Recent Developments in Federal income Taxation: The Year 2021

VI. Corporations

A. Entity and Formation

There were no significant developments regarding this topic during 2021.

B. Distributions and Redemptions

1. Tax Court holds management fees paid by C corporation to its shareholders were constructive dividends.

The issue in Aspro, Inc. v. Commissioner was whether Aspro, Inc. (Aspro) was entitled to deduct management fees paid to its shareholders. Aspro was an Iowa C corporation for federal tax purposes and was engaged in the asphalt paving business. The company had three shareholders: Jackson Enterprises, Corp. (40%) (Jackson), Mannatt’s Enterprises, Ltd. (40%), and Mr. Dakovich, Aspro’s president (20%). In each year relevant to this dispute, the shareholders received, among other forms of payment, substantial management fees that Aspro deducted. In examining whether the payments were in fact distributions of earnings rather than compensation for services rendered, the Tax Court (Judge Pugh) turned for guidance to Regulation section 1.162-7(b)(1), which governs the classification of such payments. This regulation provides:

Any amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible. An ostensible salary paid by a corporation may be a distribution of a dividend on stock. This is likely to occur in the case of a corporation having few shareholders, practically all of whom draw salaries. If in such a case the salaries are in excess of those ordinarily paid for similar services and the excessive payments correspond or bear a close relationship to the stockholdings of the officers or employees, it would seem likely that the salaries are not paid wholly for services rendered, but that the excessive payments are a distribution of earnings upon the stock.

The Tax Court concluded that Aspro had failed to show the management fees were paid purely or wholly for services and agreed with the Service that Aspro could not deduct the fees. The Tax Court came to this conclusion for numerous reasons. Aspro did not enter into any written agreement and did not agree on any management fee rate or billing structure with any one or more of its shareholders. Rather, the board of directors approved management fees each year. The minutes of the board of directors’ meetings did not reflect how the directors determined to approve the management fees paid to the shareholders. The board did not attempt to value or quantify any of the management services performed. The management fees paid to each shareholder were approximately the same each year even though the services provided by each shareholder varied from year to year. The percentage of management fees paid roughly corresponded to each of the three shareholders’ respective ownership interests. Aspro paid the management fees as a lump sum at the end of each year even though services were rendered throughout the year. Another circumstance that influenced the Tax Court was the coincidence that Aspro had very little income after deducting management fees. Finally, it was unfortunate for Aspro that none of the witnesses that testified could explain how the company had determined the appropriate amount of management fees. The testimony regarding how management fees were valued was vague and contradictory. No expert testimony was introduced to aid the court in establishing the reasonableness of the amounts paid for the purported management services. For these reasons, Aspro failed to prove that the management fees it had paid to shareholders qualified as compensation for services rendered.

Whether management fees along with other compensation paid to Mr. Dakovich was reasonable compensation. Having found at every turn that Aspro had failed to provide any evidence to support its deduction for management fees as compensation for services rendered, the court then turned to whether the payments to Mr. Dakovich in his capacity as president of the company were deductible as reasonable compensation. With respect to shareholder-employees, one approach to determining reasonable compensation commonly used by courts is a multi-factor test. The Tax Court relied on these factors and on the analysis in the report of the Service’s expert, Mr. Nunes (the Nunes Report), which the court found persuasive. Mr. Dakovich had decades of experience as Aspro’s top executive. He had wide-ranging duties and worked long hours. Only this factor was found to weigh in favor of treating Mr. Dakovich’s compensation as reasonable. On the other hand, under the prevailing economic conditions, which were found to be stable, Aspro’s sales declined by seven percent. Further, the Nunes Report supported a finding that individuals with positions similar to Mr. Dakovich within the same industry had an upper quartile compensation rate substantially less than Mr. Dakovich did. Because the management fees paid to Mr. Dakovich were in addition to his salary, and his salary was in excess of that paid to individuals in comparable positions, this factor weighed heavily against treating the management fees as reasonable compensation. In computing compensation paid to shareholders as a percentage of net income before shareholder compensation is paid, the Tax Court found that Aspro’s shareholder compensation was 90%, over 100%, and 67% of net income for the years in issue. These high percentages were found to weigh against treating the amounts paid to Mr. Dakovich as reasonable compensation. Finally, the Tax Court observed that Aspro had never paid dividends. By paying such high shareholder compensation, Aspro was less profitable than its industry peers. Low profits led to low retained earnings which, in turn, led to low returns for Aspro shareholders. Needless to say, the Tax Court found Mr. Dakovich’s compensation to be unreasonably high.

Aftermath and observations. Because the management fees that Aspro paid to its shareholders did not constitute reasonable compensation, the court upheld the Service’s disallowance of the corporation’s deductions and treated the management fees as nondeductible distributions to shareholders. The decision presents a roadmap of how not to approach compensation of shareholders who provide services to the corporation. In the inverse, this case provides an excellent menu of how a closely held C corporation can structure reasonable compensation and avoid or survive a challenge by the Service. Given the court’s heavy reliance on the Nunes Report, one of the most important steps that might be taken is to seek a qualified valuation expert who can support the compensation paid by the corporation to employee-shareholders in high level positions.

2. Tax Court holds rent paid by a corporation to its shareholders is partially a constructive dividend.

In Plentywood Drug, Inc. v. Commissioner, Plentywood Drug, Inc. (Plentywood) is a Montana C corporation that operates a pharmacy in a building located in Plentywood, Montana, that the corporation occupies as a tenant. Plentywood has four shareholders (two married couples). In their individual capacities, the four shareholders equally co-own the building that is leased by Plentywood. In 2011, Plentywood paid a total of $83,548 in rent to the four shareholders. In 2012 and the following year, the rent was increased to $192,000. By having the corporation deduct the rent from its income each year, Plentywood and its shareholders were able, to an extent, to avoid the normal double taxation of a C corporation’s income. On audit, the Service disallowed substantial portions of the rental deductions and took the position that the rent paid far exceeded what the fair market rent would have been in each of the years. In the words of Judge Holmes, the Service “lassoed” the shareholder owners of the building, characterized a portion of the rents as nondeductible constructive dividends to the four shareholders, and then “branded” the shareholders and the corporation with accuracy-related penalties. The Tax Court noted that the Service does not often question the reasonableness of rents, but sometimes does so when the “landlord and tenant might not have an incentive to drive a hard bargain”:

“When there is a close relationship between lessor and lessee and in addition there is no arm’s length dealing between them, an inquiry into what constitutes reasonable rental is necessary to determine whether the sum paid is in excess of what the lessee would have been required to pay had he dealt at arm’s length with a stranger.”

The issue was whether the rent paid by Plentywood to the four shareholders was a fair market rent. To the extent that the rent paid by Plentywood exceeded a fair market rent, the excess of the actual rent paid over a fair market rent would be a constructive dividend to the shareholders. As is typical in valuation cases, each side introduced expert testimony. The determination of a fair market rent was made more difficult by the small size of the town of Plentywood, which had a population of only 1,700. The taxpayer and the Service each criticized the methodology and conclusion of the opposing side’s expert. For example, the Service argued that Plentywood’s expert did not adhere to the Uniform Standards of Professional Appraisal Practice (USPAP). The USPAP, the court noted, are not federal rules of evidence. Although Montana requires licensed appraisers to follow USPAP, the court relied on its prior decisions in which it had declined to adopt USPAP as the sole standard for reliability of an expert appraiser. According to the court, although the failure of Plentywood’s expert to follow USPAP may adversely affect the weight the court gives to expert testimony, it does not, by itself, make the testimony so unreliable as to be inadmissible.

The court had its own criticisms of the methodology used by each side’s expert. For example, Judge Holmes was critical of the use by Plentywood’s expert of comparables from the neighboring town of Williston, Montana, which is eight times larger than the town of Plentywood and had experienced an economic boom in the oil industry that affected rents. Judge Holmes was also critical of the use by the Service’s expert of two government-subsidized multifamily residential housing units and a very small donut shop as comparable properties in assessing the rent paid for space used for a retail drug store operation. Instead, Judge Holmes focused on the Post Office building in Williston as the most comparable building for purposes of determining a fair market rent. To “round up” the analysis of the Tax Court here, Plentywood, Inc. and its shareholders asserted that the annual rent of $192,000 per year was reasonable while the Tax Court concluded that the fair market rent for the space was $171,187.50.

Finally, the court declined to uphold the accuracy-related penalties the Service sought to impose under section 6662(a) on the shareholders because the Service had failed to meet its burden of production to show that it had obtained supervisory approval of the initial determination of the penalties as required by section 6751(b). The corporation, the court reasoned, could not rely on section 6751(b) to avoid accuracy-related penalties because the corporation bore the burden of production for its own case and had failed to show that the Service had not obtained the required supervisory approval. Nevertheless, the court concluded, the corporation was not subject to accuracy-related penalties because neither ground relied on by the Service (substantial understatement of income or negligence or disregard of rules) was satisfied. Given that the rent in question was overstated by only approximately $20,000, the court concluded, there was no substantial understatement of income as that term is defined in section 6662(d)(1)(B). And given the difficulty in determining a fair market rent and the small overstatement of rent that occurred, the corporation had a reasonable cause, good-faith defense to the claim that it had been negligent or disregarded rules. As valuation opinions go, one could reasonably conclude that these Montana taxpayers “wrangled” an excellent outcome.

3. More than 30 years after the Technical and Miscellaneous Revenue Act of 1988, the regulations under section 301 are updated to make conforming changes.

The Service and the Treasury Department have finalized, with no substantive changes, proposed regulations issued in 2019 under section 301 regarding corporate distributions to reflect statutory changes made by the Technical and Miscellaneous Revenue Act of 1988. The Technical and Miscellaneous Revenue Act of 1988 amended sections 301(b)(1) and 301(d), effective as if the amendments had been included in the Tax Reform Act of 1986, to eliminate certain distinctions that previously existed between corporate and noncorporate distributees and certain special rules for distributions to or from foreign corporations. As amended, these statutory provisions state that the amount of a corporate distribution is the amount of money received plus the fair market value of property received (section 301(b)(1)), and that the basis of property received from a corporation is the fair market value of that property (section 301(d)). These final amendments update Regulation section 1.301-1 to reflect these changes and make certain nonsubstantive changes including modifying cross-references and reorganizing some provisions. Although the final regulations apply to distributions made after September 22, 2021, the statutory changes that they reflect are already effective and apply to distributions made in taxable years beginning after December 31, 1986.

C. Liquidations

There were no significant developments regarding this topic during 2021.

D. S Corporations

There were no significant developments regarding this topic during 2021.

E. Mergers, Acquisitions, and Reorganizations

1. Wait, what? “I want a do-over” seems to have worked. The Tax Court allowed taxpayer to disavow the form of its issuance of stock in exchange for assets in favor of the substance of the transaction and thereby deduct amortization expenses.

The opinion of the Tax Court (Judge Halpern) in Complex Media, Inc. v. Commissioner is lengthy (more than 100 pages) and complex and could well have been classified by the court as a Tax Court division opinion. The opinion is novel in that the Tax Court allowed the petitioner, Complex Media, Inc. (CMI), to disavow the original form of its stock-for-assets transaction in favor of a different form, which allowed CMI to increase the amortizable basis of a portion of the intangible assets it received when it issued stock in exchange for assets in a transaction purportedly subject to section 351.

On audit, the Service disallowed amortization deductions claimed by CMI with respect to intangible assets CMI had acquired from a limited liability company (LLC) classified for federal tax purposes as a partnership, Complex Media Holdings, LLC (CMH LLC). At the time of CMI’s acquisition of the assets, Mr. Gerszberg, who was a member of (i.e., partner in) CMH LLC, was not interested in the acquisition and wanted to have his partnership interest redeemed. However, CMH LLC did not have sufficient liquid funds to redeem Mr. Gerszberg’s partnership interest prior to the transaction. In order to accomplish certain goals, CMI engaged in multiple related steps of an overall transaction. In one step, CMI acquired OnNetworks, Inc. (ONI) through a newly formed, wholly owned corporate subsidiary (Acquisition Sub) of CMI that merged into ONI. After the merger, CMI’s Acquisition Sub ceased to exist and only ONI remained. Pursuant to the merger agreement, the original shareholders of ONI exchanged stock in ONI for preferred stock in CMI. Contemporaneous with the ONI merger transaction, CMH LLC contributed assets it acquired from its two lower tier LLCs to CMI with CMH LLC receiving CMI stock in the exchange. Immediately after CMH LLC’s contribution of assets in exchange for CMI stock, CMI redeemed a portion of its shares back from CMH LLC. The total consideration paid by CMI in the redemption was $3 million, with $2,700,000 being paid up front and $300,000 to be paid later. The $3 million of cash was then used by CMH LLC to completely redeem Mr. Gerszberg’s partnership interest in CMH LLC. CMI and CMH LLC agreed in the relevant documents setting forth the parties’ agreement to treat CMH LLC’s contribution of assets in exchange for CMI stock as a transaction eligible for nonrecognition pursuant to section 351(a) and to treat CMI’s redemption of a portion of the shares issued to CMH LLC as a separate transaction. However, CMI reported on its corporate return that the $3 million paid to redeem a portion of the shares held by CMH LLC was taxable boot in the section 351 transaction, which triggered gain recognition for CMH LLC and increased CMI’s basis in the assets it received by the amount of gain recognized by CMH LLC. CMI took amortization deductions under section 197 calculated on the assumption that CMH LLC recognized gain of $3 million from its receipt of boot (i.e., CMI increased its basis in the assets by $3 million). Stated another way, CMI initially agreed to treat the transactions as a section 351 nonrecognition transaction in which it acquired assets from CMH LLC with the same basis that CMH LLC had in those assets, followed by a redemption of stock owned by CMH LLC in a separate transaction. But, after the fact, CMI treated the $3 million redemption as boot paid in the section 351 transaction. The Service, however, argued that CMI was bound by the form of the transaction it had chosen (i.e., a nontaxable transaction subject to section 351 with no boot) and that CMI therefore was not entitled to a step-up of $3 million in the basis of the intangible assets received.

The issues. According to the Tax Court, the issues were (1) whether the tax consequences to CMI should follow the form of its written agreement wherein CMI issued shares of stock in exchange for assets in a transaction that qualified for nonrecognition under section 351, (2) if not, whether, the transaction should be recharacterized under the step-transaction doctrine to treat as taxable boot the $2.7 million in cash and the right to an additional $300,000 ($3 million total) that CMI paid to CMH LLC in redemption of CMI shares, and (3) if the step-transaction doctrine applied, what portion of the boot received by CMH LLC in the exchange was allocable to certain section 197 intangibles thereby increasing CMI’s amortizable basis in such intangibles. The increased basis and resulting amortization deductions related to these intangibles were at the core of this dispute between CMI and the Service.

Whether the tax consequences must follow the form of CMI’s written agreement. Initially, the Tax Court noted that CMI and the Service both agreed that CMI acquired the assets from CMH LLC in a transaction eligible for nonrecognition under section 351. If the transaction did qualify for nonrecognition under section 351 and CMI’s redemption of a portion of the stock held by CMH LLC was a separate transaction, then CMI would have inherited CMH LLC’s basis in the assets that CMH LLC transferred. If the transaction qualified for nonrecognition under section 351 but the $3 million paid to redeem a portion of CMH LLC’s stock was taxable boot, then CMI’s basis in the assets it acquired would have increased by the portion of the $3 million boot allocated to the intangibles. In contrast, if the transaction did not qualify for nonrecognition under section 351, then CMH LLC’s contribution of assets in exchange for CMI stock would have been a taxable asset acquisition that would have allowed CMI to capitalize the full $7,616,852 value of the intangible assets and amortize that amount. CMI and the Service both argued that the transaction qualified for nonrecognition under section 351. They differed as to the appropriate treatment of the $3 million CMI paid to redeem a portion of the shares held by CMH LLC. CMI asserted that the $3 million was boot in the section 351 transaction and the Service argued that the $3 million was a separate redemption of stock that did not affect CMI’s basis in the assets it acquired from CMH LLC (i.e., the Service asserted that CMI was bound by the form and tax treatment of the transaction to which it had agreed in the relevant documentation).

The Tax Court expressed skepticism that the control test of section 351(a), which requires that those transferring property to the corporation own stock possessing at least 80% of total combined voting power and value immediately after the exchange, was met. CMI argued that both the ONI shareholders, who received preferred stock, and CMH LLC shareholders should be considered together for purposes of determining control. Together, CMH LLC and ONI shareholders owned 100% of CMI after the transaction. The Tax Court concluded, however, that the ONI shareholders had not contributed property to CMI and therefore could not be included in determining control. CMH LLC clearly had transferred property to CMI in exchange for CMI common stock, but CMH LLC by itself was not “in control” of CMI immediately after the exchange as required under section 351(a). Although the Tax Court was not convinced that CMH LLC’s transfer of assets to CMI in exchange for CMI stock qualified for nonrecognition under section 351, the court nevertheless treated the transaction as qualifying under section 351. The court reasoned that CMI was the only party that would benefit from a determination that its acquisition of assets was a taxable purchase rather than a section 351 exchange, that CMI had steadfastly maintained that the acquisition was covered by section 351, and that the duty of consistency might well prevent CMI from taking a contrary position.

