Recent Developments in Federal Income Taxation: The Year 2022

The announcement modifies Notice 2022-3. Except as modified, all other provisions of Notice 2022-3 continue to apply.

2. Up in Smoke: this medical marijuana business could not include depreciation of production assets in its cost of goods sold, because depreciation deductions are disallowed by section 280E and cannot be included in cost of goods sold under the uniform capitalization rules of section 263A.

In Lord v. Commissioner, the taxpayers, a married couple, held ownership interests in two businesses that produced and sold marijuana products. Both businesses were organized under Colorado law, one as a partnership and the other as a subchapter S corporation for federal income tax purposes. The main issue in the case was whether each business could include depreciation of production assets in its inventory costs. The businesses maintained their books on a tax basis and calculated depreciation under the accelerated cost recovery system of section 168. The businesses claimed both bonus depreciation under section 168(k) and regular depreciation for the year in issue, 2012, and included such amounts in their cost of goods sold. The Service objected on the basis of section 280E, which disallows any deduction or credit otherwise allowable for amounts paid or incurred in connection with a trade or business “if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances . . . .” The taxpayers’ marijuana business, though legal under Colorado law, was such a trade or business.

The Service had conceded in previous cases that, while section 280E disallows deductions, it does not disallow cost of goods sold. Nonetheless, the Tax Court (Judge Kerrigan) agreed with the Service that the businesses could not include depreciation of production assets in determining cost of goods sold. The court observed that a business determines cost of goods sold under the rules of section 471, which provide that a business must include both direct and indirect costs. Section 471 and its accompanying Regulations then refer to section 263A for additional rules. Section 263A and the Regulations promulgated thereunder confirm that businesses must include indirect costs in cost of goods sold and broadly define indirect costs to include depreciation. The court, however, concluded that the rules of section 263A did not apply to the taxpayer because of the flush language of section 263A(a)(2), which provides: “Any cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.”

The court previously had interpreted this flush language to mean that “if something wasn’t deductible before Congress enacted section 263A, taxpayers cannot use that section to capitalize it.” The court also previously had concluded that the deduction for depreciation is disallowed by section 280E. Because the deduction for depreciation is disallowed by section 280E, the court reasoned, the businesses in this case could not use the rules of section 263A to include depreciation as an indirect cost in determining cost of goods sold. Accordingly, the court held that the businesses’ inventory accounting method did not clearly reflect income and upheld the Service-imposed change in inventory accounting method.

3. Congress has modified the section 179D deduction for making commercial buildings energy efficient for taxable years beginning after December 31, 2022.

Section 179D provides a limited deduction for the cost of energy-efficient commercial building property. Generally, these are improvements designed to reduce energy and power costs with respect to the interior lighting systems, heating, cooling, ventilation, and hot water systems of a commercial building by a specified percentage in comparison to certain standards. The deduction was made permanent by the Taxpayer Certainty and Disaster Tax Relief Act of 2020. Under current law, the lifetime limit on deductions under section 179D is $1.80 per square foot, adjusted for inflation for taxable years beginning after 2020. For 2022, this figure is $1.88 per square foot. Under section 179D(c)(1)(D), as in effect for 2022, the improvements must reduce energy and power costs by 50% or more in comparison to certain standards. In section 13303 of the Inflation Reduction Act, Congress amended section 179D for taxable years beginning after December 31, 2022. As amended, the statute provides that the improvements must reduce energy and power costs by 25% (rather than 50%) in comparison to certain standards. The amendments also reduce the amount of the deduction to $0.50 per square foot, increased by $0.02 for each percentage point above 25% by which the energy improvements reduce energy and power costs, with a maximum amount of $1.00 per square foot. For projects that meet certain prevailing wage and apprenticeship requirements, the deduction is increased to $2.50 per square foot, increased by $0.10 for each percentage point above 25% by which the energy improvements reduce energy and power costs, with a maximum amount of $5.00 per square foot. The maximum deduction amount is the total deduction available with respect to the building less deductions claimed with respect to the building in the preceding three years. In the case of buildings to which energy-efficient improvements are made owned by a tax-exempt entity, section 179D(d)(3) of the amended statute directs the Treasury Department to issue Regulations that allow the tax-exempt entity to allocate the deduction to the person primarily responsible for designing the property.

E. Depreciation & Amortization

1. Section 280F 2022 depreciation tables for business autos, light trucks, and vans.

Section 280F(a) limits the depreciation deduction for passenger automobiles. For this purpose, the term “passenger automobiles” includes trucks and vans with a gross vehicle weight of 6,000 pounds or less. In Revenue Procedure 2022-17, the Service has published depreciation tables with the 2022 depreciation limits for business use of passenger automobiles acquired after September 27, 2017, and placed in service during 2022:

For leased vehicles used for business purposes, section 280F(c)(2) requires a reduction in the amount allowable as a deduction to the lessee of the vehicle. Under Treasury Regulation section 1.280F-7(a), this reduction in the lessee’s deduction is expressed as an income inclusion amount. The revenue procedure provides a table with the income inclusion amounts for lessees of vehicles with a lease term beginning in 2022. For 2022, this income inclusion applies when the fair market value of the vehicle exceeds $56,000.

F. Credits

1. Congress has modified and extended through 2032 the section 45L credit for eligible contractors that build and sell new energy-efficient homes.

Before its amendment by the Inflation Reduction Act, section 45L provided a credit of $2,000 or $1,000 (depending on the projected level of fuel consumption), which an eligible contractor can claim for each qualified new energy-efficient home constructed by the contractor and acquired before 2022 by a person from the contractor for use as a residence during the tax year. Section 13304 of the Inflation Reduction Act extends the credit through 2032 and modifies it for homes acquired after December 31, 2022. As modified, the credit is $2,500 for new homes that meet certain Energy Star efficiency standards and is $5,000 for new homes that are certified as zero-energy ready homes (generally, a home that is able to generate as much (or more) energy onsite than the total amount of energy it consumes). For multifamily dwellings, these credit amounts are $500 and $1,000 per unit, respectively. The credit for multifamily dwelling units is increased to $2,500 per unit (or $5,000 per unit for zero-energy ready multifamily dwellings) if the taxpayer ensures that laborers and mechanics employed by contractors and subcontractors in the construction of the residence are paid wages not less than prevailing wages as determined by the Secretary of Labor.

G. Natural Resources Deductions & Credits

There were no significant developments regarding this topic during 2022.

H. Loss Transactions, Bad Debts, and NOLs

1. Disallowance of excess business losses of noncorporate taxpayers extended through 2028.

The TCJA included new section 461(l), which disallows the deduction of “excess business losses” (over $250,000 for single filers and $500,000 for joint filers) by noncorporate taxpayers. Losses disallowed by section 461(l) are carried over to the next taxable year and are treated as NOL carryforwards. As enacted, the provision was effective for tax years beginning before January 1, 2027. Section 13903 of the Inflation Reduction Act extends the effective period of section 461(l) to include tax years ending before January 1, 2029.

I. At-Risk and Passive Activity Losses

There were no significant developments regarding this topic during 2022.

III. Investment Gain and income

A. Gains and Losses

There were no significant developments regarding this topic during 2022.

B. Interest, Dividends, and Other Current Income

There were no significant developments regarding this topic during 2022.

C. Profit-Seeking Individual Deductions

There were no significant developments regarding this topic during 2022.

D. Section 121

There were no significant developments regarding this topic during 2022.

E. Section 1031

There were no significant developments regarding this topic during 2022.

F. Section 1033

There were no significant developments regarding this topic during 2022.

G. Section 1035

There were no significant developments regarding this topic during 2022.

H. Miscellaneous

There were no significant developments regarding this topic during 2022.

IV. Compensation issues

A. Fringe Benefits

1. Limits for contributions to health savings accounts for 2023.

In Revenue Procedure 2022-24,he Service has issued the inflation-adjusted figures for calendar year 2023 contributions to health savings accounts. The annual 2023 limitation on deductions under section 223(b)(2)(A) and (B) is $3,850 for an individual with self-only coverage ($7,750 for an individual with family coverage) under a high deductible health plan. For this purpose, for calendar year 2023, a “high deductible health plan” is defined under section 223(c)(2)(A) as a health plan with an annual deductible that is not less than $1,500 for self-only coverage or $3,000 for family coverage, and for which the annual out-of-pocket expenses (deductibles, co-payments, and other amounts, but not premiums) do not exceed $7,500 for self-only coverage or $15,000 for family coverage.

2. There are no adverse tax consequences for employees if they forgo their vacation, sick, or personal leave in exchange for the employer’s contributions to charitable organizations providing aid to victims of the further Russian invasion of Ukraine.

In Notice 2022-28, the Service provided guidance on the tax treatment of cash payments that employers make pursuant to leave-based donation programs to aid victims of the further Russian invasion of Ukraine that began on February 24, 2022. For this purpose, victims of the further Russian invasion of Ukraine include citizens and residents of Ukraine, individuals working, traveling, or currently present in Ukraine, and refugees from Ukraine. Under leave-based donation programs, employees can elect to forgo vacation, sick, or personal leave in exchange for cash payments that the employer makes to charitable organizations described in section 170(c). The notice provides that: (1) cash payments an employer makes before January 1, 2023, to charitable organizations described in section 170(c) to aid victims of the further Russian invasion of Ukraine in exchange for vacation, sick, or personal leave that its employees elect to forgo will not be treated as gross income, wages, or compensation of the employees; and (2) employees making or having the opportunity to make such an election will not be treated as having constructively received gross income, wages, or compensation. Employers are permitted to deduct these cash payments either under the rules of section 170 as a charitable contribution or under the rules of section 162 as a business expense if the employer otherwise meets the requirements of either provision. Employees who make the election cannot claim a charitable contribution deduction under section 170 for the value of the forgone leave. The employer should not include cash payments made pursuant to the program in Box 1, 3 (if applicable), or 5 of the employee’s Form W-2.

B. Qualified Deferred Compensation Plans

1. Final Regulations provide guidance under section 401 relating to new life expectancy and distribution period tables used to calculate minimum distributions for 2022 from qualified plans, IRAs, and annuities.

In 2020, the Treasury Department and the Service finalized Proposed Regulations that provide guidance on the use of updated life expectancy and distribution period tables under Regulation section 1.401(a)(9)-9. In general, the Regulations seek to update the existing tables using current mortality data based on mortality rates for 2022. The new tables allow for longer life expectancies than the current tables under the existing regulations and generally result in a reduction of required minimum distributions (RMDs). In turn, this allows for retention of larger amounts in retirement accounts in contemplation of participants having slightly longer lives. The preamble to the final Regulations gives the following example:

[A] 72-year-old IRA owner who applied the Uniform Lifetime Table under formerly applicable § 1.401(a)(9)-9 to calculate required minimum distributions used a life expectancy of 25.6 years. Applying the Uniform Lifetime Table set forth in these Regulations, a 72-year-old IRA owner will use a life expectancy of 27.4 years to calculate required minimum distributions.

The updated life expectancy and distribution period tables apply to distribution calendar years beginning on or after January 1, 2022. Thus, for an individual who attained the age at which RMDs must begin (age 72) in 2021, the regulations would not apply to the distribution for the 2021 calendar year (which must be taken by April 1, 2022). The Regulations would apply to the required minimum distribution for the individual’s 2022 calendar year, which must be taken by December 31, 2022. The Regulations also include a transition rule that applies under certain circumstances if an employee dies prior to January 1, 2022. The transition rule applies in three situations: (1) the employee died with a non-spousal designated beneficiary; (2) the employee died after the required beginning date without a designated beneficiary; and (3) the employee, who is younger than the designated beneficiary, died after the required beginning date. Under these circumstances, a set of specific rules applies in relation to the distribution period for calendar years following the calendar year of the employee’s death. A similar transition rule applies if an employee’s sole beneficiary is the employee’s surviving spouse and the spouse died before January 1, 2022.

The following table compares selected life expectancies used for calculating RMDs under the old tables, which apply through 2021, and the new tables, which apply to distribution calendar years beginning on and after January 1, 2022:

2. Some more inflation-adjusted numbers for 2023.

Notice 2022-55 provides that:

The limit on elective deferrals in section 401(k), 403(b), and 457 plans is increased to $22,500 (from $20,500), with a catch-up provision for employees aged 50 or older that is increased to $7,500 (from $6,500).

The limit on contributions to an IRA is increased to $6,500 (from $6,000). The adjusted gross income (AGI) phase-out range for contributions to a traditional IRA by employees covered by a workplace retirement plan is increased to $73,000–$83,000 (from $68,000–$78,000) for single filers and heads of household, $116,000–$136,000 (from $109,000–$129,000) for married couples filing jointly in which the spouse who makes the IRA contribution is covered by a workplace retirement plan, and $218,000–$228,000 (from $204,000–$214,000) for an IRA contributor who is not covered by a workplace retirement plan and is married to someone who is covered. The phase-out range for contributions to a Roth IRA is increased to $218,000–$228,000 (from $204,000–$214,000) for married couples filing jointly, and $138,000–$153,000 (from $129,000–$144,000) for singles and heads of household.

The limit on the annual benefit from a defined benefit plan under section 415 is increased to $265,000 (from $245,000).

The limit for annual additions to defined contribution plans is increased to $66,000 (from $61,000).

The amount of compensation that may be taken into account for various plans is increased to $330,000 (from $305,000), and is increased to $490,000 (from $450,000) for government plans.

The AGI limit for the retirement savings contribution credit for low- and moderate-income workers is increased to $73,000 (from $68,000) for married couples filing jointly, $54,750 (from $51,500) for heads of household, and $36,500 (from $34,000) for singles and married individuals filing separately.

3. Proposed Regulations on required minimum distributions.

Treasury and the Service have issued Proposed Regulations that address RMDs from qualified retirement plans and annuity contracts and related matters. The Proposed Regulations would update existing Regulations to reflect a number of statutory changes. The most significant of these statutory changes were made by the SECURE Act, enacted on December 20, 2019. Among other changes, the SECURE Act amended section 401(a)(9)(E) to modify the RMD rules for inherited retirement accounts (defined contribution plans and IRAs). The Proposed Regulations are lengthy and address these and a number of other issues. This outline will focus on only the guidance provided by the Proposed Regulations on the change made by the SECURE Act to RMDs for inherited retirement accounts. Readers should consult the Proposed Regulations for additional guidance.

The SECURE Act changes to RMDs from inherited retirement accounts. The SECURE Act’s amendments in this regard require all funds to be distributed by the end of the tenth calendar year following the year of death (the “ten-year rule”). The statute contains no requirement to withdraw any minimum amount before that date. Section 401(a)(9)(H)(i)(II), as also amended by the SECURE Act, provides that this rule applies whether or not RMDs to the employee or IRA owner have begun. The current rules, which permit taking RMDs over life expectancy, continue to apply to a designated beneficiary who is an “eligible designated beneficiary,” which is any of the following: (1) a surviving spouse, (2) a child of the participant who has not reached the age of majority, (3) disabled within the meaning of section 72(m)(7), (4) a chronically ill individual within the meaning of section 7702B(c)(2) with some modifications, or (5) an individual not in any of the preceding categories who is not more than ten years younger than the deceased individual. These changes generally apply to distributions with respect to those who die after December 31, 2019.

The Proposed Regulations’ interpretation of the SECURE Act. The Proposed Regulations adopt an interpretation of the ten-year rule that appears to differ from the plain language of the statute and from the interpretation of of most advisors. The statute provides that, when the designated beneficiary is not an eligible designated beneficiary, all funds must be distributed by the end of the tenth calendar year following the year of death and that this rule applies whether or not RMDs to the employee or IRA owner have begun. There appears to be no requirement to withdraw any minimum amount before that date. The Preamble to the Proposed Regulations, however, explains that the Proposed Regulations distinguish between situations in which the employee or IRA owner dies before the required beginning date for distributions and situations in which death occurs after such date. When the employee or IRA owner dies before the required beginning date, no distribution is required before the tenth calendar year following the year of death. However, in situations in which the employee or IRA owner dies after the required beginning date, a designated beneficiary who is not an eligible designated beneficiary must take RMDs before the tenth calendar year following the year of death:

For example, if an employee died after the required beginning date with a designated beneficiary who is not an eligible designated beneficiary, then the designated beneficiary would continue to have required minimum distributions calculated using the beneficiary’s life expectancy as under the existing Regulations for up to nine calendar years after the employee’s death. In the tenth year following the calendar year of the employee’s death, a full distribution of the employee’s remaining interest would be required.

This interpretation differs not only from the plain language of the statute and from the interpretation of most advisors, but also from Publication 590-B, which was issued for 2021 and provides:

The 10-year rule requires the IRA beneficiaries who are not taking life expectancy payments to withdraw the entire balance of the IRA by December 31 of the year containing the 10th anniversary of the owner’s death. For example, if the owner died in 2021, the beneficiary would have to fully distribute the IRA by December 31, 2031. The beneficiary is allowed, but not required, to take distributions prior to that date.

The 10-year rule applies if (1) the beneficiary is an eligible designated beneficiary who elects the 10-year rule, if the owner died before reaching his or her required beginning date; or (2) the beneficiary is a designated beneficiary who is not an eligible designated beneficiary, regardless of whether the owner died before reaching his or her required beginning date.

Many of the comments on the Proposed Regulations urge the Service to change its interpretation or at least to delay the effective date of the interpretation, because many beneficiaries subject to the ten-year rule did not take distributions in 2021.

a. The Service will not assert that the 50% excise tax of section 4974 is due from those who failed to take certain RMDs from inherited retirement accounts in 2021 or 2022. Notice 2022-53 announces that, when the Proposed Regulations described above become final, the final Regulations will apply no earlier than the 2023 distribution calendar year. The notice also addresses the tax treatment of individuals who failed to take RMDs in 2021 or 2022 under the interpretation of the ten-year rule set forth in the Proposed Regulations. Section 4974 provides that, if the amount distributed from a qualified retirement plan during the year is less than the RMD for that year, an excise tax is imposed equal to 50% of the deficiency. The notice provides that the Service will not assert that this excise tax is due from an individual who did not take a “specified RMD.” It also provides that, if an individual paid the excise tax for a missed RMD in 2021 that constitutes a specified RMD, the taxpayer can request a refund of the excise tax paid. A “specified RMD” is defined as any distribution required to be made in 2021 or 2022 under a defined contribution plan or IRA if the payment would be required to be made to (1) a designated beneficiary of an employee or IRA owner who died in 2020 or 2021 and on or after the employee or IRA owner’s required beginning date, and (2) the designated beneficiary is not taking lifetime or life expectancy payments as required by section 401(a)(9)(B)(iii). In other words, the Service will not assert that the excise tax of section 4974 is due from a beneficiary who (1) is not an eligible designated beneficiary (and who therefore is subject to the ten-year rule), (2) inherited the retirement account from an employee or IRA owner who died in 2020 or 2021 and on or after the required beginning date of distributions, and (3) was required to take RMDs in 2021 or 2022 under the interpretation of the ten-year rule in the Proposed Regulations but failed to do so. The notice provides the same relief to beneficiaries of eligible designated beneficiaries if the eligible designated beneficiary died in 2020 or 2021 and was taking lifetime or life expectancy distributions.

The notice does not explicitly address what RMD must occur in 2023. The issue is whether, in 2023, a beneficiary who failed to take an RMD in 2021 or 2022 must take the 2023 RMD and also any RMDs previously missed. The notice does not explicitly require missed RMDs to be withdrawn. The notice provides only that the Service will not assert that an excise tax is due from those who failed to take RMDs in 2021 or 2022 under the Proposed Regulations’ interpretation of the ten-year rule. In the authors’ view, the notice implies that, in 2023, only the 2023 RMD must be withdrawn. For example, if an employee or IRA owner died in 2021 with a designated beneficiary who was not an eligible designated beneficiary, that beneficiary should have begun taking RMDs in 2022, which should continue through 2030 (the ninth year after the employee or IRA owner’s death), and the remaining balance of the account should be fully withdrawn in 2031. The authors’ interpretation is that the beneficiary in this example should simply begin taking RMDs in 2023 (calculated as if they had begun in 2022), which should continue through 2030, and the remaining balance of the account should be fully withdrawn in 2031. The final Regulations may provide further guidance on this question.

4. Congress has increased the age at which RMDs must begin to 73 and eventually to 75.

Section 107 of the SECURE 2.0 Act amended section 401(a)(9)(C)(i)(I) to increase the age at which RMDs from a qualified plan (including IRAs) must begin from 72 to 73. Pursuant to this amendment, RMDs must begin by April 1 of the calendar year following the later of the calendar year in which the employee attains age 73 and, in the case of an employer plan, the calendar year in which the employee retires. This latter portion of the rule allowing deferral of RMDs from employer plans until retirement does not apply to a “5-percent owner” (as defined in section 416). The increase in the age at which RMDs must begin to age 73 applies to distributions required to be made after December 31, 2022, with respect to individuals who attain age 73 after such date. Thus, an individual who attained age 72 in 2022 must take his or her first RMD by April 1, 2023, but an individual who attains age 72 in 2023 need not take the first RMD until April 1, 2025. The legislation further increases the age at which RMDs must begin to age 75 for individuals who attain age 75 after 2032.

5. The penalty for failing to take an RMD is now 25% (and possibly ten percent) rather than 50%.

If a taxpayer fails to take the full amount of a RMD from a qualified retirement plan (including an IRA), section 4974(a) imposes an excise tax. The tax is a percentage of the amount by which the RMD exceeds the actual amount distributed during the year. Before legislative changes made in 2022, the percentage was 50%. Section 302 of the SECURE 2.0 Act amended section 4974(a) to reduce the percentage to 25%. New section 4974(e) further reduces the percentage to ten percent if an individual receives all of their past-due RMDs and files a tax return that reflects the excise tax on such RMDs before the earliest of three dates: (1) the date of mailing of a notice of deficiency with respect to the excise tax, (2) the date on which the excise tax is assessed, and (3) the last day of the second taxable year that begins after the close of the taxable year in which the excise tax is imposed (apparently, the close of the second taxable year after the year of the missed RMD). These changes apply to taxable years beginning after December 29, 2022, the date of enactment of the SECURE 2.0 Act.

6. RMDs are no longer required for Roth accounts in employer-sponsored plans.

Section 325 of the SECURE 2.0 Act amended section 402A(d) by adding new section 402A(d)(5), which makes Roth accounts in employer-sponsored retirement plans exempt from the requirement that RMDs begin at age 73. Before this change, although RMDs were not required for Roth IRAs, they were required for Roth accounts in employer-sponsored retirement plans. This change is effective for taxable years beginning after December 31, 2023, but does not apply to distributions required for 2023 that are permitted to be paid after 2023.

7. Go ahead and steal your spouse’s identity, at least for purposes of receiving RMDs.

Section 327 of the SECURE 2.0 Act amended section 401(a)(9)(B)(iv) to provide that, if a retirement account participant dies before reaching the age at which RMDs must begin and has designated a spouse as the sole beneficiary, then the spouse may make an irrevocable election to be treated as the participant for purposes of receiving RMDs. Making this election allows the surviving spouse to defer RMDs until the deceased spouse would have reached the age at which RMDs must begin. For example, if a husband passes away at age 63 and is survived by his wife, who is age 68 and is his sole designated beneficiary, then she can elect to be treated as her husband for purposes of receiving RMDs. This means that she can defer taking RMDs from the account until her husband would have reached age 73 (a period of ten years in this example) rather than when she attains age 73. This change is effective for calendar years beginning after December 31, 2023.

8. Individuals who are ages 60–63 will be able to make to make additional catch-up contributions to employer-sponsored plans beginning in 2025.

Section 414(v) allows individuals who are age 50 and older to make so-called “catch-up” contributions to employer-sponsored retirement plans such as section 401(k) plans in addition to the basic amount ($22,500 in 2023) that individuals are allowed to contribute. The limit on catch-up contributions is $7,500 in 2023 and is adjusted annually for inflation. Section 109 of the SECURE 2.0 Act amended section 414(v)(2) to allow individuals who are ages 60 to 63 at the close of the taxable year to make larger catch-up contributions up to the “adjusted dollar amount,” which is defined in new section 414(v)(2)(E). As defined, the adjusted dollar amount is equal to the greater of $10,000 or 150% of the regular catch-up contribution amount for 2024. This $10,000 figure will be adjusted annually for inflation after 2025. This change is effective for taxable years beginning after 2024.

The ability of those ages 60 to 63 to make larger catch-up contributions to employer-sponsored plans will take effect in 2025. In that year, the limit on such catch-up contributions will be the greater of $10,000 or 150% of the regular catch-up contribution limit for 2024. Because the regular catch-up contribution limit is already $7,500 in 2023, and 150% of that figure is $11,250, the larger catch-up contribution limit for those ages 60 to 63 will be greater than $10,000 in the first year it is effective.

9. Effective in 2024, all catch-up contributions to employer-sponsored plans must be deposited in a Roth account if the participant had wages in the preceding year of more than $145,000.

Section 603 of the SECURE 2.0 Act amended section 414(v) by adding new section 414(v)(7). New section 414(v)(7) provides that, if a participant in an employer-sponsored retirement plan had wages in the preceding calendar year from the employer sponsoring the plan that exceeded $145,000, then the participant cannot make catch-up contributions unless those contributions are designated Roth contributions. This $145,000 figure will be adjusted for inflation in tax years beginning after 2024. The legislation further provides that, if this new “Roth-only” rule applies to any participant for the year, then no participant in the plan can make catch-up contributions unless the plan offers all participants a Roth option. This rule effectively will force employer-sponsored plans to offer Roth options to their participants. These changes apply to taxable years beginning after December 31, 2023.

10. Subject to certain exceptions, section 401(k) and 403(b) plans established on or after December 29, 2022, must automatically enroll eligible participants beginning in 2025.

Section101 of the SECURE 2.0 Act amended the Code by adding new section 414A. New section 414A requires that section 401(k) and 403(b) plans automatically enroll participants—i.e., participants are enrolled unless they elect not to participate. To meet the requirements of section 414A, the percentage of compensation contributed by participants must be at least three percent and not more than ten percent in the first year of participation. Whatever the initial percentage of compensation contributed, the plan must provide that the percentage is increased by one percentage point per year until the percentage contributed is at least ten percent and not more than 15% of compensation. A participant can elect not to participate or to contribute less than these amounts. Certain plans are not subject to new section 414A. These include (1) section 401(k) and 403(b) plans established before the date of enactment of the SECURE 2.0 Act (December 29, 2022), (2) plans maintained by employers that have been in existence fewer than three years, (3) plans maintained by employers that normally employ ten or fewer employees, and (4) governmental plans (within the meaning of section 414(d)) and church plans (within the meaning of section 414(e)). The new rules apply to plan years beginning after December 31, 2024.

11. Is a water bottle or a low-value gift card all it takes to get employees to participate in an employer-sponsored retirement plan? Go ahead and offer these sorts of de minimis financial incentives, says Congress.

Generally, sections 401(k)(4) and 403(b)(12)(A) preclude a section 401(k) or 403(b) plan from being tax-qualified if the employer offers any benefit that is conditioned on an employee’s election to defer (or not defer) amounts to the plan. This prohibition is subject to limited exceptions and does not preclude employers from offering matching contributions. Section 113 of the SECURE 2.0 Act amended sections 401(k)(4) and 403(b)(12)(A) to provide that the prohibition on offering benefits conditioned on the employee’s participation does not apply to a “de minimis financial incentive” as long as the incentive is not paid for with plan assets. The legislation does not define the term “de minimis financial incentive.” But the legislative history of the provision suggests that low-value gift cards would qualify. The new rules apply to plan years beginning after the date of enactment of the SECURE 2.0 Act (December 29, 2022).

