to make a public performance or display digital content would be added to the list of copyright rights to be used in distinguishing the transfer of a copyright right versus the transfer of a copyrighted article on the one hand and the sale of a copyright versus the license of a copyright on the other.[21] When a transaction is characterized as the sale of a copyrighted article and the article is transferred electronically, the location where the sale occurs would be determined by where the article was downloaded or installed on the end-user’s device.[22]

Cloud transactions would be characterized either as the provision of services or the lease of property.[23] A “cloud transaction” would be defined as “a transaction through which a person obtains on-demand network access to computer hardware, digital content . . . , or other similar resources . . . .”[24] The term would not include network access to download digital content.[25] In determining whether a cloud transaction is the provision of services or the lease of property, all relevant factors would have to be considered.[26] Factors indicating that a cloud transaction is the provision of services would include:

the customer doesn’t physically possess the property;
the customer doesn’t control the property;
the provider can determine which property is used in the cloud transaction and replace that property with comparable property;
the property is part of an integrated operation in which the provider has other responsibilities, including maintaining and updating the property;
the customer doesn’t have any significant economic or possessory interest in the property;
the provider bears the risk of substantially diminished receipts or substantially increased expenditures for nonperformance under the contract;
the provider uses the property to provide significant services to entities unrelated to the customer;
the provider’s fee is primarily based on a measure of work performed or the level of the customer’s use rather than mere passage of time; and
the total contract price substantially exceeds the rental value of the property for the contract period.[27]

Parting Thoughts on Computer Program Taxation

With the increasing digitalization of everyday life, rules for characterizing cloud transactions and transactions involving computer programs and digital content will become increasingly relevant. Expect more on this in the future.

Freeman Law Tax Attorneys

[1] 26 C.F.R. § 1.861-18(a)(1). The parts of the Internal Revenue Code to which the regulation specifically applies include Chapter 1, Subchapter N (“Tax Based on Income From Sources Within or Without the United States”), Section 367 (“Foreign Corporations”), Section 404A (“Deduction For Certain Foreign Deferred Compensation Plans”), Section [14] I.R.C. § 482 (“Allocation Of Income And Deductions Among Taxpayers”), Section 679 (“Foreign Trusts Having One Or More United States Beneficiaries”), Section 1059A (“Limitation On Taxpayer’s Basis Or Inventory Cost In Property Imported From Related Persons”), Chapter 3 (“Withholding of Tax on Nonresident Aliens and Foreign Corporations”), Section 842 (“Foreign Companies Carrying On Insurance Business”), Section 845 (“Certain Reinsurance Agreements”), and transfers to foreign trusts not covered by Section 679. Id.

The Internal Revenue Service also intends these rules to apply for purposes of applying and interpreting U.S. tax treaties. 63 Fed. Reg. 52971, 52972 (Oct. 2, 1998).

[2] 26 C.F.R. § 1.861-18(a)(3).

[3] Id.

[4] Id. § 1.861-18(g)(1).

[5] Id. § 1.861-18(h) ex.(5)(ii)(B).

[6] Id. § 1.861-18(g)(2).

[7] See id. § 1.861-18(b)(1), (f)(1), (f)(2).

[8] See id. 26 C.F.R. § 1.861-18(b)(1), (f)(1), (f)(2).

[9] Id. § 1.861-18(c)(1)(i), (2). A purchaser doesn’t have the right to distribute a computer program to the public if it is only allowed to distribute the program to a related person or identified persons. Id. § 1.861-18(g)(3)(i). This applies regardless of the number of the number of employees or independent contractors of the transferee who are permitted to use the computer program. Id. § 1.861-18(g)(3)(ii).

[10] Id. § 1.861-18(f)(1). The regulations specify that most of the rules for sourcing sales of personal property apply to the sales of a copyright with the notable exception of the rule that applies to the sale of inventory property. See id.; 26 U.S.C. § 865(b).

[11] 26 C.F.R. § 1.861-18(f)(1). Under the income sourcing rules, U.S. source income “includes rentals or royalties from property located in the United States or from any interest in such property, including rentals or royalties for the use of, or for the privilege of using, in the United States patents, copyrights, secret processes and formulas, good will, trademarks, trade brands, franchises, and other like property.” Id. § 1.861-5; see also 26 U.S.C. § 861(a)(4).

The transfer of nonexclusive rights to reproduce a computer program for a limited period of time is indicative a license. 26 C.F.R. § 1.861-18(h) ex. (6)(ii)(B), (8)(ii).

[12] Id. § 1.861-18(c)(1)(ii). Among the factors that are considered in determining whether the benefits and burdens of ownership have been transferred to the purchaser is any limitation on the p of the period of time during which transferee may use the computer program. For instance, if the transferee can only use the program for certain period of time (after which period, the computer program is to be returned, destroyed, or locked), then the transaction is characterized as a lease of a copyrighted article. Id. § 1.861-18(f)(3), (h) Ex. (3)(ii)(B), Ex. (4)(ii)(B).

[13] Id. § 1.861-18(f)(2).

[14] Id. § 1.861-18(f)(2). Rental income is sourced in the same way as royalties. See 26 U.S.C. §§ 861(a)(4), 862(a)(4); 26 C.F.R. § 1.861-5.

[15] 26 C.F.R. § 1.861-18(d).

[16] Id. § 1.861-18(d). Thus, when Party A enters into a contract Party B pursuant to which Party B will develop a new computer program in which, regardless of whether the Party B completes the program, all copyright rights in the program and any of its constituent elements will belong to Party A and Party B will retain all payments from Party A, Party B is treated as providing services to Party A. Id. § 1.861-18(h) ex. (15).

[17] Id. § 1.861-18(e).

[18] 63 Fed. Reg. 52971.

[19] 84 Fed. Reg. 40317 (Aug. 14, 2019).

[20] Id. at 40324 (Prop. 26 C.F.R. § 1.861-18(a)(2)).

[21] Id. at 40324 (Prop. 26 C.F.R. § 1.861-18(c)(2)(iii), (iv)).

[22] Id. at 40325 (Prop. 26 C.F.R. § 1.861-18(f)(2)(ii)).

[23] Id. at 40326 (Prop. 26 C.F.R. § 1.861-19(a)).

[24] Id. at 40326 (Prop. 26 C.F.R. § 1.861-19(b)).

[25] Id.

[26] Id. at 40326 (Prop. 26 C.F.R. § 1.861-19(c)(1)).

[27] Id. at 40326 (Prop. 26 C.F.R. § 1.861-19(c)(2)). These factors are largely adapted from those listed in 26 U.S.C. § 7701(e). Id. at 40232.

The Tax Court in Brief March 29 – April 2, 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: Tax Court Cases: The Week of March 29 – April 2, 2021

Crandall v. Comm’r
Rowen v. Comm’r
Purple Heart Patient Center, Inc. v. Comm’r
Walton v. Comm’r| T.C. Memo. 2021-40
Max v. Comm’r| T.C. Memo. 2021-37
Rowen v. Comm’r| 156 T.C. No. 8

Crandall v. Comm’r | T.C. Memo 2021-39

March 29, 2021 | Vasquez, J. | Dkt. No. 9203-17

Tax Disputes Short Summary: The case discusses whether the IRS is allowed to determine a deficiency after entering into a closing agreement with a taxpayer for a certain period.

During 2003 through 2011 (the tax years), Mr. and Mrs. Crandall (the taxpayers) lived between the U.S. and Italy. Mrs. Crandall was also an Italian citizen and for some time was employed by the Italian Government, becoming eligible for a pension. They also paid Italian income tax on this income.

The taxpayers did not report their foreign income (pension income), interest and dividend income nor did they claim a foreign tax credit (FTC) for the taxes paid in Italy.

In 2012, the taxpayers entered into the Offshore Voluntary Disclosure Program (OVDP) and submitted 1040X for the tax years along with the appropriate payments. On the amended returns, they claimed FTCs in diverse amounts for the tax years. The OVDP submission was not accepted. The IRS then proposed adjustments to the 1040x basically reducing the amount of FTCs claimed. For 2011, a deficiency of $4,382 was proposed.

In 2015, the taxpayers and the IRS signed a Form 906, Closing Agreement on Final Determination Covering Specific Matters (the closing agreement). However, in the closing agreement, no reference was made to the amount of FTC to which the taxpayers were entitled in 2011.

In November 2015, the IRS assessed additional income tax for the 2011 taxable year, exceeding the amount originally proposed by the IRS. Although some part of this assessment was reduced, the IRS opened an examination for the 2011 tax return. As a result of the examination, the IRS issued a notice of deficiency for which the taxpayers filed a petition.

Tax Litigation Key Issues:

Whether the IRS is allowed to determine a deficiency for a period for which the taxpayer and the IRS had entered a closing agreement.

Primary Holdings: A closing agreement is a contract, consequently, the agreement must be construed in accordance with such intent. The IRS is not allowed to determine a deficiency for an item that was subject to a closing agreement and for which the parties intended to include within the agreement.

Key Points of Law:

The IRS can settle tax liabilities with any person for any taxable period by means of a closing agreement. R.C. 7121(a). Closing agreements can be entered by using one of two forms, Form 866, used to determined conclusively a taxpayer’s total tax liability, or Form 906, used to agree on separate items affecting the tax liability of the taxpayer. See Urbano v. Comm’r, 122 T.C. at 393; Zaentz v. Commissioner, 90 T.C. 753 , 760-761 (1988).
A closing agreement encompasses only the issues enumerated in the agreement itself. However, closing agreements are contracts. See Analog Devices, Inc. v. Commissioner, 147 T.C. at 446. As contracts, the closing agreements are subject to the Federal common law contract interpretation. And contracts are construed according to the intent of the parties. Based on these premises, the Court analyzed the agreement as a whole and in the context in which it was written.
The Court analyzed that multiple paragraphs of the closing agreement established that the taxpayer had FTC for 2011, although the amount was undetermined. Based on the language of the closing agreement, the Court determined that the provisions “reflected an intention to accord finality to the tax consequences stemming from petitioners’ income items that they disclosed”.
The Court also analyzed two additional arguments made by the IRS: First, that the FTC for 2011 was not included in the voluntary disclosure of the petitioners. Second, even if it was included, a subsequent adjustment to the item was permissible.
As for the first argument, the Court determined that the FTC for 2011 was part of the closing agreement because the taxpayers disclosed that the FTC pertained to their foreign-source income, was addressed in the closing agreement, and affected the calculation of additional tax liabilities. This allowed the Court to conclude that the 2011 FTC was an item to which the parties intended to accord finality.
In the analysis of the second argument, the Court determined that failure to specify an amount for the FTC did not mean there was no agreement about the FTC. Under three possible scenarios, the Court ruled that the FTC was in the amount shown in the original return, considering that the IRS had not accepted the amounts showed in the amended returns, nor had it argued that the FTC was the amount paid by the taxpayers as part of the closing agreement (waiving its right to make such claim).
Based on the previous reasonings, the Court ruled that the closing agreement precluded the IRS from determining a deficiency.

Tax Litigation Insight:

This case represents a victory to the taxpayers and more importantly, reaffirms the importance of the language of the closing agreements entered with the IRS. As seen in the case, the IRS advances theories that intend to allow further assessments for periods that have been part of closing agreements. Careful detail must be given when framing the agreements between a taxpayer and the IRS.

Purple Heart Patient Center, Inc. v. Comm’r

March 29, 2021 | Pugh, J. | Dkt. No. 24994-15

Tax Dispute Short Summary:

The Tax Court held the Taxpayer, who operated a medical cannabis retail dispensary under California law, underreported its gross income, was not entitled to offset its gross receipts with any cost of goods sold (COGS) because it failed to substantiate its COGS expenses, and was liable for the accuracy-related penalty under Sec. 6662(a). The court noted that the individual who organized the dispensary had destroyed the dispensary’s business records and thus the court was unable to estimate the dispensary’s COGS.

The Taxpayer did not cultivate its own cannabis plants. The Taxpayer obtained its cannabis products from its members, then processed such products and dispensed the product to other members.

The Taxpayer purchased all of its inventory with cash and all of its sales were cash transactions. The Taxpayer maintained a cash register and general ledger to record its purchases and sales. The Taxpayer did not deposit all of its cash into its bank account.

The Taxpayer did not preserve the general ledger or any other documentation during the years in issue. During the audit of the Taxpayer by the IRS, the Taxpayer was not able to provide the IRS any books or records. The IRS then performed a bank deposit and cash expenditures analysis. Since the Taxpayer did not deposit all of its cash it received into its bank account, therefore the IRS added the purchases the Taxpayer reported on its IRS Forms 1120 for computing COGS to its net deposits to determine yearly gross receipts. Furthermore, the IRS disallowed any offset of COGS or other expenses because it failed to substantiate such COGS or expenses.

The IRS assessed underpayment penalties for negligence and/or a substantial understatement of income tax for the years in issue under section 6662(a) and (b)(1) and (2).

Tax Litigation Key Issues:

Whether the Taxpayer: (1) was entitled to offset its gross receipts with any COGS; and (2) underreported its gross income and was liable for penalties under section 6662.

Primary Holdings:

Because the Taxpayer was not able to substantiate its COGS or expenses that were taken on its Form 1120s.

The Taxpayer underreported its gross receipts; therefore, it was subject to penalties under section 6662.

Key Points of Law:

All businesses, including cannabis dispensaries, may offset their gross receipts with COGS to compute gross income. See, e.g., New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); Olive v. Commissioner, 139 T.C. at 20 n.2; Californians Helping to Alleviate Medical Problems, Inc. v. Commissioner (CHAMP), 128 T.C. 173, 178 n.4 (2007); see also sec. 1.61-3(a), Income Tax Regs.
COGS is not a deduction within the meaning of section 162(a) but is subtracted from gross receipts to determine a taxpayer’s gross income. Metra Chem Corp. v. Commissioner, 88 T.C. 654, 661 (1987); secs. 1.61-3(a), 1.162- 1(a), Income Tax Regs.
A taxpayer is required to maintain sufficient reliable records to substantiate its COGS. See sec. 6001; Newman v. Commissioner, T.C. Memo. 2000-345, 2000 WL 1675519, at *2; sec. 1.6001-1(a), Income Tax Regs.; see also King v. Commissioner, T.C. Memo. 1994-318, 1994 WL 330613, at *2 (“[A]ny amount allowed as cost of goods sold must be substantiated.”), aff’d without published opinion, 69 F.3d 544 (9^th Cir. 1995).
If a taxpayer is able to demonstrate that he paid or incurred an expense but cannot substantiate the precise amount, we generally may estimate the amount of the expense while “bearing heavily * * * upon the taxpayer whose inexactitude is of his own making.” Cohan v. Commissioner, 39 F.2d at 543-544;
Section 61(a) provides that gross income means “all income from whatever source derived”. See Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955). Taxpayers are responsible for maintaining adequate books and records sufficient to establish their income. See sec. 6001; DiLeo v. Commissioner, 96 T.C. 858, 867 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992).
When a taxpayer fails to maintain adequate books and records, the Commissioner is authorized to compute the taxpayer’s income by any method that, in the Commissioner’s opinion, clearly reflects income. Sec. 446(b); see also Choi v. Commissioner, 379 F.3d at 63
Section 6662(a) and (b)(1) and (2) imposes a penalty equal to 20% of the portion of an underpayment of tax required to be shown on the return that is attributable to “[n]egligence or disregard of rules or regulations” or a “substantial understatement of income tax.” Negligence includes “any failure to make a reasonable attempt to comply with the provisions of this title”. Sec. 6662(c); see also Allen v. Commissioner, 92 T.C. 1, 12 (1989).
A section 6662(b)(2) penalty may be reduced or eliminated if the taxpayer adequately disclosed the position attributable to a portion (or all) of the underpayment and had a reasonable basis for it. Sec. 6662(d)(2)(B)(ii); see Campbell v. Commissioner, 134 T.C. 20, 30 (2010), aff’d, 658 F.3d 1255 (11^th Cir. 2011).

Tax Litigation Insight:

A significant majority of Tax Court decisions relate to substantiation or lack thereof. The Purple Heart decision reminds taxpayers that they must keep good records to substantiate items on a tax return.

Max v. Comm’r| T.C. Memo. 2021-37

March 29, 2021 | Buch, J. | Dkt. No. 20237-16

Tax Dispute Short Summary: Mr. Max was a designer and businessman. He founded a company that produces and sells millions of garments a year. Related to these activities, he claimed tax credits under Section 41 for research activities.

Tax Litigation Key Issues: Whether the activities Mr. Max engages in qualify for the Section 41 research credit.

Primary Holdings: No, because Mr. Max failed to establish that he met the Section 174 test, the technological information test, the business component test, or the process of experimentation test.

Key Points of Law:

Generally, the IRS’ determinations in a notice of deficiency are presumed correct and taxpayers bear the burden of proving otherwise.

Section 41 permits taxpayers to claim a credit for increasing research activities. The credit is 20% of the excess of a taxpayer’s qualified research expenses for the tax year over the base amount. 41(a)(1) Qualified research expenses are: (1) in-house research expenses, including wages for employees working on qualified research and costs paid or incurred for supplies for qualified research; and (2) contract research expenses. Sec. 41(b)(1) and (2)(A).

To be qualified research, the research must relate to a new or improved function, performance, reliability, or quality of the product or process. But, qualified research does not include research after commercial production; adaptation or duplication of an existing business component; market research, testing, or development; or routine or ordinary testing or inspection for quality control. 41(d)(4).

To be qualified research under Section 41, activities or projects must meet four tests. These four tests are: (1) the Section 174 test; (2) the technological information test; (3) the business component test; and (4) the process of experimentation test. 41(d); Siemer Milling Co. v. Comm’r, T.C. Memo. 2019-37.

Section 174 generally allows taxpayers to deduct research and experimental expenditures during the tax year in which they are paid or incurred. The regulations define research and experimental expenditures as “expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense.” Reg. § 1.174-2(a)(1). Research and development costs in the experimental or laboratory sense are “activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product.” Treas. Reg. § 1.174-2(a)(1).

Essentially, for there to be experimental expenditures, the taxpayer must show: (1) that it does not already have information that can address a capability or method for improving the product or design of the product and (2) its activities were meant to eliminate those uncertainties. Union Carbide Corp. & Subs. v. Comm’r, T.C. Memo. 2009-50.

Certain activities cannot qualify as research or experimental expenditures at all. Reg. § 1.174-2(a)(3). That regulation provides that “[t]he term research or experimental expenditure does not include expenditures for . . . [t]he ordinary testing or inspection of materials or products for quality control (quality control testing).” The regulations further define “quality control testing” as “testing or inspection to determine whether particular units of material or products conform to specified parameters.” Treas. Reg. § 1.174-2(a)(4).

To be “qualified research” an activity must be undertaken for purpose of discovering information that is “technological in nature”. 41(d)(1)(B)(i). Information is technological in nature “if the process of experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences, engineering, or computer science.” Treas. Reg. § 1.41-4(a)(4). A taxpayer may rely on existing principles of science and engineering to satisfy this requirement. Treas. Reg. § 1.41-4(a)(4).

The process of experimentation test requires that substantially all of the research activities constitute elements of a process of experimentation for a qualified purpose. 41(d)(1)(C); Union Carbide Corp. & Subs. v. Comm’r, 97 T.C.M. (CCH) at 1255. This test consists of three elements: (1) the “substantially all” element; (2) the “process of experimentation” element; and (3) the “qualified purpose” element. Union Carbide Corp. & Subs v. Comm’r, 97 T.C.M (CCH) at 1255. These elements are applied to each of the taxpayer’s business components. Sec. 41(d)(2)(A); Treas. Reg. § 1.41-4(a)(6).

The business component test requires that research undertaken to discover information must be intended to be used to develop “a new or improved business component of the taxpayer.” 41(d)(1)(B)(ii). A business component is “any product, process, computer software, technique, formula, or invention which is . . . held for sale, lease, or license, or . . . used by the taxpayer in . . . [its] trade or business.” Sec. 41(d)(2)(B).

Insight: The Max decision shows the hoops a taxpayer must jump through in order to obtain the tax credit under Section 41. Prior to claiming the tax credit, taxpayers should speak to a tax professional regarding their eligibility for the Section 41 credit.

Rowen v. Comm’r| 156 T.C. No. 8

March 30, 2021 | Toro, J. | Dkt. No. 18083-18P

Tax Dispute Short Summary: The taxpayer did not pay assessed tax liabilities in excess of $474,846 relating to his 1994, 1996, 1997, and 2003 through 2007 tax years. Accordingly, the IRS certified that he had a “seriously delinquent tax debt” within the meaning of Section 7345(b). The taxpayer petitioned the Tax Court to determine whether the IRS’ certification was erroneous under Section 7345(e)(1). During those proceedings, the taxpayer moved for summary judgment on the basis that Section 7345 violates the Due Process Clause of the Fifth Amendment to the Constitution because it infringes on the right to international travel. The taxpayer further alleged that Section 7345 violates his human rights as expressed in the Universal Declaration of Human Rights.

Tax Litigation Key Issues: Whether Section 7345 violates the Due Process Clause and whether the Universal Declaration of Human rights provides a federal court remedy?

Primary Holdings: No, because Section 7345 does not authorize any passport-related decision and does not prohibit international travel—indeed, the IRS may well not know whether a particular taxpayer has a valid passport or intends to seek one when the passport certification is made. Moreover, in this case, the taxpayer’s passport remains in effect. In addition, because Section 7345 does not limit the right to travel (rather, other parts of the FAST Act do), the UDHR cannot provide any grounds for invalidating the IRS’ certification under Section 7345.

Key Points of Law:

Enacted in 2015, Section 7345 authorizes the IRS to send to the Secretary of Treasury a certification that an individual has a “seriously delinquent tax debt.” The Secretary of the Treasury, in turn, must transmit the certification to the Secretary of State “for action with respect to denial, revocation, or limitation of a passport pursuant to section 32101 of the . . . [Fixing America’s Surface Transportation Act (FAST ACT), Pub. L. No. 114-94, 129 Stat. at 1729 (2015)]”. Sec. 7345(a).
In cases that are decided on the administrative record (record rule cases), the Tax Court ordinarily decides the issues raised by the parties by reviewing the administrative record using a summary adjudication procedure. See Van Bemmelen v. Comm’r, 155 T.C. ___, 2020 U.S. Tax Ct. LEXIS 21 (Aug. 27, 2020).
Section 7345(a) provides: If the Secretary receives certification by the Commissioner of Internal Revenue that an individual has a seriously delinquent tax debt, the Secretary shall transmit such certification to the Secretary of State for action with respect to denial, revocation, or limitation of a passport pursuant to section 32101 of the FAST Act.
Section 7345(b)(1) generally defines a “seriously delinquent tax debt” as an “unpaid, legally unenforceable Federal tax liability” that “has been assessed,” “is greater than” $51,000, for which “a notice of lien has been filed pursuant to section 6323 and the administrative rights under section 6320 . . . have been exhausted or have lapsed, or . . . levy is made pursuant to section 6331.” Section 7345(b)(2) excludes from the definition of a “seriously delinquent tax debt” any debt that is “being paid in a timely manner pursuant to an agreement . . . under section 6159 or 7122” and any debt for which “collection is suspended . . . because a due process hearing under section 6330 is requested or pending, or . . . because” relief under section 6015 is requested. Section 7345(d) requires the IRS to contemporaneously notify a taxpayer of any certification under subsection (a).
Section 7345(c) provides rules for reversing a certification. It requires the IRS to “notify the Secretary (and the Secretary shall subsequently notify the Secretary of State) if such certification is found to be erroneous [by a court under section 7345(e) as described below] or if the debt with respect to such certification is fully satisfied or ceases to be a seriously delinquent tax debt by reason of subsection (b)(2).” As with a certification, the IRS must notify the taxpayer of a reversal or a certification. 7345(d).
The Tax Court’s jurisdiction to consider passport revocation cases is in section 7345(e). Specifically, that section provides that after the IRS notifies an individual of an adverse passport determination, the taxpayer may bring a civil action against the United States in a district court of the United States, or against the IRS in Tax Court, to determine whether the certification was erroneous or whether the IRS has failed to reverse the certification. If the court determines that such certification was erroneous, then the court may order the Secretary to notify the Secretary of State that such certification was erroneous.
Section 7345(e) does not set any deadline for filing the civil action it authorizes. Once the IRS notifies a taxpayer that a certification under section 7345(a) has been made, the taxpayer may challenge that certification in a civil action filed either in the Tax Court or a federal district court.
22 U.S.C. section 2714a provides that upon receiving a certification from the Secretary of the Treasury, the Secretary of State shall not issue a passport to any individual who has a seriously delinquent tax debt. However, the Secretary of State may issue a passport, in emergency circumstances or for humanitarian reasons, to an individual. Thus, once the Secretary of State receives notification of the certification, the Secretary of State is required (absent emergency or humanitarian considerations) to deny a passport (or renewal of a passport) to a seriously delinquent taxpayer and is permitted to revoke any passport previously issued to such person. 84 Fed. Reg. 67184 (Dec. 9, 2019).
Section 7345(e)(1) authorizes the Tax Court to “determine whether the certification was erroneous.” In general, an action is “erroneous” if it is “incorrect” or “inconsistent with the law or the facts.” Black’s Law Dictionary 659 (10^th 2014).
The Tax Court has authority under Section 7345(e) to determine whether the passport statute is constitutional. See Battat v. Comm’r, 148 T.C. 32, 46 (2017) (noting that the Tax Court, like all federal courts, may adjudicate constitutional questions that arise within its jurisdiction and collecting authorities).
Under the UDHR, “(1) [e]veryone has the right to freedom of movement and residence within the borders of each state” and “(2) [e]veryone has the right to leave the country, including his own, and to return to his country.” However, the Supreme Court “has reasoned that . . . [the UDHR] does not of its own force impose obligations as a matter of international law nor does it create obligations enforceable in the federal courts.” Sosa v. Alvarez-Machain, 542 U.S. 692, 734-35 (2004).

Tax Litigation Insight: In a significant concurring opinion, Judge Marvel noted that the Rowen decision “does not foreclose a constitutional challenge, in a future case with appropriate facts and squarely presented arguments, to the entire tax collection mechanism created by the [FAST ACT].” Expect to see more on this soon.

Walton v. Comm’r| T.C. Memo. 2021-40

March 30, 2021 | Urda, J. | Dkt. No. 6405-18

Tax Dispute Short Summary: The taxpayer failed to include on her 2015 federal income tax return $169,425 in nonemployee compensation that she had earned that year. The IRS’ Automated Underreporter Program (AUR) detected the omission of income and issued a notice of deficiency, asserting a deficiency of $62,514 and an accuracy-related penalty of $12,503. The taxpayer filed a petition with the Tax Court conceding the omission of income but contending that the penalty was not appropriate.

Tax Litigation Key Issues: Whether the Section 6662(a) accuracy-related penalty should be imposed for the failure to report income?

Primary Holdings: Yes, because: (1) Section 6751(b) managerial approval does not apply where the notice has been issued through electronic means; and (2) the taxpayer failed to show reasonable cause.