Having concluded that it would accept the parties’ characterization of the transaction as one that qualified under section 351, the court turned to the appropriate treatment of the $3 million that CMI paid to redeem a portion of the stock held by CMH LLC. The court began this analysis by quoting the rule of law adopted by the Court of Appeals for the Third Circuit in Commissioner v. Danielson, in which the court stated:

a party can challenge the tax consequences of his agreement as construed by the Commissioner only by adducing proof which in an action between parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc.

The Service argued that, because CMI did not challenge the relevant agreements on grounds of fraud, mistake, undue influence, or duress, CMI could not deviate from the terms of the agreements, but the Tax Court disagreed. The Tax Court also acknowledged the rule in Ullman v. Commissioner, in which the Court of Appeals for the Second Circuit held that a taxpayer may not be required to adhere to the form of its agreement if there is “strong proof” that the terms of the agreement do not comport with economic reality. While CMI did not claim that it satisfied the strong proof standard by proving that the provisions of the relevant agreements did not reflect economic reality, CMI did claim that the strong proof test did not apply because neither the policy concerns of that test nor the policy concerns in Danielson were raised by the facts of the case. According to CMI, this was so because the parties involved ultimately treated it as a section 351 transaction with $3 million of boot. Mr. Gerszberg, whose interest in CMH LLC was redeemed with the cash received from CMI, reported the funds as income on his individual tax return. CMI treated the payment as taxable boot, stepped up its basis in the section 197 intangibles received in the exchange, and calculated its amortization deductions on the stepped-up basis. As discussed below, the Tax Court ultimately permitted CMI to disavow the form of its transaction and treat the $3 million paid to CMH LLC as taxable boot rather than an amount paid to redeem stock, but first had to address what showing a taxpayer must make in order to disavow the form of a transaction.

What a taxpayer must show to disavow the form of a transaction. The Tax Court noted that it was, at one time, less willing to allow a taxpayer to disavow the form of a transaction but “has become more hospitable” to doing so. After a lengthy review of prior decisions addressing this issue, the court concluded “that the additional burden the taxpayer has to meet in disavowing transactional form relates not to the quantum of evidence but instead to its content—not how much evidence but what that evidence must show by the usual preponderance.” More specifically, the Tax Court concluded:

The Commissioner can succeed in disregarding the form of a transaction by showing that the form in which the taxpayer cast the transaction does not reflect its economic substance. For the taxpayer to disavow the form it chose (or at least acquiesced to), it must make that showing and more. In particular, the taxpayer must establish that the form of the transaction was not chosen for the purpose of obtaining tax benefits (to either the taxpayer itself, as in Estate of Durkin, or to a counterparty, as in Coleman) that are inconsistent with those the taxpayer seeks through disregarding that form. When the form that the taxpayer seeks to disavow was chosen for reasons other than providing tax benefits inconsistent with those the taxpayer seeks, the policy concerns articulated in Danielson will not be present.

After reviewing at length how the transaction would be taxed under the form to which CMI had agreed and how it would be taxed under the form that CMI reflected on its corporate tax return, and the reasons why CMI might have selected the form it chose, the court concluded that it had no reason to believe that tax benefits were the goal of CMI’s planning or that such planning would be inconsistent with allowing CMI to obtain a basis step-up in the assets it acquired from CMH LLC. The Tax Court therefore concluded that CMI could rely on the substance-over-form doctrine and turned to the question of how the step-transaction doctrine applied. Under the step-transaction doctrine, the court reasoned, CMI was required to disregard the step in which it issued and immediately redeemed for $3 million a portion of the shares issued to CMH LLC because that step did not have economic substance. By application of the step-transaction doctrine, the Tax Court concluded that CMI should be treated as having acquired assets from CMH LLC in exchange for shares of stock and boot of $3 million.

Assuming the transaction is recharacterized under the step-transaction doctrine, whether a portion of the gain recognized by CMH LLC in the exchange was allocable to certain section 197 intangibles. Finally, the court addressed the specific amount of the basis increase to amortizable section 197 intangibles to which CMI was entitled. The court applied the residual allocation method of section 1060 by subtracting from the total value of assets received by CMI ($8 million) the estimated total value of the assets that were not section 197 intangibles (roughly $383,000) to arrive at the value allocated to the section 197 intangibles (roughly $7.62 million). Because the section 197 intangibles were worth approximately 95% of the total assets received by CMI, the court assigned the same percentage of the boot received by CMH LLC to the section 197 intangibles to determine the basis increase in the intangibles to which CMI was entitled.

F. Corporate Divisions

There were no significant developments regarding this topic during 2021.

G. Affiliated Corporations and Consolidated Returns

There were no significant developments regarding this topic during 2021.

H. Miscellaneous Corporate Issues

1. After more than 200 pages, how about next time we just flip a coin? Four Circuits have rejected the government’s argument that the substance-over-form doctrine applies to recharacterize the ownership of DISC or FSC stock by a Roth IRA.

The following cases dramatically illustrate the uncertainties faced by advisors, the Service, and the courts when deciding between transactions that constitute creative but legitimate tax planning and those that are considered “abusive.” The cases involve taxpayers using statutorily sanctioned tax-planning devices in tandem (Roth IRAs coupled with a DISC or a FSC). Four Courts of Appeal have rejected the government’s argument that the substance-over-form doctrine applies to recharacterize the ownership of DISC or FSC stock by a Roth IRA. If this is no surprise to you, you can stop here. If you are intrigued, read further.

a. Form is substance, says the Sixth Circuit. The Service is precluded from recharacterizing a corporation’s payments to a DISC held by a Roth IRA. In Summa Holdings, Inc. v. Commissioner, two members of the Benenson family each established a Roth IRA by contributing $3,500. Each Roth IRA paid $1,500 for shares of a Domestic International Sales Corporation (DISC). These members of the Benenson family were the beneficial owners of 76.05% of the shares of Summa Holdings, Inc., the taxpayer in this case and a Subchapter C corporation. Summa Holdings paid (and deducted) commissions to the DISC, which paid no tax on the commissions. The DISC distributed dividends to each of the Roth IRAs, which paid unrelated-business-income tax on the dividends (at roughly a 33% rate according to the court) pursuant to section 995(g). (The structure involved a holding company between the Roth IRA and the DISC, but the presence of the holding company appears not to have affected the tax consequences.) This arrangement allowed the balance of each Roth IRA to grow rapidly. From 2002 to 2008, the Benensons transferred approximately $5.2 million from Summa Holdings to the Roth IRAs through this arrangement, including $1.5 million in 2008, the year in issue. By 2008, each Roth IRA had accumulated over $3 million. The Service took the position that the arrangement was an impermissible way to avoid the contribution limits that apply to Roth IRAs. The Service disallowed the deductions of Summa Holdings for the commissions paid to the DISC and asserted that, under the substance-over-form doctrine, the arrangement should be recharacterized as the payment of dividends by Summa Holdings to its shareholders, followed by contributions to the Roth IRAs by the two members of the Benenson family who established them. The Service determined that each Roth IRA had received a deemed contribution of $1.1 million. By virtue of their level of income, the two Benenson family members were ineligible to make any Roth IRA contributions. Pursuant to section 4973, the Service imposed a six percent excise tax on the excess contributions.

The Tax Court’s decision (Summa I). The Tax Court (Judge Kerrigan) upheld the Service’s recharacterization. Judge Kerrigan relied upon Repetto v. Commissioner and Notice 2004-8, both of which addressed using related-party businesses and Roth IRAs in tandem to circumvent excess contribution limits. Foreshadowing its argument in Repetto, the Service had announced in Notice 2004-8 that these arrangements were listed transactions and that it would attack the arrangements on several grounds, including “that the substance of the transaction is that the amount of the value shifted from the Business to the Roth IRA Corporation is a payment to the Taxpayer, followed by a contribution by the Taxpayer to the Roth IRA and a contribution by the Roth IRA to the Roth IRA Corporation.” Importantly, subsequent Tax Court decisions, Polowniak v. Commissioner and Block Developers, LLC v. Commissioner adopted the Service’s position in Notice 2004-8 and struck down tandem Roth IRA/related-party business arrangements like the one under scrutiny in Summa I.

The Sixth Circuit’s decision (Summa (II)). In an opinion by Judge Sutton, the Court of Appeals for the Sixth Circuit reversed. The court emphasized that “[t]he Internal Revenue Code allowed Summa Holdings and the Benensons to do what they did.” The issue was whether the Service’s application of the substance-over-form doctrine was appropriate. The court first expressed a great deal of skepticism about the doctrine:

Each word of the “substance-over-form doctrine,” at least as the Commissioner has used it here, should give pause. If the government can undo transactions that the terms of the Code expressly authorize, it’s fair to ask what the point of making these terms accessible to the taxpayer and binding on the tax collector is. “Form” is “substance” when it comes to law. The words of law (its form) determine content (its substance). How odd, then, to permit the tax collector to reverse the sequence—to allow him to determine the substance of a law and to make it govern “over” the written form of the law—and to call it a “doctrine” no less.

Although the court expressed the view that application of the substance-over-form doctrine makes sense when a “taxpayer’s formal characterization of a transaction fails to capture economic reality and would distort the meaning of the Code in the process,” this was not such a case. The substance-over-form doctrine as applied by the Service in this case, the court stated, was a “distinct version” under which the Service claims the power to recharacterize a transaction when there are two possible options for structuring a transaction that lead to the same result and the taxpayer chooses the lower-tax option. The court concluded that the Service’s recharacterization of Summa Holding’s transactions as dividends followed by Roth IRA contributions did “not capture economic reality any better than the taxpayer’s chosen structure of DISC commissions followed by dividends to the DISC’s shareholders.”

b. The First Circuit has agreed with the Sixth Circuit and declined to recharacterize a corporation’s payments to a DISC held by a Roth IRA. In an opinion by Judge Stahl in Benenson v. Commissioner, the Court of Appeals for the First Circuit has upheld the same Roth IRA-DISC transaction considered by the Tax Court in Summa I and the Sixth Circuit in Summa II. The First Circuit considered the appeal of the Tax Court’s decision in Summa I by shareholders who were residents of Massachusetts, who appealed the Tax Court’s decision that they should be treated as having made excess Roth IRA contributions. Like the Sixth Circuit, the First Circuit declined to apply the substance-over-form doctrine, which the court characterized as “not a smell test,” but rather “a tool of statutory interpretation.” The court reasoned that Congress appeared to contemplate ownership of DISCS by IRAs when it enacted relevant statutory provisions such as section 995(g), which imposes unrelated-business-income tax on distributions that a DISC makes to tax-exempt organizations that own shares of the DISC. The court concluded:

The Benensons used DISCs, a unique, congressionally designed corporate form their family’s business was authorized to employ, and Roth IRAs, a congressionally designed retirement account all agree they were qualified to establish, to engage in long-term saving with eventual tax-free distribution. Such use violates neither the letter nor the spirit of the relevant statutory provisions.

. . .

Some may call the Benensons’ transaction clever. Others may call it unseemly. The sole question presented to us is whether the Commissioner has the power to call it a violation of the Tax Code. We hold that he does not. . . . When, as here, we find that the transaction does not violate the plain intent of the relevant statutes, we can push the doctrine no further.

In a dissenting opinion, Judge Lynch argued that the Service’s application of the substance-over-form doctrine should be upheld. In Judge Lynch’s view, the parties had not used the DISC for the purpose intended by Congress, but rather to evade the Roth IRA contribution limits. Judge Lynch also disagreed with the majority that the relevant statutory provisions contemplated a Roth IRA holding stock in a DISC. At most, Judge Lynch noted, Congress might have intended to allow traditional IRAs to own DISC stock, but taxpayers have not used DISCs as a way to circumvent the contribution limits on traditional IRAs because, in contrast to Roth IRAs, distributions from a traditional IRA are not tax-free.

c. The Second Circuit has jumped on the bandwagon and declined to apply the substance-over-form doctrine to recharacterize a corporation’s payments to a DISC held by a Roth IRA. In an opinion by Judge Raggi in Benenson v. Commissioner, the Court of Appeals for the Second Circuit has agreed with the First and Sixth Circuits that the government could not apply the substance-over-form doctrine to recharacterize as nondeductible dividends the commissions paid by Summa Holdings, Inc. to a DISC, the stock of which was held (indirectly) by Roth IRAs formed by some of Summa Holdings’ shareholders. The court first rejected the taxpayers’ argument that the Sixth Circuit’s decision in Summa II, which refused to uphold application of the substance-over-form doctrine with respect to Summa Holdings, precluded the government from relitigating the issue of recharacterization. The court observed that offensive collateral estoppel can preclude the government from relitigating an issue only when the parties opposing the government in the prior and subsequent action are the same. This requirement can be satisfied, the court stated, when the litigant in the subsequent action (the shareholders in this case) totally controlled and financed the litigant in the prior action (the corporation, Summa Holdings). According to the court, however, the taxpayers had failed to make this showing, and therefore the government was not precluded from litigating the issue of recharacterization. With respect to the issue of recharacterizing Summa Holdings’ payment of commissions to the DISC, the court held that “the substance‐over‐form doctrine does not support recharacterization of Summa’s payment of tax‐deductible commissions to a DISC as taxable constructive dividends to Summa shareholders and, thus, cannot support the tax deficiency attributed to petitioners.” The court also held that the step-transaction doctrine, when applied together with the substance-over-form doctrine, did not warrant a different conclusion.

d. Things really are not going the government’s way on this issue. The Ninth Circuit has reversed the Tax Court’s decision and declined to recharacterize a corporation’s payments to a FSC held by a Roth IRA.

The Tax Court’s decision. In Mazzei v. Commissioner, the taxpayers were members of the Mazzei family (husband, wife, and adult daughter). They owned 100% of the stock of Mazzei Injector Corp., an S corporation. The taxpayers established separate Roth IRAs that each invested $500 in a Foreign Sales Corporation (FSC). Under prior law and somewhat like DISCs, FSCs provided a Code-sanctioned tax benefit because they were taxed at much lower rates than regular corporations pursuant to an express statutory regime. After the taxpayers’ Roth IRAs invested in the FSC, Mazzei Injector Corp. paid the FSC a little over $500,000 in deductible commissions from 1998 to 2002. These deductible payments exceeded the amounts the taxpayers could have contributed to their Roth IRAs over these years, and just as in Summa Holdings, the Service argued that substance-over-form principles applied to recharacterize the entire arrangement as distributions by the S corporation to its shareholders, followed by excess Roth IRA contributions subject to the section 4973 excise tax and related penalties.

Because the case is appealable to the Ninth Circuit, the Tax Court concluded that it was not bound by the Sixth Circuit’s decision in Summa Holdings II. Thus, the Tax Court could have followed its own decision in Summa Holdings I to agree with the Service that in substance the entire arrangement amounted to an end-run around Roth IRA contribution limits; however, the Tax Court did not adopt this Summa Holdings-inspired approach. Instead, in a reviewed opinion (12-0-4) by Judge Thornton, relying upon Ninth Circuit precedent as well as the Supreme Court’s decision in Frank Lyon Co. v. United States, the court reasoned that the Roth IRAs had no real downside risk or exposure with respect to holding the FSC stock and thus were not the true owners of the stock. Judge Thornton determined that, for federal income tax purposes, the taxpayers should be considered the owners of the stock, stating:

[B]ecause petitioners (through various pass-through entities) controlled every aspect of the transactions in question, we conclude that they, and not their Roth IRAs, were the owners of the FSC stock for Federal tax purposes at all relevant times. The dividends from the FSC are therefore properly recharacterized as dividends from the FSC to petitioners, followed by petitioners’ contributions of these amounts to their respective Roth IRAs. All of these payments exceeded the applicable contribution limits and were therefore excess contributions. We therefore uphold respondent’s determination of excise taxes under section 4973.

Notably, though, the Tax Court declined to impose penalties on the taxpayers because they relied on independent professional advice in connection with setting up the FSC and their Roth IRAs.

Dissenting opinion. Four Judges (Holmes, Foley, Buch, and Morrison) dissented, with some joining only parts of the dissenting opinion written by Judge Holmes. Judge Holmes reasoned that the majority should have followed the Sixth Circuit’s decision in Summa Holdings II instead of engaging in “judge-made doctrines.” In our view, Judge Holmes’s dissenting opinion is both entertaining and insightful, summing up the conflicting opinions in Summa I, Summa II, and Mazzei as follows: “What’s really going on here is that the Commissioner doesn’t like that the Mazzeis took two types of tax-advantaged entities and made them work together.” Judge Holmes also aptly observed:

After the Sixth Circuit released Summa II we told the parties here to submit supplemental briefs. The Mazzeis and the Commissioner agreed that the only difference between these cases and Summa II was that the Mazzeis used an FSC instead of a DISC. The Commissioner said this difference shouldn’t affect our analysis, and he admitted that the Mazzeis followed all of the necessary formalities. He nevertheless said we should ignore Summa II because it’s from a different circuit and only the commission payments’ deductibility was properly before the court there. He said we should instead follow Court Holding, look at the transaction as a whole, and decide the cases based on his views of the statute’s intent, not the Code’s plain language.

The Mazzeis urged us to follow Summa II’s reasoning. They said they should get the FSC and Roth IRA tax benefits the Code explicitly provides and that the Commissioner shouldn’t get to rewrite statutes based on his musings about congressional intent. And they said that their use of an FSC instead of a C corporation was enough to distinguish these cases from Repetto.

