This Article summarizes and provides context to understand the most important developments in federal income taxation for 2023. The items discussed primarily consist of the following: (i) significant amendments to the Internal Revenue Code; (ii) important judicial decisions; and (iii) noteworthy administrative rulings and regulations promulgated by the Treasury Department and the Service. This Article primarily focuses on subjects of broad general interest – tax accounting rules, determination of gross income, allowable deductions, treatment of capital gains and losses, corporate and partnership taxation, exempt organizations, and procedure and penalties. This Article provides only limited discussion of federal estate and gift taxation and the income taxation of trusts and estates and generally does not address items relating to qualified pension and profit-sharing plans, international taxation, or specialized industries such as banking, insurance, and financial services.
In 2023, despite the absence of major tax legislation, there were many significant federal income tax developments. The Treasury Department and the Service provided important administrative guidance, and the courts issued many notable judicial decisions. This outline discusses salient administrative guidance issued last year, summarizes any recent legislative changes that, in our judgment, are the most important, and examines significant judicial decisions rendered in 2023.
As a service to its readers, The Tax Lawyer anticipates publishing annual editions of these materials to provide tax practitioners, academics, and other professionals a comprehensive, yearly summary of the most important recent developments in federal income taxation.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
Legal expenses incurred related to the preparation of applications to the FDA for approval of generic drugs are capital expenditures while legal expenses incurred to defend patent infringement suits are currently deductible. The taxpayer, Mylan, Inc., and its subsidiaries manufacture both brand-name and generic pharmaceutical drugs. Mylan incurred substantial legal expenses in two categories. First, Mylan incurred legal expenses in connection with its applications to the FDA seeking approval of generic drugs. To obtain this approval, Mylan submitted abbreviated new drug applications (ANDAs). The FDA’s application process for generic drugs includes a requirement that the applicant certify the status of any patents covering the respective brand name drug previously approved by the FDA (referred to as a “paragraph IV certification”). One option available to the applicant is to certify that the relevant patent is invalid or will not be infringed by the sale or use of the generic version of the drug. An applicant making this certification is required to send notice letters to the holders of the patents informing them of the certification. Such a certification is treated by statute as patent infringement and the holder of the patent is entitled to bring suit in federal district court. Mylan incurred substantial legal expenses to prepare the notice letters it sent in connection with its FDA applications. Second, Mylan incurred substantial legal expenses in defending patent infringement lawsuits brought by the name-brand drug manufacturers against Mylan in response to the notice letters that Mylan sent. Mylan claimed deductions for both categories of legal expenses. The Service, however, determined that all of Mylan’s expenses were capital expenditures under section 263(a). The Tax Court (Judge Urda) held that the legal expenses incurred by Mylan to prepare notice letters were capital expenditures but the legal expenses Mylan incurred to defend patent infringement suits were currently deductible business expenses.
FDA applications for generic drugs and notice letter costs. The court first addressed the issue of whether the costs Mylan incurred to prepare the notice letters it sent in connection with its ANDAs should be capitalized under section 263. The court’s analysis focused in large part on the regulations under section 263 regarding intangibles. These regulations require a taxpayer to capitalize both amounts paid to create an intangible and amounts paid to facilitate an acquisition or creation of an intangible. With respect to creation of an intangible, Regulation section 1.263(a)-4(d)(5)(I) provides:
A taxpayer must capitalize amounts paid to a governmental agency to obtain, renew, renegotiate, or upgrade its rights under a trademark, trade name, copyright, license, permit, franchise, or other similar right granted by that governmental agency.
With respect to facilitating the acquisition or creation of an intangible, Regulation section 1.263(a)-4(e)(1) provides:
[A]n amount is paid to facilitate the acquisition or creation of an intangible (the transaction) if the amount is paid in the process of investigating or otherwise pursuing the transaction. Whether an amount is paid in the process of investigating or otherwise pursuing the transaction is determined based on all of the facts and circumstances.
Mylan and the Service disputed whether Mylan’s legal fees were incurred to “facilitate” the acquisition of a right obtained from a governmental agency and therefore were required to be capitalized. They agreed that the relevant “transaction” was the acquisition of an FDA-approved ANDA with a paragraph IV certification. But they disagreed on when this acquisition occurs. Mylan argued that the acquisition of an FDA-approved ANDA occurs when the FDA completes its scientific investigation and issues an approval letter. The Service asserted that the acquisition of an FDA-approved ANDA with a paragraph IV certification occurs only when the approval letter issued by the FDA becomes effective. The distinction is that the FDA may issue an approval letter but the approval does not grant any rights to the applicant until it becomes effective. Only when the approval becomes effective does the applicant have the right to begin delivery of a generic drug. With respect to Mylan’s legal fees incurred in preparing the notice letters relating to the filing of its ANDAs with paragraph IV certifications, the court concluded that these costs were capital expenditures. The notice is a required step in securing FDA approval of an ANDA. According to the court, because the notice requirement was a prerequisite to securing FDA approval, “the legal expenses Mylan incurred to prepare, assemble, and transmit such notice letters constitute amounts incurred ‘investigating or otherwise pursuing’ the transaction of creating FDA-approved ANDAs … and must be capitalized.”
Litigation expenses. The court reached a different conclusion regarding Mylan’s litigation expenses, holding that they were currently deductible. The Service argued that a patent infringement suit is a step in obtaining FDA approval of an ANDA. The court disagreed, however, and reasoned that the outcome of a patent litigation action has no effect on the FDA’s review of a generic drug application. The FDA continues its review process during the course of a patent infringement action and may issue a tentative or final approval of an application before the infringement action is finally decided. A successful patent dispute does not guarantee that a generic drug manufacturer will obtain FDA approval of an ANDA. While it is true that a successful challenge by a patent holder will result in a prohibition of the marketing of a generic drug found to infringe, the court reasoned that the coordination of the FDA approval process with the outcome of related patent litigation does not insert the patent litigation into the FDA’s ANDA approval process. A patent on a name-brand drug does not prevent FDA approval of a generic version of the drug and patent litigation on the part of the patent holder is not a step in the FDA’s approval process for a generic drug. In reaching its conclusion that the litigation expenses incurred by Mylan were currently deductible as ordinary and necessary expenses, the court also applied the “origin of the claim” test, which inquires as to “‘whether the origin of the claim litigated is in the process of acquisition”, enhancement, or other disposition of a capital asset.” Here, the court reasoned, Mylan’s legal expenses arose from legal actions initiated by patent holders in an effort to protect their patents. The court followed the decision of the U.S. Court of Appeals for the Third Circuit in Urquhart v. Commissioner, which held that patent litigation arises out of the exploitation of the invention embodied in the patent and, therefore, costs incurred to defend a patent infringement suit are not capital expenditures because they are not costs incurred to defend or protect title but rather are expenses incurred to protect business profits. Because Mylan’s legal expenses arose out of the patent infringement claims initiated by the patent holders, the court held, they were currently deductible.
a. Legal expenses incurred to defend patent infringement suits are currently deductible. The plaintiff in this case, Actavis Laboratories Florida, Inc. (Actavis), was the substitute agent for Watson Pharmaceuticals, Inc. (Watson). Watson manufactured both branname and generic pharmaceutical drugs. To obtain approval of generic drugs, Watson submitted to the Food and Drug Administration abbreviated new drug applications (ANDAs). The ANDA application process for generic drugs includes a requirement that the applicant certify the status of any patents covering the respective brand name drug previously approved by the FDA (referred to as a “paragraph IV certification”). One option available to the applicant is to certify that the relevant patent is invalid or will not be infringed by the sale or use of the generic version of the drug. An applicant making this certification is required to send notice letters to the holders of the patents informing them of the certification. Such a certification is treated by statute as patent infringement and the holder of the patent is entitled to bring suit in federal district court. Watson incurred substantial legal expenses in defending patent infringement lawsuits brought by the name-brand drug manufacturers against Watson in response to the notice letters that Watson sent. Watson deducted these legal expenses on its 2008 and 2009 tax returns. Following audits of these returns, the Service issued a notice of deficiency disallowing Watson’s deductions on the basis that the costs incurred in defending the patent infringement litigation were capital expenditures under section 263(a). Watson paid the amounts sought by the Service and, after filing amended returns requesting refunds, brought this action in the U.S. Court of Federal Claims seeking refunds of $1.9 million for 2008 and $3.9 million for 2009.