12. Beginning in 2024, the section 72(t) ten-percent penalty for early withdrawal from a retirement plan will not apply to distributions of up to $1,000 for “necessary personal or family emergency expenses.”

Subject to certain exceptions, section 72(t)(1) provides that, if a taxpayer who has not attained age 59.5 receives a distribution from a retirement plan, the taxpayer’s tax must be increased by ten percent of the distribution. Section 115 of the SECURE 2.0 Act amended section 72(t)(2) by adding section 72(t)(2)(I), which allows an individual to treat one distribution per calendar year as an “emergency personal expense distribution” that is not subject to the ten-percent additional tax. An individual who takes an emergency personal expense distribution can repay it, during the three-year period beginning on the day after the date on which the distribution was received, to any eligible retirement plan to which a rollover contribution could be made. The maximum amount that can be treated as an emergency personal expense distribution is $1,000. An individual who treats a distribution as an emergency personal expense distribution cannot treat a distribution in any of the three succeeding taxable years as such a distribution unless either (1) the previous distribution is fully repaid to the plan, or (2) the aggregate contributions by the employee to the plan after the previous distribution equal or exceed the amount of the previous distribution that has not been repaid. An emergency personal expenses distribution is defined in section 72(t)(2)(I)(iv) as

any distribution from an applicable eligible retirement plan … to an individual for purposes of meeting unforeseeable or immediate financial needs relating to necessary personal or family emergency expenses.

These rules apply to distributions made after December 31, 2023.

13. Beginning in 2024, survivors of domestic abuse can withdraw up to $10,000 from a retirement plan without being subject to the section 72(t) ten-percent penalty for early withdrawal.

Subject to certain exceptions, section 72(t)(1) provides that, if a taxpayer who has not attained age 59.5 receives a distribution from a retirement plan, the taxpayer’s tax must be increased by ten percent of the distribution. Section 314 of the SECURE 2.0 Act amended section 72(t)(2) by adding section 72(t)(2)(K), which allows an individual to treat a distribution as “an eligible distribution to a domestic abuse victim” that is not subject to the ten-percent additional tax. An individual who takes such a distribution can repay it, during the three-year period beginning on the day after the date on which the distribution was received, to any eligible retirement plan to which a rollover contribution could be made. The maximum amount that can be treated as an eligible distribution to a domestic abuse victim is the lesser of $10,000 or 50% of the present value of the accrued benefit of the employee under the plan. The $10,000 limitation will be adjusted for inflation for taxable years beginning after 2024. An eligible distribution to a domestic abuse victim is defined in section 72(t)(2)(K)(iii)(I) as a

distribution … from an applicable eligible retirement plan [that] is made to an individual during the 1-year period beginning on any date on which the individual is a victim of domestic abuse by a spouse or domestic partner.”

For this purpose, “domestic abuse” is defined in section 72(t)(2)(K)(iii)(II) as

physical, psychological, sexual, emotional, or economic abuse, including efforts to control, isolate, humiliate, or intimidate the victim, or to undermine the victim’s ability to reason independently, including by means of abuse of the victim’s child or another family member living in the household.

These rules apply to distributions made after December 31, 2023.

14. Beginning in 2023, terminally ill individuals can withdraw funds from a retirement plan without being subject to the section 72(t) ten-percent penalty for early withdrawal.

Subject to certain exceptions, section 72(t)(1) provides that, if a taxpayer who has not attained age 59.5 receives a distribution from a retirement plan, the taxpayer’s tax must be increased by ten percent of the distribution. Section 326 of the SECURE 2.0 Act amended section 72(t)(2) by adding section 72(t)(2)(L), which provides that distributions to a terminally ill individual on or after the date on which a physician has certified the individual as having a terminal illness are not subject to the ten-percent additional tax. An individual who takes such a distribution can repay it, during the three-year period beginning on the day after the date on which the distribution was received, to any eligible retirement plan to which a rollover contribution could be made. Under section 72(t)(2)(L)(ii), the term “terminally ill individual” has the same meaning as it does in section 101(g)(4)(A), except that “84 months” is substituted for “24 months,” which means that a “terminally ill individual” is defined as

an individual who has been certified by a physician as having an illness or physical condition which can reasonably be expected to result in death in 84 months or less after the date of the certification.

New section 72(t)(2)(L)(iii) provides that an employee is not considered to be a terminally ill individual unless the employee provides sufficient evidence to the plan administrator in the form and manner required by the Secretary of the Treasury.

These rules apply to distributions made after the date of enactment of the SECURE 2.0 Act, which was December 29, 2022.

C. Nonqualified Deferred Compensation, Section 83, and Stock Options

1. The taxpayer took a shot at a deduction for deferred compensation but only scored an A-I-R B-A-L-L! A-I-R B-A-L-L! A-I-R B-A-L-L!

In Hoops, LP v. Commissioner, the Tax Court (Judge Nega) held that an accrual method partnership could not deduct unpaid salary and wages relating to deferred compensation owed to two players (Zach Randolph and Michael Conley) for the Memphis Grizzlies of the NBA. The taxpayer-partnership, Hoops, LP (“Hoops”) sold the Memphis Grizzlies’ NBA franchise and substantially all of its assets to a buyer in 2012. The buyer assumed substantially all of the liabilities and obligations of Hoops as part of the acquisition, including the obligation to pay approximately $10.7 million (discounted to present value) in nonqualified deferred compensation to the two players. Hoops had included the accrued $10.7 million liability in its amount realized in connection with the sale. Hoops did not deduct the $10.7 million on its originally filed partnership tax return on Form 1065 for 2012. Instead, Hoops filed an amended return on Form 1065-X for 2012 in October of 2013 claiming the $10.7 million accrued liability as a deduction. Following an audit, the Service issued a notice of final partnership administrative adjustment disallowing the deduction, and Hoops petitioned the Tax Court. The parties stipulated that the $10.7 million accrued liability was nonqualified deferred compensation governed by the catch-all “other plans” provision of section 404(a)(5). Section 404(a)(5) and the Regulations under that provision allow a deduction for payments under such nonqualified deferred compensation plans “only in the taxable year of the employer in which or with which ends the taxable year of an employee in which an amount attributable to such contribution is includible in [the employee’s] gross income.” Regulation section 1.404(a)-12(b)(1). Hoops argued that the timing rule in section 404(a) is incorporated into the economic performance requirement of section 461(h), and due to the sale, the deduction was accelerated under Regulation section 1.461-4(d)(5)(i) which provides:

If, in connection with the sale or exchange of a trade or business by a taxpayer, the purchaser expressly assumes a liability arising out of the trade or business that the taxpayer but for the economic performance requirement would have been entitled to incur as of the date of the sale, economic performance with respect to that liability occurs as the amount of the liability is properly included in the amount realized on the transaction by the taxpayer.

Alternatively, Hoops argued that if the $10.7 million liability was not deductible upon the sale, then it should not have been included in Hoops’s amount realized as part of the sale. The Service argued in response that Regulation section 1.404(a)-12(b)(1), not section 461(h) or Regulation section 1.461-4(d)(5)(i), controlled to allow the deduction only when the deferred compensation is paid and includable in the players’ gross income regardless of whether economic performance had occurred or whether the liability was considered part of Hoops’s amount realized in connection with the sale.

Judge Nega’s Opinion. Judge Nega agreed with the Service and relied on the Regulations under sections 461 and 446, which provide that “[a]pplicable provisions of the Code, the Income Tax Regulations, and other guidance published by the Secretary prescribe the manner in which a liability that has been incurred [under section 461(h)] is taken into account.” Judge Nega therefore reasoned that section 404(a)(5) and Regulation section 1.404(a)-12(b)(1) controlled to disallow the partnership’s deduction unless and until the deferred compensation was paid and includable in the gross income of the players. Judge Nega cited the Ninth Circuit’s decision in Albertson’s, Inc. v. Commissioner as support. In Albertson’s, the Ninth Circuit relied upon legislative history to determine that Congress enacted section 404(a) expressly to match the timing of an employer’s deduction and an employee’s inclusion of nonqualified deferred compensation. Furthermore, regarding whether the $10.7 million deferred compensation liability should have been included in Hoops’s amount realized upon the sale, Judge Nega determined that it should, citing the general rules of sections 1001(a), 1001(b), and Regulation section 1.1001-2(a)(1), which provide that a taxpayer’s amount realized includes liabilities from which the taxpayer is discharged as a result of transferring property.

Comment. Hoops argued that the $10.7 million nonqualified deferred compensation arrangement should not be considered a “liability” includable in amount realized under section 1001(b) and Regulation section 1.1001-2(a)(1). Support for this position can be found in section 108(e)(2), which provides that “[n]o income shall be realized from the discharge of indebtedness to the extent that payment of the liability would have given rise to a deduction.” Similarly, section 357(c)(3)(i) provides that an obligation is not treated as a liability for purposes of section 351 if the payment thereof “would give rise to a deduction.” And, Regulation section 1.752-1 provides that an obligation is not treated as a liability for purposes of section 752 unless it (i) creates or increases the basis of any of the obligor’s assets (including cash); (ii) gives rise to an immediate deduction to the obligor; or (iii) gives rise to an expense that is not deductible in computing the obligor’s taxable income and is not properly chargeable to capital. The court, however, rejected Hoops’s argument and held that, under the general rules of section 1001(b) and Regulation section 1.1001-2(a)(1), “Hoops was required to take into account the amount of the deferred compensation liability in computing its gain or loss from the sale.”

Appeal: Hoops has appealed to the U.S. Court of Appeals for the Seventh Circuit.

D. Individual Retirement Accounts

1. Want to give the funds in your IRA to charity? Congress has made it even easier.

Section 408(d)(8)(A) permits individuals who have reached age 70.5 to transfer up to $100,000 per year directly from one or more IRAs to one or more public charities or private operating foundations and treat the amounts transferred as tax-free distributions from the IRA. Section307 of the SECURE 2.0 Act amended section 408 by adding section 408(d)(8)(G), which indexes the $100,000 annual limit for inflation for taxable years beginning after 2023. In addition, new section 408(d)(8)(F) permits a taxpayer, beginning in 2023, to make a one-time $50,000 distribution directly from an IRA to a “split-interest entity” and make a one-time election to treat the contributions as if they were qualified charitable distributions made directly to a charitable entity. For this purpose, a split-interest entity is defined as (1) a charitable remainder unitrust that is funded exclusively by qualified charitable distributions, (2) a charitable remainder annuity trust that is funded exclusively by qualified charitable distributions, or (3) charitable gift annuity trust that is funded exclusively by qualified charitable distributions and that begins fixed payments of five percent or greater within one year of the date of funding.

2. The $1,000 limit on catch-up contributions to IRAs will be indexed for inflation beginning in 2024.

Section 219(b)(5)(B) allows individuals who are age 50 or older to make so-called “catch-up” contributions to IRAs in addition to the basic amount that individuals are allowed to contribute ($6,500 in 2023). According to section 219(b)(5)(B)(ii), the limit on catch-up contributions is $1,000. The limit on the basic amount that individuals are permitted to contribute has long been adjusted annually for inflation but, until recent legislation, the limit on catch-up contributions was not. Section 108 of the SECURE 2.0 Act amended section 219(b)(5)(C) by adding section 219(b)(5)(C)(iii), which indexes the $1,000 annual limit on catch-up contributions for inflation for taxable years beginning after 2023.

V. Personal Income and Deductions

A. Rates

There were no significant developments regarding this topic during 2022.

B. Miscellaneous Income

1. The taxpayer’s attorneys might have committed malpractice in her personal injury suit, but the settlement she received from the law firm was not on account of her physical injuries and therefore was not excludable from her gross income.

In Blum v. Commissioner, the taxpayer allegedly fell to the floor when she attempted to sit in a broken wheelchair while in the hospital for knee replacement surgery. She brought legal action against the hospital for personal injuries. The trial court in that action granted summary judgment for the hospital, and the trial court’s decision was affirmed on appeal. The taxpayer then brought a malpractice suit against the attorneys who had represented her. The law firm settled the malpractice action for $125,000. According to the court, the settlement agreement provided:

“Blum maintains, and . . . [her former attorneys] do not dispute, that Blum did not sustain any physical injuries as a result of the alleged negligence of either . . . [of her former attorneys]” and that “Blum’s physical injuries are . . . alleged to have resulted from the . . . [hospital] incident, which did not occur as a result of any fault or negligence by . . . [her former attorneys].”

The taxpayer excluded the $125,000 from gross income under section 104(a)(2) as damages received on account of personal physical injury or physical sickness. She argued that, but for the alleged negligence of her attorneys, she would have received damages from the hospital that would have been excluded from her income under section 104(a)(2). In a memorandum opinion, the Ninth Circuit affirmed the decision of the Tax Court and held that the settlement proceeds the taxpayer received were not excludable. In its prior decision in Rivera v. Baker West, Inc., the Ninth Circuit held that damages are received on account of a personal, physical injury within the meaning of section 104(a)(2) only if there is a direct causal link between the damages and the personal injury sustained. In this case, the court concluded, the settlement was for a malpractice claim, and she had not suffered any physical injuries as a result of the alleged negligence of her attorneys. Accordingly, the court held, the taxpayer could not exclude the settlement proceeds from gross income under section 104(a)(2).

C. Hobby Losses and Section 280A Home Office and Vacation Homes

There were no significant developments regarding this topic during 2022.

D. Deductions and Credits for Personal Expenses

1. Standard deduction for 2023.

Revenue Procedure 2022-38 provides that the standard deduction for 2023 will be $27,700 for joint returns and surviving spouses (increased from $25,900), $13,850 for unmarried individuals and married individuals filing separately (increased from $12,950), and $20,800 for heads of households (increased from $19,400). For individuals who can be claimed as dependents, the standard deduction cannot exceed the greater of $1,250 (increased from $1,150) or the sum of $400 (unchanged from 2022) and the individual’s earned income. The additional standard deduction amount for those who are legally blind or who are age 65 or older is $1,850 (increased from $1,750) for those with the filing status of single or head of household (and who are not surviving spouses) and is $1,500 (increased from $1,400) for married taxpayers ($3,000 on a joint return if both spouses are age 65 or older).

2. Home mortgage interest is deductible despite the fact that the taxpayers received a discharge in bankruptcy, which converted the debt to nonrecourse debt, and sold their home in a short sale.

In Milkovich v. United States, the taxpayers purchased a home in Renton, Washington, using the proceeds of a mortgage loan and subsequently refinanced the loan. They later filed for Chapter 7 bankruptcy. The taxpayers received a discharge in the bankruptcy proceeding. The taxpayers and the government agreed that the effect of the discharge was to change their home mortgage loan from recourse to nonrecourse because it eliminated the ability of the lender, CitiMortgage, to enforce the mortgage debt personally against the taxpayers. Instead, the lender was able to enforce only the value of its lien against the property. The taxpayers were unable to make the mortgage payments, and the value of their home was significantly less than their outstanding mortgage debt. Given this situation, the lender agreed to a short sale of the property—i.e., a sale for less than the amount of mortgage debt owed. From the sale, CitiMortgage received just over $522,000, of which it credited approximately $115,000 towards accumulated unpaid interest on the loan. CitiMortgage issued a Form 1098 reporting the amount of mortgage interest paid and the taxpayers claimed a deduction for the mortgage interest, presumably on Schedule A of their return. The Service disallowed their deduction of mortgage interest. The taxpayers paid the tax allegedly due and brought this action seeking a refund.

The Service argued that the taxpayers’ mortgage interest deduction was disallowed by section 265(a)(1), which disallows deductions “allocable to one or more classes of income . . . wholly exempt from the taxes imposed by [subtitle A of the Code].” The District Court dismissed the taxpayers’ refund action not on the basis of section 265(a)(1), but instead on the basis that they had engaged in a transaction that lacked economic substance, analogous to the transaction in Estate of Franklin v. Commissioner. In Estate of Franklin, the taxpayer acquired property using the proceeds of nonrecourse debt that significantly exceeded the value of the property acquired. Although the taxpayers in this case did not acquire their property using nonrecourse debt that exceeded the value of the property, the District Court reasoned that their position was analogous to that of the taxpayer in Estate of Franklin and therefore disallowed their mortgage interest deductions.

In an opinion by Judge Collins, the Ninth Circuit reversed. According to the Ninth Circuit, the District Court erred in extending the holding of Estate of Franklin to the taxpayers’ situation. There was no suggestion, the court observed, that the taxpayers had acquired their mortgage loan in a transaction that lacked economic substance. According to the court,

Nothing in Estate of Franklin suggests that, without more, a subsequent collapse in real estate values means that the now-underwater mortgage should be considered a sham debt that cannot support a mortgage interest deduction.

The fact that the discharge changed the debt to nonrecourse debt, the court reasoned, did not alter the fact that the debt was bona fide debt that supported an interest deduction.

The court also rejected the government’s argument that section 265(a)(1) disallowed the taxpayers’ deduction. The court reviewed basic principles under which a taxpayer experiences discharge of indebtedness income if the taxpayer engages in a short sale of property subject to recourse indebtedness followed by cancellation of the remaining balance owed. In contrast, if the debt is nonrecourse, the entire amount of the debt is included in the taxpayer’s amount realized. When the debt is nonrecourse and fully included in amount realized, the taxpayer does not experience cancellation of indebtedness income. Accordingly, the taxpayers did not have any cancellation of indebtedness that was excluded from their income, and therefore it was inappropriate to disallow their mortgage interest deduction. The court also concluded that, even if a discharge of indebtedness had occurred in the context of the bankruptcy proceeding, section 265(a)(1) did not preclude the taxpayer’s deduction. The court reasoned that taxpayers who exclude cancellation of indebtedness income from gross income pursuant to section 108(a)(1)(A) because the cancellation occurred in a bankruptcy proceeding must reduce favorable tax attributes pursuant to section 108(b) by the amount of cancelled debt they excluded from gross income. For this reason, the court observed, the “exclusion” from gross income provided by section 108(a)(1)(A) is not a true exclusion, but rather a deferral of income. Therefore, “cancellation-of-indebtedness income exempted under section 108(a)(1)(A) is not ‘wholly exempt’ from income taxation within the meaning of section 265(a)(1).”

Dissenting opinion by Judge Stearns. Judge Stearns dissented, primarily on the basis that the taxpayers had not actually “paid” the mortgage interest in question.

3. Congress has increased and made more widely available the section 36B premium tax credit for 2021 and 2022, eliminated the need to repay excess advance premium tax credits for 2020, and made the credit available for 2021 to those who received unemployment compensation.

The American Rescue Plan Act of 2021 made several significant changes to the premium tax credit authorized by section 36B. This credit is available to individuals who meet certain eligibility requirements and purchase coverage under a qualified health plan through a health insurance exchange. First, for taxable years beginning in 2021 or 2022, section 9661 of the Act amends section 36B(b)(3)(A) by adding new clause (iii), which increases the amount of the credit at every income level and makes the credit available to those whose household income is 400% or more of the federal poverty line. Second, for any taxable year beginning in 2020, section 9662 of the Act suspends the rule of section 36B(f)(2)(B), which requires repayment of excess premium tax credits. An individual who receives advance premium tax credit payments is required by section 36B(f)(1) to reconcile the amount of the advance payments with the premium tax credit calculated on the individual’s income tax return for the year and, normally, pursuant to section 36B(f)(2)(B), must repay any excess credit received. This repayment obligation now does not apply for 2020. Third, for taxable years beginning in 2021, section 9663 of the Act amends section 36B by adding new subsection (g), which caps the household income of those receiving unemployment compensation at 133% of the federal poverty line. This has the effect of making such persons eligible for the maximum amount of premium tax credit.

a. Congress has extended certain changes related to the section 36B premium tax credit through 2025. Section 12001 of the Inflation Reduction Act extends through 2025 the effective period of sections 36B(b)(3)(A)(iii) and (c)(1)(E), which increase the amount of the credit at every income level and make the credit available to those whose household income is 400% or more of the federal poverty line.

4. Congress has modified and extended through 2032 the section 25C credit for certain energy-efficient improvements to a taxpayer’s principal residence. The changes apply to property placed in service after December 31, 2022.

Section 13301 of the Inflation Reduction Act extended, with some modifications, the section 25C credit for certain energy-efficient home improvements to a taxpayer’s principal residence. As modified, the credit is 30% (increased from ten percent) of the amount paid or incurred by a taxpayer for qualified energy efficiency improvements (such as insulation materials or systems, exterior windows, and exterior doors), 30% of the amount paid or incurred by a taxpayer for residential energy property expenditures (such as high-efficiency furnaces, water heaters, and air conditioning systems), and 30% of the amount paid or incurred for a home energy audit. Although energy-efficient roofs were formerly treated as qualified energy efficiency improvements, they are no longer treated in this manner (and therefore are not eligible for the section 25C credit) under the revised statute. The credit is subject to a an annual per-taxpayer limit of $1,200 and an annual $600 per-item limit. In addition, the maximum annual credit is $600 for all exterior windows and skylights and $500 for all exterior doors (with a per-door limit of $250). The maximum credit for a home energy audit is $150. For geothermal and air source heat pumps and biomass stoves, the annual limit on the credit is $2,000. The changes generally apply to property placed in service after December 31, 2022. As extended, the credit is available for property placed in service before January 1, 2033.

5. Congress has extended through 2034 the section 25D credit for residential clean energy property.

Section 13302 of the Inflation Reduction Act extended the section 25D credit for qualified solar electric property, qualified solar water heating property, qualified fuel cell property, qualified small wind energy property, qualified geothermal heat pump property and qualified biomass fuel property. Generally, these properties must be installed in a dwelling unit located in the United States that is used by the taxpayer as a residence. In the case of qualified fuel cell property, the dwelling unit must be used by the taxpayer as a principal residence. For qualified biomass fuel property, the credit was available only for property placed in service through 2022. Beginning in 2023, a credit is available for a new category, qualified battery storage technology. The credit for all categories of eligible property is 30% for property placed in service in 2022 through 2032 and phases down to 26% for property placed in service in 2033 and 22% for property placed in service in 2034.

E. Divorce Tax Issues

1. A hedge fund manager’s deductions of $18 million and $33 million for alimony were properly disallowed, says the Eighth Circuit.

Andrew and Elizabeth Redleaf were married in 1984. Following Andrew’s initiation of divorce proceedings in Minnesota state court in 2007, they entered into, and submitted to the court with jurisdiction over their divorce proceeding, a Marital Termination Agreement (MTA). The MTA, which provided that its terms would become part of any subsequent divorce decree, provided for division of the extensive marital assets, including a home in Telluride, Colorado, valuable artwork, and five vehicles. Among other requirements, the MTA provided, in a section entitled “Property Settlement,” that Andrew, the founder and manager of a hedge fund, would pay $1.5 million to Elizabeth each month for sixty months, followed by a final payment of $30 million. Pursuant to these provisions, Andrew paid Elizabeth $18 million in 2012 and $33 million in 2013.

Before 2019, section 215 permitted an above-the-line deduction for the payor of alimony, and section 71 required the recipient to include the alimony in gross income. On their respective federal income tax returns for 2012 and 2013, Andrew deducted the payments as alimony, while Elizabeth did not report them as income. The Service issued them both notices of deficiency. The notice issued to Andrew disallowed his deductions on the basis that the payments were not alimony but rather a nondeductible property settlement. The notice issued to Elizabeth increased her income by the amount of the payments on the basis that the payments were alimony. Both parties filed petitions in the Tax Court, where the cases were consolidated. In the Tax Court, the Service changed its position with respect to Elizabeth and argued that she was entitled to summary judgment because the payments were a nondeductible property settlement. The Tax Court (Judge Holmes) agreed that the payments were not alimony within the meaning of section 71(b) and granted Elizabeth’s motion for summary judgment and the government’s motion for summary judgment with respect to Andrew.

In an opinion by Judge Loken, the Eighth Circuit affirmed. Under former section 71(b)(1), the term “alimony or separate maintenance payment” was defined to mean any payment in cash that met four requirements. One of these requirements, set forth in former section 71(b)(1)(D), was that the payor could not have any liability to make the payments (or any substitute for the payments) after the recipient’s death. The court observed that, in determining whether there is any obligation to make the payments after the recipient’s death, many courts look first for any unambiguous termination provision in the parties’ agreement and then, if there is no such provision, to state law. If state law is ambiguous, then the court will look solely to the parties’ divorce or separation instrument. In this case, the court concluded, the MTA did not plainly state whether the payments would continue after Elizabeth’s death. Turning to state law, the court observed that “maintenance” payments do not continue after the recipient’s death under Minnesota law, but concluded that the payments at issue did not qualify as maintenance payments for this purpose, which would require a showing of need on the part of the recipient. Despite Andrew’s argument that Elizabeth needed tens of millions of dollars “to self-support her extravagant lifestyle,” the court concluded that there was no showing of need. Accordingly, the court disallowed Andrew’s deductions on the basis that the payments were part of a property settlement.

F. Education

1. Beginning in 2024, beneficiaries of section 529 college savings plans that have been open for more than 15 years will be able to roll over up to $35,000 during their lifetime from the 529 plan to a Roth IRA (subject to annual Roth IRA contribution limits).

Section 126 of the SECURE 2.0 Act amended section 529(c)(3) by adding section 529(c)(3)(E), which permits distributions from a section 529 college savings account to be tax-free if they are rolled over to a Roth IRA maintained for the benefit of the designated beneficiary of the section 529 account, provided that certain requirements are met. The requirements are that (1) the section 529 account must have been maintained for the 15-year period ending on the date of the distribution, (2) the distribution does not exceed the amount contributed to the section 529 plan (plus earnings) during the five-year period ending on the date of the distribution, and (3) the distribution is paid in a direct trustee-to-trustee transfer to a Roth IRA maintained for the benefit of the designated beneficiary of the section 529 account. The amount rolled over each year is subject to two limitations. First, the amount rolled over cannot exceed the annual limit on Roth IRA contributions for the designated beneficiary reduced by the aggregate contributions made during the year to all IRAs maintained for the benefit of the designated beneficiary. For example, the limit on Roth IRA contributions for 2023 is $6,500. If the designated beneficiary of a section 529 account contributes $1,000 to a traditional IRA for the year, then the maximum amount that the individual could roll over from the section 529 account to the Roth IRA would be $5,500. Second, the amount rolled over in the current year and in all prior years cannot exceed $35,000—i.e., the lifetime limit on rollovers from the section 529 account to a Roth IRA is $35,000. These changes apply to distributions from section 529 accounts made after December 31, 2023.

G. Alternative Minimum Tax

There were no significant developments regarding this topic during 2022.

VI. Corporations

A. Entity and Formation

There were no significant developments regarding this topic during 2022.

B. Distributions and Redemptions

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

Aspro, Inc. v. Commissioner, addressed 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. (Jackson) (40%), Mannatt’s Enterprises, Ltd. (Mannatt’s) (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 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 paid to Jackson and Mannatt’s 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. Among these was the fact that 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. Further, 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; and 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 taxable 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, and 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 Jackson and Mannatt’s 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—at least in regard to Jackson and Mannatt’s—]o support its deduction for management fees as compensation for services rendered, the court 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 commonly used by courts to determine reasonable compensation 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, 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 further 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 a employee-shareholders in high-level positions.