The Ninth Circuit’s decision. In a lengthy opinion by Judge Collins, the Court of Appeals for the Ninth Circuit reversed the Tax Court’s decision. After reviewing in detail the relevant statutory provisions regarding IRAs and FSCs, the court concluded that the Tax Court had erred in holding that, because the Roth IRAs had no real downside risk or exposure with respect to holding the FSC stock, the individuals who had established the Roth IRAs, rather than the IRAs themselves, should be treated as the owners of the FSC’s stock. According to the court:

It makes no sense to ask whether the formal owner of the FSC stock would, by virtue of that purchase, be exposed to any risk as a result of that ownership because the statute allows FSCs to be set up so as to eliminate any risk from owning the FSC stock. Specifically, the statute explicitly authorizes the establishment of a FSC that will not conduct any operations itself, and in such cases the FSC will effectively be a shell corporation that generates value only by virtue of the reduced rate of taxation that is paid on moneys that are funneled through it in accordance with strict statutory formulas. . . . Such a shell corporation presents little, if any, risk at all to its owner because it will be used only if and when there is value (in the form of tax savings) to be obtained by flowing funds through it.

In the court’s view, Congress had expressly chosen to depart from substance-over-form principles in enacting the relevant statutory provisions governing Roth IRAs and FSCs. For this reason, the court concluded, the Service could not invoke those principles in a way that would reverse the judgment of Congress.

VII. Partnerships

A. Formation and Taxable Years

There were no significant developments regarding this topic during 2021.

B. Allocations of Distributive Share, Partnership Debt, and Outside Basis

1. ♫♪“You got to know when to hold ‘em, know when to fold ‘em, know when to walk away, and know when to run . . . .”♫♪ Carried (a/k/a profits) interests still qualify for preferential long-term capital gain rates, but the holding period is three years for specified interests in hedge funds and other investment partnerships.

Section 13309 of the TCJA created new section 1061 and redesignated pre-TCJA section 1061 as section 1062. New section 1061 was Congress’s lame attempt to close the carried interest (a/k/a profits interest) “loophole,” under which managers of real estate, hedge fund, and other investment partnerships were taxed at preferential long-term capital gain rates (e.g., 20%) on their distributive shares of partnership income notwithstanding the fact that they received their interests in these partnerships as part of their compensation for services rendered (which compensation otherwise would be taxed at ordinary income rates). Essentially, section 1061 imposes a three-year holding period requirement before allocations of income or gain (including gain on disposition of an interest) with respect to an “applicable partnership interest” qualify for preferential long-term capital gain rates. An “applicable partnership interest” is one that is transferred to a taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any “applicable trade or business.” An “applicable trade or business” means any activity conducted on a regular, continuous, and substantial basis which, regardless of whether the activity is conducted in one or more entities, consists, in whole or in part, of “raising or returning capital,” and either “investing in (or disposing of) specified assets (or identifying specified assets for such investing or disposition),” or “developing specified assets.” Specified assets for this purpose generally are defined as securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and (big, furrowed brow here) “an interest in a partnership to the extent of the partnership’s proportionate interest in any of the foregoing” (e.g., tiered partnerships).

There are significant exceptions, though, for (1) employees of another entity holding interests in a partnership that only performs services for that other entity and (2) partnership interests acquired for invested capital (including via a section 83(b) election for a capital interest in a partnership).

a. Thirty-four new defined terms created under the final regulations. Recently issued final regulations clarify the application of section 1061 and answer several questions that had been raised by tax advisors and commentators; however, the regulations do so by creating no less than 34 defined terms. These defined terms are too numerous and intertwined to summarize here. Suffice it to say for our purposes that new section 1061 works by transmuting (1) otherwise net long-term capital gain (as defined in section 1222) attributable to an “applicable partnership interest” (i.e., all of a taxpayer’s net long-term capital gain as normally calculated) into short-term capital gain but (2) only to the extent such gain exceeds net long-term capital gain (as defined in section 1222) attributable to the disposition of partnership property (or a partnership interest) held by the partnership (or by the partner) for three years or more (i.e., net long-term gain that is excluded from transmutation under section 1061). The regulations define the above-described excess attributable to an applicable partnership interest (API) as the “recharacterization amount.” Short- and long-term capital gains (or losses) attributable to an API (“API Gains and Losses”) are determined at the partnership (or partner) level under section 1222 by reference to the disposition of a “capital asset” as defined in section 1221. Importantly, the regulations impose new reporting rules for APIs that take effect for taxable years beginning on or after January 19, 2021.

Section 1231 quasi-capital gains escape new section 1061. Recall that section 1221 excludes section 1231 assets from the definition of “capital assets.” Thus, one question raised by tax advisors and commentators was whether API Gains and Losses subject to recharacterization under section 1061 would include section 1231 quasi-capital gains attributable to an API. The preamble to the final regulations answers this question in the negative, stating “API Gains and Losses do not include long-term capital gain determined under sections 1231 and 1256 [contracts marked to market], qualified dividends described in section 1(h)(11)(B), and any other capital gain that is characterized as long-term or short-term without regard to the holding period rules in section 1222.” Of course, this considerably reduces the impact of new section 1061, especially with respect to real estate investment partnerships.

The Treasury Department and the Service double down on the position that the term “corporation” in section 1061 does not include S corporations. Under new section 1061(c)(4)(A), an interest in a partnership is not an API if it is held “directly or indirectly . . . by a corporation.” This exception makes sense in the context of C corporations (which do not qualify for the capital gains preference), but if the exception includes S corporations, Congress created a major loophole in section 1061. In other words, an easy way to avoid new section 1061 would be to form an S corporation to hold a taxpayer’s APIs. In Notice 2018-18, however, the Treasury Department and the Service announced that regulations under section 1061 “will provide that the term ‘corporation’ for purposes of section 1061(c)(4)(A) does not include an S corporation.” Sure enough, the final regulations provide that an API is subject to new section 1061 if it is held by an “Owner Taxpayer” (the person subject to federal income taxation) or a “Passthrough Entity” (which has the usual meaning, but expressly includes S corporations). The preamble to the final regulations notes that one commentator argued that interpreting the term “corporations” to exclude S corporations “is subject to substantial doubt and contrary to the plain text of the statute.” Another commentator suggested that a legislative clarification should be enacted by Congress before the Treasury Department and the Service take this position. Who’s right? Stay tuned. This issue is almost certain to be litigated.

A bit of good news? The final regulations reverse the Treasury Department and the Service’s position taken in the proposed regulations that certain dispositions of section 1061 carried interests to related parties trigger gain recognition, notwithstanding that the disposition otherwise is not a taxable event. Commentators heavily criticized this aspect of the proposed regulations. The final regulations, though, clarify that section 1061 is only a gain recharacterization provision, not a gain acceleration provision. Therefore, a gift of a section 1061 carried interest (not subject to debt) to a “related person” (within the meaning of section 1061(d)(2)), or a nontaxable capital contribution of such an interest to a “related-person” partnership, does not trigger gain recognition to the transferor. Instead, the carried interest remains subject to section 1061 in the hands of the transferee. On the other hand, a part-gift/part-sale transaction, or a partnership capital contribution in which gain is recognized in part, will trigger the application of section 1061 to the extent of the gain recognized.

Who cares? Although it cannot be ignored by partnerships issuing carried (a/k/a profits) interests, the practical effect of new section 1061 appears minimal. The provision likely will catch only those rare taxpayers who either (1) fail to hold their carried interests for more than three years or (2) lack the sophisticated advice to plan around the statute. One commentator characterizes the new statute as a “joke” given that most managers of real estate, hedge funds, and investment partnerships hold their carried interests for well over three years.

C. Distributions and Transactions Between the Partnership and Partners

1. Tax Court holds that amounts transferred to the partnership by one partner are loans rather than capital contributions and their cancellation resulted in C.O.D. income to the partnership.

There were several issues in Hohl v. Commissioner, that arose out of several purported capital contributions by one partner, Mr. Rodriguez, which were treated by the other three partners, Messers. Hohl, Blake, and Bowles, as loans. Upon formation of Echo partnership (Echo), Messrs. Hohl, Blake, and Bowles owned 30% each while Mr. Rodriguez owned ten percent. Over the life of the partnership, Mr. Hohl, the partnership’s bookkeeper, recorded loans to Echo in substantial amounts received by Echo from Mr. Rodriguez in sequential years. Echo’s partnership tax return on Form 1065 consistently reflected a note payable to Mr. Rodriguez in an amount equal to Mr. Rodriguez’ transfers to Echo. None of the partners’ Schedule K-1s for the year indicated a beginning capital contribution. Rather, Messrs. Hohl, Blake, and Bowles’ capital accounts were all based upon their respective contributions of services. On its Form 1065, Echo reported a net loss each year primarily related to deductions taken for guaranteed payments to partners. Each partner’s capital account balance began at zero and then reduced each year by Echo’s loss for the year. This resulted in negative capital account balances for the partners. Echo’s balance sheet showed an increase each year in liabilities related to amounts transferred by Mr. Rodriquez to Echo. After several years of operations, Echo filed a final return upon which the liability to Mr. Rodriquez was reflected on the balance sheet, but no partner reported any allocation of a share of that liability. The partnership did not report any discharge of indebtedness, nor did Echo allocate any income to any of the partners. After an audit, the Service adjusted Messers. Hohl and Mr. Blake’s income upward by the amount of each partner’s negative capital account balance. The increases represented each partner’s share of cancellation of indebtedness.

The issue addressed by the Tax Court (Judge Buch) was whether Mr Rodriguez’ transfers to Echo were loans or capital contributions. Mr. Hohl and Mr. Blake argued that the transfers were capital contributions while the Service contended that the transfers to Echo were loans. Focusing on the substance of the transaction and applying the test developed in Greenberg v. Commissioner, Judge Buch focused on three factors: (1) the presence of a written agreement, (2) the intent of the parties; and (3) the likelihood of obtaining a similar loan from disinterested investors. In finding that transfers by Mr. Rodriguez were loans, the Tax Court initially noted that there was no written document. In determining intent, Echo reported the amounts transferred by Mr. Rodriguez as loans on its Form 1065 and allocated a share of liabilities to each partner on their respective Forms K-1. Both Echo and Mr. Rodriguez failed to include the transfers in Mr. Rodriguez’ capital account balance, and Mr. Rodriguez’ ownership percentage never changed as a result of any of the transfers. The Tax Court was persuaded that each of these facts was consistent with the transfers being treated as loans from Mr. Rodriguez to Echo and not capital contributions. Having concluded that the transfers were loans, the court concluded that, when Echo ceased operations and it became certain that Echo would not repay the debt to Mr. Rodriguez, Echo realized income from the discharge of indebtedness. The Tax Court declined to accept Messers. Hohl and Blake’s argument that all of the discharge of indebtedness income should be allocated to Mr. Rodriquez, finding instead that the partnership agreement lacked economic effect because the operating agreement allocated partners distributive shares based upon each partner’s capital account. Relying on all the facts and circumstances, the Tax Court followed the partners’ course of conduct wherein Echo allocated losses of 10% to Mr. Rodriguez and 30% to the other three partners. As such, Messrs. Hohl and Blake were each allocated 30% of the cancellation of indebtedness (C.O.D.) income. The court adopted the Service’s argument that Messrs. Hohl and Blake should each include their respective 30% allocation of C.O.D. in income.

Aftermath and commentary. While the court’s opinion focuses on the facts of the case and does not address new issues of law, the outcome can be instructive on “what not to do” in a partnership. Here, Messrs. Hohl and Blake contributed services but characterized the transfers by Mr. Rodriguez to the partnerships as loans. Because they contributed services rather than capital, their respective outside bases were determined to be zero. Therefore, the service contributors had no basis against which they could deduct losses generated by the guaranteed payments the partnership made to them. Presumably, in order to obtain basis in their partnership interests, the partners succumbed to the allure of treating the transfers by Mr. Rodriguez to the partnership as loans which, in turn, resulted in each partner having a share of the resulting partnership liability and therefore an increased outside basis. When the venture ceased operations, the negative capital accounts generated by the losses represented each partner’s share of the partnership’s C.O.D. income. And, that C.O.D. income in the end was allocated not in accordance with their capital accounts. Rather, it was allocated in accordance with how they had allocated losses. These partners with zero (and ultimately negative) capital accounts ended up being allocated substantial C.O.D. income and, in turn, owing taxes accordingly. In retrospect, if these partners had properly characterized Mr. Rodriguez’s transfers as contributions to capital, the noncontributing partners would have avoided any allocation of C.O.D. income.

D. Sales of Partnership Interests, Liquidations, and Mergers

There were no significant developments regarding this topic during 2021.

E. Inside Basis Adjustments

There were no significant developments regarding this topic during 2021.

F. Partnership Audit Rules

There were no significant developments regarding this topic during 2021.

G. Miscellaneous

1. Relief for not reporting negative tax capital accounts.

The updated 2018 Instructions for Form 1065 and accompanying Schedule K-1 now require a partnership that does not report tax basis capital accounts to its partners to report, on line 20 of Schedule K-1 (Form 1065) using code AH, the amount of a partner’s tax basis capital both at the beginning of the year and at the end of the year if either amount is negative. Aware that some taxpayers and their advisors may not have been prepared to comply with this new requirement for 2018 returns, the Service, in Notice 2019-20, has provided limited relief. Specifically, the Service will waive penalties (1) under section 6722 for failure to furnish a partner a Schedule K-1 (Form 1065) and under section 6698 for failure to file a Schedule K-1 (Form 1065) with a partnership return, (2) under section 6038 for failure to furnish a Schedule K-1 (Form 8865), and (3) under any other section of the Code for failure to file or furnish a Schedule K-1 or any other form or statement, for any penalty that arises solely as a result of failing to include negative tax basis capital account information provided the following conditions are met:

1. The Schedule K-1 or other applicable form or statement is timely filed, including extensions, with the IRS; is timely furnished to the appropriate partner, if applicable; and contains all other required information.
2. The person or partnership required to file the Schedule K-1 or other applicable form or statement files with the IRS, no later than one year after the original, unextended due date of the form to which the Schedule K-1 or other applicable form or statement must be attached, a schedule setting forth, for each partner for which negative tax basis capital account information is required:
   1. the partnership’s name and Employer Identification Number, if any, and Reference ID Number, if any;
   2. the partner’s name, address, and taxpayer identification number; and
   3. the amount of the partner’s tax basis capital account at the beginning and end of the tax year at issue.

The above-described supplemental schedule should be captioned “Filed Under Notice 2019-20” in accordance with instructions and additional guidance posted by the Service on IRS.gov. The due date for this supplemental schedule is determined without consideration of any extensions, automatic or otherwise, that may apply to the due date for the form itself. Furthermore, the schedule should be sent to the address listed in the Notice, and the penalty relief applies only for taxable years beginning after December 31, 2017, but before January 1, 2019.

a. The Service has issued FAQ guidance on negative tax basis capital account reporting. The Service has issued guidance on the requirement to report negative tax basis capital account information in the form of frequently asked questions (FAQs) on its website.

(i) Definition and calculation of tax basis capital accounts. In the FAQs, the Service explains that “[a] partner’s tax basis capital account (sometimes referred to simply as ‘tax capital’) represents its equity as calculated using tax principles, not based on GAAP, § 704(b), or other principles.” The FAQs provide guidance on the calculation of a partner’s tax basis capital account. A partner’s tax basis capital account is increased by the amount of money and the adjusted basis of any property contributed by the partner to the partnership (less any liabilities assumed by the partnership or to which the property is subject) and is decreased by the amount of money and the adjusted basis of any property distributed by the partnership to the partner (less any liabilities assumed by the partner or to which the property is subject). The partner’s tax basis capital account is increased by certain items, such as the partner’s distributive share of partnership income and gain, and is decreased by certain items, such as the partner’s distributive share of partnership losses and deductions. The FAQs make clear that a partner’s tax basis capital account is not the same as a partner’s basis in the partnership interest (outside basis) because outside basis includes the partner’s share of partnership liabilities, whereas a partner’s tax basis capital account does not.

(ii) Effect of section 754 Elections and Revaluations of Partnership Property. If a partnership has a section 754 election in effect, then it increases or decreases the adjusted basis of partnership property pursuant to section 743(b) when there is a transfer of a partnership interest or pursuant to section 734(b) when there is a distribution by the partnership. These adjustments can also be triggered when the partnership does not have a section 754 election in effect but has a substantial built-in loss and a transfer of a partnership interest occurs (section 743(b) basis adjustment) or experiences a substantial basis reduction in connection with a distribution (section 734(b) basis adjustment). The FAQs clarify that a partner’s tax basis capital account is increased or decreased by a partner’s share of basis adjustments under section 743(b) and section 734(b). In contrast, according to the FAQs, revaluations of partnership property pursuant to section 704 (such as upon the entry of a new partner) do not affect the tax basis of partnership property or a partner’s tax basis capital account.

(iii) Examples. The FAQs provide the following examples of the calculation of a partner’s tax basis capital account:

Example 1: A contributes $100 in cash and B contributes unencumbered, nondepreciable property with a fair market value (FMV) of $100 and an adjusted tax basis of $30 to newly formed Partnership AB. A’s initial tax basis capital account is $100 and B’s initial tax basis capital account is $30.

Example 2: The facts are the same as in Example 1, except B contributes nondepreciable property with a FMV of $100, an adjusted tax basis of $30, and subject to a liability of $20. B’s initial tax basis capital account is $10 ($30 adjusted tax basis of property contributed, less the $20 liability to which the property was subject).