The U.S. Court of Federal Claims (Judge Holte) held that the legal expenses incurred by Watson in defending the patent infringement litigation were currently deductible. The Service argued that the costs were capital expenditures under Regulation section 1.263(a)-4(b)(1), which requires taxpayers to capitalize amounts paid to acquire or create an intangible and amounts paid to facilitate an acquisition or creation of an intangible. According to the government, the costs facilitated the acquisition of an intangible, specifically, an FDA-approved ANDA. The court, however, disagreed. The court relied on the “origin of the claim” test established by the U.S. Supreme Court in United States v. Gilmore. As interpreted by a later decision, Woodward v. Commissioner, the deductibility of litigation expenses under the origin of the claim test depends not on the taxpayer’s primary purpose in incurring the costs, but “involves the simpler inquiry whether the origin of the claim litigated is in the process of acquisition [of a capital asset] itself.” Here, the court reasoned, Watson’s legal expenses arose from legal actions initiated by patent holders in an effort to protect their patents. The court followed a long line of decisions, including that of the U.S. Court of Appeals for the Third Circuit in Urquhart v. Commissioner, which have held that costs incurred to defend a patent infringement suit are not capital expenditures because they are not costs incurred to defend or protect title but rather are expenses incurred to protect business profits. Because Watson’s legal expenses arose out of the patent infringement claims initiated by the patent holders, the court held, they were currently deductible. The court further concluded that Regulation section 1.263(a)-4(b)(1) did not require the costs to be capitalized because Watson’s defense of the patent infringement litigation was not a step in the FDA’s approval process for a generic drug:
The FDA’s review of an ANDA does not include patent related questions. When a generic drug company files an ANDA with a Paragraph IV certification, it certifies the patents associated with the relevant [drug] are either invalid or will not be infringed by the proposed generic drug. The FDA performs no assessment of that certification as a part of its ANDA review process—“[a]ccording to the agency, it lacks ‘both [the] expertise and [the] authority’ to review patent claims[.]”
The court’s analysis and conclusions in this case are consistent with those of the Tax Court in Mylan.
b. The Third Circuit has agreed that legal expenses incurred by a taxpayer seeking FDA approval of a generic drug to defend patent infringement suits are currently deductible. In an opinion by Judge Jordan, the U.S. Court of Appeals for the Third Circuit has affirmed the Tax Court’s decision and has held that legal expenses incurred by a taxpayer seeking FDA approval of a generic drug to defend patent infringement suits are currently deductible.
Costs of preparing and sending notice letters to holders of patents on brand name drugs. As described earlier, the FDA’s approval process for an ANDA requires the applicant to make one of certain types of certifications regarding the status of any existing patents on the relevant brand name drug. One option available to the applicant is to certify that the relevant patent is invalid or will not be infringed by the sale or use of the generic version of the drug. An applicant making this type of certification is required by the FDA’s approval process to notify the holders of patents on relevant brand name drugs that it has made this certification. In this case, Mylan incurred legal fees to prepare and send such notice letters. The Tax Court held that these costs were capital expenditures because they facilitated the acquisition of an intangible (an FDA-approved application) within the meaning of Regulation section 1.263(a)-4(b)(1)(v). Neither party appealed this aspect of the Tax Court’s decision and the Third Circuit’s opinion therefore does not address it.
Costs of defending patent infringement litigation. As described earlier, the taxpayer incurred substantial legal fees in defending patent infringement litigation brought by holders of patents on brand name drugs in response to the notice letters that the taxpayer sent. The Tax Court held that these costs were not capital expenditures and that the taxpayer therefore could deduct them currently as ordinary and necessary business expenses. The government appealed this aspect of the Tax Court’s decision. On appeal, the Third Circuit affirmed the Tax Court’s decision. The court reviewed at length the FDA’s approval process for an ANDA. The key question, the court observed, was whether the costs incurred by the taxpayer to defend patent infringement litigation facilitated the acquisition or creation of an intangible within the meaning of Regulation sections 1.263(a)-4(b)(1)(v) and 1.263(a)-4(e)(1)(i). The court noted that the Service, beginning in 2011, had issued several non-binding memoranda asserting that generic drug companies must capitalize and amortize the costs of defending patent infringement suits filed in response to the type of certifications made by the taxpayer. The court disagreed with the Service’s position. According to the court, whether the FDA approves (or disapproves) an application for approval to market a generic drug does not depend on the outcome of the patent infringement litigation: “The FDA can approve an ANDA for an infringing generic and deny an ANDA for a non-infringing generic.” The court quoted with approval the following summary from the Tax Court’s opinion:
The outcome of a [patent infringement] suit has no bearing on the FDA’s safety and bioequivalence review. The FDA continues its review process during the pendency of the patent infringement suit and may issue a tentative or final approval before the suit is resolved. The FDA does not analyze patent issues as part of its review, and neither the statute nor regulations suggest that patent issues might block approval of an ANDA. And winning a patent litigation suit does not ensure that the generic drug manufacturer will receive approval, as the FDA can disapprove an ANDA for not meeting safety and bioequivalence standards.
The Fourth Circuit upholds a Tax Court decision that a portion of compensation paid to a C corporation shareholder-employee was unreasonable and nondeductible, but vacates the Tax Court’s imposition of underpayment penalties.
The taxpayer in this case was a C corporation formed in 1980 to engage in the land excavation and grading business. The CEO, Clary Hood, and his spouse were 50/50 shareholders of the taxpayer and the sole members of the board of directors. Since its inception, the taxpayer-corporation never paid dividends. (Uh, oh.) From 2000 to 2010, the taxpayer-corporation averaged approximately $21 million in annual gross revenue and less than $1 million per year in net income before taxes. During those years, Mr. Hood’s annual salary was roughly $130,000, and in some of those years, Mr. Hood received a bonus, the largest of which was approximately $321,000. Then in 2011, at Mr. Hood’s direction, the taxpayer-corporation shifted away from residential to commercial projects, and the taxpayer-corporation’s revenues grew substantially. By 2015, the taxpayer-corporation’s annual revenue grew to $44 million. By 2016, annual revenue grew to $69 million. Nevertheless, Mr. Hood’s annual salary was only $168,559 for 2015 and only $196,500 for 2016. (Uh, oh.) Accordingly, the taxpayer-corporation decided to pay Mr. Hood a bonus of $5 million for 2015 and another $5 million for 2016. (Uh, oh.) The taxpayer-corporation, in consultation with its accountants, determined that the $5 million bonuses paid to Mr. Hood in each of the years 2015 and 2016 were appropriate to reflect the taxpayer-corporation’s recent success and to remedy undercompensating Mr. Hood in prior years. On audit, the Service challenged the taxpayer-corporation’s bonuses to Mr. Hood as unreasonable and therefore nondeductible to the extent of $1.3 million for 2015 and $3.6 million for 2016. The Service also imposed substantial underpayment penalties for years 2015 and 2016 under section 6662.
a. The Tax Court’s Decision. The Tax Court (Judge Greaves) largely sided with the Service after a six-day trial. The Service’s expert testified that, although Mr. Hood was undercompensated for the years 2000 to 2012, the taxpayer-corporation had begun to address this discrepancy in 2013 when Mr. Hood was paid $1.4 million in salary and bonuses. The Service’s expert further concluded that by the end of 2014, Mr. Hood had been undercompensated approximately $2.3 million in prior years. The Service expert’s report concluded that reasonable compensation amounts for Mr. Hood would have been roughly $3.7 million for 2015 and roughly $1.4 million for 2016. The taxpayer-corporation submitted two opposing expert reports; however, Judge Greaves determined that the taxpayer-corporation’s expert reports deserved “little to no weight” due to “dubious assumptions” underlying the reports and the lack of supporting calculations. Consequently, in a 64-page opinion, Judge Greaves held for the Service and concluded that the taxpayer-corporation could deduct about $3.7 million of Mr. Hood’s $5 million bonus for 2015 and about $1.4 million of Mr. Hood’s $5 million bonus for 2016. The Tax Court further determined that the taxpayer-corporation should not be subject to a section 6662 substantial understatement penalty for 2015 because it reasonably relied on professional tax advice in good faith, but for 2016, the taxpayer-corporation could not show reasonable cause and should be subject to a section 6662 substantial understatement penalty for that year. The taxpayer-corporation appealed to the Fourth Circuit.
b. The Fourth Circuit’s Decision. The Fourth Circuit, in an opinion written by Judge Niemeyer, initially recited the applicable law of section 162(a)(1) limiting a taxpayer’s deduction for salaries and other compensation to a “reasonable allowance . . . for personal services actually rendered.” Judge Niemeyer then highlighted the directive of Regulation section 1.162-7(b) that reasonable compensation is determined by taking into account “all the circumstances.” The Fourth Circuit further observed that compensation paid by closely held corporations is subject to “close scrutiny” because such payments may be disguised dividends. Ultimately, the Fourth Circuit stated, the reasonableness of compensation is determined based upon a multi-factor analysis which considers the “totality of the circumstances,” including:
the employee’s qualifications; the nature, extent and scope of the employee’s work; the size and complexities of the business; a comparison of salaries paid with gross income and net income; the prevailing general economic conditions; comparison of salaries with distributions to stockholders; the prevailing rates of compensation for comparable positions in comparable concerns; [and] the salary policy of the taxpayer as to all employees.
Moreover, the Fourth Circuit noted that the reasonableness of compensation in closely-held corporations may consider additional factors such as pay for prior years and shareholder-employee guarantees of corporate debt. The Fourth Circuit agreed that the Tax Court (Judge Greaves) properly adopted the multi-factor analysis described above as the test for determining reasonable compensation.