Key Points of Law:

Section 6662(a) and (b)(2) impose a 20% penalty on the portion of any underpayment of tax that is attributable to “any substantial understatement of income tax”.
Section 6751(b) requires that penalties be “personally approved (in writing) by the immediate supervisor of the individual making such determination.” Chai v. Comm’r, 851 F.3d 190, 217 (2d Cir. 2017), aff’g in part, rev’g in part, T.C. Memo. 2015-42; see also Graev v. Comm’r, 149 T.C. 485 (2017), supplementing and overruling in part, 147 T.C. 460 (2016).
Section 6751(b)(2)(B) carves out an exception to the supervisory approval requirement for “any . . . penalty automatically calculated through electronic means.” The Tax Court has recently explored the contours of this exception, explaining that it encompasses a penalty “determined mathematically by a computer software program without the involvement of a human IRS examiner.” Walquist v. Comm’r, 152 T.C. 61, 70 (2019).
Section 6664(c)(1) provides that the penalty under Section 6662(a) shall not apply to any portion of an underpayment if it is shown that there was reasonable cause for the taxpayer’s position and that the taxpayer acted in good faith and with respect to that portion. See Higbee v. Comm’r, 116 T.C. at 448. The taxpayer bears the burden of proving reasonable cause and good faith. See id. at 446-47. “Reasonable cause requires that the taxpayer have exercised ordinary business care and prudence as to the disputed item.” Neonatology Assocs., P.A. v. Comm’r, 115 T.C. 43, 98 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002). 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.” See Reg. § 1.6664-4(b)(1). Generally, the most important fact in determining the existence of reasonable cause is the taxpayer’s efforts to ascertain her proper tax liability. Id.
Good-faith reliance on the advice of an independent, competent tax professional as to the tax treatment of an item may meet the reasonable cause requirement. Neonatology Assocs., 115 T.C. at 98. For the reliance to be reasonable, a taxpayer must prove: (1) the adviser was a competent professional who had sufficient expertise to justify reliance; (2) the taxpayer provided necessary and accurate information to the adviser; and (3) the taxpayer actually relied in good faith on the adviser’s judgment. at 99.
Unconditional reliance on a tax return preparer or CPA does not by itself constitute reasonable reliance in good faith; taxpayers must also exercise “diligence and prudence.” Stough v. Comm’r, 144 T.C. 306, 323 (2015). “Even if all data is furnished to the preparer, the taxpayer still has a duty to read the return and make sure all income items are included.” Magill v. Comm’r, 70 T.C. 465, 479-80 (1978), aff’d, 651 F.2d 1233 (6^th 1981). “Reliance on a preparer with complete information regarding a taxpayer’s business activities does not constitute reasonable cause if the taxpayer’s cursory review of the return would have revealed errors.” Stough v. Comm’r, 144 T.C. at 323.

Tax Litigation Insight: Another Section 6751(b) case! The Walton decision shows how important it is to respond to IRS notices in a timely manner, if possible. If the IRS issues a computer-generated notice asserting penalties, and the taxpayer fails to respond, the taxpayer essentially waives the Section 6751(b) defense.

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Everything that You Need to Know about IRS Offers in Compromise

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:

The Service determines that the offer was submitted solely to delay collection;
The taxpayer fails to file a return or pay a liability;
The taxpayer files for bankruptcy;
The offer is no longer processable; or
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:

Divorce decrees or separation agreements to determine the disposition of assets in the property settlements;
Homeowners or renters insurance policies and riders to identify high value personal items such as jewelry, antiques, or artwork;
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:

If…	And…	Then…
The account is an Individual Retirement Account (IRA), 401(k), or Keogh Account	The taxpayer is not retired or close to retirement	Equity is the cash value less any tax consequences for liquidating the account and early withdrawal penalty, if applicable.
The account is an Individual Retirement Account (IRA), 401(k), or Keogh Account	The taxpayer is retired or within one year of retirement	· Equity is the cash value less any tax consequences for liquidating the account and early withdrawal penalty, if applicable. · The plan may be considered as income, if the income from the plan is required to provide for necessary living expenses.
The contribution to a retirement plan is required as a condition of employment	The taxpayer is able to withdraw funds from the account	Equity is the amount the taxpayer can withdraw less any tax consequences and early withdrawal penalty, if applicable.
The contribution to an employer’s plan is required as a condition of employment	The taxpayer is unable to withdraw funds from the account but is permitted to borrow on the plan	Equity is the available loan value.
Any retirement plan that may not be borrowed on or liquidated until separation from employment	The taxpayer is retired, eligible to retire, or close to retirement	Equity is the cash value less any tax consequences for liquidating the account and early withdrawal penalty, if applicable, or plan may be considered as income if the income from the plan is necessary to provide for necessary living expenses.
The plan may not be borrowed on or liquidated until separation from employment and the taxpayer has no ability to access the funds within the terms of the offer	The taxpayer is not eligible to retire until after the period for which we are calculating future income	The plan has no equity.
The taxpayer may not access the funds in the retirement account due to an existing loan	The taxpayer is not eligible to retire until after the period for which we are calculating future income	Determine what equity remains in the account taking into consideration when the loan was taken out, whether the proceeds were used for necessary living expenses, and the remaining equity in the account. If the loan proceeds were used for necessary and allowable expenses and you confirm the taxpayer cannot further access (borrow against) the account given the outstanding loan, the value of the account should be the equity remaining in the plan less the amount of the loan. If the loan proceeds were not used for necessary and allowable living expenses, the IRS may analyze the proceeds under the dissipation of assets rules.
The plan includes a stock option	The taxpayer is eligible to take the option	Equity is the value of the stock at current market price less any expense to exercise the option.

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:

If…	Then…
There is no equity in the assets	There is no adjustment necessary to the income stream.
There is equity and no available income stream (i.e. profit) produced by those assets	There is no adjustment necessary to the income stream.
There are both equity in assets that are determined to be necessary for the production of income and an available income stream produced by those assets	The IRS will compare the value of the income stream produced by the income producing asset(s) to the equity that is available.
An asset used in the production of income will be liquidated to help fund an offer	The IRS may adjust the income to account for the loss of the asset.
A taxpayer borrows against an asset that is necessary for the production of income, and devotes the proceeds to the payment of the offer.	The IRS may allow the loan payment as an expense and will consider the effect that the loan will have on the future income stream.

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.

If…	Then…
Income will increase or decrease or current necessary expenses will increase or decrease	Adjust the amount or number of payments to what is expected during the appropriate number of months.
A taxpayer is temporarily or recently unemployed or underemployed	The IRS will generally use the level of income expected if the taxpayer were fully employed and if the potential for employment is apparent. The IRS will also consider special circumstances or ETA issues.
A taxpayer is unemployed and is not expected to return to their previous occupation or previous level of earnings	When considering future income, the IRS will allow anticipated increases in necessary living expenses and/or applicable taxes.
A taxpayer is long-term unemployed	The IRS will use the taxpayer’s current income in the future income calculation. If there is a verified expectation the taxpayer will be securing employment then the use of anticipated future income may be appropriate. The IRS may use anticipated future income where the future employment is uncertain.
A taxpayer is long-term underemployed	The IRS will generally use the taxpayer’s current income.
A taxpayer has an irregular employment history or fluctuating income	The IRS may use the taxpayer’s average earnings over the three prior years. However, this does not apply to wage earners. Calculations for wage earners are generally based on current income unless the taxpayer has unique circumstances.
A taxpayer is in poor health and their ability to continue working is questionable	The IRS will generally reduce the number of payments to the appropriate number of months that it is anticipated the taxpayer will continue working. The IRS will consider special circumstances that may warrant adjustments.
A taxpayer is close to retirement and has indicated they will be retiring	If the taxpayer can substantiate that retirement is imminent, the IRS will generally adjust the taxpayer’s future earnings and expenses accordingly. If not, the IRS will generally base the calculation on current earnings.
Taxpayer is currently receiving overtime.	If the overtime is regular and customary, it will generally be included in current income. If the overtime is sporadic, the IRS will use the taxpayer’s base pay.
The taxpayer is at or above the full retirement age to receive social security benefits and has decided to continue working	If the taxpayer is past the age when the taxpayer’s income does not impact receipt of their full social security benefits, the IRS may include the taxpayer’s potential social security benefits in current income. The IRS may seek to determine the taxpayer’s potential benefits by having the taxpayer secure an estimate from the Social Security Administration.
A taxpayer will file a petition for liquidating bankruptcy	Under these circumstances, the IRS may reduce the value of future income. It will not reduce the total value of future income to an amount less than what could be paid toward non-dischargeable periods, or what could be recovered through bankruptcy, whichever is greater.

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.

If…	Then…
The offer will be paid in 5 months or less and 5 or fewer payments	The IRS will use the realizable value of assets plus the amount that could be collected in 12 months.
The offer is payable in six to 24 months	The IRS will use the realizable value of assets plus the amount that could be collected in 24 months.

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:

The IRS will determine the taxpayer’s gross income over a specific time period (normally annually);
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:

Payment Type	Payment Terms	Number of Months Future Income Required
Lump Sum Cash	5 or less installments within 5 months	12 months or the remaining statutory period, whichever is less
Periodic Payment	Within 6 to 24 months	24 months or the remaining statutory period, whichever is less

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 taxpayer requests 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.

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The Week of February 8 – February 12, 2021

BM Construction v. Comm’r, T.C. Memo. 2021-13
Complex Media, Inc. v. Comm’r, T.C. Memo. 2021-14

BM Construction v. Comm’r, T.C. Memo. 2021-13

February 8, 2021 | Urda, J. | Dkt. No. 24352-17L

Opinion

Short Summary: The IRS initiated an examination of the tax liabilities associated with Mr. Bernotas and his sole proprietorship, BM Construction. After issuing an initial report on May 7, 2014, the examination officer issued two Letters 950-D: (1) to Mr. Bernotas with respect to his income taxes on June 6, 2014; and (2) to BM Construction with respect to backup withholding tax liabilities on June 13, 2014. The examination officer detailed these actions in the file’s activity log and noted that neither of the mailed letters were returned. At more than one subsequent in-person meeting, Mr. Bernotas was notified of his appeal rights—particularly that he had 30 days from the date of Letter 950-D.

Mr. Bernotas did not file an official protest, and the examination officer closed BM Construction’s tax file. The IRS then assessed withholding taxes, penalties, and interest and issued a Notice of Intent to Levy and Notice of Your Right to a Hearing to BM Construction. Mr. Bernotas requested a Collection Due Process Hearing, and a CDP Hearing was held between a settlement officer and Mr. Bernotas’ CPA. The CPA attempted to dispute the underlying liability. The settlement officer noted that BM Construction was precluded from challenging the underlying liability and ultimately sustained the levy notice. BM Construction petitioned the Tax Court for review.

Key Issues:

(1) Whether BM Construction received a Letter 950-D with respect to the 2012 backup withholding tax liability; and
(2) Whether the settlement officer abused his discretion in sustaining the notice of intent to levy.

Primary Holdings:

(1) The examination officer mailed Letter 950-D to BM Construction on June 13, 2014, and BM Construction subsequently received that letter. BM Construction and/or Mr. Bernotas failed to offer credible rebutting evidence.
(2) The settlement officer did not abuse his discretion in sustaining the proposed levy action.

Key Points of Law:

Sole proprietorships and their owners, as well as single-member LLCs and their members, are a single taxpayer for federal tax purposes to whom notice is given. See Med. Practice Sols, LLV v. Comm’r, 132 T.C. 125, 127 (2009), aff’d without published opinion sub nom.
With respect to employment tax liabilities, “An opportunity to dispute the underlying liability includes a prior opportunity for a conference with Appeals that was offered either before or after the assessment of the liability.” See 26 C.F.R. § 301.6330-1(e)(3), Q&A-E2, Proced. & Admin. Regs.
The mailing of a properly addressed letter creates a “presumption that it reached its destination and was actually received by the person to whom it was addressed”, which a taxpayer must rebut with “credible” evidence. Rivas v. Comm’r, T.C. Memo. 2017-56, at *20.
A “taxpayer’s self-serving claim that he did not receive the notice of deficiency will generally be insufficient to rebut the presumption.” Klingenberg v. Comm’r, T.C. Memo. 2012-292, at *12, aff’d, 670 F. App’x 510 (9th Cir. 2016).
The determination by an appeals officer shall take into consideration the following: (1) verification that the requirements of any applicable law or administrative procedure have been met; (2) consideration of any relevant issues raised by the taxpayer; and (3) consideration of whether any proposed collection action balances the need for the efficient collection of taxes with the legitimate concern of the person that any collection action be no more intrusive than necessary. SeeR.C. § 6330(c)(3).

Insight: Notices and letters issued by the IRS are presumed to reach their ultimate destination unless credible evidence can rebut the presumption. BM Construction highlights the fact that self-serving statements from the taxpayer are not enough to overcome this presumption. Additionally, taxpayers should dispute a proposed tax liability during the examination process. Waiting to challenge the tax liability at issue until the taxpayer’s case is turned over to IRS collections will likely prove to be a problem.

Complex Media, Inc. v. Comm’r, T.C. Memo. 2021-14

February 10, 2021 | Halpern, J. | Dkt. Nos. 13368-15 and 19898-17

Opinion

Short Summary: Taxpayer-corporation (Corp.) acquired the assets of a business from a third-party partnership (P’ship). In exchange for the transferred assets, Corp. issued approximately 5 million shares of common stock. Immediately thereafter, Corp. redeemed 1.875 million of the common shares held by P’ship in exchange for $2.7 million in cash and Corp’s obligation to make an additional payment of $300,000 a year later. P’ship paid the cash and assigned its right to the additional payment to one of its partners in redemption of that partner’s interest in P’ship. Corp. claimed an increased basis of $3 million in intangible assets it acquired from P’ship and amortized that additional basis under I.R.C. § 197(a). The IRS disallowed the deductions under I.R.C. § 197(a).

Key Issues: Whether Corp. is entitled to the amortization deductions under I.R.C. § 197(a)?

Primary Holdings: Yes, in part, because: (1) Corp’s issuance and immediate redemption of 1,875,000 common shares had no economic substance and should be disregarded under the step transaction doctrine, with the cash and the deferred payment right treated as additional consideration for the assets Corp. acquired from P’ship; (2) the parties agree that I.R.C. § 351 governs the tax consequences of the transactions at issue and accordingly, P’ship recognized gain in the transaction to the extent of the $2.7 million cash it received and the fair market value of its right to the additional $300,000 payment; this increases the basis of the assets transferred to Corp.; and (3) when assets transferred in an I.R.C. § 351 exchange with taxable boot constitute a trade or business, the residual method of allocation prescribed by I.R.C. § 1060 can appropriately be used to allocate the boot among the transferred assets; consequently, P’ship’s gain in amortizable I.R.C. 197 intangibles, and the corresponding increase in asset bases allowed to Corp., is determined by subtracting from the agreed total asset value the estimated values of those assets other than amortizable I.R.C. § 197 intangibles.

Key Points of Law:

Section 197(a) allows taxpayers amortization deductions in respect of intangible assets that qualify as “amortizable section 197 intangible[s].” A taxpayer can recover its adjusted basis in an amortizable section 197 intangible over 15 years beginning with the month of acquisition. 197(a).
Section 197(d) identifies a broad range of assets as “section 197 intangible[s]”, including goodwill, going-concern value, workforce-in-place, business books and records, patents, copyrights, know-how, government licenses and permits, customer and supplier relationships, covenants not to compete, franchises, trademarks, and trade names. To qualify as “amortizable section 197 intangibles,” most section 197 intangibles have to meet three conditions. First, the taxpayer must have acquired the asset after August 10, 1993. 197(c)(1)(A). Second, the taxpayer has to hold the asset in connection with the conduct of a trade or business or other income-producing activity. Sec. 197(c)(1)(B). And third, subject to enumerated exceptions, the asset cannot have been created by the taxpayer. Sec. 197(c)(2). The exclusion for self-created intangibles does not apply to governmental licenses or permits, covenants not to compete, franchises, trademarks, or trade names. Id.
Section 351 generally provides nonrecognition treatment to incorporations and other transactions in which the controlling shareholders of a corporation transfer property to it in exchange for its stock. In particular, section 351(a) provides as a general rule: “No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control * * * of the corporation.” Section 368(c) defines “control,” for purposes of section 351 and other specified sections, to mean “the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation.” If a shareholder receives nonstock consideration in an exchange that would otherwise qualify for nonrecognition treatment under section 351(a), the shareholder cannot recognize any loss but has to recognize any realized gain in an amount not in excess of the sum of the money and the fair market value of any other nonstock property (collectively, boot) the shareholder receives. 351(b). The transferee corporation’s basis in property received in a section 351 exchange is “the same as it would be in the hands of the transferor, increased in the amount of gain recognized to the transferor on such transfer.” Sec. 362(a).
If a section 351 exchange includes a section 197 intangible, the transferee corporation is treated as the transferor shareholder “with respect to so much of the adjusted basis in the hands of the * * * [corporation] as does not exceed the adjusted basis in the hands of the transferor.” 197(f)(2)(A). The corporation, in effect, steps into the transferor’s shoes and can “continue to amortize its adjusted basis, to the extent it does not exceed the transferor’s adjusted basis, ratably over the remainder of the transferor’s 15-year amortization period.” Treas. Reg. § 1.197-2(g)(2)(ii)(B). Any increase in the basis of the section 197 intangible allowed by section 362(a) as a result of gain recognized by the shareholder is treated as though the corporation acquired the assets other than in a section 351 exchange (i.e., by the purchase). Treas. Reg. § 1.197-2(g)(2)(ii)(B).
For Section 351 purposes, and in applying the “control-immediatley-after” requirement of Section 351(a), Tax Court jurisprudence requires us to take the effects of the redemption into account—even if, as respondent would have us do, we were to treat the redemption as separate from the asset transfer. As explained in Intermountain Lumber Co., 65 T.C. 1025 (1976), a determination of “ownership” as that term is used in Section 368(c) and for purposes of control under section 351 depends upon the obligation and freedom of action of the transferee with respect to the stock when he acquired it from the corporation. Such traditional ownership attributes as legal title, voting rights, and possession of stock certificates are not conclusive.
A taxpayer owes the Commissioner the duty to be consistent in the tax treatment of items and will not be permitted to benefit from the taxpayer’s own prior error or omission. Cluck v. Comm’r, 105 T.C. 324, 331 (1995). This duty applies when, after the expiration of the period of limitations on assessing tax for an earlier year, the taxpayer, for the purpose of determining its tax liability for a later year, seeks to take a position on an issue of fact contrary to reporting or representations on which the Commissioner relied, or to which he acquiesced, in regard to the earlier year. See LeFever v. Comm’r, 103 T.C. 523, 543-44 (1994), supplemented by C. Memo. 1995-321, aff’d, 100 F.3d 778 (10^th Cir. 1988). The duty of consistency is usually understood to encompass both the taxpayer and parties with sufficient identical economic interests. LeFever v. Comm’r, 100 F.3d at 788.
While a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not, and may not enjoy the benefit of some other route he might have chosen to follow but did not. Comm’r v. Nat’l Alfalfa Dehydrating & Milling Co., 417 U.S. at 149. Thus, a party can challenge the tax consequences of his agreement as construed by the Commissioner only by adducing proof in which an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc. Comm’r v. Danielson, 378 F.2d at 775. Although Danielson itself did not involve a choice between the form of a transaction and its alleged substance, the Tax court and others have extended the Danielson rule to limit a taxpayer’s eligibility to challenge not only the terms of the contracts governing a transaction but also the form of the transactions as established by those contractual terms. And the Tax Court has long accepted that both the Danielson rule and Ullman’s “strong proof” test “apply beyond the confines of allocating payments to a convenant not to compete.” Coleman v. Comm’r, 87 T.C. 178, 202 (1986), aff’d without published opinion, 833 F.2d 303 (3d Cir. 1987).
But to the extent the Danielson rule limits a taxpayer’s eligibility to disavow the form of its transactions as well as the terms of the contracts that govern those transactions, the rule has no application to these cases because the Tax Court has never accepted the Danielson See Schmitz v. Comm’r, 51 T.C. 306, 316 (1968), aff’d sub nom. Throndson v. Comm’r, 457 F.2d 10122 (9^th Cir. 1972).
As the Tax Court’s caselaw has evolved, it has become more hospitable to taxpayers seeking to disavow the form of their transactions. But, the taxpayer has to meet an additional burden in attempting to disavow transactional form, and such burden relates not to how much evidence but what that evidence must show. In these cases, the Commissioner can succeed in disregarding the form of a transaction by showing that the form in which the taxpayer cast the transaction does not reflect its economic substance. For the taxpayer to disavow the form it chose (or at least acquiesced to), it must make that showing and more. In particular, the taxpayer must establish that the form of the transaction was not chosen for the purpose of obtaining tax benefits (to etierh the taxpayer itself or a counterparty) that are inconsistent with those the taxpayer seeks through disregarding that form. When the form that the taxpayer seeks to disavow was chosen for reasons other than providing tax benefits inconsistent with those the taxpayer seeks, the policy concerns articulated in Danielson will not be present.
Much ink has been spilled on the question of how proximate various steps must be, in time or intention, for them to be combined under the step transaction doctrine. See, e.g., Andantech, LLC v. Comm’r, T.C. Memo. 2002-97. If the step transaction doctrine has any potency, it necessarily applies to combine a first step that occurs when a preexisting obligation requires the immediate execution of a second step that undoes the first.
Because the character of any gain recognized in a Section 351 exchange may differ depending on the nature of the transferred assets, a transferor who receives taxable boot in addition to stock of the transferee corporation must determine gain on an asset-by-asset basis. See Easson v. Comm’r, 33 T.C. 963, 975 (1960); see also Rul. 68-55, 1968-1 C.B. 140. The transferee corporation’s basis in each asset equals the transferor’s basis in the asset increased by the gain recognized by the transferor in the exchange of that asset for stok and boot. Easson v. Comm’r, 33 T.C. at 975.
The Tax Court looks with disavor on any effort by the IRS to take a position contrary to one of its reveue rulings. See, e.g., Rauenhorst v. Comm’r, 119 T.C. 157, 171 (2002) (rejecting the proposition that the Commissioner is not bound to follow his revenue rulings in Tax Court proceedings).
The Cohan rule allows the Tax Court to estimate the amounts of allowable deductions when there is evidence that the taxpayer incurred deductible expenditures. Ashkouri v. Comm’r, T.C. Memo. 2019-95. To do so, however, the Tax Court must have some basis on which to make an estimate. The Tax Court has relied on Cohan to estimate a taxpayer’s basis in property. See, e.g., Huzella v. Comm’r, T.C. Memo. 2017-210.
Under the residual method of Section 1060, the assets in each of seven classes are assigned, in succession, a portion of the purchase price equal to their fair market value. Reg. § 1.1060-1(a)(1). Any value not attributable to assets in the first five classes is assigned to Section 197 intangibles. Treas. Reg. § 1.338-6(b).
By its terms, Section 1060 applies to “applicable asset acquisitions.” Section 1060(c) defines “applicable asset acquisition” to mean “any transfer (1) of assets which constitute a trade or business, and (2) with respect to which the transferee’s basis in such assets is determined wholly by reference to the consideration paid for such assets.” Despite the statutory definition, Treas. Reg. § 1.1060-1(b)(8) provides: “A transfer may constitute an applicable asset acquisition notwithstanding the fact that no gain or loss is recognized with respect to a portion of the group of assets transferred.”

Insight: Complex Media is a 103 page reminder of the potential federal income tax complexities inherent in certain taxable or tax-free transactions. As discussed in the opinion, in many cases, taxpayers are bound to the transactional form they choose, even to their peril. This can lead to surprising tax results, particularly if not vetted by tax counsel.

Little Sandy Coal Company, Inc. v. Comm’r, T.C. Memo. 2021-15

February 11, 2021 | Halpern, J. | Dkt. No. 17431-17

Opinion

Short Summary: Little Sandy Coal Company, Inc. (the “Petitioner”) owns a shipbuilding subsidiary, Corn Island Shipyard, Inc. (“CIS”). In the course of developing 11 separate vessels, Petitioner claimed a research credit under Sections 38 and 41(a) for its taxable year ended June 30, 2014. CIS’s projects included, in part: Project 720 (building a tank barge under contract with Apex Oil, Inc.); Project 730 (building a dry dock for Detyens Shipyard); and Projects 749 and 750 with Tell City Boat Works.

The Internal Revenue Service disallowed the research tax credit noted above related to CIS’s developing the 11 vessels. As a result, the Internal Revenue Service determined a deficiency in federal income taxes and also assessed an accuracy-related penalty under Section 6662 for the same year.

The Petitioner ultimately petitioned the Tax Court. The Petitioner argued, in part, that substantially all of the activities of its subsidiary’s research in developing the vessels constituted elements of a process of experimentation for purposes of I.R.C. § 41(d)(1)(C) and Treas. Reg. § 1.41-4(a)(6) because more than 80 percent of the elements of each vessel differed from those of vessels CIS had previously developed.

Prior to trial, both the Petitioner and the Internal Revenue Service agreed to treat two of the vessels—Projects 720 and 730—as representative of the others in regard to the common issues. For purposes of this opinion, the Tax Court only addressed the specific issues below related to the four projects outlined above.

Key Issues:

(1) Whether the Petitioner conducted qualified research under I.R.C. § 41(d) with respect to the business components identified for Project 720 (Apex tanker) and Project 730 (dry dock);
(2) Whether any exclusion found in I.R.C. § 41(d)(4) applies with respect to the business components identified for Projects 720 and 730;
(3) The includible amount of qualified research expenses for the business components identified for Project 720 and Project 730; and
(4) The Tell City Boat Works (“TCBW”) issues with respect to Projects 749 and 750.

Primary Holdings:

(1) The Petitioner did not conduct qualified research under I.R.C. § 41(d) with respect to Projects 720 or 730;
(2) Because the Petitioner did not conduct qualified research, the Tax Court need not consider the applicability to either project of the exclusions provided in Section 41(d)(4);
(3) Because the Petitioner did not conduct qualified research, the Tax Court need not determine the includible amount of qualified research expenses for the business components identified for Projects 720 and 730; and
(4) Because the parties agreed to treat Projects 720 and 730 as representative in regard to the general issues common to all of the development projects, the issues related to Projects 749 and 750 are rendered moot.

Key Points of Law:

A taxpayer’s research credit includes 20 percent of any excess of the taxpayer’s “qualified research expenses (“QREs”) for the taxable year” over a prescribed “base amount.” I.R.C. § 41(a)(1).
A taxpayer’s QREs include any “in-house research expenses” and “contract research expenses” “paid or incurred by the taxpayer during the taxable year in carrying on any trade or business of the taxpayer.” I.R.C. § 41(b)(1).
Qualified services mean “services consisting of—(i) engaging in qualified research, or (ii) engaging in the direct supervision or direct support of research activities which constitute qualified research.” I.R.C. § 41(b)(2)(B).
Research is qualified research if it meets the four requirements provided in Section 41(d)(1) and is not covered by an exclusion provided in Section 41(d)(4). The four requirements are as follows: (1) the research expenditures must be eligible for treatment as expenses under Section 174; (2) the research must be undertaken to discover technological information; (3) the application of that information must be intended to be useful in the development of a new or improved business component of the taxpayer; and (4) substantially all of the activities of research must constitute elements of a process of experimentation for a purpose related to a new or improved function, performance, or reliability or quality. I.R.C. § 41(d)(1).
The fourth requirement of Section 41(d)(1) is arguably the most stringent requirement. See Union Carbide Corp. & Subs. v. Comm’r, T.C. Memo. 2009-50 (2009). The Regulations provide an arithmetic test for determining when “substantially all” of a taxpayer’s otherwise qualifying research activities in regard to a business component involve a process of experimentation. See Reg. § 1.41-4(a)(6).

Insight: The Little Sandy case emphasizes the importance of the fourth requirement of Section 41(d)(1) with respect to qualified research. The fourth requirement focuses on a taxpayer’s activities, not the physical components, supplies, or supervisors related to the research. Further, it appears that the taxpayer ultimately hampered its own case here where it agreed to treat two of its projects (vessels) as representative of the others. This foreclosed the Tax Court’s ability to separately evaluate the taxpayer’s other projects, such as the TCBW issues.

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Tax Court in Brief | Medtronic, Inc. v. Comm’r | Section 482, Comparable Uncontrolled Transaction, Comparable Profits Method

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

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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.

Everything That You Need To Know About International Tax Penalties

International information return penalties are civil penalties assessed by the IRS against a United States person for failing to timely file complete and accurate international information returns required by specific Internal Revenue Code (IRC) sections. Those information returns cover a broad spectrum of reporting obligations, and include IRS Forms 5471, 5472, 3520, 3520-A, 8938, 926, 8865, 8621, 8858 and others.

U.S. taxpayers are required to report their worldwide income. International information returns require taxpayers to report information relating to foreign assets, interests in various entities, certain transactions, and information relating to foreign-sourced income.

As a general matter, international information returns are required for entities or events that the taxpayer has “control” over or that the taxpayer has the power or authority to administer or that the taxpayer is beneficiary of. However, the reporting obligations under the Code or substantially more expansive and cover various other reporting matters.

Returns that are filed but that are not substantially complete and accurate are considered “un-filed” and may result in penalty assessments.