The Eighth Circuit agrees: management fees paid by C corporation to its shareholders are constructive dividends. In an opinion by Judge Gruender, the U.S. Court of Appeals for the Eighth Circuit affirmed the Tax Court’s decision that disallowed the deductions taken by Aspro, Inc., a subchapter C corporation, for “management fees” paid to its shareholders. As previously discussed, the corporation had three shareholders: Jackson Enterprises, Corp. (40%) (Jackson), Mannatt’s Enterprises, Ltd. (40%) (Mannatt’s), and Mr. Dakovich, Aspro’s president (20%). The court first considered the management fees paid to Jackson and Mannatt’s. The court concluded that the Tax Court had not clearly erred in finding that Aspro had failed to meet its burden to show that the management fees were reasonable. Aspro, the court observed, had failed to quantify the value of services provided, failed to produce documentary evidence of a service relationship with Jackson and Mannatt’s, and produced no evidence of how it had determined the amount of the management fees. Further, the court agreed with the Tax Court that the management fees paid to Jackson and Mannatt’s were not purely for services rendered and instead were disguised distributions of profit. The court noted that Aspro had not paid dividends since the 1970s and that the management fees were roughly proportional to the ownership interests of these two shareholders. Next, the court considered the management fees that Aspro had paid to its president, Mr. Dakovich, and concluded, for similar reasons, that Aspro could not deduct the management fees. According to the court, Aspro had not quantified the value of the management services provided by Mr. Dakovich. The government’s expert, the court observed, had concluded that the salary and bonus that Aspro paid to him exceeded the industry average and median by a substantial margin and that the management fees, which were paid in addition to his salary and bonus, were not reasonable. In addition, the court noted, the sum of the management fees plus the excess salary and bonus paid to Mr. Dakovich was roughly proportional to his ownership interest in the corporation. Finally, the court concluded, the management fees paid to Mr. Dakovich were not purely for services rendered and instead were disguised distributions of profit:

Aspro paid the management fees as lump sums at the end of the tax year even though the purported services were performed throughout the year, had an unstructured process of setting the management fees that did not relate to the services performed, and had a relatively small amount of taxable income after deducting the management fees.

Accordingly, the court concluded, the Tax Court did not clearly err in finding that Aspro had failed to carry its burden of showing that the management fees were reasonable and purely for services actually performed.

2. A new excise tax of 1% on redemptions of stock by publicly traded corporations.

The Inflation Reduction Act, section 10201, adds new section 4501, which imposes on a publicly traded U.S. corporation, a 1 percent excise tax on the value of any of its stock that is repurchased by the corporation during the taxable year. The term “repurchase” means a redemption within the meaning of Section 317(b) with regard to the stock of the corporation and any other economically similar transaction as determined by the Secretary of Treasury. The amount of repurchases subject to the tax is reduced by the value of any new issuance to the public and stock issued to the employees of the corporation. A subsidiary of a publicly traded U.S. corporation that performs the buyback for its parent or a U.S. subsidiary of a foreign corporation that buys back its parent’s stock is subject to the excise tax. The provision excludes certain repurchases from the excise tax. The provision applies to repurchases of stock after December 31, 2022.

a. Yay! We get to teach corporate redemptions again. The Treasury Department and the Service have announced interim guidance under section 4501 in the form of Notice 2023-2. The Notice is extensive and foreshadows the inevitably complicated Regulations that ultimately will be promulgated under section 4501. Section 2 of Notice 2023-2 summarizes relevant law and provides introductory guidance, including the meaning of a “covered corporation” and “covered repurchases.” Section 2 further identifies certain transactions that trigger the tax even if section 317(b) technically may not apply, such as stock purchases by a “specified affiliate” and “transactions economically similar to a section 317(b) redemption.” Section 2 of Notice 2023-2 also clarifies that, pursuant to section 275(a)(6), any tax paid under section 4501 is not deductible by the covered corporation. Section 3 of Notice 2023-2 comprises the bulk of the new guidance. Section 3 provides rules concerning amounts includable in the excise tax base, amounts excludable from the excise tax base, and other aspects of the application of section 4501. Section 3 also includes twenty-six helpful examples, a few of which are reproduced here regarding preferred stock redemptions, stock dividends, boot in acquisitive reorganization transactions, cash paid for fractional shares in an acquisitive reorganization, corporate liquidations, and purchases by a disregarded entity.

Example 1: Redemption of preferred stock-

Facts. Corporation X has outstanding common stock that is traded on an established securities market, as well as mandatorily redeemable preferred stock that is not traded on an established securities market. The preferred stock is stock for Federal tax purposes. On January 1, 2023, Corporation X redeems the preferred stock pursuant to its terms.

Analysis. The redemption by Corporation X of its mandatorily redeemable preferred stock is a repurchase because (i) Corporation X redeemed an instrument that is stock for Federal tax purposes (that is, mandatorily redeemable preferred stock issued by Corporation X), and (ii) the redemption by Corporation X is a section 317(b) redemption.

Example 5: Pro rata stock split -

Facts. On October 1, 2023, Corporation X distributes three shares of Corporation X common stock with respect to each existing share of its outstanding common stock (Corporation X Stock Split).

Analysis. The common stock distributed by Corporation X to its shareholders through the Corporation X Stock Split is not an issuance because Corporation X distributed the stock to its shareholders with respect to its outstanding common stock. See section 3.08(4)(b) of this notice. Therefore, the stock distributed by Corporation X is not taken into account for purposes of the netting rule. See section 3.08(4)(a) of this notice (disregarding such types of issuances). Accordingly, Corporation X’s stock repurchase excise tax base for its 2023 taxable year is not reduced by the Corporation X Stock Split.

Example 6: Acquisition of a target corporation in an acquisitive reorganization -

Facts. On October 1, 2023, Target merges into Corporation X (Target Merger). The Target Merger qualifies as an A reorganization. On the date of the Target Merger, the fair market value of Target’s outstanding stock is $100x. In the Target Merger, Target’s shareholders exchange $60x of their Target stock for Corporation X common stock, and $40x of their Target stock for $40x of cash.

Analysis regarding repurchase treatment, timing, and amount. The exchange by the Target shareholders of their Target stock for the consideration received in the Target Merger is a repurchase by Target because that exchange is an economically similar transaction. See section 3.04(4)(a)(i) of this notice. This repurchase occurs on October 1, 2023 (that is, the date on which the Target shareholders exchange their Target shares as part of the Target Merger). See section 3.06(1)(b) of this notice. The amount of this repurchase by Target is $100x, which equals the aggregate fair market value of the Target stock at the time that stock is exchanged by the Target shareholders as part of the Target Merger (that is, October 1, 2023). See section 3.06(2)(a) of this notice.

Analysis regarding impact of Target Merger on Target’s stock repurchase excise tax base. Target’s stock repurchase excise tax base for its 2023 taxable year is initially increased by $100x on account of the Target Merger. Under the qualifying property exception, the fair market value of the Target stock exchanged by the Target shareholders for Corporation X stock in the Target Merger (that is, $60x of Target stock) is a qualifying property repurchase that reduces Target’s stock repurchase excise tax base. See sections 3.03(3)(a) and 3.07(2)(a) of this notice (regarding acquisitive reorganizations). However, the fair market value of the Target stock exchanged by the Target shareholders for the $40x of cash in the Target Merger does not qualify for the qualifying property exception. See sections 3.03(3)(a) and 3.07(2)(a) of this notice. Therefore, Target’s stock repurchase excise tax base for its 2023 taxable year is increased by $40x ($100x repurchase - $60x exception = $40x).

Analysis regarding Corporation X’s stock repurchase excise tax base. Corporation X’s transfer of Corporation X stock to Target in the Target Merger is not an issuance for purposes of the netting rule because Corporation X’s issuance of that stock is part of a transaction to which the qualifying property exception applies. See generally section 3.08(4)(d) of this notice. Specifically, Corporation X’s transfer of Corporation X stock to Target is not an issuance for purposes of the netting rule because (i) the Corporation X stock constitutes property permitted to be received under section 354 without the recognition of gain, (ii) the Corporation X stock is used by a covered corporation (that is, Target) to repurchase its stock in a transaction that is a repurchase under section 3.04(4)(a)(i) of this notice, and (iii) the repurchase by Target is not included in Target’s stock repurchase excise tax base because it is a qualifying property repurchase. See section 3.08(4)(d) of this notice. Therefore, Corporation X does not take into account any of the $60x of its stock transferred to Target in the Target Merger to reduce its stock repurchase excise tax base for Corporation X’s 2023 taxable year. See section 3.08(4)(a) of this notice (disregarding such types of issuances).

Example 7: Cash paid in lieu of fractional shares -

Facts. The facts are the same as in section 3.09(6)(a) of this notice (Example 6). Additionally, the exchange ratio in the Target Merger is 1.25 shares of Corporation X stock for each share of Target stock. As part of the Target Merger, Shareholder A, who owns two shares of Target stock, receives two shares of Corporation X stock as well as additional cash in lieu of a 0.5 fractional share in Corporation X. The payment by Corporation X to Shareholder A of cash in lieu of a fractional share of Corporation X stock (i) was not separately bargained-for consideration (that is, the cash paid by Corporation X in lieu of a fractional Corporation X share represented a mere rounding off of the two Corporation X shares issued in the exchange), (ii) was carried out solely due to administrative necessity (and therefore, solely for nontax reasons), and (iii) was for an amount of cash with regard to a fractional share of Corporation X stock that did not exceed the value of one share.

Analysis. The payment by Corporation X of cash to Shareholder A in lieu of a fractional share of Corporation X stock is treated for Federal income tax purposes as though the 0.5 fractional share were (i) distributed by Corporation X to Shareholder A as part of the Target Merger, and then (ii) redeemed by Corporation X for cash. Corporation X’s deemed redemption of the fractional share treated as received by Shareholder A in the Target Merger is not a repurchase because, in addition to the facts described in section 3.09(7)(a) of this notice (this Example 7), the payment of cash by Corporation X is carried out as part of a transaction that qualifies as an acquisitive reorganization (that is, the Target Merger). See section 3.04(3)(b) of this notice. In addition, Corporation X’s deemed issuance of the fractional share to Shareholder A is not taken into account for purposes of the netting rule. See section 3.08(4)(f) of this notice.

Example 16: Distribution in complete liquidation of a covered corporation -

Facts. Corporation X adopts a plan of complete liquidation that becomes effective on March 1, 2023 (Corporation X Liquidation). Corporation X has 100x shares of common stock outstanding. On April 1, 2023, all shareholders of Corporation X receive a liquidating distribution by Corporation X in full payment for their Corporation X common stock. At the time at which Corporation X distributes all of its corporate assets to its shareholders in complete liquidation (that is, April 1, 2023), Corporation X stock trades at $1x per share. Each distribution in complete liquidation is subject to section 331.

Analysis. A distribution in complete liquidation of a covered corporation (that is, Corporation X) to which section 331 (but not section 332(a)) applies is not a repurchase by the covered corporation. See section 3.04(4)(b)(i) of this notice. Therefore, none of the distributions by Corporation X in complete liquidation is a repurchase by Corporation X, and Corporation X’s stock repurchase excise tax for its 2023 taxable year is not increased as a result of the Corporation X Liquidation.

Example 17: Complete liquidation of a covered corporation to which both sections 331 and 332(a) apply -

Facts. The facts are the same as in section 3.09(16)(a) of this notice (Example 16), except that one of Corporation X’s shareholders is a corporation (Corporation Z). As of the date of adoption of the plan of liquidation of Corporation X (that is March 1, 2023), Corporation Z has continued to be at all times until the receipt of the Corporation X liquidating distribution the owner of 80x shares of Corporation X common stock. In other words, Corporation Z has continued to be at all times until the receipt of the Corporation X liquidating distribution the owner of stock in Corporation X meeting the requirements of section 1504(a)(2) (that is, Corporation Z is an 80-percent distributee within the meaning of section 337(c)). Therefore, the liquidating distribution by Corporation X to Corporation Z as part of the Corporation X Liquidation qualifies as a liquidation under section 332(a). The liquidating distributions by Corporation X to the other shareholders described in section 3.09(16)(a) of this notice (Example 16) are distributions in liquidation subject to section 331.

Analysis. In the case of a complete liquidation of a covered corporation, if sections 331 and 332(a), respectively, apply to component distributions of the complete liquidation, (i) a distribution to which section 331 applies is a repurchase by the covered corporation, and (ii) the distribution to which section 332(a) applies is not a repurchase by the covered corporation. See section 3.04(4)(a)(v) of this notice. Therefore, as a result of the component liquidating distributions of the Corporation X Liquidation to which section 331 applies, Corporation X repurchased 20x shares of its stock on April 1, 2023. Accordingly, the Corporation X Liquidation results in a $20x increase in Corporation X’s stock repurchase excise tax base for its 2023 taxable year because the fair market value of Corporation X’s stock at the time of repurchase (that is, April 1, 2023) was $1x per share (20x shares x $1x = $20x). See section 3.06(2)(a) of this notice.

Example 18: Acquisition by disregarded entity -

Facts. Corporation X owns all the interests in LLC, a domestic limited liability company that is disregarded as an entity separate from its owner for Federal tax purposes (disregarded entity) under Regulation section 301.7701-3 of the Procedure and Administration Regulations (26 CFR part 301). On May 31, 2023, LLC purchases shares of Corporation X’s stock for cash from an unrelated shareholder.

Analysis. Because LLC is a disregarded entity, the May 31, 2023, acquisition of Corporation X stock is treated as an acquisition by Corporation X. Accordingly, the acquisition is a section 317(b) redemption and is therefore a repurchase. See section 3.04(2) of this notice. Regulation section 301.7701-2(c)(2)(v) (treating disregarded entities as corporations for purposes of certain excise taxes) does not apply to treat LLC as a corporation because section 4501 is not described in Regulation section 301.7701-2(c)(2)(v)(A).

Affected taxpayers may rely upon Notice 2023-2 until proposed regulations are issued.

C. Liquidations

There were no significant developments regarding this topic during 2022.

D. S Corporations

There were no significant developments regarding this topic during 2022.

E. Mergers, Acquisitions and Reorganizations

There were no significant developments regarding this topic during 2022.

F. Corporate Divisions

There were no significant developments regarding this topic during 2022.

G. Affiliated Corporations and Consolidated Returns

There were no significant developments regarding this topic during 2022.

H. Miscellaneous Corporate Issues

1. Congress has revived the corporate AMT for corporations with “applicable financial statement income” over $1 billion.

The corporate alternative minimum tax (AMT) was repealed by the 2017 Tax Cuts and Jobs Act. The Inflation Reduction Act, section 10101, amends section 55(b) to reinstate a corporate AMT. Specifically, the legislation imposes a 15 percent minimum tax on corporations (other than S corporations, regulated investment companies, and real estate investment trusts) with average “adjusted financial statement income” measured over three years of over $1 billion. Adjusted financial statement income (AFSI) is the net income or loss stated on the taxpayer’s “applicable financial statement” with certain modifications. One modification is that AFSI is adjusted to allow depreciation deductions calculated for tax purposes rather than book purposes. An “applicable financial statement” is defined as (1) a financial statement that is certified as being prepared in accordance with generally accepted accounting principles that is (a) a 10-K or annual statement to shareholders required to be filed with the Securities and Exchange Commission, (b) an audited financial statement used for credit purposes, reporting to shareholders, partners, other proprietors, or beneficiaries, or for any other substantial nontax purpose, or (c) filed with any other federal agency for purposes other than federal tax purposes; (2) certain financial statements made on the basis of international financial reporting standards and filed with certain agencies of a foreign government; or (3) a financial statement filed with any other regulatory or governmental body specified by the Service. The corporate AMT applies for tax years beginning after December 31, 2022.

a. Guidance on the revived corporate AMT. Pending forthcoming proposed regulations, the Treasury Department and the Service have announced interim guidance on “time-sensitive” issues under newly amended section 55(b). Notice 2023-7 also provides that Treasury and the Service intend to issue additional interim guidance to address other corporate AMT issues, particularly concerning unintended adverse consequences to the insurance industry and certain other industries. Taxpayers may rely upon this interim guidance until proposed regulations are issued.

VII. Partnerships

A. Formation and Taxable Years

1. A partnership made profitable by the availability of a tax credit was a bona fide partnership, says the D.C. Circuit.

In an opinion by Judge Katsas, the U.S. Court of Appeals for the District of Columbia Circuit has affirmed a decision of the U.S. Tax Court and held that a partnership that was made profitable only by the availability of tax credits was a bona fide partnership. Congress enacted a refined-coal tax credit in 2004 to encourage the production of cleaner-burning coal. The credit, which was set forth in former section 45(c)(7)(A), was available to those who opened refined coal production facilities before 2012. Eligible taxpayers could claim the credit for each ton of refined coal sold for a ten-year period. AJG Coal, Inc. (AJG), sought to take advantage of the new credit by forming Cross Refined Coal, LLC (Cross), to operate a refined coal production facility in South Carolina. Cross entered into certain agreements with Santee Cooper, a state-owned electric and water utility that owned the power station where the new refined coal production facility would be located. These agreements included a lease that allowed Cross to build and operate a coal-refining facility at the power station and a purchase-and-sale agreement under which Cross would purchase unrefined coal from Santee, refine it, and then sell it back to Santee for $0.75 less per ton than Cross had paid for it. This guaranteed that Cross would lose money on each purchase and sale. Cross also entered into a license agreement with AJG under which Cross obtained the right to use AJG’s coal-refining technology. The lease, the purchase-and-sale agreement, and the license agreement all had ten-year terms that matched the ten-year period during which the refined coal tax credit was available. AJG formed two other LLCs that entered into similar agreements with Santee and AJG at two other power stations owned by Santee. The business model of Cross could produce a profit only by taking into account the refined-coal tax credit:

Considering (1) the operating expenses that Cross incurred to refine coal, (2) the losses it sustained in buying and then re-selling the coal, and (3) the royalties it paid to obtain the necessary technology, Cross’s operations inevitably would produce a pre-tax loss. Its sole opportunity to turn a profit was to claim a tax credit that exceeded these costs.

Within a few months after Cross built and began operating the new coal-refining facility, AJG recruited two other investors, who became members of Cross. One of the new members purchased a 51% interest in Cross for $4 million, and the other purchased a 25% interest for $1.8 million. Because of limitations on the refined-coal tax credit, AJG could use only a portion of the available credit each year and had to carry forward the excess. Bringing in new members who could use the credit effectively allowed AJG to monetize the credit by selling interests in Cross and minimizing the credits it carried forward. The two new members of Cross also contributed to Cross a total of approximately $1.6 million to cover the business’s operating expenses. All three members were actively involved in Cross’s operations. Because of lengthy shutdowns attributable to various factors, Cross failed to produce the $140 million in profits that AJG had projected over the relevant ten-year period. Nevertheless, Cross did generate $19 million in after-tax profits over the four years during which the two additional members AJG had recruited were members. During 2011 and 2012, Cross claimed more than $25.8 million in refined-coal tax credits and $25.7 million in ordinary business losses. Cross, which was classified as a partnership for federal tax purposes, allocated the credits and losses among its members. Following an audit, the Service issued a final notice of partnership administrative adjustment in which it concluded that Cross was not a partnership and, accordingly, only AJG could claim the refined-coal tax credits. The Service:

determined that Cross was not a partnership for federal tax purposes “because it was not formed to carry on a business or for the sharing of profits and losses,” but instead “to facilitate the prohibited transaction of monetizing ‘refined coal’ tax credits.”

Cross challenged the final notice of partnership administrative adjustment by filing a petition in the U.S. Tax Court. In a ruling from the bench, the Tax Court (Judge Gustafson) held that Cross was a bona fide partnership because all three members had made substantial contributions, participated in management, and shared in profits and losses.

The U.S. Court of Appeals for the D.C. Circuit affirmed the Tax Court’s decision. For guidance, the court relied on the U.S. Supreme Court’s decisions in Commissioner v. Tower, 327 U.S. 280 (1946), and Commissioner v. Culbertson, 337 U.S. 733 (1949). According to the court, Tower and Culbertson provided a definition of a partnership that has two requirements: (1) those involved must intend to carry on a business as a partnership, i.e., the enterprise must be undertaken for profit or for another legitimate nontax business purpose, and (2) those involved must intend to share in profits, losses, or both. The court concluded that Cross satisfied this definition. First, the court held that the Tax Court had correctly concluded that AJG and the two other members of Cross intended to carry on a business jointly. The court observed that AJG had legitimate, nontax reasons for forming Cross and recruiting investors, including AJG’s “spreading its investment risk over a larger number of projects.” Further, the court added,

there was nothing untoward about seeking partners who could apply the refined-coal credits immediately, rather than carrying them forward to future tax years. Low-tax entities (like AJG) often use the prospect of tax credits to attract high-tax entities … into a partnership, and in return, the high-tax partners provide the financing needed to make the tax-incentivized project possible.

The court also emphasized that the two other investors, although motivated by the availability of tax credits, made substantial contributions of capital and were actively involved in Cross’s day-to-day operations. The court rejected the government’s argument that Cross’s members did not have the requisite intent to carry on a business because there was no expectation of a pre-tax profit. After reviewing relevant judicial decisions, the court concluded that transactions that are profitable only on a post-tax basis can still have a “nontax business purpose.” Congress’s objective in enacting the refined-coal tax credit, the court explained, was to encourage investments that would not otherwise have been made, and if the government is permitted to treat a partnership as a sham simply because there is no expectation of a pre-tax profit, then the only investments that would be made are those that would have been made without the congressional incentive. According to the court, this approach would undermine Congress’s ability to use tax credits to encourage socially desirable activities.

Second, the court held that the Tax Court had correctly concluded that all members of Cross shared in profits and losses. The two investors that AJG recruited for Cross, the court concluded, clearly shared in profits and faced downside risk from Cross’s business. The court rejected the government’s argument that the investors did not face meaningful downside risk given the expected tax benefits. The government argued that the imbalance between the amounts of capital contributed by the investors and their expected tax benefits demonstrated that the investors merely bought tax credits and did not become true equity partners. The court emphasized that the amount of tax credits available to the partners depended on the amount of refined coal sold by Cross and that it was entirely possible that the investors would not recover much of their capital. In fact, the court observed, these same investors lost substantial amounts of money on their investments in another LLC formed by AJG to produce refined coal and that had the same investment structure as Cross.

In summary, the court held that Cross was a bona fide partnership for federal tax purposes.

2. An investor entitled to interest measured by the net cash flow from real property owned by a partnership and by the appreciation in value of the partnership’s assets was a lender and not a participant in a joint venture with the partnership; therefore, the partnership was entitled to deduct the interest paid.

In Deitch v. Commissioner, the issue was whether a party that provided financing for a partnership’s acquisition and renovation of real property was a lender or instead a participant in a joint venture with the partnership. Two individuals, Mr. Deitch and Mr. Barry, formed West Town Square Investment Group, LLC (WTS), which was classified as a partnership for federal tax purposes. These two individuals, along with Mr. Barry’s wife, were the petitioners in this case. They formed WTS to acquire commercial real property in Rome, Georgia, renovate it, and lease a portion of the property to a hospital that sought space in which to provide physical therapy services. Protective Life Insurance Co. (PLI) provided financing for the project. PLI offered both conventional loans and participating loans. In this case, PLI agreed to lend $4.4 million to WTS in the form of a participating loan. The loan documents consisted of a promissory note providing for a fixed rate of interest (6.25%), a security agreement giving PLI a security interest in the property, and an “Additional Interest Agreement” that obligated WTS to pay additional interest of two types: NCF Interest (50 percent of net cash flow from the property) and Appreciation Interest (50 percent of the appreciation in value of the property if it was ever sold or the loan was terminated). Both the promissory note and the Additional Interest Agreement provided that the relationship between PLI and WTS “shall be solely that of creditor and debtor” and that noting in any of the loan documents would be construed to create a partnership, joint venture, “or any relationship other than that of creditor and debtor.” From 2006 to 2014, WTS paid interest on the loan, including NCF Interest, which it reported on Form 1065, the partnership’s tax return. In 2014, WTS sold the property and reported (1) a net section 1231 gain of $2.6 million, which it allocated equally between WTS’s two members, and (2) a deduction of approximately $1 million for Appreciation Interest, which had the effect of producing a net rental loss of approximately $1.2 million for 2014. The Schedule K-1s issued to Mr. Deitch and Mr. Barry for 2014 each reported one-half of the $1.3 million net section 1231 gain and one-half of the $1.2 million net rental loss. The Service audited the 2014 returns filed by the two individuals and took the position that each of them had a share of WTS’s net rental loss of approximately $100,000 rather than $600,000 because they had not established that the $1 million of Appreciation Interest deducted by WTS was either interest or an ordinary and necessary business expense. Accordingly, the Service increased each individual’s taxable income by approximately $500,000. Mr. Deitch and Mr. and Mrs. Barry each challenged the’s position by filing petitions in the U.S. Tax Court. In the Tax Court, the government argued that the Additional Interest Agreement created a joint venture between WTS and PLI and that the $1 million of Appreciation Interest paid by WTS was a nondeductible return on PLI’s equity interest in the joint venture. The Tax Court (Judge Gustafson) held that PLI and WTS had not formed a joint venture classified as a partnership and that their relationship was that of creditor-debtor. The court observed that the government had stipulated that the original promissory note, later amendments to the note, and the security agreement constituted genuine indebtedness, and that the Additional Interest Agreement could not be separated from those three agreements. These stipulations contradicted the government’s position that PLI and WTS had formed a joint venture. Nevertheless, the court analyzed whether PLI and WTS had formed a joint venture by applying the eight factors from the court’s decision in Luna v. Commissioner.The first factor, the agreement of the parties and their conduct in executing its terms, the court observed, weighed against the existence of a joint venture because the agreements between PLI and WTS expressly provided that their relationship was creditor-debtor and expressly disclaimed the existence of a joint venture. The second factor, the contributions (if any) that each party has made to the venture, weighed against the existence of a joint venture because PLI provided capital in its capacity as an arm’s-length lender. The third factor, the parties’ control over income and capital and the right of each to make withdrawals, weighed in favor of the existence of a joint venture because, in the court’s view, PLI had significant control over the capital, was guaranteed to receive more than half of the income from the property (because of the manner in which net cash flow was defined), and was not liable for operating losses, which meant that its interest resemble that of a preferred equity holder. The fourth factor is

whether each party was a principal and coproprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income.

This fourth factor, the court reasoned, weighed against the existence of a joint venture because, although PLI shared in profits, it did not share in operating losses. The fifth factor, whether business was conducted in the joint names of the parties, weighed against the existence of a joint venture because, as the government conceded, the business was conducted under the name WTS and not that of PLI or any other entity. The sixth factor, whether the parties filed federal partnership returns or otherwise represented to the Service or to persons with whom they dealt that they were joint venturers, weighed against the existence of a joint venture because, as the government conceded, WTS and PLI did not file partnership tax returns indicating they were partners and did not otherwise represent that they were partners. The seventh factor, whether separate books of account were maintained for the venture, weighed against the existence of a joint venture because, although the parties agreed on how books and records would be kept, this was solely for purposes of calculating the interest due to PLI and “WTS and PLI did not jointly maintain books of account that would normally be expected in the operation of a business.” The eighth factor, whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise, weighed against the existence of a joint venture because, although PLI exercised control over the capital it provided to WTS, WTS exercised primary responsibility for and control over the rental operations of the property and most of the terms set forth in the security agreement were standard terms present in an arm’s-length secured commercial loan. In short, seven of the eight Luna factors weighed against the existence of a joint venture. Accordingly, the court held that the relationship between PLI and WTS was that of creditor-debtor and that the Appreciation Interest paid by WTS was interest that WTS was entitled to deduct under section 163(a).

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

1. Are partners not keeping track of outside basis? It could come back to bite them. New compliance campaigns by the Service focus on losses and distributions that exceed a partner’s outside basis.