The Fourth Circuit acknowledged that the various factors used to determine reasonable compensation may be viewed from the perspective of a hypothetical independent investor (i.e., whether such an investor would be willing to compensate an employee at the same level). The court declined, however, to accept the taxpayer-corporation’s argument that the Fourth Circuit should reverse the Tax Court and adopt the Seventh Circuit’s “independent investor” test as the exclusive approach to deciding reasonable compensation cases. In Menard, Inc. v. Commissioner, and Exacto Spring Corp. v. Commissioner, Judge Posner used the “independent investor” test to allow a taxpayer to establish a “rebuttable presumption” that compensation is reasonable so long as the corporation’s shareholders are receiving a sufficiently high rate of return on their investment in the stock of the corporation. According to the taxpayer-corporation, if the Tax Court and the Fourth Circuit adopted the Seventh Circuit’s “independent investor” test, they would conclude that Mr. Hood’s compensation was reasonable because the taxpayer-corporation generated a 22% rate of return on equity for its shareholders in 2015 and a 36% rate of return on equity for 2016.
The Fourth Circuit then found no error in the Tax Court’s application of the multi-factor approach to determining reasonable compensation for Mr. Hood. The Fourth Circuit emphasized, as did the Tax Court, that the taxpayer-corporation had never declared or paid a dividend to its shareholders. The Fourth Circuit also emphasized Mr. Hood’s testimony that in 2015 he became aware of the taxpayer-corporation’s need from an “income tax” perspective to begin “getting money out of [the] corporation” to prepare for a “changing of the guard.” The Tax Court also found that the taxpayer-corporation had no “structured system in place” for determining compensation and that Mr. Hood’s compensation was determined for the years in issue solely by himself and his wife as the only members of the board of directors. The Fourth Circuit considered this finding by the Tax Court to be significant, stating it was “glaring” that the taxpayer-corporation’s other officers each received bonuses of $100,000 or less for 2015 and 2016, while Mr. Hood received bonuses of $5 million for each of those years. In addition, the Fourth Circuit thought that the Tax Court’s reliance on comparability data provided by the Service’s expert was appropriate. The Service’s expert acknowledged that, based on comparability data, Mr. Hood deserved compensation in the 99th percentile for similarly situated taxpayers, but that the $5 million bonuses paid in 2015 and 2016 exceeded even that amount. In sum, the Fourth Circuit found that the taxpayer-corporation had not demonstrated on appeal that the Tax Court’s findings or the Service expert’s report were clearly erroneous.
The Fourth Circuit did, however, agree with the taxpayer-corporation that the Tax Court erred in upholding the Service’s imposition of a section 6662 substantial understatement penalty for 2016. The Fourth Circuit believed that the taxpayer-corporation’s reliance upon the professional advice of its accountants for 2016 established reasonable cause, just as the Tax Court had found reasonable cause for 2015 based upon the same professional advice provided to the taxpayer-corporation for that year.
c. Observation. Of course, hindsight is always 20/20, but the authors cannot help but wonder why the taxpayer-corporation in this case was not an S corporation. Perhaps the capital-intensive nature of the excavation and grading business conducted by the taxpayer-corporation argued for C corporation status and lower corporate-level income tax rates. Yet, the taxpayer-corporation had only two individual shareholders, Mr. Hood and his wife, and seemingly could have been an S corporation. Presumably, because the taxpayer is a C corporation, the Service will assert that the amount of excess compensation paid to Mr. Hood for 2015 and 2016 constitutes disguised dividends to Mr. Hood and his wife for those years. Thus, the taxpayer-corporation’s and Mr. Hood’s IRS troubles may not be over.
Notice 2024-8. The standard mileage rate for business miles in 2024 goes up to 67 cents (from 65.5 cents in 2023) and the medical/moving rate goes down to 21 cents per mile (from 22 cents in 2023). The charitable mileage rate remains fixed by section 170(i) at 14 cents. The portion of the business standard mileage rate treated as depreciation goes up to 30 cents per mile (from 28 cents in 2023). The maximum standard automobile cost may not exceed $62,000 (up from $60,800 in 2023) for passenger automobiles (including trucks and vans) for purposes of computing the allowance under a fixed and variable rate (FAVR) plan.
The notice reminds taxpayers that (1) the business standard mileage rate cannot be used to claim an itemized deduction for unreimbursed employee travel expenses because, in the 2017 Tax Cuts and Jobs Act, Congress disallowed miscellaneous itemized deductions for 2024, and (2) the standard mileage rate for moving has limited applicability for the use of an automobile as part of a move during 2024 because, in the 2017 Tax Cuts and Jobs Act, Congress disallowed the deduction of moving expenses for 2024 (except for members of the military on active duty who move pursuant to military orders incident to a permanent change of station, who can still use the standard mileage rate for moving).
The following table summarizes the optional standard mileage rates:
| Category | 2022 | 2023 | 2024 | |
|---|---|---|---|---|
| Jan.-Jun. | Jul.-Dec. | |||
| Business miles | 58.5 cents | 62.5 cents | 65.5 cents | 67 cents |
| Medical/moving | 18 cents | 22 cents | 22 cents | 21 cents |
| Charitable mileage | 14 cents | 14 cents | 14 cents | 14 cents |
The Inflation Reduction Act amended sections 30C, 45, 45L, 45Q, 48, 48C, and 179D to provide increased credit or deduction amounts for taxpayers who satisfy certain requirements. The same legislation added sections 45U, 45V, 45Y, 45Z, and 48E to the Code to provide new credits, which also contain provisions for increased credit amounts for taxpayers who satisfy certain requirements. Specifically, increased credit amounts are available under sections 30C, 45, 45Q, 45V, 45Y, 45Z, 48, 48C, and 48E, and an increased deduction is available under section 179D, for taxpayers satisfying certain prevailing wage and apprenticeship requirements. Increased credit amounts are available under sections 45L and 45U for taxpayers satisfying certain prevailing wage requirements. Generally, if a taxpayer satisfies the prevailing wage and apprenticeship requirements or the prevailing wage requirements, whichever one applies (or meets an exception to these requirements), the amount of the credit or deduction is equal to the otherwise determined amount of the credit or deduction multiplied by five.
a. The Service has provided initial guidance on the prevailing wage and apprenticeship requirements. This notice provides guidance on the prevailing wage and apprenticeship requirements that generally apply to certain provisions of the Code, as amended by the Inflation Reduction Act. As amended by the Inflation Reduction Act, these provisions generally authorize an increased credit or deduction if a taxpayer meets either prevailing wage requirements (as in the case of the credit authorized by section 45L) or prevailing wage and apprenticeship requirements. A facility generally must meet the prevailing wage and apprenticeship requirements to receive the increased credit or deduction amounts under sections 30C, 45, 45Q, 45V, 45Y, 48, 48E, and 179D if construction (or installation for purposes of section 179D) of the facility begins on or after the date 60 days after the Secretary publishes guidance with respect to the prevailing wage and apprenticeship requirements of the Code. The notice serves as the published guidance establishing the 60-day period and provides that the date that is 60 days after the Secretary published guidance is January 30, 2023. The notice also provides guidance for determining the beginning of construction of a facility for certain credits allowed under the Code, and the beginning of installation of certain property with respect to the energy efficient commercial buildings deduction under the Code. The notice provides that Treasury and the Service anticipate issuing proposed regulations and other guidance with respect to the prevailing wage and apprenticeship requirements.
b. Proposed regulations provide further guidance on the prevailing wage and apprenticeship requirements. The Treasury Department and the Service have issued proposed regulations under a variety of Code provisions to reflect legislative changes enacted in August 2022 by the Inflation Reduction Act. The Inflation Reduction Act amended sections 30C, 45, 45L, 45Q, 48, 48C, and 179D to provide increased credit or deduction amounts for taxpayers who satisfy certain requirements. The same legislation added sections 45U, 45V, 45Y, 45Z, and 48E to the Code to provide new credits, which also contain provisions for increased credit amounts for taxpayers who satisfy certain requirements. Specifically, increased credit amounts are available under sections 30C, 45, 45Q, 45V, 45Y, 45Z, 48, 48C, and 48E, and an increased deduction is available under section 179D, for taxpayers satisfying certain prevailing wage and apprenticeship requirements. Increased credit amounts are available under sections 45L and 45U for taxpayers satisfying certain prevailing wage requirements. Generally, if a taxpayer satisfies the prevailing wage and apprenticeship requirements or the prevailing wage requirements, whichever one applies (or meets an exception to these requirements), the amount of the credit or deduction is equal to the otherwise determined amount of the credit or deduction multiplied by five.
c. Prevailing wage and apprenticeship requirements. Generally, a taxpayer satisfies the prevailing wage requirements if the taxpayer ensures that laborers and mechanics employed by the taxpayer (or by any contractor or subcontractor) in the construction, alteration, or repair of a facility are paid wages at rates not less than those set forth in applicable wage determinations issued by the Secretary of Labor. For this purpose, the applicable general wage determination is the wage determination in effect for the specified type of construction in the geographic area when the construction, alteration, or repair of the facility begins. A taxpayer satisfies the apprenticeship requirement by ensuring that two basic requirements are met. First, qualified apprentices must perform not less than the “applicable percentage” of the total labor hours of the construction, alteration, or repair work of any qualified facility (referred to as the labor hours requirement). For this purpose, the applicable percentage is 10 percent, 12.5 percent, or 15 percent, depending on when construction of the facility begins. Second, a taxpayer, contractor, or subcontractor who employs four or more individuals to perform construction, alteration, or repair work with respect to the construction of a qualified facility must employ one or more qualified apprentices to perform the work (referred to as the participation requirement). The proposed regulations provide that construction, alteration, or repair does not include maintenance work that occurs after the facility is placed in service. For this purpose, maintenance is work that is ordinary and regular in nature and designed to maintain the existing functionality of a facility as opposed to an isolated or infrequent repair of a facility to restore specific functionality or adapt it for a different or improved use.