Certain international information returns are also considered un-filed if the taxpayer does not provide required information when requested by the IRS, and penalties may be assessed even if the required return has been submitted.

A U.S. person may have several reporting obligations for a particular tax year and thus may have exposure to multiple penalty assessments. Penalties may apply to each information return that was required to be filed for each year.

Common Terms

U.S. Person—Generally, the term “U.S. person” includes citizens or residents of the United States, domestic corporations, domestic partnerships, U.S. estates, or trusts. Trusts are considered U.S. persons only if they satisfy a two-part test: (1) a court within the U.S. is able to exercise primary supervision over the administration of the trust, and (2) one or more U.S. persons have the authority to control all substantial decisions of the trust. See IRC 7701(a)(30)(E).

Assessable Penalties—Assessable penalties are not subject to the IRC’s deficiency procedures set forth in IRC 6211 through IRC 6215. Assessable penalties are required to be paid upon notice and demand. For assessable penalties, there is no notice requirement prior to assessment. As a general rule, penalties are assessable without deficiency procedures when they are not dependent upon the determination of a deficiency. If a penalty is not dependent upon the determination of a deficiency, then the penalty may not be subject to deficiency procedures. See Smith v. Commissioner, 133 T.C. 424, 429 (2009).

Statute of Limitations—The IRS maintains that penalties that are not considered taxes generally have no statute of limitation for assessment. As a result, it maintains that the statute of limitations may remain open for such items—in many cases, for an unlimited number of years. Penalties related to returns, however, are generally treated as taxes and governed by the statute of limitation for assessment. Section 6501(c)(8) often governs the statute of limitations with respect to international information returns.

Reasonable Cause—Reasonable cause is a defense to most, but not all, of international information return penalties. However, the IRS maintains that taxpayers who conduct business or transactions offshore or in foreign countries have a responsibility to exercise ordinary business care and prudence in determining their filing obligations and other requirements. The IRS’s position is that it is not reasonable or prudent for taxpayers to have no knowledge of, or to solely rely on others for, the tax treatment of international transactions.

The IRS takes the position that reasonable cause does not apply to penalties assessable after the taxpayer was notified of the requirement to file or was requested to provide specific required information.

The fact that reasonable cause relief was granted to the related income tax return does not automatically provide relief for the failure to timely file the information returns.

The IRS takes the position that reasonable cause should not be granted to a taxpayer merely because of the following:1) A foreign country would impose penalties on them for disclosing the required information,

A foreign trustee refuses to provide them information for any other reason, including difficulty in producing the required information or provisions in the trust instrument that prevent the disclosure of required information, or
The taxpayer relied on another person to file returns. The IRS believes that it is the taxpayer’s responsibility to ensure that all returns are filed timely and accurately.

Appeal Rights—Appeals currently provides a prepayment, post assessment appeal process for all international penalties. Appeals also provides for an accelerated process for certain international penalties.

Information Returns—Information returns generally must be attached to the related income tax return. In addition, certain information returns must also be separately filed with the IRS campus site identified in the instructions for such form. Any information return required to be attached to the related income tax return is due on the due date of the income tax return, including extensions. Form 3520, Annual Return to Report Transactions With Foreign Trust and Receipt of Certain Foreign Gifts, and Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner are not required to be attached to an income tax return.

Form 8278—International penalties are assessed on Form 8278, Assessment and Abatement of Miscellaneous Civil Penalties, with a Form 886-A, Explanation of Items, attached to identify what penalty is being assessed, how the penalty was calculated, and why reasonable cause was not applicable.

Penalty Tax Adjustments—Some of the IRC penalty sections include penalty adjustments to income tax or penalties that are based on the amount of income tax. Penalties based on the amount of income tax, income tax deficiency, adjustments to taxable income, tax credits, or income tax computations are return-related penalties and are covered by deficiency procedures. Return-related penalties must be included in an examination report.

Related Statute for Assessment—The IRS takes the position that IRC section 6501(c)(8) extends the statute for assessment on the related income tax return regarding items related to the information required to be reported until 3 years after the information required by IRC 6038, IRC 6038A, IRC 6038B, IRC 6038D, IRC 6046, IRC 6046A, and IRC 6048 is furnished to the IRS. Thus, failing to file information returns may affect the statute for assessment on the related income tax return.

While IRC 6501(c)(8) may apply to extend the limitations period for assessment on the related tax return, there is a reasonable cause exception.

Other Penalties

Criminal penalties may apply to U.S. and foreign taxpayers who willfully fail to file a return (IRC 7203) or file a false or fraudulent return (IRC 7206 and IRC 7207).

IRC 6662(e), Substantial Valuation Misstatement Under Chapter 1, and IRC 6662(h), Increase in Penalty in Case of Gross Valuation Misstatements, may be applicable in the international reporting context.

In addition, the following reporting and filing requirements are subject to failure to deposit penalties and are applicable to Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons.

Statute	Subject
IRC 1441	Withholding of Tax on Nonresident Aliens
IRC 1442	Withholding of Tax on Foreign Corporations
IRC 1446	Withholding Tax on Foreign Partners’ Share of Effectively Connected Income

31 U.S.C. 5321—Report of Foreign Bank and Financial Accounts (FBAR), FinCEN Form 114 (as of September 30, 2013)

Generally, a U.S. person having one or more foreign accounts with aggregate amounts in the accounts of over $10,000 any time during the calendar year is required to maintain records and submit FinCEN Form 114 by the due date in the following year.

Penalties for a failure to file may apply in the following situations:

Under 31 U.S.C. 5321(a)(5)(B) for any non-willful violation of the recordkeeping and filing requirements under 31 U.S.C. 5314.
Under 31 U.S.C. 5321(a)(5)(C) for any willful violation of the recordkeeping and filing requirements under 31 U.S.C. 5314.
Under 31 5321(a)(6)(A) for negligently failing to meet the filing and recordkeeping requirements for financial institutions or non-financial trades or businesses.
Under 5321(a)(6)(B) for a pattern of negligent violations of any provision of 31 U.S.C. 5311-5332 by financial institutions or non-financial trades or businesses.

See 31 U.S.C. 5321(b) for the statute of limitations on assessment and collection.

Assessment Procedures for Penalties Not Subject to Deficiency Procedures

The IRS maintains that deficiency procedures under Subchapter B of Chapter 63 (relating to deficiency procedures for income, estate, gift, and certain excise taxes) generally do not apply to international information return penalties discussed herein.

Requirement to File—The IRS makes a determination whether an information return was required to be filed. The IRS believes that the following types of information support a presumptive requirement to file an international information return:

Testimony of the taxpayer or other reliable persons.
Late filed return.
A filed return indicating that information returns are due for prior or subsequent periods or for related entities.
A filed return that does not include all the required information or the required supporting information was not provided when requested.
Information that the taxpayer has control over, is receiving benefits from, or is receiving distributions or income from an account in the name of a foreign entity.
Statement in the name of the foreign entity addressed to the taxpayer.
Information received from promoter investigations that indicates the taxpayer owns or has control over a foreign entity, is controlled by a foreign entity, or meets another filing requirement.

Generally, the information returns or statements are required to be attached to the related income tax return and the due date is the same as the related income tax return (including extensions). Specific exceptions, however, may apply.

Some returns have dual filing requirements and the penalty can apply for failure to file either return.

Notice Letter Provisions—Penalties under IRC 6038, IRC 6038A, IRC 6038D, IRC 6677, and IRC 6679 have “notice letter” provisions and a continuation penalty may apply. The provisions state the following:

If the required returns are not filed or the required information is not received on or before the 90th day after the notice letter is issued, additional penalties of $10,000 per month (or fraction thereof) may be assessed.
The penalty continues to increase until the required information is received, or the information returns are filed, or the maximum penalty is assessed.
The maximum penalty amount for the continuation penalty is different for each IRC section and is referenced in each penalty section.

Reasonable Cause—The IRS takes the position that reasonable cause does not apply to the initial penalty in some relevant IRC sections.

Many of the penalty sections, however, have specific provisions for reasonable cause.

The IRS takes the position that a taxpayer’s repeated failure to file does not support testimony that the taxpayer demonstrated normal business care or prudence for the older, late-filed years.

Continuation Penalties—A continuation penalty is associated with several penalties and can either be assessed at the same time as the initial penalty or at a later date. There are maximum limits to some continuation penalties while others have no limitation on the amount that can be assessed.

Approval—IRC 6751 requires that managers approve penalties prior to assertion. IRS guidance requires that managers approve the case control, sign the notice letters, and approve the penalty by signing Form 8278 prior to closing the penalty case file.

Penalty Assessment–Form 8278, Assessment and Abatement of Miscellaneous Civil Penalties

If a continuation penalty is proposed in conjunction with an initial penalty, a separate Form 8278 is required for each type of penalty, for each tax year, and for each IRC section for which a penalty assessment is made.

IRC 6038—Information Reporting With Respect to Foreign Corporations and Partnerships

IRC 6038(b) provides a monetary penalty for failure to furnish information with respect to certain foreign corporations and partnerships.

The filing requirements apply to both entities which are treated as associations taxable as corporations or as partnerships under Treas. Reg. 301.7701-3.

Reporting and Filing Requirements

Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, and Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, are used for reporting purposes.

Foreign Corporations—IRC 6038(a) and Treas. Reg. 1.6038-2(a) require a U.S. person to furnish information with respect to certain foreign corporations. The required information includes foreign corporation entity data, stock ownership data, financial statements, and intercompany transactions with related persons. Other provisions that must be considered include the following:

A taxpayer meets the requirement by providing the required information on a timely filed Form 5471. A Schedule M attached to Form 5471 is used to report related party transactions. The information is for the annual accounting period of the foreign corporation ending with or within the U.S. person’s taxable year. Form 5471 is filed with the U.S. person’s income tax return on or before the date required by law for the filing of that person’s income tax return, including extensions. See Treas. Reg. 1.6038–2(i).
Regulations provide exceptions for attaching the Form 5471 to the related income tax return when the return is filed by another shareholder. The non-Form-5471-filer must attach a statement to his or her income tax return with the name and TIN of the person filing the Form 5471. If the required return was not filed timely by the other party, the penalty applies. No statement is required to be attached to tax returns for persons claiming the constructive ownership exception. See Treas. Reg. 1.6038-2(j)(2).
Dormant Corporations. Proc. 92-70 provides for summary reporting of dormant corporations. By using the summary filing procedure, the filer agrees that it will provide any information required within 90 days of being asked to do so on audit. The monetary penalty or the foreign tax credit reduction can be imposed if the information is not provided within the 90 days.

Foreign Partnerships—IRC 6038(a) and Treas. Reg. 1.6038-3(a) require a U.S. person to furnish information with respect to certain foreign partnerships. The required information includes foreign partnership entity data, ownership data, financial statements, and intercompany transactions with related persons. The information is furnished to the IRS as follows:

A taxpayer meets the requirement by providing the required information on a timely filed Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships.
Schedule N, attached to Form 8865, is used to report related party transactions. The information is for the annual accounting period of the foreign partnership ending with or within the U.S. person’s taxable year.
Form 8865 is filed with the U.S. person’s income tax return on or before the date required by law for the filing of that person’s income tax return, including extensions. See Treas. Reg. 1.6038-3(i).

Penalty Computation

Initial Penalty—The initial penalty is $10,000 per failure to timely file complete and accurate information on each Form 5471 or Form 8865. The penalty is assessed for each form (of each foreign corporation or partnership) for each year that was not timely filed with complete and accurate information.

Continuation Penalty—If any failure continues more than 90 days after the day on which the notice of such failure was mailed to the taxpayer (90-day period), additional “continuation” penalties are generally applicable. The continuation penalty is $10,000 for each 30-day period (or fraction thereof) during which such failure continues after the expiration of the 90-day period. The maximum continuation penalty for IRC 6038(b) is $50,000 per required Form 5471 or Form 8865.

Thus, the maximum total penalty under IRC 6038(b) is $60,000 per Form 5471 or Form 8865 required to be filed per year (an initial penalty maximum of $10,000 plus the continuation penalty maximum of $50,000 per return).

Of course, criminal penalties may also be applicable to U.S. and foreign taxpayers who willfully fail to file a return (IRC 7203) or file a false or fraudulent return (IRC 7206 and IRC 7207).

Reasonable Cause

Initial Penalties—To demonstrate that reasonable cause exists, a taxpayer should make an affirmative showing of the facts that demonstrates reasonable cause. Taxpayers are strongly encouraged to engage legal counsel both for attorney-client privilege reasons and for purposes of providing a penalty defense submission that complies with IRS procedures and substantive legal requirements. For a failure to file Form 5471, the written statement must contain a declaration that it is made under the penalties of perjury. Additional information required by IRS regulations is available as set forth below:

Form 5471 see Treas. Reg. 1.6038-2(k)(3).
Form 8865 see Treas. Reg. 1.6038-3(k)(4).

Continuation Penalty—The IRS maintains that there is no reasonable cause exception for this penalty. Freeman Law disagrees with this position.

The IRS maintains that first-time abatement (FTA) penalty relief generally does not apply to event-based filing requirements such as with Form 5471.

IRC 6038(c)—Reduction of Foreign Tax Credit

IRC 6038(c) provides for a reduction in foreign tax credits for a failure to furnish information with respect to a controlled foreign corporation (see IRC 957) or a controlled foreign partnership that is required to be filed under IRC 6038.

The foreign tax credit reduction is limited to the greater of $10,000 or the income of the foreign entity for the applicable accounting period.

Not every controlled foreign entity carries a foreign tax credit to the U.S. income tax return.

Coordination With IRC 6038(b). The amount of the IRC 6038(c) penalty is reduced by the amount of the dollar penalty imposed by IRC 6038(b).

Penalty Computation

Initial Penalties:

Application of IRC 901—The amount of taxes paid or deemed paid by the U.S. person is reduced by 10 percent.
Application of IRC 902 and IRC 960—The amount of taxes paid or deemed paid by each of the U.S. person’s controlled foreign corporations is reduced by 10 percent. The 10 percent reduction is not limited to the taxes paid or deemed paid by the foreign corporation(s) with respect to which there is a failure to file information but applies to the taxes paid or deemed paid by all foreign corporations controlled by that United States person.

Continuation Penalties—If such failure continues for more than 90 days after the day on which the notice of such failure was mailed to the taxpayer (90-day period), an additional reduction of 5 percent of the taxpayer’s foreign tax credit is applied for each 3-month period, or fraction thereof, during which such failure continues after the expiration of the 90-day period.

Limitation—The amount of the foreign tax credit reduction for each failure to furnish information with respect to a foreign entity may not exceed the greater of the following:

$10,000, or
The income of the foreign entity for its annual accounting period with respect to which the failure occurs.

Reasonable Cause

Initial Penalties— To demonstrate that reasonable cause exists, a taxpayer should make an affirmative showing of the facts that demonstrates reasonable cause. Taxpayers are strongly encouraged to engage legal counsel both for attorney-client privilege reasons and for purposes of providing a penalty defense submission that complies with IRS procedures and substantive legal requirements. For failure to file Form 5471, the written statement must contain a declaration that it is made under the penalties of perjury. Additional information is available for the following:

Form 5471 see Treas. Reg. 1.6038-2(k)(3).
Form 8865 see Treas. Reg. 1.6038-3(k)(4).

Continuation Penalty—The IRS maintains that there is no reasonable cause exception for this penalty.

IRC 6038A(d)—Information Reporting for Certain Foreign-Owned Corporations

IRC 6038A provides a penalty for certain foreign-owned domestic corporations that fail to report required information or to maintain records.

Reporting and Filing Requirements

IRC 6038A(a) and Treas. Reg. 1.6038A-2 generally require that a reporting corporation report detailed information regarding each person who is a related party and who had any transaction with the reporting corporation during the taxable year, including, but not limited to the following:

Name,
Business address,
Nature of business,
Country in which organized or resident,
Name and address of all direct and indirect 25-percent shareholders,
Name and address of all related parties with which the reporting corporation had a reportable transaction,
Nature of relationship of each related party to the reporting corporation, and
Description and value of transactions between the reporting corporation and each foreign person who is a related party.

Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business (Under Sections 6038A and 6038C of the Internal Revenue Code), is required to be filed as an attachment to the taxpayer’s U.S. income tax return by the due date of that return, including extensions. If the reporting corporation’s income tax return is not timely filed, Form 5472 nonetheless must be timely filed at the IRS campus where the return is due. In such case, when the income tax return is ultimately filed, a copy of Form 5472 is required to be attached.

Note that a separate Form 5472 must be filed with respect to each related party that has a reportable transaction with the reporting corporation.

A taxpayer is also required to maintain relevant records to verify the correct tax treatment of transactions with related parties. See IRC 6038A(a) and Treas. Reg. 1.6038A-3.

Exceptions. The following exceptions apply:

A reporting corporation that, along with all related reporting corporations, has less than $10,000,000 in U.S. gross receipts for a taxable year is not subject to the specific record maintenance requirement of Treas. Reg. 1.6038A-3 or the authorization of agent requirement of Treas. Reg. 1.6038A-5 for such taxable year. See Treas. Reg. 1.6038A-1(h).
If the total value of all gross payments (both made to and received from) foreign related parties (including the value of transactions involving less than full consideration) with respect to related party transactions for a taxable year is not more than $5,000,000 and is less than 10 percent of its U.S. gross income, the reporting corporation is not subject to the record maintenance requirement and the authorization of agent requirement for those transactions. See Treas. Reg. 1.6038A-1(i).

These exceptions apply only to the IRC 6038A record maintenance requirements and the authorization of agent requirement. These exceptions do not apply to the reporting requirements for Form 5472 and the general record maintenance requirements of IRC 6001.

Reporting Corporation—For purposes of IRC 6038A, a reporting corporation is a domestic corporation that is 25 percent (or more) foreign-owned. A corporation is 25-percent foreign-owned if it has at least one direct or indirect 25-percent foreign shareholder at any time during the taxable year.

In addition, a foreign corporation engaged in a trade or business within the U.S. at any time during a tax year is a reporting corporation. Reg § 1.6038A-1(c)(1).

25 Percent Foreign-Owned—A corporation is 25 percent foreign-owned if it has, at any time during the taxable year, at least one direct or indirect 25 percent foreign shareholder (a foreign person owning at least 25 percent of the total voting power of all classes of stock of such corporation entitled to vote or the total value of all classes of stock of such corporation). The attribution rules of IRC 318 apply, with modifications. See IRC 6038A(c)(5).

Attribution under section 318. For purposes of determining whether a corporation is 25-percent foreign-owned and whether a person is a related party under section 6038A, the constructive ownership rules of section 318 apply, and the attribution rules of section 267(c) also apply to the extent they attribute ownership to persons to whom section 318 does not attribute ownership. However, “10 percent” is substituted for “50 percent” in section 318(a)(2)(C), and Section 318(a)(3)(A), (B), and (C) is not applied so as to consider a U.S. person as owning stock that is owned by a person who is not a U.S. person. Additionally, section 318(a)(3)(C) and §1.318-1(b) are not applied so as to consider a U.S. corporation as being a reporting corporation if, but for the application of such sections, the U.S. corporation would not be 25-percent foreign owned.

Related Party—The term “related party” means:

Any direct or indirect 25 percent foreign shareholder of the reporting corporation;
Any person who is related (within the meaning of IRC 267(b) or IRC 707(b)(1)) to the reporting corporation or to a 25 percent foreign shareholder of the reporting corporation; and
Any other person who is related within the meaning of IRC 482 to the reporting corporation.

Foreign Person—For purposes of IRC 6038A, the term “foreign person” generally means:

Any individual who is not a citizen or resident of the United States;
Any individual who is a citizen of any possession of the United States and who is not otherwise a citizen or resident of the United States;
Any partnership, association, company, or corporation that is not created or organized in the United States or under the law of the United States or any State thereof;
Any foreign trust or foreign estate, as defined in IRC 7701(a)(31); or
Any foreign government (or agency or instrumentality thereof).

Records

Generally, the records that must be maintained pursuant to IRC 6038A are required to be maintained within the U.S. However, a reporting corporation may maintain such records outside the U.S. if such records are not ordinarily maintained in the U.S. and if within 60 days of the request to produce them the reporting corporation makes the records available to the Service, or brings the records to the U.S. and complies with the notice requirements under Treas. Reg. 1.6038A-3(f)(2)(ii).

Satisfying the Records Requirements—Generally, a taxpayer meets the requirement by complying with the IRS’s request for books, records, or documents.

Penalty Computation

Initial Penalty—The initial penalty for a reporting failure is $10,000 for each failure during a taxable year of a reporting corporation to:

Timely file a separate Form 5472 with respect to each related party with which it had a reportable transaction during such taxable year,
Maintain the required records relating to a reportable transaction, or
In the case of records maintained outside the U.S., meet the non-U.S. record maintenance requirements.

Continuation Penalties—If any failure continues more than 90 days after the day on which the IRS mails notice of such failure to the taxpayer (the 90-day period), additional “continuation” penalties may apply. The continuation penalty is $10,000 for each 30-day period (or fraction thereof) during which such failure continues after the expiration of the 90-day period.

Unlike the initial penalty, if both a reporting failure and a maintenance failure continue with respect to the same related party, separate continuing penalties may be asserted by the IRS (i.e., for a total of $20,000 each month).

Under certain circumstances, the IRS may impose an additional penalty for a taxable year if, at a time subsequent to the assessment of the initial penalty, a second failure is determined and the second failure continues after notification. See Treas. Reg. 1.6038A-4(d)(2) and Treas. Reg. 1.6038A-4(f) Example (2).

Reasonable Cause

Initial Penalty— To demonstrate that reasonable cause exists, a taxpayer should make an affirmative showing of the facts that demonstrates reasonable cause. Taxpayers are strongly encouraged to engage legal counsel both for attorney-client privilege reasons and for purposes of providing a penalty defense submission that complies with IRS procedures and substantive legal requirements.

Treas. Reg. 1.6038A-4(b)(2)(ii) states that reasonable cause should be applied liberally when a small corporation had no knowledge of the IRC 6038A requirements, has limited presence in (and contact with) the U.S., promptly and fully complies with all requests to file Form 5472, and promptly and fully complies with all requests to furnish books and records relevant to the reportable transaction.

A “small corporation” for purposes of this section is defined as a corporation whose gross receipts for a taxable year are $20,000,000 or less.

There is not a small corporation exception for filing Form 5472. All corporations are subject to filing requirements of Form 5472 (if otherwise applicable).

Continuation Penalty—Generally, if there is reasonable cause for a failure to file or maintain records, the IRS maintains that the latest date that reasonable cause can exist is 90 days from the date of notification of the failure by the Service. See Treas. Reg. 1.6038A-4(b)(1).

IRC 6038A(e)—Noncompliance Penalty for Certain Foreign-owned Corporations

IRC 6038A provides that a foreign related party is required to authorize the reporting corporation to act as its limited agent for purposes of an IRS summons regarding transaction(s) with the related party. IRC 6038A further provides that a reporting corporation is required to substantially comply in a timely manner to an IRS summons for records or testimony relating to a transaction with a related party. The penalty for failure to authorize an agent or for failure to produce records is set forth in IRC 6038A(e)(3).

Reporting and Filing Requirements

A taxpayer meets the requirement by providing an executed “Authorization of Agent” form within 30 days of request by the Service or, in the case of production of records, by complying with the request for books, records, or documents. The penalty will not be imposed if a taxpayer quashes a summons other than on grounds that the records were not maintained as required by IRC 6038A(a).

Statute of Limitations—The running of any period of limitations under IRC 6501 and IRC 6531 may be suspended as set forth in in IRC 6038A(e)(4)(D) relating to proceedings to quash and for a review of a determination of noncompliance.

Penalty Assertion

The IRS will generally assert a penalty when an examiner determines that:

A foreign related party, upon request, failed to authorize the reporting corporation to act as its agent for IRS summons purposes pursuant to the requirements set forth in Treas. Reg. 1.6038A-5, or
The reporting corporation has failed to respond substantially and timely to a proper summons for records.

The noncompliance penalty is subject to deficiency procedures and is reflected on a notice of deficiency.

Penalty Computation

The IRS takes the position that the noncompliance penalty adjustment permits the Service, in its discretion, to adjust the amount of deductions and to adjust the cost of property with respect to the related party transaction(s) based upon information available to the Service. See IRC 6038A(e)(3).

Reasonable Cause

In exceptional circumstances, the IRS may treat a reporting corporation as authorized to act as agent for a related party for IRS summons purposes in the absence of an actual agency appointment by the foreign related party in circumstances where the absence of an appointment is reasonable. See Treas. Reg. 1.6038A-5(f).

IRC 6038B(c)—Failure to Provide Notice of Transfers to Foreign Persons

IRC 6038B(c) provides a penalty for failure to furnish information with respect to certain transfers of property by a U.S. person to certain foreign persons.

Reporting and Filing Requirements

Form 8865 Schedule O, Transfer of Property to a Foreign Partnership (Under section 6038B), and Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, are utilized and required for reporting purposes.

Foreign Corporations—IRC 6038B(a) and the regulations issued thereunder require that any U.S. person that transfers property to a foreign corporation (including cash, stock, or securities) in an exchange described in IRC 332, IRC 351, IRC 354, IRC 355, IRC 356, IRC 361, IRC 367(d), or IRC 367(e) report certain information concerning the transfer:

Reg. 1.6038B-1(b) provides the general reporting requirements.
Reg. 1.6038B-1(b)(1) states that notwithstanding any statement to the contrary on Form 926, the form and attachments must be filed with the transferor’s tax return for the taxable year that includes the date of the transfer.

Form 926 must be complete, accurate, and filed with the taxpayer’s income tax return by the due date of the return (including extensions) at the IRS campus where the taxpayer is required to file in order to meet the requirements outlined in Treas. Reg. 1.6038B-1(b).

Exceptions Relating to Certain Transfers to Foreign Corporations—Under the section 6038B regulations, a Form 926 is not required to be filed, and therefore the penalty does not apply, in certain situations as follows:

For transfers of stock or securities to a foreign corporation in a transaction described in IRC 6038B(a)(1)(A) in which the requirements of Treas. Reg. 1.6038B-1(b)(2)(i) are satisfied and Form 926 need not be filed.

Under Treas. Reg. 1.6038B-1(b)(3), for transfers of cash in a transfer described in IRC 6038B(a)(1)(A), Form 926 is only required to be filed in the following situations:

1) When immediately after the transfer, such person holds directly, indirectly, or by attribution (determined under the rules of IRC 318(a), as modified by IRC 6038(e)(2)) at least 10 percent of the total voting power or the total value of the foreign corporation; or

2) When the amount of cash transferred by such person or any related person (determined under IRC 267(b)(1) through (3) and (10) through (12)) to such foreign corporation during the 12-month period ending on the date of the transfer exceeds $100,000.

Transfers to Foreign Partnerships—IRC 6038B(a) and (b) as well as Treas. Reg. 1.6038B-2 require, in certain circumstances, a U.S. person that transfers property to a foreign partnership in a contribution described in IRC 721 to report certain information concerning the transfer. In addition, note the following:

Reporting is required under these rules if:
- i) Immediately after the transfer, the U.S. person owns, directly, indirectly, or by attribution, at least a 10% interest in the partnership, as defined in section 6038(e)(3)(C) and the regulations thereunder; or
- ii) The value of the property transferred by the U.S. person, when added to the value of any other property transferred in a section 721 contribution by the person (or any related person) to the partnership during the 12-month period ending on the date of the transfer, exceeds $100,000. See Treas. Reg. 1.6038B-2(a)(1).

Note: The value of any property transferred is the fair market value at the time of its transfer.

If a domestic partnership transfers property to a foreign partnership in a section 751 contribution, the domestic partnership’s partners are considered to have transferred a proportionate share of the contributed property to the foreign partnership. However, if the domestic partnership files Form 8865 and properly reports all the required information with respect to the contribution, its partners are not required to report the transfer. See Treas. Reg. 1.6038B-2(a)(2).

Taxpayers meet the reporting requirements by filing Form 8865 Schedule O with their federal income tax return by the due date of the return (including extensions) at the campus where they are required to file.

Description of Transfer to Foreign Corporations—A transfer described in IRC 367(a) occurs if a U.S. person transfers property to a foreign person in connection with an exchange described in IRC 332, IRC 351, IRC 354, IRC 355, IRC 356, or IRC 361, provided an exception in IRC 367(a) is not applicable.