The Service has announced compliance campaigns focusing on losses and distributions that exceed a partner’s outside basis. Pursuant to the limitation set forth in section 704(d), a partner can deduct the partner’s share of partnership losses only to the extent of the partner’s basis in the partnership interest, as determined under section 705. Under the rules that apply to distributions in section 731(a), a partner’s basis in the partnership interest functions as a limitation on the partner’s ability to receive certain liquidating and non-liquidating distributions without the recognition of gain. In February 2022, the Service announced a compliance campaign focusing on the allocation of losses to a partner that exceed the partner’s outside basis. The identification of this issue as the focus of a compliance campaign is available on the Service website. In August 2022, the Service also announced a compliance campaign focusing on distributions to a partner that exceed the partner’s outside basis. The identification of this issue as the focus of a compliance campaign is available on the Service website through the following link: https://perma.cc/M4PR-UERJ.

Partnerships now must report annually a partner’s tax capital account on Schedule K-1. Query whether the Service plans to use a partner’s tax capital account as a proxy for the partner’s basis in the partnership interest. This possibility combined with the new compliance campaigns reinforce the importance of partners having records to support the determination of their basis in the partnership interest.

C. Distributions and Transactions Between the Partnership and Partners

There were no significant developments regarding this topic during 2022.

D. Sales of Partnership Interests, Liquidations and Mergers

There were no significant developments regarding this topic during 2022.

E. Inside Basis Adjustments

1. The Service has finally recognized that partnership returns are filed electronically. Section 754 elections no longer require a partner’s signature.

The Treasury Department and the Service have finalized, without changes, Proposed Regulations that eliminate the requirement that a section 754 election made by the partnership be signed by one of the partners. If a partnership wishes to make a section 754 election, the former Regulations (Regulation section 1.754-1(b)) required the partnership to attach to its return a written statement that (i) set forth the name and address of the partnership making the election, (ii) was signed by one of the partners, and (iii) contained a declaration that the partnership elects under section 754 to apply the provisions of sections 734(b) and 743(b). Many partnership returns are filed electronically with section 754 elections that, in the Service’s view, do not comply with the requirement that the election be signed by one of the partners. As a result, the Service received many requests for so-called “9100 relief” to make a late section 754 election. In these final Regulations, the Service has eliminated the requirement that a partnership’s section 754 election be signed by one of the partners. Pursuant to this amendment, a section 754 election must comply only with the other two requirements to be a valid election. This change applies to taxable years ending on or after August 5, 2022, but taxpayers can apply the change to taxable years ending before that date. Therefore, partnerships filing their returns electronically with an otherwise valid section 754 election need not request 9100 relief.

F. Partnership Audit Rules

There were no significant developments regarding this topic during 2022.

G. Miscellaneous

There were no significant developments regarding this topic during 2022.

VIII. Tax Shelters

A. Tax Shelter Cases and Rulings

There were no significant developments regarding this topic during 2022.

B. Identified “Tax Avoidance Transactions”

There were no significant developments regarding this topic during 2022.

C. Disclosure and Settlement

There were no significant developments regarding this topic during 2022.

D. Tax Shelter Penalties

There were no significant developments regarding this topic during 2022.

IX. Exempt Organizations and Charitable Giving

A. Exempt Organizations

There were no significant developments regarding this topic during 2022.

B. Charitable Giving

1. What does “protected in perpetuity” mean? These cases provide some answers in the context of conservation easements.

It is well known that the Service is battling syndicated conservation easements. Moreover, after recent victories, the Service has announced a time-limited settlement offer to certain taxpayers with pending Tax Court cases involving syndicated conservation easements. Other than challenging valuations, the Service’s most successful strategy in combating syndicated conservation easements generally has centered around the “protected in perpetuity” requirement of section 170(h)(2)(C) and (h)(5)(A). The Service has argued successfully in the Tax Court that the “protected in perpetuity” requirement is not met where the taxpayer’s easement deed fails to meet the strict requirements of the “extinguishment regulation.” The extinguishment regulation ensures that conservation easement property is protected in perpetuity because, upon destruction or condemnation of the property and collection of any proceeds therefrom, the charitable donee must proportionately benefit. According to the Service’s and Tax Court’s reading of the extinguishment regulation, the charitable donee’s proportionate benefit must be determined by a fraction determined at the time of the gift as follows: the value of the conservation easement as compared to the total value of the property subject to the conservation easement (hereinafter the “proportionate benefit fraction”). Thus, upon extinguishment of a conservation easement due to an unforeseen event such as condemnation, the charitable donee must be entitled to receive an amount equal to the product of the proportionate benefit fraction multiplied by the proceeds realized from the disposition of the property. As part of its litigation strategy against syndicated conservation easements, the Service pounces upon any technical flaws in the deed’s extinguishment clause/proportionate benefit fraction language. In fact, the Service recently has been successful in challenging extinguishment clause/proportionate benefit fraction language that either (i) would allow the donor to reclaim from the charitable donee property subject to a conservation easement by conveying to the donee substitute property in exchange therefor or (ii) would reduce the charitable donee’s benefit upon extinguishment of the conservation easement by the fair market value of post-contribution improvements made to the subject property after the date of the taxpayer-donor’s deductible gift. The latter argument by the Service—that a properly-drafted extinguishment clause/proportionate benefit fraction cannot give the donor credit for post-contribution improvements to the conservation easement property—is particularly potent. This argument by the Service is the subject of the two Tax Court companion opinions rendered in Oakbrook Land Holdings, LLC v. Commissioner, as discussed below. Reportedly, many conservation easement deeds have such language, especially syndicated conservation easement deeds originating in the southeastern U.S. Hence, the Tax Court’s opinions in Oakbrook Land Holdings, LLC are very important to the conservation easement industry. For a discussion of other Service and Tax Court developments relating to conservation easements, see the Agricultural Law and Taxation Blog post of July 8, 2020.

a. A crack in the Service’s armor with respect to syndicated conservation easements? Or, a death knell for taxpayers? You be the judge. Oakbrook Land Holdings LLC v. Commissioner, including the companion memorandum opinion. In these companion opinions totaling 172 pages, the Tax Court disallowed a taxpayer-donor’s charitable contribution deduction because the language in the conservation easement deed was found to be defective under either of two theories argued by the Service and supported by the Tax Court’s reading of Regulation section 1.170A-14(g)(6)(ii). See below for further discussion. The taxpayer-donor’s counter-arguments, that the conservation easement deed’s language was correct and that Regulation section 1.170A-14(g)(6)(ii) is invalid, failed to persuade the Tax Court. Just to keep us on our toes, perhaps, the Tax Court’s decision resulted in two lengthy opinions. Judge Lauber wrote the majority opinion for the Tax Court’s reviewed decision regarding one theory of the case, while Judge Holmes wrote a memorandum decision based upon another theory of the case. Interestingly, Oakbrook Land Holdings did not arise out of a syndicated conservation easement; however, it is very informative as to the Service’s litigation strategy with respect to syndicated conservation easements as well as the Tax Court’s view of the law applicable to conservation easements generally.

Facts. The facts of Oakbrook Land Holdings are typical of recent conservation easement cases litigated in the Tax Court. The taxpayer-donor, Oakbrook Holdings LLC, acquired a 143-acre parcel of property near Chattanooga, Tennessee in 2007 for $1.7 million. The plan was to develop the property for “higher-end, single family residences.” In late 2008 Oakbrook Holdings LLC transferred approximately 37 acres of the property to related entities to allow a portion of the property to be developed without restrictions relating to the remainder of the property. The remaining 106 acres of the property then was subjected to a conservation easement in favor of Southeast Regional Land Conservancy (the “Conservancy”), a section 501(c)(3) organization. The taxpayer-donor, Oakbrook Holdings LLC, claimed a charitable contribution deduction of over $9.5 million for the donated conservation easement even though the contribution occurred only a little over a year after Oakbrook Holdings LLC had acquired the property for $1.7 million.

Oakbrook Holdings LLC, the taxpayer-donor, largely relied upon the charitable donee, the Conservancy, and its attorneys to draft the conservation easement deed. The Conservancy in turn relied upon language found in similar conservation easement deeds that have been executed and approved by numerous taxpayers and their attorneys. The deed provided as follows in relevant part:

This Conservation Easement gives rise to a real property right and interest immediately vested in [the Conservancy]. For purposes of this Conservation Easement, the fair market value of [the Conservancy]’s right and interest shall be equal to the difference between (a) the fair market value of the Conservation Area as if not burdened by this Conservation Easement and (b) the fair market value of the Conservation Area burdened by this Conservation Easement, as such values are determined as of the date of this Conservation Easement, (c) less amounts for improvements made by O[akbrook] in the Conservation Area subsequent to the date of this Conservation Easement, the amount of which will be determined by the value specified for these improvements in a condemnation award in the event all or part of the Conservation Area is taken in exercise of eminent domain as further described in this Article VI, Section B(3) below. If a change in conditions makes impossible or impractical any continued protection of the Conservation Area for conservation purposes, the restrictions contained herein may only be extinguished by judicial proceeding. Upon such proceeding, [the Conservancy], upon a subsequent sale, exchange or involuntary conversion of the Conservation Area, shall be entitled to a portion of the proceeds equal to the fair market value of the Conservation Easement as provided above. [The Conservancy] shall use its share of the proceeds in a manner consistent with the conservation purposes set forth in the Recitals herein.

Article VI, Section B(3) of the deed further stated:

Whenever all or part of the Conservation Area is taken in exercise of eminent domain * * * so as to abrogate the restrictions imposed by this Conservation Easement, * * * [the] proceeds shall be divided in accordance with the proportionate value of [the Conservancy]’s and O[akbrook]’s interests as specified above; all expenses including attorneys fees incurred by O[akbrook] and [the Conservancy] in this action shall be paid out of the recovered proceeds to the extent not paid by the condemning authority.

First argument of the Service and taxpayer’s response. The Service’s first argument to disallow the taxpayer-donor’s charitable contribution deduction was that the above-quoted language of the conservation easement deed only entitled the charitable donee, the Conservancy, to a fixed (not proportionate) benefit (i.e., historical value of the conservation easement at the time of the gift) upon the destruction or condemnation of the subject property. According to the Service, Regulation section 1.170A-14(g)(6)(ii) requires that the charitable donee be entitled to a proportionate (i.e., fractional) benefit upon extinguishment of a conservation easement. Further, the Service’s position is that the amount of the benefit must be determined by applying the proportionate benefit fraction against the fair market value of the subject property at the time of the extinguishment. Put differently, the Service contends that Regulation section 1.170A-14(g)(6)(ii) does not merely establish a baseline amount equal to the value of the conservation easement as the amount of the benefit to be received by the charitable donee upon extinguishment of a conservation easement. Rather, upon extinguishment of the easement, if the subject property has appreciated in value the charitable donee must be entitled to receive more than the claimed charitable contribution value of the conservation easement. (It is not entirely clear what the Service’s position would be under Regulation section 1.170A-14(g)(6)(ii) if upon extinguishment of the easement the subject property has decreased in value after the taxpayer-donor’s gift, although consistency would argue that the charitable donee should receive less than the claimed charitable contribution value.)

On the other hand, the taxpayer-donor argued, of course, that the above-quoted language in the deed complied with Regulation section 1.170A-14(g)(6)(ii) because the Regulation should be read to require only a fixed (not fractional) amount that must be received by the charitable donee upon extinguishment of a conservation easement. In other words, the taxpayer-donor believed that Regulation section 1.170A-14(g)(6)(ii) was meant to protect the charitable donee’s downside risk: i.e., that the event extinguishing the conservation easement would result in proceeds much less than the taxpayer-donor’s claimed charitable contribution deduction. The taxpayer-donor’s reading of Regulation section 1.170A-14(g)(6)(ii) was that the extinguishment clause in a conservation easement deed must entitle the charitable donee to an amount equal to the previously claimed charitable contribution deduction (or, if less, all of the proceeds from the disposition of the property).

Memorandum Opinion of Judge Holmes. In Oakbrook, Judge Holmes, citing the Tax Court’s prior decision in Coal Property Holdings, LLC v. Commissioner, agreed with the Service’s position regarding Regulation section 1.170A-14(g)(6)(ii) and the conservation easement language at issue, thereby disallowing the taxpayer-donor’s more than $9.7 million charitable contribution deduction. Judge Holmes reasoned that the language in the deed did not grant a fractional proportionate benefit to the Conservancy. It granted only a minimum benefit equal to the amount of the taxpayer-donor’s claimed charitable contribution deduction. Judge Holmes agreed with the Service that Regulation section 1.170A-14(g)(6)(ii) requires a fractional benefit, not a fixed amount. Other cases also have interpreted Regulation section 1.170A-14(g)(6) to require a fractional, not fixed, benefit in favor of the charitable donee. This aspect of the Tax Court’s decision in Oakbrook Land Holdings is not novel, and presumably this lack of novelty is the reason for this memorandum decision written separately from the Tax Court’s reviewed opinion written by Judge Lauber.

Second argument of the Service and taxpayer’s response. Alternatively, the Service argued that the above-quoted language in the conservation easement deed was flawed in another respect. Specifically, the Service contended that the deed’s extinguishment language, which required that the charitable donee’s benefit upon destruction or condemnation of the property be reduced by the value of improvements to the property made by the taxpayer-donor after the contribution, was not allowed by the strict requirements of Regulation section 1.170A-14(g)(6)(ii). This position of the Service is not explicitly supported by Regulation section 1.170A-14(g)(6)(ii) and is a novel argument by the Service. The taxpayer-donor responded that to the extent Regulation section 1.170A-14(g)(6)(ii) is read to disallow such a reduction in the charitable donee’s benefit upon extinguishment of a conservation easement, the extinguishment regulation violates either the procedural or substantive requirements of the Administrative Procedures Act (“APA”) and is invalid. This alternative argument by the Service, and the taxpayer-donor’s response, was the subject of the Tax Court’s reviewed opinion by Judge Lauber, discussed below.

Reviewed opinion of Judge Lauber. In Oakbrook, a reviewed opinion (12-4-1) by Judge Lauber, the Tax Court agreed with the Service’s position concerning Regulation section 1.170A-14(g)(6)(ii) and post-contribution improvements to conservation easement property by a taxpayer-donor. We will spare the reader pages and pages of arguments and counter-arguments regarding the requirements of the APA. Suffice it to say that a majority of the Tax Court held that Regulation section 1.170A-14(g)(6)(ii) reflects a reasonable interpretation of the “protected in perpetuity” requirement of sections 170(h)(2)(C) and (h)(5)(A). The majority also agreed with the Service’s position that Regulation section 1.170A-14(g)(6)(ii) does not permit the extinguishment clause of a conservation easement deed to reduce the charitable donee’s proportionate benefit by the fair market value of post-contribution improvements to the subject property made by the donor. Hence, the majority disallowed the taxpayer-donor’s claimed $9.7 million plus charitable contribution deduction based upon the Service’s alternative argument (in addition to the grounds expressed in Judge Holmes’s separate memorandum opinion).

Concurring opinion of Judge Toro. In a concurring opinion, Judge Toro, joined by Judge Urda and in part by Judges Gustafson and Jones, wrote that, although the majority reached the correct result for the reasons expressed in Judge Holmes’s memorandum decision, the majority was mistaken concerning whether Regulation section 1.170A-14(g)(6)(ii) violates the APA and whether the Service’s interpretation of the extinguishment regulation (regarding post-contribution improvements made by a taxpayer-donor) was permissible.

Dissenting opinion of Judge Holmes. In an interesting twist, Judge Holmes (who held in favor of the Service in his memorandum opinion) dissented from the Tax Court’s reviewed opinion. Judge Holmes wrote: “Our decision today will likely deny any charitable deduction to hundreds or thousands of taxpayers who donated the conservation easements that protect perhaps millions of acres.” And Judge Holmes made his views clear regarding the Service’s interpretation of Regulation section 1.170A-14(g)(6)(ii) to prohibit reduction of a charitable donee’s extinguishment benefit for the value of improvements made by a taxpayer-donor and Treasury’s compliance with the APA: “[I]f the majority is right, the Treasury Department can get by with the administrative-state equivalent of a quiet shrug, a knowing wink, and a silent fleeting glance from across a crowded room.”

b. The Eleventh Circuit has agreed that a conservation easement with an extinguishment clause that does not allow the charitable donee, in the event the easement is extinguished, to share in appreciation of the property due to improvements does not comply with applicable regulations. The taxpayer in this case donated to a qualifying organization (a land conservancy) a conservation easement on 652 acres of undeveloped land in Van Buren County, Tennessee. As required by Regulation section 1.170A-14(g)(6)(ii), the deed granting the easement addressed the rights of the donee organization in the event the easement was extinguished. The deed provided that, upon extinguishment of the easement, the donee organization would be entitled to a proportionate share of the sale proceeds resulting from the extinguishment. The proportionate share was to be determined by comparing, at the time of donation, (i) the value of the easement to (ii) the value of the property subject to the easement without reduction by the value of the easement. In other words, the donee’s proportionate share of extinguishment proceeds would be determined by constructing a fraction, the numerator of which was the value of the easement at the time of donation and the denominator of which was the value of the entire property (without reduction by the value of the easement) at the time of donation. So far, so good. However, the deed provided that, if the easement were extinguished, the donee’s proportionate share of sale proceeds would be determined by applying this fraction to:

the fair market value of the Property unencumbered by this Easement (minus any increase in value after the date of this grant attributable to improvements) …

The effect of this language was to preclude the charitable donee from sharing, upon extinguishment of the easement, in any increase in value of the property attributable to post-donation improvements. In an opinion by Judge Anderson, the U.S. Court of Appeals for the Eleventh Circuit agreed with the Service that this provision in the deed conveying the easement did not comply with Regulation section 1.170A-14(g)(6)(ii):

Appellants do not seriously dispute that the formula in … the deed is different from [the] regulatory formula. Nor could they plausibly do so…. [T]he regulation does not allow for “any increase in value after the date of th[e] grant attributable to improvements” to be subtracted from the extinguishment (e.g. condemnation) proceeds before the fraction is applied to the proceeds. No such “minus” language is included in the formula set out in section 1.170A-14(g)(6)(ii). Thus, the deed is different from and out of compliance with the formula set out in the regulation.

The court noted that its holding was consistent with the holding of the Fifth Circuit in PBBM Rose Hill, Ltd. and that of the Tax Court in Coal Property Holdings.

The court also rejected the taxpayer’s argument that the language in the deed complied with the applicable regulation because it stated that the donee organization’s proportionate share of proceeds resulting from extinguishment of the easement would be determined either in accordance with the deed or in accordance with Regulation section 1.170A-14 “if different.” The court referred to this provision as the “Treasury Regulation Override.” “For federal tax purposes,” the court observed, “courts and the Service have refused to enforce a clause that purports to save an instrument from being out of compliance with the tax laws if the clause is operative by way of a condition subsequent.” The court concluded that the Treasury Regulation Override was a condition subsequent savings clause that did not bring the language in the deed into compliance with the applicable regulation.

The court also upheld the Tax Court’s valuation of the easement in question, the Tax Court’s imposition of accuracy-related penalties, and held that the Service had complied with section 6751(b) by obtaining the required supervisory approval of the penalties.

The taxpayer in this case did not challenge the validity of the regulation in question, Regulation section 1.170A-14(g)(6)(ii), under the APA. In a subsequent case, Hewitt v. Commissioner, the Eleventh Circuit held that the regulation was arbitrary and capricious under the APA for failing to comply with the APA’s procedural requirements and therefore is invalid.

c. According to the Eleventh Circuit, Regulation section 1.170A-14(g)(6)(ii), as interpreted by the Service, is arbitrary and capricious under the Administrative Procedure Act for failing to comply with procedural requirements and therefore is invalid. In an opinion by Judge Lagoa, the U.S Court of Appeals for the Eleventh Circuit has held that Regulation section 1.170A-14(g)(6)(ii), as interpreted by the Service, violates the APA and therefore is invalid. The taxpayers in this case donated to a qualifying organization a conservation easement on land in Randolph County, Alabama. Like the deed in TOT Property Holdings, the deed conveying the easement in this case provided that, in the event of judicial extinguishment of the easement, the value of post-donation improvements to the property would be subtracted from the extinguishment proceeds before determining the donee’s share of the proceeds. The Service argued that this subtraction of the value of post-donation improvements is not permitted by the relevant regulation, Regulation section 1.170A-14(g)(6)(ii). The Eleventh Circuit had agreed with the Service on this issue in TOT Property Holdings,. In this case, however, the taxpayers, unlike the taxpayers in TOT Property Holdings, argued that the regulation was invalid under the APA. The APA generally prescribes a three-step process for notice-and-comment rulemaking. First, the agency must issue a general notice of proposed rulemaking. Second, assuming notice is required, the agency must consider and respond to significant comments received during the period for public comment. Third, in issuing final rules, the agency must include a concise general statement of the rule’s basis and purpose. The taxpayer argued that, in issuing Regulation section 1.170A-14(g)(6)(ii), Treasury had not complied with the second step because seven commenters, including the New York Land Conservancy (NYLC), had expressed concern about the required allocation of proceeds upon extinguishment of the easement reflected in the proposed version of the regulation. The NYLC specifically had commented on the issue of whether post-donation improvements to the property subject to the easement should be taken into account in determining the charitable donee’s proportionate share of extinguishment proceeds and had argued that such a requirement was undesirable to prospective donors and that the proposed version of the regulation should be revised. When the Treasury Department issued the final version of the regulation, the preamble stated that Treasury had considered all comments submitted but did not specifically address or respond to the comments submitted on allocation of post-extinguishment proceeds. The Eleventh Circuit agreed with the taxpayer:

Simply put, NYLC’s comment was significant and required a response by Treasury to satisfy the APA’s procedural requirements. And the fact that Treasury stated that it had considered “all comments,” without more discussion, does not change our analysis, as it does not “enable [us] to see [NYLC’s] objections and why [Treasury] reacted to them as it did.”

Accordingly, the court held that the Service’s interpretation of Regulation section 1.170A-14(g)(6)(ii) as precluding the subtraction of post-donation improvements to the easement property in determining the donee organization’s proportionate share of extinguishment proceeds is arbitrary and capricious and therefore invalid under the APA’s procedural requirements. The court therefore reversed the Tax Court’s decision that had disallowed the taxpayer’s charitable contribution deduction.

d. The Sixth Circuit has disagreed with the Eleventh Circuit and has held that Treasury complied with the Administrative Procedure Act in issuing Regulation section 1.170A-14(g)(6)(ii) and that the regulation is valid. Oakbrook Land Holdings, LLC v. Commissioner, 28 F.4th 700 (6th Cir. 3/14/22), aff’g, 154 T.C. 180 (5/12/20). The taxpayers in this case donated to a qualifying organization a conservation easement on 106 acres of land on White Oak Mountain, an outcropping of the Appalachians near Chattanooga, Tennessee. As discussed above, the deed conveying the easement provided that, if the easement were to be extinguished, the done organization’s proportionate share of the extinguishment proceeds would be determined by subtracting the value of any post-donation improvements to the property. The Tax Court had held in a reviewed opinion that Treasury had complied with the APA in issuing the regulation. In an opinion by Judge Moore, the U.S. Court of Appeals for the Sixth Circuit has affirmed the Tax Court’s decision. The taxpayers in this case, like those in Hewitt v. Commissioner, argued that Treasury had failed to comply with the APA in issuing the regulation. The APA generally prescribes a three-step process for notice-and-comment rulemaking. First, the agency must issue a general notice of proposed rulemaking. Second, assuming notice is required, the agency must consider and respond to significant comments received during the period for public comment. Third, in issuing final rules, the agency must include a concise general statement of the rule’s basis and purpose. The taxpayer argued that, in issuing Regulation section 1.170A-14(g)(6)(ii), Treasury had not complied with the either the second or third steps. With respect to the third step, the taxpayer argued that Treasury had not adequately explained the purpose and basis of the Regulations because the Preamble to the final version of the Regulations stated only that the Regulations “provide necessary guidance to the public for compliance with the law and affect donors and donees of qualified conservation contributions.” The court rejected this argument. Even without an ideal statement of basis and purpose for regulations, the court explained, a regulation can meet the requirement of including a concise statement of its basis and purpose if the basis and purpose are obvious. In its notice of proposed rulemaking for Regulation section 1.170A-14, Treasury had discussed the legislative history of section 170(h) and had described how Congress had shifted from limiting the deductibility of conservation easements to allowing them when the easement was perpetual. Here, the court reasoned,

the statutory text and the legislative history that Treasury contemplated in promulgating Treas. Regulation section 1.170A-14(g)(6)(ii) illuminate the regulation’s basis and purpose: to provide an administrable mechanism that would ensure that an easement’s conservation purpose as per [section] 170(h)(5)(A) continued to be protected should the interest be extinguished.

With respect to the second step for notice-and-comment rulemaking, the taxpayers argued that several commenters, including the NYLC, had expressed concern about the required allocation of proceeds upon extinguishment of the easement reflected in the proposed version of the regulation. The NYLC specifically had commented on the issue of whether post-donation improvements to the property subject to the easement should be taken into account in determining the charitable donee’s proportionate share of extinguishment proceeds and had argued that such a requirement was undesirable to prospective donors and that the proposed version of the regulation should be revised. When the Treasury Department issued the final version of the regulation, the preamble stated that Treasury had considered all comments submitted but did not specifically address or respond to the comments submitted on allocation of post-extinguishment proceeds. The court held that none of the comments identified by the taxpayers required a response by Treasury. None of the comments, the court observed, raised a concern that Regulation section 1.170A-14(g)(6)(ii), which addresses allocation of proceeds to the donee organization upon extinguishment of the easement, failed to satisfy the perpetuity requirement of section 170(h)(2)(C) and (h)(5)(A), which was Congress’s central concern. The court rejected as unpersuasive the contrary decision of the Eleventh Circuit in Hewitt.

The court also rejected the taxpayer’s argument that Regulation section 1.170A-14(g)(6)(ii) reflects an impermissible construction of section 170(h). 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 170(h)(5)(A), is ambiguous, and in step two that Regulation section 1.170A-14(g)(6)(ii) is a reasonable interpretation of the statute.

Finally, the court rejected as unpersuasive the taxpayer’s argument that Treasury had acted arbitrarily or capriciously in issuing Regulation section 1.170A-14(g)(6)(ii) because it had provided no explanation for why it adopted the rule, and because it had failed to consider a variety of alternatives.

Concurring opinion by Judge Guy. In a concurring opinion, Judge Guy concluded that Regulation section 1.170A-14(g)(6)(ii) is procedurally invalid under the APA for substantially the same reasons articulated by the Eleventh Circuit in Hewitt v. Commissioner. Nevertheless, Judge Guy concurred in the court’s judgment affirming the Tax Court’s decision. Judge Guy reasoned that the relevant statute, section 170(h)(2)(C), requires that the donee organization receive the fair market value of the easement upon judicial extinguishment of the easement, that this right be protected in perpetuity, and that the provisions in the deed conveying the easement in this case failed to comply with this requirement. In other words, Judge Guy reasoned that it is unnecessary to rely on Regulation section 1.170A-14(g)(6)(ii) to conclude that the easement in this case failed to satisfy the statutory requirement. The majority declined to consider this argument by the government because the government had failed to raise it in the Tax Court. Judge Guy observed that parties can be permitted to raise arguments for the first time on appeal in exceptional cases, and concluded that this was an exceptional case.

2. If you are donating a used motor vehicle, boat, or airplane, you better not neglect to obtain and attach to your return Form 1098-C, says the Tax Court. Izen v. Commissioner.