Example 3: The facts are the same as in Example 1, except in Year 1, the partnership earns $100 of taxable income and $50 of tax-exempt income. A and B are each allocated $50 of the taxable income and $25 of the tax-exempt income by the partnership. At the end of Year 1, A’s tax basis capital account is increased by $75, to $175, and B’s tax basis capital account is increased by $75, to $105.

Example 4: The facts are the same as in Example 3. Additionally, in Year 2, the partnership has $30 of taxable loss and $20 of expenditures which are not deductible in computing partnership taxable income and which are not capital expenditures. A and B are each allocated $15 of the taxable loss and $10 of the expenditures which are not deductible in computing partnership taxable income and which are not capital expenditures. At the end of Year 2, A’s tax basis capital account is decreased by $25, to $150, and B’s tax basis capital account is decreased by $25, to $80.

Example [5]: On January 1, 2019, A and B each contribute $100 in cash to a newly formed partnership. On the same day, the partnership borrows $800 and purchases Asset X, qualified property for purposes of § 168(k), for $1,000. Assume that the partnership properly allocates the $800 liability equally to A and B under § 752. Immediately after the partnership acquires Asset X, both A and B have tax basis capital accounts of $100 and outside bases of $500 ($100 cash contributed, plus $400 share of partnership liabilities under § 752). In 2019, the partnership recognizes $1,000 of tax depreciation under § 168(k) with respect to Asset X; the partnership allocates $500 of the tax depreciation to A and $500 of the tax depreciation to B. On December 31, 2019, A and B both have tax basis capital accounts of negative $400 ($100 cash contributed, less $500 share of tax depreciation) and outside bases of zero ($100 cash contributed, plus $400 share of partnership liabilities under § 752, and less $500 of share tax depreciation).

(iv) Tax Basis Capital Account of a Partner Who Acquires the Partnership Interest from Another Partner. A partner who acquires a partnership interest from another partner, such as by purchase or in a nonrecognition transaction, “has a tax basis capital account immediately after the transfer equal to the transferring partner’s tax basis capital account immediately before the transfer with respect to the portion of the interest transferred . . . .” However, any section 743(b) basis adjustment the transferring partner may have is not transferred to the acquiring partner. Instead, if the partnership has a section 754 election in effect, the tax basis capital account of the acquiring partner is increased or decreased by the positive or negative adjustment to the tax basis of partnership property under section 743(b) as a result of the transfer.

(v) Safe-Harbor Method for Determining a Partner’s Tax Basis Capital Account. The FAQs provide a safe-harbor method for determining a partner’s tax basis capital account. Under this method, “[p]artnerships may calculate a partner’s tax basis capital account by subtracting the partner’s share of partnership liabilities under § 752 from the partner’s outside basis (safe-harbor approach). If a partnership elects to use the safe-harbor approach, the partnership must report the negative tax basis capital account information as equal to the excess, if any, of the partner’s share of partnership liabilities under § 752 over the partner’s outside basis.”

(vi) Certain partnerships are exempt from reporting negative tax basis capital accounts. Partnerships that satisfy four conditions (those provided in question 4 on Schedule B to Form 1065) do not have to comply with the requirement to report negative tax basis capital account information. This is because a partnership that satisfies these conditions is not required to complete item L on Schedule K-1. The four conditions are:

(a) the partnership’s total receipts for the tax year were less than $250,000;

(b) the partnership’s total assets at the end of the tax year were less than $1 million;

(c) Schedules K-1 are filed with the return and furnished to the partners on or before the due date (including extensions) for the partnership return; and

(d) the partnership is not filing and is not required to file Schedule M-3.

b. The Service has issued a draft of revised Form 1065 and Schedule K-1 for 2019. The Service has issued a draft of the partnership tax return, Form 1065, and accompanying Schedule K-1 for 2019. The Service has also released draft instructions for the 2019 Form 1065 and draft instructions for the 2019 Schedule K-1. Compared to the 2018 versions, the 2019 versions reflect several significant changes that likely will require a substantial amount of time in many cases on the part of those preparing the return to ensure compliance. Among the significant changes are the following:

Reporting of tax basis capital accounts for each partner on Schedule K-1. Previous versions of Schedule K-1 gave partnerships the option to report a partner’s capital accounts on a tax basis, in accordance with GAAP, as section 704(b) book capital accounts, or on some “other” basis. Tax basis capital accounts were required beginning in 2018 only if a partner’s tax capital account at the beginning or end of the year was negative. The 2019 draft Schedule K-1 requires partnerships to report each partner’s capital account on a tax basis regardless of whether the account is negative. For partnerships that have not historically reported tax basis capital accounts, this requirement would appear to involve recalculating tax capital accounts in prior years and rolling them forward.

Reporting a partner’s share of net unrecognized section 704(c) gain or loss on Schedule K-1. Previous versions of Schedule K-1 required reporting whether a partner had contributed property with a built-in gain or built-in loss in the year of contribution. The 2019 draft Schedule K-1 still requires partnerships to report whether a partner contributed property with a built-in gain or loss, but adds new item N in Part II, which requires reporting the “Partner’s Share of Net Unrecognized Section 704(c) Gain or (Loss).” This means that a partnership must report on an annual basis any unrecognized gain or loss that would be allocated to the partner under section 704(c), if the partnership were to sell its assets, as a result of either the partner contributing property with a fair market value that differs from its adjusted basis or the revaluation of partnership property such as a revaluation occurring upon the admission of a new partner.

Separation of guaranteed payments for capital and services. Previous versions of Schedule K-1 required reporting a single category of guaranteed payments to a partner. The 2019 draft Schedule K-1 refines this category in item 4 of Part III and requires separate reporting of guaranteed payments for services, guaranteed payments for capital, and the total of these two categories.

Reporting on Schedule K-1 more than one activity for purposes of the at-risk and passive activity loss rules. Items 21 and 22 have been added to Part III of Schedule K-1 to require the partnership to check a box if the partnership has more than one activity for purposes of the at-risk or passive activity loss rules. The 2019 draft instructions for Form 1065 indicate that the partnership also must provide an attached statement for each activity with detailed information for each activity to allow the partner to apply correctly the at-risk and passive activity loss rules.

Section 199A deduction moved to supplemental statement. The 2018 version of Schedule K-1 required reporting information relevant to the partner’s section 199A deduction in item 20 of Part III with specific codes. The draft 2019 instructions for Form 1065 provide that, for partners receiving information relevant to their section 199A deduction, only code Z should be used in box 20 along with an asterisk and STMT to indicate that the information appears on an attached statement. According to the instructions, among other items, the statement must include the partner’s distributive share of (1) qualified items of income, gain, deduction, and loss, (2) W-2 wages, (3) unadjusted basis immediately after acquisition of qualified property, (4) qualified publicly traded partnership items, and (5) section 199A dividends (qualified REIT dividends). The statement also must report whether any of the partnership’s trades or businesses are specified service trades or businesses and identify any trades or businesses that are aggregated.

Disregarded entity as a new category of partner on Schedule K-1. Previous versions of Schedule K-1 required the partnership to indicate whether the partner was domestic or foreign. The 2019 draft Schedule K-1 adds a new category in item H of Part II in which the partnership must indicate whether the partner is a disregarded entity and, if so, the partner’s taxpayer identification number and type of entity.

c. The Service has postponed the requirements to use tax basis capital accounts for Schedule K-1 and to report detailed information for purposes of the at-risk rules and has clarified certain other reporting requirements. In response to comments expressing concern that those required to file Form 1065 and Schedule K-1 might be unable to comply in a timely manner with the requirement to report capital accounts on a tax basis for 2019, the Treasury Department and the Service have deferred this requirement, which will now apply to partnership tax years beginning on and after January 1, 2020. According to Notice 2019-66:

This means that partnerships and other persons may continue to report partner capital accounts on Forms 1065, Schedule K-1, Item L, or 8865, Schedule K-1, Item F, using any method available in 2018 (tax basis, Section 704(b), GAAP, or any other method) for 2019. These partnerships and other persons must include a statement identifying the method upon which a partner’s capital account is reported.

The requirement to report capital accounts for 2019 using any method available in 2018 includes the requirement that partnerships that do not report tax basis capital accounts to partners must report, on line 20 of Schedule K-1 (Form 1065) using code AH, the amount of a partner’s tax basis capital both at the beginning of the year and at the end of the year if either amount is negative.

The draft 2019 Schedule K-1 included Items 21 and 22 in Part III to require the partnership to check a box if the partnership has more than one activity for purposes of the at-risk or passive activity loss rules. The 2019 draft instructions for Form 1065 also required a partnership to provide an attached statement for each activity with detailed information for each activity to allow the partner to apply correctly the at-risk and passive activity loss rules. In response to comments expressing concern that those required to file Form 1065 and Schedule K-1 might be unable to comply in a timely manner with the requirement to provide this detailed information in an attached statement, Notice 2019-66 defers this requirement. This requirement now will apply to partnership tax years beginning on and after January 1, 2020. The Notice leaves in place for 2019 the requirement that a box be checked in Items 21 and 22 in Part III of Schedule K-1 if the partnership has more than one activity for purposes of the at-risk or passive activity loss rules.

Notice 2019-66 also leaves in place for 2019 the requirement that a partnership must report on an annual basis a partner’s share of “net unrecognized Section 704(c) gain or loss.” The draft 2019 instructions for Schedule K-1, however, had not defined the term “net unrecognized Section 704(c) gain or loss.” The Notice defines this term as “the partner’s share of the net (net means aggregate or sum) of all unrecognized gains or losses under section 704(c) of the Code (Section 704(c)) in partnership property, including Section 704(c) gains and losses arising from revaluations of partnership property.” This definition applies solely for purposes of completing 2019 forms. The Notice clarifies that publicly traded partnerships need not report net unrecognized section 704(c) gain for 2019 and future years until further notice.

Notice 2019-66 also indicates that commenters had requested additional guidance on section 704(c) computations, especially on issues such as those addressed in Notice 2009-70, which solicited comments on the rules relating to the creation and maintenance of multiple layers of forward and reverse section 704(c) gain and loss to partnerships and tiered partnerships. The Notice provides that, “[f]or purposes of reporting for 2019, partnerships and other persons should generally resolve these issues in a reasonable manner, consistent with prior years’ practice for purposes of applying Section 704(c) to partners.”

Notice 2019-66 provides that taxpayers who follow its provisions will not be subject to any penalty for reporting in accordance with the guidance it provides.

d. The Service has proposed two exclusive methods for satisfying the requirement to report tax basis capital accounts for partnership taxable years ending on or after December 31, 2020, and has asked for comments. In Notice 2020-43, the Service has proposed a requirement that partnerships use only one of two exclusive methods for reporting a partner’s tax capital account that would apply to partnership taxable years that end on or after December 31, 2020. Pursuant to the proposed requirement, partnerships would no longer be permitted to report partner capital accounts using any other method, including reporting capital accounts in accordance with GAAP or as section 704(b) book capital accounts. The Notice indicates that comments received in response to the Notice “will help inform the development of the instructions to be included in Form 1065 . . . for taxable year 2020.”

(i) Background. According to the Notice, commenters have indicated that they determine tax basis capital accounts using what the Notice refers to as a “Transactional Approach.” It appears that this approach is analogous to the method for determining a partner’s book capital account prescribed in the regulations regarding the substantial economic effect requirement of section 704(b), except that the adjusted basis of property is used instead of the property’s fair market value. Under this Transactional Appproach, a partner’s tax capital account is (1) increased by the amount of money and the adjusted basis of property contributed by a partner (less any liabilities assumed by the partnership or to which the property is subject) and by allocations to the partner of partnership income or gain and (2) decreased by the amount of money and the adjusted basis of property distributed to the partner (less any liabilities assumed by the partner or to which the distributed property is subject) and by allocations to the partner of partnership loss or deduction. The Notice indicates that the Treasury Department and the Service understand that partnerships using the Transactional Approach “may not have been adjusting partner tax capital accounts in the same way under similar fact patterns.”

Further, issuing detailed guidance to promote consistent application of the Transactional Approach, according to some commenters, would be a major project that would consume significant Service resources. Accordingly, the Notice rejects a Transactional Approach to determining tax capital accounts and indicates that tax capital accounts determined in this manner will not satisfy the requirement to report partner tax capital accounts. Instead, the Notice prescribes two alternative proposed methods for determining a partner’s tax capital account: (1) the “Modified Outside Basis Method” and (2) the “Modified Previously Taxed Capital Method.” These methods are discussed below.

(ii) Modified Outside Basis Method. The Notice indicates that a partnership using the Modified Outside Basis Method to determine a partner’s tax capital account must determine, or be provided by the partner, the partner’s adjusted basis in the partnership interest (determined under the principles and provisions of Subchapter K, including sections 705, 722, 733, and 742) and subtract from it the partner’s share of partnership liabilities under section 752. (This method was described as a safe-harbor approach in the FAQs discussed above, which appear on the Service’s website.) If the partnership is using this method, a partner must notify the partnership in writing of changes to the partner’s basis in the partnership during the year other than those attributable to contributions by the partner, distributions to the partner, and allocations to the partner of income, gain, loss or deduction that are reflected on the partnership’s Schedule K-1. An example of a situation in which notification to the partnership would be required is if a person purchases a partnership interest. A partnership using the Modified Outside Basis Method is entitled to rely on information provided by partners regarding their basis in partnership interests unless the partnership has knowledge of facts indicating that the information is clearly erroneous.

(iii) Modified Previously Taxed Capital Method. The Modified Previously Taxed Capital Method is a modified version of the method prescribed in Regulation section 1.743-1(d). The method prescribed in this regulation is used in determining the adjustments to the basis of partnership property under section 743(b) when a person purchases a partnership interest and the partnership has in effect a section 754 election. One adjustment is to increase the adjusted basis of partnership property by the excess of the purchasing partner’s basis in the partnership interest over the partner’s proportionate share of the adjusted basis of partnership property. A partner’s proportionate share of the adjusted basis of partnership property is the purchasing partner’s interest as a partner in the partnership’s previously taxed capital, plus his or her share of partnership liabilities. In essence, the method prescribed in Regulation section 1.743-1(d) determines the partner’s interest in the partnership’s previously taxed capital (i.e., tax capital account) by first determining the partner’s share of total capital and then backing out the portion that has not yet been taxed. Specifically, Regulation section 1.743-1(d) provides that a partner’s share of previously taxed capital is determined by performing a hypothetical disposition by the partnership of all of its assets in a fully taxable transaction for cash equal to the fair market value of the assets and ascertaining:

1. The amount of cash the partner would receive on a liquidation following the hypothetical disposition of assets, increased by
2. The amount of tax loss that would be allocated to the partner from the hypothetical disposition of assets, and decreased by
3. The amount of tax gain that would be allocated to the partner from the hypothetical disposition of assets.

The Notice modifies this method in two ways. First, it modifies the hypothetical disposition of assets to permit partnerships to use the fair market of assets if the fair market value is readily available or, alternatively, the bases of assets determined under section 704(b) (i.e., section 704(b) book basis), GAAP, “or the basis set forth in the partnership agreement for purposes of determining what each partner would receive if the partnership were to liquidate, as determined by partnership management.” Second, for purposes of the second and third parts of the method set forth (allocation of tax loss and gain), the Notice provides that all partnership liabilities are treated as nonrecourse “to avoid the burden of having to characterize the underlying debt and to simplify the computation.” Partnerships that use the Modified Previously Taxed Capital Method will be required, for each year that the method is used, to attach to the partnership tax return a statement indicating that the Modified Previously Taxed Capital Method is used and the method used to determine the partnership’s net liquidity value (such as fair market value, section 704(b) book basis, or GAAP).

(iv) Consistency and Change of Methods. The Notice indicates that, whichever of the two methods the partnership uses, it must use the same method with respect to all partners. The first year for which the requirement to use one of these two methods to determine tax capital accounts will apply is 2020. For taxable years after 2020, the partnership can change methods by attaching a disclosure to each Schedule K-1 that describes the change (if any) to the amount attributable to each partner’s beginning and end-of-year balances and the reason for the change.

(v) Request for Comments. The Service has requested comments, due by August 4, 2020, on the following five topics:

1. Whether the two proposed exclusive methods described above for determining tax capital accounts should be modified or adopted;
2. Whether, in connection with the hypothetical disposition of assets required as part of the Modified Previously Taxed Capital Method, an ordering rule should apply to the value used in the hypothetical disposition, e.g., use of fair market value might be required if readily available, and if it is not readily available, then section 704(b) book basis might be required unless the partnership does not maintain book capital accounts in accordance with section 704(b), in which case GAAP would be required;
3. How, if at all, the requirement to report tax capital accounts should be modified to apply to publicly traded partnerships;
4. Whether a Transactional Approach to determining tax capital accounts should be permitted and what additional guidance would be necessary to permit this approach; and
5. Whether (and in what circumstances) limitations should be imposed on partnerships to change from one method of determining tax capital accounts to another, including how partnerships would comply with such limitations in the case of the merger of partnerships using different methods.

e. The instructions for Form 1065 and Schedule K-1 for 2020 require reporting tax basis capital accounts using a transactional approach. The Service released draft instructions for the 2020 Form 1065 and draft instructions for the 2020 Schedule K-1. The final version of the instructions was issued on February 12, 2021. Previous versions of Schedule K-1 gave partnerships the option to report a partner’s capital accounts on a tax basis, in accordance with GAAP, as section 704(b) book capital accounts, or on some “other” basis. Tax basis capital accounts were required beginning in 2018 only if a partner’s tax capital account at the beginning or end of the year was negative.