Note: A transfer described in IRC 367(d) occurs if a U.S. person transfers intangible property to a foreign corporation in an exchange described in IRC 351 or IRC 361.

Description of Transfer to Foreign Partnerships—A transfer described in IRC 721 occurs if a U.S. person transfers property to a foreign partnership in exchange for an interest in the partnership.

Statute of Limitations—The IRS takes the position that the HIRE Act amendments to IRC 6501(c)(8), as well as the additional amendments in the Education Jobs and Medicaid Assistance Act, Public Law No. 111-226, provide that the IRC 6501(c)(8) period applies to the entire return, not just those items associated with the failure to file under IRC 6038B, unless the taxpayer can show reasonable cause. In the case of a taxpayer who demonstrates reasonable cause, only those items related to the failure under IRC 6038B are subject to the longer period under IRC 6501(c)(8).

Penalty Assertion

A penalty is asserted on Form 8278 when the IRS believes that the taxpayer:

Is a U.S. person and has made a transfer to a foreign corporation or a foreign partnership as described above;
Has failed to timely file Form 926 and attachments, or Form 8865 Schedule O, Transfer of Property to a Foreign Partnership (Under section 6038B), as specified in IRC 6038B and the regulations thereunder, and
Has not shown that such failure to comply was due to reasonable cause.

The penalty under IRC 6038B(c) is not subject to deficiency procedures. However, the income tax adjustment for gain recognition is subject to deficiency procedures.

Penalty Computation

If a U.S. person fails to furnish information in accordance with IRC 6038B regarding some or all of the property transferred and the reasonable cause exception does not apply, then:

With respect to transfers of property to a foreign corporation, the property is not considered to have been transferred for use in the active conduct of a trade or business outside the U.S. for purposes of IRC 367(a) and the regulations thereunder. See Treas. Reg. 1.6038B-1(f);
With respect to transfers of property to a foreign partnership, the U.S. person must recognize gain on the property. See Treas. Reg. 1.6038B-2(h); and
The U.S. person must pay a penalty equal to 10% of the fair market value of the property on the date of transfer, not to exceed $100,000, unless the failure was due to intentional disregard. See Treas. Reg. 1.6038B-1(f) and Treas. Reg. 1.6038B-2(h).

The period for limitations on assessment of tax on the transfer of such property does not begin to run until the date on which the U.S. person complies with the reporting requirements.

Note: IRC 6501(c)(8) applies to the income tax deficiency from items required to be reported under IRC 6038B.

Reasonable Cause

The IRS maintains that no reasonable cause should be considered until the taxpayer has filed applicable forms for all open years (not on extension).

IRC 6038B(c)(2) provides that no penalty shall apply to any failure if the U.S. person demonstrates that such failure is due to reasonable cause and not to willful neglect.

IRC 6038C—Information With Respect to Foreign Corporations Engaged in U.S. Business

Generally, a foreign corporation engaged in a trade or business within the United States at any time during the taxable year is a “reporting corporation.” See IRC 6038C and Treas. Reg. 1.6038A-1(c)(1).

Reporting and Filing Requirements

Generally, each reporting corporation as defined in Treas. Reg. 1.6038A-1(c) shall make a separate annual information return on Form 5472 with respect to each related party as described in Treas. Reg. 1.6038A-1(d) with which the reporting corporation has had any “reportable transaction.” See Treas. Reg. 1.6038A-2(a)(2) and Treas. Reg. 1.6038A-2(a)(1).

Generally, a reporting corporation must keep the permanent books of account or records as required by IRC 6001 that are sufficient to establish the correctness of the federal income tax return of the corporation, including information, documents, or records to the extent they may be relevant to determine the correct U.S. tax treatment of transactions with related parties. Such records must be permanent, accurate, and complete, and must clearly establish income, deductions, and credits. See Treas. Reg. 1.6038A-3(a)(1).

Penalty Assertion

An initial penalty is asserted on IRS Form 8278 when the IRS determines a penalty under Treas. Reg. 1.6038A-4(a).

Penalty Computation

Initial Penalty—Generally, if a reporting corporation fails to furnish the information described in Treas. Reg. 1.6038A-2 within the time and manner prescribed by Treas. Reg. 1.6038A-2(d) and (e), fails to maintain or cause another to maintain records as required by Treas. Reg. 1.6038A-3, or (in the case of records maintained outside the United States) fails to meet the non-U.S. record maintenance requirements, within the applicable time prescribed in Treas. Reg. 1.6038A-3(f), the IRS will assess a penalty of $10,000 for each taxable year with respect to which such failure occurs. See Treas. Reg. 1.6038A-4(a)(1).

Continuation Penalty—Generally, if any such failure continues for more than 90 days after the day on which the Service mails notice the failure to the reporting corporation, the IRS will assess against the reporting corporation an additional penalty of $10,000 with respect to each related party for which a failure occurs for each 30-day period during which the failure continues after the expiration of the 90-day period. Any uncompleted fraction of a 30-day period shall count as a 30-day period for this purpose. See Treas. Reg. 1.6038A-4(d)(1).

Reasonable Cause

Generally, certain failures may be excused for reasonable cause, including not timely filing Form 5472, not maintaining or causing another to maintain records as required by Treas. Reg. 1.6038A-3, and not complying with the non-U.S. maintenance requirements described in Treas. Reg. 1.6038A-3(f). See Treas. Reg. 1.6038A-4(b)(1).

Generally, if there is reasonable cause for a failure, the beginning of the 90-day period after mailing of a notice by the Service of a failure shall be treated as not earlier than the last day on which reasonable cause existed. See Treas. Reg. 1.6038A-4(b)(1).

IRC 6038C(d)—Noncompliance Penalty for Certain Foreign Corporations Engaged in U.S. Business

IRC 6038C(d) requires that a foreign related party authorize the reporting corporation to act as its limited agent for summons purposes and requires that the reporting corporation maintain and produce records regarding transactions with the foreign related party.

Reporting and Filing Requirements

The requirement is the same as that of IRC 6038A(e).

Penalty Assertion

Generally, a penalty is asserted when:

For purposes of determining the amount of the reporting corporation’s liability for tax, the IRS issues a summons to the reporting corporation to produce (either directly or as an agent for a related party who is a foreign person) any records or testimony,
Such summons is not quashed in a judicial proceeding described in IRC 6038(d)(4) and is not determined to be invalid in a proceeding begun under IRC 7604(b) to enforce such summons, and
The reporting corporation does not substantially comply in a timely manner with such summons and the IRS has sent by certified or registered mail a notice to such reporting corporation that such reporting corporation has not so substantially complied.

The noncompliance penalty follows deficiency procedures and is reflected in the notice of deficiency.

Penalty Computation

The noncompliance penalty adjustment permits the IRS to deny deductions and adjust cost of goods sold with respect to the related party transaction(s) based upon information available to the Service. See IRC 6038(d)(3).

Reasonable Cause

The IRS maintains that there is no reasonable cause exception for this penalty.

IRC 6039F(c)—Large Gifts From Foreign Persons

IRC 6039F provides reporting requirements for U.S. persons who receive large gifts from foreign persons.

Reporting and Filing Requirements

U.S. persons who receive gifts from a foreign individual or foreign estate during the taxable year that in the aggregate exceed $10,000 must file Form 3520, Annual Return to Report Transactions With Foreign Trust and Receipt of Certain Foreign Gifts, and fill out Part IV of Form 3520. These gifts are reportable under IRC 6039F(a). See Notice 97-34.[1]

The threshold for gifts (or bequests) received from nonresident alien individuals and foreign estates is statutorily $10,000, but the amount was raised to $100,000 under Notice 97-34. Once that threshold is reached, reporting is only required with respect to each such gift that is in excess of $5,000. The threshold for gifts (or bequests) received from a foreign corporation or a foreign partnership was statutorily $10,000, but the amount is adjusted each year for inflation. The instructions for Form 3520 for any year will have the applicable dollar threshold for the filing requirement for that year. Failure to report gifts (or bequests) above the applicable dollar threshold for the relevant year is subject to penalties under IRC 6039F. Gifts from foreign trusts are reportable as distributions from a foreign trust under IRC 6048(c) and failure to report such distributions on Part III of the Form 3520 is subject to penalties under IRC 6677.

Section 6048(a) generally provides that any U.S. person who directly or indirectly transfers money or other property to a foreign trust (including a transfer by reason of death) must report such transfer at the time and in the manner prescribed by the Secretary. Section 6048(a)(2). Transfers to foreign trusts described in sections 402(b), 404(a)(4), or 404A, or trusts determined by the Secretary to be described in section 501(c)(3) are not reportable under these requirements. Section 6048(a)(3)(B)(ii). Transfers involving fair market value sales are also not reportable. Section 6048(a)(3)(B)(i). The Secretary may exempt other types of transfers from being reported if the United States does not have a significant interest in obtaining the required information. Section 6048(d)(4). A person who fails to comply with the reporting requirements of section 6048(a) with respect to a transfer occurring after August 20, 1996, will be subject to a 35 percent penalty on the gross value of the property transferred. Section 6677(a).

One of the purposes of the reporting requirements in section 6048(a) is to ensure that U.S. transferors comply with section 679. Section 679 generally treats a U.S. person as the owner of a foreign trust if the U.S. person transfers property to the foreign trust and the trust could benefit a U.S. person. However, a U.S. person will not be treated as the owner of the trust under section 679 if, in exchange for the property transferred to the trust, the U.S. person receives property whose value is at least equal to the fair market value of the property transferred. Section 679(a)(2)(B).

Certain transfers of property by U.S. persons to foreign trusts may be described in section 1491 as well as section 6048(a). Section 1491 generally provides that a U.S. person who transfers property to a foreign trust is subject to a 35 percent excise tax on any unrecognized gain in the transferred property. Section 1494 generally provides that transfers described in section 1491 to certain foreign entities (including foreign trusts) must be reported. Notice 97-18, 1997-10 I.R.B. 35, provided that in the case of transfers to foreign trusts, reporting obligations under section 1494 may be satisfied if the U.S. transferor complies with its reporting obligations under section 6048(a) and the U.S. transferor does not owe excise tax under section 1491.

Note: Form 3520 has four different parts that relate to different filing requirements for filing a Form 3520. The obligation to file a Form 3520 to report the receipt of a large gift (or bequest) from a foreign person by a U.S. person is reportable on Part IV of the form.

Form 3520 is required to be filed separately from the U.S. person’s income tax return with the Ogden Campus. The due date for filing is the same as the due date for filing a U.S. person’s income tax return, including extensions. In the case of a Form 3520 filed with respect to a U.S. decedent, Form 3520 is due on the date that Form 706, United States Estate (and Generation-Skipping) Tax Return, is due, including extensions, or would be due if the estate were required to file a return. A Form 3520 is filed once a year for all reportable gifts (and bequests) within the year with respect to each U.S. person.

Penalty Assertion

The penalty is asserted on Form 8278 when the examiner determines the following:

A U.S. person received a reportable gift (or bequest) from a foreign person.
Has failed to timely file Form 3520.
Has not shown that failure to file was due to reasonable cause.

Penalty Tax Adjustment—IRC 6039F(c)(1)(A) states that the Secretary will determine the tax consequence of the receipt of such gift (or bequest) if the information is not filed timely. This adjustment is subject to deficiency procedures.

Penalty Computation

The penalty for failure to report a large gift (or bequest) from a foreign person on a timely, complete, and accurate Form 3520 is 5 percent of the amount of such foreign gift (or bequest) for each month for which the failure continues after the due date of the reporting U.S. person’s income tax return (not to exceed 25% of such amount in the aggregate).

Reasonable Cause

IRC 6039F(c)(2) provides that no penalty shall apply for failure to furnish the required information if the U.S. person shows that the failure is due to reasonable cause and not to willful neglect.

IRC 6039G—Expatriation Reporting Requirements

IRC 6039G (originally designated as IRC 6039F) was added by the Health Insurance Portability and Accountability Act in 1996, P.L. 104-191.

The American Jobs Creation Act of 2004 (AJCA), P.L. 108-357, made significant amendments to IRC 6039G for individuals who expatriated after June 3, 2004 and before June 17, 2008. Individuals who relinquished their United States citizenship or lost their U.S. long-term resident status were required to file Form 8854, Initial and Annual Expatriation Information Statement, in order to complete their tax expatriation. Otherwise these individuals are still taxed as U.S. persons until they file the Form 8854.

The Heroes Earnings Assistance and Relief Tax Act of 2008 (HEART Act) made additional amendments to IRC 6039G to reflect the enactment of IRC 877A (see below) which applies to individuals who relinquish their U.S. citizenship or lose their long-term resident status on or after June 17, 2008.

Reporting and Filing Requirements

Pre-AJCA—For individuals who expatriated prior to June 4, 2004, a Form 8854 was due on the date of expatriation (for U.S. citizens) or the due date of the individual’s U.S. income tax return (for long-term residents). There was no annual requirement to file a Form 8854 after the initial form was filed.

Post-AJCA—For individuals who expatriated after June 3, 2004, and before June 17, 2008, there was no due date for the initial Form 8854. But their expatriation will not be recognized for tax purposes until a complete initial Form 8854 is filed with the IRS. If the expatriate was subject to the alternate expatriation tax regime (under IRC 877(b)) on the date of expatriation, an annual Form 8854 is then required for each of 10 tax years after the date of expatriation.

IRC 877A—This section generally provides that all property of a “covered expatriate” (defined below) is treated as sold on the day before the individual’s expatriation date. Gain or loss from the deemed sale must be taken into account at that time (subject to an exclusion amount that is indexed for inflation annually).

Note: Exclusion amount are provided in the Form 8854 instructions.

The following information is required on the Form 8854 by the individual who expatriates:

Taxpayer’s TIN
Mailing address of such individual’s principal foreign residence
Foreign country in which the individual resides
Foreign country of which the individual is a citizen
Information detailing the income, assets, and liabilities of such individual
Number of days the individual was physically present in the U.S. during the taxable year
Such other information the Secretary shall prescribe

Post-HEART Act-U.S. citizens and long-term residents who expatriate on or after June 17, 2008 must file Form 8854 by the due date of the income tax return (including extensions) for the year that includes their expatriation date. Under certain circumstances, such expatriates must file Form 8854 for subsequent years.

Form W-8CE—”Covered expatriates” who had an interest in a deferred compensation plan, a specified tax-deferred account (which includes an IRA), or a non-grantor trust on the day before their date of expatriation must file a Form W-8CE with each payer of these interests. The purpose of the Form W-8CE is to notify each payer that the individual is a “covered expatriate” and is subject to special rules with regard to these interests. Form W-8CE is filed with each payer on the earlier of (a) the day before the first distribution on or after the expatriation date, or (b) 30 days after the expatriation date for each item of deferred compensation, specified tax deferred account or interest in a non-grantor trust.

“Covered Expatriate” —An individual is a “covered expatriate” if the individual is either a former citizen or former long-term resident and:

The individual’s average annual net income tax for the five years ending before the date of expatriation or termination of residency is more than a specified amount that is adjusted for inflation as provided in the Form 8854 instructions,
The individual’s net worth is $2 million or more on the date of expatriation, or
The individual fails to certify on Form 8854 that he or she has complied with all U.S. federal tax obligations for the five years preceding the date of the individual’s expatriation.

Former Long-Term Resident—A former long-term-resident is any individual who was a lawful permanent resident of the United States for all or any part of 8 of the last 15 years preceding the date of expatriation.

Treatment of Deferred Compensation Plans, Specified Tax-Deferred Accounts, and Non-Grantor Trusts—The “mark-to-market” rules (of IRC 877A(a)) do not apply to a covered expatriate’s interest in a deferred compensation plan, a specified tax-deferred account nor a non-grantor trust.

Deferral of “Mark-to-Market” Tax—Covered expatriates may elect to defer the payment of all or part of the amount of the “mark-to-market” tax to which they are subject. This election is not available for tax due with respect to a covered expatriate’s interest in a deferred compensation plan, a specified tax-deferred account, or a non-grantor trust in which the covered expatriate held an interest on the day before expatriation. See Notice 2009-85 and the Form 8854 instructions for more information.

Penalty Assertion

IRC 6039G(c) imposes a $10,000 penalty for a failure to timely file a complete and accurate Form 8854, unless it is shown such failure is due to reasonable cause and not to willful neglect.

The penalty is applied as follows:

Pre-AJCA—For individuals who expatriated prior to June 4, 2004, if the individual has failed to file a complete, accurate and timely initial Form 8854, the penalty for failure to file the initial Form 8854 is asserted.
Post-AJCA—For individuals who expatriate after June 3, 2004 but before June 17, 2008, the penalty applies for failure to file a required annual Form 8854.
Post-HEART Act—For individuals who expatriate after June 16, 2008, if the individual has failed to file a complete, accurate and timely initial Form 8854, the penalty for failure to file the initial Form 8854 is asserted.

Note: Certain expatriates may only be required to file an initial Form 8854 and have no continued obligation to file Form 8854 annually.

Penalty Computation

The penalty computation under IRC 6039G depends on the date an individual expatriates as follows:

Pre-AJCA—For individuals who expatriated prior to June 4, 2004, if the individual failed to file a complete, accurate and timely initial Form 8854, the penalty is the greater of 5% of the tax required to be paid under IRC 877 or $1,000 for each taxable year that the 8854 was not filed.
Post-AJCA—For individuals who expatriated after June 3, 2004, and before June 17, 2008, the penalty for failure to file an annual 8854 is $10,000 per required annual form.
Post-HEART Act—For individuals who expatriate after June 16, 2008, the penalty for each failure to file a required Form 8854 is $10,000.

Reasonable Cause

The penalty is improper if the failure to provide the required statement and information was due to reasonable cause and not to willful neglect.

The IRS may, however, refuse to recognize the existence of reasonable cause until the taxpayer has filed the required information for all open years (not on extension).

IRC 6652(f)—Foreign Persons Holding U.S. Real Property Investments

IRC 6652(f) provides a penalty for a failure to meet reporting requirements under IRC 6039C.

Reporting and Filing Requirements

IRC 6039C states that, to the extent provided in regulations, any foreign person holding a direct investment in U.S. real property interests for a calendar year must file a return. The requirement is met by providing information such as name and address, a description of all U.S. real property interests, etc.

However, until such time as the regulations under IRC 6039C are issued, these provisions are not operative. Note, however, that there are other reporting requirements under the Foreign Investment in Real Property Tax Act (FIRPTA) that must still be satisfied. See, e.g., IRC secs. 897 and IRC 1445.

Penalty Computation

IRC 6652(f)(2) provides that the amount of penalty with respect to any failure shall be $25 for each day during which such failure continues.

IRC 6652(f)(3) limits the amount of the penalty determined to the lesser of the following:

$25,000, or
5 percent of the aggregate of the fair market value of the United States real property interests owned by such person at any time during such year.

Reasonable Cause

IRC 6652(f)(1) provides for a defense to penalties if the failure to report is due to reasonable cause and not to willful neglect.

IRC 6677(a)—Failure to File Information with Respect to Certain Foreign Trusts—Form 3520

IRC 6677 provides that U.S. persons, who have an IRC 6048 filing obligation because they engaged in certain transactions with a foreign trust or are treated as owning a foreign trust, who fail to file a complete and accurate Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, or fail to ensure that a foreign trust has filed a Form 3520-A, Annual Return of Foreign Trust With a U.S. Owner, may be assessed penalties for such failures unless it is shown that such failure was due to reasonable cause and not to willful neglect.

Notice 97-34 provides additional guidance on the filing requirements and penalties.

Reporting and Filing Requirements

Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, is required to be filed by a U.S. person for the following:

Report the creation of a foreign trust by a U.S. person during the tax year,
Report certain transfers of money or other property to a foreign trust by a U.S. person,
Identify U.S. persons who are treated as owners of a foreign trust during all or part of the tax year,
Provide information about distributions received by a U.S. person from a foreign trust,
Report the receipt of a loan from a foreign trust during the tax year,
Report the receipt of uncompensated use of trust property from a foreign trust (applicable only after March 18, 2010), or
Provide information about certain gifts or bequests received from foreign persons (penalties related to the failure to report the receipt of such gifts or bequests from foreign persons are imposed under IRC 6039F).

Form 3520 must be timely, complete and accurate to be considered filed.

U.S. Owners: Creation or Transfer—IRC 6048(a) generally provides that any U.S. person who creates a foreign trust and directly or indirectly transfers money or other property to a foreign trust (including a transfer by reason of death) must report such transfer. This reporting is performed on Part I of Form 3520.

Generally, a U.S. person who transfers property to a foreign trust is considered the owner of that portion of the foreign trust unless there is no possibility now or in the future of the trust having a U.S. beneficiary. IRC 679 and the regulations thereunder more specifically describe individuals who are considered owners of foreign trusts and describe exceptions to the general rule.

Other things to consider are as follows:

S. persons who make transfers to Canadian Registered Retirement Savings Plans (RRSPs) or Registered Retirement Income Funds (RRIFs) are not required to report such transfers on Form 3520. See Notice 2003-75 and the instructions to Form 8891, U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans.
Generally, foreign trusts described in IRC 402(b), IRC 404(a)(4), IRC 404A, or IRC 501(c)(3) are not reportable under these requirements. See IRC 6048(a)(3)(B)(ii) and Notice 97-34.
Transfers involving fair market value sales are also not reportable. See IRC 6048(a)(3)(B)(i), Notice 97-34, IRC 679, and the regulations thereunder for additional information.

IRC 6048(b) provides that if at any time during the taxable year a U.S. person is treated as the owner of any portion of a foreign trust under the grantor trust rules (IRC 671 through IRC 679), such person must submit certain information and must ensure that the trust files certain information. The U.S. person must report ownership of the trust for the current tax year on Part II of Form 3520 and, if available, must attach a copy of the owner’s statement (from Form 3520-A) to Form 3520.

Even if the U.S. owner is not required to complete and file the other parts of Form 3520 in a particular year, the U.S. owner must nevertheless complete and file Part II of Form 3520. In addition, the U.S. owner must ensure that the foreign trust files Form 3520-A annually. If the foreign trust fails to file Form 3520-A, the U.S. owner must complete and attach a substitute Form 3520-A to his or her Form 3520.

Distributions: U.S. Beneficiaries—IRC 6048(c) generally requires a U.S. person who receives a distribution or is treated as receiving a distribution, directly or indirectly, from a foreign trust, to report on Form 3520 the name of the trust, the aggregate amount of distributions received from the trust during the taxable year and such other information as the Secretary may prescribe.

Some examples of distributions to U.S. persons from a foreign trust that are reportable or nonreportable are as follows:

Description	Reportable
Distributions to the grantor or owner of the foreign trust.	Yes
Distributions from non-grantor foreign trusts.	Yes
Non-arm’s length loans from a foreign trust or the uncompensated use of trust property.	Yes
Indirect distributions. For example, distributions by use of a credit card, where the charges on that credit card are paid or otherwise satisfied by a foreign trust or guaranteed or secured by the assets of a foreign trust for the year in which the charge occurs.	Yes
Distributions reported as taxable compensation on the income tax return of the recipient.	No
Distributions from Canadian Registered Retirement Savings Plans (RRSPs) or Registered Retirement Income Funds (RRIFs). See Notice 2003-75 and the instructions to Form 8891.	No

Form 3520 is required to be filed separately from the U.S. person’s income tax return and must not be attached to the related income tax return. In addition:

Form 3520 is filed once a year with respect to each U.S. person and each foreign trust. A separate Form 3520 is required for each foreign trust.
Form 3520, filed by a U.S. owner, is required to have a copy of the owner’s statement from Form 3520-A attached to the Form 3520.
Form 3520 is required to be filed by the due date of the income tax return of a U.S. person, including extensions.
A separate Form 3520 must be filed by each U.S. person. However, married individuals who file married filing joint may file one Form 3520.

Penalty Letters, Notice Letters, and Notices

Letter 3804—This is an opening notice letter issued under the provisions of IRC 6677(a).

Letter 3943—This is the closing acceptance letter utilized after the IRS determines that no penalties will be asserted.

Letter 3944—This is the closing no response letter is issued when a taxpayer either fails to respond to notice letter (Letter 3804) or when a taxpayer does not provide a statement of reasonable cause for failing to file such returns.

Letter 3946—This is the closing reasonable cause rejected letter that is issued after the IRS determines that penalties will be asserted.

Penalty Computation

Gross Reportable Amount—The gross reportable amount is defined in IRC 6677(c) as follows:

Contributions to the foreign trust: The gross value of the property involved in the event (determined as of the date of the event) in the case of a failure relating to IRC 6048(a),
The gross value of the portion of the trust’s assets at the close of the year treated as owned by the U.S. person in the case of a failure relating to IRC 6048(b)(1), and
Distributions from the foreign trust: The gross amount of the distributions in the case of a failure relating to IRC 6048(c).

Inaccurate reporting: The penalty applies only to the extent that the transaction is not reported or is reported inaccurately. Thus, if a U.S. person transfers property worth $1,000,000 to a foreign trust, but reports only $400,000 of that amount, penalties may be imposed only on the unreported $600,000.

Also, if the return is not filed and the Service assesses a penalty based on available information, additional assessments can be made if additional information is received.

Initial Penalty—Prior to 2010 under IRC 6677, the initial penalty for failure to timely file a complete and accurate Form 3520 was calculated based on the respective percentages below of the gross reportable amount. There was no minimum penalty. Beginning with 2010, a minimum threshold was added and the initial penalty is equal to the greater of $10,000 or the following:

35 percent of the gross reportable amount of any property transferred to a foreign trust for failure by a U.S. transferor to report the creation of, or transfer to, a foreign trust;
35 percent of the gross reportable amount of the distributions received from a foreign trust for failure by a U.S. person to report receipt of the distribution; or
5 percent of the gross reportable amount of the portion of the trust’s assets treated as owned by a U.S. person for failure by the U.S. person to report the U.S. owner information (this penalty is imposed under IRC 6677(b).

In the case of a U.S. person treated as the owner of a foreign trust, penalties are assessed in the case of a failure to report such ownership pursuant to IRC 6048(b) on a Form 3520-A rather than on the Form 3520.

Continuation Penalty—If any failure continues more than 90 days after the day on which the notice of such failure was mailed to the taxpayer (90-day period), additional penalties will apply. The continuation penalty is $10,000 for each 30-day period (or fraction thereof) during which such failure continues after the expiration of the 90-day period.

The maximum penalty (both initial penalty and continuation penalty) for each failure to file Form 3520 is the gross reportable amount each year.

Non-Compliance Tax Adjustment—IRC 6048(c)(2) provides that any distribution from a foreign trust, whether from income or corpus, to a U.S. beneficiary will be treated as an accumulation distribution includible in the gross income of that U.S. beneficiary if adequate records are not provided to the Secretary to determine the proper treatment of the distribution. The interest charge under IRC 668 shall apply to the distribution treated as an accumulation distribution. In determining the interest amount under IRC 668, the applicable number of years will be equal to one half of the number of years that the trust has been in existence. This adjustment is subject to deficiency procedures.

Interest—The interest charge will be determined using the normal interest rate and method as described in IRC 6621, unless the period is prior to 1996, when a simple interest rate of 6% will be used. This interest is not deductible.

Reasonable Cause

No reasonable cause should be considered until the taxpayer has filed the complete and accurate information required for all open years (not on extension).

IRC 6677 provides specific exclusions with respect to the initial penalty for reasonable cause and Notice 97-34 provides additional information:

A taxpayer will not have reasonable cause merely because a foreign country would impose a civil or criminal penalty on the taxpayer (or other person) for disclosing the required information. See IRC 6677(d).
Refusal on the part of a foreign trustee to provide information for any other reason, including difficulty in producing the required information or provisions in the trust instrument that prevent the disclosure of required information, will not be considered reasonable cause.

The fact that the trustee did not provide the taxpayer with a copy of the owner’s statement of Form 3520-A is not reasonable cause. The taxpayer owner is also the person responsible for ensuring that the Form 3520-A is filed and that he or she receives a copy of the owner’s statement.