d. Correction of failure to satisfy the prevailing wage and apprenticeship requirements. The proposed regulations permit a taxpayer who claims the increased credit or deduction and who fails to satisfy the prevailing wage requirement to cure the failure. To do so, a taxpayer must (1) pay any laborer or mechanic who was not paid a prevailing wage the difference between the prevailing wage required and the amount actually paid plus interest at the federal short-term rate plus 6 percentage points, and (2) pay a penalty of $5,000 for each laborer or mechanic who was not paid a prevailing wage. The penalty generally is waived with respect to a laborer or mechanic if the taxpayer makes a correction payment by the earlier of 30 days after the taxpayer becomes aware of the error or the date on which the increased credit is claimed and if certain other requirements are met. The correction payment is increased to three times the normal amount and the penalty is increased to $10,000 per laborer or mechanic if the Service determines that the failure to satisfy the prevailing wage requirement was intentional. The proposed regulations also provide a mechanism for a taxpayer to cure a failure to satisfy the apprenticeship requirement. Generally, a taxpayer can cure such a failure either by submitting requests for apprentices or paying a penalty equal to $50 for each labor hour for which the apprenticeship requirements (either the labor hours requirement or participation requirement) were not satisfied. The $50 per hour penalty is increased to $500 per hour if the Service determines that the failure to satisfy the apprenticeship requirements was intentional.
e. Recordkeeping requirements. The proposed regulations provide guidance on the types of records taxpayers should maintain to demonstrate compliance with the prevailing wage and apprenticeship requirements. At a minimum, to demonstrate compliance with the prevailing wage requirement, those records include payroll records for each laborer and mechanic (including each qualified apprentice) employed by the taxpayer, contractor, or subcontractor in the construction, alteration, or repair of the qualified facility. In addition, the proposed regulations provide that records sufficient to demonstrate compliance with the prevailing wage requirement may include eight other categories of records, including identifying information (such as name, social security or tax identification number, address, telephone number, and email address) for each laborer or mechanic (including qualified apprentices) employed. The proposed regulations provide that sufficient records to demonstrate compliance with the apprenticeship requirements may include (1) any written requests for the employment of apprentices from registered apprenticeship programs, including any contacts with the Department of Labor or state apprenticeship agency regarding requests for apprentices, (2) any agreements entered into with registered apprenticeship programs with respect to the construction, alteration or repair of the facility, (3) documents reflecting the standards and requirements of any registered apprenticeship program, including the ratio requirement prescribed by each program, (4) the total number of labor hours worked by apprentices, and (5) records reflecting the daily ratio of apprentices to journeyworkers.
f. Effective date and period for comments. The proposed regulations would apply to facilities, property, projects, or equipment placed in service in taxable years ending after the date on which final regulations are published as final in the Federal Register and the construction or installation of which begins after the date on which final regulations are published. Nevertheless, taxpayers can rely on the proposed regulations with respect to construction or installation of a facility, property, project, or equipment beginning on or after January 29, 2023, and on or before the date final regulations are published, provided that, beginning after the date that is 60 days after August 29, 2023, taxpayers follow the proposed regulations in their entirety and in a consistent manner. Treasury and the Service have invited comments on the proposed regulations. Any comments must be submitted by October 30, 2023. A public hearing on the proposed regulations is scheduled for November 21, 2023.
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, which is adjusted for inflation for taxable years beginning after 2020. For 2022, this figure is $1.88 per square foot. As in effect for 2022, the improvements must reduce energy and power costs by 50 percent or more in comparison to certain standards. In the Inflation Reduction Act, section 13303, 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 percent in comparison to certain standards (rather than by 50 percent). 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 percent 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 percent 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.
For guidance on the prevailing wage and apprenticeship requirements that make the taxpayer eligible for an increased deduction under section 179D, including proposed regulations issued in August 2023, see item II.D.2 in this outline.
Rev. Proc. 2023-14. 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. The Service has published depreciation tables with the 2023 depreciation limits for business use of passenger automobiles acquired after September 27, 2017, and placed in service during 2023:
| 2023 Passenger Automobiles with section 168(k) first year recovery | |
|---|---|
| 1st Tax Year | $20,200 |
| 2nd Tax Year | $19,500 |
| 3rd Tax Year | $11,700 |
| Each Succeeding Year | $6,960 |
| 2023 Passenger Automobiles (no section 168(k) first year recovery): | |
|---|---|
| 1st Tax Year | $12,200 |
| 2nd Tax Year | $19,500 |
| 3rd Tax Year | $11,700 |
| Each Succeeding Year | $6,960 |
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 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 2023. For 2023, this income inclusion applies when the fair market value of the vehicle exceeds $60,000.
Congress has modified and extended through 2032 the section 45L credit for eligible contractors that build and sell new energy-efficient homes. Under current law, section 45L provides a credit of $2,000 or $1,000 (depending on the projected level of fuel consumption) an eligible contractor can claim for each qualified new energy-efficient home constructed by the contractor and acquired by a person from the contractor for use as a residence during the tax year. The Inflation Reduction Act, section 13304, 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 that meet certain Energy Star efficiency standards, the credit is $500 per unit and is $1,000 per unit for zero-energy ready multifamily dwellings. 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.
For guidance on the prevailing wage requirements that make the taxpayer eligible for an increased credit under section 45L, including proposed regulations issued in August 2023, see item II.D.2 in this outline.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
In Rev. Proc. 2023-23, the Service issued the inflation-adjusted figures for contributions to health savings accounts. For calendar year 2024, the annual limitation on deductions under section223(b)(2)(A) for an individual with self-only coverage under a high deductible health plan is increased to $4,150 (from $3,850 in 2023). For calendar year 2024, the annual limitation on deductions under section 223(b)(2)(B) for an individual with family coverage under a high deductible health plan is increased to $8,300 (from $7,750 in 2023). For this purpose, for calendar year 2024, 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 $1,600 (increased from $1,500 in 2023) for self-only coverage or $3,200 (increased from $3,000 in 2023) for family coverage, and for which the annual out-of-pocket expenses (deductibles, co-payments, and other amounts, but not premiums) do not exceed $8,050 for self-only coverage (increased from $7,500 in 2023) or $16,100 for family coverage (increased from $15,000 in 2023).
The following table summarizes the limits for contributions to health savings accounts:
| Health Savings Account Limitations | ||||
|---|---|---|---|---|
| Category | Self-Only Coverage | Family Coverage | ||
| 2023 | 2024 | 2023 | 2024 | |
| Limit on Deductions for Contributions to HSAs | $3,850 | $4,150 | $7,750 | $8,300 |
| High-Deductible Health Plan | ||||
| Minimum Deductible | $1,500 | $1,600 | $3,000 | $3,200 |
| Limit on Out-of-Pocket Expenses | $7,500 | $8,050 | $15,000 | $16,100 |
Treasury and the Service have issued proposed regulations that address required minimum distributions (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 of 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.
a. The SECURE Act changes to RMDs from inherited retirement accounts. SECURE Act, section 401 amended section 401(a)(9)(E) to modify the required minimum distribution (RMD) rules for inherited retirement accounts (defined contribution plans and IRAs). The amendments require all funds to be distributed by the end of the 10th calendar year following the year of death (the “10-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 10 years younger than the deceased individual. These changes generally apply to distributions with respect to those who die after December 31, 2019.
b. The proposed regulations’ interpretation of the SECURE Act. The proposed regulations adopt an interpretation of the 10-year rule that appears to differ from the plain language of the statute and from the interpretation of the legislation 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 10th 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 for distributions, the proposed regulations provide that no distribution is required before the 10th calendar year following the year of death. However, in situations in which the employee or IRA owner dies after the required beginning date for distributions, the proposed regulations provide that a designated beneficiary who is not an eligible designated beneficiary must take RMDs before the 10th 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 the legislation of most advisors, but also from IRS Publication 590-B, which was issued for 2021. IRS Publication 590-B 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 10-year rule did not take distributions in 2021.
c. 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. This notice 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 10-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, then an excise tax is imposed equal to 50 percent of the amount by which the RMD exceeds the amount actually distributed. The notice provides that the Service will not assert that an excise tax is due under section 4974 from an individual who did not take a “specified RMD.” It also provides that, if an individual paid an 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 10-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) were required to take RMDs in 2021 or 2022 under the interpretation of the 10-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 interpretation of the 10-year rule in the proposed regulations. 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.
d. The Service has granted a further reprieve: the Service will not assert that the excise tax of section 4974 is due from those who failed to take certain RMDs from inherited retirement accounts in 2021, 2022, or 2023. This notice announces that, when the proposed regulations described above become final, the final regulations will apply no earlier than the 2024 calendar year. The notice provides that the Service will not assert that an excise tax is due under section 4974 from an individual who did not take a “specified RMD.” 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, 2021, or 2022 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 section401(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 10-year rule), (2) inherited the retirement account from an employee or IRA owner who died in 2020, 2021, or 2022 and on or after the required beginning date of distributions, and (3) were required to take RMDs in 2021, 2022, or 2023 under the interpretation of the 10-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, 2021, or 2022 and was taking lifetime or life expectancy distributions.