On April 14, 2016, during a pending Tax Court proceeding, the taxpayer filed an amended federal income tax return for 2010 and claimed a charitable contribution deduction of $338,080 for his donation of a 50 percent interest in a 1969 model Hawker-Siddley DH125-400A private jet to the Houston Aeronautical Heritage Society (Society), an organization exempt from tax under section 501(c)(3), which operates a museum at the William P. Hobby Airport. The taxpayer included with his amended return: (1) an acknowledgment letter dated December 30, 2010, and signed by the president of the Society; (2) a Form 8283, Noncash Charitable Contributions, dated April 13, 2016, and executed by the managing director of the Society; (3) a copy of an “Aircraft Donation Agreement” allegedly executed on December 31, 2010, by the president of the Society (but not by the taxpayer); and (4) an appraisal dated April; 7, 2011, stating that the fair market value of the taxpayer’s 50 percent interest in the aircraft, as of December 30, 2010, was $338,080. The Service moved for summary judgment and asserted that the taxpayer was not entitled to the charitable contribution deduction because he had failed to satisfy the substantiation requirements of section 170(f)(12), which applies to contributions of used motor vehicles, boats, and airplanes. Section 170(f)(8) requires a contemporaneous written acknowledgment from the donee organization as a condition for deducting charitable contributions of $250 or more, but section 170(f)(12) imposes more stringent substantiation requirements. Section 170(f)(12) requires a more detailed contemporaneous written acknowledgment and, unlike section 170(f)(8), requires the taxpayer to include the acknowledgment with the return that includes the deduction. The statute directs the donee organization to provide to the government the information contained in the acknowledgment, and the Service has designated for this purpose Form 1098-C, Contributions of Motor Vehicles, Boats, and Airplanes, a copy of which is to be provided to the donor. The taxpayer did not submit Form 1098-C with his amended return. The Tax Court (Judge Lauber) concluded that the documentation the taxpayer did submit with his amended return did not comply with the requirements of section 170(f)(12). Accordingly, the court disallowed the taxpayer’s deduction.

a. The Fifth Circuit has agreed: no 1098-C, no deduction. Izen v. Commissioner. In a per curiam opinion, the U.S. Court of Appeals for the Fifth Circuit has affirmed the Tax Court’s decision. Section 170(f)(12) requires a taxpayer to attach Form 1098-C to the return in order to claim a deduction for a charitable contribution of used motor vehicles, boats, and airplanes. The court rejected the taxpayer’s argument that he had substantially complied with the statute’s requirements by attaching to the return the documentation that he did:

The doctrine of substantial compliance may support a taxpayer’s claim where he or she acted in good faith and exercised due diligence but nevertheless failed to meet a regulatory requirement. We cannot accept the argument that substantial compliance satisfies statutory requirements. Congress specifically required the contemporaneous written acknowledgment include the taxpayer identification number, but that is lacking here.

3. The Tax Court reminds us yet again that no CWA, no charitable deduction, regardless of how obvious it is that the donation was without return consideration. Albrecht v. Commissioner.

Section 170(f)(8) requires a contemporaneous written acknowledgment (“CWA”) from the donee organization as a condition for a taxpayer’s deduction of charitable contributions of $250 or more. The CWA must include (i) the amount of cash and a description (but not value) of any property other than cash contributed; (ii) whether the donee organization provided any goods or services in consideration, in whole or in part, for any such property; and (iii) a description and good faith estimate of the value of any such goods or services. The taxpayer in this case went to great lengths to document her “unconditional and irrevocable” donation of Native American jewelry and artifacts to an exempt museum; however, the documents executed by the taxpayer and the museum in connection with the donation did not contain language stating that the taxpayer received “no goods or services” in return for her gift. Hence, the Tax Court (Judge Greaves) disallowed the taxpayer’s claimed charitable contribution deduction based on section 170(f)(8).

4. For contributions of property to donor advised funds, to CYA you better get the CWA to state that the DAF has “exclusive legal control.” Keefer v. United States.

Section 170(f)(8) requires a contemporaneous written acknowledgment (“CWA”) from the donee organization as a condition for a taxpayer’s deduction of charitable contributions of $250 or more. The CWA must include (i) the amount of cash and a description (but not value) of any property other than cash contributed; (ii) whether the donee organization provided any goods or services in consideration, in whole or in part, for any such property; and (iii) a description and good faith estimate of the value of any such goods or services. In addition to satisfying the CWA requirements of section 170(f)(8), contributions to a “donor advised fund” or “DAF” (as defined in section 4966(d)(2)) must comply with section 170(f)(18) as a condition to the donor’s charitable contribution deduction. Specifically, section 170(f)(18)(B) requires the CWA issued by the DAF in connection with a donation of $250 or more to state that the DAF has “exclusive legal control over the assets contributed.” The taxpayer in this refund case assigned a 4 percent interest in a hotel partnership to a DAF shortly before the hotel’s sale, claiming a charitable contribution deduction of approximately $1.25 million generating tax savings of roughly $508,000. Upon audit, the Service denied the taxpayer’s claimed charitable contribution deduction because the CWA issued by the DAF (along with other documents executed in connection with the donation) did not expressly state that the DAF had “exclusive legal control” over the contributed partnership interest. The taxpayer paid the tax and filed a claim for refund, which the Service also denied. The taxpayer then filed a suit for refund in the United States District Court for the Northern District of Texas, Dallas Division. Ruling on cross-motions for summary judgment, Judge Boyle agreed with the Service and denied the taxpayer’s refund claim. Judge Boyle determined, as the Service had argued, that neither the CWA nor the other documents relating to the taxpayer’s donation to the DAF contained the “exclusive legal control” language. Without this language, Judge Boyle held, the taxpayer’s charitable contribution deduction and refund claim could not be sustained.

5. After 2022, syndicated conservation easements are on life support if not DOA.

A well-hidden provision of the SECURE 2.0 Act, Division T, Title VI, section 605 of the Consolidated Appropriations Act, 2023, amended section 170(h) to add a new subsection (7) severely restricting charitable deductions for “qualified conservation contributions” by partnerships, S corporations, and other pass-through entities. “Qualified conservation contributions” are defined by section 170(h)(1) to include (but are not limited to) conservation easements granted to charitable organizations in connection with syndicated conservation easements. As described in Notice 2017-10, a typical syndicated conservation easement involves a promoter offering prospective investors the possibility of a charitable contribution deduction in exchange for investing in a partnership. The partnership subsequently grants a conservation easement to a qualified charity, allowing the investing partners to claim a charitable contribution deduction under section 170.

New “2.5 times” proportionate outside basis rule will limit the charitable deduction for conservation contributions by pass-through entities. New section 170(h)(7)(A) generally provides that a partner’s charitable contribution deduction for a qualified conservation contribution by a partnership (whether via a direct contribution or as an allocable share from lower-tier partnership) cannot exceed “2.5 times the sum of [such] partner’s relevant basis” in the partnership. The term “relevant basis” is defined by new section 170(h)(7)(B)(i) to mean that portion of a partner’s “modified basis” which is allocable (under rules similar to those used under section 755) to the real property comprising the qualified conservation contribution. “Modified basis” (defined in section 170(h)(7)(B)(ii)) essentially refers to a partner’s outside basis exclusive of the partner’s share of partnership liabilities under section 752. Thus, reading between the lines and subject to further guidance, relevant basis appears to equate to an investor’s cash investment (a/k/a initial tax and book capital account) in a syndicated conservation easement partnership. Many syndicated conservation easement partnerships claim that investors may secure a charitable deduction that is five times their cash investment. New section 170(h)(7)(A) thus limits the charitable deduction to “2.5 times” an investor’s cash contribution, making a syndicated conservation easement much less attractive. New section 170(h)(7) also contains three exceptions: (i) partnerships making conservation easement contributions after a three-year holding period applicable at the partnership- and partner-level, including through tiered partnerships; (ii) ”family partnerships” (as defined) making conservation easement contributions; and (iii) partnerships making conservation easement contributions relating to historic structures. Moreover, new section 170(h)(7)(F) authorizes Treasury to issue regulations applying similar rules to S corporations and other pass-through entities. Related provisions of the legislation make dovetailing amendments to (i) section 170(f) (charitable contribution substantiation and reporting requirements); (ii) sections 6662 and 6664 (underpayment penalties attributable to valuation misstatements); (iii) section 6011 (reportable transactions); and (vi) sections 6235 and 6501 (statute of limitations). New section 170(h)(7) applies to qualified conservation contributions made by partnerships and other pass-through entities after December 29, 2022.

Some welcome news for non-syndicated conservation easement donors? In an uncodified provision (see section 605(d)), the legislation directs Treasury to publish “safe harbor deed language for extinguishment clauses and boundary line adjustments” relating to qualified conservation contributions (whether via partnerships or otherwise). Treasury is directed to publish such safe harbor deed language within 120 days of the date of enactment of new section 170(h)(7) (i.e., by April 28, 2023), and donors have 90 days after publication of the safe harbor language to execute and file corrective deeds. This special, uncodified relief provision seems to be targeted toward donors like those who lost battles with the Service over highly-technical language in their conservation easement deeds. Importantly, however, the foregoing uncodified relief provision does not apply to syndicated conservation easements as described in Notice 2017-10 or to conservation easement cases (and related penalty disputes) docketed in the federal courts before the date a corrective deed is filed.

X. Tax Procedure

A. Interest, Penalties, and Prosecutions

1. Is the Service ever going to learn that the section 6751(b) supervisory approval requirement is not met unless the required supervisory approval of a penalty occurs before the initial determination that formally communicates the penalty to the taxpayer? Laidlaw’s Harley Davidson Sales, Inc. v. Commissioner.

The taxpayer, a C corporation, failed to disclose its participation in a listed transaction as required by section 6011 and Regulation section 1.6011-4(a). The Service’s revenue agent examining the taxpayer’s return issued a 30-day letter to the taxpayer offering the opportunity for the taxpayer to appeal the proposal to the IRS Office of Appeals (IRS Appeals). The 30-day letter proposed to assess a penalty under section 6707A for failing to disclose a reportable transaction. Approximately three months after the 30-day letter was issued, the revenue agent’s supervisor approved the penalty by signing a Civil Penalty Approval Form. Following unsuccessful discussions with IRS Appeals, the Service assessed the penalty and issued a notice of levy. The taxpayer requested a collection due process (CDP) hearing with Appeals, following which Appeals issued a notice of determination sustaining the proposed levy. In response to the notice of determination, the taxpayer filed a petition in the Tax Court. In the Tax Court, the taxpayer filed a motion for summary judgment on the basis that the had failed to comply with the supervisory approval requirement of section 6751(b). Section 6751(b)(1) requires 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 Tax Court (Judge Gustafson) granted the taxpayer’s motion. The court first concluded that the supervisory approval requirement of section 6751(b) applies to the penalty imposed by section 6707A. Next the court concluded that the supervisory approval of the section 6707A penalty in this case was not timely because it had not occurred before the Service’s initial determination of the penalty. The parties stipulated that the 30-day letter issued to the taxpayer reflected the’s initial determination of the penalty. The supervisory approval of the penalty occurred three months later and therefore, according to the court, was untimely. The Service argued that the supervisory approval was timely because it occurred before the Service’s assessment of the penalty. In rejecting this argument, the court relied on its prior decisions interpreting section 6751(b), especially Clay v. Commissioner, in which the court held in a deficiency case “that when it is ‘communicated to the taxpayer formally … that penalties will be proposed’, section 6751(b)(1) is implicated.” In Clay, the Service had issued a 30-day letter when it did not have in hand the required supervisory approval of the relevant penalty. The Service can assess the penalty imposed by section 6707A without issuing a notice of deficiency. Nevertheless, the court observed “[t]hough Clay was a deficiency case, we did not intimate that our holding was limited to the deficiency context.” The court summarized its holding in the present case as follows:

Accordingly, we now hold that in the case of the assessable penalty of section 6707A here at issue, section 6751(b)(1) requires the to obtain written supervisory approval before it formally communicates to the taxpayer its determination that the taxpayer is liable for the penalty.

The court therefore concluded that it had been an abuse of discretion for the IRS Office of Appeals to determine that the Service had complied with applicable laws and procedures in issuing the notice of levy. The court accordingly granted the taxpayer’s motion for summary judgment.

a. “We are all textualists now,” says the Ninth Circuit. When the Service need not issue a notice of deficiency before assessing a penalty, the language of section 6751(b) contains no requirement that supervisory approval be obtained before the Service formally communicates the penalty to the taxpayer. Laidlaw’s Harley Davidson Sales, Inc. v. Commissioner. In an opinion by Judge Bea, the U.S. Court of Appeals for the Ninth Circuit has reversed the decision of the Tax Court and held that, when the Service need not issue a notice of deficiency before assessing a penalty, the Service can comply with the supervisory approval requirement of section 6751(b) by obtaining supervisory approval of the penalty before assessment of the penalty provided that approval occurs when the supervisor still has discretion whether to approve the penalty. As previously discussed, the taxpayer, a C corporation, failed to disclose its participation in a listed transaction as required by section 6011 and Regulation section 1.6011-4(a). The revenue agent examining the taxpayer’s return issued a 30-day letter to the taxpayer offering the opportunity for the taxpayer to appeal the proposal to the IRS Office of Appeals (IRS Appeals). The 30-day letter proposed to assess a penalty under section 6707A for failing to disclose a reportable transaction. After the taxpayer had submitted a letter protesting the proposed penalty and requesting a conference with IRS Appeals, and approximately three months after the revenue agent issued the 30-day letter, the revenue agent’s supervisor approved the proposed penalty by signing Form 300, Civil Penalty Approval Form. The Tax Court held that section 6751(b)(1) required the Service to obtain written supervisory approval before it formally communicated to the taxpayer its determination that the taxpayer was liable for the penalty, i.e., before the revenue agent issued the 30-day letter. On appeal, the government argued that section 6751(b) required only that the necessary supervisory approval be secured before the Service’s assessment of the penalty as long as the supervisory approval occurs at a time when the supervisor still has discretion whether to approve the penalty. The Ninth Circuit agreed. In agreeing with the government, the court rejected the Tax Court’s holding that section 6751(b) requires supervisory approval of the initial determination of the assessment of the penalty and therefore requires supervisory approval before the Service formally communicates the penalty to the taxpayer. According to the Ninth Circuit, “[t]he problem with Taxpayer’s and the Tax Court’s interpretation is that it has no basis in the text of the statute.” The court acknowledged the legislative history of section 6751(b), which indicates that Congress enacted the provision to prevent revenue agents from threatening penalties as a means of encouraging taxpayers to settle. But the text of the statute as written, concluded the Ninth Circuit, does not support the interpretation of the statute advanced by the Tax Court and the taxpayer. The court summarized its holding as follows:

Accordingly, we hold that section 6751(b)(1) requires written supervisory approval before the assessment of the penalty or, if earlier, before the relevant supervisor loses discretion whether to approve the penalty assessment. Since, here, Supervisor Korzec gave written approval of the initial penalty determination before the penalty was assessed and while she had discretion to withhold approval, the satisfied section 6751(b)(1).

The court was careful to acknowledge that supervisory approval might be required at an earlier time when the Service must issue a notice of deficiency before assessing a penalty because, “once the notice is sent, the Commissioner begins to lose discretion over whether the penalty is assessed.” The can assess the penalty in this case, imposed by section 6707A, without issuing a notice of deficiency.

Dissenting opinion by Judge Berzon. In a dissenting opinion, Judge Berzon emphasized that the 30-day letter the revenue agent sent to the taxpayer was an operative determination. The letter indicated that, if the taxpayer took no action in response, the penalty would be assessed. Judge Berzon analyzed the text of the statute and its legislative history and concluded as follows:

In my view, then, the statute means what it says: a supervisor must personally approve the “initial determination” of a penalty by a subordinate, or else no penalty can be assessed based on that determination, whether the proposed penalty is objected to or not. 26 U.S.C. § 6751(b)(1). That meaning is consistent with Congress’s purpose of preventing threatened penalties never approved by supervisory personnel from being used as a “bargaining chip” by lower-level staff, S. Rep. No. 105-174, at 65 (1998); see Chai v. Commissioner, 851 F.3d 190, 219 (2d Cir. 2017), which is exactly what happened here.

Because the 30-day letter was an operative determination, according to the dissent, “supervisory approval was required at a time when it would be meaningful-before the letter was sent.”

b. Is the tide turning in favor of the government? The Eleventh Circuit has held that, when the must issue a notice of deficiency before assessing tax, the government can comply with the requirement of section 6751(b) that there be written supervisory approval of penalties by securing the approval at any time before assessment of the penalty. In an opinion by Judge Marvel, the U.S. Court of Appeals for the Eleventh Circuit has held that, when the Service must issue a notice of deficiency before assessing a penalty, the Service can comply with the supervisory approval requirement of section 6751(b) by obtaining supervisory approval at any time before assessment of the penalty. The court’s holding is contrary to a series of decisions of the Tax Court and contrary to a decision of the U.S. Court of Appeals for the Second Circuit. Section 6751(b)(1) provides:

No penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.

Second Circuit’s reasoning in Chai v. Commissioner. In Chai v. Commissioner, the Second Circuit focused on the language of section 6751(b)(1) and concluded that it is ambiguous regarding the timing of the required supervisory approval of a penalty. Because of this ambiguity, the court examined the statute’s legislative history and concluded that Congress’s purpose in enacting the provision was “to prevent IRS agents from threatening unjustified penalties to encourage taxpayers to settle.” That purpose, the court reasoned, undercuts the conclusion that approval of the penalty can take place at any time, even just prior to assessment. The court held “that section 6751(b)(1) requires written approval of the initial penalty determination no later than the date the IRS issues the notice of deficiency (or files an answer or amended answer) asserting such penalty.” Further, the court held “that compliance with section 6751(b) is part of the Commissioner’s burden of production and proof in a deficiency case in which a penalty is asserted. … Read in conjunction with section 7491(c), the written approval requirement of section 6751(b)(1) is appropriately viewed as an element of a penalty claim, and therefore part of the IRS’s prima facie case.”

Tax Court’s prior decisions in other cases. In Graev v. Commissioner, a reviewed opinion by Judge Thornton, the Tax Court (9-1-6) reversed its earlier position and accepted the interpretation of section 6751(b)(1) set forth by the Second Circuit in Chai v. Commissioner. Since Graev, the Tax Court’s decisions have focused on what constitutes the initial determination of the penalty in question. These decisions have concluded that the initial determination of a penalty occurs in the document through which the Service Examination Division notifies the taxpayer in writing that the examination is complete and it has made a decision to assert penalties. Accordingly, if the Service notifies the taxpayer that it intends to assert penalties in a document such as a revenue agent’s report, and if the Service fails to secure the required supervisory approval before that notification occurs, then section 6751(b)(1) precludes the Service from asserting the penalty.

Facts of this case. In the current case, Kroner v. Commissioner, the taxpayer failed to report as income just under $25 million in cash transfers from a former business partner. The Service audited and, at a meeting with the taxpayer’s representatives on August 6, 2012, provided the taxpayer with a letter (Letter 915) and revenue agent’s report proposing to increase his income by the cash he had received and to impose just under $2 million in accuracy-related penalties under section 6662. The letter asked the taxpayer to indicate whether he agreed or disagreed with the proposed changes and provided him with certain options if he disagreed, such as providing additional information, discussing the report with the examining agent or the agent’s supervisor, or requesting a conference with the Service Appeals Office. The letter also stated that, if the taxpayer took none of these steps, the Service would issue a notice of deficiency. The Service later issued a formal 30-day letter (Letter 950) dated October 31, 2012, and an updated examination report. The 30-day letter provided the taxpayer with the same options as the previous letter if he disagreed with the proposed adjustments and stated that, if the taxpayer took no action, the Service would issue a notice of deficiency. The 30-day letter was signed by the examining agent’s supervisor. On that same day, the supervisor also signed a Civil Penalty Approval Form approving the accuracy-related penalties. The subsequently issued a notice of deficiency and, in response, the taxpayer filed a timely petition in the U.S. Tax Court.

Tax Court’s reasoning in this case. The Tax Court (Judge Marvel) upheld the Service’s position that the cash payments the taxpayer received were includible in his gross income but held that the Service was precluded from imposing the accuracy-related penalties. The Tax Court reasoned that the August 6 letter (Letter 915) was the Service’s initial determination of the penalty and that the required supervisory approval of the penalty did not occur until October 31, and therefore the Service had not complied with section 6751(b).

Eleventh Circuit’s reasoning in this case. The Eleventh Circuit rejected the reasoning of the Tax Court as well as the reasoning of the Second Circuit in Chai v. Commissioner:

We disagree with Kroner and the Tax Court. We conclude that the IRS satisfies Section 6751(b) so long as a supervisor approves an initial determination of a penalty assessment before it assesses those penalties. See Laidlaw’s Harley Davidson Sales, Inc. v. Comm’r, 29 F.4th 1066, 1071 (9th Cir. 2022). Here, a supervisor approved Kroner’s penalties, and they have not yet been assessed. Accordingly, the IRS has not violated Section 6751(b).

The Eleventh Circuit first reasoned that the phrase “determination of such assessment” in section 6751(b) is best interpreted not as a reference to communications to the taxpayer, but rather as a reference to the Service’s conclusion that it has the authority and duty to assess penalties and its resolution to do so. The court explained:

The “initial” determination may differ depending on the process the IRS uses to assess a penalty. … But we are confident that the term “initial determination of such assessment” has nothing to do with communication and everything to do with the formal process of calculating and recording an obligation on the IRS’s books.

The court then turned to the question of when a supervisor must approve a penalty in order to comply with section 6751(b). The court analyzed the language of section 6751(b) and concluded: “We likewise see nothing in the text that requires a supervisor to approve penalties at any particular time before assessment.” Thus, according to the Eleventh Circuit, the Service can comply with section 6751(b) by obtaining supervisory approval of a penalty at any time, even just before assessment.

Finally, the court reviewed the Second Circuit’s decision in Chai v. Commissioner, in which the court had interpreted section 6751(b) in light of Congress’s purpose in enacting the provision, which, according to the Second Circuit, was to prevent Service agents from threatening unjustified penalties to encourage taxpayers to settle. According to the Eleventh Circuit, the Chai decision did not take into account the full purpose of section 6751(b). The purpose of the statute, the court reasoned, was not only to prevent unjustified threats of penalties but also to ensure that only accurate and appropriate penalties are imposed. There is no need for supervisory approval to occur at any specific time before assessment of penalties, the court explained, to ensure that penalties are accurate and appropriate and therefore carry out this aspect of Congress’s purpose in enacting the statute. Further, the Eleventh Circuit concluded, that there is no need for a pre-assessment deadline for supervisory approval to reduce the use of penalties as a bargaining chip by Service agents. This is so, according to the court, because negotiations over penalties occur even after a penalty is assessed, such as in administrative proceedings after the Service issues a notice of federal tax lien or a notice of levy. (This latter point by the court seems to us to be a stretch. Although it is possible to have penalties reduced or eliminated post-assessment, such post-assessment review does not meaningfully reduce the threat of penalties by agents to encourage settlement at the examination stage.)

Concurring opinion by Judge Newsom. In a concurring opinion, Judge Newsom cautioned against interpreting statutes by reference to their legislative histories: “Without much effort, one can mine from section 6751(b)’s legislative history other—and sometimes conflicting—congressional ‘purposes.’” The legislative history, according to Judge Newsom, is “utterly unenlightening.” Statutes, in his view, should be interpreted by reference to their text.

2. Tax Court holds that the Service does not need written supervisory approval to apply the section 72(t) 10% 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 this case, 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 10 percent of the distribution. In filing her tax return, Ms. Grajales did not report any retirement plan distributions as income. The Service 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 was required by section 6751(b) 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 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 prior decisions 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 have held that the section 72(t) exaction is a “tax.” The court previously had held that the section 72(t) exaction is not a “penalty, addition to tax, or additional amount” within the meaning of section 7491(c) for purposes of imposing the burden of production. Further, in El v. Commissioner, the Tax Court had 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 sections 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” under which the U.S. Supreme Court applied a constitutional analysis to conclude that the section 72(t) 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) and (c), the section 72(t) exaction is a “tax,” not a “penalty,” “addition to tax,” or “additional amount.” Therefore, section 6751(b) did not require written supervisory approval.

a. The Second Circuit has agreed: the need not comply with the section 6751(b) supervisory approval requirement to apply the section 72(t) 10% penalty for early withdrawal from a retirement plan. In an opinion by Judge Wesley, the U.S. Court of Appeals for the Second Circuit has affirmed the Tax Court’s decision and held that the 10-percent additional amount imposed by section 72(t) on early distributions from a retirement plan is not a penalty and therefore is not subject to the supervisory approval requirement of section 6751(b). The court emphasized that the plain language of section 72(t) indicates that the exaction it imposes is a tax and not a penalty. That language, the court observed, states that a “taxpayer’s tax … shall be increased by an amount equal to 10 percent of the portion of such amount which is includible in gross income.” (emphasis added). The terms “penalty,” additional amount,” and “addition to tax,” the court reasoned, do not appear in the language of section 72(t). The court rejected the taxpayer’s argument that the exaction of section 72(t) is a penalty because it is calculated by adding ten percent to the taxpayer’s tax, and therefore is not calculated in the same way as the underlying tax and is a separate exaction based on income that has already been taxed. According to the court, the fact that the exaction of section 72(t) is calculated differently from the regular income tax does not mean that it is not a tax:

Like various other taxes, the Exaction is calculated differently than regular income tax. But that does not make it a penalty—it is a feature, not a bug in the Code triggering the written supervisory approval requirement.

Similarly, the court rejected the taxpayer’s argument that the purpose of section 72(t) is to discourage individuals from making early withdrawals from retirement plans and therefore is penal in nature. What is determinative, the court reasoned, is not the purpose of the statute, but rather the meaning that Congress ascribed to it. The court observed that at least six other provisions of the Code refer to the exaction of section 72(t) as a tax. The court concluded:

Together with the substantive text of Section 72(t)(1), the plain language of Section 72(t) considered in connection with the rest of the Code is unambiguous: the Exaction is a tax, not a penalty.

3. Updated instructions on how to rat yourself out.

This revenue procedure updates Rev. Proc. 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.

4. According to Ronald Reagan, “The nine most terrifying words in the English language are ‘I’m from the government and I’m here to help.’” Well, this time they’re true! The Service has provided relief from late-filing and other penalties with respect to certain 2019 and 2020 returns.

This notice provides relief for certain taxpayers from certain late-filing penalties and certain international information return penalties with respect to tax returns for taxable years 2019 and 2020 that are filed on or before September 30, 2022. More specifically, the notice provides relief from late-filing penalties imposed by section 6651(a) for failure to timely file several types of income tax returns, including individual income tax returns (Form 1040 series), income tax returns of trusts and estates (Form 1041 and Form 1041-QFT), corporate income tax returns (Form 1120 series), and certain returns of exempt organizations (Forms 990-PF and 990-T). The notice also provides relief from late-filing penalties for partnership returns (Form 1065) and returns of subchapter S corporations (Form 1120-S). In addition, the notice provides relief from certain information return penalties with respect to taxable year 2019 returns that were filed on or before August 1, 2020, and with respect to taxable year 2020 returns that were filed on or before August 1, 2021. This latter relief applies to most information returns on Form 1099. The notice provides relief only from specific penalties and with respect to specific returns. Accordingly, readers should consult the notice in determining whether relief is available in specific situations. The penalties to which the notice applies will be automatically abated, refunded, or credited, as appropriate, without any need for taxpayers to request relief. The Service issued this notice pursuant to the emergency declaration issued by the President on March 13, 2020, in response to the COVID-19 pandemic. That declaration instructed the Secretary of the Treasury “to provide relief from tax deadlines to Americans who have been adversely affected by the COVID-19 emergency, as appropriate, pursuant to 26 U.S.C. 7508A(a).”