The 2020 draft instructions for Form 1065 and Schedule K-1 require partnerships to report each partner’s capital account on a tax basis regardless of whether the account is negative. Further, each partner’s tax capital account must be determined using a transactional approach. For partnerships that reported capital accounts on a tax basis in the prior year (and those that did not report tax capital accounts but maintained tax basis capital accounts in their books and records), a partner’s beginning tax capital account generally will be the partner’s ending tax capital account from the prior year, or zero for a partner that acquired his or her partnership interest by making a contribution during the year, or the transferor partner’s capital account for a partner that acquired his or her partnership interest during the year from another partner.

For partnerships that did not report tax basis capital accounts in the prior year and did not maintain tax capital accounts in their books and records, a partner’s beginning tax capital account can be determined for this year only using the tax basis method (presumably a transactional approach) or one of three alternative methods. These alternative methods are (1) the modified outside basis method, (2) the modified previously taxed capital method, or (3) the section 704(b) method. The first two of these methods were proposed in Notice 2020-43. Under the section 704(b) method, the amount to report as the partner’s beginning tax capital account is equal to the partner’s section 704(b) book capital account, minus the partner’s share of built-in gain that would be allocated to the partner under section 704(c) plus the partner’s share of built-in loss that would be allocated to the partner under section 704(c) if the partnership were to sell its assets. Such allocations of built-in gain or loss under section 704(c) can result from either the partner contributing property with a fair market value that differs from its adjusted basis or the revaluation of partnership property (such as a revaluation occurring upon the admission of a new partner).

f. The Service provides relief for partnerships from certain penalties related to the reporting of partners’ 2020 beginning capital account balances. Notice 2021-13, provides partnerships with relief from certain penalties that normally would result from incorrectly reporting partners’ beginning capital account balances on the 2020 Schedules K-1 (Forms 1065 and 8865). Relief is also granted from accuracy-related penalties for the portion of an imputed underpayment attributable to incorrect information in a partner’s beginning capital account balance for 2020. Pursuant to section 6031 and the corresponding provisions of the regulations, the Service has for many years required the reporting of partners’ capital account balances. Prior to 2020, partnerships could report partner capital accounts on Schedule K-1 using one of several possible methods (tax basis, GAAP, section 704(b) book, or other method).

Beginning in 2018, however, the instructions to the partnership tax return, Form 1065, required a partnership that did not report tax basis capital accounts to its partners to report, on line 20 of Schedule K-1 (Form 1065) using code AH, the amount of a partner’s tax basis capital account both at the beginning of the year and at the end of the year if either amount was negative. Beginning in 2020, the instructions to Form 1065 and Schedule K-1 require partnerships to report each partner’s capital account on a tax basis regardless of whether the account is negative. Reporting capital accounts on another basis such as GAAP is no longer permitted.

Further, each partner’s tax capital account must be determined using a transactional approach. Under a transactional approach, partnerships must adjust a partner’s capital account for contributions by and distributions to the partner, for the partner’s share of items of income and loss, and for other appropriate events, all using tax basis principles. For partnerships that did not report tax basis capital accounts in 2019 and did not maintain tax capital accounts in their books and records, a partner’s beginning tax capital account can be determined for 2020 only using the tax basis method (a transactional approach) or one of three alternative methods. These alternative methods are (1) the modified outside basis method, (2) the modified previously taxed capital method, or (3) the section 704(b) method (each as described in the 2020 Form 1065 Instructions).

(i) Penalties. Section 6698 imposes a penalty for failing to timely file, show correct information, or not fully report information on a Form 1065 or Schedule K-1. A section 6698 penalty is not imposed if it is shown that the failure is due to reasonable cause. There are also penalties under section 6721 for failure to file timely, accurate information returns and under section 6722 for failure to furnish timely, accurate payee statements. Section 6724 provides that the penalties for any failure under sections 6721 and 6722 do not apply if it is shown that the failure is due to reasonable cause and not to willful neglect. Under Regulation section 301.6724-1, a penalty may be waived for reasonable cause only if

the filer establishes either [that] there are significant mitigating factors with respect to the failure or that the failure arose from events beyond the filer’s control. In addition, the filer must establish that the filer acted in a responsible manner both before and after the failure occurred.

Finally, section 6662 imposes an accuracy-related penalty on portions of an underpayment attributable to, among other things, negligence or a substantial understatement of income tax. For partnerships subject to the centralized audit regime enacted by the Bipartisan Budget Act of 2015, section 6221 provides that the applicability of any penalties, additions to tax, or additional amounts that relate to an adjustment to a partnership-related item must be determined at the partnership level. Under section 6233, partnerships subject to the centralized audit regime are liable for the section 6662 penalties calculated on the imputed underpayment.

(ii) Relief from penalties under sections 6698, 6721, and 6722. Notice 2021-13 provides relief from the penalties imposed under sections 6698, 6721, and 6722 that is in addition to the relief from penalties for reasonable cause described earlier. According to the Notice, a partnership will not be subject to penalties under sections 6698, 6721, or 6722 due to the misreporting of its partners’ beginning capital account balances on 2020 Schedules K-1 if the partnership can show that it took ordinary and prudent business care in following the 2020 Form 1065 Instructions to report its partners’ beginning capital account balances using any one of the permissible methods for determining beginning tax capital accounts set forth in the instructions to Form 1065 and described earlier. In general, “‘ordinary and prudent business care’ means the standard of care that a reasonably prudent person would use under the circumstances in the course of its business in handling account information.”

In addition, a partnership will not be subject to a penalty under sections 6698, 6721, or 6722 due to the inclusion of incorrect information in reporting its partners’ ending capital account balances on Schedules K-1 in taxable year 2020 or its partners’ beginning or ending capital account balances on Schedules K-1 in taxable years after 2020 to the extent the incorrect information is attributable solely to the incorrect information reported as the beginning capital account balance on the 2020 Schedule K1 for which relief under the Notice is available. A partnership that fails to timely file or include beginning and ending capital accounts on a 2020 Form 1065, Form 8865, and Schedules K-1 is not eligible for the relief.

(iii) Relief from penalties under section 6662. According to the Notice, the Service will waive any accuracy-related penalty under section 6662 for any taxable year with respect to any portion of an imputed underpayment that is attributable to an adjustment to a partner’s beginning capital account balance reported by the partnership for the 2020 taxable year, but only to the extent the adjustment arises from the inclusion of incorrect information for which the partnership qualifies for relief under section 3 of the Notice.

VIII. Tax Shelters

A. Tax Shelter Cases and Rulings

There were no significant developments regarding this topic during 2021.

B. Identified “Tax Avoidance Transactions”

There were no significant developments regarding this topic during 2021.

C. Disclosure and Settlement

There were no significant developments regarding this topic during 2021.

D. Tax Shelter Penalties

There were no significant developments regarding this topic during 2021.

IX. Exempt Organizations and Charitable Giving

A. Exempt Organizations

1. Multiple exempt organization regulatory projects closed (or “canned”?) in 2020 and early 2021.

The 2017 TCJA made significant changes with respect to the taxation of exempt organizations, including one change that since has been retroactively repealed. We summarize below the recent developments with respect to these changes as well as final regulations relating to the reporting requirements of exempt organizations under section 6033.

a. “Phubit” parking tax goes the way of the dodo. Section 13703 of the TCJA added new section 512(a)(7) effective as of January 1, 2018. The effect of section 512(a)(7) was to create or increase an organization’s unrelated business taxable income by the amount of any expenses paid or incurred by an organization that are disallowed by the changes made to section 274 for qualified transportation fringe benefits (generally, subsidized parking for employees). In short, new section 512(a)(7) turned out to be a disaster—in part because for some organizations, it worked not just to increase but to create phantom unrelated business income tax (a/k/a “phubit”) where none had existed previously. Wisely, perhaps, Congress retroactively repealed section 512(a)(7) as part of the Taxpayer Certainty and Disaster Tax Relief Act of 2019, effective as of the date of enactment in 2017. This retroactive repeal not only eliminated the need for guidance, but also engendered refund claims by affected exempt organizations. Those organizations may file an amended Form 990-T to claim refunds.

b. Final regulations consolidating, reconciling, and otherwise clarifying the numerous changes to the annual information return requirements of section 6033. Pursuant to section 6033, organizations exempt from taxation under section 501(a) generally are required to file annual information returns and make such returns publicly available for inspection. Exceptions to filing exist (e.g., churches), including exceptions to public disclosure of certain items otherwise reportable on these annual information returns. The applicable rules and exceptions thereto have been modified over the past several years, so in 2020 the Treasury Department and the Service finalized regulations reflecting the cumulative changes. The final regulations are effective on May 28, 2020, and generally apply to returns filed on or after January 30, 2020.

c. No more offsetting UBTI from one trade or business with UBTI from another trade or business. Organizations described in section 401(a) (pension and retirement plans) and section 501(c) (charitable and certain other entities) generally are exempt from federal income taxation. Nevertheless, sections 511 through 514 impose federal income tax upon the “unrelated business taxable income” (UBTI) of such organizations, including for this purpose state colleges and universities. The principal sources of UBTI are sections 512 and 513 “unrelated trade or business” gross income (minus deductions properly attributable thereto) and section 514 “unrelated debt-financed income” (minus deductions), including a partner’s allocable share of income from a partnership generating UBTI. Under pre-TCJA law, if an exempt organization had unrelated business income (UBI) from one activity, but unrelated losses from another activity, then the income and losses could offset, meaning that the organization would report zero or even negative UBI. New section 512(a)(6), effective as of January 1, 2018, provides that income and losses from separate unrelated trades or businesses no longer may be aggregated. The “catch” to new section 512(a)(6), though, is that exactly what constitutes a separate “trade or business” for UBTI purposes has never been defined, and new section 512(a)(6) did not do so either.

In 2020, the Treasury Department and the Service finalized proposed regulations providing guidance on how exempt organizations segregate trades or businesses for purposes of determining UBI in accordance with section 512(a)(6). Generally, the new regulations provide that an exempt organization must identify and segregate each of its separate unrelated trades or businesses using the first two digits of the North American Industry Classification System code (NAICS 2-digit code). Organizations should do so by choosing the NAICS 2-digit code that most accurately describes the unrelated trade or business. Notably, the regulations do not adopt the approach taken by the section 199A regulations because, in the view of the Treasury and the Service, section 512(a)(6) and section 199A serve different purposes.

The final regulations are detailed and complex and will not be discussed further here. They are, however, a must read for tax advisors to exempt organizations that have UBTI. The regulations are applicable to taxable years beginning on or after December 2, 2020. In addition, affected exempt organizations may choose to apply the regulations to taxable years beginning on or after January 1, 2018, and before December 2, 2020. Alternatively, affected exempt organizations may rely on a reasonable, good-faith interpretation of section 512(a)(6) for such taxable years. For this purpose, a reasonable, good-faith interpretation includes the methods of aggregating or identifying separate trades or businesses provided in Notice 2018-67 or the previously published proposed regulations.

d. Final guidance from the Treasury Department and the Service admits Congress’s “airball” when enacting new section 4960. Another change to the taxation of exempt organizations was the addition of new section 4960 by section 13602 of the TCJA. Section 4960 imposes a 21% excise tax on “applicable tax-exempt organizations” (ATEOs) and broadly defined “related organizations” paying over $1 million annually to “covered employees.” In addition to section 527 political organizations and section 521 farmers cooperatives, ATEOs include the following two additional types of organizations: (1) those exempt from tax under section 501(a) (most nonprofits, including churches, hospitals, and private schools) and (2) those with “income excluded from taxation under section 115(l).” A “covered employee” is defined as any one of the five highest compensated employees of an ATEO for either (1) the current taxable year or (2) any year beginning after December 31, 2016. Licensed medical or veterinarian professionals, however, are excluded from the definition of “covered employee.”

The Treasury Department and the Service issued proposed regulations regarding section 4960 in June of 2020 that were finalized in early January 2021. These proposed and then final regulations followed interim guidance issued early in 2019. The regulations are technical and extensive, so they will not be discussed in detail here. Importantly, though, new section 4960 essentially does not apply to governmental entities (including state colleges and universities) with highly compensated executives (e.g., coaches), even though Congress apparently thought that it would. The reason such governmental entities generally escape section 4960 is because Congress attempted to describe them as organizations with “income excluded from taxation under section 115(l).” The Service’s longstanding position, however, is that governmental entities (including state colleges and universities) which are not separately incorporated are exempt under the doctrine of implied statutory immunity notwithstanding section 115(l) (unless and until Congress enacts a specific statutory provision, like section 511(a)(2)(B) regarding UBIT, subjecting such state-affiliated organizations to tax). The preamble to the proposed regulations confirms this important point, stating that “a governmental entity (including a state college or university) that does not have a determination letter recognizing its exemption from taxation under section 501(a) and that does not exclude income from gross income under section 115(1) is not an ATEO.” Furthermore, a state college or university that has secured exemption under section 501(a) (because it applied for tax-exempt status thereunder using Form 1023 and received a determination letter) “may relinquish this status pursuant to the procedures described in section 3.01(12) of Rev. Proc. 2020-5 . . . (or the analogous section in any successor revenue procedure).” The final regulations are effective as of January 15, 2021, and apply to taxable years beginning after December 31, 2021.

B. Charitable Giving

There were no significant developments regarding this topic during 2021.

X. Tax Procedure

A. Interest, Penalties, and Prosecutions

1. “Uh, about those estimated tax penalties attributable to certain NOLs” . . . says the Service.

Recall that the CARES Act modified several of the rules for NOLs that were introduced into the Code by the TCJA. Section 2303(b) of the CARES Act amended section 172(b)(1) by adding a new subparagraph (D) to allow NOL carrybacks previously barred by the TCJA. Under new section 172(b)(1)(D), NOLs arising in taxable years beginning after December 31, 2017, but before January 1, 2021 (generally 2018, 2019, and 2020), may be carried back to each of the five preceding taxable years. Special rules and limitations apply to REITs, life insurance companies, and taxpayers subject to section 965 (controlled foreign corporations). Guidance regarding NOL carrybacks under new section 172(b)(1)(D) was provided in Revenue Procedure 2020-24, in Notice 2020-26, and in FAQs found on the Service’s website. Further, the CARES Act, section 2303(a), amended section 172(a) such that, for taxable years beginning before January 1, 2021 (generally 2019 and 2020), the 80% taxable income limitation on NOL carryforwards enacted by the TCJA does not apply. Last but not least, section 2304 of the CARES Act amended section 461(l) to repeal temporarily the rule, added by the TCJA, that disallows and carries forward “excess business losses” (over $250,000 for single filers and $500,000 for joint filers) of noncorporate taxpayers attributable to taxable years beginning in 2018 and subsequent years. The temporary repeal applies to taxable years beginning before January 1, 2021. Thus, noncorporate taxpayers (including partners and Subchapter S shareholders) whose 2018 and 2019 “excess business losses” were limited and carried forward by the prior version of section 461(l) must file amended returns to claim “excess business losses” that were disallowed and carried forward from those years.

a. The Service exercises its “equity and good conscience”—who knew?—to waive estimated tax underpayment penalties under section 6654, but only with respect to underpayments attributable to amended section 461(l) for original returns filed by July 15, 2020 (or, if extended, October 15, 2020). In Notice 2021-8, the Service acknowledges that an individual (including for this purpose trusts and estates) may have underpaid estimated taxes for 2019 if the individual anticipated using an “excess business loss” in 2019 under the prior version of section 461(l). Specifically, due to the CARES Act, section 2304, amendment of section 461(l), the taxpayer’s anticipated 2019 “excess business loss” is not available because it should be claimed on an amended 2018 return. So, exercising its “equity and good conscience” under section 6654(e)(3)(A)), the Service will waive the imposition of any 2019 estimated tax penalty under section 6654 attributable to amended section 461(l) if a taxpayer otherwise meets the requirements of Notice 2021-8. With respect, however, to elective carrybacks of NOLs under amended section 172(b)(1)(D) that may result in the imposition of a penalty under section 6654 for 2019, Notice 2021-8 provides that “equity and good conscience” do not require the Service to extend a similar waiver. The Service differentiates between the two circumstances by reasoning that taxpayers cannot elect out of amended section 461(l), but they can forgo the five-year carryback of NOLs under new section 172(b)(1)(D). The conditions and limitations of Notice 2021-8 are technical and complex, and affected taxpayers must request the waiver to qualify for relief under Notice 2021-8. In summary, therefore, individual taxpayers (including trusts and estates) with 2018 or 2019 NOLs against whom the Service has asserted estimated tax penalties under section 6654 should study Notice 2021-8 carefully to determine whether and to what extent a waiver is available.

2. Tax Court holds that the Service does not need written supervisory approval to apply the section 72(t) ten-percent penalty for early withdrawal from a retirement plan.

In general, under section 7491(c), the Service has the burden of production with respect to “any penalty, addition to tax, or additional amount.” To satisfy this burden, section 6751(b)(1) requires the Service to prove that “the initial determination of [the assessment of any penalty was] . . . personally approved (in writing) by the immediate supervisor of the individual making such determination.” Pursuant to section 6751(c), the term “penalties” as used in section 6571 includes “any addition to tax or any additional amount.”

