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

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

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

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

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

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

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

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

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

Key Issue:

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

Primary Holdings:

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

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

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

Key Points of Law:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Tax Court in Brief – February 6th – February 10th, 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 6th, 2022, through February 10th, 2023

• Rawat v. Comm’r, T.C. Memo. 2023-14| February 7, 2023 | Gustafson, J. | Dkt. No. 15340-16

3M Company and Subsidiaries v. Comm’r, 160 T.C. No. 3| February 9, 2023 |Morrison, J. | Dkt. No. 5816-13

Summary: In this 346-page opinion (including multiple concurring opinions and dissents) the Tax Court addresses federal income tax issues arising from 3M Company (3M) and its domestic and foreign subsidiaries’ (Subs) consolidated ownership of trademarks in 3M. Other intellectual properties, such as patents and non-patented technology, was owned by a second-tier wholly owned U.S. subsidiary of 3M (Sub-IP).

Pursuant to three separate licenses—dating back to 1952 but amended over the many decades—a Brazilian subsidiary (Sub-Brazil) paid royalties to 3M for Sub-Brazil’s sales of products involving 3M’s trademarks. The operative license agreements were entered into in 1998. Under those agreements (generally), if a product sale involved trademarks covered by multiple of the three licenses, 3M and Sub-Brazil calculated the royalties owed by a “stacking principle.” Based on legal counsel 3M received from its Brazilian lawyers that 3M would have to disclose non-patented technology and other intellectual property to the Brazilian Patent and Trademark Office (thus risking disclosure of such information to competitors), 3M did not require Sub-Brazil to pay 3M or Sub-IP for Sub-Brazil’s use of other intellectual property. On its 2006 consolidated tax return (Form 1120, U.S. Corporation Income Tax Return), 3M reported the trademark royalty income.

The IRS determined that 3M’s income should be increased by $23,651,332 to reflect an arm’s length rate of compensation under section 482 to account for Sub-Brazil’s use of 3M and Sub-IP’s other intellectual property. The IRS’s determination did not take into account the effect of Brazilian legal restrictions. See 26 C.F.R. § 1.482-1(h)(2) (Effect of foreign legal restrictions; setting forth the requirements that must be met before the IRS “will take into account the effect of a foreign legal restriction” under I.R.C. § 482).

3M challenged that determination, claiming that the IRS’s allocation should have corresponded to the maximum amount that Sub-Brazil could have paid for the intellectual property under the laws of Brazil. 3M asserted that the requirements of section 1.482-1(h)(2) of the Treasury Regulation are invalid under regulatory-approval test (“step 2 test”) developed by the United States Supreme Court. Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984) (determining, under Justice John Paul Stevens’ lead, the extent to which a court reviewing agency action should give deference to the agency’s construction of a statute that the agency has been delegated to administer); Motor Vehicle Mfrs. Ass’n of the U.S., Inc. v. State Farm Mut. Auto. Ins. Co., 463 U.S. 29 (1983) (determining, under Justice Byron White’s lead, that an “arbitrary and capricious” standard for reviewing agency actions applied to rescind regulations as that to enact regulations); Commissioner v. First Security Bank of Utah, N.A., 405 U.S. 394 (1972). 3M also claimed that, under those precedents, the IRS failed to adequately respond to comments to the applicable regulations thus rendering it invalid, and that, under “step 1 test” of Chevron, the IRS cannot make allocation of income to a taxpayer, like 3M, who did not receive income and could not legally receive the income.

Key Issues: Whether the IRS’s section 482 adjustment was improper to the extent that payments were barred by Brazilian law and that therefore the proper section 482 adjustment is only a fraction of the amount determined, specifically, $165,783 as asserted by 3M.

Divided Tax Court:

The main, 273-page opinion was penned by Tax Court Judge, Morrison, and that opinion was agreed upon by Judges Kerrigan, Gale, and Paris.

Judge Copeland presented a 7-page concurrence, and that concurrence was agreed to by Kerrigan, Gale, and Paris, JJ.

Chief Judge Kerrigan provide a 6-page concurrence, agreeing with the outcome in the main opinion but providing a concurrence mainly to respond to the dissents’ focus on the validity of Treasury Regulation § 1.482-1(h)(2) (blocked income regulation). Judges Gale, Paris, Ashford, and Copeland agreed with this concurring opinion.

Judge Buch provided a 19-page dissent, which was agreed to by Judges Urda, Jones, Toro, and Greaves.

Judge Pugh provided an additional 1-page dissent, which was agreed to by Judges Foley, Buch, Urda, and Toro.

Judge Toro provided a 40-page dissent, which was agreed to by Judges Buch, Urda, Jones, Greaves, and Weiler.

Main Opinion Primary Holdings: Under 26 C.F.R. §1.482-1(h)(2) (2006), which governed the effect of foreign legal restrictions on section 482 adjustments, the Brazilian restrictions on payments by Sub-Brazil are disregarded. The Tax Court rejected 3M’s various arguments that the regulation is invalid.

• The requirement of 26 C.F.R. § 1.482-1(h)(2)(i) that “a foreign legal restriction will be taken into account only to the extent that it is shown that the restriction affected an uncontrolled taxpayer under comparable circumstances” is not invalid under Chevron step 2.
• The requirement that foreign legal restrictions be taken into account under I.R.C. § 482 only if they are publicly promulgated, 26 C.F.R. § 1.482-1(h)(2)(ii)(A) (2006), means that the foreign legal restrictions must be in writing.
• The Brazilian legal restrictions at issue do not meet the requirement in 26 C.F.R. § 1.482-1(h)(2)(ii)(A) that foreign legal restrictions be taken into account under I.R.C. § 482 only if they are publicly promulgated.
• The requirement that foreign legal restrictions be taken into account under I.R.C. § 482 only if they are publicly promulgated, 26 C.F.R. § 1.482- 1(h)(2)(ii)(A) (2006), is not invalid under Chevron step 2 test.
• The requirement that foreign legal restrictions be taken into account under I.R.C. § 482 only if they are “generally applicable to all similarly situated persons (both controlled and uncontrolled)”, 26 C.F.R. § 1.482-1(h)(2)(ii)(A), is not invalid under Chevron step 2 test.
• The 1994 regulation, 26 C.F.R. § 1.482-1(h)(2) (2006), is valid under Chevron step 1.
• The 1994 regulation, 26 C.F.R. § 1.482-1(h)(2) (2006), is not invalid under 3M’s State Farm theory.

DISSENTS:

Judge Buch’s Dissent. Judge Buch provided a 19-page dissent. Buch, J. based his dissent on the concept of “blocked income,” being income that a taxpayer is prohibited by law from receiving. According to this dissent, 3M had a blocked income problem in that its Brazilian subsidiary was compelled by foreign law to pay below-market royalty rates. The IRS sought to apply section 482 to allocate blocked income to 3M. Pursuant to First Security Bank, Buch, J. found that section 482 cannot be used to allocate blocked income to someone who did not receive it and could not receive it. And, to the extent the Treasury Regulations are inconsistent with limits on section 482, as described in First Security Bank, those regulations are invalid, according to Buch, J.

Judges Urda, Jones, Toro, and Greaves agreed with Buch, J.’s dissent.

Judge Pugh’s Dissent. Judge Pugh provided an additional 1-page dissent. Pugh, J. likewise leaned on the “blocked income” theory and “stare decisis” approach based on Commissioner v. First Security Bank of Utah, N.A., 405 U.S. 394, 407 (1972) and the Tax Court’s application of First Security Bank in Procter & Gamble Co. v. Commissioner, 95 T.C. 323, 336 (1990), that is, First Security Bank was controlling and therefore “section 482 simply does not apply” to reallocate income that a Spanish subsidiary could not pay under Spanish law. See Procter & Gamble Co., 95 T.C. at 336, aff’d, 961 F.2d 1255 (6th Cir. 1992).

Judges Foley, Buch, Urda, and Toro agreed with Pugh, J.’s dissent.

Judge Toro’s Dissent. Judge Toro provided a 40-page dissent. Toro, J. opined that the Department of the Treasury and the IRS failed to comply with procedural requirements of the Administrative Procedure Act (APA), 5 U.S.C. §§ 551–559, 701–706, in promulgating Treasury Regulation § 1.482-1(h)(2) (2006). Toro, J. noted, in part: “When it adopted Treasury Regulation § 1.482-1(h)(2), Treasury offered no explanation for its choices with respect to the rule. Not a single sentence. Treasury did not explain why a revision to the existing rule was needed. . . . Providing reasons for Treasury’s proposed approach was particularly important here, where several prior judicial decisions, including a Supreme Court decision, had rejected the approach Treasury adopted.”

Judges Buch, Urda, Jones, Greaves, and Weiler agreed with Toro, J.’s dissent.

Key Points of Law:

COMMENT 1: Inasmuch as the 346-page opinion (including concurrences and dissents) addresses multiple iterations of the Code sections in issue, Treasury Regulations that have changed over time, and Brazilian laws in effect and repealed, this blog contains but a snippet of legal principles addressed in the monster opinion. Reference is made to the opinion itself for further and detailed information.

COMMENT 2: After 2006 (the tax year at issue)—specifically, in 2017 and 2018—operative section 482 was affected by several amendments, including with respect to the meaning of “intangible property” as defined in the also-applicable section 936(h)(3)(B). Because those amendments did not retroactively apply to 3M, the Tax Court applied section 482 as it existed before the 2017 and 2018 changes.

Section 482 (eff. for tax year in issue). Section 482 authorizes the IRS to apportion or allocate income between organizations controlled by the same interests “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 such organizations . . . .” 26 U.S.C. § 482 (1994). The relevant regulation explains that the purpose of § 482 is “to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer” and to ensure that controlling entities conduct their subsidiaries’ transactions in such a way as to reflect the “true taxable income” of each controlled taxpayer. 26 C.F.R. § 1.482-1A(b)(1) (1996). The regulation further explains that “[t]he standard to be applied in every case is that of an uncontrolled taxpayer dealing at arm’s length with another uncontrolled taxpayer.” Id.

Insights: Given the divide on this opinion amongst the judges within the Tax Court, and given the increased income for taxation in issue (approximately $26,000,000), an appeal of the main holding is likely. The venue for appeal in this case will be the U.S. Court of Appeals for the Eighth Circuit unless the parties stipulate another circuit. See 26 U.S.C. § 7482(a), (b)(1)(B), (2); 28 U.S.C. § 41 (2018). Stay tuned…

Transfer pricing has to do with the allocation of income among parties controlled by the same persons (controlled parties) that engage in transactions with each other (controlled transactions).[1] In the international context where controlled parties may operate in different countries with different tax burdens, the concern is that the controlled parties may shift income from a higher-taxed country from a lower-taxed country. Here’s a simple example:

The Example

Here ProdCo and WidgCo are controlled parties because they are both 100% owned by Owner. And they’re engaged in a controlled transaction, because ProdCo is purchasing Widgets from WidgCo, which ProdCo then incorporates into Product which it sells to consumers for $100 a pop. ProdCo is based out of Country A, which has a 20% income tax rate, while WidgCo is based out Country B with a 10% income tax rate.

Under these circumstances, there’s an incentive to increase the price that ProdCo pays WidgCo for the Widgets, perhaps even beyond the going market rate for Widgets. Doing so would shift the income that ProdCo earns from the sale of Product from the tax base of Country A (with its 20% income tax rate and under the assumption that Country A would allow ProdCo to deduct the amount it pays WidgCo for the Widgets) to Country B (with its 10% income tax rate).

The Law

That’s where transfer pricing comes into the picture. In the United States, controlled transactions must meet what’s called the arm’s length standard.[2] In other words, does the controlled transaction match up with what happens (or would happen) in uncontrolled transactions under the same circumstances.[3] The parenthetical “would happen” is key, because identical controlled and uncontrolled transactions can only rarely be found.[4] Thus, the need to find comparable transactions under comparable circumstances—a process the rules for which take up much real estate in the Treasury Regulations.[5]

Interwoven with the idea of comparability is what’s called the best method rule. Under the best method rule, whether a controlled transaction achieves an arm’s length result must be determined by applying the method that achieves the most reliable measure of an arm’s length result.[6]  The two factors that go into determining the best method are comparability and between the controlled and uncontrolled transaction and the quality of the data and assumption used in the analysis.[7]

The Treasury Regulations set out several methods for determining an arm’s length result that vary based whether property of a service is the subject of the controlled transaction and, if property, whether it’s tangible or intangible. Each of these methods also emphasizes certain comparability criteria in addition to generally comparability criteria.

In this post, we’ll focus on methods involving controlled transfers of property.

The Methods

The Treasury Regulations lay out six methods for determining the arm’s length price in a controlled transfer of tangible property. These are:

1. the comparable uncontrolled price method;
2. the resale price method;
3. the cost plus method;
4. the comparable profits method;
5. the profit split method; and
6. unspecified methods.[8]

Many of the same methods show up for determining the arm’s length price in controlled transfers of intangible property. These are:

1. the comparable uncontrolled transaction method;
2. the comparable profits method;
3. the profit split method; and
4. unspecified methods.[9]

Comparable Uncontrolled Price (“CUP”) Method and Comparable Uncontrolled Transaction (“CUT”) Method

The CUP method and CUT method are basically analogous. The main difference between the methods is that they’re applied to different types of property. The CUP method is used for transfers of tangible property, while the CUT method is used for transfers of intangible property.

Under the CUP and CUT methods, the amount charged in the transfer of property in a controlled transaction is compared to the amount charged in a comparable uncontrolled transactions.[10] In order for controlled transaction and uncontrolled transaction to be comparable for purposes of these methods, both sets of transactions should involve similar products, similar economic conditions, and similar contractual terms.[11] Provided these comparability factors are present, these method generally will be the most direct and reliable measure of an arm’s length price.[12]

However, there’s rarely sufficient comparability between controlled and controlled transactions for the use of the CUP and CUT methods to be immune from question oer challenge by the IRS.

Resale Price Method (“RPM”)

The RPM is specific to the transfer of tangible property. The RPM compares whether the amount charged in a controlled transaction is arm’s length by reference to the gross profit margin realized in comparable uncontrolled transaction.[13]The RPM is typically used in cases where there is the purchase and resale of tangible goods and the reseller does not add substantial value to the tangible goods by physically altering them before resale.[14] Thus, the RPM establishes an arm’s length price for the sale between a supplier and a related reseller.

For there to be comparability between controlled and uncontrolled transactions under the RPM, there must be similarity of functions performed, risks borne, and contractual terms, physical similarity between the products transferred, the presence of intangibles, cost structures, business experience, and management efficiency.[15]

Cost Plus Method

This is another method that is specific to the transfer of tangible property. The cost plus method compares gross profit markup in controlled and comparable uncontrolled transactions.[16] This method is typically used in cases where there is the production of tangible goods sold to related parties.[17] For controlled and uncontrolled transactions to be comparable there should be similarity of the functions performed, risks borne, and contractual terms, physical similarity between the products transferred, the presence of intangibles, cost structures, business experience, and management efficiency.[18]

Comparable Profits Method (“CPM”)

The CPM is the most commonly used method and is used for transfers of tangible and intangible property. Under the CPM, the amount charged in a controlled transaction is determined to be arm’s length based on profit level indicators derived from uncontrolled taxpayers that engage in similar business activities in similar circumstances.[19] In determining comparable transactions for this method, there should be similar size and scope of operations, lines of business, product, and service markets involved, asset composition, and the age in the business product cycle.[20]

Profit Split Method (“PSM”)

The PSM also is also used for transfers of both tangible or intangible property. The profit split method analyzes the allocation of the combined operating profit or loss attributable to controlled transactions to the relative value of each controlled party’s contribution to that combined operating profit or loss, which should correspond to the allocation of profit or loss in uncontrolled transactions where each party performs functions similar to those of the controlled parties.[21] There are two types of PSMs: the comparable PSM and the residual PSM.

The comparable PSM divides the total operating income the buyer and seller in the controlled transaction in a manner that is consistent with the way comparable uncontrolled parties divide their operating income in similar transactions.[22] The comparable profit split method requires similarity of functions, risks, and contractual terms, and generally can’t be used if the combined operating profits of the uncontrolled comparable varies significantly from that earned by the controlled parties.[23]

The residual profit split method has two steps. First, an arm’s length return is assigned to the routine activities of the buyer and seller in the controlled transaction for the function they perform that contribute to profits.[24] Such functions include manufacturing, distributing, marketing, the performance of services, and the exploitation of routine intangibles.[25]Second, the residual profit is allocated between the buyer and seller based on the relative value of their relative nonroutine contributions to the business activity.[26]

Unspecified Methods

The Treasury Regulations also acknowledge the possibility that the best method for determining an arm’s length result may be one that they don’t mention. Hence, the unspecified methods. These unspecified methods still need to “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.”[27]

So not much to go on. But recently, the Tax Court has indicated that an unspecified method could be a combination of various other specified methods, given the right circumstances.[28]

Final Thoughts

Transfer pricing is a complicated topic. If you have questions, don’t hesitate to contact us for a free consultation.

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[1] See 26 U.S.C. § 482.

[2] 26 C.F.R. § 1.482-1(b)(1).

[3] Id.

[4] Id.

[5] Id.

[6] Id. § 1.482-1(c)(1).

[7] Id. § 1.482-1(c)(2).

[8] 26 C.F.R. § 1.482-3(a).

[9] Id. § 1.482-4(a). For these purposes intangible property includes a:

1. patent, invention, formula, process, design, pattern, or know-how;
2. copyright, literary, musical, or artistic composition;
3. trademark, trade name, or brand name,
4. franchise, license, or contract;
5. method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, or technical data;
6. goodwill, going concern value, or workforce in place (including its composition and terms and conditions (contractual or otherwise) of its employment); or
7. other item the value or potential value of which is not attributable to tangible property or the services of any individual. See id. §§ 367(d)(4), 482.

[10] Id. §§ 1.482-3(b)(1), -4(c)(1).

[11] Id. §§ 1.482-3(b)(2)(ii)(A), -4(c)(2)(iii)(B).

[12] Id. §§ 1.482-3(b)(2)(ii)(A), -4(c)(2)(ii).

[13] Id. § 1.482-3(c).

[14] 26 C.F.R. § 1.482-3(c).

[15] Id. 1.482-3(c)(3)(ii)(A), (B).

[16] Id. § 1.482-3(d)(1).

[17] Id. § 1.482-3(d)(1).

[18] Id. § 1.482-3(d)(3)(ii)(A), (B).

[19] Id. § 1.482-5(a).

[20] 26 C.F.R. § 1.482-5(c)(2)(i).

[21] Id. § 1.482-6(a), (b).

[22] Id. § 1.482-6(c)(2)(i).

[23] Id. § 1.482-6(c)(2)(ii)(B)(1).

[24] Id. § 1.482-6(c)(3)(i)(A).

[25] Id. § 1.482-6(c)(3)(i)(A).

[26] 26 C.F.R. § 1.482-6(c)(3)(i)(B).

[27] Id. §§ 1.482-3(e)(1), -4(d)(1).

[28] Medtronic, Inc. v. Comm’r, T.C. Memo. 2022-84. See our Tax Court in Brief post here for a break down of the case.

The concept of “transfer pricing” relates to the pricing of transactions between controlled entities. For example, when a US parent (Parent) sells a product to its controlled foreign corporation (CFC), I.R.C. section [14] I.R.C. § 482 requires Parent to sell that product at an arm’s length price to its CFC. Under IRC [14] I.R.C. § 482, controlled entities should price transactions in the same way that uncontrolled entities would under similar circumstances. This is, in essence, the “arm’s length standard,”—the price of the product that Parent charges its CFC should be the same as it would charge to an unrelated party for the same product under similar circumstances.

If the transfer price is not arm’s length, section [14] I.R.C. § 482 provides the IRS with the authority to make adjustments by reallocating items of gross income, deductions, credits, or allowances in order to properly reflect income between the entities.

When Does Section 482’s Arm’s Length Standard Apply?

Section 482 allows the IRS to make adjustments and allocations in order to ensure that transactions clearly reflect income attributable to controlled transactions and to prevent the evasion of taxes.

The statutory language of section [14] I.R.C. § 482 envisions three basic requirements before it applies:

1) Two or more organizations, trades or businesses;

2) common ownership or control, either directly or indirectly; and

3) An IRS determination that an allocation is necessary either to prevent evasion of taxes, or to clearly reflect the income of the entities.

Section 482 encompasses the so-called arm’s-length standard.  The arm’s-length standard applies to outbound and inbound transactions.

What Is “Control” For Section 482 Purposes?

Treas. Reg. section 1.[14] I.R.C. § 482-1(i)(4) provides a broad definition of what constitutes control.  That definition provides that any kind of control, direct or indirect, may give rise to “control” within the meaning of section [14] I.R.C. § 482, whether the control is legally enforceable or not.  In addition, where two or more taxpayers act in concern or with a common goal or purpose, it may be sufficient to constitution “control” within the meaning of section [14] I.R.C. § 482.  The reality—not the form—of the control is decisive

The regulations further provide that, “A presumption of control arises if income or deductions have been arbitrarily shifted.”

Reallocation to Clearly Reflect Income

Section 482 may apply where an allocation is necessary to:

• prevent evasion of taxes, or
• clearly reflect income

Allocations affecting taxable income can be made to income, deductions, credits and other allowances.  Generally, allocations have been upheld by the courts unless the taxpayer can demonstrate that the IRS determination was arbitrary and capricious.

What is The Best Method Rule?

There are various pricing methods available in the regulations under IRC [14] I.R.C. § 482. These include the Comparable Uncontrolled Price (CUP), Resale Price Method, Cost Plus Method, Comparable Profits Method (CPM) and various Profit Split Methods. There is no per se hierarchy among these methods. The taxpayer must select the method that provides the most reliable measure of an arm’s length result taking into consideration all the data available. This is known as the “best method rule.”

Parties in a controlled transaction are required to use the best method to determine the arm’s length price of goods sold between entities. There are transactional-based and profit-based methods. Determining the best method depends on many factors including, but not limited to, the existence of comparable transactions and the degree of similarity of these comparables. Comparables are determined based on the degree of similarity in the functions performed and other factors including risks assumed, contractual terms, economic conditions, and property or services included in the transaction.

Documentation

The taxpayer is required to be able to support the pricing method selected. One manner to determine and document that the taxpayer selected the best method is to obtain a Transfer Pricing Study. A Transfer Pricing Study is the documentation that a taxpayer prepares to show that its transfer pricing was conducted at arm’s length.  Freeman Law can assist with transfer Pricing Studies.

Competent Authority

If the IRS pursues a valuation adjustment, the adjustment may give rise to double taxation.  In such case, the taxpayer may have access to double tax relief under Article 25 of the US Model Tax Treaty and the Mutual Agreement Process.  Taxpayers may need to invoke competent authority procedures under such circumstances.

The Tax Cuts and Jobs Act of 2017 enacted a number of important tax-law changes.  Few changes are more notable than those contained in the international tax provisions. Perhaps chief among the international tax changes was the Section 965 “transition” tax—a.k.a. the “deemed repatriation” tax.

Section 965 generally requires that shareholders—as defined under section 951(b) of the I.R.C.—pay a “transition” tax on their pro rata share of the untaxed foreign earnings of certain “specified foreign corporations.”  The tax is imposed by increasing a specified foreign corporation’s subpart F income for its last tax year beginning before January 1, 2018.  The shareholder’s pro rata share of that subpart F income is included in income as if those foreign earnings had been repatriated to the United States—hence the “deemed repatriation” moniker.  The mandatory inclusion is subject to tax at an effective tax rate of either 15.5% or 8%, depending upon the extent to which the inclusion is attributable to earnings and profits that are deemed to consist of “cash” or other liquid assets.

A “specified foreign corporation” is generally defined as any Controlled Foreign Corporation under section 957 or a foreign corporation (other than a PFIC) that has a “United States shareholder” (as defined under section 951) that is a domestic corporation.  Thus, a shareholder of such a foreign corporation is required to include its share of that foreign corporation’s historic earnings and profits in income as if the amount had been repatriated.

Amounts owed under Section 965 are generally due by the due date or extended due date of the taxpayer’s 2017 tax return.  However, the new law provided for an election to pay the tax in installments.  There are also special rules applicable to S-Corporations that may effectively allow for the indefinite postponement of such payment.

The IRS recently issued guidance on the section 965 tax in the form of FAQs. Below is a summary of that guidance:

Q1.  Who is required to report amounts under section 965 of the Code on a 2017 tax return?

A1.  A person that is required to include amounts in income under section 965 of the Code in its 2017 taxable year, whether because, the person is a United States shareholder of a deferred foreign income corporation (as defined under section 965(d) of the Code) or because it is a direct or indirect partner in a domestic partnership, a shareholder in an S corporation, or a beneficiary of another passthrough entity that is a United States shareholder of a deferred foreign income corporation, is required to report amounts under section 965 of the Code on its 2017 tax return.

Q2.  How are amounts under section 965 of the Code reported on a 2017 tax return?

A2.  Amounts required to be reported on a 2017 tax return should be reported on the return as reflected in the table included in Appendix: Q&A2. The table reflects only how items related to amounts included in income under section 965 of the Code should be reported on a 2017 tax return. It does not address the reporting in other scenarios, including distributions made in 2017, which should be reported consistent with the Code and the current forms and instructions.

Posted: 03/13/2018

Q3.  Is there any other reporting in connection with section 965 of the Code required on a 2017 tax return?