IRC 6677(a) and (b)—Foreign Trusts With U.S. Owners—Form 3520-A

The penalties for failure to file Form 3520-A are similar to the penalties for failure to file Form 3520 except that IRC 6677(b) changes the amount of the initial penalty to the greater of $10,000 or 5 percent of the gross reportable amount. The gross reportable amount is defined in IRC 6677(c)(2) as the gross value of the portion of the trust’s assets at the close of the year treated as owned by the U.S. person.

If a foreign trust fails to file Form 3520-A, the penalties are imposed on the U.S. person who is treated as the owner of the foreign trust. The grantor trust rules are in IRC 671 through 679. The U.S. owner may be able to avoid penalties by attaching a substitute Form 3520-A to a timely filed Form 3520.

Reporting and Filing Requirements

Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner, is due by the 15th day of the third month after the end of the trust’s tax year. Each U.S. person treated as an owner of a foreign trust under IRC 671 through IRC 679 is responsible for ensuring that the foreign trust files an annual return setting forth a full and complete accounting of all trust activities, trust operations, and other relevant information as the Secretary prescribes. See IRC 6048(b)(1). In addition, the U.S. owner is responsible for ensuring that the trust annually furnishes such information as the Secretary prescribes to U.S. owners and U.S. beneficiaries of the trust. See IRC 6048(b)(1)(B), Treas. Reg. 404.6048-1, and Notice 97-34.

IRC 6048 authorizes the Secretary to prescribe the information required to be reported. The instructions to Form 3520-A include all information required to be provided.

U.S. persons who are treated as owners of Canadian RRSPs or RRIFs do not need to ensure that the RRSP or RRIF files a Form 3520-A and do not need to file a substitute Form 3520-A.

Form 3520-A includes an owner’s statement (Foreign Grantor Trust Owner Statement) for each U.S. person considered to be an owner of a portion of the foreign trust. The owner’s statement is required to be provided to each U.S. owner of the foreign trust.

Form 3520-A includes a beneficiary’s statement (Foreign Grantor Trust Beneficiary Statement) for any distributions made to U.S. persons. The beneficiary’s statement is required to be provided to each U.S. beneficiary.

U.S. Agent—A copy of the authorization of agent must be attached to the Form 3520-A and must be substantially identical to the format shown in the instructions. The U.S. agent has a binding contract with the foreign trust to act as the foreign trust’s limited agent for purposes of applying IRC 7602, IRC 7603, and IRC 7604 with respect to a request by the IRS to examine records, produce testimony, or respond to a summons by the IRS for such records or testimony.

Trusts without U.S. agents must have the following attached to the Form 3520-A to be considered complete:

A summary of the terms of the trust including a summary of any oral or written agreements or understandings that the U.S. owner(s) has with the trustee whether or not legally enforceable.
Copy of any of the following that have not been previously provided:
- All trust documents and instruments,
- Any amendments to the trust agreement,
- All letters of wishes prepared by the settlor,
- Memorandum of wishes by trustee summarizing the settlor’s wishes, and
- Any other similar documents.

Penalty Letters, Notice Letters, and Notices

Letter 3804—This is an opening notice letter issued under the provisions of IRC 6677(a).

Letter 3943—This is the closing acceptance letter utilized after the IRS determines that no penalties will be asserted.

Letter 3946—This is the closing reasonable cause rejected letter that is issued after the IRS determines that penalties will be asserted.

Penalty Assertion

Form 3520-A is considered incomplete in the following situations:

The U.S. owner or beneficiary is not timely provided with the required statements.
A foreign trust without a U.S. agent does not provide all the required attachments, e.g., summary of the terms of the trust, copies of trust documents or amendments to trust documents, and other required information (See IRM 20.1.9.14.1(7)).
The U.S. agent does not provide information with respect to the trust after a request in writing as required by the terms of the U.S. agent agreement. Reasonable cause does not apply to the penalty in situations relating to a failure to provide information when requested.
Form 3520-A does not contain substantially all of the required information on the return, e.g., amount of contributions and distributions, amount deemed as owned by each U.S. person, and balance sheet and income statement information.

Penalty Computation

Initial Penalty—Prior to 2010, the initial penalty for failure to timely file a complete and accurate Form 3520-A was 5 percent of the gross reportable amount. There was no minimum penalty. Beginning with 2010, a minimum threshold was added and the initial penalty is the greater of $10,000 or 5 percent of the gross reportable amount at the close of the year treated as owned by the U.S. person. See IRC 6677(b) for the penalty and IRC 6677(c) for the meaning of “gross reportable amount.” In addition:

The initial penalty is computed for failure to provide information or inaccurate reporting. The penalty applies only to the extent that the transaction is not reported or is reported inaccurately. Thus, if a U.S. person reports the value of the account as worth $400,000, but the correct value is $1,000,000, penalties may be imposed on the unreported $600,000. See Notice 97-34.
If the return is not filed and the Service assesses a penalty based on available information, adjustments or additional assessments can be made if additional information is received.

Reasonable Cause

IRC 6677(d) provides specific exceptions with respect to the penalty for reasonable cause and Notice 97-34 provides additional information. In addition:

The U.S. owner is responsible for ensuring that Form 3520-A is filed timely and includes all required information. The failure of the trustee or agent to timely file complete and accurate returns or provide information when requested is not reasonable cause for this penalty.
A taxpayer will not have reasonable cause merely because a foreign country would impose a civil or criminal penalty on the taxpayer (or other person) for disclosing the required information. See IRC 6677(d).
Refusal on the part of a foreign trustee to provide information for any other reason, including difficulty in producing the required information or provisions in the trust instrument that prevent the disclosure of required information, will not be considered reasonable cause.

IRC 6679—Return of U.S. Persons With Respect to Certain Foreign Corporations and Partnerships

IRC 6679 provides a penalty for failure to furnish information and timely file a return required under IRC 6046 or IRC 6046A.

Reporting and Filing Requirement

For tax years that began before January 1, 2005, IRC 6679 provided a penalty for failure to furnish information and timely file a return required under IRC 6035. IRC 6035 required a U.S. citizen or resident who was an officer, director, or 10 percent shareholder of a foreign personal holding company to file Form 5471 Schedule N by the due date of the taxpayer’s income tax return, including extensions.

Note: Foreign personal holding company provisions have been repealed effective for tax years of foreign corporations beginning after December 31, 2004, and to tax years of U.S. shareholders with or within which such tax year of the foreign corporation ends. Therefore, there is no Form 5471 Schedule N filing requirement for periods after the rules have been repealed.

IRC 6046 requires Form 5471 Schedule O to be filed by the due date of the taxpayer’s income tax return, including extensions and must be filed by the following:

A U.S. citizen or resident who is an officer or director of a foreign corporation in which a U.S. person has acquired:
- Stock which meets the 10% stock ownership requirement with respect to the foreign corporation, or
- An additional 10% or more of the outstanding stock of the foreign corporation.
A U.S. person who acquires stock in a foreign corporation which, when added to any stock owned on the date of acquisition, meets the 10% stock ownership requirement with respect to the foreign corporation.
A U.S. person who acquires stock in a foreign corporation which, without regard to stock already owned on the date of acquisition, meets the 10% stock ownership requirement with respect to the foreign corporation.
Each person who is treated as a U.S. shareholder under IRC 953(c) with respect to the foreign corporation.
Each person who becomes a U.S. person while meeting the 10% stock ownership requirement with respect to the foreign corporation.
A U.S. person who disposes of sufficient stock in the foreign corporation to reduce his or her interest to less than the stock ownership requirement.

IRC 6046A requires Form 8865 Schedule P, to be filed by the due date of the taxpayer’s income tax return, including extensions. The form must be filed by any U.S. person who:

Acquires an interest in a foreign partnership,
Disposes of an interest in a foreign partnership, or
Whose proportional interest in a foreign partnership changes substantially.

Penalty Computation

Initial Penalty—The penalty is $10,000 per failure.

Note: For tax years beginning prior to January 1, 2005, the penalty for failure to file Form 5471 Schedule N, Return of Officers, Directors, and 10% or More Shareholders of a Foreign Personal Holding Company, was $1,000 per failure and was assessed with PRN 614.

Continuation Penalty—If any failure continues more than 90 days after the day on which the notice of such failure was mailed to the taxpayer (90-day period), additional penalties of $10,000 for each 30-day period (or fraction thereof) during which such failure continues after the expiration of the 90-day period will apply. The maximum continuation penalty is limited to $50,000 per failure.

Reasonable Cause

IRC 6679(a)(1) provides a reasonable cause exception to the initial penalty.

The IRS maintaines that a reasonable cause defense does not apply to the continuation penalty. Freeman Law disagrees with this position.

IRC 6686—Information Returns for IC-DISCs

IRC 6686 was added by P.L. 92-178 for Domestic International Sales Corporations (DISC) or former Foreign Sales Corporations (FSC).

The provisions for FSCs were repealed by P.L. 106-519 effective generally for transactions after September 30, 2000.

Although the FSC provisions were repealed, the Interest Charge Domestic International Sales Corporations (IC-DISC) provisions remain in effect.

Reporting and Filing Requirements

An IC-DISC is a domestic corporation that has elected to be an IC-DISC on Form 4876-A, Election To Be Treated as an Interest Charge DISC, and its election is still in effect.

An IC-DISC must file an annual U.S. tax return even though it pays no U.S. income taxes. See IRC 6011(c)(2) and Treas. Reg. 1.991-1.

Penalty Computation

The penalty under IRC 6686 is $100 for each failure to supply information (but the total amount imposed for all such failures during any calendar year shall not exceed $25,000) and $1,000 for each failure to file a Form 1120-IC-DISC.

Reasonable Cause

IRC 6686 provides for such penalties unless it is shown that such failure to file or supply information is due to reasonable cause.

To be considered for reasonable cause, the taxpayer must make an affirmative showing of reasonable cause in a written statement containing a declaration that it was made under the penalties of perjury.

IRC 6688—Reporting for Residents of U.S. Possessions (U.S. Territories)

IRC 6688 applies to any person described in IRC 7654(a) who is required to furnish information and who fails to comply with such requirement unless it is shown that such failure is due to reasonable cause and not to willful neglect.

Reporting and Filing Requirements

IRC 6688 provides a penalty for individuals with total worldwide gross income of more than $75,000 who take the position that, for U.S. income tax reporting purposes (see IRC 937(c)), they became or ceased to be bona fide residents of a U.S. possession (U.S. territory) and fail to meet the requirements under IRC 937 by filing Form 8898, Statement for Individuals Who Begin or End Bona Fide Residence in a U.S. Possession.

Note that:

The instructions to Form 8898 currently specify that the form only needs to be filed by such individuals if they have more than $75,000 in worldwide gross income in the taxable year that they take the position that they became or ceased to be a bona fide resident of a U.S. possession.
S. Possessions—Guam, American Samoa, the Commonwealth of the Northern Mariana Islands (CNMI), the Commonwealth of Puerto Rico, and the U.S. Virgin Islands are U.S. possessions, as that term is used in the IRC. These jurisdictions are more commonly referred to as U.S. territories..
Form 8898 is filed separately with the Philadelphia Campus (or campus identified in future instructions), not with the individual’s tax return.

The penalty also applies to individuals who have adjusted gross income of $50,000 and gross income of $5,000 from sources within Guam or CNMI and who fail to file Form 5074, Allocation of Individual Income Tax to Guam or the Commonwealth of the Northern Mariana Islands (CNMI), as required under Treas. Reg. 301.7654-1(d) for individuals who file U.S. income tax returns.

Subsequent to 2005, Form 8898 must be filed by the due date (including extensions) for filing Form 1040, U.S. Individual Income Tax Return, or Form 1040NR, U.S. Nonresident Alien Income Tax Return.

Penalty Computation

For tax years ending after October 22, 2004, the penalty is $1,000 for failure to file the respective Form 8898, Form 5074, Form 8689, or for filing incorrect or incomplete information.

For tax years ending before October 23, 2004, the penalty is $100.

Reasonable Cause

IRC 6688 provides for such penalties unless it is shown that such failure is due to reasonable cause and not to willful neglect.

IRC 6689—Failure to File Notice of Foreign Tax Redetermination

IRC 6689 provides a penalty for failure to notify the Service of a foreign tax redetermination with respect to the following:

The amount of foreign taxes paid, accrued, or deemed paid by the taxpayer for which a notice is required under IRC 905(c), or
The amount of adjustment to the deduction for certain foreign deferred compensation plans under IRC 404A(g).

Reporting and Filing Requirements

A taxpayer is required to notify the Service of any foreign tax redetermination that may affect U.S. tax liability. If a taxpayer has a reduction in the amount of foreign tax liability, the taxpayer must provide notification by filing Form 1040X, Amended U.S. Individual Income Tax Return, or Form 1120X, Amended U.S. Corporation Income Tax Return, and Form 1116, Foreign Tax Credit, or Form 1118, Foreign Tax Credit—Corporations, by the due date (with extensions) of the original return for the taxpayer’s taxable year in which the foreign tax redetermination occurred. See former Treas. Reg. 1.905-4T(b)(1)(ii).

In addition:

If a foreign tax redetermination results in an additional assessment of foreign tax, the taxpayer has the 10-year period provided by IRC 6511(d)(3)(A) to file a claim for refund based on additional foreign tax credits. See former Treas. Reg. 1.905-4T(b)(1)(iii).
When a foreign tax redetermination affects the indirect or deemed paid credit under IRC 902, the taxpayer must provide notification by reflecting the adjustments to the foreign corporation’s pools of post-1986 undistributed earnings and post-1986 foreign income taxes on a Form 1118 for the taxpayer’s first taxable year with respect to which the redetermination affects the computation of foreign taxes deemed paid.

Redetermination of IRC 404A Deduction—A taxpayer is required to notify the Service, in the time and manner specified in the regulations under IRC 905, if the foreign tax deduction for deferred compensation expense is adjusted. See IRC 404A(g)(2)(B).

Foreign Tax Redetermination—Former Treas. Reg. 1.905-3T(c) defines a foreign tax redetermination as a change in the foreign tax liability that may affect a U.S. taxpayer’s foreign tax credit and includes the following:

Accrued taxes that when paid differ from the amounts added to post-1986 foreign income taxes or claimed as credits by the taxpayer,
Accrued taxes that are not paid before the date two years after the close of the taxable year to which such taxes relate, or
Any tax paid that is refunded in whole or in part, and
For taxes taken into account when accrued but translated into dollars on the date of payment, the difference between the dollar value of the accrued foreign tax and the dollar value of the foreign tax actually paid attributable to fluctuations in the value of the foreign currency relative to the dollar between the date of accrual and the date of payment.

Statute of Limitations—IRC 6501(c)(5) independently suspends the normal statute of limitations for additions to tax resulting from a redetermination of foreign tax. IRC 905(c) contains special rules for such changes.

Penalty Computation

The examiner determines the deficiency attributable to the foreign tax redetermination and to this deficiency is added a penalty computed as follows:

5 percent of the deficiency if the failure to file a notice of foreign tax redetermination is for not for more than 1 month;
An additional 5 percent of the deficiency for each month (or fraction thereof) during which the failure continues, but not to exceed in the aggregate 25 percent of the deficiency; and
If this penalty applies, then the penalty under IRC 6662(a) and IRC 6662(b)(1), relating to the failure to pay by reason of negligent or intentional disregard of rules and regulations, shall not apply.

Reasonable Cause

The IRS maintains that reasonable cause should only be considered if the taxpayer has filed amended returns for all affected years for which the particular foreign tax redetermination results in a U.S. tax deficiency and for which amended returns are required under former temporary Treas. Reg. 1.905-4T.

IRC 6689(a) provides for such a penalty unless it is shown that such failure is due to reasonable cause and not due to willful neglect.

IRC 6712—Failure to Disclose Treaty-Based Return Position

IRC 6712 provides a penalty for failure to disclose a treaty-based return position as required by IRC 6114.

Reporting and Filing Requirements

IRC 6114 generally requires that if a taxpayer takes a position that any treaty of the U.S. overrules or modifies any provision of the Code, the taxpayer must disclose the position. A taxpayer meets the disclosure requirement by attaching Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b), or appropriate successor form to his or her timely filed tax return (including extensions).

Note: A taxpayer may be able to treat payments or income items of the same type (e.g., interest items) received from the same ultimate payor (e.g., the obligor of a note) as a single separate payment or income item. See Treas. Reg. 301.6114-1(d)(3)(ii) for guidance on rules for single separate payment or income item.

If an individual would not otherwise be required to file a tax return, the individual must file Form 8833 at the IRS campus where he or she would normally file a return to make the treaty-based return position disclosure under IRC 6114. See Treas. Reg. 301.6114-1(a)(1)(ii) or Treas. Reg. 301.7701(b)-7.

Penalty Computation

Individuals—For an individual, the penalty is $1,000 for each separate treaty-based return position taken and not properly disclosed.

Corporations—For a C corporation, the penalty is $10,000 for each separate failure to disclose a treaty-based return position.

Reasonable Cause

IRC 6712(b) provides that the Secretary may waive all or any part of the penalty on a showing by the taxpayer that there was reasonable cause for the failure and that the taxpayer acted in good faith.

Waiver Criteria—Treas. Reg. 301.6712-1(b) provides the authority to waive, in whole or in part, the penalty imposed under IRC 6712 if the taxpayer’s failure to disclose the required information is not due to willful neglect. An affirmative showing of lack of willful neglect must be made by the taxpayer in the form of a written statement setting forth all the facts alleged to show lack of willful neglect and must contain a declaration by the taxpayer that the statement is made under penalties of perjury.

IRC 6039E—Failure to Provide Information Concerning Resident Status (Passports and Immigration)

IRC 6039E provides a penalty for failure to provide information concerning resident status.

Reporting and Filing Requirements

Passports—IRC 6039E generally requires that any individual, who applies for a United States (U.S.) passport, must include with such application the taxpayer’s TIN (if the individual has one), any foreign country in which such individual is residing, and any other information as the Secretary may prescribe.

Immigration—IRC 6039E generally requires that any individual, who applies to be lawfully accorded the privilege of residing permanently in the U.S. as an immigrant in accordance with the immigration laws, must include with such application the taxpayer’s TIN (if the individual has one), information with respect to whether such individual is required to file a return of the tax imposed by Chapter 1 for such individual’s most recent 3 taxable years, and any other information as the Secretary may prescribe.

Penalty Letters, Notice Letters, and Notices

Letter 4318, IRC 6039E Initial (Passport), and attachment Form 13997, Validating Your TIN and Reasonable Cause, are used by the IRS to propose a penalty.

Letter 4319, IRC 6039E No Penalty (Passport), is used by the IRS to notify the taxpayer that no penalty will be asserted.

Letter 4320, IRC 6039E Penalty (Passport), is used by the IRS to notify the taxpayer that it found that he or she did not have reasonable cause and that the proposed penalty will be asserted.

Penalty Computation

The penalty is $500 for such failure.

Only one $500 penalty may be asserted per application.

Reasonable Cause

IRC 6039E provides for such penalties unless it is shown that such failure is due to reasonable cause and not to willful neglect.

IRC 6038D—Information With Respect to Specified Foreign Financial Assets

IRC 6038D was added by P.L. 111-147, the Hiring Incentives to Restore Employment (HIRE) Act, for any individual failing to disclose information with respect to specified foreign financial assets during any taxable year beginning after March 18, 2010.

Reporting and Filing Requirements

A complete and accurate Form 8938, Statement of Specified Foreign Financial Assets, attached to a timely filed tax return fulfills the reporting requirements.

The required information for such specified foreign financial assets include the following:

For all accounts and assets:
- The maximum value of each account or asset during the year, and
- The foreign currency in which the account or asset is designated, the exchange rate used to convert the account or asset value into U.S. dollars, and the source of the exchange rate if other than the U.S. Treasury Financial Management Service.
In the case of any foreign deposit or custodial account:
- The account type, including account number, and account opening and closing dates, and
- The name and address of the financial institution in which the account is maintained.
In the case of any stock of, or interest in, a foreign entity:
- A description of the stock or interest in the entity, including any identifying number, and acquisition and disposition dates, and
- The name, address, and type of foreign entity.
In the case of all other specified foreign financial assets:
- A description of the asset, including any identifying number, and
- The names and addresses of all issuers and counter-parties with respect to the asset.

Penalty Computation

Initial Penalty—The initial penalty is $10,000 for each taxable year with respect to which such failure occurs.

Reasonable Cause

IRC 6038D(g) provides that no penalty shall apply if the individual shows that the failure is due to reasonable cause and not to willful neglect.

An individual will not have reasonable cause merely because a foreign jurisdiction would impose a civil or criminal penalty on any person for disclosing the required information.

Quick Reference Guide to International Penalties

Taxpayer		Filing Requirement	Penalty Code Section
U.S. person with interest in:	Foreign Corporation (FC)	Form 5471	IRC 6038(b)
	Foreign Partnership (FP)	Form 8865
	Foreign Disregarded Entity	Form 8858
Penalty reducing Foreign Tax Credit:	Foreign Corporation (FC)	Form 5471	IRC 6038(c)
	Foreign Partnership (FP)	Form 8865
	FC or FP with Foreign Disregarded Entity	Form 8858
25 percent foreign-owned U.S. corporations		Form 5472	IRC 6038A(d)
25 percent foreign-owned U.S. corporations that fail to: 1) authorize the reporting corporation to act as agent of a foreign related party, or 2) substantially comply with a summons for information		Not applicable	IRC 6038A(e)
Transferor of certain property to foreign persons:	Foreign Corporation	Form 926	IRC 6038B(c)
Transferor of certain property to foreign persons:	Foreign Partnership	Form 8865 Schedule O	IRC 6038B(c)
Foreign corporations engaged in U.S. business		Form 5472	IRC 6038C(c)
Individuals receiving gifts from foreign persons exceeding $100,000 or $10,000 in the case of a gift from a foreign corporation or foreign partnership (adjusted annually for cost of living)		Form 3520	IRC 6039F(c)
Individuals that relinquish their U.S. citizenship or abandon their long-term resident status		Form 8854	IRC 6039G(c)
Foreign persons holding direct investments in U.S. real property interests		Not applicable	IRC 6652(f)
U.S. person who creates a foreign trust, transfers property to a foreign trust or receives a distribution from a foreign trust		Form 3520	IRC 6677(a)
U.S. Owner of a foreign trust		Form 3520-A	IRC 6677(b)
Failure to file returns with respect to acquisitions of interests in:	Foreign Corporation	Form 5471 Schedule O	IRC 6679,
	Foreign Partnership	Form 8865 Schedule P	IRC 6679,
IC-DISC, or FSC failure to file returns or supply information:	IC-DISC	Form 1120-IC-DISC	IRC 6686
	FSC	Form 1120-FSC	IRC 6686
Allocation of Individual Income Tax to Guam or the CMNI		Form 5074	IRC 6688
Statement for Individuals Who Begin or End Bona Fide Residence in a U.S. Possession		Form 8898	IRC 6688
Taxpayer’s failure to file notice of foreign tax redetermination under IRC 905(c) or IRC 404A(g)(2)		Form 1116 or Form 1118 (attached to Form 1040-X or Form 1120-X)	IRC 6689
Taxpayer’s failure to file notice of foreign deferred compensation plan under IRC 404A(g)(2)		Not applicable	IRC 6689
Taxpayer’s failure to disclose treaty-based return position		Form 8833 or statement	IRC 6712
Failure to Provide Information Concerning Resident Status (Passports and Immigration)		Not applicable	IRC 6039E(c)
Taxpayer’s failure to furnish information with respect to specified foreign financial assets		Form 8938	IRC 6038D(d)

Reference Guide to Forms

Form	Description
Form 886-A	Explanation of Items
Form 870	Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment
Form 926	Return by a U.S. Transferor of Property to a Foreign Corporation
Form 1040-X	Amended U.S. Individual Income Tax Return
Form 1041	U.S. Income Tax Return (for Estates and Trusts)
Form 1042	Annual Withholding Tax Return for U.S. Source Income of Foreign Persons (Refer to IRM 4.10.21, Examination of Returns, U.S. Withholding Agent Examinations—Forms 1042 )
Form 1042-S	Foreign Person’s U.S. Source Income Subject to Withholding (Refer to IRM 4.10.21)
Form 1116	Foreign Tax Credit (Individual, Estate or Trust)
Form 1118	Foreign Tax Credit—Corporations
Form 1120-FSC	U.S. Income Tax Return of a Foreign Sales Corporation
Form 1120-IC-DISC	Interest Charge Domestic International Sales Corporation Return
Form 1120-X	Amended U.S. Corporation Income Tax Return
Form 3198	Special Handling Notice for Examination Case Processing
Form 3210	Document Transmittal
Form 3244	Payment Posting Voucher
Form 3520	Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts
Form 3520-A	Annual Return of Foreign Trust With U.S. Owner
Form 3870	Request for Adjustment
Form 4549	Income Tax Examination Changes
Form 4549-A	Income Tax Discrepancy Adjustments
Form 5074	Allocation of Individual Income Tax to Guam or the Commonwealth of the Northern Mariana Islands
Form 5344	Examination Closing Record
Form 5471	Information Return of U.S. Person With Respect to Certain Foreign Corporations
Form 5472	Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business
Form 8278	Assessment and Abatement of Miscellaneous Civil Penalties
Form 8288	U.S. Withholding Tax Return for Disposition by Foreign Persons of U.S. Real Property Interests
Form 8288-A	Statement of Withholding on Disposition by Foreign Persons of U.S. Real Property Interests
Form 8689	Allocation of Individual Income Tax to the U.S. Virgin Islands
Form 8804	Annual Return for Partnership Withholding Tax (Section 1446)
Form 8805	Foreign Partner’s Information Statement of Section 1446 Withholding Tax
Form 8813	Partnership Withholding Tax Payment Voucher (Section 1446)
Form 8833	Treaty Based Return Position Disclosure Under Section 6114 or 7701(b)
Form 8854	Initial and Annual Expatriation Information Statement
Form 8858	Information Return of U.S. Persons With Respect to Foreign Disregarded Entities
Form 8865	Return of U.S. Persons With Respect to Certain Foreign Partnerships
Form 8898	Statement for Individuals Who Begin or End Bona Fide Residence in a U.S. Possession
Form 8938	Statement of Specified Foreign Financial Assets
Form W-8CE	Notice of Expatriation and Waiver of Treaty Benefits