5. Is what happened in this complicated taxpayer deposit case the tax equivalent of a shell game?

The facts and holding in this Court of Federal Claims case remind us of a street-corner shell game, only the stakes were roughly $10 million of underpayment/overpayment interest arbitrage. Essentially, the Service held for over two years almost $72 million of a section 6603 deposit made by a trustee on behalf of numerous trusts, but nevertheless, the charged the taxpayer trusts with section 6621(a)(2) underpayment interest during those two years at a higher rate than the deposits earned in section 6611 overpayment interest. Read on for more details, but the upshot appears to be that any section 6603 deposits with the should be made separately by each potentially liable taxpayer, and the taxpayer must ensure that the deposit is credited to the taxpayer’s account as a payment of tax. The is not legally required to honor, and may not properly account for, a lump sum deposit made under section 6033 on behalf of several different taxpayers, even if those taxpayers are trusts with a common trustee.

Factual Background. The facts of the case are exceedingly complicated, but the following summary should suffice. The taxpayers were nine original trusts (the “Original Trusts”) that eventually became thirty continuing and successor trusts (each with distinct taxpayer identification numbers) during the period of the Service’s examination. All the trusts were potentially liable for taxes, penalties, and interest as transferees under section 6901. The trusts’ potential transferee liability apparently stemmed from distributions they received from a corporate taxpayer with large unpaid liabilities for taxes, interest, and penalties. The Service’s examination of the Original Trusts began in 2014, but six of the Original Trusts already had been terminated by that time and their assets moved to successor trusts. The Service was aware of the termination of the six Original Trusts and that the successor trusts would remain liable as secondary transferees under section 6901. The subsequent events leading to the dispute are as follows:

• First, in May of 2015, while the Service’s examination remained ongoing, the trustee paid to the Service a total of approximately $72 million as deposits pursuant to section 6603 to stop the running of potential underpayment interest under section 6621 against the remaining three Original Trusts and the successor trusts to the six terminated Original Trusts. Oddly (but perhaps practically), instead of writing multiple deposit checks (one for each trust) totaling almost $72 million, the trustee wrote one check for approximately $72 million and asked the Service to credit each trust with their respective deposit shares according to an allocation schedule.
• The Service, however, did not allocate the $72 million across the thirty separate trusts. Instead, the Service deposited the $72 million to a “general ledger account,” not the taxpayer accounts for each distinct trust.
• Next, in 2016, the Service issued statutory notices of liability under section 6901 to the nine Original Trusts (but not the successor trusts). As noted above, though, six of the Original Trusts were no longer in existence with their assets being held by successor trusts. The Service was fully aware of the circumstances involving the Original Trusts and the successor trusts.
• After receipt of the notices of transferee liability, the trustee then filed protests with the Service’s Appeals Division on behalf of all the trusts.
• Next, in early March 2017, the trustee again requested that roughly $20 million of the total $72 million deposit be allocated across the three remaining Original Trusts, and that the balance of approximately $52 million continue to be held as a deposit for the successor trusts.
• Still, the Service did not allocate any portion of the $72 million across the separate taxpayer accounts for the trusts. The examining agent involved in the examinations explained that no amounts were allocated because “[Service] procedures do not authorize a person to direct the [Service] to apply a deposit to another person’s liability,” citing Rev. Proc. 2005-18, 2005 C.B. 798.
• Shortly thereafter, on March 16, 2017, the trustee requested the return of approximately $20 million of the $72 million deposit.
• By May of 2017, though, the Service had not returned any portion of the $72 million deposit. The Service had, however, credited two of the Original Trusts with deposits of roughly $250,000 each (a total of approximately $500,000). The remaining $71.5 million was not credited to any taxpayer accounts for the other trusts.
• Next, in July of 2017, the Service agreed to return the full $72 million along with approximately $1 million of interest.
• Nevertheless, the $72 million deposit was not actually returned by the Service until October of 2017.
• During the interim period between July 2017 and October 2017, the trustee paid the Service approximately $79 million in assessed section 6901 transferee liabilities (including accrued underpayment interest) on behalf of the trusts. A short time thereafter, the trustee paid approximately another $4 million in assessed section 6901 transferee liabilities (including accrued underpayment interest) on behalf of the trusts.
• The trustee then filed suit in the Court of Federal Claims alleging that, because the Service did not stop the accrual of underpayment interest against all the trusts as of May 2015 when the original $72 million deposit was made, the trusts were owed roughly $10 million of underpayment interest that they should not have been required to pay.

The initial subject matter jurisdiction issue. In response to the trustee’s suit, the Service moved for partial summary judgment, arguing that the trustee’s $10 million interest claim on behalf of the trusts should be dismissed for lack of subject matter jurisdiction. The taxpayer trusts, of course, objected, arguing that section 7422 permitting refund claims should apply. The taxpayer trusts also cited 28 U.S.C. § 1491, which grants the Federal Court of Claims jurisdiction over “any claim against the United States founded … upon … any act of Congress.” After analyzing relevant precedent, Judge Bruggink decided the jurisdictional issue for the trusts and against the Service, holding that the Court of Federal Claims had subject matter jurisdiction over the trusts’ interest claim. Judge Bruggink then turned to the merits of the dispute.

Service’s argument. In further support of its motion for partial summary judgment, the Service argued that, although the accrual of underpayment interest can be suspended by a cash deposit under section 6603, subsection (b) of the statute requires the deposit to be “used by the Secretary to pay tax.” Therefore, according to the Service, the accrual of underpayment interest is not suspended under section 6033 if the Service does not actually use a deposit as a tax payment. The Service argued that this is precisely what happened in this case: the deposit was never credited as a tax payment during the two-year period it was in the hands of the Service. The deposit was not so credited because “[the Service’s] procedures do not authorize a person to direct the [Service] to apply a deposit to another person’s liability.” Moreover, section 6603(c) contemplates that to the extent the deposit is not used by the Service as a tax payment, the Service is not obligated to return the deposit or any portion thereof absent a written request by the taxpayer. The Service acknowledged that section 4.02 of Rev. Proc. 2005-18 allows a section 6033 deposit to be posted to a taxpayer’s account as a tax payment after the taxpayer has received a notice of deficiency, but Rev. Proc. 2005-18 does not address a notice of transferee liability issued by the Service and therefore could not be used to compel the Service to credit the trusts’ taxpayer accounts in this case.

The taxpayer trusts. The taxpayer trusts argued that the foregoing position by the Service constituted an abuse of administrative agency discretion, especially given the “parade of IRS mistakes” in handling the examinations and the $72 million deposit. The taxpayer trusts also argued that the Service should have followed its own internal guidance, which suggests that, like notices of deficiency, the notices of transferee liability for a terminated entity should be sent to the terminated entity’s successor in interest—here, the successor trusts to the six terminated Original Trusts. If the Service had followed its own internal guidance, the taxpayer trusts asserted, then there would have been no administrative impediment to the Service crediting the deposit to various taxpayer trust accounts as the Service does in accordance with section 4.02 of Rev. Proc. 2005-18 after issuing notices of deficiency.

The court. The Court of Federal Claims (Judge Bruggink) seemed sympathetic to the plight of the taxpayer trusts; however, Judge Bruggink could not find that the Service had violated any law or abused its discretion in failing to credit the deposit to the various taxpayer accounts. Judge Bruggink reasoned that section 6033(a), which authorizes deposits, is permissive—using the term “may” not “shall.” Thus, the Service is authorized to accept deposits for the purpose of suspending underpayment interest, but the Service was not required to treat the deposit as a payment of tax under the unique circumstances before the court. Judge Bruggink concluded:

For the IRS collection of underpayment interest here to have violated the law, one of two things must have been true: either the I.R.C. mandates applying a deposit as a tax payment when the taxpayer makes such a request (thus triggering interest suspension under section 6603(b)), or the I.R.C. requires suspension of interest when a section 6603 deposit is made, even if the Secretary does not use the deposit for a payment of tax. The plain language of the I.R.C. does not allow for either result.

B. Discovery: Summonses and FOIA

There were no significant developments regarding this topic during 2022.

C. Litigation Costs

1. A taxpayer who offered to concede 100 percent of the proposed tax and penalties but who reserved the right to seek innocent spouse protection was not entitled to reasonable litigation costs under section 7430(a)(2) because her offer was not a qualified offer and the Service’s position was substantially justified.

The issue in this case is whether the taxpayer was a prevailing party and therefore entitled to recover reasonable litigation costs from the Service pursuant to section 7430(a)(2). Generally, section 7430(a) provides that, in an administrative or court proceeding brought by or against the government in connection with the determination, collection, or refund of any tax, interest, or penalty, the prevailing party is entitled to recover reasonable administrative costs in connection with an administrative proceeding within the Service and reasonable litigation costs incurred in connection with a court proceeding. The taxpayer here sought only reasonable litigation costs. The taxpayer filed joint returns with her former husband for 2008, 2009, and 2010. The Service audited the returns and proposed adjustments and penalties. The taxpayer responded by sending a letter to the Service that stated she was making a qualified offer pursuant to section 7430(g). If a taxpayer makes a qualified offer, and if the liability of the taxpayer pursuant to the judgment in the court proceeding is equal to or less than the liability of the taxpayer that would have resulted if the government had accepted the qualified offer, then, pursuant to section 7430(c)(4)(E), the taxpayer is treated as a prevailing party. In her letter to the Service, the taxpayer offered to concede 100 percent of the tax and penalties proposed by the Service for the years in question and to agree to an immediate assessment of the tax and penalties, but she reserved all collection rights, including (among others) the right to seek innocent spouse relief and to submit an offer-in-compromise. The Service neither accepted nor rejected the taxpayer’s offer, which accordingly lapsed. The Service later issued a notice of deficiency, in response to which the taxpayer filed a petition in the U.S. Tax Court in which she asserted that she was entitled to innocent spouse protection under section 6015(b) and (c). In its answer, the Service admitted that the taxpayer had sought innocent spouse protection and committed to reviewing her request and making a determination regarding her eligibility for it. Although the taxpayer refused to submit a claim for innocent spouse protection on Form 8857 as the Service requested, the Service ultimately determined that she was entitled to innocent spouse protection for all years in question under section 6015(c) and moved for entry of a decision granting her relief from joint and several liability. The taxpayer moved for an award of reasonable litigation costs.

The Tax Court (Judge Pugh) denied the taxpayer’s motion for an award of reasonable litigation costs. The court first considered whether the taxpayer had submitted a qualified offer and therefore treated as a prevailing party under section 7430(c)(4)(E). The court noted that one requirement of a qualified offer, specified in section 7430(g)(1)(B), is that the offer must “specif[y] the offered amount of the taxpayer’s liability (determined without regard to interest).” The relevant Regulation, section 301.7430-7(c)(3), provides that the offer may be expressed as a specific dollar amount or as a percentage and “must be an amount, the acceptance of which by the United States will fully resolve the taxpayer’s liability, and only that liability … for the type or types of tax and the taxable year or years at issue in the proceeding.” The court agreed with the Service that the taxpayer’s offer was not a qualified offer because her offer reserved the right to challenge the assessed liability by seeking innocent spouse relief. The text of the Code provision that authorizes innocent spouse relief (section 6015), the court reasoned, makes clear that it does not relate to collection of tax, but rather provides relief from liability for tax. For this reason, the court concluded, the taxpayer’s offer did not specify the offered amount of the taxpayer’s liability. The court noted that, if the Service had accepted the taxpayer’s offer to agree to assessment of 100% of the proposed tax and penalties, the acceptance would not have fully resolved the taxpayer’s liabilities because her reserved right to seek innocent spouse relief could (and in fact did) result in her liability for the years in question being reduced to zero.

After concluding that the taxpayer could not be considered a prevailing party pursuant to section 7430(c)(4)(E) because she had not submitted a qualified offer, the court turned to the issue whether the taxpayer was a prevailing party under the generally applicable rules of section 7430(c)(4) for determining status as a prevailing party. Under section 7430(c)(4)(B), a party is not considered a prevailing party if the Service’s position is “substantially justified.” The relevant Regulation, section 301.7430-5(d)(1), provides:

A significant factor in determining whether the position of the Internal Revenue Service is substantially justified as of a given date is whether, on or before that date, the taxpayer has presented all relevant information under the taxpayer’s control and relevant legal arguments supporting the taxpayer’s position to the appropriate Internal Revenue Service personnel. …

The Service’s position, reflected in its answer in the Tax Court proceeding, was a concession that the taxpayer had sought innocent spouse protection and a commitment to review her request and make a determination regarding her eligibility for it. The court concluded that the Service’s position was substantially justified because the taxpayer had not submitted all relevant information regarding her request:

A reasonable person could require information such as Form 8857 or other documentation supporting petitioner’s claim for innocent spouse relief before making a determination.

Because the taxpayer had not submitted a qualified offer, and because the Service’s position was substantially justified, the court concluded, that taxpayer was not a prevailing party and therefore was not entitled to reasonable litigation costs under section 7430(a)(2).

D. Statutory Notice of Deficiency

There were no significant developments regarding this topic during 2022.

E. Statute of Limitations

1. ♪♫Eight miles high and when you touch down, you’ll find that it’s stranger than known.♫♪ These United Airlines employees paid FICA taxes on the present value of future retirement benefits they will never receive and filed their refund claims too late.

In 2000 and 2001, these taxpayers retired from their positions as employees of United Airlines. Pursuant to section 3121(v)(2), the present values of their future retirement benefits (approximately $348,000 and $415,000 respectively) were included in their FICA bases for the years of their retirement. Section 3121(v)(2) provides that amounts deferred under a nonqualified deferred compensation plan must be taken into account for FICA purposes as of the later of the time the services are performed or the time when there is no substantial risk of forfeiture of the right to such amounts. The Regulations issued under section 3121(v)(2), Regulation section 31.3121(v)(2)-(1)(c)(2)(ii), prescribe the method of determining the present value of the future retirement benefits and provide that the present value cannot be discounted to take into account the risk of the future benefits not being paid. United Airlines entered bankruptcy proceedings in 2002 and its liability for the taxpayer’s retirement benefits was ultimately discharged in 2006. The taxpayers received only a portion of the promised benefits. The taxpayers brought this action in the U.S. Court of Federal Claims seeking refunds of the FICA taxes they paid on the retirement benefits they never received. In a prior decision, the U.S. Court of Appeals for the Federal Circuit had upheld the method of determining present that is set forth in Regulation section 31.3121(v)(2)-(1)(c)(2)(ii) and declined to order a refund for a similarly situated United Airlines employee.

In this litigation, the government moved to dismiss for lack of subject matter jurisdiction on the ground that the taxpayers had filed their administrative claims for refund late. Section 7422(a) provides that no suit or proceeding for a refund of tax can be maintained unless an administrative claim for refund has been “duly filed.” Accordingly, if a taxpayer has not filed a timely administrative claim for a tax refund, the taxpayer is barred from bringing legal action seeking the refund. Section 6511(a) provides that a claim for refund must be filed within the later of two years from the time tax was paid or three years from the time the return was filed.

In a per curiam opinion, the U.S. Court of Appeals for the Federal Circuit affirmed the Claims Court’s decision that the taxpayers had not filed timely administrative claims for refunds. In the case of FICA taxes, the court explained, pursuant to section 6513(c), a return for any quarterly period ending in a calendar year is considered filed on April 15 of the following year, and a tax with respect to any quarterly period is considered paid on the following April 15 (as long as it was actually paid before that date). In this case, the two taxpayers paid the FICA taxes in 2000 and 2001, which means the quarterly returns filed by United Airlines were filed on April 15, 2001, and April 15, 2002, respectively. Therefore, the deadline to file administrative claims for refunds were April 15, 2004, and April 15, 2005, respectively. The taxpayers did not file their administrative claims for refunds until 2007. Accordingly, the court held, the taxpayers had not duly filed administrative claims for refunds and were barred by section 7422 from brining legal action for refunds. This was so even though United Airlines’ obligation to pay their retirement benefits was not discharged until 2006. In reaching this conclusion, the court rejected various arguments by the taxpayers that they should be entitled to equitable exceptions to the limitations period on claims for refunds. Among other authorities, the court relied on the U.S. Supreme Court’s decision in United States v. Brockamp, in which the Court held that the limitations periods of section 6511(a) on claims for refund are not subject to equitable exceptions. The court concluded:

But, ultimately, to the extent this case illustrates that there may be a problem of unfairness in the way that the Internal Revenue Code operates with respect to taxes paid on deferred compensation retirement benefits when an employer later goes bankrupt, that would be a problem for Congress and the Treasury Department to address.

2. The 90-day period specified in section 6213(a) for filing a petition in the U.S. Tax Court is jurisdictional and is not subject to equitable tolling, according to the Tax Court.

In a unanimous, reviewed opinion by Judge Gustafson, the Tax Court has held that the 90-day period specified by section 6213(a) within which taxpayers can challenge a notice of deficiency by filing a petition in the Tax Court is jurisdictional and is not subject to equitable tolling. In this case, the Service sent a notice of deficiency to the taxpayer. Pursuant to section section 6213(a), the taxpayer then had 90 days within which to challenge the notice of deficiency by filing a petition in the U.S. Tax Court. The last day of this 90-day period was September 1, 2021. The taxpayer electronically filed its petition on September 2, 2021, which was one day late. In the petition, the taxpayer stated: “My CPA . . . contracted COVID/DELTA over the last 40 days and kindly requests additional time to respond.” In other words, it appears that the taxpayer was requesting an extension of the section 6213(a) 90-day period.

Procedural history. The Tax Court issued an order to show cause in which it ordered the parties to respond as to why the court should not, on its own motion, dismiss the action for lack of jurisdiction. The taxpayer requested that the court defer ruling on the matter until the U.S. Supreme Court issued its opinion in Boechler, P.C. v. Commissioner, which was pending in the Supreme Court. The Tax Court declined to defer ruling and dismissed the taxpayer’s action. After the U.S. Supreme Court issued its opinion in Boechler, the taxpayer moved to vacate the court’s order of dismissal. After receiving briefing, the court issued a unanimous, reviewed opinion denying the motion to vacate its prior order of dismissal.

Tax Court’s holding. In a lengthy (57 pages) and extraordinarily thorough opinion, the Tax Court examined the text and history of section 6213(a) and concluded that Congress had clearly indicated that the 90-day period specified in the statute is jurisdictional. The court observed that the Tax Court is a court of limited jurisdiction and has only whatever jurisdiction it has been granted by Congress. Accordingly, because the 90-day period is jurisdictional, in the court’s view, the court must dismiss cases, such as this one, in which the taxpayer’s petition is filed late. And because the statute is jurisdictional, the court concluded, it is not subject to equitable tolling, i.e., taxpayers cannot argue for exceptions on the basis that they had good cause for failing to meet the deadline. The court also concluded rather briefly that its view on the jurisdictional nature of section 6213(a) was not affected by the U.S. Supreme Court’s decision in Boechler. In Boechler, the Court 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 collection due process hearing is not jurisdictional and is subject to equitable tolling. According to the Tax Court, Boechler “emphatically teaches that” section 6213(a) and section 6330(d)(1) “are different sections” that “[e]ach must be analyzed in light of its own text, context, and history.” The fact that, in Boechler, the Supreme Court concluded that the 30-day period specified in section 6330(d)(1) is not jurisdictional did not change the Tax Court’s view that the 90-day period specified in section 6213(a) is jurisdictional. Accordingly, the Tax Court dismissed the taxpayer’s action.

F. Liens and Collections

1. 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.

Following a collection due process hearing, the Service issued a notice of determination upholding proposed collection action. The notice informed the taxpayer, a law firm in Fargo, North Dakota, that, if it wished to contest the determination, it could do so by filing a petition with the United States 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 its 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 U.S. 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:

The 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 this conclusion, the court found persuasive the reasoning of the U.S. 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. We are sure that Justice Barrett was thrilled to be assigned to write, as one of her first opinions, an opinion on a technical issue of tax procedure. The U.S. Supreme Court has reversed the Eighth Circuit and held that the 30-day period for requesting review in the Tax Court of a notice of determination following a CDP hearing is not jurisdictional and is subject to equitable tolling. In a unanimous opinion by Justice Barrett, the U.S. Supreme Court has reversed the Eighth Circuit and 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 not jurisdictional and is subject to equitable tolling. The Court began with the proposition that a procedural requirement is jurisdictional only if Congress clearly states that the provision is jurisdictional. The provision in question, section 6330(d)(1), provides:

The 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).

Although the parenthetical expression at the end of the provision refers to the Tax Court having jurisdiction, the Court reasoned that whether the provision is jurisdictional depends on whether the phrase “such matter” at the end of the provision refers to the entire first clause of the sentence (as the government argued) or instead refers to the immediately preceding phrase that states “petition the Tax Court” (as the taxpayer argued). In other words, the question is whether the provision indicates that the Tax Court has jurisdiction over the taxpayer’s petition, or instead indicates that the Tax Court has jurisdiction only if the taxpayer complies with the 30-day period for requesting review. The Court reasoned that the provision “does not clearly mandate the jurisdictional reading,” but that the non-jurisdictional reading “is hardly a slam dunk for Boechler.” Nevertheless, the Court concluded that “Boechler’s interpretation has a small edge.” According to the Court, there are multiple plausible interpretations of the phrase “such matter,” and “[w]here multiple plausible interpretations exist—only one of which is jurisdictional—it is difficult to make the case that the jurisdictional reading is clear.” Further, the Court reasoned, other tax provisions enacted around the same time as section 6330(d)(1) are much more clear that the filing deadlines they contain are jurisdictional. For example, section 6015(e)(1)(A), which governs the filing of petitions in the Tax Court by taxpayers seeking innocent spouse protection, provides:

In addition to any other remedy provided by law, the individual may petition the Tax Court (and the Tax Court shall have jurisdiction) to determine the appropriate relief available to the individual under this section if such petition is filed … [within a 90-day period].

Such provisions “accentuate the lack of clarity in section 6330(d)(1).”

Having concluded that the 30-day period specified in section 6330(d)(1) is not jurisdictional, the Court turned to the issue of whether this 30-day period is subject to equitable tolling. The Court previously had held in Irwin v. Department of Veterans Affairs, that non-jurisdictional limitations periods are presumptively subject to equitable tolling, and the Court saw “nothing to rebut the presumption here.” The Court rejected the government’s argument that the 30-day limitations period set forth in section 6330(d)(1) is similar to the limitations periods for filing claims for refund in section 6511, which the Court had held were not subject to equitable tolling in United States v. Brockamp:

Section 6330(d)(1)’s deadline is a far cry from the one in Brockamp. This deadline is not written in “emphatic form” or with “detailed” and “technical” language, nor is it reiterated multiple times. The deadline admits of a single exception (as opposed to Brockamp’s six), which applies if a taxpayer is prohibited from filing a petition with the Tax Court because of a bankruptcy proceeding. That makes this case less like Brockamp and more like Holland v. Florida, 560 U. S. 631 (2010), in which we applied equitable tolling to a deadline with a single statutory exception.

Accordingly, the Court reversed the judgment of the Eighth Circuit and remanded for further proceedings, which will require a determination of whether the taxpayer’s circumstances warrant equitable tolling of section 6330(d)(1)’s 30-day period.

2. When a taxpayer seeks review in the Tax Court of a Service determination to uphold proposed collection action, the Tax Court does not have jurisdiction to consider the taxpayer’s refund claim if the proposed collection action becomes moot.

The issue in this case was whether the Tax Court had jurisdiction to consider the taxpayer’s claim for a refund. After the taxpayer filed his 2008 return, the Service disallowed his claimed business deductions on Schedule C and determined that he had underreported his tax liability by $23,615. The Service issued a notice of deficiency, but the taxpayer and the Service agreed that the taxpayer never received it. After assessing the tax allegedly due, the Service issued a notice of federal tax lien. In response, the taxpayer requested a CDP hearing. In a CDP hearing, section 6330(c)(2)(B) permits a taxpayer to challenge the existence or amount of the taxpayer’s underlying tax liability 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.” Because the taxpayer had not received the notice of deficiency, the Service’s Settlement Officer allowed the taxpayer to present evidence to substantiate his business deductions and allowed approximately one-half of the deductions, which reduced the amount of tax allegedly due. Following the CDP hearing, the Service issued a notice of determination sustaining the notice of federal tax lien, and the taxpayer filed a petition in the Tax Court. In the Tax Court, the taxpayer presented evidence of his claimed deductions, and the Service ultimately conceded that (1) the taxpayer was entitled to deductions that exceeded those he initially claimed, (2) there was no tax due, and (3) the taxpayer was entitled to abatement of his tax liability for 2008 and release of the lien. The taxpayer’s petition to the Tax Court did not claim that he was entitled to a refund. Following these concessions, in a conference call with the court, the taxpayer asserted for the first time that he was entitled to a refund of tax paid for 2008. The Tax Court (Judge Halpern) concluded that it did not have jurisdiction to consider the taxpayer’s refund claim. In an opinion by Judge Motz, the U.S. Court of Appeals for the Fourth Circuit affirmed the Tax Court’s decision. According to the Fourth Circuit, the question was whether section 6330(c)(2)(B) (which applies in CDP hearings held to review a notice of federal tax lien pursuant to section 6320(c)) gives the Tax Court jurisdiction to hear a claim for refund. Section 6330(c)(2)(B) provides:

The person may also raise at the [CDP] hearing challenges to the existence or amount of the underlying tax liability for any tax period 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.

(Emphasis added.) Further, section 6330(d)(1) provides that the Tax Court has jurisdiction to review the Services’s determination following the CDP hearing. The Fourth Circuit reasoned that “the phrase ‘underlying tax liability’ does not provide the Tax Court jurisdiction over independent overpayment claims when the collection action no longer exists.” Here, the court explained:

When as here, the Commissioner has already conceded that a taxpayer has no tax liability and that the lien should be removed, any appeal to the Tax Court of the Appeals Office’s determination as to the collection action is moot. No collection action remains, for which there is underlying tax liability, to appeal.

Accordingly, the Fourth Circuit affirmed the Tax Court’s decision that the Tax Court did not have jurisdiction to consider the taxpayer’s refund claim.

The analysis required to conclude that the Tax Court did not have jurisdiction to consider the taxpayer’s refund claim is far more nuanced than the Fourth Circuit’s opinion suggests. The Tax Court’s opinion in this case engages in an extensive analysis of the relevant statutory provisions and of the Tax Court’s prior decision in Greene-Thapedi v. Commissioner. In Greene-Thapedi, the taxpayer filed a petition in the Tax Court seeking review of the Service’s determination in a CDP hearing to uphold a proposed levy, but the proposed levy became moot because the Service applied the taxpayer’s refund from a later year to the year in question, which reduced her tax liability to zero. The taxpayer sought a refund of accrued interest on the liability. The Tax Court concluded that, in enacting section 6330, Congress did not intend to provide for the allowance of tax refunds. In this case, the Tax Court declined to reconsider its holding in Greene-Thapedi and rejected the taxpayer’s arguments that Greene-Thapedi was distinguishable. The Fourth Circuit’s opinion in this case discusses Greene-Thapedi in a footnote and concludes that it is unnecessary to consider whether section 6330 ever allows a taxpayer to claim a refund because the limited holding in this case is that section 6330 does not permit a claim for refund when the Service’s proposed collection action that provides the basis for the Tax Court’s jurisdiction becomes moot.