A3. Yes.  A person that has income under section 965 of the Code for its 2017 taxable year is required to include with its return an IRC 965 Transition Tax Statement, signed under penalties of perjury and, in the case of an electronically filed return, in Portable Document Format (.pdf) with a filename of “965 Tax”.  Multiple IRC 965 Transition Tax Statements can be combined into a single .pdf file.  The IRC 965 Transition Tax Statement must include the following information:

• The person’s total amount required to be included in income under section 965(a) of the Code.
• The person’s aggregate foreign cash position, if applicable.
• The person’s total deduction under section 965(c) of the Code.
• The person’s deemed paid foreign taxes with respect to the total amount required to be included in income by reason of section 965(a).
• The person’s disallowed deemed paid foreign taxes pursuant to section 965(g).
• The total net tax liability under section 965 (as determined under section 965(h)(6)). _[1]
• The amount of the net tax liability under section 965 to be paid in installments (including the current year installment) under section 965(h) of the Code, if applicable, which will be assessed. _[2]
• The amount of the net tax liability under section 965, the payment of which has been deferred, under section 965(i) of the Code, if applicable. _[3]
• A listing of elections under section 965 of the Code or the election provided for in Notice 2018-13 that the taxpayer has made, if applicable.

A model statement is included in Appendix: Q&A3.  Adequate records must be kept supporting the section 965(a) inclusion amount, deduction under section 965(c) of the Code, and net tax liability under section 965, as well as the underlying calculations of these amounts.  Moreover, additional reporting may be required when filing returns for subsequent tax years, and the manner of reporting may be different.  See also Q&A8 concerning Form 5471 filing.

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[1] Use section 965(h)(6) to calculate the total net tax liability under section 965 even if an election to pay the net tax liability under section 965 in installments has not been made and even if the person is not a United States shareholder of a deferred foreign income corporation.  Do not reduce this amount by any net tax liabilities under section 965 with respect to which section 965(i) is effective.  Section 965(h)(6) generally determines a person’s net tax liability under section 965 by starting with (i) the taxpayer’s tax liability with all section 965 amounts included and then subtracting (ii) the tax liability with no section 965 amounts included and with dividends received from deferred foreign income corporations disregarded.  See Publication 5292 for instructions to be used in computing the net tax liability under section 965.

[2]  If both one or more elections under section 965(i) have been made and an election under section 965(h) has been made, the amount of the net tax liability under section 965 to be paid in installments is: (i) the amount of the total net tax liability under section 965 as determined above less (ii) the aggregate amount of the taxpayer’s net tax liabilities under section 965 with respect to which section 965(i) elections are effective.   See Publication 5292 for more information.

[3]  See Publication 5292 for more information regarding the calculation of amounts eligible for S corporation shareholder deferral under section 965(i).

Updated: 04/13/2018

Q4.  What elections are available with respect to section 965 of the Code on a 2017 tax return?

A4.  Section 965 of the Code permits multiple elections related to amounts included in income by reason of section 965 of the Code or the payment of a taxpayer’s net tax liability under section 965 (as determined under section 965(h)(6)). Statutory elections can be found in section 965(h), (i), (m), and (n).

Furthermore, the Treasury Department and the IRS have announced another election that may be made with respect to the determination of the post-1986 earnings and profits of a specified foreign corporation. This election is described in Notice 2018-13, 2018-6 I.R.B. 341, Section 3.02.

Posted: 03/13/2018

Q5.  Who can make an election with respect to section 965 of the Code on a 2017 tax return?

A5.  The elections under section 965 of the Code are limited to taxpayers with a net tax liability under section 965 (in the case of section 965(h) of the Code), taxpayers that are shareholders of S corporations and that have a net tax liability under section 965 (in the case of section 965(i) of the Code), taxpayers that are REITs (in the case of section 965(m) of the Code), or taxpayers with an NOL (in the case of section 965(n) of the Code).  Thus, a domestic partnership or an S corporation that is a United States shareholder of a deferred foreign income corporation may not make any of the elections under section 965 of the Code.  The Treasury Department and the IRS provided further guidance concerning the availability of the elections under section 965 of the Code to direct and indirect partners in domestic partnerships, shareholders in S corporations, and beneficiaries in other passthrough entities that are United States shareholders of deferred foreign income corporations. See Section 3.05(b) of Notice 2018-26.

The election under Notice 2018-13, Section 3.02 may be made on behalf of a specified foreign corporation pursuant to the rules of §1.964-1(c)(3).

In the case of a consolidated group (as defined in §1.1502-1(h)), in which one or more members are United States shareholders of a specified foreign corporation, the agent for the group (as defined in §1.1502-77) must make the elections on behalf of its members.

Updated: 04/13/2018

Q6.  When must an election with respect to section 965 of the Code be made?

A6.  An election with respect to section 965 of the Code must be made by the due date (including extensions) for filing the return for the relevant year. However, even if an election is made under section 965(h) of the Code to pay a net tax liability under section 965 of the Code in installments, the first installment must be paid by the due date (without extensions) for filing the return for the relevant year.

Posted: 03/13/2018

Q7.  How is an election with respect to section 965 of the Code made on a 2017 tax return?

A7.  A person makes an election under section 965 of the Code or the election provided for in Notice 2018-13, Section 3.02, by attaching to a 2017 tax return a statement signed under penalties of perjury and, in the case of an electronically filed return, in Portable Document Format (.pdf), for each such election. Each such statement must include the person’s name, taxpayer identification number and any other information relevant to the election, such as the net tax liability under section 965 with respect to which the installment election under section 965(h)(1) of the Code applies, the name and taxpayer identification number of the S corporation with respect to which the deferral election under section 965(i)(1) of the Code is made, the section 965(a) inclusion amount with respect to which the election under section 965(m)(1)(B) of the Code applies, the amount described in section 965(n)(2) of the Code to which the election under section 965(n)(1) of the Code applies, and the name and taxpayer identification number, if any, of the specified foreign corporation with respect to which the election under Notice 2018-13, Section 3.02, is made. Model statements are included in Appendix: Q&A7. Each election statement must have the applicable title and, in the case of an attachment in Portable Document Format (.pdf) included with an electronically filed return, the file name reflected in the following table:

Posted: 03/13/2018

Q8.  Is a Form 5471 with respect to all specified foreign corporations with respect to which a person is a United States shareholder required to be filed with the person’s 2017 tax return, regardless of whether the specified foreign corporations are CFCs?

A8. Yes. In order to collect information relevant to the calculation of a United States shareholder’s section 965(a) inclusion amount, a person that was a United States Shareholder of a specified foreign corporation during its 2017 taxable year, including on the last day of such year, and owned stock of the specified foreign corporation on the last day of the specified foreign corporation’s year that ended during the person’s year must file a Form 5471 with respect to the specified foreign corporation completed with the identifying information on page 1 of Form 5471 above Schedule A, as well as Schedule J.  The exceptions to filing in the instructions to Form 5471 otherwise will continue to apply.  United States shareholders not otherwise required to file Form 5471 should consult the instructions to Form 5471 to determine the correct category of filer.  Notice 2018-13, Section 5.02 also provides an exception to filing Form 5471 for certain United States shareholders considered to own stock by “downward attribution” from a foreign person. The IRS intends to modify the instructions to the Form 5471 as necessary.

Updated: 04/13/2018

Q9.  Are domestic partnerships, S corporations, or other passthrough entities required to report any additional information to their partners, shareholders, or beneficiaries in connection with section 965 of the Code?

A9.  Yes. A domestic partnership, S corporation, or other passthrough entity should attach a statement to its Schedule K-1s, if applicable, that includes the following information for each deferred foreign income corporation for which such passthrough entity has a section 965(a) inclusion amount:

• The partner’s, shareholder’s, or beneficiary’s share of the partnership’s, S corporation’s, or other passthrough entity’s section 965(a) inclusion amount, if applicable.
• The partner’s, shareholder’s, or beneficiary’s share of the partnership’s, S corporation’s, or other passthrough entity’s deduction under section 965(c), if applicable.
• Information necessary for a domestic corporate partner, or an individual making an election under section 962, to compute its deemed paid foreign tax credits with respect to its share of the partnership’s, S corporation’s, or passthrough entity’s section 965(a) inclusion amount, if applicable.

For more information concerning the application of section 965 to domestic partnerships, S corporations, or other domestic passthrough entities, see Section 3.05(b) of Notice 2018-26.

Updated: 04/13/2018

Q10.  How should a taxpayer pay the tax resulting from section 965 of the Code for a 2017 tax return?

A10. A taxpayer should make two separate payments as follows: one payment reflecting tax owed without regard to section 965 of the Code, and a second, separate payment reflecting tax owed resulting from section 965 of the Code and not otherwise satisfied by another payment or credit as described in Q&A13 and Q&A14 (the 965 Payment).  See Q&A13 for information regarding how the IRS will apply 2017 estimated tax payments.  Both payments must be paid by the due date of the applicable return (without extensions).  But see Notice 2018-26, section 3.05(e), providing that if an individual receives an extension of time to file and pay under §1.6081-5(a)(5) or (6), the individual’s due date for the 965 Payment is also extended.

The 965 Payment must be made either by wire transfer or by check or money order. This may be the first year’s installment of tax owed in connection with a 2017 tax return by a taxpayer making the election under section 965(h) of the Code, or the full net tax liability under section 965 of the Code for a taxpayer who does not make such election and does not make an election under section 965(i) of the Code.  For the 965 Payment, there is no penalty for taxpayers electing to use wire transfers as an alternative to otherwise mandated EFTPS payments.  Accordingly, taxpayers that would normally be required to pay through EFTPS should submit the 965 Payment via wire transfer or they may be subject to penalties.  On a wire payment of tax owed under section 965 of the Code, the taxpayer would use a 5-digit tax type code of 09650 (for more information, see IRS, Same-Day Wire Federal Tax Payments). On a check or money order payment of tax owed resulting from section 965 of the Code, include an appropriate payment voucher (such as Form 1040-V or 1041-V) and along with all other required information write on the front of your payment “2017 965 Tax.”

For the payment owed without regard to section 965, normal payment procedures apply (for more information, see IRS, Pay Online). This payment may be made at the same or different time from the 965 Payment, but must be made by the due date of the return or penalties and interest may apply.

Updated: 04/13/2018

Q11.  If not already filed, when should an individual taxpayer electronically file a 2017 tax return?

A11. Individual taxpayers who electronically file their Form 1040 should file on or after April 2, 2018. Individual taxpayers who file a paper Form 1040 can do so at any time.

Posted: 03/13/2018

Q12. If a person has already filed a 2017 tax return, what should the person do?

A12. The person should consider filing an amended return based on the information provided in these FAQs and Appendices. Failure to submit a return in this manner may result in processing difficulties and erroneous notices being issued. Failure to accurately reflect the net tax liability under section 965 of the Code in total tax could result in interest and penalties.

In order to amend a return, a person would file the applicable form for amending the return pursuant to regular instructions and would attach:

• amended versions of forms and schedules necessary to follow the instructions in these FAQs,
• any election statements, and
• the IRC 965 Transition Tax Statement included in Appendix: Q&A3.

Posted: 03/13/2018

Q13. How will the IRS apply 2017 estimated tax payments (including credit elects from 2016) to a taxpayer’s net tax liability under section 965?

A13. The IRS will apply 2017 estimated tax payments first to a taxpayer’s 2017 net income tax liability described under section 965(h)(6)(A)(ii) (its net income tax determined without regard to section 965), and then to its tax liability under section 965, including those amounts that are subject to payment in installments pursuant to an election under section 965(h).

Added: 04/13/2018

Q14. If a taxpayer’s 2017 payments, including estimated tax payments, exceed its 2017 net income tax liability described under section 965(h)(6)(A)(ii) (its net income tax determined without regard to section 965) and the first annual installment (due in 2018) pursuant to an election under section 965(h), may the taxpayer receive a refund of such excess amounts or credit such excess amounts to its 2018 estimated income tax?

A14. No. A taxpayer may not receive a refund or credit of any portion of properly applied 2017 tax payments unless and until the amount of payments exceeds the entire unpaid 2017 income tax liability, including all amounts to be paid in installments under section 965(h) in subsequent years.  If a taxpayer’s 2017 tax payments exceed the 2017 net income tax liability described under section 965(h)(6)(A)(ii) (net income tax determined without regard to section 965) and the first annual installment (due in 2018) pursuant to an election under section 965(h), the excess will be applied to the next successive annual installment (due in 2019)  (and to the extent such excess exceeds the amount of such next successive annual installment due, then to the next such successive annual installment (due in 2020), etc.) pursuant to an election under section 965(h).

Added: 04/13/2018

Appendix: Q&A2

Updated: 04/13/2018

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[4] This includes section 965(a) inclusion amounts of a United States shareholder of a deferred foreign income corporation and distributive shares and pro rata shares of section 965(a) inclusion amounts of domestic partnerships, S corporations, and other passthrough entities.
[5] This includes deductions under section 965(c) of a United States shareholder of a deferred foreign income corporation and distributive shares and pro rata shares of deductions under section 965(c) of domestic partnerships, S corporations, and other passthrough entities.
[6] See section 965(g).
[7] See section 965(h)(6) and Q&A3.
[8] To make the 965(i) election, the taxpayer will have to file a paper Form 1040.

Updated: 04/13/2018

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[9] See also Q&A9.
[10] See section 965(f)(2) concerning the treatment of the income inclusion offset by the section 965(c) deduction for the purposes of computing adjustments to shareholder basis under section 1367(a)(1)(A) and calculating the accumulated adjustments account under section 1368(e)(1)(A).
[11] See also Q&A9.
[12]See section 965(f)(2) concerning the treatment of the income inclusion offset by the section 965(c) deduction for the purpose of computing adjustments to the basis of a partner’s interest in a partnership under section 705(a)(1)(B)

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[13] See also Q&A9.

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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 tax issues or questions.

5(a)Partnership may request modification of an imputed underpayment. A partnership that has received a notice of proposed partnership adjustment (NOPPA) under section 6231(a)(2) from the Internal Revenue Service (IRS) may request modification of a proposed imputed underpayment set forth in the NOPPA in accordance with this section and any forms, instructions, and other guidance prescribed by the IRS. The effect of modification on a proposed imputed underpayment is described in paragraph (b) of this section. Unless otherwise described in paragraph (d) of this section, a partnership may request any type of modification of an imputed underpayment described in paragraph (d) of this section in the time and manner described in paragraph (c) of this section. A partnership may request modification with respect to a partnership adjustment (as defined in §301.6241-1(a)(6)) that does not result in an imputed underpayment (as described in §301.6225-1(f)(1)(ii)) as described in paragraph (e) of this section. Only the partnership representative may request modification under this section. See section 6223 and §301.6223-2 for rules regarding the binding authority of the partnership representative. For purposes of this section, the term relevant partner means any person for whom modification is requested by the partnership that is-

(1) A reviewed year partner (as defined in §301.6241-1(a)(9)), including any pass-through partner (as defined in §301.6241-1(a)(5)), except for any reviewed year partner that is a wholly-owned entity disregarded as separate from its owner for Federal income tax purposes; or

(2) An indirect partner (as defined in §301.6241-1(a)(4)) except for any indirect partner that is a wholly-owned entity disregarded as separate from its owner for Federal income tax purposes.

(b)Effect of modification.

(1)In general. A modification of an imputed underpayment under this section that is approved by the IRS may result in an increase or decrease in the amount of an imputed underpayment set forth in the NOPPA. A modification under this section has no effect on the amount of any partnership adjustment determined under subchapter C of chapter 63 of the Internal Revenue Code (subchapter C of chapter 63). See paragraph (e) of this section for the effect of modification on adjustments that do not result in an imputed underpayment. A modification may increase or decrease an imputed underpayment by affecting the extent to which adjustments factor into the determination of the imputed underpayment (as described in paragraph (b)(2) of this section), the tax rate that is applied in calculating the imputed underpayment (as described in paragraph (b)(3) of this section), and the number and composition of imputed underpayments, including the placement of adjustments in groupings and subgroupings (if applicable) (as described in paragraph (b)(4) of this section), as well as to the extent of other modifications allowed under rules provided in forms, instructions, or other guidance prescribed by the IRS (as described in paragraph (b)(5) of this section). If a partnership requests more than one modification under this section, modifications are taken into account in the following order:

(i) Modifications that affect the extent to which an adjustment factors into the determination of the imputed underpayment under paragraph (b)(2) of this section;

(ii) Modification of the number and composition of imputed underpayments under paragraph (b)(4) of this section; and

(iii) Modifications that affect the tax rate under paragraph (b)(3) of this section.

(2)Modifications that affect partnership adjustments for purposes of determining the imputed underpayment. If the IRS approves modification with respect to a partnership adjustment, such partnership adjustment is excluded from the determination of the imputed underpayment as determined under §301.6225-1(b). This paragraph (b)(2) applies to modifications under-

(i) Paragraph (d)(2) of this section (amended returns and the alternative procedure to filing amended returns);

(ii) Paragraph (d)(3) of this section (tax-exempt status);

(iii) Paragraph (d)(5) of this section (specified passive activity losses);

(iv) Paragraph (d)(7) of this section (qualified investment entities);

(v) Paragraph (d)(8) of this section (closing agreements), if applicable;

(vi) Paragraph (d)(9) of this section (tax treaty modifications), if applicable; and

(vii) Paragraph (d)(10) of this section (other modifications), if applicable.

(3)Modifications that affect the tax rate.

(i) In general. If the IRS approves a modification with respect to the tax rate applied to a partnership adjustment, such modification results in a reduction in tax rate applied to the total netted partnership adjustment with respect to the partnership adjustments in accordance with this paragraph (b)(3). A modification of the tax rate does not affect how the partnership adjustment factors into the calculation of the total netted partnership adjustment. This paragraph (b)(3) applies to modifications under-

(A) Paragraph (d)(4) of this section (rate modification);

(B) Paragraph (d)(8) of this section (closing agreements), if applicable;

(C) Paragraph (d)(9) of this section (tax treaty modifications), if applicable; and

(D) Paragraph (d)(10) of this section (other modifications), if applicable.

(ii) Determination of the imputed underpayment in the case of rate modification. Except as described in paragraph (b)(3)(iv) of this section, in the case of an approved modification described under paragraph (b)(3)(i) of this section, the imputed underpayment is the sum of the total netted partnership adjustment consisting of the net positive adjustments not subject to rate reduction under paragraph (b)(3)(i) of this section (taking into account any approved modifications under paragraph (b)(2) of the section), plus the rate-modified netted partnership adjustment determined under paragraph (b)(3)(iii) of this section, reduced or increased by any adjustments to credits (taking into account any modifications under paragraph (b)(4) of this section). The total netted partnership adjustment not subject to rate reduction under paragraph (b)(3)(i) of this section (taking into account any approved modifications under paragraph (b)(2) of the section) is determined by multiplying the partnership adjustments included in the total netted partnership adjustment that are not subject to rate modification under paragraph (b)(3)(i) of this section (including any partnership adjustment that remains after applying paragraph (b)(3)(iii) of this section) by the highest tax rate (as described in §301.6225-1(b)(1)(iv)).

(iii) Calculation of rate-modified netted partnership adjustment in the case of a rate modification. The rate-modified netted partnership adjustment is determined as follows-

(A) Determine each relevant partner’s distributive share of the partnership adjustments subject to an approved modification under paragraph (b)(3)(i) of this section based on how each adjustment subject to rate modification was allocated in the NOPPA, or if the appropriate allocation was not addressed in the NOPPA, how the adjustment would be properly allocated under subchapter K of chapter 1 of the Internal Revenue Code (subchapter K) to such relevant partner in the reviewed year (as defined in §301.6241-1(a)(8)).

(B) Multiply each partnership adjustment determined under paragraph (b)(3)(iii)(A) of this section by the tax rate applicable to such adjustment based on the approved modification described under paragraph (b)(3)(i) of this section.

(C) Add all of the amounts calculated under paragraph (b)(3)(iii)(B) of this section with respect to each partnership adjustment subject to an approved modification described under paragraph (b)(3)(i) of this section.

(iv) Rate modification in the case of special allocations. If an imputed underpayment results from adjustments to more than one partnership-related item and any relevant partner for whom modification described under paragraph (b)(3)(i) of this section is approved has a distributive share of such items that is not the same with respect to all such items, the imputed underpayment as modified based on the modification types described under paragraph (b)(3)(i) of this section is determined as described in paragraphs (b)(3)(ii) and (iii) of this section except that each relevant partner’s distributive share is determined based on the amount of net gain or loss to the partner that would have resulted if the partnership had sold all of its assets at their fair market value as of the close of the reviewed year appropriately adjusted to reflect any approved modification under paragraphs (d)(2), (3), and (5) through (10) of this section with respect to any relevant partner. Notwithstanding the preceding sentence, the partnership may request that the IRS apply the rule in paragraph (b)(3)(iii)(A) of this section when determining each relevant partner’s distributive share for purposes of this paragraph (b)(3)(iv). Upon request by the IRS, the partnership may be required to provide the relevant partners’ capital account calculation through the end of the reviewed year, a calculation of asset liquidation gain or loss, and any other information necessary to determine whether rate modification is appropriate, consistent with the rules of paragraph (c)(2) of this section. Any calculation by the partnership that is necessary to comply with the rules in this paragraph (b)(3)(iv) is not considered a revaluation for purposes of section 704.

(4)Modification of the number and composition of imputed underpayments. Once approved by the IRS, a modification under paragraph (d)(6) of this section affects the manner in which adjustments are placed into groupings and subgroupings (as described in §301.6225-1(c) and (d)) or whether the IRS designates one or more specific imputed underpayments (as described in §301.6225-1(g)). If the IRS approves a request for modification under this paragraph (b)(4), the imputed underpayment and any specific imputed underpayment affected by or resulting from the modification is determined according to the rules of §301.6225-1 subject to any other modifications approved by the IRS under this section.

(5)Other modifications. The effect of other modifications described in paragraph (d)(10) of this section, including the order that such modification will be taken into account for purposes of paragraph (b)(1) of this section, may be set forth in forms, instructions, or other guidance prescribed by the IRS.

(c)Time, form, and manner for requesting modification.

(1)In general. In addition to the requirements described in paragraph (d) of this section, a request for modification under this section must be submitted in accordance with, and include the information required by, the forms, instructions, and other guidance prescribed by the IRS. The partnership representative must submit any request for modification and all relevant information (including information required under paragraphs (c)(2) and (d) of this section) to the IRS within the time described in paragraph (c)(3) of this section. The IRS will notify the partnership representative in writing of the approval or denial, in whole or in part, of any request for modification. A request for modification, including a request by the IRS for information related to a request for modification, and the determination by the IRS to approve or not approve all or a portion of a request for modification, is part of the administrative proceeding with respect to the partnership under subchapter C of chapter 63 and does not constitute an examination, inspection, or other administrative proceeding with respect to any other person for purposes of section 7605(b).

(2)Partnership must substantiate facts supporting a request for modification.

(i) In general. A partnership requesting modification under this section must substantiate the facts supporting such a request to the satisfaction of the IRS. The documents and other information necessary to substantiate a particular request for modification are based on the facts and circumstances of each request, as well as the type of modification requested under paragraph (d) of this section, and may include tax returns, partnership operating documents, certifications in the form and manner required with respect to the particular modification, and any other information necessary to support the requested modification. The IRS may, in forms, instructions, or other guidance, set forth procedures with respect to information and documents supporting the modification, including procedures to require particular documents or other information to substantiate a particular type of modification, the manner for submitting documents and other information to the IRS, and recordkeeping requirements. Pursuant to section 6241(10), the IRS may require the partnership to file or submit anything required to be filed or submitted under this section to be filed or submitted electronically. The IRS will deny a request for modification if a partnership fails to provide information the IRS determines is necessary to substantiate a request for modification, or if the IRS determines there is a failure by any person to make any required payment, within the time restrictions described in paragraph (c) of this section.

(ii) Information to be furnished for any modification request. In the case of any modification request, the partnership representative must furnish to the IRS such information as is required by forms, instructions, and other guidance prescribed by the IRS or that is otherwise requested by the IRS related to the requested modification. Such information may include a detailed description of the partnership’s structure, allocations, ownership, and ownership changes, its relevant partners for each taxable year relevant to the request for modification, as well as the partnership agreement as defined in § 1.704-1(b)(2)(ii)(h) of this chapter for each taxable year relevant to the modification request. In the case of any modification request with respect to a relevant partner that is an indirect partner, the partnership representative must provide to the IRS any information that the IRS may require relevant to any pass-through partner or wholly-owned entity disregarded as separate from its owner for Federal income tax purposes through which the relevant partner holds its interest in the partnership. For instance, if the partnership requests modification with respect to an amended return filed by a relevant partner pursuant to paragraph (d)(2) of this section, the partnership representative may be required to provide to the IRS information that would have been required to have been filed by pass-through partners through which the relevant partner holds its interest in the partnership as if those pass-through partners had also filed their own amended returns.

(3)Time for submitting modification request and information.

(i) Modification request. Unless the IRS grants an extension of time, all information required under this section with respect to a request for modification must be submitted to the IRS in the form and manner prescribed by the IRS on or before 270 days after the date the NOPPA is mailed.

(ii) Extension of the 270-day period. The IRS may, in its discretion, grant a request for extension of the 270-day period described in paragraph (c)(3)(i) of this section provided the partnership submits such request to the IRS, in the form and manner prescribed by forms, instructions, or other guidance prescribed by the IRS before expiration of such period, as extended by any prior extension granted under this paragraph (c)(3)(ii).