In Grajales v. Commissioner, the taxpayer, Ms. Grajales, who was in her early 40s, took loans in connection with her New York State pension plan (the “Plan”). The Plan sent her a Form 1099-R that reflected total distributions of $9,026. Subject to certain exceptions, section 72(t)(1) provides that, if a taxpayer who has not attained age 59-1/2 receives a distribution from a retirement plan, the taxpayer’s tax must be increased by ten percent of the distribution. In filing her tax return, Ms. Grajales did not report any retirement plan distributions as income. The Service, however, determined that she should have included the $9,026 of Plan distributions in her income and that the distributions were subject to the ten-percent additional tax on early distributions under section 72(t).

The issue in this case was whether the ten-percent exaction of section 72(t) is a penalty, addition to tax, or additional amount within the meaning of section 6751(c). If so, then the Service was required by section 6751(b)(1) to have written, supervisory approval in order to impose the ten-percent additional amount provided for in section 72(t). The Tax Court (Judge Thornton) held that “the section 72(t) exaction is a ‘tax’ and not a ‘penalty,’ ‘addition to tax,’ or ‘additional amount.’” Because it is a “tax,” the court held, it is not subject to the section 6751(b) written supervisory approval requirement.

In reaching this conclusion, Judge Thornton acknowledged that none of the court’s decisions up to this point in time have expressly addressed whether the section 6751(b) written supervisory approval requirement applies to the ten-percent exaction of section 72(t). Judge Thornton relied on several Tax Court decisions that held that the section 72(t) exaction is a “tax.” For example, in Williams v. Commissioner, the court previously had held that the section 72(t) exaction imposed “a ‘tax’ rather than a penalty or an addition to tax within the meaning of section 7491(c)” for purposes of imposing the burden of production. Further, in El v. Commissioner, the Tax Court concluded that the exaction under section 72(t) was a tax for the following reasons:

First, section 72(t) calls the exaction that it imposes a “tax” and not a “penalty”, “addition to tax”, or “additional amount”. Second, several provisions in the Code expressly refer to the additional tax under section 72(t) using the unmodified term “tax”. See secs. 26(b)(2), 401(k)(8)(D), (m)(7)(A), 414(w)(1)(B), 877A(g)(6). Third, section 72(t) is in subtitle A, chapter 1 of the Code. Subtitle A bears the descriptive title “Income Taxes”, and chapter 1 bears the descriptive title “Normal Taxes and Surtaxes”. Chapter 1 provides for several income taxes, and additional income taxes are provided for elsewhere in subtitle A. By contrast, most penalties and additions to tax are in subtitle F, chapter 68 of the Code.

In following the court’s prior holdings, Judge Thornton rejected the taxpayer’s argument that the exaction of section 72(t) is an “additional amount” within the meaning of section 6751(c), reasoning that use of the phrase “additional amounts” when used in a series that also includes “tax” and “additions to tax” is a term of art that refers exclusively to civil penalties. Judge Thornton rejected several other arguments made by the taxpayer, including the assertion that the Tax Court must employ the “functional approach” adopted by the Supreme Court in National Federation of Independent Businesses v. Sebelius, in a constitutional analysis to conclude that an exaction was a “penalty” and not a “tax.” Judge Thornton distinguished NFIB on the basis that the circumstances in this case presented no constitutional issue. Further, neither party argued that section 72(t) is unconstitutional in this case. According to the Tax Court, for purposes of section 6751(b)(1) and (c), “the section 72(t) exaction is a ‘tax,’ rather than a ‘penalty’, ‘addition to tax’, or ‘additional amount’.” Therefore, section 6751(b) did not require written supervisory approval.

3. IRS revenue agents really need to learn to obtain the required supervisory approval of penalties before communicating the penalties to taxpayers.

In Beland v. Commissioner, the issue was whether the Service was precluded from asserting penalties because it had failed to comply with the requirement of section 6751(b)(1) that the initial determination of the assessment of a penalty be “personally approved (in writing) by the immediate supervisor of the individual making such determination.” The revenue agent auditing the 2011 return of the taxpayers, a married couple, issued an administrative summons to the taxpayers to appear. Pursuant to the summons, the taxpayers met with the revenue agent for a closing conference, which is held during the closing phase of an examination. During the conference, the revenue agent presented Form 4549, Income Tax Examination Changes, commonly referred to as the revenue agent’s report, which included a fraud penalty. The taxpayers declined to sign the revenue agent’s report or to consent to an extension of the limitations period on assessment. Following the meeting, the revenue agent sent the examination case file and a civil penalty approval form to a General Manager for approval. The General Manager signed the civil penalty approval form.

The Tax Court (Judge Greaves) held that the Service was precluded from asserting the fraud penalty. Among other authorities, the court relied on its prior decision in Belair Woods, LLC v. Commissioner, in which the court held that initial determination of a penalty occurs in the document through which the Service’s Examination Division notifies the taxpayer in writing that the examination is complete and it has made a decision to assert penalties. In this case, the court held, the initial determination of the penalty was the revenue agent’s report, which was presented to the taxpayers during the closing conference. Because the Service failed to secure the required supervisory approval before the initial determination of the penalty, section 6751(b)(1) precluded the Service from asserting the penalty.

4. Can you avoid penalties by relying on your attorney or CPA to file an extension request? No, says the Claims Court. An executor who relied on an attorney to file an extension request for an estate tax return did not have a reasonable cause defense to late-filing and late-payment penalties.

In Andrews v. United States, the plaintiff, who was the executor of an estate, brought this action seeking a refund of late-filing and late-payment penalties assessed by the Service against the estate. The estate’s return on Form 706 was due on May 8, 2016. The plaintiff retained an estate planning law firm to assist in preparing Form 706 and authorized the firm to file Form 4768 to obtain an automatic six-month extension of time to file. The plaintiff asserted that the attorney who was to file for the extension failed to do so and, after the May 8, 2016 filing deadline, filed Form 706 late and reported tax due of approximately $3 million. The Service assessed a late-filing penalty of just over $400,000 and a late-payment penalty of just over $75,000. The estate paid the tax due and all penalties and interest, filed an administrative claim for refund of the penalties and, in this action, challenges the Service’s failure to issue the refund. The government moved to dismiss for failure to state a claim on the ground that the estate could not establish a reasonable cause defense to the penalties.

In an opinion by Judge Davis, the Court of Federal Claims granted the government’s motion to dismiss. In reaching its conclusion, the court relied on the Supreme Court’s decision in United States v. Boyle. In Boyle, the Court held that “failure to make a timely filing of a tax return is not excused by [a] taxpayer’s reliance on an agent.” The Court in Boyle distinguished relying on an agent from situations in which a taxpayer relies on the mistaken advice of counsel concerning a question of tax law, which courts have held can constitute reasonable cause. In this case, the Court of Federal Claims held the executor of the estate had not relied on mistaken advice of counsel, but rather had delegated responsibility for filing an extension request. Under the standard set forth in Boyle, the court held, such delegation to an agent does not give rise to a reasonable cause defense to penalties. Accordingly, the court granted the government’s motion to dismiss.

5. Can’t we cut this guy a break? No, says the Fifth Circuit. Even though the taxpayer was incarcerated and the person he appointed as his attorney-in-fact to file his returns and manage his affairs failed to do so and embezzled hundreds of thousands of dollars, the taxpayer could not establish a reasonable cause defense to penalties.

In Lindsay v. United States, the taxpayer was incarcerated from 2013 to 2015. He appointed an individual, Keith Bertelson, to act as his attorney-in-fact under a power of attorney that gave Bertelson authority to manage the taxpayer’s affairs. Bertelson failed to file the taxpayer’s returns and pay taxes due as he had been directed. Bertelson also embezzled the taxpayer’s funds. The taxpayer ultimately recovered more than $700,000 in actual damages from Bertelson and $1 million in punitive damages.

After being released, the taxpayer filed late returns for 2012 through 2015. The Service assessed late-filing and late-payment penalties of more than $400,000. After filing an administrative claim for refund of the penalties, the taxpayer brought this action seeking a refund on the basis that his incarceration qualified as a “disability.” In an opinion by Judge Stewart, the Court of Appeals for the Fifth Circuit rejected the taxpayer’s argument. The court relied on the Supreme Court’s decision in United States v. Boyle. In Boyle, the Court held that “failure to make a timely filing of a tax return is not excused by [a] taxpayer’s reliance on an agent.” The Court in Boyle distinguished relying on an agent from situations in which a taxpayer relies on the mistaken advice of counsel concerning a question of tax law, which courts have held can constitute reasonable cause. In this case, the Fifth Circuit concluded, the taxpayer had not relied on mistaken advice of counsel, but rather had delegated responsibility for filing his tax returns. Under the standard set forth in Boyle, the court held, such delegation to an agent does not give rise to a reasonable cause defense to penalties. The court also concluded that this was not a situation in which the taxpayer was incapable of meeting his filing obligations and therefore did not fall into the category of situations in which courts have recognized a reasonable cause defense for taxpayers who are not physically or mentally capable of complying with a filing deadline. Accordingly, the court granted the government’s motion to dismiss.

6. Updated instructions on how to rat yourself out.

Revenue Procedure 2021-52 updates Revenue Procedure 2020-54, and identifies circumstances under which the disclosure on a taxpayer’s income tax return with respect to an item or a position is adequate for the purpose of reducing the understatement of income tax under section 6662(d), relating to the substantial understatement aspect of the accuracy-related penalty, and for the purpose of avoiding the tax return preparer penalty under section 6694(a), relating to understatements due to unreasonable positions. There have been no substantive changes. The Revenue Procedure does not apply with respect to any other penalty provisions, including section 6662(b)(1) accuracy-related penalties. If this Revenue Procedure does not include an item, disclosure is adequate with respect to that item only if made on a properly completed Form 8275 or 8275-R, as appropriate, attached to the return for the year or to a qualified amended return. A corporation’s complete and accurate disclosure of a tax position on the appropriate year’s Schedule UTP, Uncertain Tax Position Statement, is treated as if the corporation had filed a Form 8275 or Form 8275-R regarding the tax position. The Revenue Procedure applies to any income tax return filed on a 2021 tax form for a taxable year beginning in 2021 and to any income tax return filed on a 2021 tax form in 2022 for a short taxable year beginning in 2022.

B. Discovery: Summonses and FOIA

There were no significant developments regarding this topic during 2021.

C. Litigation Costs

There were no significant developments regarding this topic during 2021.

D. Statutory Notice of Deficiency

There were no significant developments regarding this topic during 2021.

E. Statute of Limitations

1. Dear Shareholder-Transferees: Remember that midco transaction 24 years ago where your now-defunct C corporation dodged $13 million or so in tax? The tax bill currently stands at roughly $61 million, and the Service can still come after you.

United States v. Henco Holding Corp. demonstrates how far back into the past the Service’s collection powers can reach. The decision involved the taxpayer’s 1997 tax return. The Court of Appeals for the Eleventh Circuit noted that the Service “timely assessed tax liabilities . . . on October 26, 2007, beginning the ten-year time period for collection of those assessed taxes” per section 6502. Once the taxpayer contested the assessed taxes “in a collection due process proceeding, the statute of limitations was tolled until the conclusion of that proceeding on October 19, 2011.” Therefore, the action filed on June 27, 2018, was within the applicable ten-year statute of limitations.

F. Liens and Collections

1. Coworking might carry some tax risk. A notice of intent to levy sent by certified mail to shared office space and signed for by someone unaffiliated with the taxpayer triggered the 30-day period for requesting a CDP hearing.

In Ramey v. Commissioner, the Service had mailed a notice of intent to levy on July 13, 2018. The notice of intent to levy informed the taxpayer that he could request a collection due process (CDP) hearing by mailing Form 12153 to the Service by August 12, 2018. The Service mailed the notice by certified mail with a return receipt requested. The taxpayer did not challenge the address to which the notice was sent. An individual signed for the notice, but the taxpayer maintained that several businesses used the same address and that the individual who signed was not his employee and was not authorized to receive mail on his behalf. The taxpayer actually received the notice shortly before the August 12 deadline to request a CDP hearing. The taxpayer mailed Form 12153 to the Service after the August 12 deadline, and the IRS Appeals Office therefore treated his submission as untimely and provided an “equivalent hearing” pursuant to Regulation section 301.6330-1(i)(1).

Following the hearing, the IRS Appeals Office issued a “Decision Letter on Equivalent Hearing Under Internal Revenue Code Sections 6320 and/or 6330” upholding the proposed collection action. The taxpayer filed a petition in the Tax Court seeking review of the decision letter. The Service moved to dismiss for lack of subject-matter jurisdiction on the ground that it had not issued a notice of determination following a CDP hearing and that a decision letter following an equivalent hearing is not subject to judicial review. The taxpayer responded that the notice of intent to levy mailed by the Service was invalid because it had not been properly served and had been signed for by a “random person.”

The Tax Court (Judge Toro) granted the Service’s motion to dismiss. The court reasoned that section 6330(d)(1) grants the Tax Court jurisdiction to review a determination made by IRS Appeals under section 6330, but that the court’s jurisdiction is contingent on both the issuance of a valid notice of determination by IRS Appeals and the filing of a timely petition (within 30 days) by the taxpayer. In this case, the court observed, the Service had not issued a notice of determination. Nevertheless, the court inquired whether the taxpayer had timely requested a CDP hearing by filing Form 12153 because, in prior decisions, the court had concluded that, if the IRS Appeals Office incorrectly concludes that the taxpayer’s request for a CDP hearing was untimely and issues a decision letter, the court would treat the decision letter as a notice of determination that confers jurisdiction on the court.

The court then concluded that the taxpayer’s request for a CDP hearing was untimely. The court rejected the taxpayer’s argument that the notice of levy was deficient because he did not sign for it or receive it in a timely manner and the person who did sign for it had no authority to receive it. The court observed that, under section 6330(a)(2), there are three ways in which the Service can provide notice of its intent to levy. The third authorized method is for the notice to be “‘sent by certified or registered mail, return receipt requested,’ to the taxpayer’s last known address.” According to the court, this method

focuses on the sending of the notice, not the taxpayer’s receipt of it. It describes the type of USPS service the IRS must select—certified or registered mail, return receipt requested. . . . The primary responsibility of the IRS under this method of service is to place the notice in the hands of the USPS. So long as the IRS properly addresses the notice to the taxpayer’s last known address and selects the correct type of service from the USPS . . . the IRS complies with the terms of the statute.

This conclusion, the court observed, is reflected in the regulations under section 6330, which provide that “[a]ctual receipt is not a prerequisite to the validity of the CDP [n]otice.” Accordingly, the court concluded, the Service’s mailing of the notice of intent to levy started the running of the 30-day period for the taxpayer to request a CDP hearing and the taxpayer’s request was untimely. The court noted that the taxpayer was not left without an opportunity to seek judicial review of his tax obligations because he could pay the tax in question, seek a refund, and then bring a refund action in a federal district court or the Court of Federal Claims.

2. The 30-day period for requesting review in the Tax Court of a notice of determination following a CDP hearing is jurisdictional and not subject to equitable tolling.

In Boechler, P.C. v. Commissioner, the Service issued a notice of determination upholding proposed collection action following a CDP hearing. The notice informed the taxpayer that, if he wished to contest the determination, he could do so by filing a petition with the Tax Court within a 30-day period beginning the day after the date of the letter. The Service mailed the notice on July 28, 2017. The 30-day period expired on August 27, 2017, but because this date fell on a Sunday, the taxpayer had until the following day, August 28, to file his petition. The taxpayer mailed his petition to the Tax Court on August 29, 2017, which was one day late. The Tax Court (Judge Carluzzo) granted the government’s motion to dismiss for lack of subject-matter jurisdiction.

On appeal, the taxpayer argued that the 30-day period specified in section 6330(d)(1) for filing his Tax Court petition should be equitably tolled. In an opinion by Judge Erickson, the Court of Appeals for the Eighth Circuit affirmed the Tax Court’s decision. The court held that the 30-day period specified in section 6330(d)(1) is jurisdictional and therefore is not subject to equitable tolling. In reaching this conclusion, the court relied on the plain language of section 6330(d)(1), which provides:

A person may, within 30 days of a determination under this section, petition the Tax Court for review of such determination (and the Tax Court shall have jurisdiction with respect to such matter).

This provision, the court reasoned, “is a rare instance where Congress clearly expressed its intent to make the filing deadline jurisdictional.” According to the court, the parenthetical expression regarding the Tax Court’s jurisdiction “is clearly jurisdictional and renders the remainder of the sentence jurisdictional.” Because the 30-day period specified in section 6330(d)(1) is jurisdictional, the court concluded, it is not subject to equitable tolling.

In reaching its conclusion, the court found persuasive the reasoning of the Court of Appeals for the Ninth Circuit in Duggan v. Commissioner, in which the Ninth Circuit similarly held that the 30-day period specified in section 6330(d)(1) is jurisdictional and therefore not subject to equitable tolling. The Eighth Circuit found unpersuasive the taxpayer’s reliance on Myers v. Commissioner, in which the D.C. Circuit held that a similarly worded 30-day limitations period in section 7623(b)(4) for filing a Tax Court petition to challenge an adverse Service determination regarding entitlement to a whistleblower award was not jurisdictional and was subject to equitable tolling.

a. The Supreme Court will consider whether the 30-day period for requesting review in the Tax Court of a notice of determination following a CDP hearing is jurisdictional and not subject to equitable tolling. The Supreme Court has granted the taxpayer’s petition for a writ of certiorari in Boechler, in which the Court of Appeals for the Eighth Circuit held that the 30-day period specified in section 6330(d)(1) for requesting review in the Tax Court of a notice of determination following a CDP hearing is jurisdictional and therefore is not subject to equitable tolling. According to the Court’s grant of the writ, the question presented is:

Whether the time limit in section 6330(d)(1) is a jurisdictional requirement or a claim processing rule subject to equitable tolling.