Quick Guide for Penalty Reference Numbers For International Penalty Assessments

	Penalty Description				Penalty Rate or Amount				Reference
2009 Offshore Voluntary Disclosure Program, 2011 Offshore Voluntary Disclosure Initiative (OVDI), and the 2012 OVDI. Penalty is % of highest aggregate account and asset value in all foreign bank accounts and entities for the tax year, provided that required conditions were met.				5%			In lieu of all other penalties that may apply
				20%
				12 1/2%
				25%
			27 1/2%
Initial Penalty—Failure of Foreign Corporation Engaged in a U. S. Business to Furnish Information or Maintain Records			$10,000 per failure subject to continuation penalty					IRC 6038C(c)
Failure of Foreign Person to File Return Regarding Direct Investment in U. S. Real Property Interests			$25 each day of failure. Max at lesser of $25,000 or 5% of aggregate FMV of U.S. real property interest					IRC 6652(f)
Failure to File (FTF) Returns or Supply Information by DISC or FSC			$100 each failure (max $25,000) to supply info and $1,000 for each FTF Form 1120–DISC or Form 1120-FSC					IRC 6686
Initial Penalty—FTF Form 5471 Schedule O (IRC 6046) or Form 8865 Schedule P (IRC 6046A)			$10,000 per failure subject to continuation penalty					IRC 6679
Continuation Penalty—Penalty for Continued Failure to Provide Information After 90-Day Period			$10,000 per each 30-day period after the expiration of the 90-day initial notification period					IRC 6038(b)(2) and (c)
Initial Penalty—FTF Form 5471 or Form 8865			$10,000 per failure plus FTC reduction within 90-day initial notification period					IRC 6038(b)
Initial Penalty—Failure to Provide Information with Respect to Certain Foreign-Owned Corporations (Form 5472)			$10,000 per taxable year subject to continuation penalty					IRC 6038A
Initial Penalty—FTF Form 3520 transactions with foreign trusts (IRC 6048(a))		greater of $10,000 or 35% of the gross reportable amount				IRC 6677(a),
Initial Penalty—FTF Form 3520-A Foreign Trust with U.S. Owner (IRC 6048(b) and/or IRC 6048(c))		greater of $10,000 or 5% of the gross reportable amount				IRC 6677(b)
Failure to disclose treaty-based return position (IRC 6114)		$1,000 per failure ($10,000 in the case of a C corporation)				IRC 6712
FTF Form 3520 for reporting receipt of certain foreign gifts		5% of the amount of the gift per month not to exceed 25%				IRC 6039F
FTF Form 8898 Regarding Residence in a U.S. Possession required by IRC 937(c)		$1,000 per failure				IRC 6688
FTF Form 5074 Allocation of Income Tax to Guam or CNMI required by IRC 7654 and Treas. Reg. 301.7654-1(d)		$1,000 per failure				IRC 6688
FTF Form 8689 Allocation of Income Tax to VI required by IRC 932(a) and Treas. Reg.1.932-1T(b)(1)		$1,000 per failure				IRC 6688
Failure to File an Information Statement Regarding Loss of U. S. Citizenship or Long-term Permanent Residency FTF Form 8854 regarding expatriation		$10,000 per failure				IRC 6039G
FTF Form 926 or Form 8865 Schedule O		10% of the fair market value of property at time of transfer or exchange, not to exceed $100,000 unless the failure was caused by intentional disregard				IRC 6038B
Failure to provide information concerning resident status (passports and immigration)		$500 for each failure.				IRC 6039E
Initial Penalty—Failure to provide information with respect to specified foreign financial assets (Form 8938)		$10,000 for each taxable year for failure				IRC 6038D
Continuation Penalty—Penalty for Continued Failure to Provide Information After 90-Day Period		$10,000 per each 30-day period after the expiration of the 90-day initial notification period				IRC 6038A(d)(2)
Continuation Penalty—Penalty for Continued Failure to Provide Information After 90-Day Period—Form 3520		$10,000 per each 30-day period after the expiration of the 90-day initial notification period				IRC 6677(a)
Continuation Penalty—Penalty for Continued Failure to Provide Information After 90-Day Period—Form 3520-A		$10,000 per each 30-day period after the expiration of the 90-day initial notification period				IRC 6677(a)
Continuation Penalty—Penalty for Continued Failure to Provide Information After 90-Day Period		$10,000 per each 30-day period after the expiration of the 90-day initial notification period				IRC 6679(a)(2)
Continuation Penalty—Penalty for Continued Failure to Provide Information After 90-Day Period		$10,000 per each 30-day period after the expiration of the 90-day initial notification period				IRC 6038C(c)
Continuation Penalty—Failure to provide information with respect to specified foreign financial assets (Form 8938)		$10,000 per each 30-day period after the expiration of the 90-day initial notification period				IRC 6038D

International Penalties Subject to or Not Subject to Deficiency Proceeding

Reference	Description	Form	Deficiency Proceedings
IRC 6038(b)	Information Reporting With Respect to Certain Foreign Corporations and Partnerships—Penalty for Failure to Furnish Information	Form 5471, Form 8858, or Form 8865	No
IRC 6038(c)	Penalty of Reducing Foreign Tax Credit Plus Continuation Penalty	Form 5471, Form 8858, or Form 8865	Yes
IRC 6038A(d)	Information Reporting for Foreign-Owned Corporations	Form 5472	No
IRC 6038A(e)	Noncompliance Penalty for Failure to Authorize an Agent or Failure to Produce Records	Not applicable	Yes
IRC 6038B(c)	Failure to Provide Notice of Transfers to Foreign Persons	Form 926 or Form 8865 Schedule O	No for penalty. Yes for tax on gain
IRC 6038C(c)	Information With Respect to Foreign Corporations Engaged in U.S. Business	Form 5472	No
IRC 6038C(d)	Noncompliance Penalty for Foreign Related Party Failing to Authorize the Reporting Corporation to Act as its Limited Agent	Not applicable	Yes
IRC 6038D	Failure to Provide Information With Respect to Specified Foreign Financial Assets	Form 8938	No
IRC 6039E	Failure to Provide Information Concerning Resident Status (Passports and Immigration)	Not applicable	No
IRC 6039F(c)	Gifts from Foreign Persons	Form 3520	Yes if IRC 6039F(c)(1)(A). No if IRC 6039F(c)(1)(B).
IRC 6039G	Expatriation Reporting Requirements	Form 8854, Form W-8CE	No
IRC 6652(f)	Foreign Persons Holding U.S. Real Property Investments	Not applicable	No
IRC 6677(a)	Failure to File a Foreign Trust Information Return	Form 3520	No
IRC 6677(b)	Failure to File an Information Return With Respect to U.S. Owners of a Foreign Trust	Form 3520-A	No
IRC 6679	Return of U.S. Persons With Respect to Certain Foreign Corporations and Partnerships	Form 5471 Schedule O, Form 8865 Schedule P, or Form 5471 Schedule N	No
IRC 6686	Information Returns for Former FSCs	Form 1120-IC-DISC, or Form 1120-FSC	Yes
IRC 6688	Reporting for Residents of U.S. Possessions	Form 5074, Form 8689 or Form 8898	Yes
IRC 6689	Failure to File Notice of Foreign Tax Redetermination	Form 1116 or Form 1118 (attach to Form 1040-X or Form 1120-X)	No
IRC 6712	Failure to Disclose Treaty-Based Return Position	Form 8833	No

Reasonable Cause Relief Summary (The IRS’s Position on Relief Availability)

Penalty Code Section	Form	Reasonable Cause Relief
IRC 6038(b)	FCs—Form 5471 FPs—Form 8865 FCs and FPs with Foreign Disregarded Entities—Form 8858	Yes
IRC 6038(c)	FCs—Form 5471 FPs—Form 8865 FCs and FPs with Foreign Disregarded Entities—Form 8858	Yes
IRC 6038A(d)	Form 5472	Yes
IRC 6038A(e)	Not applicable	Not applicable
IRC 6038B(c)	Form 926 Form 8865 Schedule O	Yes
IRC 6038C(c)	Form 5472	Yes
IRC 6038C(d)	Not applicable	Not applicable
IRC 6038D	Form 8938	Yes
IRC 6039E	Not applicable	Yes
IRC 6039F(c)	Form 3520	Yes
IRC 6039G	Form 8854, Form W-8CE	Yes
IRC 6652(f)	Not applicable	Yes
IRC 6677(a)	Form 3520	Yes
IRC 6677(b)	Form 3520-A	Yes
IRC 6679	Form 5471 Schedule O for IRC 6046 Form 8865 Schedule P for IRC 6046A	Yes
IRC 6686	Form 1120-IC-DISC, or Form 1120-FSC	Yes
IRC 6688	Form 5074 Form 8689 Form 8898	Yes
IRC 6689	Form 1116 or Form 1118 (attach to Form 1040-X or Form 1120-X)	Yes

[1] Notice 97-34 provided guidance regarding the new foreign trust and foreign gift reporting provisions contained in the Small Business Job Protection Act of 1996 (the “Act”). The Act expands information reporting requirements under section 6048 of the Internal Revenue Code (the “Code”) for U.S. persons who make transfers to foreign trusts and for U.S. owners of foreign trusts. In addition, the Act adds new reporting requirements for U.S. beneficiaries of foreign trusts, extensively revises the civil penalties for failure to file information with respect to foreign trusts, and adds civil penalties for failure to report certain transfers to foreign entities. See sections 6048(c), 6677, and 1494(c). The Act also adds section 6039F 1 to the Code, creating reporting requirements for U.S. persons who receive large gifts from foreign persons.

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.

Tax Treaties and Exempt Income

Most United States tax treaties provide an exemption for certain categories of employees, including teachers, students, and researchers.[1]

Nonresident alien teachers, students, and trainees who are entitled to treaty exemptions from U.S. tax on part or all of their salary for working in the United States are generally required to file Form 8233 in order to claim the exemption.[2]

A teacher or trainee is an individual, other than a student, who is temporarily in the United States under a “J” or “Q” visa and substantially complies with the requirements of that visa. A person is considered to have substantially complied with the visa requirements if they have not engaged in activities that are prohibited by U.S. immigration laws and could result in the loss of their visa status.

Under the language generally contained in U.S. tax treaties, a non-resident “is temporarily present in the [United States] for the purpose of teaching or carrying on research at a school, college, university or other recognized educational or research institution” “shall be exempt from tax in the [United States] . . . on the remuneration received in consideration of teaching or carrying on research. . . .”

This Insight post looks at the meaning and scope of the phrase “other recognized educational . . . institution.” It sets out several relevant treaty provisions below with the relevant tax analysis and authorities. For future international tax topics, stay tuned for our International Tax Symposium.

Tax Treaties

The United States is a signatory to more than 60 income tax treaties. Our Freeman Law interactive tax treaty map provides a link to tax treaty materials for each U.S. treaty partner:

The U.S.-Czech-Republic Tax Treaty

As originally written, the United States-Czech-Republic tax treaty provides as follows:

An individual who visits a Contracting State for the primary purpose of teaching or conducting research at a university, college, school or other accredited educational or research institution in the other Contracting State, and who is, or immediately before such visit was, a resident of the other Contracting State shall be exempt from tax in the first-mentioned Contracting State for a period not exceeding two years in respect of remuneration for such teaching or research. The benefits provided in this paragraph shall not be granted to an individual who, during the immediately preceding period enjoyed the benefits of one of the preceding paragraphs of this Article. An individual shall be entitled to the benefits of this paragraph only once.

Art. 21, para 5 Tax Convention with the Czech Republic (emphasis added).

One interpretive issue with respect to this provision is the meaning and scope of the phrase “other recognized educational . . . institution” for purposes of this exemption.

The phrase “recognized educational institution” is not defined in the Convention. In the instance (United States-Bulgaria treaty) of an undefined term, paragraph 2 of Article 3, General Definitions, of the Convention provides in relevant part:

Any . . . term not defined [in the Convention] shall, unless the context otherwise requires or the competent authorities agree to a common meaning pursuant to the provisions of Article 26 (Mutual Agreement Procedure). . . have the meaning which it has at that time under the law of that State for the purposes of the taxes to which this Convention applies, any meaning under the applicable tax laws of that State [the United States] prevailing over a meaning given to the term under other laws of that State.

There is limited judicial guidance on the proper interpretation of the phrase “recognized educational institution.” The Tax Court has, however, looked to section 170 in other similar cases in an effort to interpret the scope of the phrase, giving it a similar meaning. Section 170(b)(1)(A)(ii) defines a similar phrase, “educational organization,” as an organization “which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.” Under Treas. Reg. § 1.170A–9(c)(1), an “educational organization does not include organizations engaged in both educational and noneducational activities unless the latter are merely incidental to the educational activities.” Tax Court precedent has generally applied this definition in this context.

The Tax Court’s approach is in line with the IRS’s approach as well. In rulings regarding the qualification of an educational organization under the treaty exemption provision, the IRS has fairly consistently applied the standard derived from § 170(b)(1)(A)(ii). Thus, under IRS guidance, the facility must maintain a regular faculty and curriculum and normally have a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.

In this regard, the IRS has stated that it will interpret the terms in question in accordance with the definition of the term ‘educational institution’ contained in section 151(e)(4) of the Internal Revenue Code of 1954 and section 1.151-3(c) of the Income Tax Regulations.[3] (IRS’s agreement with Japanese competent authorities that the United States would interpret the terms “educational establishments” and “other educational institutions” in accordance with the definition of the term “educational institution” contained in Code Section 1512(e)(4), which was eliminated by legislation in 1976 but language of which is contained in Section 170(b)(1)(A)(ii)); (1976 amendments to Section 151(e)(4)(a) did not affect the definition of “educational institution,” “educational establishment,” or “other educational institutions” as used in various treaties); (qualifying status of U.S. branch of Belgian university).

Thus, the IRS’s prior guidance with respect to section 151(e)(4) of the 1954 Code remains valid. The relevant regulations with respect to that section, which are still part of the current Treasury Regulations, state as follows:

(c) Educational institution. For purposes of sections 151(e) and 152, and the regulations thereunder, the term “educational institution” means a school maintaining a regular faculty and established curriculum, and having an organized body of students in attendance. It includes primary and secondary schools, colleges, universities, normal schools, technical schools, mechanical schools, and similar institutions, but does not include noneducational institutions, on-the-job training, correspondence schools, night schools, and so forth.

26 C.F.R. § 1.151-3. Notably, under this definition, the IRS has found certain organizations to be educational organizations. Certain rulings are particularly helpful in elucidating the scope of the concept of an educational organization in this context. For example, in one ruling, the IRS determined that an organization that taught people to survive in a natural environment was an educational organization. The organization conducted 12 courses annually, each term lasting 26 days. Courses were taught by a faculty of full-time instructors to regularly enrolled students. The instruction, which included lectures, demonstrations, and practical exercises, took place on an isolated island where most classes were conducted out of doors rather than in classrooms. The school was found to be an educational organization that presented a formal program of instruction and maintained a regular curriculum, faculty, and student body.

In another ruling, the IRS similarly found that an organization whose only function was conducting a summer training school with a curriculum built around a core of theological studies analogous to that of a theological seminary was an educational organization. The IRS determined that “even though the organization . . . conducted classes for only eight weeks each summer, it [wa]s, nevertheless, an educational organization within the meaning of section 170(b)(1)(A)(ii) of the Code since, during the eight weeks of operation, (1) its primary function [wa]s the presentation of formal instruction, (2) it normally maintain[ed] a regular faculty and curriculum, and (3) it normally ha[d] a regularly enrolled body of pupils and students in attendance at the place where its educational activities [we]re regularly carried on.”

These rulings provide helpful precedent. In addition to the regulations under § 1.151-3 (cited and quoted above) and the rulings interpreting it, Treasury Regulations under § 170 provide as follows:

An educational organization is described in section 170(b)(1)(A)(ii) if its primary function is the presentation of formal instruction and it normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on. The term includes institutions such as primary, secondary, preparatory, or high schools, and colleges and universities. It includes Federal, State, and other public-supported schools which otherwise come within the definition. It does not include organizations engaged in both educational and noneducational activities unless the latter are merely incidental to the educational activities. A recognized university that incidentally operates a museum or sponsors concerts is an educational organization within the meaning of section 170(b)(1)(A)(ii). However, the operation of a school by a museum does not necessarily qualify the museum as an educational organization within the meaning of this subparagraph.

Treas. Reg. § 1.170A-9.

This definition focuses on the existence of a “regular faculty” and “established curriculum,” as well as an “organized body of students in attendance.”

Moreover, the regulation’s examples, which include “primary and secondary schools” and “similar institutions,” imply that its scope encompasses certain institutions, as the examples focus on organizations with a primary focus on educational endeavors. And notably, the IRS has extended this treaty exemption to a similar context: non-resident aliens invited to teach or lecture at summer seminars in the United States. The extension of the exemption to this context is particularly relevant for certain organizations, and the facts and analysis set forth in another IRS Ruling are instructive in this regard. The facts at issue in that ruling were as follows:

B is a corporation engaged in the collection and preservation of coins and medals, the investigation of matters connected with numismatics, and the popularization of the science of Numismatology. To aid in accomplishing these objectives, B has conducted summer seminars in numismatics since 1952 and expects to continue these seminars as a regular feature of its educational program. In addition, B maintains a library and a museum and conducts lectures for the public.

With regard to the summer seminar program, B has a permanent location and facilities, maintains a regular faculty and established curriculum, and has a regularly organized body of students in attendance at the seminar. Participants in the program receive credit from their universities for their participation in the program.

. . .

Every summer, the regular faculty is supplemented by a visiting scholar. For the 1977 summer seminar, A of C was invited as the visiting lecturer. A is Professor of Ancient Numismatics at D and a recognized authority on Greek and Roman history. A is a resident of Switzerland and was present in the United States from May 30, 1977 to August 27, 1977 for the purpose of teaching at the summer seminar. A received remuneration in the amount of $3,000 for his participation in the summer seminar program, which consisted of delivering lectures and being available for consulation and discussion with the students participating in the seminar.

Article XII of the Convention provides that a professor or teacher, a resident of Switzerland, who temporarily visits the United States for the purpose of teaching for a period not exceeding two years at a university, college, school or other educational institution in the United States, shall be exempt from Federal income tax on his remuneration for teaching for such period.

Based on these facts and principles, the IRS went on to hold that:

the summer seminar program of B is an educational organization within the meaning of section 151(e)(4) of the Code and an educational institution within the meaning of Article XII of the Convention. Therefore, the $3000 remuneration paid to A by B will be exempt from Federal income tax.

The U.S.-Romania Tax Treaty

As originally written, the United States-Romania tax treaty provides as follows:

(1) Where a resident of one of the Contracting States is invited by the Government of the other Contracting State, a political subdivision, or a local authority thereof, or by a university or other recognized educational institution in that other Contracting State to come to that other Contracting State for a period not expected to exceed 2 years for the purpose of teaching or engaging in research, or both, at a university or other recognized educational institution and such resident comes to that other Contracting State primarily for such purpose, his income from personal services for teaching or research at such university for a period not exceeding 2 years from the date of his arrival in that other Contracting State.

(2) This article shall not apply to income from research if such research is undertaken not in the public interest but primarily for the private benefit of a specific person or persons.

Art. 19, para 1, Socialist Republic of Romania Double Taxation: Taxes on Income.

The definition set forth in the U.S.-Romania Treaty is almost identical to that of the Czech-Republic tax treaty—the primary difference being the use of “accredited” educational institution rather than “other recognized” educational institution.

Much as in the Czech-Republic treaty, the phrase “recognized educational institution” is not defined in the Convention. In the instance (United States-Romania treaty) of an undefined term, paragraph 2 of Article 2, General Definitions, of the Convention provides in relevant part:

Any other term used in this Convention and not defined in this Convention shall, unless the context otherwise requires, have the meaning which it has under the laws of the Contracting State whose tax is being determined. Notwithstanding the preceding sentence, if the meaning of such a term under the laws of one of the Contracting States is different from the meaning of the term under the laws of the other Contracting State, or if the meaning of such a term is not readily determinable under the laws of one of the Contracting States, the competent authorities of the Contracting States may, in order to prevent double taxation or to further any other purpose of this Convention, establish a common meaning of the term for purposes of this Convention.

Given that there is no definition of “recognized educational institution,” the IRS again looks to the section 170 definition, just like the Czech-Republic treaty. (It’s rulings have found that “The term ‘re[c]ognized educational institution’ is construed to mean “accredited educational institution.”).

The U.S.-Bulgaria Tax Treaty

As amended, the United States-Bulgaria tax treaty provides as follows:

2. An individual who is a resident of a Contracting State at the beginning of his visit to the other Contracting State and who is temporarily present in the other Contracting State for the purpose of teaching or carrying on research at a school, college, university or other recognized educational or research institution shall be exempt from tax in the other Contracting State, for a period not exceeding two years from the date of the individual’s arrival in that other State on the remuneration received in consideration of teaching or carrying on research. This paragraph shall not apply to income from research if such research is undertaken not in the public interest but primarily for the private benefit of a specific person or persons.

Art. 19, para. 2, as amended by the Protocol Amending the Convention Between the Government of the United States of American and the Government of the Republic of Bulgaria, Art. III.

Much as in the Czech-Republic treaty, there is no definition of “other recognized educational institution” in the treaty. In the instance of an undefined term, paragraph 2 of Article 3, General Definitions, of the Convention provides in relevant part:

As regards the application of this Convention at any time by a Contracting State any term not defined therein shall, unless the context otherwise requires, or the competent authorities agree to a common meaning pursuant to the provisions of Article 24 (Mutual Agreement Procedure), have the meaning which it has at that time under the law of that State for the purposes of the taxes to which this Convention applies, any meaning under the applicable tax laws of that State prevailing over a meaning given to the term under other laws of that State.

Given that there is no definition of “recognized educational institution, the IRS again looks to the section 170 definition, just like the US-Czech-Republic and US-Romania treaties.

The U.S.-Italy Tax Treaty

The United States-Italy tax treaty provides as follows:

A professor or teacher who makes a temporary visit to a Contracting State for a period that is not expected to exceed two years for the purpose of teaching or conducting research at a university, college, school, or other recognized educational institution, or at a medical facility primarily funded from governmental sources, and who is, or immediately before such visit was, a resident of the other Contracting State shall, for a period not exceeding two years, be exempt from tax in the first-mentioned Contracting State in respect of remuneration from such teaching or research.

Art. 20, para. 1 Convention Between the Government of the United States Of America and the Government of the Italian Republic for the Avoidance of Double Taxation With Respect to Taxes on Income and the Prevention of Fraud or Fiscal Evasion.

Just like the US-Romania treaty, there is no definition of “other recognized educational institution” in the treaty. In the instance (United States-Italy treaty) of an undefined term, paragraph 2 of Article 3, General Definitions, of the Convention provides in relevant part:

As regards the application of this Convention by a Contracting State any term not defined therein shall, unless the context otherwise requires, have the meaning which it has under the laws of that State concerning the taxes to which this Convention applies.

Given that there is no definition of “recognized educational institution, the IRS again looks to the section 170 definition, just like the US-Czech-Republic and US-Romania treaties.

The U.S.-Poland Tax Treaty

The United States-Poland tax treaty provides as follows:

Where a resident of one of the Contracting States is invited by the Government of the other Contracting State, a political subdivision or a local authority thereof, or by a university or other recognized educational institution in that other Contracting State to come to that other Contracting State for a period not expected to exceed 2 years for the purpose of teaching or engaging in research, or both, at a university or other recognized educational institution and such resident comes to that other Contracting State primarily for such purpose, his income from personal services for teaching or research at such university or educational institution shall be exempt from tax by that other Contracting State for a period not exceeding 2 years from the date of his arrival in that other Contracting State.

Art. 17, para 1 United States – Poland Income Tax Convention.

Just like the US-Romania treaty, there is no definition of “other recognized educational institution” in the treaty. In the instance (United States-Poland treaty) of an undefined term, paragraph 2 of Article 3, General Definitions, of the Convention provides in relevant part:

Given that there is no definition of “recognized educational institution, the IRS again looks to the section 170 definition, just like the US-Czech-Republic and US-Romania treaties.

International and Offshore Tax Compliance Attorneys

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[1] Reg. §1.1441-1(b)(7) imposes tax plus interest and penalties on the payor of U.S.-source income who does not obtain a timely Form 8233 from the foreign payee, even if the payment is clearly exempt from U.S. tax and thus would clearly be exempt from U.S. withholding tax if timely documentation were received. These rules clearly apply in the case of payments of U.S.-source compensation to nonresident aliens who are self-employed, but it is not clear from the §3401(a)(6) and §1441 regulations whether they also apply to nonresident alien employees who are supposed to follow the §1441 procedures in claiming a wage withholding exemption under Reg. §31.3401(a)(6)-1(f).

[2] Treas. Reg. § 1.1441-1(b)(7) provides, in relevant part, as follows:

1.1441-1(b)(7)(i) General Rule. —

A withholding agent that cannot reliably associate a payment with valid documentation on the date of payment and that does not withhold under this section, or withholds at less than the 30-percent rate prescribed under section 1441(a) and paragraph (b)(1) of this section, is liable under section 1461 for the tax required to be withheld under chapter 3 of the Code and the regulations thereunder, without the benefit of a reduced rate unless—

. . .

1.1441-1(b)(7)(i)(B) —

The withholding agent can demonstrate to the satisfaction of the district director or the Assistant Commissioner (International) that the proper amount of tax, if any, was in fact paid to the IRS;

. . .

1.1441-1(b)(7)(ii) Proof That Tax Liability Has Been Satisfied—

. . .

Proof that a reduced rate of withholding was, in fact, appropriate under the provisions of chapter 3 of the Code and the regulations thereunder may also be established after the date of payment by the withholding agent on the basis of a valid withholding certificate or other appropriate documentation received after that date that was effective as of the date of payment. A withholding certificate furnished after the date of payment will be considered effective as of the date of the payment if the certificate contains a signed affidavit (either at the bottom of the form or on an attached page) that states that the information and representations contained on the certificate were accurate as of the time of the payment. A withholding certificate received within 30 days after the date of the payment will not be considered to be unreliable solely because it does not contain the affidavit described in the preceding sentence. However, in the case of a withholding certificate of an individual received more than a year after the date of payment, the withholding agent will be required to obtain, in addition to the withholding certificate and affidavit, documentary evidence, as described in §1.1471-3(c)(5)(i), that supports the individual’s claim of foreign status or documentary evidence described in §1.1441-6(c)(4)(i) to support any treaty claim made on the certificate. In the case of a withholding certificate of an entity received more than a year after the date of payment, the withholding agent will be required to obtain, in addition to the withholding certificate and affidavit, documentary evidence described in §1.1471-3(c)(5)(i) that supports the entity’s claim of foreign status or documentary evidence described in §1.1441-6(c)(4)(ii) to support any treaty claim made on the certificate. If documentation other than a withholding certificate is submitted from a payee more than a year after the date of payment, the withholding agent will be required to obtain from the payee a withholding certificate and affidavit supporting the claim of chapter 3 status as of the time of the payment.

[3] Notably, since that IRS ruling, Section 1901(a)(23) of the Tax Reform Act of 1976 amended that portion of section 151(e)(4) of the Code dealing with the definition of an ‘educational institution’ and redefines that term as an ‘educational organization’ described in section 170(b)(1)(A)(ii). The 1976 amendment to section 151(e)(4), however, is not considered a substantive amendment. See S.Rep.No.94-938, 94th Cong., 2d Sess. 1 at 491 (1976), 1976-3 C.B. (Vol. 3), 49, 529. Before its amendment in 1976, section 151(e)(4) provided that the term ‘educational institution’ means only an educational institution that normally maintains a regular faculty and curriculum, and normally has a regularly organized body of students in attendance at the place where its educational activities are carried on. Section 170(b)(1)(A)(ii) describes an educational organization that normally maintains a regular faculty and curriculum, and normally has a regularly enrolled body of students in attendance at the place where its educational activities are carried on.

Expert Witnesses and the Daubert Standard

Expert testimony is often critical to establish a claim or defense. Expert testimony is allowed where scientific, technical, or other specialized knowledge will assist the judge or jury to understand the evidence in a case or to determine a fact in issue involved. An expert witness must be qualified to render an opinion. In addition, an expert’s methodology and opinion must pass muster with the court–it must find them to be sufficiently valid and reliable.

Unlike an ordinary witness, an expert is given wide latitude to offer opinions, including opinions that are not based on firsthand knowledge or observation. This latitude is based on an assumption that the expert’s opinion will have a reliable basis in the knowledge and experience of his or her discipline.

In Daubert, the Supreme Court held that Federal Rule of Evidence 702 requires a trial judge to “ensure that any and all scientific testimony … is not only relevant, but reliable.” Thus, courts serve as a gatekeeper to ensure that an expert’s testimony rests “on a reliable foundation” and will be “relevant to the task at hand.”

In subsequent opinions, the court has made clear that the rule applies to all expert testimony.

Federal Rule of Evidence 702 provides:

If scientific, technical, or other specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact in issue, a witness qualified as an expert by knowledge, skill, experience, training, or education, may testify thereto in the form of an opinion or otherwise.

The Rule’s “reliability” standard applies to all “scientific,” “technical,” or “other specialized” matters within its scope. In the words of the Supreme Court, it “requires a valid … connection to the pertinent inquiry as a precondition to admissibility.” And where the testimony’s factual basis, data, principles, methods, or their application are called sufficiently into question, the trial judge must determine whether the testimony has “a reliable basis in the knowledge and experience of [the relevant] discipline.”

To qualify as an expert witness in a Texas court, a witness must: (1) be qualified and (2) their testimony must be relevant and based on a reliable foundation.

Qualification is evaluated by a review of the expert’s training and experience. The specialized knowledge that qualifies a witness to offer an expert opinion may be derived from specialized education, practical experience, a study of technical works, or a combination of these things. The expert’s background must be tailored to the specific area of expertise in which she desires to testify, and the proponent of the expert’s testimony has the burden to show that the witness is qualified on the matter in question. If a witness has a sufficient background in a particular field, then the trial court must then determine whether that background goes to the very matter on which the witness is to give an opinion.