The notice also grants relief to those who attained age 72 in 2023 and received distributions from January 1 through July 31, 2023, that are mischaracterized as RMDs. Taxpayers who attain age 72 in 2023 are not required to begin taking RMDs for 2023 because Congress increased the age at which RMDs must begin to age 73 for those who attain age 73 after 2022. The Notice gives such taxpayers until September 30, 2023, to deposit such amounts in an eligible retirement plan and treat the deposits as a tax-free rollover. This aspect of the notice is discussed in more detail below in connection with the discussion of the change in the age at which RMDs must begin.
SECURE 2.0 Act, section 107 amended section 401(a)(9)(C)(i)(I) to increase the age at which required minimum distributions (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 or, 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.
a. Those born in 1951 (and who therefore attain age 72 in 2023) and who received distributions from January 1 through July 31, 2023, that are mischaracterized as RMDs have until September 30, 2023, to deposit such amounts in an eligible retirement plan and treat the deposit as a tax-free rollover. Plan administrators and other payors made the Service aware that automated payment systems would need to be updated to reflect the legislative change in the age at which RMDs must begin. Because such changes could take time, it is possible that those born in 1951 and who therefore attain age 72 in 2023 would receive distributions in 2023 that are mischaracterized as RMDs (and therefore normally ineligible for rollover). This notice grants relief targeted at this situation. For employer-sponsored plans, the notice provides that (1) payors or plan administrators will not be treated as having failed to satisfy applicable requirements based on failure to treat a distribution as an eligible rollover distribution merely because the plan made a distribution from January 1, 2023, through July 31, 2023, to a participant born in 1951 (or the participant’s surviving spouse) that would have been an RMD if Congress had not increased the age at which RMDs must begin from 72 to 73, and (2) participants born in 1951 who received such a distribution have until September 30, 2023, to roll over the mischaracterized distribution. For IRAs, the notice provides similar relief and specifies that IRA owners born in 1951 (or the owner’s surviving spouse) who received a distribution from the IRA from January 1, 2023, through July 31, 2023, that would have been an RMD if Congress had not increased the age at which RMDs must begin from 72 to 73 can roll over the mischaracterized distribution to an eligible retirement plan if they do so by September 30, 2023. Although IRA owners normally can make only one tax-free rollover in a 12-month period, the notice provides that IRA owners entitled to the relief provided by the notice can roll over the mischaracterized distribution even if they have already rolled over a distribution in the previous 12 months. A rollover of the mischaracterized distribution, however, will preclude the IRA owner from rolling over another distribution in the succeeding 12 months (but could still make a direct trustee-to-trustee transfer as described in Rev. Rul. 78-406).
SECURE 2.0 Act, section 603 amended section 414(v) by adding new secrtion 414(v)(7), effective in 2024. 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.
a. Apparently, the Service can simply ignore the effective date of a legislative change. The Service has announced a two-year “administrative transition period” that has the effect of delaying the effective date of the “Roth-only” rule for catch-up contributions until taxable years beginning after 2025. In response to concerns expressed by taxpayers regarding the timely implementation of the new “Roth-only” rule (new section 414(v)(7)) enacted as part of the Consolidated Appropriations Act, 2023, for catch-up contributions by employees with wages in the preceding calendar year that exceeded $145,000, the Service has effectively delayed the effective date of the Roth-only rule. As enacted, the Roth-only rule applies to taxable years beginning after December 31, 2023. In this notice, however, the Service has announced a two-year “administrative transition period.” Specifically, until taxable years beginning after December 31, 2025:
(1) … catch-up contributions will be treated as satisfying the requirements of section 414(v)(7)(A), even if the contributions are not designated as Roth contributions, and (2) a plan that does not provide for designated Roth contributions will be treated as satisfying the requirements of section 414(v)(7)(B).
The notice also announces that the Treasury Department and the Service plan to issue further guidance to assist taxpayers with the implementation of the new Roth-only rule. The guidance expected to be issued includes:
The Treasury Department and the Service have invited comments regarding the matters discussed in the notice and any other aspect of the new Roth-only rule. Comments must be submitted on or before October 24, 2023.
The Service and Treasury have announced that future guidance will be issued regarding the treatment of certain nonfungible tokens (“NFTs”) as “collectibles” under section 408(m). According to the Service:
[a]n NFT is a unique digital identifier that is recorded using distributed ledger technology and may be used to certify authenticity and ownership of an associated right or asset.
Put differently, NFTs are akin to electronic works of art, such as digital images, animations, or videos, that are bought and sold via the internet. Each NFT is a unique, one-of-a-kind digital asset or one-in-a-series of authorized digital copies. So-called “blockchain” technology identifies ownership and facilitates transfers of NFTs via the internet, like the way that cryptocurrency (which, BTW, is a “fungible” digital asset) is used to pay for goods and services via the internet. If an asset (digital or otherwise) is a “collectible” under section 408(m), then the acquisition of such an asset by an IRA or section 401 self-directed qualified plan is treated as distribution of the asset at cost to the account holder, with the attendant tax consequences. Furthermore, the sale or exchange of a “collectible” that is a capital asset held long-term is subject to the maximum 28% capital gains rate under section 1(h)(4) and (5). Whether an asset is a “collectible” also is relevant for other sections of the Code, including section 45D (new markets tax credit) and section 1397C (enterprise zone business defined). Certain coins and bullion are excluded from the definition of a “collectible” under section 408(m)(3). In Notice 2023-27, the Service and Treasury have announced that future guidance will determine whether an NFT is a section 408(m) “collectible” by applying a “look-through” analysis. Thus, the Service and Treasury will define an NFT as a “collectible” if the associated right or asset underlying the NFT would be a “collectible” under section 408(m). The notice elaborates:
For example, a gem is a section 408(m) collectible under section 408(m)(2)(C), and therefore an NFT that certifies ownership of a gem constitutes a section 408(m) collectible. Similarly, an NFT does not constitute a section 408(m) collectible if the NFT’s associated right or asset is not a section 408(m) collectible. For example, a right to use or develop a “plot of land” in a virtual environment generally is not a section 408(m) collectible, and therefore, an NFT that provides a right to use or develop the “plot of land” in the virtual environment generally does not constitute a section 408(m) collectible.
The notice also raises the issue of whether an NFT digital file itself (apparently, apart from its associated right or asset) constitutes a “work of art” such that it would be considered a “collectible” within the meaning of section 408(m)(2)(A). Notice 2023-27 states that the Service and Treasury are considering this issue further. The notice also lists no less than ten different questions regarding NFTs for which the Service and Treasury invite comments, as well as any other aspects of NFTs relating to their treatment as “collectibles” that commentators consider relevant. Comments were due by June 19, 2023.
In a memorandum opinion, the Tax Court (Jude Nega) has 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 thereunder 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.” 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.
a. Judge Nega’s Opinion. Judge Nega agreed with the Service and relied on the regulations under section 461 and section 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.
b. Comment. Hoops argued that the $10.7 million nonqualified deferred compensation arrangement should not be considered a “liability” includable in amount realized under section1001(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.”
c. Appeal: Hoops has appealed to the U.S. Court of Appeals for the Seventh Circuit.
On appeal, in an opinion by Judge Scudder, the U.S. Court of Appeals for the Seventh Circuit agreed with the Tax Court that section 404(a)(5) controlled the outcome in this case and disallowed any deduction for Hoops unless and until the deferred compensation is included in the gross income of the players. Hoops made the same argument to the Seventh Circuit that it made in the Tax Court, i.e., that Regulation section 1.461-4(d)(5)(i) allows acceleration of the deduction for the deferred compensation obligation in the context of a sale of a trade or business. As noted earlier, Regulation section1.461-4(d)(5)(i) 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.
Judge Scudder disagreed, though, reasoning that the above-quoted regulation applies where economic performance has not occurred. Here, there was no dispute that economic performance had occurred because the deferred compensation was attributable to the players’ past services rendered in prior NBA seasons. Judge Scudder wrote:
Therein lies the fundamental flaw in Hoops’s argument: it was not section 461(h)’s economic performance requirement that prevented Hoops from taking the deduction in 2012, but the rule in section 404(a)(5) governing nonqualified deferrecompensation plans.
Hoops further urged the Seventh Circuit to consider the practical implications of its decision. Specifically, Hoops argued that the deduction could be lost altogether (even though it clearly would be allowed if Hoops paid the deferred compensation at the time of sale) if the buyer, the Memphis Grizzlies, fails to pay the players or fails to communicate to Hoops the fact that the players have been paid. Judge Scudder responded:
But any risk of losing the deferred compensation deduction is foreseeable, especially given the clear instructions from Congress in section 404(a)(5). We agree with the Commissioner’s suggestion that Hoops could have avoided this tax-deduction problem in many ways—by adjusting the sales price to reflect the deductibility, contributing to qualified plans for the players to take earlier deductions, or renegotiating the players’ contracts and accelerating their compensation to the date of the sale.