3. A taxpayer cannot avoid the trust fund recovery penalty by claiming innocent spouse relief, says the Tax Court.

The taxpayer and her former husband were officers of Oasys Information Systems, Inc., a subchapter C corporation. Her former husband was the president of the corporation, and she was the secretary. The corporation withheld payroll taxes from the wages of its employees but did not pay those taxes to the government. After attempting unsuccessfully to collect the taxes from the corporation, the Service determined that the taxpayer and her former husband were responsible for total penalties equal to $146,682 of the business’ unpaid employment taxes pursuant to section 6672(a). This provision imposes a penalty (commonly referred to as the trust fund recovery penalty) on responsible persons who willfully fail to collect or pay over any tax due. The Service sent to the taxpayer by certified mail a Letter 1153 (notice of proposed assessment) informing her that the Service intended to hold her responsible for a penalty equal to the unpaid employment taxes pursuant to section 6672(a). The letter informed the taxpayer that she had the right to appeal the proposed assessment within sixty days to the IRS Office of Appeals. Although the taxpayer received Letter 1153, she did not appeal the proposed assessment. The Service assessed the penalties and issued Letter 3172, Notice of Federal Tax Lien Filing. The taxpayer requested a CDP hearing with the Service Office of Appeals. In her request for a CDP hearing, she indicated that she could not pay the balance due and that she was requesting innocent spouse relief. She sought removal of the lien. Shortly after requesting the CDP hearing, the taxpayer filed a request for innocent spouse relief on Form 8857. The Service’s Cincinnati Centralized Innocent Spouse Operation (CCISO) determined that the taxpayer did not qualify for innocent spouse relief because the provision that authorizes such relief, section 6015, applies to jointly filed income tax returns and not to liability for payroll taxes. In the CDP hearing, the IRS Settlement Officer explained that the taxpayer was not entitled to innocent spouse relief. The Settlement Officer also advised the taxpayer that she could not challenge the underlying tax liability in the CDP hearing because she had received a prior opportunity to challenge the liability when she received Letter 1153. The taxpayer also requested currently not collectible (CNC) status, but the Service Settlement Officer, after reviewing financial information submitted by the taxpayer and consulting with a Service collection specialist, determined that the taxpayer did not qualify for CNC status because she could pay $1,685 per month. 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 Lauber) granted the Service’s motion for summary judgment. First, Judge Lauber concluded that the taxpayer was precluded from challenging the underlying tax liability in the CDP hearing. 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 this case, although the Service did not issue (and was not required to issue) a notice of deficiency with respect to the section 6672(a) penalty it assessed, the court reasoned that the taxpayer had received a prior opportunity to challenge the liability when she received Letter 1153 and had declined to do so. Accordingly, the court held, the Service’s Settlement Officer had properly determined that the taxpayer could not challenge the underlying liability in the CDP hearing. Because the taxpayer was precluded from challenging the underlying tax liability, the court concluded, it was required to apply an abuse-of-discretion standard in reviewing the Settlement Officer’s decision to uphold the proposed collection action. The court agreed with the Service that the taxpayer could not avoid the trust fund recovery penalty (TFRP) by claiming innocent spouse relief:

Petitioner’s TFRP liabilities were not shown on, and did not arise from the filing of, a joint Federal income tax return. Rather, her TFRP liabilities arose from her failure to discharge her duty, as an officer of Oasys, to ensure that payroll taxes collected from the company’s workers were properly paid over to the Department of the Treasury. Petitioner was therefore not eligible for relief under section 6015(b) or (c).

The court similarly concluded that the taxpayer was not eligible for innocent spouse relief under section 6015(f) (equitable relief). Finally, the court concluded that there was no abuse of discretion in the Settlement Officer’s rejection of collection alternatives.

G. Innocent Spouse

1. When a taxpayer raises innocent spouse relief as an affirmative defense in a petition filed in the Tax Court, can the IRS Chief Counsel attorneys litigating the case refer the matter to the IRS’s Centralized Innocent Spouse Operation but then ignore CCISO’s conclusion that the taxpayer is entitled to innocent spouse protection? Yes, says the Tax Court.

The taxpayer’s former husband, William Goddard, was an attorney whom the Tax Court’s opinion characterized as “a lawyer who sold exceptionally aggressive tax avoidance strategies with his business partner David Greenberg and became very wealthy in the process.” The taxpayer filed joint returns with her former husband for the years 1999, 2000, and 2001 and therefore became jointly and severally liable with him pursuant to section 6013(d)(3) for several million dollars of tax liability associated with those returns. In response to a notice of deficiency issued in 2004, the taxpayer’s former husband, who never told her about the notice of deficiency, filed a petition on her behalf in the Tax Court raising as an affirmative defense that she was entitled to innocent spouse protection under section 6015. (Similar notices of deficiency were issued in 2005 and 2009 and the taxpayer’s former husband filed similar petitions in the Tax Court on her behalf.) In 2011, the IRS Office of Chief Counsel referred the taxpayer’s request for innocent spouse relief to the Service’s CCISO for a determination of whether she was entitled to innocent spouse protection. CCISO asked the taxpayer to submit a request for innocent spouse relief on Form 8857, which she did. In December 2011, CCISO concluded that she should be granted innocent spouse relief for all of the years in question. Rather than send a determination letter to the taxpayer, CCISO sent a letter explaining its conclusion to the Office of Chief Counsel. The Service attorneys handling the case decided that more information was necessary to determine whether the taxpayer was entitled to innocent spouse relief and asked the taxpayer to provide it. The taxpayer declined on the basis that CCISO ha already determined that she was entitled to innocent spouse relief. With a new team of lawyers, she ultimately did provide additional information to the Chief Counsel attorneys but insisted that doing so was unnecessary. The taxpayer moved for entry of a decision in her favor. The Tax Court (Judge Holmes) agreed with the Service that, when a request for innocent spouse relief is raised as an affirmative defense for the first time in a petition that invokes the court’s deficiency jurisdiction, the IRS Office of Chief Counsel has final authority to concede or settle the issue with the taxpayer and that the IRS Office of Chief Counsel therefore was not bound by CCISO’s conclusion. The court reviewed the history of innocent spouse protection and the relevant statutory provisions in detail. The court also reviewed relevant provisions of the Internal Revenue Manual and certain Chief Counsel Notices. Specifically, the court focused on IRM 25.15.12.25.2(1) which provides:

if innocent-spouse relief is raised for the first time in a case already docketed in court, “[j]urisdiction is retained by … Counsel, and a request is sent to CCISO to consider the request for relief. … Counsel … has functional jurisdiction over the matter and handles the case and request for relief, and either settles or litigates the issue on its merits, as appropriate.

The court reasoned that this provision, as well as other relevant guidance, directs CCISO to provide assistance rather than to make a determination of entitlement to innocent spouse relief. The court concluded:

The Chief Counsel in these cases has considered the determination of CCISO to grant DelPonte relief and decided not to adopt it without further investigation. That is his prerogative, and we will not force him to do otherwise.

H. Miscellaneous

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

The issue in this case is 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 percent 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”), Pub. L. No. 108-357, section 821, 118 Stat. 1418 (2004). 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. Treasury 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 v. United StatesNorman v. United States, 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), which provides the Secretary of the Treasury with discretion to determine the amount of assessable FBAR penalties and that, because the outdated Treasury 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 percent of the account value, is mandatory and removed Treasury’s discretion to provide for a smaller penalty by regulation. According to the court, the statute gives Treasury 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 U.S. 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 U.S. 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 U.S. 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 Treasury 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, the U.S. 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 U.S. Court of Appeals for the Federal Circuit in Norman v. United States. 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.” Farmer v. Brennan, 511 U.S. 825, 836 (1994); see also Safeco, 551 U.S. at 68 (same). 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) Treasury 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 U.S. Court of Appeals for the Eleventh Circuit has 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 U.S. Courts of Appeals for the Federal and Fourth Circuits in Norman v. United States and United States v. Horowitz, i.e., the court relied on the U.S. 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.” For purposes of determining whether a reckless (and therefore willful) FBAR had violation 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 that 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) Treasury 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 section 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 U.S. 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 Treasury Regulation that limits the penalty for willful FBAR violations to $100,000 per account.

Dissenting opinion by Judge Menashi. 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. This penalty falls within the statutorily authorized range. While the governing statute also authorizes penalties greater than $100,000, it nowhere mandates that the Secretary impose a higher fine. In fact, the statute gives the Secretary discretion to impose no fine at all. 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.

d. Better late than never? FinCEN finally has amended the relevant Regulations to remove the provision that limited the penalty for a willful FBAR violation. More than seventeen years after Congress changed the minimum and maximum penalties for willful FBAR violations in the American Jobs Creation Act of 2004, the Financial Crimes Enforcement Network (FinCEN) has amended the relevant Regulations to remove 31 C.F.R. section 1010.820(g), which limited the penalty for willful FBAR violations to $100,000 per account. The stated rationale for the removal is that the 2004 amendments to the statute, 31 U.S.C. section 5321(a)(5), rendered this part of the regulation obsolete. The Administrative Procedure Act permits an agency to find that notice and public procedure on the notice are impracticable, unnecessary, or contrary to the public interest. Because the statutory change rendered this provision of the Regulations obsolete, FinCEN “determined that publishing a notice of proposed rulemaking and providing opportunity for public comment [were] unnecessary.” This amendment of the Regulations is effective on December 23, 2021. Nevertheless, because the prior regulation was rendered obsolete by a 2004 statute, the government’s position presumably is that the statutory rule, rather than the now-repealed provision of the Regulations, applies for prior years as well beginning on the effective date of the statutory change.

e. The First Circuit has agreed: the penalty for a willful FBAR violation is not capped at $100,000. In an opinion by Judge Baron in United States v. Toth, the U.S. Court of Appeals for the First Circuit has agreed with every other federal court of appeals 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) superseded the 1987 Treasury Regulation that limits the penalty for willful FBAR violations to $100,000 per account:

Thus, when Congress amended section 5321(a)(5)(C)-(D) to permit the IRS to impose a penalty in excess of $100,000, the 1987 regulation was superseded because the regulation—as merely a regulation parroting a then-operative statutory maximum—could have no effect once a new statutory maximum had been set.

2. Tax Court retains jurisdiction in a section 7345 passport-revocation case to review the Service’s certification of taxpayer’s “seriously delinquent” tax liability, but finds case is moot.

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. 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 certification may petition the Tax Court to determine if it was made erroneously. If the Tax Court finds the certification was either made in error or that the Service has since reversed its certification, the court may then notify the State Department that the revocation of the taxpayer’s passport should be cancelled. This is a case of first impression in which the Tax Court interprets the requirements of section 7345. The Tax Court (Judge Lauber) held that, while the Tax Court had jurisdiction to review Ms. Ruesch’s challenge to the Services’s certification of her tax liabilities as being a “seriously delinquent tax debt,” the controversy was moot because the Service had reversed its certification as being erroneous. Further, the Service had properly notified the Secretary of State of its reversal. The Service had assessed $160,000 in penalties for failing to file proper information returns for a period of years. Thereafter, the Service sent a final notice of intent to levy and Ms. Ruesch properly appealed the penalty amounts with the Services’s Collection Appeals Program (CAP). In a series of errors, the Service mistakenly misclassified the CAP appeal as a CDP hearing. Committing yet further errors, the Service failed to properly record Ms. Ruesch’s later request for a CDP hearing and never offered Ms. Ruesch her CDP hearing. The Service then certified Ms. Ruesch’s liability to the Secretary of State as a “seriously delinquent tax debt” under section 7345(b). Discovering their many errors as well as the oversight of Ms. Ruesch’s timely requested a CDP hearing, the Service determined her tax debt was not “seriously delinquent” and reversed the certification. 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 Tax 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 Tax Court could not offer any additional relief. Judge Lauber, therefore, found the controversy was not ripe to be heard and the issues were moot.

a. The Second Circuit has agreed with the Tax Court that the taxpayer’s challenge to the Service’s certification that she had a seriously delinquent tax debt was moot, but has reminded the Tax Court that determinations of mootness must precede determinations of subject matter jurisdiction. In a per curiam opinion in Ruesch v. Commissioner, the U.S. Court of Appeals for the Second Circuit has affirmed the Tax Court’s decision to the extent that the Tax Court’s decision dismissed as moot the taxpayer’s challenge to the Service’s certification pursuant to section 7345(a) that she had a seriously delinquent tax debt. The Second Circuit agreed with the Tax Court that, because the Service had reversed its certification, her challenge to the certification in the Tax Court was moot. In reaching this conclusion, the Second Circuit rejected the taxpayer’s argument that an exception to mootness, the voluntary cessation doctrine, allowed the taxpayer to continue to pursue her challenge in the Tax Court. The voluntary cessation doctrine applies when a defendant voluntarily ceases the offending conduct and is intended to prevent defendants from avoiding judicial review temporarily changing their behavior. According to the Second Circuit, however, the voluntary cessation doctrine is not absolute and a case can still be moot if two requirements are met: (1) the defendant demonstrates that interim relief or events have irrevocably and completely eradicated the effects of the alleged violation, and (2) there is no reasonable expectation that the allegedly offending conduct will recur. In this case, the court reasoned, both requirements were satisfied. The Service’s reversal of its certification completely eradicated the effect of the erroneous certification and there was no reasonable expectation that the alleged offending conduct will recur because the Service was barred by statute from certifying her as having a seriously delinquent tax debt while her collection due process hearing with IRS Appeals was pending.

The taxpayer also had sought in the Tax Court to contest the underlying penalties the Service had imposed and that led to certification of a seriously delinquent tax debt. The Tax Court had dismissed these claims for lack of subject matter jurisdiction because section 7345 does not confer jurisdiction on the Tax Court to consider challenges to the underlying liabilities that lead to certification. The Second Circuit, however, held that the Tax Court should instead have dismissed those claims as moot. The taxpayer, the court reasoned, had already received all the relief to which she was entitled under section 7345, i.e., reversal of the Service’s certification, which rendered moot any challenges to the underlying liability for penalties. According to the court:

questions relating to Article III jurisdiction, including those concerning the doctrine of mootness, … are antecedent to and should ordinarily be decided before other issues such as statutory jurisdiction or the merits ….

3. Taxpayers did not duly file their refund claim because their attorney, rather than the taxpayers, signed their amended returns claiming refunds.

The taxpayers in this case were U.S. citizens living and working in Australia for Raytheon Corporation. They filed amended returns for 2015 and 2016 claiming refunds on the basis that they were entitled to the foreign earned income exclusion of section 911. The amended returns were signed by their attorney but no power of attorney accompanied the returns. In this litigation, the U.S. Court of Federal Claims granted the government’s motion to dismiss for lack of subject matter jurisdiction on the ground that the returns were not “duly filed” as required by section 7422, which provides:

No suit or proceeding shall be maintained . . . until a claim for refund . . . has been duly filed with the Secretary, according to the provisions of law in that regard, and the Regulations of the Secretary established in pursuance thereof.

The U.S. Court of Appeals for the Federal Circuit has affirmed the Claims Court’s decision. The court held that the “duly filed” requirement of section 7422 is not jurisdictional, but rather more akin to a claims processing rule. Nevertheless, the court agreed with the government that the taxpayer’s refund claims were not duly filed because the taxpayers had not personally signed the returns or signed them in a manner that complied with applicable Regulations. The applicable Regulations provide:

No refund or credit will be allowed after the expiration of the statutory period of limitation applicable to the filing of a claim therefore except upon one or more of the grounds set forth in a claim filed before the expiration of such period. The claim must set forth in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof. The statement of the grounds and facts must be verified by a written declaration that it is made under the penalties of perjury. A claim which does not comply with this paragraph will not be considered for any purpose as a claim for refund or credit.

This requirement can be satisfied when a taxpayer’s legal representative certifies the claim if the representative attaches evidence of a valid power of attorney. In this case, however, the attorney who prepared and signed the returns in question did not submit a power of attorney to the Service. Because the taxpayers had failed to comply with the regulation’s requirement, they had not “duly filed” their claim for refund within the meaning of section 7422. Accordingly, the court affirmed on the basis that the taxpayers had failed to state a claim on which relief could be granted.

4. The Tax Court lacks jurisdiction to review the Service’s Whistleblower Office’s threshold rejection of an application for a whistleblower award for failure to meet minimum threshold criteria for such claims.

The petitioner in this case, Ms. Li, filed Form 211, Application for Award for Original Information, with the Service’s Whistleblower Office (WBO) asserting four tax violations by a third party. The WBO concluded that Ms. Li’s allegations were “speculative and/or did not provide specific or credible information regarding tax underpayments or violations of internal revenue laws,” and that she therefore was not eligible for an award. Therefore, the WBO did not forward her form to an examiner for any potential action against the target taxpayer. The Service informed her of this in a letter that stated that she could appeal the decision to the U.S. Tax Court. Ms. Li filed a petition in the Tax Court, which held that the Service did not abuse its discretion in rejecting her application for an award. On appeal, the U.S. Court of Appeals for the D.C. Circuit (Judge Sentelle) dismissed the appeal for lack of jurisdiction and remanded to the Tax Court with a direction for the Tax Court to do the same. For the Tax Court to have jurisdiction in a whistleblower case, the court reasoned, section 7623(b)(4) requires that there be a “determination” regarding an award. In this case, the court held, the WBO’s rejection of a claim for failure to meet the minimum threshold criteria for a claim is not a determination and therefore the Tax Court has no jurisdiction. In reaching this conclusion, the court rejected and characterized as “wrongly decided” two prior decisions of the Tax Court.

5. The Service has provided simplified procedures for taxpayers who are not required to file 2021 federal income tax returns to claim the child tax credit, the 2021 recovery rebate credit, and the earned income credit.

Whether a taxpayer must file a federal income tax return generally depends on the taxpayer’s filing status and level of income. If a taxpayer has gross income that is less than the standard deduction for the taxpayer’s filing status, then the taxpayer generally is not required to file a federal income tax return. For example, for 2021, a single individual under age 65 is not required to file a return if the individual’s gross income is less than $12,550 and a married couple filing jointly where both spouses are under age 65 is not required to file a return if their gross income is less than $25,100. There are exceptions to this rule. The principal exception is that a self-employed individual with net income from self-employment of $400 or more is required to file a return.

An individual who is not required to file a federal income tax return might nevertheless want to file a return to claim certain tax benefits. This revenue procedure provides simplified filing procedures for individuals who are not required to file 2021 federal income tax returns to claim the child tax credit, 2021 recovery rebate credit, and earned income credit. Specifically, the revenue procedure provides the following simplified procedures:

• Zero income taxpayers can file electronically. The revenue procedure provides a method for taxpayers with adjusted gross income (AGI) of zero to e-file their returns. Normally, such taxpayers are precluded by most tax preparation software from filing electronically. The revenue procedure instructs taxpayers with zero AGI to list $1 of taxable interest income, $1 of total income, and $1 of AGI, all on the appropriate lines of Form 1040, Form 1040-SR, or 1040-NR. This procedure applies to returns filed after January 24, 2022.
• Taxpayers claiming the child tax credit and 2021 recovery rebate credit. The revenue procedure provides a method for taxpayers to claim the child tax credit and 2021 recovery rebate credit by making limited entries on the normal tax return, which can be e-filed or mailed to the Service. For example, the revenue procedure instructs taxpayers to enter the taxpayer’s filing status and personal information (name, address, Social Security Number, or ITIN), to indicate whether the taxpayer can be claimed as a dependent, to enter information about any qualifying children for purposes of the child tax credit, and to enter zero on or leave blank specific lines of the tax return. Taxpayers who file on paper are instructed to enter “Rev. Proc. 2022-12” at the top of the first page of the return. This procedure applies to returns filed after April 18, 2022.
• Taxpayers claiming the earned income credit, the child tax credit, and the 2021 recovery rebate credit. The revenue procedure provides a method for taxpayers with earned income to claim the earned income credit, the child tax credit and 2021 recovery rebate credit by making limited entries on the normal tax return, which can be e-filed or mailed to the Service. For example, the revenue procedure instructs taxpayers to enter the taxpayer’s filing status and personal information (name, address, Social Security Number, or ITIN), to indicate whether the taxpayer can be claimed as a dependent, to enter information about any qualifying children for purposes of the earned income credit and child tax credit, and to enter zero on or leave blank specific lines of the tax return. Taxpayers who file on paper are instructed to enter “Rev. Proc. 2022-12” at the top of the first page of the return. This procedure applies to returns filed after April 18, 2022.

The revenue procedure sets forth various criteria that taxpayers must meet to take advantage of each of these simplified methods.

6. In Notice 2007-83, the Service concluded that certain trust arrangements involving cash value life insurance policies are listed transactions. According to the Sixth Circuit, the Service failed to comply with the Administrative Procedure Act in issuing Notice 2007-83 and the notice therefore is invalid.

In an opinion by Chief Judge Sutton, the U.S. Court of Appeals for the Sixth Circuit has held that the Service failed to comply with the Administrative Procedure Act (APA) in issuing Notice 2007-83 and that the notice therefore is invalid.

Notice 2007-83. In Notice 2007-83, the Service examined certain trust arrangements being promoted to business owners. In these arrangements, a taxable or tax-exempt trust is established to provide certain benefits, such as death benefits, to owners of the business and to employees. The business makes contributions to the trust, which the trustees use to purchase cash value life insurance policies on the lives of the owners and term insurance on the lives of non-owner employees. The arrangements are structured so that, upon termination of the plan, the owners of the business receive all or a substantial portion of the assets of the trust. According to the notice, those promoting the arrangements take the position that the business can deduct contributions to the trust and that the owners have no income as a result of the contributions or the benefits provided by the trust. The notice identifies these transactions as listed transactions that must be disclosed to the Service. Accordingly, those who fail to disclose these transactions are subject to significant penalties pursuant to section 6707A.

Facts of this case. In this case, from 2013 to 2017, a corporation, Mann Construction, Inc., established an employee-benefit trust that paid the premiums on a cash value life insurance policy benefitting the corporation’s two shareholders. The corporation deducted these payments and the shareholders reported as income part of the insurance policy’s value. Neither the individuals nor the company reported this arrangement to the Service as a listed transaction. In 2019, the Service concluded that this transaction fell within Notice 2007-83 and imposed a $10,000 penalty on the corporation and on both of its shareholders ($8,642 and $7,794) for failing to disclose their participation in the transaction. The corporation and the shareholders paid the penalties for the 2013 tax year, sought administrative refunds on the ground that the Service lacked authority to penalize them, and ultimately brought legal action seeking a refund in a U.S. District Court. The District Court upheld the validity of Notice 2007-83 and held in favor of the government.

Sixth Circuit’s analysis. The U.S. Court of Appeals for the Sixth Circuit reversed the District Court’s holding and concluded that the Service had failed to comply with the APA in issuing Notice 2007-83. The APA generally prescribes a three-step process for notice-and-comment rulemaking. First, the agency must issue a general notice of proposed rulemaking. Second, assuming notice is required, the agency must consider and respond to significant comments received during the period for public comment. Third, in issuing final rules, the agency must include a concise general statement of the rule’s basis and purpose. The Service did not comply with the first requirement in issuing Notice 2007-83 because it did not issue a notice of proposed rulemaking. The government made two principal arguments as to why it was not required to comply with the APA’s notice-and-comment requirements. First, the government argued that Notice 2007-83 is an interpretive rule that is not subject to the APA’s notice-and-comment procedures rather than a legislative rule that is subject to such procedures. The Sixth Circuit rejected this argument and concluded that Notice 2007-83 is a legislative rule. According to the court, the notice imposes new duties on taxpayers by requiring them to report certain transactions and imposes penalties for failure to do so. The notice also carries out an express delegation of authority from Congress, the court reasoned, because section 6011(a) provides that the Secretary of the Treasury is to determine by regulations when and how taxpayers must file returns and statements and section 6707A(c) delegates to the Secretary of the Treasury the authority to identify which transactions have the potential for tax avoidance or evasion and which transactions are substantially similar to such transactions. Because Notice 2007-83 imposes new duties and penalties on taxpayers and carries out an express delegation of congressional authority, the court concluded, the notice is a legislative rule that is subject to the APA’s notice-and-comment procedures. Second, the government argued that, even if Notice 2007-83 is a legislative rule, Congress had exempted it from the APA’s notice-and-comment procedures. The Sixth Circuit rejected this argument as well. According to the court, nothing in the language of the relevant statutory provisions or their legislative history indicated a congressional intent to exempt the Service from the APA’s notice-and-comment procedures when the Service identifies transactions that have the potential for tax avoidance or evasion and substantially similar transactions. Because the Service was required to comply with the APA’s notice-and-comment procedures in issuing Notice 2007-83 and failed to do so, the court concluded, the notice is invalid. Accordingly, the taxpayers are entitled to a refund of the penalties they paid for failing to disclose the transaction.

Broader implications. The effect of the Sixth Circuit’s decision is to preclude the Service from imposing penalties under section 6707A for failing to disclose a transaction that the Service identifies in a notice issued without complying with the APA’s notice-and-comment requirements. Because the Service normally does not comply with the APA’s requirements in issuing notices, the broader implication of the court’s decision is that taxpayers, at least those whose appeals will be heard by the Sixth Circuit, can challenge penalties imposed pursuant to similar notices that identify transactions as listed or reportable transactions. These include Notice 2016-66, which identifies certain captive insurance arrangements, referred to as “micro-captive transactions,” as transactions of interest for purposes of Reg. section 1.6011-4(b)(6) and sections 6111 and 6112 of the Code, and Notice 2017-10, 2017-4 I.R.B. 544, which identifies certain syndicated conservation easement transactions entered into after 2009 as listed transactions.

a. ♪♫“Hey, I’m gonna get you too. Another one bites the dust.”♫♪ Notice 2017-10 held invalid for violating the APA. Aligning with the Sixth Circuit’s reasoning in Mann Construction, Inc. v. United States, the Tax Court in Green Valley Investors, LLC v. Commissioner, in a reviewed opinion (11-4-2) by Judge Weiler, has held that another notice issued by the Service identifying a transaction as a listed transaction violated the APA and therefore is invalid.

Notice 2017-10. As mentioned immediately above, the Service announced in Notice 2017-10, 2017-4 I.R.B. 544, that 2010 and later syndicated conservation easements are another type of section 6707A listed transaction. A typical syndicated conservation easement involves a promoter offering prospective investors the possibility of a charitable contribution deduction in exchange for investing in a partnership. The partnership subsequently grants a conservation easement to a qualified charity, allowing the investing partners to claim a charitable contribution deduction under section 170.

Intended Effect of Notice 2017-10. The intended effect of Notice 2017-10 was to make syndicated conservation easements subject to special disclosure and list-maintenance obligations under sections 6111 and 6112, as well as associated penalties for failure to comply. Section 6111 requires each “material advisor” (as defined) with respect to a section 6707A listed transaction to file an IRS Form 8918 (Material Advisor Disclosure Statement). Failure to file Form 8918 may result in penalties under section 6707. In addition, section 6112 requires material advisors to maintain lists of persons who were provided advice concerning a section 6707A listed transaction. Section 6662A, which is central to the Green Valley Investors case, imposes an accuracy-related penalty on an understatement of taxable income by a taxpayer participating in a section 6707A listed transaction. Furthermore, a taxpayer-participant in a listed transaction must file IRS Form 8886 (Reportable Transaction Disclosure Statement) with the taxpayer’s return and also may be subject to penalties under section 6707A for failure to disclose required information. Willful failures to file Form 8886 or Form 8918 can result in criminal sanctions under section 7203 (fines and up to one year in prison).