(iii) Expiration of the 270-day period by agreement. The 270-day period described in paragraph (c)(3)(i) of this section (including any extensions under paragraph (c)(3)(ii) of this section) expires as of the date the partnership and the IRS agree, in the form and manner prescribed by form, instructions, or other guidance prescribed by the IRS to waive the 270-day period after the mailing of the NOPPA and before the IRS may issue a notice of final partnership adjustment. See section 6231(b)(2)(A); §301.6231-1(b)(2).

(4)Approval of modification by the IRS. Notification of approval will be provided to the partnership only after receipt of all relevant information (including any supplemental information required by the IRS) and all necessary payments with respect to the particular modification requested before expiration of the 270-day period in paragraph (c)(3)(i) of this section plus any extension granted by the IRS under paragraph (c)(3)(ii) of this section.

(d)Types of modification.

(1)In general. Except as otherwise described in this section, a partnership may request one type of modification or more than one type of modification described in paragraph (d) of this section.

(2)Amended returns by partners.

(i) In general. A partnership may request a modification of an imputed underpayment based on an amended return filed by a relevant partner provided all of the partnership adjustments properly allocable to such relevant partner are taken into account and any amount due is paid in accordance with paragraph (d)(2) of this section. Only adjustments to partnership-related items or adjustments to a relevant partner’s tax attributes affected by adjustments to partnership-related items may be taken into account on an amended return under paragraph (d)(2) of this section. A partnership may request a modification for purposes of paragraph (d)(2) of this section by submitting a modification request based on the alternative procedure to filing amended returns as described in paragraph (d)(2)(x) of this section. The partnership may not request an additional modification of any imputed underpayment for a partnership taxable year under this section with respect to any relevant partner that files an amended return (or utilizes the alternative procedure to filing amended returns) under paragraph (d)(2) of this section or with respect to any partnership adjustment allocated to such relevant partner.

(ii) Requirements for approval of a modification request based on amended return. Except as otherwise provided under the alternative procedure described in paragraph (d)(2)(x) of this section, an amended return modification request under paragraph (d)(2) of this section will not be approved unless the provisions of this paragraph (d)(2)(ii) are satisfied. The partnership may satisfy the requirements of paragraph (d)(2) of this section by demonstrating in accordance with forms, instructions, and other guidance provided by the IRS that a relevant partner has previously taken into account the partnership adjustments described in paragraph (d)(2)(i) of this section, made any required adjustments to tax attributes resulting from the partnership adjustments for the years described in paragraph (d)(2)(ii)(B) of this section, and made all required payments under paragraph (d)(2)(ii)(A) of this section.

(A) Full payment required. An amended return modification request under paragraph (d)(2) of this section will not be approved unless the relevant partner filing the amended return has paid all tax, penalties, additions to tax, additional amounts, and interest due as a result of taking into account all partnership adjustments in the first affected year (as defined in §301.6226-3(b)(2)) and all modification years (as described in paragraph (d)(2)(ii)(B) of this section) at the time such return is filed with the IRS. Except for a pass-through partner calculating its payment amount pursuant to paragraph (d)(2)(vi) of this section, for purposes of this paragraph (d)(2)(ii)(A), the term tax means tax imposed by chapter 1 of the Internal Revenue Code (chapter 1).

(B) Amended returns for all relevant taxable years must be filed. Modification under paragraph (d)(2) of this section will not be approved by the IRS unless a relevant partner files an amended return for the first affected year and any modification year. A modification year is any taxable year with respect to which any tax attribute (as defined in §301.6241-1(a)(10)) of the relevant partner is affected by reason of taking into account the relevant partner’s distributive share of all partnership adjustments in the first affected year. A modification year may be a taxable year before or after the first affected year, depending on the effect on the relevant partner’s tax attributes of taking into account the relevant partner’s distributive share of the partnership adjustments in the first affected year.

(C) Amended returns for partnership adjustments that reallocate distributive shares. Except as described in this paragraph (d)(2)(ii)(C), in the case of partnership adjustments that reallocate the distributive shares of any partnership-related item from one partner to another, a modification under paragraph (d)(2) of this section will be approved only if all partners affected by such adjustments file amended returns in accordance with paragraph (d)(2) of this section. The IRS may determine that the requirements of this paragraph (d)(2)(ii)(C) are satisfied even if not all relevant partners affected by such adjustments file amended returns provided any relevant partners affected by the reallocation not filing amended returns take into account their distributive share of the adjustments through other modifications approved by the IRS (including the alternative procedure to filing amended returns under paragraph (d)(2)(x) of this section) or if a pass-through partner takes into account the relevant adjustments in accordance with paragraph (d)(2)(vi) of this section. For instance, in the case of adjustments that reallocate a loss from one partner to another, the IRS may determine that the requirements of this paragraph (d)(2)(ii)(C) have been satisfied if one affected relevant partner files an amended return taking into account the adjustments and the other affected relevant partner signs a closing agreement with the IRS taking into account the adjustments. Similarly, in the case of adjustment that reallocate income from one partner to another, the IRS may determine that the requirements of this paragraph (d)(2)(ii)(C) have been satisfied to the extent an affected relevant partner meets the requirements of paragraph (d)(3) of this section (regarding tax-exempt partners) and through such modification fully takes into account all adjustments reallocated to the affected relevant partner.

(iii) Form and manner for filing amended returns. A relevant partner must file all amended returns required for modification under paragraph (d)(2) of this section with the IRS in accordance with forms, instructions, and other guidance prescribed by the IRS. Except as otherwise provided under the alternative procedure described in paragraph (d)(2)(x) of this section, the IRS will not approve modification under paragraph (d)(2) of this section unless prior to the expiration of the 270-day period described in paragraph (c)(3) of this section, the partnership representative provides to the IRS, in the form and manner prescribed by the IRS, an affidavit from each relevant partner signed under penalties of perjury by such partner stating that all of the amended returns required to be filed under paragraph (d)(2) of this section has been filed (including the date on which such amended returns were filed) and that the full amount of tax, penalties, additions to tax, additional amounts, and interest was paid (including the date on which such amounts were paid).

(iv) Period of limitations. Generally, the period of limitations under sections 6501 and 6511 do not apply to an amended return filed under paragraph (d)(2) of this section provided the amended return otherwise meets the requirements of paragraph (d)(2) of this section.

(v) Amended returns in the case of adjustments allocated through certain pass-through partners. A request for modification related to an amended return of a relevant partner that is an indirect partner holding its interest in the partnership (directly or indirectly) through a pass-through partner that could be subject to tax imposed by chapter 1 (chapter 1 tax) on the partnership adjustments that are properly allocated to such pass-through partner will not be approved unless the partnership-

(A) Establishes that the pass-through partner is not subject to chapter 1 tax on the adjustments that are properly allocated to such pass-through partner; or

(B) Requests modification with respect to the adjustments resulting in chapter 1 tax for the pass-through partner, including full payment of such chapter 1 tax for the first affected year and all modification years under paragraph (d)(2) of this section or in accordance with forms, instructions, or other guidance prescribed by the IRS.

(vi) Amended returns in the case of pass-through partners-

(A) Pass-through partners may file amended returns. A relevant partner that is a pass-through partner, including a partnership-partner (as defined in §301.6241-1(a)(7)) that has a valid election under section 6221(b) in effect for a partnership taxable year, may, in accordance with forms, instructions, and other guidance provided by the IRS and solely for purposes of modification under paragraph (d)(2) of this section, take into account its share of the partnership adjustments and determine and pay an amount calculated in the same manner as the amount computed under §301.6226-3(e)(4)(iii) subject to paragraph (d)(2)(vi)(B) of this section.

(B) Modifications with respect to upper-tier partners of the pass-through partner. In accordance with forms, instructions, and other guidance provided by the IRS, for purposes of determining and calculating the amount a pass-through partner must pay under paragraph (d)(2)(vi)(A) of this section, the pass-through partner may take into account modifications with respect to its direct and indirect partners to the extent that such modifications are requested by the partnership requesting modification and approved by the IRS under this section.

(vii) Limitations on amended returns-

(A) In general. A relevant partner may not file an amended return or claim for refund that takes into account partnership adjustments except as described in paragraph (d)(2) of this section.

(B) Further amended returns restricted. Except as described in paragraph (d)(2)(vii)(C) of this section, if a relevant partner files an amended return under paragraph (d)(2) of this section, or satisfies paragraph (d)(2) of this section by following the alternative procedure under paragraph (d)(2)(x) of this section (the alternative procedure), such partner may not file a subsequent amended return or claim for refund to change the treatment of partnership adjustments taken into account through amended return or the alternative procedure.

(C) Subsequent returns in the case of changes to partnership adjustments or denial of modification. Notwithstanding paragraph (d)(2)(vii)(B) of this section, a relevant partner that has previously filed an amended return under paragraph (d)(2) of this section, or satisfied the requirements of paragraph (d)(2) of this section through the alternative procedure, to take partnership adjustments into account may, in accordance with forms, instructions, and other guidance prescribed by the IRS, file a subsequent return or claim for refund if a determination is made by a court or by the IRS that results in a change to the partnership adjustments taken into account in modification under paragraph (d)(2) of this section or a denial of modification by the IRS under paragraph (c)(2)(i) of this section with respect to a modification request under paragraph (d)(2) of this section. Such determinations include a court decision that changes the partnership adjustments for which modification was requested or a settlement between the IRS and the partnership pursuant to which the partnership is not liable for all or a portion of the imputed underpayment for which modification was requested. Any amended return or claim for refund filed under this paragraph (d)(2)(vii) is subject to the period of limitations under section 6511.

(viii) Penalties. The applicability of any penalties, additions to tax, or additional amounts that relate to an adjustment to a partnership-related item is determined at the partnership level in accordance with section 6221(a). However, the amount of penalties, additions to tax, and additional amounts a relevant partner must pay under paragraph (d)(2)(ii)(A) of this section for the first affected year and for any modification year is based on the underpayment or understatement of tax, if any, reflected on the amended return filed by the relevant partner under paragraph (d)(2) of this section. For instance, if after taking into account the adjustments, the return of the relevant partner for the first affected year or any modification year reflects an underpayment or an understatement that falls below the applicable threshold for the imposition of a penalty under section 6662(d), no penalty would be due from that relevant partner for such year. Unless forms, instructions or other guidance provided by the IRS allow for an alternative procedure for raising a partner-level defense (as described in §301.6226-3(d)(3)), a relevant partner may raise a partner-level defense by first paying the penalty, addition to tax, or additional amount with the amended return filed under paragraph (d)(2) of this section and then filing a claim for refund in accordance with forms, instructions, and other guidance.

(ix) Effect on tax attributes binding. Any adjustments to the tax attributes of any relevant partner which are affected by modification under paragraph (d)(2) of this section are binding on the relevant partner with respect to the first affected year and all modification years (as defined in paragraph (d)(2)(ii)(B) of this section). A failure to adjust any tax attribute in accordance with this paragraph (d)(2)(ix) is a failure to treat a partnership-related item in a manner which is consistent with the treatment of such item on the partnership return within the meaning of section 6222. The provisions of section 6222(c) and §301.6222-1(c) (regarding notification of inconsistent treatment) do not apply with respect to tax attributes under this paragraph (d)(2)(ix).

(x) Alternative procedure to filing amended returns-

(A) In general. A partnership may satisfy the requirements of paragraph (d)(2) of this section by submitting on behalf of a relevant partner, in accordance with forms, instructions, and other guidance provided by the IRS, all information and payment of any tax, penalties, additions to tax, additional amounts, and interest that would be required to be provided if the relevant partner were filing an amended return under paragraph (d)(2) of this section, except as otherwise provided in relevant forms, instructions, and other guidance provided by the IRS. A relevant partner for which the partnership seeks modification under paragraph (d)(2)(x) of this section must agree to take into account, in accordance with forms, instructions, and other guidance provided by the IRS, adjustments to any tax attributes of such relevant partner. A modification request submitted in accordance with the alternative procedure under paragraph (d)(2)(x) of this section is not a claim for refund with respect to any person.

(B) Modifications with respect to reallocation adjustments. A submission made in accordance with paragraph (d)(2)(x) of this section with respect to any relevant partner is treated as if such relevant partner filed an amended return for purposes of paragraph (d)(2)(ii)(C) of this section (regarding the requirement that all relevant partners affected by a reallocation must file an amended return to be eligible to for the modification under paragraph (d)(2) of this section) provided the submission is with respect to the first affected year and all modification years of such relevant partner as required under paragraph (d)(2) of this section.

(3)Tax-exempt partners.

(i) In general. A partnership may request modification of an imputed underpayment with respect to partnership adjustments that the partnership demonstrates to the satisfaction of the IRS are allocable to a relevant partner that would not owe tax by reason of its status as a tax-exempt entity (as defined in paragraph (d)(3)(ii) of this section) in the reviewed year (tax-exempt partner).

(ii) Definition of tax-exempt entity. For purposes of paragraph (d)(3) of this section, the term tax-exempt entity means a person or entity defined in section 168(h)(2)(A), (C), or (D).

(iii) Modification limited to portion of partnership adjustments for which tax-exempt partner not subject to tax. Only the portion of the partnership adjustments properly allocated to a tax-exempt partner with respect to which the partner would not be subject to tax for the reviewed year (tax-exempt portion) may form the basis of a modification of the imputed underpayment under paragraph (d)(3) of this section. A modification under paragraph (d)(3) of this section will not be approved by the IRS unless the partnership provides documentation in accordance with paragraph (c)(2) of this section to support the tax-exempt partner’s status and the tax-exempt portion of the partnership adjustment allocable to the tax-exempt partner.

(4)Modification based on a rate of tax lower than the highest applicable tax rate. A partnership may request modification based on a lower rate of tax for the reviewed year with respect to adjustments that are attributable to a relevant partner that is a C corporation and adjustments with respect to capital gains or qualified dividends that are attributable to a relevant partner who is an individual. In no event may the lower rate determined under the preceding sentence be less than the highest rate in effect for the reviewed year with respect to the type of income and taxpayer. For instance, with respect to adjustments that are attributable to a C corporation, the highest rate in effect for the reviewed year with respect to all C corporations would apply to that adjustment, regardless of the rate that would apply to the C corporation based on the amount of that C corporation’s taxable income. For purposes of this paragraph (d)(4), an S corporation is treated as an individual.

(5)Certain passive losses of publicly traded partnerships.

(i) In general. In the case of a publicly traded partnership (as defined in section 469(k)(2)) requesting modification under this section, an imputed underpayment is determined without regard to any adjustment that the partnership demonstrates would be reduced by a specified passive activity loss (as defined in paragraph (d)(5)(ii) of this section) which is allocable to a specified partner (as defined in paragraph (d)(5)(iii) of this section) or qualified relevant partner (as defined in paragraph (d)(5)(iv) of this section).

(ii) Specified passive activity loss. A specified passive activity loss carryover amount for any specified partner or qualified relevant partner of a publicly traded partnership is the lesser of the section 469(k) passive activity loss of that partner which is separately determined with respect to such partnership-

(A) At the end of the first affected year (affected year loss); or

(B) At the end of-

(1) The specified partner’s taxable year in which or with which the adjustment year (as defined in §301.6241-1(a)(1)) of the partnership ends, reduced to the extent any such partner has utilized any portion of its affected year loss to offset income or gain relating to the ownership or disposition of its interest in such publicly traded partnership during either the adjustment year or any other year; or

(2) If the adjustment year has not yet been determined, the most recent year for which the publicly traded partnership has filed a return under section 6031, reduced to the extent any such partner has utilized any portion of its affected year loss to offset income or gain relating to the ownership or disposition of its interest in such publicly traded partnership during any year.

(iii) Specified partner. A specified partner is a person that for each taxable year beginning with the first affected year through the person’s taxable year in which or with which the partnership adjustment year ends satisfies the following three requirements-

(A) The person is a partner of the publicly traded partnership requesting modification under this section;

(B) The person is an individual, estate, trust, closely held C corporation, or personal service corporation; and

(C) The person has a specified passive activity loss with respect to the publicly traded partnership.

(iv) Qualified relevant partner. A qualified relevant partner is a relevant partner that meets the three requirements to be a specified partner (as described in paragraphs (d)(5)(iii)(A), (B), and (C) of this section) for each year beginning with the first affected year through the year described in paragraph (d)(5)(ii)(B)(2) of this section. Notwithstanding the preceding sentence, an indirect partner of the publicly traded partnership requesting modification under this section may also be a qualified relevant partner under this paragraph (d)(5)(iv) if that indirect partner meets the requirements of paragraph (d)(5)(iii)(B) and (C) of this section for each year beginning with the first affected year through the year described in paragraph (d)(5)(ii)(B)(2) of this section.

(v) Partner notification requirement to reduce passive losses. If the IRS approves a modification request under paragraph (d)(5) of this section, the partnership must report, in accordance with forms, instructions, or other guidance prescribed by the IRS, to each specified partner the amount of that specified partner’s reduction of its suspended passive activity loss carryovers at the end of the adjustment year to take into account the amount of any passive activity losses applied in connection with such modification request. In the case of a qualified relevant partner, the partnership must report, in accordance with forms, instructions, or other guidance prescribed by the IRS, to each qualified relevant partner the amount of that qualified relevant partner’s reduction of its suspended passive activity loss carryovers at the end of the taxable year for which the partnership’s next return is due to be filed under section 6031 to be taken into account by the qualified relevant partner on the partner’s return for the year that includes the end of the partnership’s taxable year for which the partnership’s next return is due to be filed under section 6031. In the case of an indirect partner that is a qualified relevant partner, the IRS may prescribe additional guidance through forms, instructions, or other guidance to require reporting under this paragraph (d)(5)(v). The reduction in suspended passive activity loss carryovers as reported to a specified partner or qualified relevant partner under this paragraph (d)(5)(v) is a determination of the partnership under subchapter C of chapter 63 and is binding on the specified partners and qualified relevant partners under section 6223.

(6)Modification of the number and composition of imputed underpayments.

(i) In general. A partnership may request modification of the number or composition of any imputed underpayment included in the NOPPA by requesting that the IRS include one or more partnership adjustments in a particular grouping or subgrouping (as described in §301.6225-1(c) and (d)) or specific imputed underpayments (as described in §301.6225-1(g)) different from the grouping, subgrouping, or imputed underpayment set forth in the NOPPA. For example, a partnership may request under paragraph (d)(6) of this section that one or more partnership adjustments taken into account to determine a general imputed underpayment set forth in the NOPPA be taken into account to determine a specific imputed underpayment.

(ii) Request for particular treatment regarding limitations or restrictions. A modification request under paragraph (d)(6) of this section includes a request that one or more partnership adjustments be treated as if no limitations or restrictions under §301.6225-1(d) apply and as a result such adjustments may be subgrouped with other adjustments.

(7)Partnerships with partners that are “qualified investment entities” described in section 860.

(i) In general. A partnership may request a modification of an imputed underpayment based on the partnership adjustments allocated to a relevant partner where the modification is based on deficiency dividends distributed as described in section 860(f) by a relevant partner that is a qualified investment entity (QIE) under section 860(b) (which includes both a regulated investment company (RIC) and a real estate investment trust (REIT)). Modification under paragraph (d)(7) of this section is available only to the extent that the deficiency dividends take into account adjustments described in §301.6225-1 that are also adjustments within the meaning of section 860(d)(1) or (d)(2) (whichever applies).

(ii) Documentation of deficiency dividend. The partnership must provide documentation in accordance with paragraph (c) of this section of the “determination” described in section 860(e). Under section 860(e)(2), §1.860-2(b)(1)(i) of this chapter, and paragraph (d)(8) of this section, a closing agreement entered into by the QIE partner pursuant to section 7121 and paragraph (d)(8) of this section is a determination described in section 860(e), and the date of the determination is the date in which the closing agreement is approved by the IRS. In addition, under section 860(e)(4), a determination also includes a Form 8927, Determination Under Section 860(e)(4) by a Qualified Investment Entity, properly completed and filed by the RIC or REIT pursuant to section 860(e)(4). To establish the date of the determination under section 860(e)(4) and the amount of deficiency dividends actually paid, the partnership must provide a copy of Form 976, Claim for Deficiency Dividends Deductions by a Personal Holding Company, Regulated Investment Company, or Real Estate Investment Trust, properly completed by or on behalf of the QIE pursuant to section 860(g), together with a copy of each of the required attachments for Form 976.

(8)Closing agreements. A partnership may request modification based on a closing agreement entered into by the IRS and the partnership or any relevant partner, or both if appropriate, pursuant to section 7121. If modification under this paragraph (d)(8) is approved by the IRS, any partnership adjustment that is taken into account under such closing agreement and for which any required payment under the closing agreement is made will not be taken into account in determining the imputed underpayment under §301.6225-1. Any required payment under the closing agreement may include amounts of tax, including tax under chapters other than chapter 1, interest, penalties, additions to tax and additional amounts. Generally, the IRS will not approve any additional modification under this section with respect to a relevant partner to which a modification under this paragraph (d)(8) has been approved.

(9)Tax treaty modifications. A partnership may request a modification under this paragraph (d)(9) with respect to a relevant partner’s distributive share of an adjustment to a partnership-related item if, in the reviewed year, the relevant partner was a foreign person who qualified under an income tax treaty with the United States for a reduction or exemption from tax with respect to such partnership-related item. A partnership requesting modification under this section may also request a treaty modification under this paragraph (d)(9) regardless of the treaty status of its partners if, in the reviewed year, the partnership itself was an entity eligible for such treaty benefits.

(10)Other modifications. A partnership may request a modification not otherwise described in paragraph (d) of this section, and the IRS will determine whether such modification is accurate and appropriate in accordance with paragraph (c)(4) of this section. Additional types of modifications and the documentation necessary to substantiate such modifications may be set forth in forms, instructions, or other guidance prescribed by the IRS.

(e)Modification of adjustments that do not result in an imputed underpayment. A partnership may request modification of adjustments that do not result in an imputed underpayment (as described in § 301.6225-1(f)(1)(ii)) using modifications described in paragraph (d)(2) of this section (amended returns and the alternative procedure to filing amended returns), paragraph (d)(6) of this section (number and composition of the imputed underpayment), paragraph (d)(8) of this section (closing agreements), or, if applicable, paragraph (d)(10) of this section (other modifications).

(f)Examples. The following examples illustrate the rules of this section. For purposes of these examples, each partnership is subject to the provisions of subchapter C of chapter 63, each partnership and its relevant partners are calendar year taxpayers, all relevant partners are U.S. persons (unless otherwise stated), the highest rate of income tax in effect for all taxpayers is 40 percent for all relevant periods, and no partnership requests modification under this section except as provided in the example.

(1)

Example (1). Partnership has two partners during its 2019 partnership taxable year: P and S. P is a partnership, and S is an S corporation. P has four partners during its 2019 partnership taxable year: A, C, T and DE. A is an individual, C is a C corporation, T is a trust, and DE is a wholly-owned entity disregarded as separate from its owner for Federal income tax purposes. The owner of DE is B, an individual. T has two beneficiaries during its 2019 taxable year: F and G, both individuals. S has 3 shareholders during its 2019 taxable year: H, J, and K, all individuals. For purposes of this section, if Partnership requests modification with respect to A, B, C, F, G, H, J, and K, those persons are all relevant partners (as defined in paragraph (a) of this section). P, S, and DE are not relevant partners (as defined in paragraph (a) of this section) because DE is a wholly-owned entity disregarded as separate from its owner for Federal income tax purposes and modification was not requested with respect to P and S.

(2)

Example (2). The IRS initiates an administrative proceeding with respect to Partnership’s 2019 taxable year. The IRS mails a NOPPA to Partnership for the 2019 partnership taxable year proposing a single partnership adjustment increasing ordinary income by $100, resulting in a $40 imputed underpayment ($100 multiplied by the 40 percent tax rate). Partner A, an individual, held a 20 percent interest in Partnership during 2019. Partnership timely requests modification under paragraph (d)(2) of this section based on A’s filing an amended return for the 2019 taxable year taking into account $20 of the partnership adjustment and paying the tax and interest due attributable to A’s share of the increased income and the tax rate applicable to A for the 2019 tax year. No tax attribute in any other taxable year of A is affected by A’s taking into account A’s share of the partnership adjustment for 2019. In accordance with paragraph (d)(2)(iii) of this section, Partnership’s partnership representative provides the IRS with documentation demonstrating that A filed the 2019 return and paid all tax and interest due. The IRS approves the modification and, in accordance with paragraph (b)(2) of this section, the $20 increase in ordinary income allocable to A is not included in the calculation of the total netted partnership adjustment (determined in accordance with §301.6225-1). Partnership’s total netted partnership adjustment is reduced to $80 ($100 adjustment less $20 taken into account by A), and the imputed underpayment is reduced to $32 (total netted partnership adjustment of $80 after modification multiplied by 40 percent).

(3)

Example (3). The IRS initiates an administrative proceeding with respect to Partnership’s 2019 taxable year. Partnership has two equal partners during its entire 2019 taxable year: an individual, A, and a partnership-partner, B. During all of 2019, B has two equal partners: a tax-exempt entity, C, and an individual, D. The IRS mails a NOPPA to Partnership for its 2019 taxable year proposing a single partnership adjustment increasing Partnership’s ordinary income by $100, resulting in a $40 imputed underpayment ($100 total netted partnership adjustment multiplied by 40 percent). Partnership timely requests modification under paragraph (d)(3) of this section with respect to B’s partner, C, a tax-exempt entity. In accordance with paragraph (d)(3)(iii) of this section, Partnership’s partnership representative provides the IRS with documentation substantiating to the IRS’s satisfaction that C held a 25 percent indirect interest in Partnership through its interest in B during the 2019 taxable year, that C was a tax-exempt entity defined in paragraph (d)(3)(ii) of this section during the 2019 taxable year, and that C was not subject to tax with respect to its entire allocable share of the partnership adjustment allocated to B (which is $25 (50 percent x 50 percent x $100)). The IRS approves the modification and, in accordance with paragraph (b)(2) of this section, the $25 increase in ordinary income allocated to C, through B, is not included in the calculation of the total netted partnership adjustment (determined in accordance with § 301.6225-1). Partnership’s total netted partnership adjustment is reduced to $75 ($100 adjustment less C’s share of the adjustment, $25), and the imputed underpayment is reduced to $30 (total netted partnership adjustment of $75, after modification, multiplied by 40 percent).