Comment. As noted above, Hoops argued in the Tax Court that the $10.7 million nonqualified deferred compensation arrangement should not be considered a “liability” includable in amount realized under section1001(b) and Regulation section 1.1001-2(a)(1) in connection with the sale. Hoops apparently did not make this argument before the Seventh Circuit, so Judge Scudder did not address the issue. In the authors’ opinion, the problem in this case stems from Hoops’s inclusion of the $10.7 million deferred compensation obligation in amount realized upon the sale to the Memphis Grizzlies. If Hoops had not so included the $10.7 million “liability” in amount realized—based upon the authorities discussed by the authors above—then Hoops’s gain on the sale would have been correspondingly decreased, thereby avoiding the adverse effect of section 404(a)(5).
The taxpayer in this case was the estate of the well-known actor, James Caan, star of many movies including The Godfather (1972), Rollerball (1975), Misery (1990), and Elf (2003). James Caan died in 2022, but the facts relevant to this case arose in 2014-2017. During that time, Caan’s financial and business affairs were handled by a firm in California, Philpott, Bills, Stohl, and Meeks, LLP (“PBSM”). Caan held two IRAs with UBS as custodian in 2014 and most of 2015. One of Caan’s IRAs held a nontraditional asset, a partnership interest in a private hedge fund. The IRA custodian, UBS, was required by section 408(i) to report annually to the Service the fair market value of the IRA’s interest in the hedge fund. Because the interest in the hedge fund was not publicly traded, the IRA custodial agreement required Mr. Caan to specify to UBS each year the fair market value of the hedge fund interest. PBSM generally acted as Caan’s agent in these circumstances, received Caan’s mail, and liaised with Caan’s other professional and financial advisors. The following events then occurred in 2015, 2016, and 2017:
Caan’s 2015 federal income tax return reported all of his 2015 IRA rollovers from UBS to Merrill Lynch, including the distribution of the hedge fund interest, but took the position that the hedge fund interest was rolled over to Merrill Lynch along with Caan’s other IRA assets previously held at UBS. Upon examination—no doubt based upon the 2015 Form 1099-R issued by UBS—the Service disagreed with Caan’s position regarding the rollover of the hedge fund interest. Accordingly, in 2018 the Service issued Caan a notice of deficiency for 2015 concerning the reported UBS IRA distribution of the hedge fund interest. Caan timely filed a petition in Tax Court. Around the same time the petition was filed, Caan requested a private letter ruling from the Service granting him a waiver of the 60-day IRA rollover period with respect to the distributed interest in the hedge fund. See section 408(d)(3)(I). The Service denied the requested private letter ruling, citing the “same property” requirement for IRA rollovers under section 408(d)(3)(A)(i) and (D) as interpreted by Lemishow v. Commissioner. Thus, the issues before the Tax Court were (i) whether UBS distributed the hedge fund interest to Caan in 2015 and (ii) if so, whether the distribution was taxable and in what amount.
a. The Estate’s Arguments. Caan’s estate made three principal arguments that the UBS “distribution” (as described above) of the hedge fund interest was nontaxable to Caan in 2015 or, if taxable at all, was not $1,910,903 as reported by UBS on the Form 1099-R issued to Caan for 2015. The estate first argued that, despite UBS’s resignation letter to the contrary, UBS never actually distributed the hedge fund interest to Caan (i.e., it was a “phantom distribution” over which Caan had no control). And, even if UBS did distribute the interest, the distribution qualified for rollover treatment under section 408(d)(3). The estate also argued that the 2015 Form 1099-R sent by UBS was “a useless, inaccurate, [and] unreliable document” not determinative of the tax treatment or value of Caan’s hedge fund interest for 2015. Finally, the estate argued that the Service erred in denying Caan’s private letter ruling request for a waiver of the normal 60-day IRA rollover period with respect to the hedge fund interest. Caan’s estate cited section 408(d)(3)(I) as support for its argument. Section 408(d)(3)(I) states in relevant part that the Service may waive the 60-day rollover requirement where failure to do so “would be against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to such requirement.”
b. Tax Court Opinion. With respect to Caan’s argument that he never received a distribution of the hedge fund interest from UBS because he never had control over the interest or, alternatively, that any such distribution qualified for rollover treatment under section 408(d)(3), Judge Copeland disagreed. Judge Copeland pointed to UBS’s December 2015 letter specifically advising PBSM and Caan to contact the hedge fund itself for purposes of re-registering the interest into Caan’s name or having the interest registered in the name of another IRA custodian. Judge Copeland elaborated:
There are three problems with the way the [hedge fund interest] was handled. First, and most importantly, in liquidating the [hedge fund interest] Mr. Caan changed the character of the property; yet section 408(d)(3)(A)(i) required him to contribute the [hedge fund interest] itself, not cash, to another IRA in order to preserve its tax-deferred status. Second, the contribution of the cash proceeds from the liquidation occurred long after the January 25, 2016, deadline. And finally, the [hedge fund’s] three transfers [of cash] to the Merrill Lynch IRA constituted three separate contributions; yet section 408(d)(3)(B) allows for only one rollover contribution in any one-year period, making only the first transfer potentially eligible for a tax-free rollover.
With respect to the estate’s argument that UBS’s 2015 Form 1099-R erroneously reported a distribution to Caan of $1,910,903, Judge Copeland partially agreed. Judge Copeland reasoned that, as discussed above, UBS did in fact distribute the hedge fund interest to Caan on November 25, 2015; however, the value of the distribution for income tax purposes was $1,548,010, not the $1,910,903 value reported by UBS and not the $1,532,605.46 in cash proceeds resulting from the liquidation of the interest in 2017. Judge Copeland based her decision on the Service’s position that the hedge fund’s 2014 ending capital account for Caan’s partnership interest was $1,548,010 (presumably, a booked-to-market value). Moreover, Caan’s estate had not proposed or proven any other value. Thus, Judge Copeland set the amount of Caan’s 2015 taxable distribution from his UBS IRA at $1,548,010.
Lastly, Judge Copeland held that the Service properly denied Caan’s private letter ruling request for a waiver of the 60-day rollover period concerning the hedge fund interest. Before so holding, though, Judge Copeland acknowledged that the estate’s argument regarding the Service’s denial raised two issues of first impression for the Tax Court: (i) whether the court had jurisdiction to review the Service’s denial, and (ii) if so, the proper standard of review. Concerning whether the Tax Court had jurisdiction to review the Service’s denial, Judge Copeland relied upon Trimmer v. Commissioner, a case with similar circumstances but arising under section 402 (not section 408) in connection with a distribution from an employer plan. The court in Trimmer held that the Tax Court had jurisdiction to review the Service’s denial of a hardship waiver under section 402(c)(3) pursuant to its power to redetermine deficiencies under section 6213. Furthermore, Trimmer established that the appropriate standard of review with respect to the Service’s denial in that case was abuse of discretion. Therefore, Judge Copeland concluded that Trimmer applied to permit the court to review the Service’s denial under section 408(d)(3)(I) of Caan’s private letter ruling waiver request using an abuse of discretion standard. Judge Copeland then considered the circumstances surrounding the Service’s denial of Caan’s waiver request under section 408(d)(3)(I). Based upon those circumstances, Judge Copeland determined that the Service had not abused its discretion. Judge Copeland reasoned that in this case the property distributed from Caan’s IRA, the hedge fund interest, subsequently was converted to cash, and thus no IRA rollover was available to Caan under the “same property” rule of section 408(d)(3)(A)(i) and (D) as interpreted by Lemishow. Judge Copeland wrote, “It cannot be an abuse of discretion for the Service to deny a waiver where granting the waiver would not have helped the taxpayer in any way.”
There were no significant developments regarding this topic during 2023.
A cash method taxpayer who receives additional units of cryptocurrency as a reward for participating in a validation process by staking the taxpayer’s holdings through a cryptocurrency exchange has gross income equal to the fair market value of the units received in the year in which the taxpayer gains dominion and control over the validation rewards. This ruling addresses the tax consequences for a cash-method taxpayer who receives units of cryptocurrency as a reward for performing so-called validation services in connection with cryptocurrency transactions. Many cryptocurrencies such as Bitcoin use blockchain technology. Generally, blockchain, which is one form of distributed ledger technology, is a storage technology that is used for saving data on decentralized networks. Blockchain stores information in batches called blocks, which are linked together in a sequential way. The creation of new blocks on a blockchain requires the participation of multiple validators who validate the legitimacy of transactions. The validators receive as a reward one or more newly-created units of the cryptocurrency native to the blockchain. In one form of this validation process, those validating stake their holdings in cryptocurrency. If the validation is successful, the validator receives a reward. If the validation is unsuccessful, the validator may forfeit some or all of the staked units. The ruling addresses a set of facts in which a cash method taxpayer stakes 200 units of a cryptocurrency, validates a new block of transactions, and receives 2 units of cryptocurrency asa reward. The ruling concludes as follows:
If a cash-method taxpayer stakes cryptocurrency native to a proof-of-stake blockchain and receives additional units of cryptocurrency as rewards when validation occurs, the fair market value of the validation rewards received is included in the taxpayer’s gross income in the taxable year in which the taxpayer gains dominion and control over the validation rewards. The fair market value is determined as of the date and time the taxpayer gains dominion and control over the validation rewards. The same is true if a taxpayer stakes cryptocurrency native to a proof-of-stake blockchain.