Under Federal Rule of Evidence 702, a qualified witness may provide an opinion if the:

Testimony is based on sufficient facts or data.
Testimony is the product of reliable principles and methods.
Expert reliably applied the principles and methods to the facts of the case.

An expert’s testimony must also satisfy certain criteria in order to be admissible. The Supreme Court’s opinion of Daubert v. Merrill Dow Pharmaceuticals is the seminal opinion governing the reliability analysis at the federal level. Under Daubert, the court identified the following non-exhaustive factors to evaluate whether the reasoning or methodology behind an expert’s opinion is sufficiently reliable:

Whether the theory or technique in question can be and has been tested;
Whether it has been subjected to peer review and publication;
Its known or potential error rate;
The existence and maintenance of standards controlling its operation;
Whether it has attracted widespread acceptance within a relevant scientific community.

Again, these standards also extend not only to experts who will testify on scientific issues, but also to testimony based on “technical” and “other specialized” knowledge. A trial judge has significant discretion in deciding in a particular case how to determine whether particular expert testimony is reliable. Courts consider the specific factors identified in Daubert where they are reasonable measures of the reliability of expert testimony.

Texas courts utilize a “modified Daubert” standard. The Texas Supreme Court has set forth the following non-exhaustive list of factors to determine whether an expert’s opinion is admissible in Texas courts:

the extent to which the theory has been or can be tested;
the extent to which the technique relies on the subjective interpretation of the expert;
whether the theory has been subjected to peer review and/or publication;
the technique’s potential rate of error;
whether the underlying theory or technique has been generally accepted as valid by the relevant scientific community; and
the non-judicial uses which may have been made of the theory or technique.

The Daubert standard is largely designed to keep “junk science” out of the courtroom and to help the trier of fact (the judge or jury) better understand aspects of the case. The more qualified the expert and the more reliable the method utilized to form the expert’s opinion, the more likely it is that the opinion or testimony will be admissible in court.

Freeman Law Tax Attorneys

The FBAR (Report of Foreign Bank and Financial Accounts): Everything You Need to Know

What is the Report of Foreign Bank and Financial Accounts (FBAR)?

Congress enacted the statutory basis for the requirement to report foreign bank and financial accounts in 1970 as part of the “Currency and Foreign Transactions Reporting Act of 1970,” which came to be known as the “Bank Secrecy Act” or “BSA.” These anti-money laundering and currency reporting provisions, as amended, were codified at 31 USC 5311 – 5332, excluding section 5315.

The Secretary of the Treasury subsequently delegated the authority to administer civil compliance with Title II of the BSA to the Director of FinCEN. IRS Criminal Investigation (CI), however, maintains authority to enforce the criminal provisions of the BSA.

While FinCEN retains rule-making authority with respect to FBAR reporting, FinCEN redelegated civil FBAR enforcement authority to the IRS.

The FBAR regulations require that a United States person, including a citizen, resident, corporation, partnership, limited liability company, trust and estate, file an FBAR to report:

a financial interest in or signature or other authority over at least one financial account located outside the United States if
the aggregate value of those foreign financial accounts exceeded $10,000 at any time during the calendar year reported.

Penalties

A failure to file an FBAR report may result in criminal exposure—that is, the possibility of a criminal indictment or investigation. For several years, the IRS has publicly touted its intention to strongly enforce the FBAR reporting requirements.

In addition, a failure to file a FBAR report may result in exposure to civil penalties, including up to half of the balance in all unreported accounts if the government determines that the failure to report was willful or reckless.

Current penalties (adjusted for inflation) are as follows:

U.S. Code citation	Civil Monetary Penalty Description	Current Maximum
31 U.S.C. 5321(a)(5)(B)(i)	Foreign Financial Agency Transaction – Non-Willful Violation of Transaction	$12,921
31 U.S.C. 5321(a)(5)(C)	Foreign Financial Agency Transaction – Willful Violation of Transaction	Greater of $129,210, or 50% of the amount per 31 U.S.C.5321(a)(5)(D)
31 U.S.C. 5321(a)(6)(A)	Negligent Violation by Financial Institution or Non-Financial Trade or Business	$1,118
31 U.S.C. 5321(a)(6)(B)	Pattern of Negligent Activity by Financial Institution or Non-Financial Trade or Business	$86,976

FBAR Statutory Authority

The statutory authority for the FBAR is found under 31 USC § 5314. Section 5314 directs the Secretary of the Treasury to require a resident or citizen of the United States to keep records and/or file reports when making transactions or maintaining a relationship with a foreign financial agency.

31 USC § 5321(a)(5) and (a)(6) establish civil penalties for violations of the FBAR reporting and recordkeeping requirements.

FBAR Regulatory Authority

31 CFR § 1010.350 sets forth the FBAR definitions and requirements. Section 1010.350 requires that “each United States person having a financial interest in, or signature or other authority over, a bank, securities, or other financial account in a foreign country shall report such relationship to the Commissioner of Internal Revenue for each year in which such relationship exists and shall provide such information as shall be specified in a reporting form prescribed under 31 USC § 5314 to be filed by such persons.”

The report is required to be electronically filed with FinCEN on FinCEN Report 114, Report of Foreign Bank and Financial Accounts (FBAR).

Recordkeeping Requirements

31 CFR § 1010.420 requires maintenance and retention of FBAR records for a period of five years. 31 CFR 1010.810(g) references a Memorandum of Agreement between FinCEN and the IRS, which redelegates, to the IRS, FinCEN’s authority to enforce the provisions of 31 USC 5314 and 31 CFR 1010.350 and 1010.420. This includes the authority to:

Assess and collect civil FBAR penalties.
Investigate possible civil violations of these provisions.
Employ the summons power of subpart I of Chapter X.
Issue administrative rulings under subpart G of Chapter X.
Take any other action reasonably necessary for the enforcement of these and related provisions, including pursuit of injunctions.

FBAR Filing Criteria

An FBAR is required if all of the following apply:

The filer is a U.S. person.
The U.S. person has a financial interest in a financial account or signature or other authority over a financial account.
The financial account is in a foreign country.
The aggregate amount(s) in the account(s) valued in dollars exceed $10,000 at any time during the calendar year.

United States Person

A “United States person” is defined by 31 CFR § 1010.350(b) to include:

A citizen of the United States.
A resident of the United States.
An entity formed under the laws of the United States, any state, the District of Columbia, any territory or possession of the United States, or an Indian tribe.

Notably, the federal tax treatment of a United States person does not determine whether the person has an FBAR filing requirement.

Example: Single-member Limited Liability Companies (LLCs) are disregarded for federal tax purposes, but would have to file the FBAR if otherwise required to do so.

Example: Some trusts may not file tax returns but may have an FBAR filing requirement.

The definition of “United States” for this purpose is found in 31 CFR § 1010.100(hhh). For FBAR and other Title 31 purposes, a “United States” includes:

The States of the United States.
The District of Columbia.
The Indian lands (as defined in the Indian Gaming Regulatory Act).
The territories and insular possessions of the United States.

U.S. territories and insular possessions currently include:

Puerto Rico
Guam
American Samoa
S. Virgin Islands
Northern Mariana Islands

U.S. Citizen

A citizen of the U.S. has a U.S. birth certificate or naturalization papers.

U.S. citizenship is not defined by residency. A citizen of the U.S. may reside outside the U.S.

Example:

Children born of U.S. citizens living abroad are U.S. citizens despite the fact that they may never have been to the U.S.

U.S. Resident

Prior to February 24, 2011, when revised regulations were issued, the FBAR regulations did not define the term “U.S. resident.”

For FBARs required to be filed by June 30, 2011, or later, 31 CFR 1010.350(b) defines “United States resident” using the definition of resident alien in IRC 7701(b), but using the Title 31 definition of “United States.” The major tests of residency found in section 7701(b) are:

The green-card test. Individuals who at any time during the calendar year have been lawfully granted the privilege of residing permanently in the U.S. under the immigration laws automatically meet the definition of resident alien under the green-card test.
The substantial-presence test. Individuals are defined as resident aliens under the substantial-presence test if they are physically present in the U.S. for at least 183 days during the current year, or they are physically present in the U.S. for at least 31 days during the current year and meet the specifications contained in IRC 7701(b)(3).
The individual files a first-year election on his income tax return to be treated as a resident alien under IRC 7701(b)(4).
The individual is considered a resident under the special rules in section 7701(b)(2) for first-year or last-year residency.

Individuals residing in the U.S. who do not meet one of these residency tests are not considered U.S. residents for FBAR purposes. This includes individuals in the U.S. under a work visa who do not meet the substantial-presence test.

Using these rules of residency can result in a non-resident being considered a U.S. resident for FBAR purposes. This would occur when a green-card holder actually resides outside the U.S.

FinCEN clarified in the preamble to the regulations that an election under IRC 6013(g) or (h) is not considered when determining residency status for FBAR purposes.

U.S. tax treaty provisions do not affect residency status for FBAR purposes. A treaty provision which allows a resident of the U.S. to file tax returns as a non-resident does not affect residency status for FBAR purposes if one of the tests of residency in IRC 7701(b) is met.

Diplomats residing at foreign embassies in the U.S. are not generally considered U.S. residents since foreign embassies are generally considered part of the sovereign nation they represent.

U.S. Entity

A U.S. entity is a legal entity formed under the laws of the U.S., any state, the District of Columbia, any territory or possession of the U.S., or an Indian tribe.

31 CFR 1010.350(b) specifically names, but does not limit these types of entities to:

Corporations
Partnerships
Trusts
Limited Liability Companies

The preamble to the regulations clarifies that pension plans and welfare benefit plans are included as U.S. entities.

The definition of entities allows for new types of legal entities to be included in the future.

Financial Account

A reportable financial account includes a:
- Bank account, such as a savings deposit, demand deposit, checking, time deposit (CD), or any other account maintained with a financial institution or other person engaged in the business of banking.
- Securities account, securities derivatives account, or other financial instruments account held with a person engaged in the business of buying, selling, holding or trading stock or other securities.
- Other financial account, as defined in (2) below.
“Other Financial Account” is defined by the regulations to include:
- An account with a person in the business of accepting deposits as a financial agency.
- An insurance or annuity policy that has a cash value.

Note:

The preamble to the regulations clarifies that there need be no current payment of an income stream to trigger reporting. The cash value of the policy is considered the account value.

An account with a person that acts as a broker or dealer for futures or options transactions in any commodity on or subject to the rules of a commodity exchange or association.* A mutual fund or similar pooled fund defined as “a fund which issues shares available to the general public that have a regular net asset value determination and regular redemptions.”
The following are not considered financial accounts:
- Stocks, bonds, or similar financial instruments held directly by the person.
- Real estate or an account holding solely real estate (e.g., Mexican “fideicomiso” ).
- A safety deposit box.

Note:

A reportable account may exist where the financial institution providing the safety deposit box has access to the contents and can dispose of the contents upon instruction from, or prearrangement with, the person.

Precious metals, precious stones, or jewels held directly by the person.

Note:

31 USC 5314 defines “foreign financial agency” as “a person acting for a person as a financial institution, bailee, depository trustee, or agent, or acting in a similar way related to money, credit, securities, gold, or a transaction in money, credit, securities, or gold.” Therefore, a reportable account relationship may exist where a foreign agency holds precious metals on deposit or provides insurance or other services as an agent of the person owning the precious metals.

Financial Account Exceptions

The following are not considered reportable financial accounts for FBAR purposes:

- An account of a department or agency of the U.S., an Indian tribe, any state or any political subdivision of a state, any territory or insular possession of the U.S., or a wholly-owned entity, agency or instrumentality of any of the foregoing.
- An account of an international financial institution of which the U.S. government is a member. (e.g., the International Monetary Fund (IMF) and the World Bank.)
- An account in an institution known as a “United States military banking facility,” that is, a facility designated to serve U.S. military installations abroad.
- Correspondent or “nostro” accounts that are maintained by banks and used solely for bank-to-bank settlements.
- Custodial or “omnibus” accounts held for the person by a U.S. institution acting as a global custodian, as long as the person cannot directly access the foreign custodial account.

Accounts not reported on FBAR

Individuals don’t report individual retirement accounts and tax-qualified retirement plans described in Internal Revenue Code Sections 401(a), 403(a) or 403(b) on the FBAR. The FBAR instructions list other exceptions.

Account Valuation

The FBAR is required for each calendar year during which the aggregate amount(s) in the foreign account(s) exceeded $10,000, valued in U.S. dollars, at any time during that calendar year. To determine the account value to report on the FBAR follow these steps:

Determine the maximum value in locally denominated currency. The maximum value of an account is the largest amount of currency and non-monetary assets that appear on any quarterly or more frequent account statement issued for the applicable year.

Example:

If the statement closing balance is $9,000 but at any time during the year a balance of $15,000 appears on a statement, the maximum value reportable on an FBAR is $15,000.

Note:

If periodic account statements are not issued, the maximum account asset value is the largest amount of currency and non-monetary assets in the account at any time during the year.

Convert the maximum value into U.S. dollars by using the official exchange rate in effect at the end of the year at issue for converting the foreign currency into U.S. dollars. The official Treasury Reporting Rates of Exchange for recent years are posted on the FBAR home page of the IRS website. Search for the keyword “FBAR” to find the FBAR home page. Current and recent quarterly rates are also posted on the Bureau of the Fiscal Service website.

If the filer has more than one account to report on the FBAR, each account is valued separately in accordance with the previous paragraphs.

If a person has one or more but fewer than 25 reportable accounts and is unable to determine whether the maximum value of these accounts exceeded $10,000 at any time during the calendar year, the FBAR instructions state that the person is to complete the applicable parts of the FBAR for each of these accounts and enter “value unknown” in Item 15.

Financial Interest

Direct Financial Interest:

A U.S. person has a financial interest in each account for which such person is the owner of record or has legal title, whether the account is maintained for his own benefit or for the benefit of others including non-U.S. persons.
If an account is maintained in the name of two persons jointly, or if several persons each own a partial interest in an account, each of those U.S. persons has a financial interest in that account and, generally, each person must file the FBAR. However, see special rules for spousal filing in IRM 4.26.16.4.4, below.

Note:

Because the FBAR is a report of foreign financial accounts, the entire account value for jointly-owned accounts is reported on each FBAR. Accounts are not prorated for a person’s percentage of ownership interest.

Indirect financial interest: A U.S. person has an “other financial interest” in each bank, securities, or other financial account in a foreign country for which the owner of record or holder of legal title is:

A person acting as an agent, nominee, attorney, or in some other capacity on behalf of the U.S. person.
A corporation, whether foreign or domestic, in which the U.S. person owns directly or indirectly more than 50 percent of the total value of shares of stock or more than 50 percent of the voting power for all shares of stock.
A partnership, whether foreign or domestic, in which the United States person owns an interest in more than 50 percent of the profits (distributive share of income, taking into account any special allocation agreement) or more than 50 percent of the capital of the partnership.
Any other entity in which the U.S. person owns directly or indirectly more than 50 percent of the voting power, total value of the equity interest or assets, or interest in profits.
A trust, if the U.S. person is the trust grantor and has an ownership interest in the trust for U.S. federal tax purposes under 26 USC 671–679 and the regulations thereunder.
A trust, whether foreign or domestic, in which the U.S. person either has a present beneficial interest, either directly or indirectly, in more than 50 percent of the assets of the trust or from which such person receives more than 50 percent of the trust’s current income.

The family attribution rules under Title 26 do not apply to FBAR reporting.

Anti-avoidance rule: A U.S. person that causes an entity including, but not limited to, a corporation, partnership, or trust, to be created for the purpose of evading the FBAR reporting and/or recordkeeping requirements shall have a financial interest in any bank, securities, or other financial account in a foreign country for which the entity is the owner of record or holder of legal title. 31 CFR 1010.350(e)(3).

Signature or Other Authority Over an Account

An individual has signature or other authority over an account if that individual (alone or in conjunction with another) can control the disposition of money, funds or other assets held in a financial account by direct communication (whether in writing or otherwise) to the person with whom the financial account is maintained.

Individuals not considered as having signature authority:

Individuals with only the authority to buy or sell investments within the account, but no authority to disburse assets from the account.
Individuals with supervisory authority over the individuals who actually communicate with the person with whom the account is maintained. FinCEN clarified, in the preamble to the regulations at 31 CFR 1010.350, that approving a disbursement that a subordinate actually orders is not considered signature authority.

Only individuals can have signature authority. Signature authority attributed to entities must be exercised by individuals.

Signature Authority Exceptions

An officer or employee of the following institutions need not report signature or other authority over a foreign financial account owned or maintained by the institution if the officer or employee has no financial interest in the account:

A bank that is examined by the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, or the National Credit Union Administration.
A financial institution that is registered with and examined by the Securities and Exchange Commission or Commodity Futures Trading Commission.
An Authorized Service Provider for a foreign financial account owned or maintained by an investment company that is registered with the Securities and Exchange Commission.

Note:

Authorized Service Provider is an entity that is registered with and examined by the Securities and Exchange Commission and that provides services to an investment company registered under the Investment Company Act of 1940.

An entity with a class of equity securities listed (or American depository receipts listed) on any U.S. national securities exchange.

Note:

Previously, instructions to the form allowed a “large corporation” exception for listed corporations. That exception was expanded to include all listed entities.

An entity that has a class of equity securities registered (or American depository receipts registered) under section 12(g) of the Securities Exchange Act.
An officer or employee of a U.S. subsidiary of an entity described above above need not report signature authority over accounts of the subsidiary if the entity files a consolidated FBAR listing the accounts of the subsidiary.

Foreign Country

A foreign country includes all geographical areas located outside of the United States as defined in 31 CFR 1010.100(hhh). An account is “foreign” for FBAR purposes if it is located outside:

the States of the United States.
The District of Columbia.
The Indian lands (as defined in the Indian Gaming Regulatory Act).
The territories and insular possessions of the United States. See IRM 4.26.16.3.1(4) above.

It is the location of an account, not the nationality of the financial institution, that determines whether an account is “foreign” for FBAR purposes. Accounts of foreign financial institutions located in the U.S. are not considered foreign accounts for FBAR; conversely, accounts of U.S. financial institutions located outside the U.S. are considered foreign accounts. Examples are:

An account with a Hong Kong branch of a U.S.-based bank is a foreign financial account for FBAR purposes.
An account with a New York City branch of a foreign-based bank is not a foreign financial account for FBAR purposes.

Aggregate Value Over $10,000

The final criterion triggering the FBAR filing requirement is the aggregate value of all foreign financial accounts in which the person has a financial interest, or over which the individual has signature or other authority, must be greater than $10,000, valued in U.S. dollars, at any time (on a particular day) during the calendar year.

Steps to aggregate account values:

Each account should be separately valued according to the steps outlined in IRM 4.26.16.3.2.2 to determine its highest valuation during the year in the foreign denominated currency.

Exception:

Money moved from one foreign account to another foreign account during the year must only be counted once.

Each account should be converted from foreign denominated value to U.S. dollars using the FMS conversion rate for December 31st of the calendar year being reported. See IRM 4.26.16.3.2.2, Account Valuation, above.

All reportable accounts should be aggregated, including:

Solely-owned accounts.
Jointly-owned accounts.
Direct financial interest accounts.
Indirect financial interest accounts.
Signature authority accounts.

FBAR Filing Procedures

The determination to file the FBAR is made annually. For example, a person may be required to file an FBAR for one calendar year but not for a subsequent year if the person’s aggregate foreign account balance does not exceed $10,000 at any time during the year.

An FBAR must be filed for each calendar year that the person has a financial interest in, or signature authority over, foreign financial account(s) whose aggregate balance exceeds the $10,000 threshold at any time during the year.

General FBAR Filing

The FBAR must be filed on or before June 30 each year for the previous calendar year.

All FBARs filed after June 30, 2013, must be filed electronically through the FinCEN BSA E-Filing website unless the filer requested, and was granted, an exception to e-filing by FinCEN.

The FBAR should not be filed with the filer’s federal income tax return or information return.

FBAR Filing Exceptions

Individual Retirement Account (IRA) owners and beneficiaries, and participants in and beneficiaries of U.S. tax-qualified retirement plans, are not required to report a foreign financial account held by or on behalf of the IRA or retirement plan.

Caution:

This exception is for U.S. plans only. Foreign plans (e.g., a Canadian Registered Retirement Savings Plan (RRSP) and accounts managed by Mexico’s Administrators of Retirement Funds (AFORES) are normally reportable on an FBAR.

A trust beneficiary with a financial interest is not required to report the trust’s foreign financial accounts on an FBAR if the trust, trustee of the trust, or agent of the trust:

Is a U.S. person, and
Files an FBAR disclosing the trust’s foreign financial accounts.

FBAR Filing by Married Couples

Accounts owned jointly by spouses may be filed on one FBAR. The spouse of an individual who files an FBAR is not required to file a separate FBAR if the following conditions are met:

All the financial accounts that the non-filing spouse is required to report are jointly owned with the filing spouse.
The filing spouse reports the jointly owned accounts on a timely, electronically filed FBAR.
Both spouses complete and sign Part I of FinCEN Form 114a, Record of Authorization to Electronically File FBARs. The filing spouse completes Part II of Form 114a in its entirety.

Note:

The completed Form 114a is not filed but must be retained for five years. It must be provided to IRS or FinCEN upon request.

If these conditions are not met (as when both spouses have individual accounts in addition to the jointly-owned accounts), both spouses are required to file separate FBARs, and each spouse must report the entire value of the jointly-owned accounts.

For calendar years prior to 2014, use the instructions for spousal filing current for that filing year.

Electronic FBAR Filing by a Third Party

FBAR filers may authorize a paid preparer or other third party to electronically file the FBAR for them.

The person reporting financial interest in, or signature authority over, foreign accounts must complete and sign Part I of FinCEN Form 114a.

The preparer or other third-party filer must complete Part II of Form 114a.

Form 114a is not filed. Both parties must retain the form for five years. It must be provided to IRS or FinCEN upon request.

It remains the responsibility of the filer to ensure that filing takes place timely and the report is accurate. Form 114a contains a disclaimer that states: “…it is my/our legal responsibility, not that of the preparer listed in Part II, to timely file an FBAR if required by law to do so.”

FBAR Filing for Financial Interest in 25 or More Accounts

31 CFR 1010.350(g) provides that a United States person that has a financial interest in 25 or more foreign financial accounts only needs to provide the number of financial accounts and certain other basic information on the report, but will be required to provide detailed information concerning each account if the IRS or FinCEN requests it.

Filers must comply with FBAR record-keeping requirements.

FBAR Filing for Signature Authority for 25 or More Accounts

31 CFR 1010.350(g) provides that A United States person that has signature or other authority over 25 or more foreign financial accounts only needs to provide the number of financial accounts and certain other basic information on the report, but will be required to provide detailed information concerning each account if the IRS or FinCEN requests it.

Filers must comply with FBAR record-keeping requirements.

FBAR Filing for U.S. Persons Residing and Employed Outside the United States

The FBAR filing instructions allow for modified reporting by a U.S. person who meets all three of the following criteria:

Resides outside the U.S.
Is an officer or employee of an employer located outside the U.S.
Has signature authority over a foreign financial account(s) of that employer.

In such cases, the U.S. Person should file the FBAR by:

Completing filer information.
Omitting account information.
Completing employer information one time only.

Filing A Consolidated FBAR

31 CFR 1010.350(g) allows an entity that is a U.S. person that owns directly or indirectly a greater than 50 percent interest in another entity that is required to file an FBAR to file a consolidated FBAR on behalf of itself and such other entity.

Each controlled entity that has an FBAR filing obligation must be listed in Part V, even if that entity owns foreign accounts only indirectly.

No FBAR Filing Extension

There is no statutory authority to extend the time for filing an FBAR, and any request for such an extension will be denied.

Extensions of time to file federal income tax returns or information returns do not extend the time for filing FBARs.

IRC section 7508 “Time for performing certain acts postponed by reason of service in combat zone or contingency operation” does not grant U.S. persons that are U.S. Armed Forces members an extension to file the FBAR.

This is not to be confused with extension of the statute of limitations on assessment or collection of penalties, which is possible.

Delinquent FBAR Filing Procedures

Delinquent FBARs should be filed using the current electronic report, but using the instructions for the year being reported to determine if an FBAR filing requirement exists.

On page one of FinCEN Report 114, explain the reason the FBAR was not filed timely. Select a common reason from the drop-down box or select Other, and a 750-character text box appears to allow an explanation.

Keep a copy of the FBAR for recordkeeping purposes.

No penalty will be asserted if the IRS determines that the failure to timely file an FBAR was not willful and was due to reasonable cause.

Amending a Filed FBAR

To amend a filed FBAR, filers should:

Check the “Amended” box in Item 1 at the top of page two and fill in the “Prior Report BSA Identifier” for the original filing in the block provided.
Complete the report in its entirety using the amended information.

FBAR Recordkeeping

If the FBAR is required, certain records must be retained by the filer. 31 CFR 1010.420. Each person having a financial interest in or signature or other authority over any such account must keep the following records:

Name in which the account is maintained.
Number or other designation identifying the account.
Name and address of the foreign financial institution or other person with whom the account is maintained.
Type of account.
Maximum value of each account during the reporting period.

The records must be kept for five years from the June 30 due date for filing the FBAR for that calendar year and be available at all times for inspection as provided by law.

Note that persons are not required to keep copies of FBARs filed, only the records that underlie the filing.

An officer or employee who files an FBAR to report signature authority over an employer’s foreign financial account is not required to personally retain records regarding that account.

FBAR Recordkeeping For Filers Having 25 Or More Accounts

A filer who has financial interest in or signature authority over 25 or more foreign financial accounts must also comply with the record keeping requirements.

Filers will be required to provide detailed information concerning each account if the IRS or FinCEN requests it.

FBAR Penalties

The IRS has been delegated authority to assess civil FBAR penalties.

When there is an FBAR violation, the examiner will either issue the FBAR warning letter, Letter 3800, Warning Letter Respecting Foreign Bank and Financial Accounts Report Apparent Violations, or determine a penalty. However, when multiple years are under examination and a monetary penalty is imposed for some but not all of the years under examination, a Letter 3800 will not be issued for the year(s) for which a monetary penalty is not imposed.

Penalties should be determined to promote compliance with the FBAR reporting and recordkeeping requirements. In exercising discretion, examiners must consider whether the issuance of a warning letter and the securing of delinquent FBARs, rather than the determination of a penalty, will achieve the desired result of improving compliance in the future.

Example:

An individual failed to report the existence of five small foreign accounts with a combined balance of $20,000 for all five accounts, but properly reported the income from each account and made no attempt to conceal the existence of the accounts. The examiner must consider all the facts and circumstances of this case to determine if a warning letter is appropriate in this case or if it would be appropriate to determine civil FBAR penalties.

Civil FBAR penalties have varying upper limits, but no floor. The examiner has discretion in determining the amount of the penalty, if any.
The IRS developed mitigation guidelines to assist examiners in determining the amount of civil FBAR penalties.
There may be multiple civil FBAR penalties if there is more than one account owner, or if a person other than the account owner has signature or other authority over the foreign account. Each person can be liable for the full amount of the penalty.
Managers must perform a meaningful review of the employee’s penalty determination prior to assessment.

FBAR Penalty Authority

IRS was delegated the authority to assess and collect civil FBAR penalties. 31 CFR 1010.810(g). The delegation includes the authority to investigate possible civil FBAR violations, provided in Treasury Directive No. 15-41 (December 1, 1992), and the authority to assess and collect the penalties for violations of the reporting and recordkeeping requirements.

When performing these functions, IRS is not acting under Title 26 but, instead, is acting under the authority of Title 31. Provisions of the Internal Revenue Code generally do not apply to FBARs.

Criminal Investigation was delegated the authority to investigate possible criminal violations of the Bank Secrecy Act. 31 CFR 1010.810(c)(2).

FBAR Penalty Structure

There are four civil penalties available for FBAR violations:

31 USC 5321(a)(6)(A).
Pattern of negligent activity. 31 USC 5321(a)(6)(B).
Penalty for non-willful violation. 31 USC 5321(a)(5)(A) and (B).

Note:

Although the term “non-willful” is not used in the statute, it is used to distinguish this penalty from the penalty for willful violations.