3. A taxpayer who failed to request a CDP hearing in response to a notice of federal tax lien was barred by section 6330(c)(2)(B) from challenging his underlying tax liability when he later received a notice of levy and requested a CDP hearing because the prior opportunity for a CDP hearing provided the taxpayer with an opportunity to contest his underlying tax liability.

Section 6330(c)(2)(B) permits a taxpayer to challenge the existence or amount of the taxpayer’s underlying tax liability in a CDP hearing only “if the person did not receive any statutory notice of deficiency for such tax liability or did not otherwise have an opportunity to dispute such tax liability.” In Jeffers v. Commissioner, the Service assessed additional tax with respect to the taxpayer’s 2008 return, and the taxpayer filed a 2009 return on which he reported that he owed more than $12,000 in tax, which he did not pay. The Service later mailed the taxpayer a notice of federal tax lien with respect to both years. The notice informed the taxpayer of his right to request a CDP hearing, but the taxpayer did not request one. He then filed amended returns claiming additional refunds with respect to both years. Before the amended returns were processed, the Service issued a final notice of intent to levy, in response to which the taxpayer requested a CDP hearing. In the CDP hearing, the IRS settlement officer took the position that section 6330(c)(2)(B) precluded the taxpayer from challenging the underlying tax liability for both years because the taxpayer previously had been provided the option to request a CDP hearing in response to the notice of federal tax lien, which meant that the taxpayer had a prior opportunity to dispute the underlying liability within the meaning of the statute. Following the CDP hearing, the Service issued a notice of determination upholding the collection action, and the taxpayer filed a petition in the Tax Court.

The Tax Court (Judge Paris) granted the government’s motion for summary judgment and held that the taxpayer had a prior opportunity to contest the underlying liability and therefore was precluded by section 6330(c)(2)(B) from contesting the liability in the CDP hearing that resulted in the notice of determination. In an opinion by Judge Manion, the Court of Appeals for the Seventh Circuit affirmed. The relevant regulation, Regulation section 301.6330-1(e)(3), Q&A-E7, provides:

If the taxpayer previously received a CDP Notice under section 6320 [the provision for notice of a federal lien] with respect to the same tax and tax period and did not request a CDP hearing with respect to that earlier CDP Notice, the taxpayer had a prior opportunity to dispute the existence or amount of underlying tax liability.

In this case, the court reasoned, the taxpayer had previously received a CDP notice with respect to the same tax and tax periods and had failed to request a CDP hearing, and therefore had a prior opportunity to dispute the underlying liability. The court assessed the validity of the regulation by applying the two-step analysis of Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc. The court concluded in Chevron step one that the statute, section 6330(c)(2)(B), is ambiguous, and in step two that Regulation section 301.6330-1 is a reasonable interpretation of the statute.

4. Economic-hardship relief from a levy is not available to a corporate taxpayer.

In Seminole Nursing Home, Inc. v. Commissioner, the taxpayer, a corporation that operated a nursing home in rural Oklahoma, failed to pay its federal withholding and employment taxes in the amount of just over $60,000 for the fourth quarter of 2013. In response to the Service’s final notice of intent to levy, the taxpayer requested a CDP hearing, proposed an installment agreement, and submitted a letter to the IRS settlement officer challenging the appropriateness of the levy on the grounds of economic hardship. The taxpayer argued that it was operating at a loss and could not “‘provide essential care services to the patients residing at [its] nursing facility’” if the Service were permitted to levy. The taxpayer’s assets included more than $313,000 in accounts receivable from Medicare and Medicaid. At the CDP hearing, the IRS settlement officer rejected the proposed installment agreement on the grounds that the taxpayer had sufficient assets to pay its outstanding tax liability and that the taxpayer was not current with its federal employment tax deposits for 2014. The IRS settlement officer also declined to consider the economic-hardship argument because, under the relevant regulation, relief is available only on account of economic hardship of an individual taxpayer. The regulation provides that the Service must release a levy if one of several conditions is satisfied, including the following:

The levy is creating an economic hardship due to the financial condition of an individual taxpayer. This condition applies if satisfaction of the levy in whole or in part will cause an individual taxpayer to be unable to pay his or her reasonable basic living expenses.

The IRS settlement officer issued a notice of determination upholding the collection action.

The taxpayer filed a petition in the Tax Court and moved for summary judgment on the grounds that the regulation’s limitation of economic-hardship relief to individuals is contrary to the statute (section 6343(a)(1)(D)) and therefore invalid and that the settlement officer had abused her discretion by failing to consider its request for economic-hardship relief. The Tax Court had previously upheld the validity of the regulation in Lindsay Manor Nursing Home, Inc. v. Commissioner, and in this case the Tax Court (Judge Paris) adhered to its prior decision. Following a remand to the IRS Appeals Office and the Service’s issuance of a supplemental notice of determination upholding the collection action, the Tax Court, in an unpublished order, sustained the Service’s notice of determination.

On appeal, in an opinion by Judge Hartz, the Court of Appeals for the Tenth Circuit upheld the validity of the regulation and concluded that the settlement officer had not abused her discretion in sustaining the collection action. The relevant statute, section 6343(a)(1)(D), provides that, “under regulations prescribed by the Secretary,” a levy shall be released if “the Secretary has determined that such levy is creating an economic hardship due to the financial condition of the taxpayer.” The regulation in question interprets the economic-hardship exception as being available only to individual taxpayers. The court assessed the validity of the regulation by applying the two-step analysis of Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc. The court concluded in Chevron step one that the statute, section 6343(a)(1)(D), is ambiguous, and in step two that Regulation section 301.6343-1 is a permissible construction of the statute. In its analysis of Chevron step one, the court examined not only the plain language of the statute but also its structure and apparent purpose. The court reasoned:

In what sense, though, might a corporation suffer economic hardship that could reasonably excuse releasing a tax levy on its assets? Say the corporation is in absolutely dire straits; it cannot survive even if the levy is released, or even if the tax liability is canceled altogether. In that circumstance, what purpose could possibly be served by preventing the IRS from seizing corporate assets under the levy? Perhaps another creditor of the corporation would benefit because it could collect through assets that would otherwise be seized by the IRS. But benefiting other creditors (likely at the expense of the IRS) could hardly be the purpose of the economic-hardship exception. This example points up an essential difference between an individual and a nonindividual entity.

Accordingly, the court affirmed the decision of the Tax Court.

G. Innocent Spouse

There were no significant developments regarding this topic during 2021.

H. Miscellaneous

1. Micro-captive insurance transactions are “transactions of interest” that might be on their way to being listed.

Notice 2016-66 identifies certain captive insurance arrangements, referred to as “micro-captive transactions,” as transactions of interest for purposes of Regulation section 1.6011-4(b)(6) and sections 6111 and 6112. Generally, these arrangements involve a person who owns an insured business and that same person, or a related person also owns an interest in the insurance company providing coverage. The insured business deducts the premiums paid to the insurance company, and the insurance company, by making the election under section 831(b) to be taxed only on taxable investment income, excludes the premiums from gross income. An insurance company making the section 831(b) election can receive up to $2.2 million in premiums annually (adjusted for inflation after 2015). The Notice describes the coverage under these arrangements as having one or more of the following characteristics:

(1) the coverage involves an implausible risk;

(2) the coverage does not match a business need or risk of Insured;

(3) the description of the scope of the coverage in the Contract is vague, ambiguous, or illusory; or

(4) the coverage duplicates coverage provided to Insured by an unrelated, commercial insurance company, and the policy with the commercial insurer often has a far smaller premium.

The Treasury Department and the Service believe these transactions have a potential for tax avoidance or evasion but lack enough information to determine whether the transactions should be identified specifically as a tax avoidance transaction. Transactions that are the same as, or substantially similar to, the transaction described in section 2.01 of the Notice are identified as “transactions of interest” for purposes of Regulation section 1.6011-4(b)(6) and sections 6111 and 6112 effective November 1, 2016. Persons entering into these transactions after November 1, 2006, must disclose the transaction as described in Regulation section 1.6011-4.

a. Participants in micro-captive insurance transactions have until May 1, 2017, to disclose their participation in years for which returns were filed before November 1, 2016. Notice 2017-8 extends the due date for participants to disclose their participation in the micro-captive insurance transactions described in Notice 2016-66. Generally, under Regulation section 1.6011-4(e)(2)(i), if a transaction becomes a transaction of interest or a listed transaction after a taxpayer has filed a return reflecting the taxpayer’s participation in the transaction, then the taxpayer must disclose the transaction for any year for which the limitations period on assessment was open on the date the transaction was identified as a listed transaction or transaction of interest within 90 calendar days after the date on which the transaction was identified. This meant that, for open years for which returns already had been filed on November 1, 2016 (the date on which Notice 2016-66 was issued), disclosures were due on January 30, 2017. In Notice 2017-8, the Service has extended the due date from January 30 to May 1, 2017.

b. Sixth Circuit sides with the Service against micro-captive advisor’s attack on Notice 2016-66 and “reportable transactions.” In CIC Services, LLC v. Internal Revenue Service, a 2-1 decision reflected in an opinion by Judge Clay, the Court of Appeals for the Sixth Circuit affirmed the district court’s dismissal of a lawsuit against the Service challenging the Service’s categorization of certain micro-captive insurance arrangements as “reportable transactions” in Notice 2016-66. The plaintiff, CIC Services, LLC, advises taxpayers with respect to micro-captive insurance arrangements. Generally, these arrangements involve a taxpayer who owns an insured business while that same taxpayer or a related person also owns an interest in an insurance company providing coverage to the business. The insured business deducts the premiums paid to the insurance company, and the insurance company, by making the election under section 831(b) to be taxed only on taxable investment income, excludes the premiums from gross income. In 2019, an insurance company making the section 831(b) election could receive up to $2.3 million in excludable premiums. Back in 2016, the Service issued Notice 2016-66, which identified certain of these micro-captive insurance arrangements as abusive and thus “transactions of interest” for purposes of the “reportable transaction” rules of sections 6111 and 6112 and Regulation section 1.6011-4(b)(6). Significant penalties can be imposed upon taxpayers and their material advisers for failing to comply with the “reportable transaction” rules.

The plaintiff took offense at the Service’s position regarding micro-captives and filed suit in the District Court for the Eastern District of Tennessee to enjoin enforcement of Notice 2016-66. The plaintiff alleged that the Service had promulgated Notice 2016-66 in violation of the Administrative Procedure Act and the Congressional Review Act. The Service countered that the plaintiff’s complaint was barred by the Anti-Injunction Act and the tax exception to the Declaratory Judgment Act (together, the AIA). Generally, the AIA bars lawsuits filed “for the purpose of restraining the assessment or collection of any tax” by the Service. Responding to the Service, the plaintiff characterized its suit as one relating to tax reporting requirements, not tax assessment and collection. The plaintiff therefore contended that its lawsuit was not barred by the AIA. The Service, on the other hand, argued that the case ultimately was about tax assessment and collection because the penalties imposed under the “reportable transaction” regime are treated as taxes for federal income tax purposes. The plaintiff cited as support for its argument the Supreme Court’s decision in Direct Marketing Ass’n v. Brohl, which allowed a lawsuit to proceed against Colorado state tax authorities despite the Tax Injunction Act (TIA). The TIA, which protects state tax assessments and collections, is modeled on the AIA. The Service, on the other hand, argued that the decision of the Court of Appeals for the District of Columbia Circuit in Florida Bankers Ass’n v. U.S. Dep’t of the Treasury, which distinguished Direct Marketing, reflected the proper analysis. The court in Florida Bankers Ass’n held that the AIA applied to bar a suit seeking to enjoin the Service’s enforcement of certain penalties. The suit was barred by the AIA, according to the court in Florida Bankers Ass’n, because the penalties at issue in that case were treated as federal income taxes for assessment and collection purposes, unlike the action challenged in Direct Marketing.

Writing for the majority, Judge Clay rejected the plaintiff’s Direct Marketing argument and agreed with the Service’s Florida Bankers Ass’n argument. Judge Clay reasoned that, like the penalties at issue in Florida Bankers Ass’n, the “reportable transaction” penalties are located in Chapter 68, Subchapter B of the Code and thus are treated as taxes for federal income tax purposes. Therefore, the decision of the D.C. Circuit in Florida Bankers Ass’n is directly on point. Judge Clay also ruled that the plaintiff’s lawsuit did not fall within any of the exceptions to the AIA. Hence, the AIA barred the plaintiff’s lawsuit because the plaintiff, by seeking to enjoin enforcement of Notice 2016-66, is indirectly attempting to thwart the Service’s assessment and collection of a tax.

Judge Nalhandian dissented and would have held that the suit was not barred by the AIA. He reasoned that the suit involved a challenge to a tax reporting requirement, albeit one with a penalty attached for noncompliance, and that the AIA does not bar challenges to tax reporting requirements.

c. The Service is making time-limited settlement offers to those with micro-captive insurance arrangements. The Service has announced that it has begun sending time-limited settlement offers to certain taxpayers with micro-captive insurance arrangements. The Service has done so following three recent decisions of the Tax Court that disallowed the tax benefits associated with these arrangements. The terms of the offer, which must be accepted within 30 days of the date of the letter making the offer, generally are as follows: (1) the Service will deny 90% of any deductions claimed for captive insurance premiums; (2) the captive insurance company will not be required to recognize taxable income for received premiums; (3) the captive must already be liquidated, will be required to liquidate, or agree to a deemed liquidation that results in dividend income for the shareholders; (4) accuracy-related penalties are reduced to a rate of ten percent and can be reduced to five percent or zero percent if certain conditions are met; (5) if none of the parties to the micro-captive insurance transaction disclosed it as required by Notice 2016-66, a single penalty of $5,000 will be applied under section 6707A (Penalty for Failure to Include Reportable Transaction Information with Return), and (6) additions to tax for failure to file or pay tax under section 6651 and failure to pay estimated income tax under sections 6654 and 6655 may apply.

d. Approximately 80% of taxpayers receiving micro-captive insurance settlement offers accepted them. The Service is establishing 12 new examination teams that are expected to open audits related to thousands of taxpayers. The Service previously announced that it had begun sending time-limited settlement offers to certain taxpayers with micro-captive insurance arrangements. The Service has now announced that “[n]early 80% of taxpayers who received offer letters elected to accept the settlement terms.” The Announcement also informs taxpayers that “the IRS is establishing 12 new examination teams that are expected to open audits related to thousands of taxpayers in coming months.” Finally, the Announcement reminds taxpayers that Notice 2016-66 requires disclosure of micro-captive insurance transactions with the IRS Office of Tax Shelter Analysis and that failure to do so can result in significant penalties.

Note: The authors understand that, in March 2020, the Service issued Letter 6336 to thousands of taxpayers seeking information about their participation in micro-captive insurance transactions. The letters initially asked for a response by May 4, 2020, which subsequently was extended to June 4, 2020.

e. The Supreme Court revives a taxpayer’s challenge to Notice 2016-66. In a unanimous opinion by Justice Kagan in CIC Services, LLC v. Internal Revenue Service, the Supreme Court reversed the decision of the Court of Appeals for the Sixth Circuit and held that the AIA did not bar the suit by CIC Services, LLC, challenging the Service’s categorization in Notice 2016-66 of certain micro-captive insurance arrangements as “transactions of interest” for the purposes of sections 6011 and 6012 and Regulation section 1.6011-4, which impose disclosure and information maintenance and reporting requirements, with which the failure to comply results in the imposition of penalties. The Court reasoned that a suit to enjoin a reporting requirement is not an action to restrain the assessment or collection of a tax, even if the information will help the Service collect future tax revenue, such as by identifying sham insurance transactions. Although noncompliance with the Notice’s reporting requirement could result in penalties, the Court concluded that this did not change the result because the suit contested the legality of the Notice, not of the statutory penalty that served as a way to enforce it.

2. You say “FBAR.” We say “FUBAR.” Although the Treasury Depart-ment has failed to update relevant FBAR regulations, the penalty for willful violations is not capped at $100,000 per account, says the Federal Circuit.

One of the issues in Norman v. United States was whether substantial foreign bank account reporting (FBAR) penalties assessed by the Service were reduced. Under 31 U.S.C. section 5321(a)(5)(A), the Secretary of the Treasury “may impose” a penalty for FBAR violations, and pursuant to administrative orders, the authority to impose FBAR penalties has been delegated by the Secretary to the Service. Further, under the current version of 31 U.S.C. section 5321(a)(5)(B)(i), the normal penalty for an FBAR violation is $10,000 per offending account; however, the penalty for a willful FBAR violation “shall be increased to the greater of” $100,000 or 50% of the balance in the offending account at the time of the violation. These minimum and maximum penalties for willful FBAR violations were changed by the American Jobs Creation Act of 2004 (AJCA). The prior version of 31 U.S.C. section 5321(a)(5) provided that the penalty for willful FBAR violations was the greater of $25,000 or the balance of the unreported account up to $100,000. Regulations issued under the pre-AJCA version of 31 U.S.C. section 5321(a)(5), reflecting the law at the time, capped the penalty for willful FBAR violations to $100,000 per account.