The ruling cautions that it does not address issues that might arise under any rules not cited in the ruling, including section 83.
In 2022, some states made payments to individuals residing in those states. The payments generally were related to the COVID-19 pandemic. The Service issued a news release on February 10, 2023, IR-2023-23, to provide certainty for the 2023 filing season for 2022 returns. The news release provided that, in the best interest of sound tax administration, the Service would not challenge a taxpayer’s exclusion of these payments from gross income. The news release identified 17 states that qualified for this treatment. That guidance, however, applied only for tax year 2022. This notice provides guidance for 2023 and future years. The notice addresses the general tax treatment of a state refund of tax. If the payment is a refund of tax, then it is not included in a taxpayer’s gross income except to the extent required by the tax benefit rule, i.e., to the extent the taxpayer deducted the payment and received a tax benefit from the deduction in a prior year. (A state payment if considered a refund of tax only to the extent that the payment is limited to taxes paid.) The notice also addresses payments received from states that are eligible for exclusion under the general welfare exclusion. To qualify for the general welfare exclusion, state payments must (1) be paid from a governmental fund, (2) be for the promotion of general welfare (that is, based on the need of the individual or family receiving such payments), and (3) not represent compensation for services absent a specific Federal income tax exclusion. The notice provides examples of payments that qualify, such as payments to eligible residents under an “Energy Relief Payment Program” to help those low-income residents who may not otherwise be able to afford to pay their heating bills.
Section 183 applied to limit deductions, because the taxpayer covered year-over-year losses from his trust fund, ignored cost-saving strategies because he was “not so much [concerned about] income and expenses,” threw “pretty lavish parties” attended by people “you would never meet otherwise,” intermingled personal and company expenses (including wedding costs), and lived rent-free on the company farm. The headline more or less sums up this case from the U.S. Court of Appeals for the Third Circuit affirming the Tax Court. The taxpayers were owners of a horse-breeding farm conducted through an LLC classified as a partnership for federal income tax purposes. The LLC had operated at a loss for twelve consecutive years before the taxpayers were audited by the Service for losses claimed via the LLC with respect to their taxable years 2010-2013. The Service assessed a deficiency on the grounds that section 183 applied to disallow any deductions in excess of the income from the LLC for the years 2010-2013. The taxpayers petitioned the Tax Court, which upheld the proposed deficiency. The taxpayers appealed to the Third Circuit, alleging that the Tax Court misapplied the nine-factor test under Regulation section 1.183-2(b) for determining whether an activity is engaged in for profit: (1) the manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his advisors; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer’s history of income or losses with respect to the activity; (7) the amount of occasional profits, if any; (8) the financial status of the taxpayer; and (9) elements of personal pleasure or recreation. Judge Lauber of the Tax Court found that five factors (1, 6, 7, 8, and 9) favored the Service, three factors (3, 4, and 5) were neutral, and only one factor (2) favored the taxpayers. The Third Circuit, in an opinion written by Judge Hardiman, essentially agreed with Judge Lauber’s analysis of the nine factors and found no clear error in the Tax Court’s ultimate conclusion that the taxpayers’ horse breeding activity was not engaged in for profit for years 2010-2013 within the meaning of section 183. On the one hand, Judge Hardiman reiterated the facts stated in the headline above, especially the LLC’s long history of operating losses prior to and after the period 2010-2013 (factor 6). Judge Hardiman also reasoned that, as Judge Lauber emphasized, factor 8 (financial status of the taxpayer) favored the Service because the taxpayers continually used trust funds and income from other activities to prop up the LLC’s year-over-year losses. On the other hand, Judge Hardiman was mildly critical of Judge Lauber’s analysis of factor 7 (occasional profits) because the taxpayers were able to show that a third party paid $325,000 for a 15% interest in the LLC in 2001 and the LLC made a small profit in 2016 from the sale of an interest in one breeding horse. Ultimately, though, Judge Hardiman ruled that Judge Lauber had not erred in holding that factor 7 favored the Service. Similarly, Judge Hardiman critiqued Judge Lauber’s analysis of factor 9 (elements of personal pleasure or recreation). Judge Hardiman did not view the evidence as supporting the conclusion that the opportunity for socializing, as opposed to making a profit, was the primary motive of the taxpayers vis-à-vis the LLC’s activities. Nevertheless, considering that the LLC’s farm was used rent-free by the taxpayers as a residence and that personal expenditures (including wedding costs) were intermingled with horse-breeding expenses, Judge Hardiman agreed with Judge Lauber that factor 9 favored the Service. Lastly, concerning a separate issue of whether the taxpayers were entitled to NOL carryforwards from years prior to 2010, Judge Hardiman ruled that Judge Lauber had not clearly erred in finding that the taxpayers failed to adequately substantiate such carryforward losses.
“Pease” limitation of section 67 regarding miscellaneous itemized deductions sinks hobby loss expenses otherwise allowable under section 183(b)(2) for taxpayer’s yacht chartering activity. The taxpayer in this case engaged in a yacht chartering activity where expenses equaled or exceeded the taxpayer’s gross income from the activity during taxable years 2014 and 2015. During the audit and in Tax Court, the taxpayer and the Service agreed that the taxpayer’s yacht chartering activity during the years in issue was subject to the hobby loss rules of section 183. Consequently, the taxpayer and the Service further agreed that any deductible expenses from the yacht chartering activity during those years were subject to the gross income limitation of section 183(b)(2). The taxpayer and the Service disagreed, however, whether the deductions otherwise allowable under section 183(b)(2) are (i) permitted above-the-line as an offset against gross income in determining adjusted gross income under section 62 or (ii) subject to the so-called “Pease” limitation of section 67(a) (allowing “miscellaneous itemized deductions” below-the-line only to the extent the deductions exceed a floor of 2 percent of the taxpayer’s adjusted gross income). Because the taxpayer earned substantial taxable income during the years in issue—over $19 million in 2014 and over $80 million in 2015—the “Pease” limitation had the effect of disallowing the taxpayer’s yacht chartering expenses entirely, even if the expenses were allowable in part under section 183(b)(2). [Note: The 2-percent “Pease” limitation applied to the taxable years at issue in this case, but beginning in 2018 through 2025, “miscellaneous itemized deductions” are completely disallowed under section 67(g). Thus, under current law, the taxpayer’s yacht chartering expense deductions otherwise allowable under section 183(b)(2) would be disallowed entirely under section 67(g) regardless of the taxpayer’s adjusted gross income.] The taxpayer moved for partial summary judgment in Tax Court arguing that the “Pease” limitation does not apply to hobby loss deductions under section 183(b)(2). The Service argued to the contrary, and Judge Jones of the Tax Court agreed with the Service, thereby disallowing the taxpayer’s hobby loss deductions that otherwise would be permitted under section 183(b)(2).
Appeal: On appeal to the Eleventh Circuit, the taxpayer made several arguments that section 183(b)(2) hobby loss deductions are not “miscellaneous itemized deductions” subject to section 67. First and foremost, the taxpayer argued that section 183 should be read on a standalone basis to allow hobby activity expenses as above-the-line deductions offsetting hobby activity gross income. Put differently, the taxpayer argued that section 183 should be read as a corollary to section 162 which allows trade or business expenses above the line as an offset against trade or business gross income in determining adjusted gross income under section 62. Thus, according to the taxpayer, section 183 is merely a qualifier designed to limit hobby activity deductions to hobby activity gross income, but otherwise section 183 operates like section 162. The Eleventh Circuit (Judge Brasher), however, disagreed, stating: “Section 183(b)(2) permits a deduction otherwise disallowed by section 183(a) and identifies its amount. But the deduction allowed by section 183(b)(2) is its own thing, not a trade or business expense.” Further, Judge Brasher reasoned that, as Judge Jones of the Tax Court had concluded, that section 183(b)(2) “is a benchmark for capping the deduction—it is not a command to apply hobby loss deductions against a taxpayer’s total gross income.” Judge Brasher then turned to the statutory scheme of sections 62 (defining “adjusted gross income”), 63 (defining “itemized deductions”), and 67 (defining “miscellaneous itemized deductions”). Judge Brasher concluded that because section 62 does not list section 183 as one of the deductions allowable in computing adjusted gross income, and because section 63 does not carve out section 183 deductions for special treatment (unlike the special treatment given the standard deduction, the section 199A QBI deduction, and the section 170 charitable deduction), hobby loss deductions are subject to the “Pease” limitation of section 67. Judge Brasher cited as support (i) Regulation section 1.67-1T(a)(1)(iv) (“expenses for an activity for which a deduction is otherwise allowable under section 183”]; (ii) two lower-court cases, Purdey v. United States and Strode v. Commissioner; and (iii) commentary.