Penalty for willful violations. 31 USC 5321(a)(5)(C).

A filing violation occurs at the end of the day on June 30th of the year following the calendar year to be reported (the due date for filing the FBAR).

A recordkeeping violation occurs on the date when the records are requested by the IRS examiner if the records are not provided.

A civil money penalty may be imposed for an FBAR violation even if a criminal penalty is imposed for the same violation. 31 USC 5321(d).

BSA Negligence Penalties

There are two negligence penalties that apply generally to all BSA provisions. 31 USC 5321(a)(6)

A negligence penalty up to $500 may be assessed against a financial institution or non-financial trade or business for any negligent violation of the BSA, including FBAR violations.
An additional penalty up to $50,000 may be assessed for a pattern of negligent violations.

These two negligence penalties apply only to trades or businesses, and not to individuals.

The FBAR penalties under section 5321(a)(5) and the FBAR warning letter, Letter 3800, adequately address most FBAR violations identified. The FBAR warning letter may be issued in the cases where the revenue agent determines none of the 5321(a)(5) FBAR penalties are warranted. If the revenue agent believes, however, that assertion of a section 5321(a)(6) negligence penalty is warranted in a particular case, the revenue agent should contact a Bank Secrecy Act FBAR program analyst for guidance.

Negligence Defined

Actual knowledge of the reporting requirement is not required to find negligence. For example, if a financial institution or nonfinancial trade or business exercising ordinary business care and prudence for its particular industry should have known about the FBAR filing and record keeping requirements, failure to file or maintain records is negligent. Therefore, standards of practice for a particular industry are relevant in determining whether a negligent violation of 31 USC 5314 occurred. If the failure to file the FBAR or to keep records is due to reasonable cause, and not due to the negligence of the person who had the obligation to file or keep records, the negligence penalty should not be asserted.

Negligent failure to file does NOT exist when, despite the exercise of ordinary business care and prudence, the person was unable to file the FBAR or keep the required records.

Use general negligence principles in determining whether or not to apply the negligence penalty. Treas. Reg. 1.6664-4, Reasonable Cause and Good Faith Exception to section 6662 penalties, may serve as useful guidance in determining the factors to consider.

BSA Simple Negligence Penalty

A negligence penalty up to $500 may be assessed against a business for any negligent violation of the BSA, including FBAR violations.

The simple negligence penalty applies only to businesses, not individuals.

BSA Simple Negligence Penalty Amount

For each negligent violation of any requirement of the Bank Secrecy Act committed after October 27, 1986, a civil penalty may be assessed not to exceed $500.

Generally, the full amount of this $500 penalty is assessed. Although 31 USC 5321(a)(6) permits discretion to assert a lower amount, there are no mitigation guidelines for this penalty.

BSA Pattern of Negligence Penalty

31 USC 5321(a)(6)(B) provides for a civil money penalty of not more than $50,000 on a business that engages in a pattern of negligent BSA violations including violations of the FBAR rules. This penalty is in addition to any $500 negligence penalty.

The pattern of negligence penalty has applied to financial institutions since 1986. For violations occurring after October 26, 2001, the penalty applies to all trades or businesses. This penalty does not apply to individuals.

BSA Pattern of Negligence Penalty Amount

If any trade or business engages in a pattern of negligent violations of any provision (including the FBAR requirements)] of the BSA, a civil penalty of not more than $50,000 may be imposed. This is in addition to the simple negligence $500 penalty. 31 USC 5321(a)(6)(B). The examiner is given discretion to determine the penalty amount up to the $50,000 ceiling.

There are no mitigation guidelines for this penalty. The pattern of negligence penalty should be asserted only in egregious cases.

Penalty for Nonwillful FBAR Violations

For violations occurring after October 22, 2004, a penalty, not to exceed $10,000 per violation, may be imposed on any person who violates or causes any violation of the FBAR filing and recordkeeping requirements. 31 USC 5321(a)(5)(B).

The penalty should not be imposed if:

The violation was due to reasonable cause, and
The person files any delinquent FBARs and properly reports the previously unreported account.

Penalty for Nonwillful Violations – Calculation

After May 12, 2015, in most cases, examiners will recommend one penalty per open year, regardless of the number of unreported foreign accounts. The penalty for each year is limited to $10,000. Examiners should still use the mitigation guidelines and their discretion in each case to determine whether a lesser penalty amount is appropriate.

For multiple years with nonwillful violations, examiners may determine that asserting nonwillful penalties for each year is not warranted. In those cases, examiners, with the group manager’s approval after consultation with an Operating Division FBAR Coordinator, may assert a single penalty, not to exceed $10,000, for one year only.

For other cases, the facts and circumstances (considering the conduct of the person required to file and the aggregate balance of the unreported foreign financial accounts) may indicate that asserting a separate nonwillful penalty for each unreported foreign financial account, and for each year, is warranted. In those cases, examiners, with the group manager’s approval after consultation with an Operating Division FBAR Coordinator, may assert a separate penalty for each account and for each year. The examiner’s workpapers must support such a penalty determination and document the group manager’s approval.

In no event will the total amount of the penalties for nonwillful violations exceed 50 percent of the highest aggregate balance of all unreported foreign financial accounts for the years under examination.

Penalty for Willful FBAR Violations

The penalty for willful FBAR violations may be imposed on any person who willfully violates or causes any violation of any provisions of 31 USC 5314 (the FBAR filing and recordkeeping requirements). 31 USC 5321(a)(5)(C).

The penalty applies to individuals as well as financial institutions and nonfinancial trades or businesses for all years.

For violations occurring after October 22, 2004, the statutory ceiling is the greater of $100,000 or 50% of the balance in the account at the time of the violation.

There may be both a reporting and a recordkeeping violation regarding each account.

The date of a violation for failure to timely file an FBAR is the end of the day on June 30th of the year following the calendar year for which the accounts are being reported. This date is the last possible day for filing the FBAR so that the close of the day with no filed FBAR represents the first time that a violation occurred. The balance in the account at the close of June 30th is the amount to use in calculating the filing violation.

The date of a violation for failure to keep records is the date the examiner first requests records. The balance in the account at the close of the day that the records are first requested is the amount used in calculating the recordkeeping violation penalty. The date of the violation is tied to the date of the request, and not a later date, to assure the taxpayer is unable to manipulate the amount in the account after receiving a request for records. The balance in the account at the close of the day on which the records are first requested is the amount to use in calculating the penalty for failing to keep records as required by statute.

IRS developed guidelines for the exercise of the examiner’s discretion in arriving at the amount of a penalty for a willful violation. See discussion of mitigation, below.

Willful FBAR Violations – Defining Willfulness

The test for willfulness is whether there was a voluntary, intentional violation of a known legal duty.

A finding of willfulness under the BSA must be supported by evidence of willfulness.

The burden of establishing willfulness is on the Service.

Willfulness is shown by the person’s knowledge of the reporting requirements and the person’s conscious choice not to comply with the requirements. In the FBAR situation, the person only need know that a reporting requirement exists. If a person has that knowledge, the only intent needed to constitute a willful violation of the requirement is a conscious choice not to file the FBAR.

Under the concept of “willful blindness,” willfulness is attributed to a person who made a conscious effort to avoid learning about the FBAR reporting and recordkeeping requirements.

Example:

Willful blindness may be present when a person admits knowledge of, and fails to answer questions concerning, his interest in or signature or other authority over financial accounts at foreign banks on Schedule B of his Federal income tax return. This section of the income tax return refers taxpayers to the instructions for Schedule B, which provides guidance on their responsibilities for reporting foreign bank accounts and discusses the duty to file the FBAR. These resources indicate that the person could have learned of the filing and recordkeeping requirements quite easily. It is reasonable to assume that a person who has foreign bank accounts should read the information specified by the government in tax forms. The failure to act on this information and learn of the further reporting requirement, as suggested on Schedule B, may provide evidence of willful blindness on the part of the person.

Note:

The failure to learn of the filing requirements coupled with other factors, such as the efforts taken to conceal the existence of the accounts and the amounts involved, may lead to a conclusion that the violation was due to willful blindness. The mere fact that a person checked the wrong box, or no box, on a Schedule B is not sufficient, in itself, to establish that the FBAR violation was attributable to willful blindness.

The following examples illustrate situations in which willfulness may be present:

A person files the FBAR, but omits one of three foreign bank accounts. The person had previously closed the omitted account at the time of filing the FBAR. The person explains that the omission was due to unintentional oversight. During the examination, the person provides all information requested with respect to the omitted account. The information provided does not disclose anything suspicious about the account, and the person reported all income associated with the account on his tax return. The penalty for a willful violation should not apply absent other evidence that may indicate willfulness.
A person filed the FBAR in earlier years but failed to file the FBAR in subsequent years when required to do so. When asked, the person does not provide a reasonable explanation for failing to file the FBAR. In addition, the person may have failed to report income associated with foreign bank accounts for the years that FBARs were not filed. A determination that the violation was willful would likely be appropriate in this case.
A person received a warning letter informing him of the FBAR filing requirement, but the person continues to fail to file the FBAR in subsequent years. When asked, the person does not provide a reasonable explanation for failing to file the FBAR. In addition, the person may have failed to report income associated with the foreign bank accounts. A determination that the violation was willful would likely be appropriate in this case.

Willful FBAR Violations – Evidence

Willfulness can rarely be proven by direct evidence, since it is a state of mind. It is usually established by drawing a reasonable inference from the available facts. The government may base a determination of willfulness on inference from conduct meant to conceal sources of income or other financial information. For FBAR purposes, this could include concealing signature authority, interests in various transactions, and interests in entities transferring cash to foreign banks.

Documents that may be helpful in establishing willfulness include:

Copies of statements for the foreign bank account.
Notes of the examiner’s interview with the foreign account holder/taxpayer about the foreign account.
Correspondence with the account holder’s tax return preparer that may address the FBAR filing requirement.
Documents showing criminal activity related to the non-filing of the FBAR (or non-compliance with other BSA provisions).
Promotional material (from a promoter or offshore bank).
Statements for debit or credit cards from the offshore bank that, for example, reveal the account holder used funds from the offshore account to cover everyday living expenses in a manner that conceals the source of the funds.
Copies of any FBARs filed previously by the account holder (or FinCEN Query printouts of FBARs).
Copies of Information Document Requests with requested items that were not provided highlighted along with explanations as to why the requested information was not provided.
Copies of debit or credit card agreements and fee schedules with the foreign bank, which may show a significantly higher cost than typically associated with cards from domestic banks.
Copies of any investment management or broker’s agreement and fee schedules with the foreign bank, which may show significantly higher costs than costs associated with domestic investment management firms or brokers.
The written explanation of why the FBAR was not filed, if such a statement is provided. Otherwise, note in the workpapers whether there was an opportunity to provide such a statement.
Copies of any previous warning letters issued or certifications of prior FBAR penalty assessments.
An explanation, in the workpapers, as to why the examiner believes the failure to file the FBAR was willful.

Documents available in an FBAR case worked under a Related Statute Determination under Title 26 that may be helpful in establishing willfulness include:

Copies of documents from the administrative case file (including the Revenue Agent Report) for the income tax examination that show income related to funds in a foreign bank account was not reported.
A copy of the signed income tax return with Schedule B attached, showing whether or not the box pertaining to foreign accounts is checked or unchecked.
Copies of tax returns (or RTVUEs or BRTVUs) for at least three years prior to the opening of the offshore account and for all years after the account was opened, to show if a significant drop in reportable income occurred after the account was opened. (Review of the three years’ returns prior to the opening of the account would give the examiner a better idea of what the taxpayer might have typically reported as income prior to opening the foreign account).
Copies of any prior Revenue Agent Reports that may show a history of noncompliance.
Two sets of cash T accounts (a reconciliation of the taxpayer’s sources and uses of funds) with one set showing any unreported income in foreign accounts that was identified during the examination and the second set excluding the unreported income in foreign accounts.
Any documents that would support fraud (see IRM 4.10.6.2.2 for a list of items to consider in asserting the fraud penalty).

Penalty for Willful FBAR Violations – Calculation

For violations occurring after October 22, 2004, a penalty for a willful FBAR violation may be imposed up to the greater of $100,000 or 50% of the amount in the account at the time of the violation, 31 USC 5321(a)(5)(C). For cases involving willful violations over multiple years, examiners may recommend a penalty for each year for which the FBAR violation was willful.

After May 12, 2015, in most cases, the total penalty amount for all years under examination will be limited to 50 percent of the highest aggregate balance of all unreported foreign financial accounts during the years under examination. In such cases, the penalty for each year will be determined by allocating the total penalty amount to all years for which the FBAR violations were willful based upon the ratio of the highest aggregate balance for each year to the total of the highest aggregate balances for all years combined, subject to the maximum penalty limitation in 31 USC 5321(a)(5)(C) for each year.

Note: Examiners should still use the mitigation guidelines and their discretion in each case to determine whether a lesser penalty amount is appropriate

Examiners may recommend a penalty that is higher or lower than 50 percent of the highest aggregate account balance of all unreported foreign financial accounts based on the facts and circumstances. In no event will the total penalty amount exceed 100 percent of the highest aggregate balance of all unreported foreign financial accounts during the years under examination.

If an account is co-owned by more than one person, a penalty determination must be made separately for each co-owner. The penalty against each co-owner will be based on his her percentage of ownership of the highest balance in the account. If the examiner cannot determine each owner’s percentage of ownership, the highest balance will be divided equally among each of the co-owners.

Mitigation

The statutory penalty computation provides a ceiling on the FBAR penalty. The actual amount of the penalty is left to the discretion of the examiner.

IRS has adopted mitigation guidelines to promote consistency by IRS employees in exercising this discretion for similarly situated persons. Exhibit 4.26.16-1.

Mitigation Threshold Conditions

For most FBAR cases, if IRS has determined that if a person meets four threshold conditions, then that person may be subject to less than the maximum FBAR penalty depending on the amounts in the accounts.

For violations occurring after October 22, 2004, the four threshold conditions are:

The person has no history of criminal tax or BSA convictions for the preceding 10 years, as well as no history of past FBAR penalty assessments.
No money passing through any of the foreign accounts associated with the person was from an illegal source or used to further a criminal purpose.
The person cooperated during the examination (i.e., IRS did not have to resort to a summons to obtain non-privileged information; the taxpayer responded to reasonable requests for documents, meetings, and interviews; and the taxpayer back-filed correct reports).
IRS did not sustain a civil fraud penalty against the person for an underpayment for the year in question due to the failure to report income related to any amount in a foreign account.

FBAR Penalties – Examiner Discretion

The examiner may determine that the facts and circumstances of a particular case do not justify asserting a penalty.

When a penalty is appropriate, IRS penalty mitigation guidelines aid the examiner in applying penalties in a uniform manner. The examiner may determine that a penalty under these guidelines is not appropriate or that a lesser penalty amount than the guidelines would otherwise provide is appropriate or that the penalty should be increased (up to the statutory maximum). The examiner must make such a determination with the written approval of the examiner’s manager and document the decision in the workpapers.

Factors to consider when applying examiner discretion may include, but are not limited to, the following:

Whether compliance objectives would be achieved by issuance of a warning letter.
Whether the person who committed the violation had been previously issued a warning letter or assessed an FBAR penalty.
The nature of the violation and the amounts involved.
The cooperation of the taxpayer during the examination.

Given the magnitude of the maximum penalties permitted for each violation, the assertion of multiple penalties and the assertion of separate penalties for multiple violations with respect to a single FBAR, should be carefully considered and calculated to ensure the amount of the penalty is commensurate to the harm caused by the FBAR violation.

Managerial Involvement and Approval of FBAR Penalties

Managers must perform a meaningful review of the examiner’s penalty determination prior to assessment.

The manager must verify that the penalties were fairly imposed and accurately computed; that the examiner did not improperly assert the penalties in the first instance; and that the conclusions regarding “reasonable cause” (or the lack thereof) were proper.

For BSA cases, written managerial approval must be documented on the Violations Summary Form – Title 31, workpaper 400-1.1.

For SB/SE examination cases, written managerial approval must be documented on the Penalty Approval Form, workpaper 300.

For LB&I cases, managerial approval must be documented on the penalty leadsheets.

For SB/SE campus cases, written managerial approval must be documented on Form 4700, Examination Workpapers.

FBAR Penalty Mitigation Guidelines for Violations Occurring After October 22, 2004

The Bank Secrecy Act (BSA) allows the Secretary of the Treasury some discretion in determining the amount of penalties for violations of the FBAR reporting and record keeping requirements. There is a penalty ceiling but no minimum amount. This discretion has been delegated to the FBAR examiner.

The examiner may determine that the facts and circumstances of a particular case do not justify a penalty.

If there was an FBAR violation but no penalty is appropriate, the examiner must issue the FBAR warning letter, Letter 3800.

When a penalty is appropriate, IRS established penalty mitigation guidelines to ensure the penalties determined by the examiner’s discretion are uniform. The examiner may determine that:

A penalty under these guidelines is not appropriate, or
A lesser amount than the guidelines otherwise provide is appropriate.

The examiner must make this determination with the written approval of that examiner’s manager. The examiner’s workpapers must document the circumstances that make mitigation of the penalty under these guidelines appropriate. When determining the proper penalty amount, the examiner should keep in mind that manager approval is required to assert more than one $10,000 non-willful penalty per year, and in no event can the aggregate non-willful penalties asserted exceed 50% of the highest aggregate balance of all accounts to which the violations relate during the years at issue. Similarly, manager approval is required to assert willful penalties that, in the aggregate, exceed 50% of the highest aggregate balance of all accounts to which the violations relate during the years at issue, and in no event can the aggregate willful penalties exceed 100% of the highest aggregate balance of all accounts to which the violations relate during the years at issue.

To qualify for mitigation, the person must meet four criteria:

The person has no history of criminal tax or BSA convictions for the preceding 10 years and has no history of prior FBAR penalty assessments.
No money passing through any of the foreign accounts associated with the person was from an illegal source or used to further a criminal purpose.
The person cooperated during the examination.
IRS did not determine a fraud penalty against the person for an underpayment of income tax for the year in question due to the failure to report income related to any amount in a foreign account.

FBAR Penalty Mitigation Guidelines – Per Person Per Year
Non-Willful (NW) Penalties
To Qualify for Level I-NW – Determine Aggregate Balance	If the maximum aggregate balance for all accounts to which the violations relate did not exceed $50,000 at any time during the calendar year, Level I – NW applies to all violations. See IRM 4.26.16.3.6, Aggregate Value Over $10,000, above for instruction on determining the maximum aggregate balance.
The Level I-NW Penalty is	$500 per violation, not to exceed a total of $5,000 per year.
To Qualify for Level II-NW – Determine Aggregate Balance	If the maximum aggregate balance of all accounts to which the violations relate exceeds $50,000, but does not exceed $250,000, Level II-NW applies to all violations.
The Level II-NW Penalty is	$5,000 per violation.
To Qualify for Level III-NW – Determine Aggregate Balance	If the maximum aggregate balance of all accounts to which the violations apply exceeds $250,000, Level III-NW applies to all violations.
The Level III-NW Penalty is	$10,000 per violation, the statutory maximum penalty for non-willful violations.
Penalties for Willful Violation
To Qualify for Level I-Willful – Determine Aggregate Balance		If the maximum aggregate balance for all accounts to which the violations relate did not exceed $50,000 during the calendar year, Level I-Willful mitigation applies to all violations. See IRM 4.26.16.3.6, Aggregate Value Over $10,000, above for instruction on determining the maximum aggregate balance.
The Level I Willful Penalty is		The greater of $1,000 per year or 5% of the maximum aggregate balance of the accounts during the year to which the violations relate.
To Qualify for Level II-Willful – Determine Aggregate Balance		If the maximum aggregate balance for all accounts to which the violations relate exceeds $50,000 but does not exceed $250,000, Level II-Willful mitigation applies to all violations. Level II-Willful penalties are computed on a per account basis.
The Level II-Willful Penalty is		For each account for which there was a violation, the greater of $5,000 or 10% of the maximum account balance during the calendar year at issue.
To Qualify for Level III-Willful – Determine Aggregate Balance		If the maximum aggregate balance for all accounts to which the violations relate exceeds $250,000 but does not exceed $1,000,000, Level III-Willful mitigation applies to all violations. Level III-Willful penalties are computed on a per account basis..
The Level III-Willful Penalty is		For each account for which there was a violation, the greater of 10% of the maximum account balance during the calendar year at issue or 50% of the account balance on the day of the violation.
To Qualify for Level IV-Willful – Determine Aggregate Balance		If the maximum aggregate balance for all accounts to which the violations relate exceeds $1,000,000, Level IV-Willful mitigation applies to all violations. Level IV-Willful penalties are computed on a per account basis..
The Level IV-Willful Penalty is		For each account for which there was a violation, the greater of 50% of the balance in the account at the time of the violation or $100,000 (i.e., the statutory maximum penalty).

Money Transmitter FBAR Filing Requirements
Money transmitters in the U.S. send money overseas generally through the use of foreign banks or non-bank agents located in foreign countries. The arrangement permits the money transmitter to readily send payments, in the currency of the foreign country, to the recipient. The U.S. money transmitter wires funds to the foreign bank or non-bank agent and provides instructions to make payments to the recipient located in the foreign country. The money transmitter typically does not have signature or other authority over the agent’s bank account. In this situation, the money transmitter is not required to file an FBAR for the agent’s bank account.

However, if the money transmitter has a direct financial interest in the foreign financial account, has signature authority, or other authority, over the foreign financial account and the aggregate value is in excess of $10,000 at any time during the year in question, the money transmitter is required to file an FBAR. Another person holding the foreign account on behalf of the money transmitter does not negate the FBAR filing requirement.

Frequently Asked Questions (FAQ’s):

Is there an FBAR filing requirement when the money transmitter wires funds to a foreign bank account or has a business relationship with someone located in a foreign country?

Answer: No. Merely wiring funds to a foreign bank account or having a business relationship with someone located in a foreign country does not create an FBAR filing requirement.

Is there an FBAR filing requirement where the money transmitter owns a bank account located in a foreign country or has signature authority over someone else’s bank account located in a foreign country?

Answer: Yes, if the account exceeded $10,000 at any time during the calendar year and the money transmitter was a United States person for FBAR purposes.

Is an FBAR required to be filed by a money transmitter engaged in Informal Value Transfer System (IVTS)/Hawala transactions?

Answer: There would be no FBAR filing requirement if there is no foreign bank or other foreign financial accounts involved. The money transmitter’s relationship with a foreign affiliate, by itself, does not create an FBAR filing requirement. However, if the money transmitter owned a bank account located in a foreign country or had signature authority over someone else’s bank account located in a foreign country, was a United States person, and the account value exceeded $10,000 at any time, the money transmitter would be required to file an FBAR.

What constitutes “other authority” for FBAR reporting purposes?

Answer: “Other authority” is comparable to signature authority in that a person exercising “other authority” can through communication to the bank or other person with whom the account is maintained exercise power over the account. A distinction, however, must be drawn between having authority over a bank account of a non-bank foreign agent and having authority over a foreign agent who owns a foreign bank account. Having authority over a person who owns a foreign bank account is not the same as having authority over a foreign bank account.

Does a money transmitter who has a business relationship with a person located in a foreign country have a financial interest in a foreign financial account if the person in the foreign country is providing services of a financial institution (such as money transmission services) and both parties maintain books and records of their business transactions (including books and records of offsetting transactions or trade accounts receivable or payable)?

Answer: No. The money transmitter does not have a financial interest in a foreign financial account. A “financial account” for FBAR filing purposes includes bank accounts, investment accounts, savings accounts, demand checking, deposit accounts, time deposits, or any other account maintained with a financial institution or other person engaged in the business of a financial institution. “Accounts” as used to describe or identify the books and records of ordinary business transactions between businessmen are not “financial accounts” for FBAR reporting purposes.

Do receivables accounts maintained by foreign non-bank agents which net out the US money transmitter settlement obligations to the foreign agent constitute a financial account for FBAR filing purposes?

Answer: No. Such receivables in accounting records are not financial accounts for FBAR reporting purposes.

Do the FBAR filing requirements apply when a money transmitter maintains a bank account with a foreign bank for the purpose of settling money transmission transactions with a foreign bank?

Answer: Yes. If a money transmitter owns the account maintained with the foreign bank or has signature or other authority over it, the money transmitter may be required to file an FBAR.

FBAR Penalty Defense Attorneys

FBAR penalty defense requires a proactive representation and a deep knowledge of the nuances of FBAR compliance and its defenses. Freeman Law represents clients with offshore tax compliance disputes involving FBAR penalties and international information return penalties. Failing to file an FBAR can give rise to significant penalties, including a non-willful penalty and willful FBAR penalty. The risks of tax and reporting non-compliance have never been more real and the threat of international penalties, particularly FBAR penalties, has never been more clear. Schedule a consultation or call (214) 984-3000 to discuss your FBAR penalty concerns or questions.

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Battling the Counterfeiters: White-Collar Intellectual Property Enforcement

Criminal Copyright Infringement

I. Introduction: History and Purpose

II. Elements of Felony & Misdemeanor Infringement

a. Valid Copyright

b. Infringed by the Defendant

c. Willfully

d. For Purposes of Commercial Advantage or Private Financial Gain

III. Section 2319 Penalties

IV. Defenses

a. Statute of Limitations

b. Jurisdiction

c. The First Sale Doctrine

Trafficking In Counterfeit Trademarks, Service Marks, and Certification Marks

I. Introduction: History and Purpose

II. Elements: 18 U.S.C. § 2320

III. Defenses

a. Authorized-Use Defense

b. Repackaging Genuine Goods Defense

c. Statute of Limitations Defense

d. Vagueness Defense

IV. Special Issues

a. High-Quality and Low-Quality Counterfeits

b. Scope of 18 U.S.C. § 2320

V. Penalties

a. Fines and Imprisonment

b. Restitution

VI. Other Charges to Consider

Theft of Commercial Trade Secrets

I. Generally

a. Theft Benefitting a Foreign Government | Section 1831

b. Theft of Commercial Trade Secrets | Section 1832

II. Elements of a Trade Secret

a. Standard of Secrecy

b. Independent Economic Value

III. Defenses

IV. Future of the EEA

Digital Millennium Copyright Act

I. Background & History of the Act

II. 17 U.S.C. § 1201: Circumvention of Copyright Protection Systems

III. 17 U.S.C. § 1202: Integrity of Copyright Management Information

IV. Elements of the Key Provisions

a. Circumventing Access Controls: 17 U.S.C. §§ 1201(a)(1), 1204

b. Trafficking in Access Control Circumvention Tools and Services: 17 U.S.C. §§ 1201(a)(2), 1204

c. Trafficking in Tools, Devices, and Services to Circumvent Copy Controls: 17 U.S.C. §§ 1201(b)(1), 1204

d. 17 U.S.C. § 1202

V. 17 U.S.C. § 1203: Civil Remedies

VI. 17 U.S.C. § 1204: Criminal Offenses & Penalties

VII. Possible Defenses

a. Statute of Limitations

b. Exemption for Non-Profit Entities

c. Exemption for Information Security

Counterfeit and Illicit Labels, Counterfeit Documentation and Packaging

I. Introduction: History and Purpose

II. Elements: 18 U.S.C. § 2318

III. Defenses

a. Statute of Limitations Defense

b. First-Sale Defense

IV. Special Issues

a. Electronic Copies of Labels, Documentation, or Packaging

b. Advantages of Charging a § 2318 Offense

a. Fines and Imprisonment

b. Restitution

I. Offenses Involving: Copyright (Including Bootleg Music, Camcorded Movies, and the Unauthorized Use of Satellite, Radio, and Cable Communications), Trademark, Counterfeit Labeling, and the DMCA.

a. Calculating the Infringement Amount | General

b. Infringement Amount | Counterfeit Goods and Labels

c. Infringement Amount | Bootleg and Camcord

II. Offenses Involving the Economic Espionage Act (EEA)

a. Additional Penalties | Abuse of Position of Trust or Use of Special Skill

b. Additional Penalties | Sophisticated Means

c. EEA | Calculating Loss

i. Calculating Loss | Criminal Cases

ii. Calculating Loss | Civil Cases

The Research & Development Credit | Section 41

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