(4)

Example (4). The facts are the same as in Example 3 in paragraph (f)(3) of this section, except $10 of the $25 of the adjustment allocated to C is unrelated business taxable income (UBTI) as defined in section 512 because it is debt-financed income within the meaning of section 514 (no section 512 UBTI modifications apply) with respect to which C would be subject to tax if taken into account by C. As a result, the modification under paragraph (d)(3) of this section with respect to C relates only to $15 of the $25 of ordinary income allocated to C that is not UBTI. Therefore, only a modification of $15 ($25 less $10) of the total $100 partnership adjustment may be approved by the IRS under paragraph (d)(3) of this section and, in accordance with paragraph (b)(2) of this section, excluded when determining the imputed underpayment for Partnership’s 2019 taxable year. The total netted partnership adjustment (determined in accordance with §301.6225-1) is reduced to $85 ($100 less $15), and the imputed underpayment is reduced to $34 (total netted partnership adjustment of $85, after modification, multiplied by 40 percent).

(5)

Example (5). The facts are the same as in Example 3 in paragraph (f)(3) of this section, except that Partnership also timely requests modification under paragraph (d)(2) of this section with respect to an amended return filed by B, and, in accordance with (d)(2)(iii) of this section, Partnership’s partnership representative provides the IRS with documentation demonstrating that B filed the 2019 return and paid all tax and interest due. B reports 50 percent of the partnership adjustments ($50) on its amended return, and B calculates an amount under paragraph (d)(2)(vi)(A) of this section and §301.6226-3(e)(4)(iii) that, pursuant to paragraph (d)(2)(vi)(B) of this section, takes into account the modification under paragraph (d)(3) of this section approved by the IRS with respect to B’s partner C, a tax-exempt entity. B makes a payment pursuant to paragraph (d)(2)(ii)(A) of this section, and the IRS approves the requested modification. Partnership’s total netted partnership adjustment is reduced by $50 (the amount taken into account by B). Partnership’s total netted partnership adjustment (determined in accordance with § 301.6225-1) is $50, and the imputed underpayment, after modification, is $20.

(6)

Example (6). The facts are the same as in Example 3 in paragraph (f)(3) of this section, except that in addition to the modification with respect to tax-exempt entity C, which reduced the imputed underpayment by excluding from the determination of the imputed underpayment $25 of the $100 partnership adjustment reflected in the NOPPA, Partnership timely requests modification under paragraph (d)(2) of this section with respect to an amended return filed by individual D, and, in accordance with paragraph (d)(2)(iii) of this section, Partnership’s partnership representative provides the IRS with documentation demonstrating that D filed the 2019 return and paid all tax and interest due. D’s amended return for D’s 2019 taxable year takes into account D’s share of the partnership adjustment (50 percent of B’s 50 percent interest in Partnership, or $25) and D paid the tax and interest due as a result of taking into account D’s share of the partnership adjustment in accordance with paragraph (d)(2) of this section. No tax attribute in any other taxable year of D is affected by D taking into account D’s share of the partnership adjustment for 2019. The IRS approves the modification and the $25 increase in ordinary income allocable to D is not included in the calculation of the total netted partnership adjustment (determined in accordance with §301.6225-1). As a result, Partnership’s total netted partnership adjustment is $50 ($100, less $25 allocable to C, less $25 taken into account by D), and the imputed underpayment, after modification, is $20.

(7)

Example (7). The IRS initiates an administrative proceeding with respect to Partnership’s 2019 taxable year. All of Partnership’s partners during its 2019 taxable year are individuals. The IRS mails a NOPPA to Partnership for the 2019 taxable year proposing three partnership adjustments. The first partnership adjustment is an increase to ordinary income of $75 for 2019. The second partnership adjustment is an increase in the depreciation deduction allowed for 2019 of $25, which under §301.6225-1(d)(2)(i) is treated as a $25 decrease in income. The third adjustment is an increase in long-term capital gain of $10 for 2019. Under the partnership agreement in effect for Partnership’s 2019 taxable year, the long-term capital gain and the increase in depreciation would be specially allocated to B and the increase in ordinary income would be specially allocated to A. In accordance with §301.6225-1(c) and (d), the three adjustments are placed into three separate subgroupings within the residual grouping because the partnership adjustments would not have been netted at the partnership level and would not have been required to be allocated to the partners of the partnership as a single, net partnership-related item for purposes of section 702(a), other provisions of the Code, regulations, forms, instructions, or other guidance prescribed by the IRS. Accordingly, the total netted partnership adjustment is $85 ($75 net positive adjustment to ordinary income plus $10 net positive adjustment to long term capital gain), and the imputed under payment is $34 ($85 multiplied by 40 percent). The net negative adjustment to depreciation is an adjustment that does not result in an imputed underpayment subject to treatment under §301.6225-3. Partnership requests a modification under paragraph (d)(6) of this section to determine a specific imputed underpayment with respect to the $75 adjustment to ordinary income allocated to A. The specific imputed underpayment is with respect to $75 of the increase in income specially allocated to A and the general imputed underpayment is with respect to $10 of the increase in capital gain and the $25 increase in depreciation deduction specially allocated to B. If the modification is approved by the IRS, the specific imputed underpayment would consist of the $75 increase in ordinary income, and thus the total netted partnership adjustment for the specific imputed underpayment would be $75. The specific imputed underpayment is thus $30 ($75 multiplied by 40 percent). The general imputed underpayment would consist of two adjustments: The long term capital gain adjustment and the depreciation adjustment. The long term capital gain adjustment and the depreciation adjustment would be placed in different subgroupings under §301.6225-1(d) because they are treated separately under section 702. Accordingly, the long term capital gain adjustment and the depreciation adjustment are not netted, and the long term capital gain adjustment would be a net positive adjustment while the depreciation adjustment would be a net negative adjustment. The long term capital gain net positive adjustment would be the only net positive adjustment, resulting in a total netted partnership adjustment of $10. The general imputed underpayment is $4 ($10 multiplied by 40 percent), and the net negative adjustment to depreciation of $25 would be an adjustment that does not result in an imputed underpayment under § 301.6225-1(f) associated with the general imputed underpayment.

(8)

Example (8). Partnership has two reviewed year partners, C1 and C2, both of which are C corporations. The IRS mails to Partnership a NOPPA with two adjustments, both based on rental real estate activity. The first adjustment is an increase of rental real estate income of $100 attributable to Property A. The second adjustment is an increase of rental real estate loss of $30 attributable to Property B. The Partnership did not treat the leasing arrangement with respect to Property A and Property B as an appropriate economic unit for purposes of section 469. If the $100 increase in income attributable to Property A and the $30 increase in loss attributable to Property B were included in the same subgrouping and netted, then taking the $30 increase in loss into account would result in a decrease in the amount of the imputed underpayment. Also, the $30 increased loss might be limited or restricted if taken into account by any person under the passive activity rules under section 469. For instance, under section 469, rental activities of the two properties could be treated as two activities, which could limit a partner’s ability to claim the loss. In addition to the potential limitations under section 469, there are other potential limitations that might apply if the $30 loss were taken into account by any person. Therefore, in accordance with §301.6225-1(d), the two adjustments are placed in separate subgroupings within the residual grouping, the total netted partnership adjustment is $100, the imputed underpayment is $40 ($100 x 40 percent), and the $30 increase in loss is an adjustment that does not result in an imputed underpayment under § 301.6225-1(f). Partnership requests modification under paragraph (d)(6) of this section, substantiating to the satisfaction of the IRS that C1 and C2 are publicly traded C corporations, and therefore, the passive activity loss limitations under section 469 of the Code do not apply. Partnership also substantiates to the satisfaction of the IRS that no other limitation or restriction applies that would prevent the grouping of the $100 with the $30 loss. The IRS approves Partnership’s modification request and places the $100 of income and the $30 loss into the subgrouping in the residual grouping under the rules described in §301.6225-1(c)(5). Under §301.6225-1(e), because the two adjustments are in one subgrouping, they are netted together, resulting in a total netted partnership adjustment of $70 ($100 plus -$30) and an imputed underpayment of $28 ($70 x 40 percent). After modification, none of the adjustments is an adjustment that does not result in an imputed underpayment under §301.6225-1(f) because the $30 loss is now netted with the $100 of income in a net positive adjustment for the residual grouping.

(g)Applicability date.

(1)In general. Except as provided in paragraph (g)(2) of this section, this section applies to partnership taxable years beginning after December 31, 2017, and ending after August 12, 2018.

(2)Election under §301.9100-22 in effect. This section applies to any partnership taxable year beginning after November 2, 2015, and before January 1, 2018, for which a valid election under §301.9100-22 is in effect.

T.D. 9844, 2/21/2019

The Branch Profits Tax

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

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

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

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

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

The Branch Profits Tax, Generally

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

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

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

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

The Dividend Equivalent Amount

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

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

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

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

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

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

Tax Treaties

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

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

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

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

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

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

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

International and Offshore Tax Compliance Attorneys

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

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

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

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

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

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

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

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

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

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

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

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

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

The Week of 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

Bruno v. Comm’r, T.C. Memo. 2020-156

November 16, 2020 | Lauber, J. | Dkt. No. 15525-18

Short Summary:  The Internal Revenue Service determined deficiencies of $15,438, $20,409, and $12,527 with respect to petitioner’s Federal income tax for 2013, 2014, and 2016, respectively.

Petitioner divorced from ex-spouse.  The divorce decree directed an equitable distribution of the their marital property, which required that petitioner’s ex-spouse transfer certain properties to her.  Petitioner did not receive this property because the ex-spouse persistently disregarded the orders of the divorce court, which repeatedly held him in contempt and ordered him to pay interest on his unpaid obligations.

On her returns for 2013 and 2014 petitioner claimed and the IRS disallowed NOL carryforward deductions of $12,622,635 and $12,543,221, respectively. These carryforwards included an alleged 2012 loss attributable to an asserted “illegal transfer, conveyance and fraudulent concealment of * * * [the ex-spouse’s] LLC business interests.”

Key Issue:  The sole issue or decision is petitioner’s claim that she sustained in 2015 a deductible theft loss of approximately $2.5 million. Petitioner contends that this loss resulted from her ex-husband’s refusal to  transfer marital property awarded to her in 2008 by order of a Connecticut divorce  court. Petitioner contends that this theft loss generated a net operating loss (NOL) in 2015, which she seeks to carry forward to 2016 and back to 2013 and 2014.

Primary Holdings: 

• Petitioner failed to establish that she sustained a theft loss in 2015 (or in any other year at issue).
• The Tax Court concluded that petitioner in December 2015 had “bona fide claims for recoupment” from [ex-spouse] and his co-defendants and that there was “a substantial possibility that such claims w[ould] be decided in * * * [her] favor.” Because petitioner had “a claim for reimbursement with respect to which there [wa]s a reasonable prospect of recovery,” no portion of her alleged loss is deemed sustained “until the taxable year in which it can be ascertained with reasonable certainty whether or not such reimbursement will be received.”

Key Points of Law:

• With respect to certain items, such as NOL carryforward and carryback deductions, the Tax Court may need to consider evidence from other tax years. As a rule, however, it has no power to determine an overpayment or underpayment of tax for a year not in issue. See sec. 6214(b).
• Section 7491(a)(1) provides that, if “a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer * * * , the Secretary shall have the burden of proof with respect to such issue.” “Credible evidence is the quality of evidence which, after critical analysis, the court would find sufficient upon which to base a decision on the issue if no con- trary evidence were submitted[.]”
• Any shift in the burden of proof under section 7491(a)(1) is subject to the limitations set forth in section 7491(a)(2). Among these limitations is that the taxpayer must have “maintained all records required under this title and ha[ve] cooperated with reasonable requests by the Secretary for witnesses, information, documents, meetings, and interviews.” Sec. 7491(a)(2)(B). The taxpayer bears the burden of proving that she has met these requirements.
• Theft Losses.  The Code allows individual taxpayers to deduct losses arising from theft that are sustained during the taxable year and not compensated by insurance or otherwise. Sec. 165(a), (c)(3). To establish a theft loss, a taxpayer must first prove the occurrence of a theft under the law of the relevant jurisdiction.
• The taxpayer must then establish the amount of the loss and the year in which the loss was sustained. See sec. 1.165-1(c) and (d)(1), Income Tax Regs. A loss arising from theft is generally treated “as sustained during the taxable year in which the taxpayer discovers such loss.” Sec. 165(e); see 1.165- 1(d)(3), Income Tax Regs.
• To establish a theft a taxpayer need not demonstrate a criminal conviction. But she must prove by a preponderance of the evidence that an actual theft occurred.
• Petitioner is not entitled to a deduction unless she can establish the amount of the loss and the year in which it was sustained. See sec. 1.165-1(c) and (d)(1), Income Tax Regs.
• A theft loss is generally treated as sustained in the year “in which the taxpayer discovers such loss.” Sec. 165(e); sec. 1.165-1(d)(3), Income Tax Regs. However, if in the year of discovery there exists a claim for reimbursement with respect to which there is a reasonable prospect of recovery, no portion of the loss with respect to which reimbursement may be received is sustained until the taxable year in which it can be ascertained with reasonable certainty whether or not such reimbursement will be received. Sec. 1.165-1(d)(3), Income Tax Regs.; see also id. sec. 1.165-8(a)(2).
• “A reasonable prospect of recovery exists when the taxpayer has bona fide claims for recoupment from third parties or otherwise, and when there is a substantial possibility that such claims will be decided in his favor.
• Whether a taxpayer had a reasonable prospect of recovery at the end of a particular year “is a question of fact to be determined upon an examination of all facts and circumstances.” Sec. 1.165-1(d)(2)(i), Income Tax Regs.

Insight: The Bruno case demonstrates yet again that the theft-loss provisions of the Code require careful analysis and present significant hurdles for taxpayers.  Particularly with respect to complex embezzlement and similar theft losses, taxpayers should generally seek legal advice from a qualified attorney to ensure that all technicalities are satisfied.

Aghadjanian v. Comm’r, T.C. Memo. 2020-155

November 16, 2020 | Greaves T. | Dkt. No. 9339-18W

Short Summary:  Petitioner filed a petition with the Tax Court appealing the denial of his whistleblower claim.  The IRS filed a Rule 121 motion for summary judgment, arguing that Petitioner failed to timely file his petition or alternatively that the IRS Whistleblower Office (“WBO” did not abuse its discretion in denying Petitioner’s claim for an award. The Tax Court granted the IRS’ motion finding that the Petitioner did not timely file his petition.

Key Issue:  Did the Petitioner timely file his petition with the Tax Court in accordance with IRC § 7623(b)(4)?

Primary Holdings: 

• A taxpayer has 30 days from the date that the determination is mailed or personally delivered to the taxpayer at his last known address to file a Tax Court petition appealing the denial of a whistleblower claim from the WBO.

Key Points of Law:

• IRC § 7623(b)(4) permits the Tax Court to review a WBO award determination if a petition is filed within 30 days of the determination.
• A IRC § 7623(b)(4) review applies to determinations under paragraph (1), (2), or (3) of IRC § 7623(b). Although the WBO’s denial letter says it “does not contain a determination regarding an award under section 7623(b)”, that disclaimer does not deprive the Tax Court of jurisdiction.  See Cooper v. Commissioner, 135 T.C. 70,75-76 (2010).
• The 30-day period of IRC § 7623(b)(4) begins on the date that the determination is mailed or personally delivered to the whistleblower at his last known address. See Kasper v. Commissioner, 137 T.C. 37, 45(2011)
• A taxpayer timely mails a petition to the Tax Court when it is delivered to the U.S. Postal Service on or before the due date. See IRC § 7502(a); See also 26 CFR § 301.7502-1(a), (c)(1)(iii)(A).

Insight:  This case highlights the importance of meeting filing deadlines.  It shows that taxpayers who do not timely file have little or no recourse to appeal a denial of a claim.

Kane v. Comm’r, T.C. Memo. 2020-154

November 16, 2020 | Morrison, J. | Dkt. No. 17338-16

Short Summary:  Padda, who filed joint returns with spouse, Kane, practices medicine through his wholly owned C corporation,  Interventional Center, a pain-management clinic. Between 2008 and 2012, Padda and CFO, Grimes, opened five restaurants.

During the relevant years, Padda owned a 50% interest in each of the five restaurant partnerships; Grimes owned the other 50%. Grimes did not contribute cash or other property to acquire her interests in the partnerships. Although Padda owned only 50% of each of the five restaurant partnerships, he was allocated 100% of the losses. Grimes was not allocated any losses. The IRS does not challenge this loss allocation.

Padda also invested in a brewery operated by Ninkasi, LLC. During the years at issue, Padda owned a 90% interest in Ninkasi; Grimes owned 5% and Padda’s brother (who was also his attorney) owned the remaining 5%. Ninkasi opened for business in 2008 and operated under the name Cathedral Square Brewery. Although Padda owned 90% of Ninkasi, he was allocated 100% of the losses. Grimes and Padda’s brother were not allocated any of the losses. The IRS does not challenge this loss allocation.

On their 2010 return, Padda and Kane filed an “Election to Group Activities”. They elected to group the following activities: (1) Ninkasi with 3914 Lindell, LLC; and (2) Cafe Ventana with 3919 West Pine, LLC.

On May 2, 2016, the IRS issued a notice of deficiency to Padda and Kane for the 2010, 2011, and 2012 taxable years. The notice determined deficiencies for all three years based on the following determinations: (1) the restaurants and the brewery were passive activities for all three years and (2) Padda and Kane failed to report constructive-dividend income for 2010. As indicated at the beginning of the opinion, the notice of deficiency determined section 6662(a) penalties for all three years.

Key Issues:

• Did Padda meet the material-participation requirements of section 469 for the activities of five restaurants and a brewery?
• Did Padda receive a constructive dividend in 2010 because his wholly owned medical corporation2 paid $81,828 of his expenses?
• Are Padda and Kane liable for a section 6651(a)(1) addition to tax for failing to timely file their 2012 return?
• Are Padda and Kane liable for accuracy-related penalties under section 6662(a) for 2010, 2011, and 2012?

Primary Holdings: 

• For each activity for each year (i.e., for each of the restaurants and the brewery), Padda’s hours exceeded the 100-hour threshold required for an activity to be a significant participation activity. Each activity was therefore a significant participation activity for each year. Because for each year Padda had at least these six significant participation activities, his aggregate participation in all significant participation activities during the year exceeded the 500-hour threshold of section 1.469-5T(a)(4), Temporary Income Tax Regs., supra. The five restaurants and the brewery were not passive activities.
• Held that Padda and Kane received an $81,828 constructive dividend in 2010 for the travel, dining, and entertainment expenses paid by Interventional Center.
• Held taxpayers liable for section 6651(a)(1) penalties, and section 6662(a) penalties for the portion of the underpayment related to constructive dividends.

Key Points of Law:

• Taxpayers are allowed deductions for certain business and investment expenses under sections 162 and 212. However, a taxpayer may not deduct losses from passive activities to the extent the losses exceed the taxpayer’s income from passive activities.
• A passive activity is generally an activity involving the conduct of a trade or business in which the taxpayer does not materially participate.
• Generally, taxpayers materially participate in an activity if they are involved in the operations of the activity on a regular, continuous, and substantial basis. Sec. 469(h)(1). Material participation in an activity may be established by any reasonable means.
• Generally, “reasonable means” include the “identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative summaries.” Id. While daily time reports, logs, or similar documentation are not required, a taxpayer must provide other reasonable means to establish participation in the activity.
• A taxpayer can establish material participation in an activity by satisfying any one of seven tests set forth in section 1.469-5T(a), Temporary Income Tax Regs., 53 Fed. Reg. 5725-5726 (Feb. 25, 1988).
• Paragraph (a)(4) provides that the fourth test (at issue here) is met if the “activity is a significant participation activity * * * for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours”. A significant participation activity is a trade or business activity in which the individual participates for more than 100 hours during the year. Id. para. (c), 53 Fed. Reg. 5726.
• A taxpayer may treat one or more trade or business activities as a single activity if the activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of the passive-activity rules. Sec. 1.469-4(c)(1), Income Tax Regs. Once a taxpayer has grouped activities, the taxpayer may not regroup the activities in later taxable years unless the taxpayer complies with disclosure requirements prescribed by the IRS.
• A distribution of property made by a corporation to a shareholder with respect to its stock is governed by section 301(c). Sec. 301(a). Under section 301(c)(1), a distribution that is a “dividend” is includable in the shareholder’s income. See also sec. 61(a)(7). A dividend is any distribution a corporation makes to its shareholders out of earnings and profits. Sec. 316(a).
• One type of distribution governed by section 301(c) is a constructive distribution. United States v. Smith, 418 F.2d 589, 593 (5th Cir. 1969). To determine whether a shareholder received a constructive distribution, this Court looks to whether the distribution was primarily for the shareholder’s benefit rather than for the corporation’s benefit. The determination of whether the shareholder or the corporation primarily benefits is a question of fact.
• The IRS bears the burden of production for additions to tax determined under section 6651(a)(1). See sec. 7491(c); Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001). The IRS satisfies its burden by producing sufficient evidence to establish that the taxpayer failed to timely file a required return. See Wheeler v. Commissioner, 127 T.C. 200, 207-208 (2006), aff’d, 521 F.3d 1289 (10th Cir. 2008); Higbee v. Commissioner, 116 T.C. at 447. Once the IRS has satisfied its burden of production, the taxpayer has the burden of proving that the lateness was due to reasonable cause and not willful neglect. Higbee v. Commissioner, 116 T.C. at 447. Reasonable cause excusing a failure to timely file exists if the taxpayer exercised ordinary business care and prudence but nevertheless was unable to file the return by the deadline. See sec. 301.6651- 1(c)(1), Proced. & Admin. Regs. Willful neglect means a conscious, intentional failure, or reckless indifference.
• In considering whether a taxpayer has exercised reasonable care and prudence, courts have held that the taxpayer’s duty to file a timely return cannot be avoided by delegating to another party, including an accountant, the responsibility for preparing and filing the return. Mauldin v. Commissioner, 60 T.C. 749, 762 (1973); see also Boyle, 469 U.S. at 251-252 (holding that reliance on an agent to file a return does not establish reasonable cause because “[i]t requires no special training or effort to ascertain a deadline and make sure that it is met”)
• Section 6662(a) and (b)(1) and (2) imposes a penalty equal to 20% of any portion of an underpayment of tax that is attributable to negligence or to a substantial understatement of income tax. An underpayment is the difference between the correct tax and the tax reported on the return, with exceptions not relevant here. Sec. 6664(a). Negligence includes any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws or to exercise ordinary and reasonable care in the preparation of a tax return. Sec. 6662(c); sec. 1.6662-3(b)(1), Income Tax Regs. Negligence may also include the failure to properly substantiate an item. Higbee v. Commissioner, 116 T.C. at 449;
  1.6662-3(b)(1), Income Tax Regs. A substantial understatement of income tax exists if (1) the understatement exceeds 10% of the tax required to be shown on the return and (2) the understatement exceeds $5,000. Sec. 6662(d)(1)(A). An understatement is the difference between the correct tax and the tax reported on the return, with exceptions not relevant here. Sec. 6662(d)(2)(A).
• No section 6662 penalty is imposed with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion. Circumstances that indicate reasonable cause and good faith include reliance on the advice of a tax professional. Sec. 1.6664-4(b), Income Tax Regs. The taxpayer has the burden of proving that he or she acted with reasonable cause and in good faith. Rule 142(a); Higbee v. Commissioner, 116 T.C. at 446-447.

Insight: The Bruno case demonstrates the IRS’s continued focus on passive activity losses and constructive dividends.  Passive Activity Losses (PALs) have long been a focus for the IRS and a basis for denying deductions attributable to passive activities.  The Bruno case, however, demonstrates an important planning consideration: activity “grouping.”  In addition, the IRS has often asserted that distributions or payments from closely-held corporations are constructive dividends under certain circumstances.  Courts often look to the Fifth Circuit’s decision in United States v. Smith, 418 F.2d 589, 593 (5th Cir. 1969) to analyze constructive dividend claims.

U.S. Tax Court Summaries

The Coca-Cola Company & Subsidiaries v. Comm’r, 155 T.C. No. 10 

November 18, 2020 | Lauber, J. | Dkt. No. 31183-15

Short Summary:  The case involved the validity of the transfer pricing methodology used by the IRS to reallocate income to Coca-Cola from its subsidiaries, under section [14] I.R.C. § 482 for the 2007-2009 period.

Coca-Cola (the taxpayer) licensed its intellectual property (IP) to foreign manufacturing affiliates (called supply points and referred here as foreign affiliates). The foreign affiliates used this IP to manufacture concentrate, which was then sold to bottlers, who produced the beverages using the concentrate. In return for using the IP, the foreign affiliates compensated Coca-Cola using a “10-50-50” method, which allowed them to retain profit equal to 10% of the gross sales, and the remainder to be split 50-50 with Coca-Cola. It must be mentioned that this formulary apportionment method had been agreed by the taxpayer and the IRS in 1996 as part of a settlement (the 1996 agreement) entered by the taxpayer and the IRS for tax liabilities concerning the 1987-1995 period. The 1996 agreement also allowed the foreign affiliates to cover their royalty payments – for the use of the IP-, by actually paying royalties or remit dividends to the taxpayer. During the 2007-2009, the foreign affiliates remitted “dividends” to the taxpayer in the amount of $1.8 billion as royalties’ payment.