In Norman, the government assessed a penalty of $803,500 for failure to file an FBAR in 2007 with respect to a Swiss bank account. The taxpayer argued that the “may impose” language of the relevant statute, 31 U.S.C. section 5321(a)(5), provides the Secretary of the Treasury with discretion to determine the amount of assessable FBAR penalties and that, because the outdated regulations had not been amended to reflect the AJCA’s increase in the minimum and maximum FBAR penalties, the Service’s authority was limited to the amount prescribed by the existing regulations. The court reasoned that the amended statute, which provides that the amount of penalties for willful FBAR violations shall be increased to the greater of $100,000 or 50% of the account value, is mandatory and removed the Treasury Department’s discretion to provide for a smaller penalty by regulation. According to the court, the statute gives the Treasury Department discretion whether to impose a penalty in particular cases, but not discretion to set a cap on the penalty that is different than the cap set forth in the statute.

Recklessness as willfulness. The relevant statute provides an enhanced penalty for a person who “willfully” fails to comply with the requirement to file an FBAR. The court considered whether a taxpayer who recklessly fails to comply with the requirement to file an FBAR can be treated as having committed a willful violation. The taxpayer argued “that willfulness in this context require[d] a showing of actual knowledge of the obligation to file an FBAR.” The court disagreed. The court relied on the Supreme Court’s decision in Safeco Ins. Co. of Am. v. Burr, in which the Court had observed that, when willfulness is a statutory condition of civil (as opposed to criminal) liability, the Court had “‘generally taken it to cover not only knowing violations of a standard, but reckless ones as well.’” Accordingly, in this case, the court held, “willfulness in the context of [31 U.S.C.] § 5321(a)(5) includes recklessness.” The court observed that its interpretation of the statute was consistent with prior decisions of the Courts of Appeals for the Third and Fourth Circuits. The court examined the taxpayer’s conduct, which included false statements to the Service about her foreign account, and concluded that the Court of Federal Claims had not clearly erred in determining that she had willfully violated the requirement to file an FBAR. Specifically, the court rejected the taxpayer’s argument that her failure could not be willful because she had not read her federal income tax return before signing it.

Other courts have concluded that the penalty for willful violations is not capped at $100,000. Several federal district courts have considered whether the outdated regulation limits the penalty for a willful FBAR violation to $100,000 per account and reached different conclusions.

a. The Fourth Circuit agrees that recklessness is sufficient to establish a willful FBAR violation and that the penalty for a willful FBAR violation is not capped at $100,000. In an opinion by Judge Niemeyer in United States v. Horowitz, the Court of Appeals for the Fourth Circuit held that (1) recklessness is sufficient to establish a willful FBAR violation and (2) the penalty for a willful FBAR violation is not capped at $100,000. With respect to the first issue, the court adopted the same line of reasoning as the Court of Appeals for the Federal Circuit in Norman (i.e., the court relied on the Supreme Court’s decision in Safeco, in which the Court had observed that, when willfulness is a statutory condition of civil (as opposed to criminal) liability, the Court had “generally taken it to cover not only knowing violations of a standard, but reckless ones as well”). The court provided further guidance on the meaning of the term “recklessness”:

In the civil context, “recklessness” encompasses an objective standard—specifically, “[t]he civil law generally calls a person reckless who acts or (if the person has a duty to act) fails to act in the face of an unjustifiably high risk of harm that is either known or so obvious that it should be known.” . . . In this respect, civil recklessness contrasts with criminal recklessness and willful blindness, as both of those concepts incorporate a subjective standard.

In this case, the court concluded, the taxpayers, who were aware that their Swiss bank account was earning interest and that interest was taxable income and who failed to disclose the foreign account to the accountant preparing their tax return, had been reckless and therefore willful in failing to file an FBAR.

The court also rejected the taxpayer’s argument that, because the “may impose” language of 31 U.S.C. section 5321(a)(5)(A) leaves the amount of assessable FBAR penalties to the discretion of the Secretary of the Treasury and the (albeit outdated) regulations had not been amended to reflect the AJCA’s increase in the minimum and maximum FBAR penalties, the Service’s authority was limited to the amount prescribed by the existing regulations. The existing regulations limit the FBAR penalty for willful violations to $100,000 per unreported account. The court reasoned that the relevant statute did not authorize the Secretary of the Treasury to impose a lower maximum penalty for willful FBAR operations. According to the court, “the 1987 regulation on which the Horowitzes rely was abrogated by Congress’s 2004 amendment to the statute and therefore is no longer valid.”

b. The Eleventh Circuit agrees: recklessness is sufficient to establish a willful FBAR violation and the penalty for a willful FBAR violation is not limited to $100,000. In a per curiam opinion in United States v. Rum, the Court of Appeals for the Eleventh Circuit held that (1) recklessness is sufficient to establish a willful FBAR violation and (2) the penalty for a willful FBAR violation is not capped at $100,000. With respect to the first issue, the court adopted the same line of reasoning as the Courts of Appeals for the Federal and Fourth Circuits in Norman and Horowitz. For purposes of determining whether a reckless (and therefore willful) FBAR violation had occurred, the Eleventh Circuit adopted the meaning of recklessness set forth in Safeco:

The Safeco Court stated that “[w]hile the term recklessness is not self-defining, the common law has generally understood it in the sphere of civil liability as conduct violating an objective standard: action entailing an unjustifiably high risk of harm that is either known or so obvious that it should be known.”

In this case, the taxpayer had filed tax returns for many years on which he indicated that he had no interest in a foreign financial account despite the fact he had a Swiss bank account at UBS. He also reported the account for some purposes, such as to demonstrate his financial strength when obtaining a mortgage, but not for others, such as applying for financial aid for his children’s college costs. According to the Eleventh Circuit, the district court had not erred in granting summary judgment to the government on the issue of whether the taxpayer had acted recklessly and therefore willfully in failing to file FBARs.

The court also rejected the taxpayer’s argument that, because the “may impose” language of 31 U.S.C. section 5321(a)(5)(A) leaves the amount of assessable FBAR penalties to the discretion of the Secretary of the Treasury and the (albeit outdated) regulations had not been amended to reflect the AJCA’s increase in the minimum and maximum FBAR penalties, the Service’s authority was limited to the amount prescribed by the existing regulations:

The plain text of § 5321(a)(5)(C) makes it clear that a willful penalty may exceed $100,000 because it states that the maximum penalty “shall be . . . the greater of (I) $100,000, or (II) 50 percent of the amount determined under subparagraph (D),” which is the balance of the account.

c. The Second Circuit also holds that the penalty for a willful FBAR violation is not capped at $100,000. In an opinion by Judge Kearse in United States v. Kahn, the Court of Appeals for the Second Circuit has agreed with the other federal courts of appeal that have considered the issue and held that the penalty for willful FBAR violations is not capped at $100,000 per account. The court concluded that the 2004 amendments to 31 U.S.C. section 5321(a)(5)(C) rendered invalid the 1987 regulation that limits the penalty for willful FBAR violations to $100,000 per account.

In a dissenting opinion, Judge Menashi argued that the regulation does not conflict with the statute and that the Treasury Department was bound by its own regulation:

The Treasury Department’s current regulations provide that the penalty for Harold Kahn’s willful failure to file a Report of Foreign Bank and Financial Accounts (“FBAR”) may not exceed $100,000. See 31 C.F.R. § 1010.820(g)(2). This penalty falls within the statutorily authorized range. See 31 U.S.C. § 5321(a)(5). While the governing statute also authorizes penalties greater than $100,000, it nowhere mandates that the Secretary impose a higher fine. See id. In fact, the statute gives the Secretary discretion to impose no fine at all. See id. § 5321(a)(5)(A). The current regulation therefore does not conflict with the governing statute and the Secretary must adhere to that regulation as long as it remains in effect.

3. Surely it’s not constitutional for the government to revoke or refuse to issue an individual’s passport just for having a seriously delinquent tax debt? Isn’t there some sort of fundamental right to travel? Don’t pack your bags just yet.

Section 7345, which addresses the revocation or denial of passports for seriously delinquent tax debts, was enacted in 2015 as section 32101(a) of the Fixing America’s Surface Transportation Act (FAST Act). It provides that, if the Service certifies that an individual has a “seriously delinquent tax debt,” the Secretary of the Treasury must notify the Secretary of State “for action with respect to denial, revocation, or limitation of a passport.” In general, a seriously delinquent tax debt is an unpaid tax liability in excess of $50,000 for which a lien or levy has been imposed. A taxpayer who seeks to challenge such a certification may petition the Tax Court (or bring an action in a federal district court) to determine if the certification was made erroneously. If the Tax Court concludes the certification was either made in error or that the Service has since reversed its certification, the court may order the Secretary of the Treasury to notify the State Department that the certification was erroneous. In the following cases, the courts have addressed the constitutionality of this regime.

a. Section 7345 does not prohibit international travel and therefore cannot violate either the Due Process Clause of the Fifth Amendment or the Universal Declaration of Human Rights, says the Tax Court. The opinion of the Tax Court (Judge Toro) in Rowen v. Commissioner begins as follows:

For more than two decades, petitioner, Robert Rowen, failed to pay his Federal tax as required by law. The Internal Revenue Service (“IRS”) attempted to collect the outstanding amounts through its usual means—sending demands, filing liens, attempting to levy on assets—all without much success. In 2018, when Dr. Rowen’s outstanding tax balance was close to $500,000, the Commissioner of Internal Revenue turned to a new tool in his collection toolbox—section 7345.

The petitioner, Dr. Rowen, was a medical doctor licensed in California who frequently traveled to developing countries to offer medical services free of charge to underserved populations. Pursuant to section 7345, the Service issued a notice of certification of a “seriously delinquent tax debt” and notified the Secretary of State that his passport should be revoked. As permitted by section 7345(e)(1), Dr. Rowen filed a petition in the Tax Court and asked the court to determine that the Service’s certification of his tax debt as seriously delinquent was erroneous. He argued that section 7345 is unconstitutional because it prohibits international travel in violation of his rights under the Due Process Clause of the Fifth Amendment. He also argued that the statute “violates his human rights as expressed in the Universal Declaration of Human Rights (UDHR).” The Tax Court rejected both arguments. The court noted that an uncodified provision of the FAST Act authorizes the Secretary of State to revoke or deny the passport of an individual who has been certified as having a seriously delinquent tax debt. The Tax Court reasoned that, because section 7345 authorizes the Commissioner only to certify that an individual has a seriously delinquent tax and leaves all passport-related decisions to the Secretary of State for action pursuant to the uncodified provision of the FAST Act, section 7345 does not prohibit international travel and therefore cannot violate either the Due Process Clause of the Fifth Amendment or the UDHR.

b. Section 7345 survives a constitutional challenge. The plaintiff in Maehr v. United States had approximately $250,000 in unpaid federal tax liabilities from 2011. In 2018, pursuant to section 7345, the Service issued a notice of certification of a “seriously delinquent tax debt” and notified the Secretary of State that his passport should be revoked. The State Department then revoked his passport. The plaintiff brought this action in federal district court challenging the authority of the State Department to revoke passports on the basis of tax liabilities. The district court concluded that it did not have subject-matter jurisdiction over the plaintiff’s claims and granted the government’s motion to dismiss for failure to state a claim.

On appeal, in an opinion by Judge Lucero, the Court of Appeals for the Tenth Circuit first concluded that the district court did have subject-matter jurisdiction over the action. The court then addressed the merits of the plaintiff’s claims. Specifically, the Tenth Circuit unanimously rejected two of the plaintiff’s arguments. The plaintiff argued that “the Privileges and Immunities Clause of Article IV, Section 2 and the Privileges or Immunities Clause of the Fourteenth Amendment encompass the right to international travel and thereby limit the federal government’s ability to restrict such travel.” The court rejected this argument because the Privileges and Immunities clauses apply only to the states and not to the federal government and do not protect the right to international travel.

The court also rejected the plaintiff’s argument that the court should review the State Department’s revocation of his passport under a standard similar to the standard used by courts to review a writ of ne exeat republica. “A writ of ne exeat republica is a form of injunctive relief ordering the person to whom it is addressed not to leave the jurisdiction of the court or the state, for example, to aid the sovereign to compel a citizen to pay his taxes.” The court concluded that, for several reasons, a writ of ne exeat republica, an equitable, common-law remedy, is readily distinguishable from the legislatively authorized passport revocation provided for in the FAST Act.

In a separate opinion written by Judge Matheson that was the majority opinion of the court on the issue, the court also rejected the plaintiff’s argument that the State Department’s revocation of his passport violated his rights under the Due Process Clause of the Fifth Amendment. Specifically, the court concluded that international travel is not a fundamental right that must be reviewed under so-called strict scrutiny. If the court’s standard of review were strict scrutiny, then any legislative infringement of a fundamental right must be narrowly tailored to serve a compelling government interest. Instead, the court held, because international travel is not a fundamental right, the constitutionality of section 7345 must be determined under a rational basis standard of review. Under this standard, the court noted, we will uphold a law ‘if there is any reasonably conceivable state of facts that could provide a rational basis for the [infringement].’” Section 7345, the court concluded, meets this standard. The federal government has a legitimate interest in raising revenue through taxes and “Congress’s decision to further this legitimate interest by providing for revocation of passports for those who have a ‘seriously delinquent tax debt,’ 26 U.S.C. § 7345(a), is rational.”

In a lengthy concurring opinion, Judge Lucero advocated the view that the proper standard of review for the plaintiff’s Fifth Amendment claims is intermediate scrutiny, which falls between the rational basis and strict scrutiny standards. Because neither party argued for that standard of review, Judge Lucero concurred in the court’s judgment.

4. Married taxpayers who receive separate but substantially identical notices of certification of a “seriously delinquent” tax debt in a section 7345 passport revocation case may file a joint petition challenging the certification in the Tax Court.

In Garcia v. Commissioner, the taxpayers, a married couple, filed a joint federal income tax return for 2012. The Service issued a notice of certification of a seriously delinquent tax debt to the wife showing an unpaid tax liability of $583,803 and subsequently issued a substantially identical notice to the husband showing the same delinquent tax debt. The taxpayers jointly petitioned the Tax Court and sought review of the certifications. The taxpayers asserted that they had submitted an offer-in-compromise that the Service had failed to consider. The Service subsequently determined that the taxpayers’ offer-in-compromise was processable and remained pending and that the pendency of their offer suspended collection of their tax debt so that the debt was not “seriously delinquent.” Accordingly, the Service reversed the certifications and notified the Secretary of State. Because the certifications had been reversed, the Service moved to dismiss the case on the grounds of mootness.

The Tax Court (Judge Lauber) first addressed an issue of first impression, which was whether the taxpayers could file a joint petition seeking review of the Service’s certification of a seriously delinquent tax debt. Neither section 7345 nor the Tax Court’s Rules provide guidance on this question. The court noted that Tax Court Rule 34(a)(1) permits a married couple to file a joint petition in a deficiency action (i.e., when the Service has issued joint or separate notices of deficiency for a year to a married couple that has filed a joint return). The court concluded that “equity and common sense” support extending this permission to challenges to notices of certification of seriously delinquent tax debts:

In this case petitioners received substantially identical notices of certification from the IRS. These notices informed them that they had a delinquent tax debt of $583,803, stemming from an unpaid joint Federal income tax liability for 2012, and that the IRS had certified to the State Department that they were persons owing a “seriously delinquent tax debt.” Both petitioners presented the same question: “whether the certification was erroneous.” . . . And both petitioners presented the same argument: that the certifications were “prematurely issued” because they had submitted an offer-in-compromise that remained pending at the IRS. . . .

It is natural for spouses to file a joint petition in these circumstances.

To hold that the taxpayers could not file a joint petition, the court reasoned, “would occasion unnecessary delay and expense.”

Because, under section 7345, the Tax Court’s jurisdiction in passport revocation cases is limited to reviewing the Service’s certification of the taxpayer’s liabilities as “seriously delinquent,” the only relief the court may grant is to issue an order to the Service to notify the Secretary of State that the Service’s certification was in error. Since the Service had already notified the Secretary of State of the error, the court could not offer any additional relief. The court therefore concluded that the issues were moot and granted the government’s motion to dismiss. The Tax Court had previously ruled that a taxpayer’s challenge to the Service’s certification of a tax debt as seriously delinquent should be dismissed as moot when the Service had reversed the certification.

XI. Withholding and Excise Taxes

A. Employment Taxes

There were no significant developments regarding this topic during 2021.

B. Self-Employment Taxes

There were no significant developments regarding this topic during 2021.

C. Excise Taxes

There were no significant developments regarding this topic during 2021.

XII. Tax Legislation

A. Enacted

1. The American Rescue Plan Act of 2021 provides significant tax benefits for many taxpayers.

The American Rescue Plan Act of 2021, signed by the President on March 11, 2021, made several significant changes. The changes made by this legislation include expanding credits such as the child tax credit and earned income credit, suspending the requirement to repay excess advance premium tax credit payments, and providing exclusions for up to $10,200 of unemployment compensation and for cancellation of student loans.

2. The Infrastructure Investment and Jobs Act ends the employee retention credit of section 3134 for the fourth quarter of 2021.

The Infrastructure Investment and Jobs Act, signed by the President on November 15, 2021, contains relatively few significant tax provisions but section 80604 of the legislation ends the employee retention credit of section 3134 for the fourth quarter of 2021.