Green Valley Investors. This consolidated case involves Service examinations of four different syndicated conservation easement partnerships claiming approximately $90 million in combined charitable contribution deductions for tax years 2014 and 2015. In each of the four cases, the Service filed motions for summary judgment claiming that certain penalties, including the accuracy-related penalty under section 6662A, were properly assessed. The Service argued that section 6662A applies because the syndicated conservation easements at issue are section 6707A listed transactions as described in Notice 2017-10. The taxpayers objected to the Service’s motions for summary judgment and filed cross-motions for summary judgment that section 6662A should not apply based upon two grounds: (i) because Notice 2017-10 was not issued until after the tax years at issue, the Service cannot impose the section 6662A penalty retroactively, and (ii) the Service failed to comply with the notice-and-comment rulemaking procedures of the APA when issuing Notice 2017-10. With respect to the taxpayers’ argument that Notice 2017-10 and any corresponding penalties could not be assessed retroactively, the Tax Court declined to rule; however, Judge Weiler’s opinion was skeptical of the taxpayers’ argument, noting that (i) retroactive penalties have been upheld by the Tax Court in prior cases and (ii) Reg. section 1.6011-4(e)(2) imposes a duty on taxpayers to disclose any transaction that subsequently becomes a listed transaction as long as the period of limitations for assessment remains open. With respect to the taxpayers’ second argument that the Service failed to comply with the notice-and-comment rulemaking procedures of the APA when issuing Notice 2017-10, the Tax Court held for the taxpayers, thereby invalidating the notice. The Tax Court rejected the same arguments that the Service made in Mann Construction and largely followed the reasoning of the Sixth Circuit. The court concluded that Notice 2017-10 is a legislative rule because it “creates new substantive reporting obligations for taxpayers and material advisors, including petitioner and the LLCs, the violation of which prompts exposure to financial penalties and sanctions.” Because Notice 2017-10 is a legislative rule, the court concluded, it was subject to the APA’s notice-and-comment procedures. The Service had not complied with those procedures in issuing Notice 2017-10, and the notice therefore was invalid.

Concurring opinion of Judge Pugh. Judge Pugh wrote a lengthy concurring opinion joined by Judges Ashford, Copeland, Kerrigan, and Paris—essentially that the notice-and-comment procedures of the APA should not apply because Congress explicitly authorized Treasury and the Service to identify listed transactions when Congress enacted the statutory scheme surrounding section 6707A—but ultimately agreed with the majority. Judge Pugh believed that the Service could and should have invoked the “good cause exception” to the notice-and-comment procedures of the APA to issue temporary regulations (instead of merely a notice). Judge Pugh pointed out that the Service previously had used the “good cause exception” when it issued Notice 2000-44 (Son-of-Boss transactions) followed by Temporary Regulations.

Dissenting opinions of Judges Gale and Nega. Judges Gale and Nega dissented from the majority’s opinion, piggybacking on Judge Pugh’s concurring opinion, but concluded that use of the “good cause exception” was unnecessary and that the APA’s notice-and-comment procedures should not apply given the clear statutory scheme surrounding section 6707A.

b. ♪♫“I get knocked down, but I get up again. You’re never gonna keep me down.”♫♪ The Service issues Proposed Regulations identifying syndicated conservation easements as listed transactions. Perhaps following Judge Pugh’s cue in Green Valley Investors, Treasury and the Service have issued Proposed Regulations identifying syndicated conservation easements as listed transactions for purposes of section 6707A. The Proposed Regulations will be effective on the date they are published as final regulations in the Federal Register.

7. The shared responsibility payment imposed by section 5000A for failure to maintain health insurance is a tax for bankruptcy purposes and is entitled to priority.

Section 5000A of the Code, enacted as part of the Affordable Care Act, requires individuals to maintain health insurance that provides minimum essential coverage. Prior to tax year 2019, the statute imposed a penalty, referred to as a shared responsibility payment, on individuals who did not maintain minimum essential coverage. The taxpayers in these two consolidated cases filed Chapter 13 bankruptcy petitions. The Service filed a proof of claim in each proceeding for a shared responsibility payment based on their failure to maintain minimum essential coverage in 2017 and 2018. The proof of claim characterized the shared responsibility payment as an “excise/income tax.” The taxpayers argued that the shared responsibility payment was a penalty and not a tax, and therefore was not entitled to priority in bankruptcy. In NFIB v. Sebelius, the U.S. Supreme Court held that the shared responsibility payment is a tax for constitutional purposes but is not a tax for purposes of the Anti-Injunction Act. In an opinion by Judge Stout, the court concluded that the penalty is a tax for bankruptcy purposes. The court also concluded that it is a tax described in section 507(a)(8) of the Bankruptcy Code and therefore entitled to priority in bankruptcy.

Dissenting opinion of Chief Judge Dales. In a dissenting opinion, Chief Judge Dales argued that the shared responsibility payment is not a tax. He argued that the general approach of courts to be sparing in permitting priority treatment and the text of the statute (section 5000A), which consistently refers to the shared responsibility payment as a penalty, suggest that the shared responsibility payment is a penalty rather than a tax. Judge Dales also relied on prior decisions of the Sixth Circuit, which provide guidance on determining when a payment to a governmental entity is a tax:

Where a State “compel[s] the payment” of “involuntary exactions, regardless of name,” and where such payment is universally applicable to similarly situated persons or firms, these payments are taxes for bankruptcy purposes.

The shared responsibility payment, he argued, is not universally applicable to similarly situated persons because it is triggered only by default, i.e., by virtue of an individual’s failure to maintain minimum essential coverage. Because the shared responsibility payment is not a tax, he concluded, it is not entitled to priority in bankruptcy.

a. The Third Circuit has agreed: the shared responsibility payment imposed by section 5000A for failure to maintain health insurance is a tax for bankruptcy purposes and is entitled to priority. The taxpayers in this case, a married couple, filed a Chapter 13 bankruptcy petition. The Service filed a proof of claim for a shared responsibility payment based on their failure to maintain minimum essential coverage in 2018. The proof of claim characterized the shared responsibility payment as an excise tax. The taxpayers argued that the shared responsibility payment was a penalty and not a tax, and therefore was not entitled to priority in bankruptcy. The U.S. Court of Appeals for the Third Circuit concluded that the penalty is a tax for bankruptcy purposes. The court also concluded that it is a tax described in section 507(a)(8) of the Bankruptcy Code and therefore entitled to priority in bankruptcy.

8. This bloke working in the Australian Outback reversed course to send Uncle Sam on a tricky section 911(a) foreign earned income exclusion walkabout, but Judge Toro’s opinion demonstrates that the Tax Court is not a Kangaroo court.

In the highly unusual circumstances of this case, the Tax Court held that a U.S. citizen working in Australia could not avoid U.S. tax by refuting the terms of a section 7121 advance closing agreement with the Service to claim the benefits of the section 911(a) foreign earned income exclusion. The taxpayer was a U.S. citizen working as an engineer for Raytheon at “Pine Gap,” a joint U.S.-Australian defense facility in the Outback. For the years in issue, 2016-2018, the taxpayer had signed a closing agreement with the Service waiving the taxpayer’s right to make an election under section 911(a). Section 911(a) allows a “qualified individual” (as defined) to elect to exclude “foreign earned income” (as defined) from U.S. gross income. Thus, the taxpayer agreed in advance that his earnings while in Australia would be subject to U.S. federal income taxation (not Australia’s income tax). This advance closing agreement arrangement between the taxing authorities of the U.S. and Australia is sanctioned by treaty and has been standard practice with U.S. citizens employed at Pine Gap for quite some time. Here’s where things went “down under,” so to speak. After filing his original U.S. income tax return on Form 1040 for the years 2016 and 2017 reporting U.S. taxable income and paying tax thereon, the taxpayer filed amended returns for those years claiming the foreign earned income exclusion under section 911(a). The taxpayer also filed an original return for 2018 claiming the exclusion under section 911(a). (Apparently, the enrolled agent advising the taxpayer suggested this course of action, and the opinion states that nineteen other similar cases are before the Tax Court involving the same enrolled agent. No doubt this is why the Tax Court’s opinion is so lengthy and thorough.) The Service then issued refunds to the taxpayer for 2016-2017 and initially accepted the taxpayer’s Form 1040 claiming the section 911(a) exclusion for 2018. Not surprisingly, however, the Service soon caught on to the taxpayer’s course reversal, and the Service issued notices of deficiency for the years 2016-2018. On cross-motions for summary judgment, the Service argued before the Tax Court to uphold the closing agreement and the deficiency determinations, while the taxpayer made two principal arguments for invalidating the agreement and overturning the deficiency determinations. First, the taxpayer argued that the Service director (the Director, Treaty Administration, in the Service’s Large Business and International Division) who signed the closing agreement on behalf of the Service was not properly delegated authority to sign by the “Secretary” as required by section 7121. Second, the taxpayer argued that, even if the Service director was authorized to sign, the closing agreement should be set aside under section 7121(b) because the Service committed malfeasance by disclosing confidential taxpayer information under section 6103 and because the Service misrepresented material facts in the terms of the closing agreement. Section 7121(b) provides that the finality accorded a closing agreement can be avoided only “upon a showing of fraud or malfeasance or misrepresentation of a material fact.” The Tax Court (Judge Toro) sided with the Service and against the taxpayer on both arguments. With respect to the taxpayer’s first argument, Judge Toro examined and analyzed the relevant Treasury delegation orders to uphold the Service director’s authority to sign the section 7121 closing agreement with the taxpayer. With respect to the taxpayer’s second argument, Judge Toro assumed without deciding that willful disclosure of confidential return information in violation of section 6103 is an act of malfeasance for purposes of section 7121(b). Making that assumption, however, the court concluded that no malfeasance had occurred “‘in the making of’ the 2016–18 Closing Agreement either because no return information was disclosed in contravention of section 6103 or because any inappropriate disclosure did not affect the making of the agreement.” Accordingly, the court found no fraud, malfeasance, misrepresentation, or other circumstances that would invalidate the closing agreement. The court therefore granted in part the government’s motion for summary judgment.

9. 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. 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 U.S. District Court to determine if the certification was made erroneously. If the Tax Court or U.S. District 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 this case, the Service assessed $421,766 in penalties for the plaintiff’s failure to file accurate tax returns and failure to report a foreign trust of which he was the beneficial owner. The began collection efforts in 2018. These included issuing a notice of federal tax lien and levying on his Social Security benefits. 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 attempted to eliminate his liability by submitting two separate offers-in-compromise for doubt as to liability, both of which were rejected by the Service. He then brought an action in the U.S. District Court for the Northern District of Texas. Among other claims, he asserted various claims related to the Service’s alleged failure to obtain supervisory approval of the penalties as required by section 6751(b). He also challenged the constitutionality of the State Department’s revocation of his passport and argued that the revocation violated his rights under the Fifth Amendment. The District Court dismissed the plaintiff’s claims under section 6751(b) for lack of subject matter jurisdiction and concluded that, although it had subject matter jurisdiction over his constitutional claim, that claim did not have merit because the passport-revocation scheme of the FAST Act was constitutional under a rational basis standard of review.

Section 6751(b) claims. Section 6751(b)(1) requires 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 Fifth Circuit concluded that the District Court had correctly dismissed the plaintiff’s claims for lack of subject matter jurisdiction. Subject to certain exceptions, the full payment rule established by Flora v. United States requires that a taxpayer pay the full amount of tax that the Service seeks to collect and then seek a refund. A federal district court lacks jurisdiction to hear the claims of a taxpayer who seeks a refund of tax but who has not complied with the full payment rule (or qualified under an exception to it). Further, the Anti-Injunction Act (AIA) bars lawsuits filed “for the purpose of restraining the assessment or collection of any tax” by the Service. The Fifth Circuit concluded that each of the plaintiff’s claims under section 6751(b) implicitly challenged the validity of the penalties the Service had assessed and therefore violated the AIA. The court recognized that, in CIC Services, LLC v. IRS, the U.S. Supreme Court had held that a challenge to a reporting requirement could proceed even if failure to comply with the reporting requirement resulted in penalties. But the Court in CIC Services, the Fifth Circuit observed, had reaffirmed that a challenge to the assessment or collection of a tax or penalty is still barred by the AIA. The plaintiff’s claims in this case based on the Service’s alleged failure to obtain supervisory approval of the penalties as required by section 6751(b), the court concluded, implicitly challenged the validity of the penalties and were therefore barred by the AIA.

Constitutional claims. The Fifth Circuit also affirmed the District Court’s dismissal of the plaintiff’s constitutional challenge for failure to state a claim on which relief can be granted. The plaintiff argued 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 either a rational basis standard of review or under so-called intermediate scrutiny. Under a rational basis standard, the court observed, “the restriction at issue survives as long as it is ‘rationally related to a legitimate government interest.’” Under an intermediate scrutiny standard, “the challenged restriction ‘must serve important governmental objectives and must be substantially related to achievement of those objectives.’” The Fifth Circuit declined to decide whether the passport-revocation scheme must be judged under rational basis review or instead intermediate scrutiny because, the court held, even under the higher standard of intermediate scrutiny, the statute is constitutional. The federal government’s interest in collecting taxes, the court concluded, “is undoubtedly an important one.” The passport-revocation scheme, the court held, is substantially related to achieving the government’s objective:

The passport-revocation scheme is also clearly connected to that goal: delinquent taxpayers will be well-incentivized to pay the government what it is owed to secure return of their passports, and those same taxpayers will find it much more difficult to squirrel away assets in other countries if they are effectively not allowed to legally leave the country.

10. The First Circuit has applied the Beard test to conclude that a taxpayer’s late-fled return was not a “return” and therefore the taxpayer’s tax debt was not discharged in bankruptcy.

The taxpayer filed his federal income tax returns for 1997 and 2000 in 2007. In 2012, the taxpayer filed a petition in bankruptcy. After receiving a general discharge of his debts in bankruptcy, the issue arose whether the taxpayer’s federal tax liability for 1997 and 2000 had been discharged. In an opinion by Judge Kayatta, the First Circuit held that the tax liability of the taxpayer, whose returns for 1997 and 2000 were filed after the Service had assessed tax for those years, was not dischargeable in bankruptcy. The court declined to decide whether its prior decision in In re Fahey was controlling. In In re Fahey, the court adopted the “one day late” approach and held that a late-filed Massachusetts state income tax return was not a “return” for purposes of Bankruptcy Code section 523(a). Instead, the court applied the four-factor Beard test to determine whether the taxpayer had filed a “return” for purposes of Bankruptcy Code section 523(a). The fourth factor of the Beard test is that there must be an honest and reasonable attempt to satisfy the requirements of the tax law. The court stated:

Under the subjective version of the Beard test, Kriss’s alleged facts, even viewed most favorably to him, fall well short of plausibly qualifying as descriptions of a reasonable effort to file timely returns. Kriss’s only excuse for his very belated filings is that his wife falsely assured him that she had filed the returns for him. But the United States tells us that Kriss and his wife were filing separate returns—an assertion that Kriss does not challenge. Kriss also makes no allegation explaining why he did not respond to notices sent by the IRS inquiring about the status of his unfiled returns. He does not even allege that he ever signed any returns for 1997 or 2000 until 2007. Therefore, applying the Beard test that Kriss urged the bankruptcy court to adopt, he never filed “returns” for the tax years relevant here.

11. Either this taxpayer has the right “moves,” the Service is just too sneaky, or bad facts make bad law. You decide!

In an opinion by Judge Jordan (and joined by Judges Luck and Lagoa), the U.S. Court of Appeals for the Eleventh Circuit has held that, although the Anti-Injunction Act of 1867 (codified at section 7421(a)) generally forecloses a “suit” against the Service, it does not prohibit a defensive “motion” for a protective order in a Service-initiated administrative action to assess penalties against a taxpayer-promoter. The taxpayer in this case, Michael L. Meyer, was sued in 2018 by the U.S. Department of Justice (the “2018 litigation”) for promoting bogus charitable deduction tax-evasion schemes. After extensive discovery, including admissions by Mr. Meyer regarding his tax-evasion schemes, the 2018 litigation settled and ostensibly was “closed” in 2019 when the U.S. District Court entered a permanent injunction against Mr. Meyer. The injunction prohibited Mr. Meyer from (among other things) ever “representing anyone other than himself before the IRS; preparing federal tax returns for others; or furnishing tax advice regarding charitable contributions.” Then, in 2020, the Service assessed penalties against Mr. Meyer (the “2020 administrative action”) under section 6700 (promoting abusive tax shelters). The Service expressly relied upon the admissions that Mr. Meyer made in the 2018 litigation to support its assessment of penalties under section 6700 in the 2020 administrative action. Mr. Meyer objected, eventually filing a motion for a protective order in the same U.S. District Court that handled the 2018 litigation. Mr. Meyer’s motion sought a protective order prohibiting the Service from using his admissions connected to the 2018 litigation in the 2020 administrative action. The Service argued in U.S. District Court that Mr. Meyer’s motion for a protective order was barred by the Anti-Injunction Act, which, subject to very specific exceptions (e.g., Tax Court petitions under section 6213, jeopardy assessments under section 7429, etc.), prohibits any person from maintaining a “suit for the purpose of restraining the assessment or collection of any tax . . . in any court . . . whether or not such person is the person against whom such tax was assessed.” The U.S. District Court held that Mr. Meyer’s motion for a protective order was barred by the Anti-Injunction Act because, although a “motion” is not a “suit,” granting the motion would have the practical effect of restraining the Service’s assessment and collection of tax. Mr. Meyer appealed the U.S. District Court’s decision to the Eleventh Circuit. Perhaps fatally, the Service did not argue in the U.S. District Court that the 2018 litigation (which was with the U.S. Department of Justice) was closed and thus the court had no jurisdiction sto hear Mr. Meyer’s motion vis-à-vis the Service.

The Eleventh Circuit’s Decision. The Eleventh Circuit held that Mr. Meyer’s motion was not barred by the Anti-Injunction Act. The Eleventh Circuit reasoned that the term “suit” used in the AIA was itself specific—based upon the 1867 and 1954 usage of the term—and did not extend to a defensive motion filed in connection with the 2018 litigation. Thus, the Eleventh Circuit seems to have viewed Mr. Meyer’s motion as part of his defense to the (ostensibly closed?) 2018 litigation initiated by the U.S. Department of Justice, not the Service’s separate 2020 administrative action. The Eleventh Circuit rejected the U.S. District Court’s and the Service’s broader reading of the AIA (which has been adopted by some courts) that entertaining or granting Mr. Meyer’s motion for a protective order would have the practical effect of restraining the assessment or collection of tax and therefore should be denied. Instead, the Eleventh Circuit reasoned that Mr. Meyer’s motion was comparable to cases decided in the Second and Third Circuits. In both those cases, the taxpayer intervened in actions initiated by the Service against a taxpayer’s bank to access the taxpayer’s safe deposit box. The Second and Third Circuits held in those cases that intervening in a suit between the Service and the taxpayer’s bank was not barred by the AIA because the underlying action was not one for the assessment or collection of a tax. The Eleventh Circuit thus vacated the U.S. District Court’s decision and remanded the case for further proceedings consistent with its opinion. The Eleventh Circuit declined to hear the Service’s argument that the U.S. District Court had no jurisdiction to entertain Mr. Meyer’s motion because the 2018 litigation was closed, determining that the argument was raised for the first time on appeal and therefore should be heard by the U.S. District Court first.

XI. Withholding and Excise Taxes

A. Employment Taxes

There were no significant developments regarding this topic during 2022.

B. Self-employment Taxes

There were no significant developments regarding this topic during 2022.

C. Excise Taxes

1. Butane does not qualify as a liquified petroleum gas and therefore does not qualify for the alternative fuel mixture credit authorized by section 6426(e), says the Fifth Circuit.

In an opinion by Judge Willett, the U.S. Court of Appeals for the Fifth Circuit in Vitol, Inc. v. United States has held that butane does not qualify as a liquified petroleum gas (LPG) and therefore does not qualify for the alternative fuel mixture credit authorized by section 6426(e). The taxpayer brought this action seeking a tax refund of $8.8 million on the basis that it was entitled to the credit provided by section 6426(e). Sections 4081 and 4041(a)(2)(A) impose excise taxes on fuel made from certain components. Section 6426(e) provides a credit for a fuel that is “a mixture of alternative fuel and taxable fuel.” The term “alternative fuel” is defined in section 6426(d) to include LPG. The court adopted a textualist approach and declined to rely on legislative history. The court acknowledged that the common meaning of LPG includes butane. According to the court, however, section 4083 defines butane as a taxable fuel for purposes of the excise tax imposed by section 4081.

the statutory framework is mutually exclusive: A given fuel is either taxable or alternative, but not both. The statutory context of section 6426 provides sound reason to depart from butane’s common meaning.

If butane is a taxable fuel, the court reasoned, it cannot be an alternative fuel, and therefore cannot be LPG within the meaning of section 6426(d).

Dissenting opinion by Judge Elrod. In a thoughtful dissenting opinion, Judge Elrod rejected the statutory analysis set forth in the majority opinion. According to Judge Elrod, the majority was too quick to reject the ordinary meaning of the term LPG and the government had not persuasively shown that Congress meant to override the ordinary meaning of that term:

As everyone in the oil and gas industry knows, and as the United States readily concedes, butane is an LPG. Indeed, the government’s own witness testified that “butane is always an LPG.” That should be the end of it: Vitol gets a tax credit.

a. The U.S. Court of Federal Claims also has concluded that butane is not LPG and therefore does not qualify for the alternative fuel mixture credit authorized by section 6426(e). In an opinion by Judge Meyers, the U.S. Court of Federal Claims also concluded that butane is not LPG and therefore does not qualify for the alternative fuel mixture credit authorized by section 6426(e).

2. The tax imposed by section 4611 on oil exported from the United States is a tax on exports in violation of Article I, section 9 of the U.S. Constitution and therefore is unconstitutional.

In Trafigura Trading, LLC v. United States, the taxpayer, a commodity trading company, purchased and exported from the United States approximately 50 million barrels of crude oil between 2014 and 2017. Section 4611(b) of the Code imposes a tax on “any domestic crude oil [that] is used in or exported from the United States.” The taxpayer paid over $4 million to the Service based on the oil it exported and filed an administrative claim for a refund of the tax. When the Service denied the claim, the taxpayer brought legal action seeking a refund in a federal district court. In the U.S. District Court for the Southern District of Texas, the taxpayer argued that the tax imposed on exported oil by section 4611(b) violates the Export Clause of the U.S. Constitution (Art. I, section 9, cl. 5), which provides: “No Tax or Duty shall be laid on Articles exported from any State.” The U.S. District Court (Judge Hanen) granted summary judgment in favor of the taxpayer and the government appealed. In an opinion by Judge Ho, the U.S. Court of Appeals for the Fifth Circuit affirmed the District Court’s decision. The Fifth Circuit observed that, according to the U.S. Supreme Court’s decisions in United States v. U.S. Shoe Corp., 523 U.S. 360 (1998), and Pace v. Burgess, 92 U.S. 372 (1876), the label Congress uses to describe an impost (e.g., as a tax) is not controlling and the Export clause does not bar a charge or user fee that lacks the attributes of a generally applicable tax and instead is “designed as compensation for Government-supplied services, facilities, or benefits.” Thus, according to the Fifth Circuit, the question is whether section 4611(b) imposes an impermissible tax or instead a permissible user fee. According to section 9509(b)(1), proceeds from section 4611(b) go to the Oil Spill Liability Trust Fund. The Oil Spill Liability Trust Fund is used for several purposes, including reimbursing those held liable for the cleanup costs of an oil spill, covering costs incurred by federal, state, and Indian tribe trustees for natural resource damage assessment and restoration, and supporting certain environmental research and testing. The “tax” imposed by section 4611(b) therefore might be characterized as a user fee that provides a source of funds for these initiatives. After analyzing relevant precedent from the U.S. Supreme Court, Judge Ho summarized the guiding principles regarding whether an impost is a tax or instead a user fee as follows:

First, we must consider whether the charge under section 4611(b) is based on the quantity or value of the exported oil—if so, then it is more likely a tax. Second, we must consider the connection between the Fund’s services to exporters, if any, and what exporters pay for those services under section 4611(b). That connection need not be a perfect fit. See Pace, 92 U.S. at 375–76. But a user fee must “fairly match” or “correlate reliably with” exporters’ use of government services. U.S. Shoe, 523 U.S. at 369–70. Finally, we apply “heightened scrutiny,” Matter of Buffets, LLC, 979 F.3d 366, 380 (5th Cir. 2020), and strictly enforce the Export Clause’s ban on taxes by “guard[ing] against . . . the imposition of a [tax] under the pretext of fixing a fee.”

With respect to the first issue, Judge Ho concluded that the charge imposed by section 4611(b) is based on the volume of oil transported and therefore is based on the quantity or value of the exported oil, which makes it more likely that the charge is a tax. With respect to the second issue, Judge Ho concluded that there is not a sufficient connection between exporters’ payment of the charge imposed by section 4611(b) and their use if government services. He reasoned that “[a] user fee is a charge for a specific service provided to, and used by, the payor,” and that the charge imposed by section 4611(b) does not meet this criterion. Section 4611(b) requires oil exporters to pay for several things that cannot be regarded as services provided to the oil exporters, such as reimbursements to federal, state, and Indian tribe trustees for assessing natural resource damage; research and development for oil pollution technology; studies into the effects of oil pollution; marine simulation research; and research grants to universities. Although oil exporters benefit indirectly from these initiatives, they do not receive a specific service in return for the amounts they pay. Society as a whole benefits from these initiatives. By analogy, Judge Ho reasoned,”[t]he fact that people pay taxes to fund police and fire protection does not somehow turn those taxes into user fees.” Accordingly, the court held that the charge imposed by section 4611(b) is a tax rather than a user fee, and because it is a tax on exports, it violates the Export clause and is unconstitutional.

Concurrence of Judge Wiener. Judge Wiener concurred in the judgment of the court.

Dissenting opinion of Judge Graves. In a dissenting opinion, Judge Graves concluded that there are genuine issues of material fact as to whether section 4611(b) imposes a user fee and that it was therefore inappropriate for the District Court to grant summary judgment in favor of the taxpayer. Judge Graves disagreed with Judge Ho’s conclusion that the charge imposed by section 4611(b) is based on the quantity or value of the exported oil. In his view, the charge is a per-barrel fee that does not depend on the value of the exported oil. He also disagreed with Judge Ho’s analysis regarding exporters’ payment of the charge and their receipt of services:

it is implausible to suggest that random taxpayers or random members of society are the primary beneficiaries of exporters simply being responsible for their own actions and business practices. There would be no oil spills, resulting damage, or need for research and development regarding oil pollution if oil was not exported. The oil was not exported by random taxpayers or random members of society, and they are neither responsible for any subsequent pollution/damage of precious natural resources nor the beneficiaries of any cap on liability. The oil is exported by exporters, who are not forced to share any resulting profit with random taxpayers or random members of society. To borrow from the plurality, exporters pay and exporters benefit.

XII. Tax Legislation

A. Enacted

1. The Inflation Reduction Act enacts a corporate AMT, imposes a 1 percent excise tax on redemptions of corporate stock by publicly traded corporations, and makes certain other changes.

The Inflation Reduction Act, Pub. L. No. 117-169, signed by the President on August 16, 2022, imposes a 15 percent AMT on corporations with “applicable financial statement income” over $1 billion, imposes an excise tax of 1 percent on redemptions of stock by publicly traded corporations, extends through 2025 certain favorable changes to the premium tax credit of section 36B, and extends through 2028 the section 461(l) disallowance of “excess business losses” for noncorporate taxpayers.

2. The SECURE 2.0 Act increases the age at which RMDs must begin, modifies the rules regarding catch-up contributions, and makes many other significant changes that affect retirement plans.

The Consolidated Appropriations Act, 2023, Pub. L. No. 117-328, signed by the President on December 29, 2022, includes the SECURE 2.0 Act of 2022, which increases the age at which RMDs must begin to age 73, reduces the penalty for failure to take RMDs, modifies the rules for catch-up contributions to qualified retirement plans, and makes many other significant changes that affect retirement plans.