The IRS examined the 2007-2009 taxpayer’s return and determined that the methodology used by the taxpayer did not reflected arm’s-length rules, by undercompensating the taxpayer (and reducing taxable income in the U.S.) and overcompensating the foreign affiliates. To reallocate income to the taxpayer under section [14] I.R.C. § 482, the IRS applied the Comparable Profits Method (CPM) and used unrelated bottlers, as comparable parties. Using this methodology, the IRS assessed a $9M deficiency in taxable income.

The taxpayer challenged such deficiency in Tax Court alleging that the IRS had abused its discretion to reallocate income to the taxpayer under the CPM. The taxpayer also argued that the 1996 agreement prevented the IRS from changing its allocation method. Finally, it argued that the remitted dividends from the foreign affiliates in satisfaction to the royalty obligations should reduce the reallocations of the IRS.

The Court ruled in a 244 pages judgment that the IRS did not abused its discretion when applying the CPM and using the independent bottlers as comparable parties. Moreover, it ruled that the 1996 agreement did not prevented the IRS from reallocating income during the period of examination; it also ruled that the IRS did not erred by recomputing section 987 losses of the taxpayer after the CPM change the allocable income to the taxpayer’s Mexican affiliate; and finally the Court sided with the taxpayer by allowing the remitted dividends to reduce the reallocations considering the timely election to employ dividend offset.

Key Issues: (i) Whether the IRS abused its discretion by applying the CPM method to the taxpayer’s transactions using the independent bottlers as comparable parties; (ii) Is the IRS allowed to recompute section 987 losses of the taxpayer after making a section [14] I.R.C. § 482 allocation? and (iii) Is the taxpayer allowed to apply dividend offset even if it did not meet the formal requirements established on the Regulations?

Primary Holdings: (i) The IRS did not abuse its discretion under section [14] I.R.C. § 482 by using the CPM to reallocate income to the taxpayer from its subsidiaries; (ii) the IRS did not erred by recomputing the taxpayer’s section 987 losses after the CPM changed the income allocable to the taxpayer’s Mexican affiliate and (iii) the taxpayer made a timely election to employ dividend offset treatment regarding the dividends paid by the foreign affiliates, and consequently such dividends should be allowed to reduce the IRS’ reallocation amount.

Key Points of Law:

Section 482 allows the IRS to apportion or allocate gross income, deductions, credits between related parties. The discretionary action of the IRS under this section can be invalid if the IRS abuses its discretion when the determination is arbitrary, capricious, and unreasonable. See Guidant LLC v. Comm’r, 146 T.C. 60, 73(2016). To determine whether the IRS abuses its discretion is a question of fact. See Amazon.com, Inc. 148 T.C. at 150. Additionally, the abuse of discretion is determined upon the reasonableness of the IRS’ result and not the methodology involved. To evidence such, the taxpayer requires evidence of comparable uncontrolled transactions, but in certain cases, considering that there are not comparable transactions because of the uniqueness of the property, the taxpayer must establish the unreasonableness of the methodology.

Considering the standard described, the Court considered some important factors to determine whether the IRS’ reallocation result was unreasonable because of the method employed:

• First, it determined that the 1996 Agreement (which included the use of the 10-50-50 formula) was solely executed as a closing agreement to settle a dispute for the 1987-1995 period and should not be understood as making a reference about the transfer pricing methodology to be used after the 1995 year. Additionally, the Court considered that the agreement recognized the possibility that the IRS make transfer pricing adjustments because the penalty protection provided by such agreement to the taxpayer.
• Second, under Treas. Regs. 1.[14] I.R.C. § 482-1(b)(1), the Court must determine the “true taxable income of a controlled taxpayer”. In this regard, the Court determined that the IRS properly treated the foreign affiliates and foreign serving companies as controlled taxpayers that engage in a set of discrete controlled transactions.
• The standard to determine the allocation is the arm’s length with an uncontrolled taxpayer as provided by Treas. Regs. 1.[14] I.R.C. § 482-1(b)(1) and supported by a myriad of caselaw. In the case of controlled transfers of intangible property, Regulations provide that the methods to determine the arm’s length result are the Comparable Uncontrolled Transaction (CUT), the CPM, the profit split method and unspecified method. In this case, the IRS employed the CPM which is allowed and contrary to the taxpayer’s argument, it is not inferior to any other allowed method.

Based on these assumptions, the Court determined that the CPM used by the IRS was proper considering the nature of assets and the activities performed by the controlled taxpayers (foreign affiliates) and that the IRS selection of the independent bottlers as comparable parties (to determine this point, the Court analyzed factors such as functions performed, contractual terms, risks, economic conditions and property employed or transferred).

Moreover, it determined that the CPM methodology was reasonable in this case, considering that the foreign affiliates act as wholly owned contract manufacturers. This is because the CPM evaluates the profitability only of the tested party (foreign affiliates) and determines the arm’s length profit range of such affiliates without attempting to value the hard-to-value intangible assets, which is reasonable in this case (considering the uniqueness of the intangibles of the taxpayer). Finally, the Court determined that the data employed by the IRS was reliable and represented the universe of independent bottlers. Based on these factors, the Court concluded that the IRS’ methodology to reallocate income from the foreign affiliates to the taxpayer was reasonable and not arbitrary.

As for the second question, concerning collateral adjustments including the IRS’ recomputation of the taxpayer’s section 987 loss as consequence of reallocating income from the Mexican affiliate to the taxpayer, the Court determined that as consequence of the allocation of income, the losses reported in the Mexican branch were no longer correct and consequently, the IRS was correct in recomputing them.

Finally, the Court determined that dividends remitted from the foreign affiliates to the taxpayer to meet their royalty obligations with the taxpayer, should be offset against the reallocation made by the IRS. This is because Rev. Proc. 99-32 afforded a qualifying taxpayer two forms of relief, which were available to the taxpayer here. And despite the procedural requirement added by this revenue procedure was not met by the taxpayer (which basically required the taxpayer to include a statement jointly with the tax return for each year of the section [14] I.R.C. § 482 allocation period), the Court held that IRS regulations and guidance can be satisfied by substantial rather than strict compliance. In this case, the taxpayer substantially complied by claiming dividend offsets as agreed in its 1996 Agreement which provided for such treatment.

Insight:  This case is relevant because it introduces an opinion that is favorable to the IRS when electing a new transfer pricing methodology to allocate income among related parties. Past cases, such as Amazon, had been favorable to the taxpayer in the methodology election and rejection of the choice elected by the IRS. This case will set a foundation for future tax litigation in the transfer pricing area. Special analysis must be given to the CPM method in cases where hard-to-value-intangibles are main part of the business structure.

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Gun violence in Mexico has reached frightening levels. Criminal organizations murder thousands with near total impunity, using a wide range of firearms, from high-powered, military-grade rifles to sidearms. By and large, the efforts of Mexican military and police forces to control the mounting violence have been unsuccessful. Now, the Mexican government is trying a new approach to battling gun crime within its borders.

In August of 2021, Mexico filed suit in U.S. federal court against a slew of gun manufacturers from various countries, including the United States, Austria, and Italy. The complaint alleged that the defendants share responsibility for the alarming rise in gun violence and homicides and should pay Mexico billions in damages. However, the lawsuit faces serious substantive and procedural problems that may end in its dismissal. The gun manufacturers named in the suit continue to fight for that result.

Foreign Guns and Mexico’s Homicides

Many people in the U.S. are aware of the violent gun deaths that occur in Mexico. They have seen the disturbing headlines on a weekly basis: heavily armed criminals murder each other, the police, and innocent bystanders. But they may not be aware of relevant facts and current statistics compared to Mexico’s recent past. Between the years 2004 and 2018, gun deaths rose between 25% and 69%. Mexico has alleged that U.S. gun manufacturers share responsibility for this sharp rise of violence by failing to prevent guns from entering Mexico.

The complaint constructs its liability theory on two foundations: (1) that the delivery of guns from the defendants’ factories to Mexican cartel members is foreseeable; and (2) that the defendants have a duty to prevent cartels from acquiring their products.  According to the lawsuit, the sources of this duty, include Mexican and U.S. laws. However, existing U.S. law may not allow their claim to go forward.

In Mexico, the public does not have the right to bear arms. Also, Mexico does not have a gun culture like that found in the United States. More importantly to Mexico’s lawsuit, the sale of guns in Mexico is highly restricted and limited. In fact, there is only one official shop in Mexico that sells firearms. It is located on a military base. Thus, the cartel’s guns aren’t sourced from Mexico.

An Increase in Military-Grade Firearms in Mexico

In 2005, Congress established the Protection of Lawful Commerce in Arms Act (PLCAA), exempting makers of guns and ammunition from liability for claims brought by victims of criminal acts perpetrated with firearms. Following its passage, along with the 2004 expiration of a ban on the manufacture of assault-style rifles, the industry increased the production of high-powered firearms.

The increase in production correlates directly with the rise in firearms deaths in Mexico. Government reports from both Mexico and the United States unequivocally state that these firearms are coming from north of the Rio Grande. According to the lawsuit, Mexico estimates that 500,000 arms are trafficked over the border each year.

Lawsuit Obstacles

The defendants responded quickly with a joint motion to dismiss. They argued that the PLCAA protects them from damages caused by criminal third parties. Further, the motion asserts that the Mexico failed to demonstrate that the manufacturers are the proximate cause of the gun crimes perpetrated by cartel members.

On their face, the arguments appear formidable. It is reasonable to assume dismissal is likely. However, Mexico’s response to the joint motion to dismiss opened a Pandora’s box of choice-of-law and statutory interpretation issues that have now taken center stage.

PLCAA Immunity

U.S. federal courts recognize two distinct types of immunity depending on whether the law providing immunity is procedural or substantive. If procedural, the law would furnish immunity from suit. If substantive, it would grant a defense to liability.

Immunity from suit constitutes a right that exempts a defendant from having to undergo a trial. If it is deemed to apply, the court must dismiss the case prior to a trial. In contrast, if the district court finds the PLCAA grants only a defense to liability, the manufacturers could be forced to defend Mexico’s claims at trial. Within the United States, there is support for this outcome. Thirteen U.S. states and the District of Columbia are supporting, as amicus parties, Mexico’s assertion that the PLCAA does not grant total immunity from suit.

Future Ramifications

If the court holds that the manufacturer’s immunity is substantive and finds that that Mexican substantive law, and not Massachusetts law should apply to the claims, Mexico may have the opportunity to prove its claims. The immunity provisions of the PLCAA would not prevent a trial or determine the outcome of the lawsuit.

If the case is dismissed, Mexico may have a chance to amend its complaint and use the U.N. Arms Trade Treaty as the basis for its lawsuit. However, this is a longshot, as the U.S. Senate has not ratified this treaty. If the case is allowed to move forward, it may establish a ground or precedent for allowing a wider scope of lawsuits from Mexico and other countries against U.S. businesses, including outside of the context of firearms manufacturing.

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(a)Imputed underpayment based on partnership adjustments.

(1)In general. In the case of any partnership adjustments (as defined in §301.6241-1(a)(6)) by the Internal Revenue Service (IRS), if the adjustments result in an imputed underpayment (as determined in accordance with paragraph (b) of this section), the partnership must pay an amount equal to such imputed underpayment in accordance with paragraph (a)(2) of this section. If the adjustments do not result in an imputed underpayment (as described in paragraph (f) of this section), such adjustments must be taken into account by the partnership in the adjustment year (as defined in §301.6241-1(a)(1)) in accordance with §301.6225-3. Partnership adjustments may result in more than one imputed underpayment pursuant to paragraph (g) of this section. Each imputed underpayment determined under this section is based solely on partnership adjustments with respect to a single taxable year.

(2)Partnership pays the imputed underpayment. An imputed underpayment (determined in accordance with paragraph (b) of this section and included in a notice of final partnership adjustment (FPA) under section 6231(a)(3)) must be paid by the partnership in the same manner as if the imputed underpayment were a tax imposed for the adjustment year in accordance with §301.6232-1. The FPA will include the amount of any imputed underpayment, as modified under §301.6225-2 if applicable, unless the partnership waives its right to such FPA under section 6232(d)(2). See §301.6232-1(d)(2). For the alternative to payment of the imputed underpayment by the partnership, see §301.6226-1. If a partnership pays an imputed underpayment, the partnership’s expenditure for the imputed underpayment is taken into account by the partnership in accordance with §301.6241-4. For interest and penalties with respect to an imputed underpayment, see section 6233.

(3)Imputed underpayment set forth in notice of proposed partnership adjustment. An imputed underpayment set forth in a notice of proposed partnership adjustment (NOPPA) under section 6231(a)(2) is determined in accordance with paragraph (b) of this section without regard to any modification under §301.6225-2. Modifications under §301.6225-2, if allowed by the IRS, may change the amount of an imputed underpayment set forth in the NOPPA and determined in accordance with paragraph (b) of this section. Only the partnership adjustments set forth in a NOPPA are taken into account for purposes of determining an imputed underpayment under this section and for any modification under §301.6225-2.

(b)Determination of an imputed underpayment.

(1)In general. In the case of any partnership adjustment by the IRS, an imputed underpayment is determined by-

(i) Grouping the partnership adjustments in accordance with paragraph (c) of this section and, if appropriate, subgrouping such adjustments in accordance with paragraph (d) of this section;

(ii) Netting the adjustments in accordance with paragraph (e) of this section;

(iii) Calculating the total netted partnership adjustment in accordance with paragraph (b)(2) of this section;

(iv) Multiplying the total netted partnership adjustment by the highest rate of Federal income tax in effect for the reviewed year under section 1 or 11; and

(v) Increasing or decreasing the product that results under paragraph (b)(1)(iv) of this section by-

(A) Any amounts treated as net positive adjustments (as defined in paragraph (e)(4)(i) of this section) under paragraph (e)(3)(ii) of this section; and

(B) Except as provided in paragraph (e)(3)(ii) of this section, any amounts treated as net negative adjustments (as defined in paragraph (e)(4)(ii) of this section) under paragraph (e)(3)(ii) of this section.

(2)Calculation of the total netted partnership adjustment. For purposes of determining an imputed underpayment under paragraph (b)(1) of this section, the total netted partnership adjustment is the sum of all net positive adjustments in the reallocation grouping described in paragraph (c)(2) of this section and the residual grouping described in paragraph (c)(5) of this section.

(3)Adjustments to items for which tax has been collected under chapters 3 and 4 of the Internal Revenue Code. A partnership adjustment is disregarded for purposes of calculating the imputed underpayment under paragraph (b) of this section to the extent that the IRS has collected the tax required to be withheld under chapter 3 or chapter 4 (as defined in §301.6241-6(b)(2)(ii) and (iii)) that is attributable to the partnership adjustment. See §301.6241-6(b)(3) for rules that apply when a partnership pays an imputed underpayment that includes a partnership adjustment to an amount subject to withholding (as defined in §301.6241-6(b)(2)(i)) under chapter 3 or chapter 4 for which such tax has not yet been collected.

(4)Treatment of adjustment as zero for purposes of calculating the imputed underpayment. If the effect of one partnership adjustment is reflected in one or more other partnership adjustments, the IRS may treat the one adjustment as zero solely for purposes of calculating the imputed underpayment.

(c)Grouping of partnership adjustments.

(1)In general. To determine an imputed underpayment under paragraph (b) of this section, partnership adjustments are placed into one of four groupings. These groupings are the reallocation grouping described in paragraph (c)(2) of this section, the credit grouping described in paragraph (c)(3) of this section, the creditable expenditure grouping described in paragraph (c)(4) of this section, and the residual grouping described in paragraph (c)(5) of this section. Adjustments in groupings may be placed in subgroupings, as appropriate, in accordance with paragraph (d) of this section. The IRS may, in its discretion, group adjustments in a manner other than the manner described in this paragraph (c) when such grouping would appropriately reflect the facts and circumstances. For requests to modify the groupings, see §301.6225-2(d)(6).

(2)Reallocation grouping.

(i) In general. Any adjustment that allocates or reallocates a partnership-related item to and from a particular partner or partners is a reallocation adjustment. Except in the case of an adjustment to a credit (as described in paragraph (c)(3) of this section) or to a creditable expenditure (as described in paragraph (c)(4) of this section), reallocation adjustments are placed in the reallocation grouping. Adjustments that reallocate a credit to and from a particular partner or partners are placed in the credit grouping (see paragraph (c)(3) of this section), and adjustments that reallocate a creditable expenditure to and from a particular partner or partners are placed in the creditable expenditure grouping (see paragraph (c)(4) of this section).

(ii) Each reallocation adjustment results in at least two separate adjustments. Each reallocation adjustment generally results in at least two separate adjustments. One adjustment reverses the effect of the improper allocation of a partnershiprelated item, and the other adjustment effectuates the proper allocation of the partnership-related item. Generally, a reallocation adjustment results in one positive adjustment (as defined in paragraph (d)(2)(iii) of this section) and one negative adjustment (as defined in paragraph (d)(2)(ii) of this section).

(3)Credit grouping. Each adjustment to a partnership-related item that is reported or could be reported by a partnership as a credit on the partnership’s return, including a reallocation adjustment, is placed in the credit grouping.

(4)Creditable expenditure grouping.

(i) In general. Each adjustment to a creditable expenditure, including a reallocation adjustment to a creditable expenditure, is placed in the creditable expenditure grouping.

(ii) Adjustment to a creditable expenditure.

(A) In general. For purposes of this section, an adjustment to a partnership-related item is treated as an adjustment to a creditable expenditure if 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. See §1.704-1(b)(4)(ii) of this chapter. For instance, if the adjustment is a reduction of qualified research expenses, the adjustment is to a creditable expenditure for purposes of this section 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.

(B) Creditable foreign tax expenditures. The creditable expenditure grouping includes each adjustment to a creditable foreign tax expenditure (CFTE) as defined in §1.704-1(b)(4)(viii)(b) of this chapter, including any reallocation adjustment to a CFTE.

(5)Residual grouping.

(i) In general. Any adjustment to a partnership-related item not described in paragraph (c)(2), (3), or (4) of this section is placed in the residual grouping.

(ii) Adjustments to partnershiprelated items that are not allocated under section 704(b). The residual grouping includes any adjustment to a partnership-related item 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).

(6)Recharacterization adjustments.

(i) Recharacterization adjustment defined. An adjustment that changes the character of a partnership-related item is a recharacterization adjustment. For instance, an adjustment that changes a loss from ordinary to capital or from active to passive is a recharacterization adjustment.

(ii) Grouping recharacterization adjustments. A recharacterization adjustment is placed in the appropriate grouping as described in paragraphs (c)(2) through (5) of this section.

(iii) Recharacterization adjustments result in two partnership adjustments. In general, a recharacterization adjustment results in at least two separate adjustments in the appropriate grouping under paragraph (c)(6)(ii) of this section. One adjustment reverses the improper characterization of the partnership-related item, and the other adjustment effectuates the proper characterization of the partnershiprelated item. A recharacterization adjustment results in two adjustments regardless of whether the amount of the partnership-related item is being adjusted. Generally, recharacterization adjustments result in one positive adjustment and one negative adjustment.

(d)Subgroupings.

(1)In general. If all partnership adjustments are positive adjustments, this paragraph (d) does not apply. If any partnership adjustment within any grouping described in paragraph (c) of this section is a negative adjustment, the adjustments within that grouping are subgrouped in accordance with this paragraph (d). The IRS may, in its discretion, subgroup adjustments in a manner other than the manner described in this paragraph (d) when such subgrouping would appropriately reflect the facts and circumstances. For requests to modify the subgroupings, see §301.6225-2(d)(6).

(2)Definition of negative adjustments and positive adjustments.

(i) In general. For purposes of this section, partnership adjustments made by the IRS are treated as follows:

(A) An increase in an item of gain is treated as an increase in an item of income;

(B) A decrease in an item of gain is treated as a decrease in an item of income;

(C) An increase in an item of loss or deduction is treated as a decrease in an item of income; and

(D) A decrease in an item of loss or deduction is treated as an increase in an item of income.

(ii) Negative adjustment. A negative adjustment is any adjustment that is a decrease in an item of income, a partnership adjustment treated under paragraph (d)(2)(i) of this section as a decrease in an item of income, or an increase in an item of credit.

(iii) Positive adjustment.

(A) In general. A positive adjustment is any adjustment that is not a negative adjustment as defined in paragraph (d)(2)(ii) of this section.

(B) Treatment of adjustments that cannot be allocated under section 704(b). For purposes of determining an imputed underpayment under this section, an adjustment described in paragraph (c)(5)(ii) of this section that could result in an increase in income or decrease in a loss, deduction, or credit for any person without regard to any particular person’s specific circumstances is treated, to the extent appropriate, either as a positive adjustment to income or to a credit.

(3)Subgrouping rules.

(i) In general. Except as otherwise provided in this paragraph (d)(3), an 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 partnership-related item. A negative adjustment 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 partnership-related item for purposes of section 702(a), other provision of the Code, regulations, forms, instructions, or other guidance prescribed by the IRS. For purposes of creating subgroupings under this section, 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.

(ii) Subgrouping reallocation adjustments.

(A) Reallocation adjustments in the reallocation grouping. Each positive adjustment and each negative adjustment resulting from a reallocation adjustment as described in paragraph (c)(2)(ii) of this section is placed in its own separate subgrouping within the reallocation grouping. For instance, if the reallocation adjustment reallocates a deduction from one partner to another partner, the decrease in the deduction (positive adjustment) allocated to the first partner is placed in a subgrouping within the reallocation grouping separate from the increase in the deduction (negative adjustment) allocated to the second partner. Notwithstanding the requirement that reallocation adjustments be placed into separate subgroupings, if a particular partner or group of partners has two or more reallocation adjustments allocable to such partner or group, such adjustments may be subgrouped in accordance with paragraph (d)(3)(i) of this section and netted in accordance with paragraph (e) of this section.

(B) Reallocation adjustments in the credit grouping. In the case of a reallocation adjustment to a credit, which is placed in the credit grouping pursuant to paragraph (c)(3) of this section, the decrease in credits allocable to one partner or group of partners is treated as a positive adjustment, and the increase in credits allocable to another partner or group of partners is treated as a negative adjustment. Each positive adjustment and each negative adjustment resulting from a reallocation adjustment to credits is placed in its own separate subgrouping within the credit grouping.

(iii) Subgroupings within the creditable expenditure grouping.

(A) In general. Each adjustment in the creditable expenditure grouping described in paragraph (c)(4) of this section is subgrouped in accordance with paragraphs (d)(3)(i) and (iii) of this section. For rules related to creditable expenditures other than CFTEs, see paragraph (d)(3)(iii)(C) of this section.

(B) Subgroupings for adjustments to CFTEs. Each adjustment to a CFTE is subgrouped based on the separate category of income to which the CFTE relates in accordance with section 904(d) and the regulations in part 1 of this chapter, and to account for any different allocation of the CFTE between partners. Two or more adjustments to CFTEs are included within the same subgrouping only if each adjustment relates to CFTEs in the same separate category, and each adjusted partnershiprelated item would be allocated to the partners in the same ratio had those items been properly reflected on the partnership return for the reviewed year.

(C) [Reserved]

(iv) Subgrouping recharacterization adjustments. Each positive adjustment and each negative adjustment resulting from a recharacterization adjustment as described in paragraph (c)(6) of this section is placed in its own separate subgrouping within the residual grouping. If a particular partner or group of partners has two or more recharacterization adjustments allocable to such partner or group, such adjustments may be subgrouped in accordance with paragraph (d)(3)(i) of this section and netted in accordance with paragraph (e) of this section.

(e)Netting adjustments within each grouping or subgrouping.

(1)In general. All adjustments within a subgrouping determined in accordance with paragraph (d) of this section are netted in accordance with this paragraph (e) to determine whether there is a net positive adjustment (as defined in paragraph (e)(4)(i) of this section) or net negative adjustment (as defined in paragraph (e)(4)(ii) of this section) for that subgrouping. If paragraph (d) of this section does not apply because a grouping only includes positive adjustments, all adjustments in that grouping are netted in accordance with this paragraph (e). For purposes of this paragraph (e), netting means summing all adjustments together within each grouping or subgrouping, as appropriate.

(2)Limitations on netting adjustments. Positive adjustments and negative adjustments may only be netted against each other if they are in the same grouping in accordance with paragraph (c) of this section. If a negative adjustment is in a subgrouping in accordance with paragraph (d) of this section, the negative adjustment may only net with a positive adjustment also in that same subgrouping in accordance with paragraph (d) of this section. 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.

(3)Results of netting adjustments within groupings or subgroupings.

(i) Groupings other than the credit and creditable expenditure groupings. Except as described in paragraphs (e)(3)(ii) and (iii) of this section, each net positive adjustment (as defined in paragraph (e)(4)(i) of this section) with respect to a particular grouping or subgrouping that results after netting the adjustments in accordance with this paragraph (e) is included in the calculation of the total netted partnership adjustment under paragraph (b)(2) of this section. Each net negative adjustment (as defined in paragraph (e)(4)(ii) of this section) with respect to a grouping or subgrouping that results after netting the adjustments in accordance with this paragraph (e) is excluded from the calculation of the total netted partnership adjustment under paragraph (b)(2) of this section. Adjustments underlying a net negative adjustment described in the preceding sentence are adjustments that do not result in an imputed underpayment (as described in paragraph (f) of this section).

(ii) Credit grouping. Any net positive adjustment or net negative adjustment in the credit grouping (including any such adjustment with respect to a subgrouping within the credit grouping) is excluded from the calculation of the total netted partnership adjustment. A net positive adjustment described in this paragraph (e)(3)(ii) is taken into account under paragraph (b)(1)(v) of this section. A net negative adjustment described in this paragraph (e)(3)(ii), including a negative adjustment to a credit resulting from a reallocation adjustment that was placed in a separate subgrouping pursuant to paragraph (d)(3)(ii)(B) of this section, is treated as an adjustment that does not result in an imputed underpayment in accordance with paragraph (f)(1)(i) of this section, unless the IRS determines that such net negative adjustment should be taken into account under paragraph (b)(1)(v) of this section.

(iii) Treatment of creditable expenditures.

(A) Creditable foreign tax expenditures. A net decrease to a CFTE in any CFTE subgrouping (as described in paragraph (d)(3)(iii) of this section) is treated as a net positive adjustment described in paragraph (e)(3)(ii) of this section and is excluded from the calculation of the total netted partnership adjustment under paragraph (b)(2) of this section. A net increase to a CFTE in any CFTE subgrouping is treated as a net negative adjustment described in paragraph (e)(3)(i) of this section. For rules related to creditable expenditures other than CFTEs, see paragraph (e)(3)(iii)(B) of this section.

(B) [Reserved]

(4)Net positive adjustment and net negative adjustment defined.

(i) Net positive adjustment. A net positive adjustment means an amount that is greater than zero which results from netting adjustments within a grouping or subgrouping in accordance with this paragraph (e). 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.

(ii) Net negative adjustment. A net negative adjustment means any amount which results from netting adjustments within a grouping or subgrouping in accordance with this paragraph (e) that is not a net positive adjustment (as defined in paragraph (e)(4)(i) of this section). A net negative adjustment includes a negative adjustment that was not netted with any other adjustment.

(f)Partnership adjustments that do not result in an imputed underpayment.

(1)In general. Except as otherwise provided in paragraph (e) of this section, a partnership adjustment does not result in an imputed underpayment if-

(i) After grouping, subgrouping, and netting the adjustments as described in paragraphs (c), (d), and (e) of this section, the result of netting with respect to any grouping or subgrouping that includes a particular partnership adjustment is a net negative adjustment (as described in paragraph (e)(4)(ii) of this section); or

(ii) The calculation under paragraph (b)(1) of this section results in an amount that is zero or less than zero.

(2)Treatment of an adjustment that does not result in an imputed underpayment. Any adjustment that does not result in an imputed underpayment (as described in paragraph (f)(1) of this section) is taken into account by the partnership in the adjustment year in accordance with §301.6225-3. If the partnership makes an election pursuant to section 6226 with respect to an imputed underpayment, the adjustments that do not result in that imputed underpayment that are associated with that imputed underpayment (as described in paragraph (g)(2)(iii)(B) of this section) are taken into account by the reviewed year partners in accordance with §301.6226-3.

(g)Multiple imputed underpayments in a single administrative proceeding.

(1)In general. The IRS, in its discretion, may determine that partnership adjustments for the same partnership taxable year result in more than one imputed underpayment. The determination of whether there is more than one imputed underpayment for any partnership taxable year, and if so, which partnership adjustments are taken into account to calculate any particular imputed underpayment is based on the facts and circumstances and nature of the partnership adjustments. See §301.6225-2(d)(6) for modification of the number and composition of imputed underpayments.

(2)Types of imputed underpayments.

(i) In general. There are two types of imputed underpayments: A general imputed underpayment (described in paragraph (g)(2)(ii) of this section) and a specific imputed underpayment (described in paragraph (g)(2)(iii) of this section). Each type of imputed underpayment is separately calculated in accordance with this section.

(ii) General imputed underpayment. The general imputed underpayment is calculated based on all adjustments (other than adjustments that do not result in an imputed underpayment under paragraph (f) of this section) that are not taken into account to determine a specific imputed underpayment under paragraph (g)(2)(iii) of this section. There is only one general imputed underpayment in any administrative proceeding. If there is one imputed underpayment in an administrative proceeding, it is a general imputed underpayment and may take into account adjustments described in paragraph (g)(2)(iii) of this section, if any, and all adjustments that do not result in that general imputed underpayment (as described in paragraph (f) of this section) are associated with that general imputed underpayment.

(iii) Specific imputed underpayment.

(A) In general. The IRS may, in its discretion, designate a specific imputed underpayment with respect to adjustments to a partnership-related item or items that were allocated to one partner or a group of partners that had the same or similar characteristics or that participated in the same or similar transaction or on such other basis as the IRS determines properly reflects the facts and circumstances. The IRS may designate more than one specific imputed underpayment with respect to any partnership taxable year. For instance, in a single partnership taxable year there may be a specific imputed underpayment with respect to adjustments related to a transaction affecting some, but not all, partners of the partnership (such as adjustments that are specially allocated to certain partners) and a second specific imputed underpayment with respect to adjustments resulting from a reallocation of a distributive share of income from one partner to another partner. The IRS may, in its discretion, determine that partnership adjustments that could be taken into account to calculate one or more specific imputed underpayments under this paragraph (g)(2)(iii)(A) for a partnership taxable year are more appropriately taken into account in determining the general imputed underpayment for such taxable year. For instance, the IRS may determine that it is more appropriate to calculate only the general imputed underpayment if, when calculating the specific imputed underpayment requested by the partnership, there is an increase in the number of the partnership adjustments that after grouping and netting result in net negative adjustments and are disregarded in calculating the specific imputed underpayment.

(B) Adjustments that do not result in an imputed underpayment associated with a specific imputed underpayment. If the IRS designates a specific imputed underpayment, the IRS will designate which adjustments that do not result in an imputed underpayment, if any, are appropriate to associate with that specific imputed underpayment. If the adjustments underlying that specific imputed underpayment are reallocation adjustments or recharacterization adjustments, the net negative adjustment that resulted from the reallocation or recharacterization is associated with the specific imputed underpayment. Any adjustments that do not result in an imputed underpayment that are not associated with a specific imputed underpayment under this paragraph (g)(2)(iii)(B) are associated with the general imputed underpayment.

(h)Examples. The following examples illustrate the rules of this section. For purposes of these examples, unless otherwise stated, each partnership is subject to the provisions of subchapter C of chapter 63 of the Code, each partnership and its partners are calendar year taxpayers, all partners are U.S. persons, the highest rate of income tax in effect for all taxpayers is 40 percent for all relevant periods, and no partnership requests modification under §301.6225-2.

(1)Example 1. Partnership reports on its 2019 partnership return $100 of ordinary income and an ordinary deduction of -$70. The IRS initiates an administrative proceeding with respect to Partnership’s 2019 taxable year and determines that ordinary income was $105 instead of $100 ($5 adjustment) and that the ordinary deduction was -$80 instead of -$70 (-$10 adjustment). Pursuant to paragraph (c) of this section, the adjustments are both in the residual grouping. The -$10 adjustment to the ordinary deduction would not have been netted at the partnership level with the $5 adjustment to ordinary income and would not have been required to be allocated to the partners of the partnership as a single partnership-related item for purposes of section 702(a), other provision of the Code, regulations, forms, instructions, or other guidance prescribed by the IRS. Because the -$10 adjustment to the ordinary deduction would result in a decrease in the imputed underpayment if netted with the $5 adjustment to ordinary income and because it might be limited if taken into account by any person, the -$10 adjustment must be placed in a separate subgrouping from the $5 adjustment to ordinary income. See paragraph (d)(3)(i) of this section. The total netted partnership adjustment is $5, which results in an imputed underpayment of $2. The -$10 adjustment to the ordinary deduction is a net negative amount and is an adjustment that does not result in an imputed underpayment which is taken into account by Partnership in the adjustment year in accordance with §301.6225-3.

(2)Example 2. The facts are the same as Example 1 in paragraph (h)(1) of this section, except that the -$10 adjustment to the ordinary deduction would have been netted at the partnership level with the $5 adjustment to ordinary income and would have been required to be allocated to the partners of the partnership as a single partnership-related item for purposes of section 702(a), other provision of the Code, regulations, forms, instructions, or other guidance prescribed by the IRS. Therefore, the $5 adjustment and the -$10 adjustment must be placed in the same subgrouping within the residual grouping. The $5 adjustment and the -$10 adjustments are then netted in accordance with paragraph (e) of this section. Such netting results in a net negative adjustment (as defined under paragraph (e)(4)(ii) of this section) of -$5. Pursuant to paragraph (f) of this section, the -$5 net negative adjustment is an adjustment that does not result in an imputed underpayment. Because the only net adjustment is an adjustment that does not result in an imputed underpayment, there is no imputed underpayment.

(3)Example 3. Partnership reports on its 2019 partnership return ordinary income of $300, long-term capital gain of $125, longterm capital loss of -$75, a depreciation deduction of -$100, and a tax credit that can be claimed by the partnership of $5. In an administrative proceeding with respect to Partnership’s 2019 taxable year, the IRS determines that ordinary income is $500 ($200 adjustment), long-term capital gain is $200 ($75 adjustment), long-term capital loss is -$25 ($50 adjustment), the depreciation deduction is -$70 ($30 adjustment), and the tax credit is $3 ($2 adjustment). Pursuant to paragraph (c) of this section, the adjustment to the tax credit is in the credit grouping under paragraph (c)(3) of this section. The remaining adjustments are part of the residual grouping under paragraph (c)(5) of this section. Pursuant to paragraph (d)(2) of this section, all of the adjustments in the residual grouping are positive adjustments. Because there are no negative adjustments, there are no subgroupings within the residual grouping. Under paragraph (b)(2) of this section, the adjustments in the residual grouping are summed for a total netted partnership adjustment of $355. Under paragraph (b)(1)(iv) of this section, the total netted partnership adjustment is multiplied by 40 percent (highest tax rate in effect), which results in $142. Under paragraph (b)(1)(v) of this section, the $142 is increased by the $2 credit adjustment, resulting in an imputed underpayment of $144.

(4)Example 4. Partnership reported on its 2019 partnership return long-term capital gain of $125. In an administrative proceeding with respect to Partnership’s 2019 taxable year, the IRS determines the long-term capital gain should have been reported as ordinary income of $125. There are no other adjustments for the 2019 taxable year. This recharacterization adjustment results in two adjustments in the residual grouping pursuant to paragraph (c)(6) of this section: an increase in ordinary income of $125 ($125 adjustment) as well as a decrease of longterm capital gain of $125 (-$125 adjustment). The decrease in long-term capital gain is a negative adjustment under paragraph (d)(2)(ii) of this section and the increase in ordinary income is a positive adjustment under paragraph (d)(2)(iii) of this section. Under paragraph (d)(3)(i) of this section, the adjustment to long-term capital gain is placed in a subgrouping separate from the adjustment to ordinary income because the reduction of long-term capital gain is required to be taken into account separately pursuant to section 702(a). The $125 decrease in long-term capital gain is a net negative adjustment in the long-term capital subgrouping and, as a result, is an adjustment that does not result in an imputed underpayment under paragraph (f) of this section and is taken into account in accordance with §301.6225-3. The $125 increase in ordinary income results in a net positive adjustment under paragraph (e)(4)(i) of this section. Because the ordinary subgrouping is the only subgrouping resulting in a net positive adjustment, $125 is the total netted partnership adjustment under paragraph (b)(2) of this section. Under paragraph (b)(1)(iv) of this section, $125 is multiplied by 40 percent resulting in an imputed underpayment of $50.

(5)Example 5. Partnership reported a $100 deduction for certain expenses on its 2019 partnership return and an additional $100 deduction with respect to the same type of expenses on its 2020 partnership return. The IRS initiates an administrative proceeding with respect to Partnership’s 2019 and 2020 taxable years and determines that Partnership reported a portion of the expenses as a deduction in 2019 that should have been taken into account in 2020. Therefore, for taxable year 2019, the IRS determines that Partnership should have reported a deduction of $75 with respect to the expenses ($25 adjustment in the 2019 residual grouping). For 2020, the IRS determines that Partnership should have reported a deduction of $125 with respect to these expenses (-$25 adjustment in the 2020 residual grouping). There are no other adjustments for the 2019 and 2020 partnership taxable years. Pursuant to paragraph (e)(2) of this section, the adjustments for 2019 and 2020 are not netted with each other. The 2019 adjustment of $25 is the only adjustment for that year and a net positive adjustment under paragraph (e)(4)(i) of this section, and therefore the total netted partnership adjustment for 2019 is $25 pursuant to paragraph (b)(2) of this section. The $25 total netted partnership adjustment is multiplied by 40 percent resulting in an imputed underpayment of $10 for Partnership’s 2019 taxable year. The $25 increase in the deduction for 2020, a net negative adjustment under paragraph (e)(4)(ii) of this section, is an adjustment that does not result in an imputed underpayment for that year. Therefore, there is no imputed underpayment for 2020.

(6)Example 6. On its partnership return for the 2020 taxable year, Partnership reported ordinary income of $100 and a capital gain of $50. Partnership had four equal partners during the 2020 tax year, all of whom were individuals. On its partnership return for the 2020 tax year, the capital gain was allocated to partner E and the ordinary income was allocated to all partners based on their interests in Partnership. In an administrative proceeding with respect to Partnership’s 2020 taxable year, the IRS determines that for 2020 the capital gain allocated to E should have been $75 instead of $50 and that Partnership should have recognized an additional $10 in ordinary income. In the NOPPA mailed by the IRS, the IRS may determine pursuant to paragraph (g) of this section that there is a general imputed underpayment with respect to the increase in ordinary income and a specific imputed underpayment with respect to the increase in capital gain specially allocated to E.

(7)Example 7. On its partnership return for the 2020 taxable year, Partnership reported a recourse liability of $100. During an administrative proceeding with respect to Partnership’s 2020 taxable year, the IRS determines that the $100 recourse liability should have been reported as a $100 nonrecourse liability. Under paragraph (d)(2)(iii)(B) of this section, the adjustment to the character of the liability is an adjustment to an item that cannot be allocated under section 704(b). The adjustment therefore is treated as a $100 increase in income because such recharacterization of a liability could result in up to $100 in taxable income if taken into account by any person. The $100 increase in income is a positive adjustment in the residual grouping under paragraph (c)(5)(ii) of this section. There are no other adjustments for the 2020 partnership taxable year. The $100 positive adjustment is treated as a net positive adjustment under paragraph (e)(4)(i) of this section, and the total netted partnership adjustment under paragraph (b)(2) of this section is $100. Pursuant to paragraph (b)(1) of this section, the total netted partnership adjustment is multiplied by 40 percent for an imputed underpayment of $40.

(8)Example 8. Partnership reports on its 2019 partnership return $400 of CFTEs in the general category under section 904(d). The IRS initiates an administrative proceeding with respect to Partnership’s 2019 taxable year and determines that the amount of CFTEs was $300 instead of $400 (\$100 adjustment to CFTEs). No other adjustments are made for the 2019 taxable year. The \$100 adjustment to CFTEs is placed in the creditable expenditure grouping described in paragraph (c)(4) of this section. Pursuant to paragraph (e)(3)(iii) of this section, the decrease to CFTEs in the creditable expenditure grouping is treated as a positive adjustment to (decrease in) credits in the credit grouping under paragraph (c)(3) of this section. Because no other adjustments have been made, the $100 decrease in credits produces an imputed underpayment of $100 under paragraph (b)(1) of this section.

(9)Example 9. Partnership reports on its 2019 partnership return $400 of CFTEs in the passive category under section 904(d). The IRS initiates an administrative proceeding with respect to Partnerships 2019 taxable year and determines that the CFTEs reported by Partnership were general category instead of passive category CFTEs. No other adjustments are made. Under the rules in paragraph (c)(6) of this section, an adjustment to the category of a CFTE is treated as two separate adjustments: An increase to general category CFTEs of $400 and a decrease to passive category CFTEs of $400. Both adjustments are included in the creditable expenditure grouping under paragraph (c)(4) of this section, but they are included in separate subgroupings. Therefore, the two amounts do not net. Instead, the $400 increase to CFTEs in the general category subgrouping is treated as a net negative adjustment under paragraph (e)(3)(iii)(A) of this section and is an adjustment that does not result in an imputed underpayment under paragraph (f) of this section. The decrease to CFTEs in the passive category subgrouping of the creditable expenditure grouping results in a decrease in CFTEs. Therefore, pursuant to paragraph (e)(3)(iii)(A) of this section, it is treated as a positive adjustment to (decrease in) credits in the credit grouping under paragraph (c)(3) of this section, which results in an imputed underpayment of $400 under paragraph (b)(1) of this section.

(10)Example 10. Partnership has two partners, A and B. Under the partnership agreement, $100 of the CFTE is specially allocated to A for the 2019 taxable year. The IRS initiates an administrative proceeding with respect to Partnership’s 2019 taxable year and determines that $100 of CFTE should be reallocated from A to B. Because the adjustment reallocates a creditable expenditure, paragraph (c)(4) of this section provides that it is included in the creditable expenditure grouping rather than the reallocation grouping. The partnership adjustment is a -$100 adjustment to general category CFTE allocable to A and an increase of $100 to general category CFTE allocable to B. Pursuant to paragraph (d)(3)(iii) of this section, the -$100 adjustment to general category CFTE and the increase of $100 to general category CFTE are included in separate subgroupings in the creditable expenditure grouping. The $100 increase in general category CFTEs, B-allocation subgrouping, is a net negative adjustment, which does not result in an imputed underpayment and is therefore taken into account by the partnership in the adjustment year in accordance with Sec. 301.6225-3. The net decrease to CFTEs in the general-category, A-allocation subgrouping, is treated as a positive adjustment to (decrease in) credits in the credit grouping under paragraph (c)(3) of this section, resulting in an imputed underpayment of $100 under paragraph (b)(1) of this section.

(11)Example 11. Partnership has two partners, A and B. Partnership owns two entities, DE1 and DE2, that are disregarded as separate from their owner for Federal income tax purposes and are operating in and paying taxes to foreign jurisdictions. The partnership agreement provides that all items from DE1 and DE2 are allocable to A and B in the following manner. Items related to DE1: To A 75 percent and to B 25 percent. Items related to DE2: To A 25 percent and to B 75 percent. On Partnership’s 2018 return, Partnership reports CFTEs in the general category of $300, $100 with respect to DE1 and $200 with respect to DE2. Partnership allocates the $300 of CFTEs $125 and $175 to A and B respectively. During an administrative proceeding with respect to Partnership’s 2018 taxable year, the IRS determines that Partnership understated the amount of creditable foreign tax paid by DE2 by $40 and overstated the amount of creditable foreign tax paid by DE1 by $80. No other adjustments are made. Because the two adjustments each relate to CFTEs that are subject to different allocations, the two adjustments are in different subgroupings under paragraph (d)(3)(iii)(B) of this section. The adjustment reducing the CFTEs related to DE1 results in a decrease in CFTEs within that subgrouping and under paragraph (e)(3)(iii)(A) of this section is treated as a decrease in credits in the credit grouping under paragraph (c)(3) of this section and results in an imputed underpayment of $80 under paragraph (b)(1) of this section. The increase of $40 of general category CFTE related to the DE2 subgrouping results in an increase in CFTEs within that subgrouping and is treated as a net negative adjustment, which does not result in an imputed underpayment and is taken into account in the adjustment year in accordance with Sec. 301.6225-3.

(12)Example 12. Partnership has two partners, A and B. For the 2019 taxable year, Partnership allocated $70 of long term capital loss to B as well as $30 of ordinary income. In an administrative proceeding with respect to Partnership’s 2019 taxable year, the IRS determines that the $30 of ordinary income and the $70 of long term capital loss should be reallocated from B to A. The partnership adjustments are a decrease of $30 of ordinary income (-$30 adjustment) allocated to B and a corresponding increase of $30 of ordinary income ($30 adjustment) allocated to A, as well as a decrease of $70 of long term capital loss ($70 adjustment) allocated to B and a corresponding increase of $70 of long term capital loss (-$70 adjustment) allocated to A. See paragraph (c)(2)(ii) of this section. Pursuant to paragraph (d)(3)(ii)(A) of this section, for purposes of determining the imputed underpayment, each positive adjustment and each negative adjustment allocated to A and B is placed in its own separate subgrouping. However, notwithstanding the general requirement that reallocation adjustments be subgrouped separately, the reallocation adjustments allocated to A and B may be subgrouped in accordance with paragraph (d)(3)(i) of this section because there are two reallocation adjustments allocated to each of A and B, respectively. Pursuant to paragraph (d)(3)(i) of this section, because the partnership adjustment allocated to A would not have been netted at the partnership level and would not have been allocated to A as a single partnership-related item for purposes of section 702(a), other provisions of the Code, regulations, forms, instructions, or other guidance prescribed by the IRS, the positive adjustment and the negative adjustment allocated to A remain in separate subgroupings. For the same reasons with respect to the adjustments allocated to B, the positive adjustment and the negative adjustment allocated to B also remain in separate subgroupings. As a result, the reallocation grouping would have four subgroupings, one for each adjustment: The decrease in ordinary income allocated to B (-$30 adjustment), the increase in ordinary income allocated to A ($30 adjustment), the decrease in long term capital loss allocated to B ($70 adjustment), and the increase long term capital loss allocated to A (-$70 adjustment). Pursuant to paragraph (e) of this section, no netting may occur between subgroupings. Accordingly, the ordinary income allocated to A ($30 adjustment) and the long term capital loss allocated to B ($70 adjustment) are both net positive adjustments. These net positive adjustments are added together to determine the total netted partnership adjustment of $100. The total netted partnership adjustment is multiplied by 40 percent, which results in an imputed underpayment of $40. The ordinary income allocated to B (-$30 adjustment) and the long term capital loss allocated to A (-$70 adjustment) are net negative adjustments treated as adjustments that do not result in an imputed underpayment taken into account by the partnership pursuant to Sec. 301.6225-3.

(i)Applicability date.

(1)In general. Except as provided in paragraph (i)(2) of this section, this section applies to partnership taxable years beginning after December 31, 2017, and ending after August 12, 2018.

(2)Election under §301.9100.22 in effect. This section applies to any partnership taxable year beginning after November 2, 2015 and before January 1, 2018, for which a valid election under §301.9100.22T is in effect.

T.D. 9844, 2/21/2019

The Tax Court in Brief – December 19th – December 23rd, 2022

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

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

Tax Litigation:  The Week of December 19th, 2022, through December 23rd, 2022

• Brooks v. Comm’r, T.C. Memo. 2022-122 | December 19, 2022 |Wells, J. |Docket No. 28206-15
• Ayria v Commissioner, T.C. Memo. 2022-123 | December 19, 2022 | Lauber, J.| Dkt. No. 13745-20
• Mamadou v. Comm’r, T.C. Memo. 2022-121 | December 20, 2022 | Lauber, J. | Dkt. No. 9759-21L
• Schwartz v. Comm’r, T.C. Memo. 2022-125| December 21, 2022 | Vasquez, J. | Dkt. No. 17291-14L

Starer v. Comm’r, T.C. Memo. 2022-124 | December 20, 2022 |Wells, J. |Docket No. 615-13

Summary: This 28-page opinion regards Petitioners Robert Lewis Starer and Merle Ann Starer (the “Starers”), controlling shareholders of the Bayview Corp. (Bayview), an S corporation. Bayview operated agriculture and horse-breeding businesses and served as a holding company for the Starers’ primary residence, a farm, and several unimproved subdivided properties initially marked for development. Ultimately, the Tax Court addressed six distinct issues (listed below) all stemming from the IRS’s deficiency notice issued to the Starers for tax years 2008, 2009, and 2010, which included determinations of deficiencies totaling over $1.3 million and penalties totaling over $250,000.

Boiled down in Tax Court in Brief style, the opinion regards the Starers’ tax liability arising from real property sales made by Bayview to family members and long-standing business acquaintances of the Starers (none of which appeared to have arm-length qualities in application) as well as transactions and inter-company transfers involving debt forgiveness among Bayview and two other of the Sharers’ closely held corporations, Village Builders, Inc. (Village Builders) and Historic Arms, Inc. (Historic Arms), and two later-formed grantor trusts, Old Plantation Trust and Family Plantation Trust. Village Builders operated a construction business that built modular homes. Historic Arms operated a firearms training and dealing business out of a residence in which Bayview owned but leased to the Sharers for no rent. The Starers and their related entities operated under the cash method of accounting. With regard to the real property transactions, Bayview and the Sharers (along with the purchasers) did not maintain arms-length relationships on the deals, especially in regard to Bayview’s contractual rights upon default by the purchasers, Bayview’s failure to exercise repurchase rights, and Bayview’s complete acquiescence to the substantial financial obligations owed by the defaulting purchasers. Some of the transfers appeared to be gratuitous, despite parcel valuations near $1 million.

Notice of Deficiency. The IRS conducted an examination of Bayview’s tax returns for taxable years 2008 through 2010, which led to adjustments of the Starers’ individual income tax for the same years. In the notice issued to petitioners, the IRS determined the deficiencies totaling over $1.3 million for the three-year period in issue and, pursuant to section 6662(a), penalties totaling over $250,000. The Starers timely petitioned the Tax Court for redetermination.

Key Issues and Short Answers:

(1) Whether any resulting tax liabilities from the transactions in issue should pass through to the Starers’ two grantor trusts as shareholders of record in Bayview or to Starers as reported on Bayview’s tax return?

Short Answer: No. The Sharers presented no evidence demonstrating, for these purposes, that they filed the required S Corp election or election statement as required by Treasury Regulation § 1.1361- 1(m)(2)(i) and (ii)(A).

(2) Whether the IRS’s determination that Bayview’s accounting of four transfers of property should be treated as sales rather than loans constitutes a change in Starers’ method of accounting, and if so, whether the IRS abused his discretion in making the determination?

Short Answer: The transactions in issue were sales because Bayview never intended to fulfill its repurchase obligations. And, the IRS did not abuse its discretion in making the changes to Bayview’s method of accounting.

(3) Whether two transfers of property constitute constructive distributions of appreciated property from Bayview to the Starers?

Short Answer: Yes. The transfers of two lots constituted constructive distributions of appreciated property to the Sharers as shareholders of Bayview followed by gifts or compensatory transfers to the purchasers (one a friend; the other a family member). The Starers and others in the transactions did not intend their relationship as a joint venture or partnership. And, the Sharers failed to demonstrate that Bayview’s gratuitous transfer of real property was made primarily for the benefit of Bayview.

(4) Whether the Starers’ rent-free use of their home in 2008, 2009, and 2010 constitutes a constructive dividend from Bayview to the Starers?

Short Answer: Yes, the Starers’ rent-free use of the home constituted a constructive dividend from Bayview to the Starers in the amount stipulated by them.

(5) Whether Bayview is entitled to a bad debt deduction for 2008?

Short Answer: No. The arrangement between Bayview and Village Builders lacked the objective formalities required of a bona fide debt. And, Village Builders failed to include cancellation of debt income on its 2008 Form 1120 as the 2008 Instructions for Form 1120 require. There was no indication that the corporations conducted themselves as if the transaction was a loan for which a bad debt deduction may be permitted.

(6) Whether the Starers are liable for section 6662(a) accuracy-related penalties for the years in issue?

Short Answer: No. The IRS failed to show supervisory approval for the penalties, which is a requirement for such liability pursuant to section 6751(b) of the Code. Therefore, the Sharers are not liable for accuracy-related penalties under section 6662.

Key Points of Law:

Burden of Proof. The IRS’s determinations in a notice of deficiency are generally presumed correct, and taxpayers bear the burden of proving them incorrect. See Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933).

S Corporation. In general, a corporation electing to be taxed as an S corporation does not pay tax at the corporate level. I.R.C. § 1363(a). Rather, an S corporation shareholder reports a pro rata share of the S corporation’s income, loss, and credit items on a per-share, per-day basis for the shareholder’s taxable year in which the S corporation’s taxable year ends. I.R.C. § 1366(a). An S corporation shareholder is required to recognize his or her percentage share of the S corporation’s items of income for any taxable year even if the shareholder does not receive a distribution from the S corporation for that year. Treas. Reg. § 1.1366- 1(a)(1); see also Jones v. Commissioner, T.C. Memo. 2010-112, 2010 WL 2011013, at *3.

Trusts as Shareholders of S Corporation. Certain trusts, such as a grantor trust, may be eligible shareholders of an S corporation under section 1361(c)(2). See I.R.C. § 1361(c)(2)(A)(i). Under section 671, the deemed owners of a grantor trust are taxable on the trust’s income attributable to them. See, e.g., Madorin v. Commissioner, 84 T.C. 667, 675 (1985). A trust may also be eligible to be a shareholder of an S corporation under section 1361(c)(2)(A)(v), which would treat current beneficiaries as the shareholders of the S corporation for tax purposes, or if no current beneficiaries, then the trust as the shareholder of the S corporation under section 1361(c)(2)(B)(v) (electing small business trust or ESBT). In order to qualify as an ESBT, the trust must elect to be taxed as such. This requires the filing of an ESBT election and an ESBT statement in accordance with the provisions of Treasury Regulation § 1.1361-1(m)(2)(i) and (ii)(A).

Section 481 Change in Method of Accounting Adjustment to Clearly Reflect Income. Section 446(a) sets forth the general rule that “[t]axable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.” If a taxpayer’s method of accounting does not clearly reflect income, the IRS is authorized to impose a change on the taxpayer’s method of accounting that does clearly reflect income. See I.R.C. § 446(b); Treas. Reg. § 1.446-1(b)(1). The IRS has broad discretion in determining whether a taxpayer’s method of accounting clearly reflects income. See Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (1979); RCA Corp. v. United States, 664 F.2d 881 (2d Cir. 1981). Once the IRS determines that a taxpayer’s method of accounting does not clearly reflect income and thereafter uses that legal authority to select a method of accounting that does clearly reflect income, the IRS’s selection may be challenged successfully only upon a demonstration of an abuse of discretion. See Wilkinson-Beane, Inc. v. Commissioner, 420 F.2d 352, 353 n.3 (1st Cir. 1970), aff’g T.C. Memo. 1969-79.

A “method of accounting” includes not only the taxpayer’s overall plan of accounting for gross income or deductions but also the taxpayer’s accounting treatment for any “material item” within the overall plan. Treas. Reg. §§ 1.481-1(a)(1), 1.446-1(e)(2)(ii). A material item is any item that involves the proper time for the inclusion of the item in income or the taking of a deduction. Treas. Reg. § 1.446-1(e)(2)(ii)(a). “[A] change in method of accounting does not include adjustment of any item of income or deduction that does not involve the proper time for the inclusion of the item of income or the taking of a deduction.” Treas. Reg. § 1.446- 1(e)(2)(ii)(b). Where a taxpayer’s accounting practice permanently avoids reporting of income and accordingly distorts its lifetime income, the practice is not a method of accounting and section 481(a) is inapplicable to a change of the accounting practice. Schuster’s Express, Inc. v. Commissioner, 66 T.C. 588 (1976), aff’d without published opinion, 562 F.2d 39 (2d Cir. 1977). When an accounting practice merely postpones the reporting of income, rather than permanently avoiding the reporting of income over the taxpayer’s lifetime, it involves the proper time for reporting income. See Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 510 (1989).

Constructive Transfers. Generally, unless otherwise provided, gross income under section 61 includes all accessions to wealth from whatever source derived. Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955). “[G]ain . . . constitutes taxable income when its recipient has such control over it that, as a practical matter, he derives readily realizable economic value from it. That occurs when [property] . . . is delivered by its owner to the taxpayer in a manner which allows the recipient freedom to dispose of it at will . . . .” Rogers v. Commissioner, T.C. Memo. 2011-277, 2011 WL 5885083, at *2 (quoting Rutkin v. United States, 343 U.S. 130, 137 (1952)), aff’d, 728 F.3d 673 (7th Cir. 2013).

The economic benefit is the controlling factor in determining whether gain is income. Rutkin, 343 U.S. at 137. When a corporation confers an economic benefit upon a shareholder without expectation of reimbursement, that economic benefit becomes a constructive distribution and is taxable as such. See Loftin & Woodward, Inc. v. United States, 577 F.2d 1206, 1214 (5th Cir. 1978). A distribution need not be formally declared or even intended by a corporation but can be constructive. Noble v. Commissioner, 368 F.2d 439, 442–43 (9th Cir. 1966), aff’g T.C. Memo. 1965-84. Whether a distribution is a constructive distribution depends on whether it was made primarily for the benefit of the shareholder. See Hood v. Commissioner, 115 T.C. 172, 179–80 (2000). To avoid having a distribution treated as a constructive distribution, the taxpayer must show that the corporation primarily benefited from the distribution. See id. at 181. The main focus of whether there is a constructive distribution is that the corporation has conferred a benefit on the shareholder to distribute available earnings and profits without the expectation of repayment. CTM Constr., Inc. v. Commissioner, T.C. Memo. 1988-590, 1988 Tax Ct. Memo LEXIS 619, at *11.

Petitioners maintain that they never received any ownership interest in Lot 2 in their individual names and therefore they did not receive any personal benefit or accession to wealth or derive any readily realizable economic value as a consequence of Bayview’s transfer of Lot 2 to Ravenna.

Joint Ventures – Partnerships. Joint ventures are the equivalent to partnerships for federal tax purposes. See I.R.C. § 7701(a)(2). “A partnership is generally said to be created when persons join together their money, goods, labor, or skill for the purpose of carrying on a trade, profession, or business and when there is community of interest in the profits and losses.” Commissioner v. Tower, 327 U.S. 280, 286 (1946). A partnership is an organization for the production of income to which each partner contributes one or both of the ingredients of income—capital or services. Commissioner v. Culbertson, 337 U.S. 733, 740 (1949). To decide whether a partnership exists, a court must also analyze various factors, including: (1) the contributions made by both parties to the venture; (2) the parties’ control over capital and income and the right of each party to make withdrawals; (3) whether each party shared a mutual proprietary interest in the net profits and had an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income; and (4) whether the parties exercised mutual control and assumed mutual responsibilities of the venture.

Constructive Dividend. A shareholder’s use of corporate property can result in a constructive dividend to the shareholder measured by the fair market rental value of the property. Nicholls, North, Buse Co. v. Commissioner, 56 T.C. 1225, 1240–42 (1971). The amount of the constructive dividend and Rule 91(e) requires that the Tax Court bind a taxpayer to any stipulation made with respect to the dividend amount, absent clearly contrary evidence. See Jasionowski v. Commissioner, 66 T.C. 312, 318 (1976).

Uncorroborated Testimony. The Tax Court has no obligation to accept uncorroborated self-serving testimony. Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).

Bad Debt Deduction. Section 166(a)(1) allows a deduction for any debt that becomes wholly worthless within a taxable year. To deduct a business bad debt, the taxpayer must show that the debt was created or acquired in connection with a trade or business and must also establish the amount of the debt, the worthlessness of the debt, and the year that the debt became worthless. Davis v. Commissioner, 88 T.C. 122, 142 (1987), aff’d, 866 F.2d 852 (6th Cir. 1989). An intent to establish a debtor-creditor relationship exists if, when the transfers were made, the debtor intended to repay the funds and the creditor intended to enforce repayment. See, e.g., Beaver, 55 T.C. at 91; Fisher v. Commissioner, 54 T.C. 905, 909–10 (1970). This is a question of fact. Haber v. Commissioner, 52 T.C. 255, 266 (1969), aff’d, 422 F.2d 198 (5th Cir. 1970). Factors include: (1) whether the promise to repay is evidenced by a note or other instrument that evidences indebtedness; (2) whether interest was charged or paid; (3) whether a fixed schedule for repayment and a fixed maturity date were established; (4) whether collateral was given to secure payment; (5) whether repayments were made; (6) what the source of any payments was; (7) whether the borrower had a reasonable prospect of repaying the loan and whether the lender had sufficient funds to advance the loan; and (8) whether the parties conducted themselves as if the transaction was a loan. Dixie Dairies Corp. v. Commissioner, 74 T.C. 476 (1980); see also Welch v. Commissioner, 204 F.3d 1228, 1230 (9th Cir. 2000), aff’g T.C. Memo. 1998-121; Estate of Mixon v. United States, 464 F.2d 394, 402 (5th Cir. 1972); Knutsen-Rowell, Inc. v. Commissioner, T.C. Memo. 2011-65.

Penalties. Section 6662(a) and (b)(1) and (2) imposes a 20% penalty on any portion of an underpayment of tax required to be shown on a return that is attributable to negligence 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 internal revenue laws or to exercise reasonable care in the preparation of a tax return. I.R.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(1). “Disregard” includes any careless, reckless, or intentional disregard of the Code, regulations, or certain IRS administrative guidance. I.R.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(2). An understatement of income tax is substantial if it exceeds the greater of 10% of the tax required to be shown on the return for the taxable year or $5,000. I.R.C. § 6662(d)(1)(A).

Penalties – Burdens and Procedure. Under section 7491(c), the IRS bears the burden of production regarding penalties and must come forward with sufficient evidence indicating that it is appropriate to impose penalties. Higbee v. Commissioner, 116 T.C. 438, 446–47 (2001). The IRS can meet that burden of production with regard to section 6662 by showing that the deficiencies exceed the greater of 10% of the tax required to be shown on the return or at least $5,000 for each year the penalty has been determined following a Rule 155 computation. However, part of the IRS’s burden of production in this setting includes demonstrating compliance with section 6751(b). Section 6751(b)(1) provides that “[n]o penalty . . . shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.” The IRS’s burden of production under section 7491(c) includes establishing compliance with the written supervisory approval requirement of section 6751(b). Graev v. Commissioner, 149 T.C. 485 (2017), supplementing and overruling in part 147 T.C. 460 (2016).

Insights: This Starers opinion illustrates that the IRS can and will use a taxpayer’s failure to exercise contractual rights as indicia of a taxable arrangement not indicated in the actual contracts. The Sharers (and Bayview) did not treat the real property transfers as arms-length transactions. Bayview and the related companies engaged in inter-company transfers that were not properly documented as loans, although the taxpayers’ reported them as such to the IRS. The Sharers failed to document significant financial transactions, and they failed to create, for example, temporal corporate minutes to substantiate Bayview’s business decisions that, at the time, may have been (arguably) reasonable.  When the Tax Court ultimately evaluated those past business decisions, the Court, having only the Sharers’ uncorroborated testimony, basically concluded that no reasonable business person would have conducted themselves as such; thus, leaving the Tax Court wide latitude to evaluate the IRS’s deficiency determinations under the abuse of discretion standard. The only silver lining for the Starers is that the IRS, for whatever reason, failed to show procedural compliance for the accuracy-related penalties.

All About IRS Offers in Compromise

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

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

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

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

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

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

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

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

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

(1) Doubt as to liability

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

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

(2) Doubt as to collectability

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

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

(3) Promotion of effective tax administration

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

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

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

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

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

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

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

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

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

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

Making the Offer

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

A Pending Offer

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

Returned Offers

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

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

The Taxpayer’s Ability to Pay

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

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

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

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

Taxpayer Documents

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

Equity in Assets

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

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

Ongoing Businesses

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

Net Realizable Equity

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

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

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

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

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

Jointly Held Assets

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

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

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

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

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

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

Cash

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

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

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

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

Securities and Stocks of Closely Held Entities

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

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

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

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

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

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

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

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

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

Life Insurance

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

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

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

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

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

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

Retirement or Profit-Sharing Plans

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

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

Furniture, Fixtures, and Personal Effects

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

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

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

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

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

Motor Vehicles, Airplanes, and Boats

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

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

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

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

Real Estate

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

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

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

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

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

Accounts and Notes Receivable

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

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

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

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

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

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

Income-Producing Assets

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

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

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

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

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

Example:

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

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

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

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

Inventory, Machinery, Equipment, and Tools of the Trade

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

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

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

Business as a Going Concern

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

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

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

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

Dissipation of Assets

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

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

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

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

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

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

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

Retired Debt

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

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

Future Income

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

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

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

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

Allowable Expenses

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

Necessary Expenses

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

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

National Standards

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

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

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

Housing and Utilities

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

Transportation Expenses

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

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

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

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

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

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

Other Expenses

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

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

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

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

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

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

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

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

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

Shared Expenses

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

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

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

Calculation of Future Income

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

Note:

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

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

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

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

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

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

Limited Liability Companies (LLC) Issues

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

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

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

Financial Analysis of an LLC

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

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

Financial Analysis of a Partnership Interest

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

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

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

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

Payment Terms

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

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

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

The Law

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

 I.R.C. Sec. 7122

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

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

(1) The amount of tax assessed,

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

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

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

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

(1)Partial payment required with submission

(A)Lump-sum offers

(i)In general

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

(ii)Lump-sum offer-in-compromise

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

(B)Periodic payment offers

(i)In general

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

(ii)Failure to make installment during pendency of offer

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

(2)Rules of application

(A)Use of payment

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

(B)Application of user fee

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

(C)Waiver authority

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

(3)Exception for low-income taxpayers

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

(d)Standards for evaluation of offers

(1)In general

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

(2)Allowances for basic living expenses

(A)In general

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

(B)Use of schedules

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

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

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

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

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

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

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

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

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

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

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

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

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

Treas. Reg. Sec. 301.7122-1 Compromises.

(a) In general

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

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

(b) Grounds for compromise –

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

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

(3) Promote effective tax administration.

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

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

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

(c) Special rules for evaluating offers to compromise –

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

(2) Doubt as to collectibility –

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

(ii) Nonliable spouses –

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

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

(3) Compromises to promote effective tax administration –

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

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

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

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

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

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

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

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

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

Example 1.

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

Example 2.

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

Example 3.

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

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

Example 1.

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

Example 2.

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

(d) Procedures for submission and consideration of offers –

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

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

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

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

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

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

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

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

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

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

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

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

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

(i) The amount of tax assessed;

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

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

(f) Rejection of an offer to compromise.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

(i) Statute of limitations –

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

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

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

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

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

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

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

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

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

Tax Litigation Attorneys 

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The Tax Court in Brief – September 19th – September 22nd, 2022

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

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

Tax Litigation:  The Week of September 19th, 2022, through September 22nd, 2022

• Goddard v. Comm’r; Lee, Goddard, & Duffy, LLP v. Comm’r, T.C. Memo 2022-96| September 19, 2022 | Copeland, Judge | Dkt. No. 22334-17L, 23743-18L

Vorreyer v. Comm’r / Thoma v. Comm’r / Dowson v. Comm’r, T.C. Memo 2022-97| September 21, 2022 | Greaves, Judge | Dkt. Nos. (Consolidated) 27314-16, 27846-16, 2634-19, 2636-19, 2666-19, 2670-19

Summary:  Petitioners operated an Illinois family farm individually and through several related entities, including C&J Farms and Prairieland. In 2012 C&J Farms was an S corporation for federal income tax purposes and owned equally by petitioners Chris and John Dowson. In 2014 Prairieland was treated as a general partnership for federal income tax purposes and owned equally by petitioners Lisa Dowson, Chris Dowson, Darrel Thoma, and Amy Thoma. In tax year 2012 C&J Farms owed a total of $108,9654 in property taxes, and $20,866 in utility expenses to a power company. Shareholders Chris and John Dowson directly paid these costs in 2012 on behalf of C&J Farms in proportion to their respective ownership interests in C&J Farms. Both Chris and John Dowson claimed section 162 deductions on their 2012 Forms 1040 Income Tax Return, for their respective payments. In tax year 2014 Prairieland purchased two semi-trucks for a total of $70,126 (truck expenses). Prairieland included the truck expenses as part of its claimed repairs and maintenance expense deduction on Schedule F, Profit or Loss From Farming, of its 2014 Form 1065, U.S. Return of Partnership Income. Following an audit of petitioners’ 2012 to 2014 returns, the IRS determined more than $14 million in collective deficiencies in petitioners’ income tax and over $2.8 million in penalties. The IRS then issued petitioners notices of deficiency with respect to the determined deficiencies and penalties which, among other things, disallowed the deductions for the property taxes and utility expenses on Chris and John Dowson’s 2012 individual returns and the deduction for the truck expenses as a repair expense on Prairieland’s 2014 return. Petitioners filed eight Petitions with the Tax Court seeking redetermination of the deficiencies and penalties. Following the consolidation of these eight cases, the parties filed their respective Motions for Partial Summary Judgment.

Key Issues:

(1) Whether petitioners John C. Dowson (Chris Dowson) and John J. Dowson (John Dowson) are entitled to passthrough deductions on their 2012 individual income tax returns for certain property taxes and utility expenses they paid on behalf of Chris & John Farms, Inc. (C&J Farms)?

(2) Whether expenses incurred by Prairieland Farms (Prairieland) related to the purchase of semi-trucks in tax year 2014 are fully deductible by Prairieland under section 179.2?

Primary Holdings:

(1) No. The passthrough deductions are not permitted in the S Corp scenario presented.

(2) No. A taxpayer must make an election to take advantage of a section 179 deduction with respect to qualifying expenses and that Prairieland did not make such an election on its 2014 return for the truck expenses.

Key Points of Law:

Summary Judgment Standard The purpose of summary judgment is to expedite litigation and avoid costly and unnecessary trials. FPL Grp., Inc. & Subs. v. Commissioner, 116 T.C. 73, 74 (2001). The Tax Court may grant a motion for partial summary judgment regarding an issue when there is no genuine dispute of material fact and a decision may be rendered as a matter of law. The court construes the facts and draw all inferences in the light most favorable to the nonmoving party to decide whether summary judgment is appropriate. Sundstrand Corp. v. Commissioner, 98 T.C. 518, 520 (1992), aff’d, 17 F.3d 965 (7th Cir. 1994). The nonmoving party may not rest upon the mere allegations or denials in its pleadings but must set forth specific facts showing that there is a genuine dispute for trial. Rule 121(d).

Business Expenses – Property Taxes and Utility Expenses. A taxpayer may deduct ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. 26 U.S.C. § 162(a). Deductions for personal, living, or family expenses are prohibited. Id. at § 262(a).

Deductions for Others. A taxpayer cannot deduct expenses paid on behalf of another taxpayer. Deputy v. du Pont, 308 U.S. 488, 493–99 (1940); Columbian Rope Co. v. Commissioner, 42 T.C. 800, 815 (1964). This principle extends to corporations as a corporation’s business is distinct from its shareholders. Westerman v. Commissioner, 55 T.C. 478, 482 (1970). A shareholder may not deduct as personal expenses those expenses that further the business of the corporation. Id.; Kahn v. Commissioner, 26 T.C. 273, 274–75 (1956). Although there is a recognized exception to this rule, see, e.g., Lohrke v. Commissioner, 48 T.C. 679, 684–85 (1967) (allowing a deduction by a shareholder on behalf of a corporate taxpayer for an expenditure the corporation was financially unable to pay to “protect or promote” the business), petitioners in this case do not contend that the present situation should fall within this limited exception. See Interstate Transit Lines v. Commissioner, 319 U.S. 590, 593 (1943); Int’l Trading Co. v. Commissioner, 275 F.2d 578, 584 (7th Cir. 1960) (“[U]nless the claimed deductions come clearly within the scope of the statute, they are not to be allowed.”), aff’g T.C. Memo. 1958-104.

C Corp versus S Corp. Unlike income (or loss) of a C corporation, income (or loss) of an S corporation escapes corporate-level taxation and gets “passed through” to the shareholder on a pro rata basis. See 26 U.S.C. §§ 1363(a), 1366(a)(1); Mourad v. Commissioner, 121 T.C. 1, 3 (2003), aff’d, 387 F.3d 27 (1st Cir. 2004); Berry v. Commissioner, T.C. Memo. 2021-52, at *5. Although an S corporation’s income or loss eventually flows through to the shareholders, a corporation “remains a separate taxable entity [from its shareholders] regardless of whether it is a subchapter S corporation or a subchapter C corporation.” Russell v. Commissioner, T.C. Memo. 1989-207, 1989 Tax Ct. Memo LEXIS 207, at *10. This means that the business expenses of an S corporation cannot be disregarded at the corporate level for section 162 purposes. The income of an S corporation must be matched at the corporate level against the S corporation’s expenses that were incurred to produce that income before the net income or loss amount can flow through to the shareholders. See 26 U.S.C. § 1366(a)(2) (generally defining the income or loss that flows through to an S corporation shareholder as the S corporation’s “gross income minus the deductions allowed to the [S] corporation”.

Truck Expenses. A taxpayer may elect under section 179 to deduct as a current expense the cost of certain property acquired and used in the active conduct of a trade or business and placed in service during the taxable year. 26 U.S.C. § 179(a), (c); Treas. Reg. § 1.179-5. A taxpayer must make an election to take advantage of a section 179 deduction with respect to qualifying expenses and that Prairieland did not make such an election on its 2014 return for the truck expenses. A taxpayer’s request that the Tax Court grant retroactive relief on principles of equity will likely fail because the Tax Court is not a court of equity. See Commissioner v. McCoy, 484 U.S. 3, 7 (1987); Patton v. Commissioner, 116 T.C. 206, 211 (2001).

Insights: This opinion on the issues presented provides guidance and deductibility issue-spotting for a shareholder of an S Corp and C Corp for deduction of corporate expenses paid by an individual shareholder. Such expenses paid on behalf of an S Corp may be denied deduction to the individual shareholder that pays for the expense. Limited exceptions apply, and no exception applied to this opinion. As for Prairieland’s truck expenses, Prairieland had opportunities to properly trigger deduction under section 179, but Prairieland failed to do so. And, the Tax Court is not a court of equity to grant retroactive relief on principles of equity.

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:

1. 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;
2. 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
3. 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:

1. It was not genuine or authentic;
2. It was identical to or substantially indistinguishable from a genuine mark owned by another; and
3. 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:

1. It was registered on the principal register in the United States Patent and Trademark Office; and
2. 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:

1. Conspiracy and aiding-and-abetting under 18 U.S.C. §§ 2, 371;
2. Mail and wire fraud under 18 U.S.C. §§ 1341, 1343;
3. Copyright infringement under 17 U.S.C. § 506 and 18 U.S.C. § 2319;
4. Trafficking in counterfeit labels, illicit labels, or counterfeit documentation or packaging under 18 U.S.C. § 2318;
5. Trafficking in misbranded food, drugs, and cosmetics under 21 U.S.C. §§ 331(a), 333, 343, 352, 362, and 841(a)(2); and
6. 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:

1. 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.
2. Either the documentation or the packaging was counterfeit, or the labels were counterfeit or illicit; and
3. 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]

1. 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]

1. Other Charges to Consider

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

1. Copyright infringement under 17 U.S.C. § 506 and 18 U.S.C. § 2319;
2. Trademark counterfeiting under 18 U.S.C. § 2320;
3. Mail or wire fraud under 18 U.S.C. §§ 1341, 1343;
4. Racketeer Influenced and Corrupt Organizations (RICO) under 18 U.S.C. §§ 1961-68; and
5. 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).

When unrelated enterprises transact with one another, market forces generally determine the commercial terms of their transaction—e.g., price and conditions of transfer.  But where associated enterprises transact with one another, the terms of their dealing may not be directly determined by external market forces.  When transfer pricing (the pricing between or among the entities) does not reflect objective market forces, the tax liabilities of the enterprises may be distorted.

Over time, a generally (though not universally) accepted consensus has developed in the international tax community of a concept of an “arm’s-length” transaction—a hypothetical measuring stick against which to measure the pricing and terms used by the related parties.  Where the actual terms deviate significantly from the terms that would have transpired if the transaction had been an “arm’s-length” transaction, tax authorities generally have the authority to recast the transaction and use the “arm’s-length” pricing.

In the tax treaty context, the United States generally interprets the arm’s length standard in a manner consistent with the OECD Transfer Pricing Guidelines.  The arm’s-length principle is also reflected in U.S. domestic transfer pricing provisions, particularly Code section 482. It provides that when related enterprises engage in a transaction on terms that are not arm’s-length, the taxing authorities (including the IRS) may make appropriate adjustments to the taxable income and tax liability of such related enterprises to reflect what the income and tax of these enterprises with respect to the transaction would have been had there been an arm’s-length relationship between them.

Article 9 of the OECD’s Model Tax Convention provides an authoritative statement of the arm’s length principle:

Cryptographic Hash Algorithms

Cryptography is an art of protecting and securing the communication from third parties who may or may not be our well-wishers. In any case, cryptography rescues us from being a victim of data breach and ensures that the information is accessible by only the intended receivers. It warrants this by converting information into a meaningless (sometimes meaningful) code making it difficult for a third party to make sense of our intended message. This conversion is done by following certain pre-defined steps and procedures that are collectively termed as Algorithm.  An algorithm is a set of finite steps and sequence of instructions that aimed at solving a specific problem. In our case, the algorithms which are used to convert the input of an arbitrary length to an output of a fixed length hash, are called cryptographic hash algorithms (CHA).

The cryptographic hash algorithms have certain properties in addition to what a regular hash algorithm has. When the features of Irreversibility, collision resistance, efficiency, and deterministic, added to a normal hash algorithm, it no longer remains a regular hash algorithm. It now becomes a more superior hashing algorithm called cryptographic hash algorithm.

Scope of this reading:

Although there are many CHAs, we will restrict our discussion to some of the very first CHAs along with contemporary more efficient algorithms. Further narrowing the scope of this reading, we will not be going into the details of such hashing algorithms that may only be used for hashing passwords because they tend to be very slow since we need them to be secure. In short, we will be focusing on algorithms that are being used quite frequently in cryptography for different purposes such as digital signature and message authentication. We will be steering our discussion in such a manner that it will not only enable our readers to understand the working of individual CHA but it will also provide them with hints to contextualize the shortcomings of an existing algorithm that led to the development of next, more promising, algorithm.

Message Digest-5 (MD5) and Secure Hashing Algorithm-1 (SHA-1)

MD5 and SHA-1 were two of the most popular CHAs of their times. The numeric digit after their names represents their position in reference to the number of revision that was made in the original algorithm to formulate that one. Therefore, MD5 was the fifth revision of the Message Digest Algorithm that was designed by R.L. Rivest and SHA-1 was the first revision of Secure Hashing Algorithm designed by National Security Agency (NSA).

An Overview of SHA-1

SHA-1 is a cryptographic hash algorithm that was designed by National Security Agency (NSA) back in 1995 and was added into the list of Digital Signature Algorithm. It outputs a 160-bit long hash that was considered to be secure until 2017 when it was theoretically proved that it is prone to length extension attacks. Since then, SHA-1 has been removed from the category of CHF and is no more considered secure enough to be a CHF. However, leaving that security breach discussion for another time, lets understand what SHA-1 is and how it works.

SHA-1 bears striking similarities to MD4 and MD5 as far as the structure is concerned. In this article, we have decided to explore SHA-1 because it acts as a mediator between MD5 and SHA-2 in the sense that its strengths can be studied in reference to the weaknesses of MD5 and its weaknesses can be studied in reference to the strengths of SHA-2.

As mentioned earlier, SHA-1 produces an output of 160-bit long hash which is usually rendered as a 40-digits long hexadecimal code. This bit value, as the name suggests, is a combination of 0s and 1s that appear to be completely random if we observe them in combination with the given input. That is why these CHAs are called pseudo-randomand it is one of the most important characteristics of any CHA.

For example, the 40 digits hexadecimal number for “abcd” is: 81fe8bfe87576c3ecb22426f8e57847382917acf

and a 40 digits long hexadecimal number for “aacd” is: 11b610435d3b0c855bda8ac33b9f721560d787a0)

The beauty of this CHA lies in the fact that the above-mentioned hash will remain the same as long as the input is not changed. Even the slightest of the changes in the input will completely alter the hash. Moreover, the length of hash does not depend on the size of input. It will remain same for a regular .txt file, a short video, or a complete movie.

But how exactly does SHA-1 generate the hash?

Hash Generation in SHA-1

SHA-1 has a compression function that is responsible for the generation of hash.  The primary purpose of this compression function is to combine two fixed length inputs in order to produce a single fixed length output having same size as one of the inputs. Initially, one of the inputs will be the default internal state of SHA-1 and it is set to a 160-bit long random value which is five 32-bit words (4-byte) each.

Though appear random, this default value isn’t so random. Actually, it is initialized by some constants based on certain pre-defined standards of this algorithm. The length of this default value determines the length of our hash in SHA-1 and that is why the output hash generated by SHA-1 is 160-bits long.  The second input will be our message whose hash we want to generate. The compression function takes in the message in the form of a 512-bits block at a time and keeps on setting the internal state until the message is expended.

Let’s understand the generation of hash from the below figure.

The internal state of SHA-1 is exactly copied in the compression function as one of its inputs. For the sake of simplicity, we have assumed that our message is only 512-bits long. Therefore, the second input to this compression function will be our 512-bits long message.

Essentially, SHA-1 starts with an internal state and then we bring in bits of our message (512-bits block) one at a time and we will keep on updating the internal state until no more message is left. At the end, we just read what the internal state is and that will basically be our hash. Technically, we are just taking the internal state and keep on updating it with the message until the message ends. This repetitive updating of internal state with a compression function is called MERKEL DOWN GUARD CONSTRUCTION. If the compression function is good, it will inevitably make our SHA function more secure and efficient. That is how the SHA family of hash functions primarily works.

In our case, since the message was 512-bits long, the loop will run only once to give the output hash. However, 80 rounds of SHA compression function will be performed for single run of loop to generate this output.

But why 80 rounds? Why not 50 or 100?

The logical answer to this question underlines the importance of a balance between security and efficiency. The more the number of rounds, the more will be the security but the lesser will be the efficiency of the algorithm. Therefore, there will always be a balance that needs to be maintained between the number of rounds and the security. Efficiency comes at the expense of security. The designers of SHA-1 decided to go for 80 rounds because this number of rounds was considered good against cryptanalytic attacks. In fact, It is rather more popular for preventing differential cryptoanalysis attacks that are used for attacking hashes and block ciphers

But What if the length of our message is not a multiple of 512?

In that case, either we will have a message less than 512-bits long or a fairly longer message having a length that is not a multiple of 512. For first scenario, our message is ready to be operated upon in order to become a 512-bit long. However, for the second case, we will keep on sending blocks of 512-bits to our compression function until we are left with last block which will be less than 512-bits. This message blocks will be converted to a 512-bit block by implementing the concept of Padding.

Suppose that our message is a 48-bit long message shown below:

• 0010 0110 1100 0101 0010 0110 1100 0101 1100 0101

Append 1 at the very end of your message and then this 1 will be followed by 0s.

• 0010 0110 1100 0101 0010 0110 1100 0101 1100 0101 1000 0000 0000 0000….

The message should end with 64-bit representation of our original message. 48 is equal to 0000 11. Therefore, the 512-bit long message will be something like this:

• 0010 0110 1100 0101 0010 0110 1100 0101 1100 0101 1000 0000 0000 0000…. 0000 11.

Now it is ready to be sent as an input to our compression function.

SHA-2

Unlike SHA-1, SHA-2 is not a single algorithm. Rather, it is a family of algorithms having six different hash functions including SHA-224, SHA-256, SHA-384, SHA-512, SHA-512/224, and SHA-512/256.

SHA-256 generates a 256-bit long hash or a 64 digits long hexadecimal code. it is considered to be the most suitable choice since MD5, and SHA-1 are no more secure. However, it is less efficient than either of MD5 and SHA-1.

MD5

Message-digest algorithm generates a 128-bit hash. It was initially developed for cryptographic purposes. However, its security was compromised long ago. Though it is still useful as a checksum for verification of data integrity but that too against an unintentional corruption. Primarily, it is now widely used for non-cryptographic purposes.

Though appear random, this default value isn’t so random. Actually, it is initialized by some constants based on certain pre-defined standards of this algorithm. The length of this default value determines the length of our hash in SHA-1 and that is why the output hash generated by SHA-1 is 160-bits long.  The second input will be our message whose hash we want to generate. The compression function takes in the message in the form of a 512-bits block at a time and keeps on setting the internal state until the message is expended.

Let’s understand the generation of hash from the below figure.

The internal state of SHA-1 is exactly copied in the compression function as one of its inputs. For the sake of simplicity, we have assumed that our message is only 512-bits long. Therefore, the second input to this compression function will be our 512-bits long message.

Essentially, SHA-1 starts with an internal state and then we bring in bits of our message (512-bits block) one at a time and we will keep on updating the internal state until no more message is left. At the end, we just read what the internal state is and that will basically be our hash. Technically, we are just taking the internal state and keep on updating it with the message until the message ends. This repetitive updating of internal state with a compression function is called MERKEL DOWN GUARD CONSTRUCTION. If the compression function is good, it will inevitably make our SHA function more secure and efficient. That is how the SHA family of hash functions primarily works.

In our case, since the message was 512-bits long, the loop will run only once to give the output hash. However, 80 rounds of SHA compression function will be performed for single run of loop to generate this output.

But why 80 rounds? Why not 50 or 100?

The logical answer to this question underlines the importance of a balance between security and efficiency. The more the number of rounds, the more will be the security but the lesser will be the efficiency of the algorithm. Therefore, there will always be a balance that needs to be maintained between the number of rounds and the security. Efficiency comes at the expense of security. The designers of SHA-1 decided to go for 80 rounds because this number of rounds was considered good against cryptanalytic attacks. In fact, It is rather more popular for preventing differential cryptoanalysis attacks that are used for attacking hashes and block ciphers

But What if the length of our message is not a multiple of 512?

In that case, either we will have a message less than 512-bits long or a fairly longer message having a length that is not a multiple of 512. For first scenario, our message is ready to be operated upon in order to become a 512-bit long. However, for the second case, we will keep on sending blocks of 512-bits to our compression function until we are left with last block which will be less than 512-bits. This message blocks will be converted to a 512-bit block by implementing the concept of Padding.

Suppose that our message is a 48-bit long message shown below:

• 0010 0110 1100 0101 0010 0110 1100 0101 1100 0101

Append 1 at the very end of your message and then this 1 will be followed by 0s.

• 0010 0110 1100 0101 0010 0110 1100 0101 1100 0101 1000 0000 0000 0000….

The message should end with 64-bit representation of our original message. 48 is equal to 0000 11. Therefore, the 512-bit long message will be something like this:

• 0010 0110 1100 0101 0010 0110 1100 0101 1100 0101 1000 0000 0000 0000…. 0000 11.

Now it is ready to be sent as an input to our compression function.

SHA-2

Unlike SHA-1, SHA-2 is not a single algorithm. Rather, it is a family of algorithms having six different hash functions including SHA-224, SHA-256, SHA-384, SHA-512, SHA-512/224, and SHA-512/256.

SHA-256 generates a 256-bit long hash or a 64 digits long hexadecimal code. it is considered to be the most suitable choice since MD5, and SHA-1 are no more secure. However, it is less efficient than either of MD5 and SHA-1.

MD5

Message-digest algorithm generates a 128-bit hash. It was initially developed for cryptographic purposes. However, its security was compromised long ago. Though it is still useful as a checksum for verification of data integrity but that too against an unintentional corruption. Primarily, it is now widely used for non-cryptographic purposes.

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

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

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

Summary of Unrelated Business Income Tax Laws and Regulations

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

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

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

General Rule of Unrelated Business Taxable Income

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

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

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

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

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

Regularly Carried On

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

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

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

Id. at § 1.513-1(c)(2)(i).

Exceptions to “Unrelated Trade or Business”

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

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

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

Modifications to “Unrelated Business Taxable Income”

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

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

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

Exceptions to the Modifications Applicable to Real Property and Personal Property

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

Debt-Financed Property Exceptions to the Modifications

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

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

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

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

Exceptions to Unrelated Business Income Tax Rules

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

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

See id. at § 513(a)-(a)(3).

Closing of Part 2

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

Nonprofit and Exempt Organization Attorneys

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

Using Untaxed Foreign Earnings to Recharacterize Gain from Section 311(b) Distributions or Section 964(e) Stock Sales

Introduction: Pairing Section 311(b) Distributions or Section 964(e) Stock Sales with the Section 245A DRD

U.S. multinational corporations may be able to use untaxed foreign earnings to recharacterize gain from section 311(b) distributions or section 964(e) stock sales with the section 245A dividends received deduction (“Section 245A DRD”) to treat the gain from such transaction as a tax-free dividend to the U.S. corporate shareholder. If the corporation’s untaxed foreign earnings exceed the gain from the section 311(b) distribution or the section 964(e) stock sale, the transaction may be tax-free as a result of the Section 245A DRD. As explained in detail in our prior post, the Tax Cuts and Jobs Act, Pub. L. 115-97 (2017) (the “TCJA”) enacted section 245A which provides that the foreign-source portion of dividends received by certain domestic corporations are eligible for a dividends received deduction provided that certain requirements are met. The TCJA transitioned the United States from a worldwide tax system to a quasi-territorial tax system.[1]

As part of that transition, the United States enacted the GILTI regime as a backstop to the subpart F anti-deferral regime. Generally, under GILTI, a U.S. shareholder of a controlled foreign corporation (“CFC”) must include in its gross income the U.S. shareholder’s GILTI for a taxable year (generally, income that is not otherwise subject to U.S. tax on a current basis). Despite the subpart F and GILTI regimes, certain foreign income is excluded from GILTI and may remain untaxed, on a current basis, in the United States. These untaxed earnings represent an opportunity for taxpayers as they may be able to use those untaxed foreign earnings to recharacterize gain from a section 311(b) distribution or a section 964(e) stock sale as a dividend (and tax-free to the extent of the untaxed foreign earnings) with the Section 245A DRD.

Untaxed Foreign Earnings After the Application of Subpart F and GILTI

Generally, a U.S. shareholder of a CFC must include in income its pro rata share of the CFC’s subpart F income and GILTI. Under section 951A(b) a U.S. shareholder is subject to tax on its CFCs’ combined “net CFC tested income” which is income that is not otherwise subject to U.S. tax on a current basis or specifically excluded, that exceeds the CFC’s qualified business asset investment (“QBAI”).[2] A U.S. shareholder’s net CFC tested income is the aggregate pro rata share of tested income from each of its CFCs minus the aggregate pro rata share of tested loss from each of its CFCs (but not less than zero). Accordingly, any CFC tested income that is netted against the CFC’s tested loss remains untaxed foreign earnings because it is excluded from the U.S. shareholder’s GILTI.

As discussed, generally the underlying policy for the GILTI regime was to eliminate deferral of untaxed foreign earnings and capture any income that was excluded from subpart F or not otherwise subject to current tax in the United States. Nonetheless, a CFC may continue to have untaxed foreign earnings because of the GILTI QBAI exemption and other types of gross income that are specifically excluded from the definition of “tested income” under section 951A(c)(2)(A). Relevant items of gross income that are excluded from the definition of tested income include: (i) any gross income excluded from foreign base company income (as defined in section 954) and the insurance income (as defined in section 953) of such corporation by reason of the section 954(b)(4) high tax exception (the “GILTI high-tax exclusion”),[3] (ii) any dividend received from a related person (as defined in section 954(d)(3)) (the “related-person dividend exclusion”),[4] and (iii) any foreign oil and gas extraction income (as defined in section 907(c)(1) of such corporation (the “FOGEI exclusion”).[5]

Thus, after application of subpart F and the GILTI rules the universe of untaxed foreign earnings includes income in the following categories, (i) certain tested income that was offset by tested losses, (ii) the QBAI exemption, (iii) the GILTI high-tax exclusion, (iv) the related-person dividend exclusion, and (v) the FOGEI exclusion. As discussed below, the aggregate amount of untaxed foreign earnings from the income exclusion categories noted above is tracked under section 1248 and may be used to recharacterize a stock sale or a deemed sale as a dividend to the extent of the section 1248 earnings and profits (“E&P”).

Section 1248 and Tracking Untaxed Foreign Earnings

Prior to the TCJA, any income that was not included in a U.S. shareholder’s share of subpart F income remained untaxed foreign earnings. Those untaxed foreign earnings were policed by section 1248 which generally provides that a U.S. person that sells or exchanges stock in a foreign corporation and such person owns (under section 958(a) or (b)) 10 percent or more of the total combined voting power of all classes of stock entitled to vote at any time during the five year period ending on the date of the sale or exchange of the foreign corporation stock, the U.S. person shall include the gain recognized on the sale or exchange of the foreign corporation stock as a deemed dividend (i.e., ordinary income) to the extent of the foreign corporation’s untaxed section 1248 E&P. Accordingly, section 1248 effectively served as a backstop to prevent a U.S. person that owns stock in a CFC (or a former CFC) from selling the stock of the foreign corporation to change the character of the income (i.e., capital gain on the stock sale rather than ordinary income if the earnings had been repatriated) to obtain a favorable capital gains tax rate.

Determining Untaxed Foreign Earnings and Profits Attributable to Foreign Corporation Stock 

A foreign corporation’s untaxed foreign earnings are described in section 1248(c) and are determined applying the rules in Treas. Reg. § 1.1248-2 in the case of E&P attributable to a block of stock in simple cases and Treas. Reg. § 1.1248-3 in the case of E&P attributable to a block in complex cases. The untaxed foreign earnings described above are tracked through a foreign corporation’s section 1248 E&P. Most importantly, any untaxed foreign earnings that are tracked under section 1248 are available to rechacterize any gain under a section 311(b) distribution or a section 964(e) stock sale as a dividend that is eligible for the Section 245A DRD. Thus, the greater the amount of a foreign corporation’s section 1248 E&P the greater the potential benefit of any transaction that recharacterizes the gain as a dividend to the extent of a foreign corporation’s section 1248 E&P.

Section 311(b) Distributions

Generally, non-liquidating distributions result in shareholder-level consequences to the distributee[6] under section 301 and corporate-level consequences to the distributor under section 311. Under section 311(a), a distributing corporation does not recognize gain or loss on distributions of property with respect to its stock (i.e., a section 301 transaction). However, section 311(b) provides that if a corporation distributes property in which the fair market value exceeds the distributing corporation’s basis in that property, then gain will be recognized as if the distributed property was sold to the distributee at its fair market value.[7]

For instance, consider a structure where FP, a foreign corporation, owns 100 percent of S, a domestic corporation, and S owns 100 percent of FC, a foreign corporation that is a CFC. The fair market value of S’s stock in FC exceeds its basis in FC. If S distributes its FC stock to FP, it should be treated as a section 301 distribution to which section 311(b) applies and under section 311(b)(1)(B) treated as if S had sold the FC stock to FP at its fair market value. Because the transaction is treated as if a U.S. person (S) sold the stock of a foreign corporation (FC), section 1248 applies to recharacterize S’s gain on the sale or exchange of the stock of FC, a CFC, including any gain recognized under section 301(c), as a section 1248 dividend to the extent of any untaxed foreign earnings attributable to such stock (i.e., the FC’s untaxed foreign earnings).[8] Additionally, under section 1248(j), any amount recharacterized as a deemed dividend under section 1248 is eligible for the Section 245A DRD, provided that the requirements of section 245A are met. Accordingly, FC’s untaxed foreign earnings enabled the gain realized by S on its distribution of the FC stock to FP to be recharacterized as a dividend and distributed tax-free under section 245A.

Section 964(e) Stock Sales

Similarly, under section 964(e) gain on sales of foreign corporation stock by an upper-tier CFC are treated as dividends. Section 964(e)(1), provides that a CFC that recognizes gain on the sale or exchange of stock in a foreign corporation includes such gain in the selling CFC’s gross income as a dividend “to the same extent that it would have been so included under section 1248(a) if such controlled foreign corporation were a United States person.” Thus, these rules look to the section 1248 untaxed foreign earnings of the lower-tier foreign corporation to determine the amount of gain that qualifies as a deemed dividend in the hands of the upper-tier CFC.

The section 954(c)(3)(A)(i) same-country dividend exception does not apply to such dividend; however, section 964(e)(4) provides a coordination rule of such dividends with the Section 245A DRD. Section 964(e)(4) provides that any amount treated as a dividend under section 964(e)(1) and where the selling CFC held the stock in the other foreign corporation for a year or more is treated as (i) the foreign-source portion of the dividend is treated as subpart F income of the selling CFC, (ii) the U.S. shareholder with respect to the selling CFC includes in its gross income for the taxable year that includes the CFC’s tax year end, the U.S. shareholder’s pro rata share of the amount treated as subpart F income, and (iii) the Section 245A DRD is allowable to the U.S. shareholder with respect to such subpart F income described in section 964(e)(4)(A)(ii) as if the subpart F income were a dividend received by the shareholder from the selling CFC.[9] Accordingly, in the case of a U.S.-parented group that has a chain of CFCs and lower-tier CFCs with untaxed foreign earnings, the U.S.-parented group may be able to plan into a section 964(e) stock sale to use the untaxed foreign earnings and the Section 245A DRD to recharacterize the gain from the stock sale as a dividend that is tax-free rather than foreign personal holding company income that should be includable to the selling CFC’s U.S. shareholder under section 951(a)(1)(A).

Conclusion

As discussed above, while the TCJA mostly eliminated deferral of untaxed foreign earnings, certain categories of foreign income remain untaxed. Taxpayers that have those categories of excluded income – tested income that was offset by tested losses, the QBAI exemption, the GILTI high-tax exclusion, the related-person dividend exclusion, and the FOGEI exclusion – may benefit from tax planning involving a section 311(b) distribution or a section 964(e) stock sale to recharacterize gain from these transactions as a tax-free dividend to the extent of the untaxed foreign earnings. The key to utilizing these planning strategies to recharacterize gain using untaxed foreign earnings is accurately measuring the amount of a foreign corporation’s section 1248 E&P and confirming that the requirements of section 311(b), 964(e), and section 245A are satisfied.

Expert Tax Attorneys

If you need assistance analyzing section 245A or planning section 311(b) distributions of appreciated property or section 964(e) stock sales, Freeman Law can help you navigate these complex issues and plan your transactions in a tax-efficient manner. We have experience with International and Offshore tax laws. We offer value-driven services and provide practical solutions to complex tax issues. Schedule a consultation or call (214) 984-3000 to discuss your tax concerns.

[1] The current U.S. tax system is described as “quasi-territorial” because it is a hybrid system. While the TCJA eliminated taxation of repatriated dividends it also expanded the taxation of income accrued within CFCs by enacting the global intangible low taxed income (“GILTI”) regime as a backstop to the subpart F anti-deferral regime. Thus, despite the Section 245A DRD, the Code still taxes certain foreign income.

[2] QBAI is a CFC’s average quarterly basis in depreciable tangible property used in a trade or business for the production of tested income.

[3] See section 951A(c)(2)(A)(i)(III), Treas. Reg. § 1.951A-2(c)(1)(iii). On July 23, 2020, Treasury and the IRS published final regulations in T.D. 9902 clarifying the GILTI high-tax exclusion. Generally, the final regulations provide that a “controlling domestic shareholder” of a CFC must make an election, on an annual basis, to apply the GILTI high-tax exclusion. See Treas. Reg. § 1.951A-2(c)(7)(viii)(A)(1). The election is binding on all other U.S. shareholders of the CFC and the election applies to all CFCs in a controlling domestic shareholder group. See Treas. Reg. § 1.951A-2(c)(7)(viii)(E).

[4] Section 951A(c)(2)(A)(i)(IV).

[5] Section 951A(c)(2)(A)(i)(V).

[6] At the shareholder level, the amount distributed is treated first as a dividend to the extent of the distributing corporation’s current or accumulated E&P under section 301(c)(1).  Second, as a return of the distributee shareholder’s stock basis in the distributor under section 301(c)(2). And third, any remaining gain that exceeds the distributor’s current and accumulated earnings and profits and the distributee shareholder’s stock basis in the distributor, is treated as a capital gain under section 301(c)(3).

[7] Gain recognized under section 311(b) is determined on an asset-by-asset basis. Accordingly, if both appreciated and depreciated property is distributed, gain recognized on the appreciated property is not offset by loss on the depreciated property.

[8] Note that if the facts were slightly modified and FP was instead a U.S. parent corporation that owned 100 percent of the stock of S, the section 311(b) gain recognized by S should be deferred under Treas. Reg. § 1.1502-13 until it is required to be included in income under the matching rule of Treas. Reg. § 1.1502-13(c) or the acceleration rule of Treas. Reg. § 1.1502-13(d).

[9] Section 964(e)(4)(A)(i) – (iii)