Next, the taxpayer argued that the Eleventh Circuit’s opinion in Brannen v. Commissioner compelled the conclusion that section 183 deductions are above-the-line and not subject to the “Pease” limitation. The court in Brannen held that section 183 applies to allow deductions, not to exceed gross income, for expenses connected with an activity that is not “entered into with the dominant hope and intent of realizing a profit.” Judge Brasher clarified, though, that Brannen was decided before the enactment of the “Pease” limitation of section 67, and Brannen should not be read to mean that section 183 allows an above-the-line deduction for hobby activity expenses notwithstanding the statutory scheme of sections 62, 63, and 67.
Next, the taxpayer argued that subjecting section 183(b)(2) deductions to the “Pease” limitation of section 67 contravenes Congressional intent. Pointing to legislative history, the taxpayer contended that section 183 originally was enacted to prevent wealthy taxpayers from generating artificial losses, not to prevent taxpayers from deducting legitimate hobby loss expenses. Judge Brasher countered, though, that by enacting the “Pease” limitation of section 67, Congress explicitly intended to limit a taxpayer’s ability to benefit from already-existing deductions that the Code otherwise provided.
Finally, the taxpayer made additional arguments that the Tax Court’s and the Eleventh Circuit’s interpretation of section 183 is inconsistent with other principles of statutory construction; however, Judge Brasher found none of the taxpayer’s arguments convincing, primarily because the court did not find that section 183 and the statutory scheme of sections 62, 63, and 67 were ambiguous.
Judge Wilson concurred with Judge Brasher’s opinion but wrote separately to clarify that he would reach the same result by examining the legislative history of the Tax Cuts and Jobs Act of 2017 (“TCJA”). In relevant part, the Conference Report to the TCJA lists “[h]obby expenses, but generally not more than hobby income,” as one type of deduction that would be disallowed under section 67(g) until 2026.
The standard deduction for 2024 will be $29,200 for joint returns and surviving spouses (increased from $27,700), $14,600 for unmarried individuals and married individuals filing separately (increased from $13,850), and $21,900 for heads of households (increased from $20,800). For individuals who can be claimed as dependents, the standard deduction cannot exceed the greater of $1,300 (increased from $1,250) or the sum of $450 (increased from $400) 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 $1,950 (increased from $1,850) for those with the filing status of single or head of household (and who are not surviving spouses) and is $1,550 (increased from $1,500) for married taxpayers ($3,100 on a joint return if both spouses are age 65 or older).
The following table sets forth the standard deduction for each filing status a taxpayer might have:
| 2022 | 2023 | 2024 | |
|---|---|---|---|
| Single/MFS | $12,950 | $13,850 | $14,600 |
| Head-of-Household | $19,400 | $20,800 | $21,900 |
| MFJ and Surviving Spouses | $25,900 | $27,700 | $29,200 |
The taxpayers could not deduct $1.2 million they paid to their daughter/stepdaughter, who defrauded them and other individuals and is now in prison. Normally, the authors do not report on many U.S. District Court cases; however, with a line like the above taken directly from the court’s opinion, at least one of us became too curious to resist. Essentially, the taxpayers in this case, a retired, married couple, were swindled out of nearly $2 million by their ne’er-do-well daughter/step-daughter, Suzanne Anderson (Anderson), over a two-year period. To pay this amount to Anderson, the taxpayers withdrew nearly $1.2 million from an IRA and a separate pension account in 2017. The taxpayers’ original return for 2017 reported the amounts withdrawn as income and they paid the corresponding income tax liability. In 2020, the taxpayers filed an amended return seeking a refund of approximately $412,000 by claiming a deduction equal to the withdrawn amounts. The Service denied their claim for a refund and the taxpayers brought this suit in U.S. District Court seeking a refund. As discussed below, the court, although sympathetic to the taxpayers’ situation, denied their claim.
Factual background. The taxpayers had owned a business (operated through a limited liability company) that sold pet food online. In 2016, the taxpayers decided to retire and “turned the business over” to Anderson. According to the court’s opinion, the limited liability company conducting the business was dissolved and its bank accounts closed. The assets of the business—presumably not significant due to online sales—were transferred to Anderson to carry on the business. Over the course of 2017 through 2019, Anderson convinced them, via numerous fraudulent misrepresentations, to withdraw about $1.2 million from their IRA and a separate pension fund and transfer the funds to her to support the business. Specifically, Anderson convinced the taxpayers that they were being sued by former customers and that she needed to hire an attorney to defend the business and to prevent the taxpayers from being arrested due to past business dealings. Anderson even forged documents and created a fake email address for the attorney she had “hired.” Finally, in August of 2019, the taxpayers uncovered Anderson’s elaborate scheme, she was arrested, and she currently is serving a 25-year sentence in a Florida state prison.
Court’s analysis. On cross-motions for summary judgment, the District Court (Judge Barber) reluctantly held for the Service and disallowed the taxpayers’ refund claim. The court first noted that the taxpayers were precluded from claiming a theft-loss deduction. Section 165(h)(5), enacted as part of the 2017 Tax Cuts and Jobs Act, provides:
[i]n the case of an individual, except as provided in subparagraph (B) [relating to personal casualty gains], any personal casualty loss which (but for this paragraph) would be deductible in a taxable year beginning after December 31, 2017, and before January 1, 2026, shall be allowed as a deduction under subsection (a) only to the extent it is attributable to a Federally declared disaster . . . .
The court reasoned that, although taxpayers historically were entitled to deduct theft losses in the year in which the loss was discovered, section 165(h)(5) precluded the taxpayers from claiming a theft loss deduction. The taxpayers in this case discovered the loss in 2019, a year to which section 165(h)(5) applies. The court then turned to the question whether the taxpayers were entitled to a deduction in 2017, the year for which they had filed the amended return. The taxpayers argued that they were entitled to deduct the amounts they had transferred to Anderson in 2017 under two theories. First, they asserted that they did not enjoy the benefit of the amounts withdrawn from the IRA and pension fund in 2017 and therefore should not be required to include the withdrawn amounts in gross income. Judge Barber recognized that Anderson, not the taxpayers, ultimately received the withdrawn funds; however, the taxpayers nevertheless were the “distributees” for federal income tax purposes under section 408. The taxpayers authorized and received the distributions before transferring the amounts to Anderson. The court contrasted the taxpayers’ situation to that in Roberts v. Commissioner, in which the court held that a taxpayer was not the distributee with respect to amounts withdrawn from his IRAs by his wife through forged withdrawal requests and used exclusively by her. Thus, the taxpayers in this case were taxable on the distributions. Second, the taxpayers argued that the amounts transferred to Anderson should be treated as deductible trade or business expenses under section 162. Judge Barber ruled, though, that the amounts transferred to Anderson were not deductible business expenses because, at the time the transfers were made, the taxpayers were retired and were no longer carrying on the trade or business. The fact that the taxpayers believed the amounts they paid to Anderson would be used to pay legal fees related to their past business operations, the court reasoned, did not entitle them to a deduction because none of the amounts paid were used to pay actual business expenses.
The taxpayers have appealed to the U.S. Court of Appeals for the Eleventh Circuit.
Comment: The court’s opinion does not discuss, and neither the Service nor the taxpayers may have cited, Rev. Rul. 2009-9. Rev. Rul. 2009-9 famously was issued to benefit taxpayers who suffered so-called “Ponzi scheme” losses at the hands of Bernie Madoff. Rev. Rul. 2009-9 held that, although these losses were theft losses deductible in the year in which the theft was discovered, the losses were deductible under section 165(c)(2), not section 165(c)(3), because they were attributable to a “transaction entered into for profit.” Therefore, the theft losses involved were not personal casualty losses and were not subject to the limitations on personal casualty losses in section 165(h). Under this reasoning, such losses would not be subject to the temporary disallowance rule of section 165(h)(5) quoted above. At least one author of this outline is curious as to whether the taxpayers’ theft losses, especially given that they related to a former business conducted for profit, should be allowable in 2019 (the year of discovery) under section 165(c)(2) as interpreted by the Service in Rev. Rul. 2009-9.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
This corporate taxpayer was allowed to disavow the form of its two-step acquisition transaction by subsequently treating the separate steps as a single section 351 transaction with boot, thereby post hoc generating a partial basis step-up in intangible assets it received in exchange for its stock and resulting in larger amortization deductions. This lengthy and complex 100-plus page Tax Court memorandum decision could well have been a reviewed opinion, and as the reader will discover below, perhaps should have been. Essentially, the corporate taxpayer, Complex Media, Inc., engaged in two separate acquisitive transactions. The first was a section 351 exchange in which the taxpayer acquired certain intangible assets from a partnership in exchange for the taxpayer’s common stock. In the second transaction, the taxpayer paid cash (approximately $2.7 million) and granted a “deferred payment” obligation ($300,000) to the partnership to redeem some of the common stock issued in the preceding section 351 exchange. (The cash and deferred payment obligation then were used by the partnership to redeem one reluctant partner’s partnership interest.) Complex Media and the partnership from which it acquired the intangible assets agreed in the relevant documentation of the transaction to treat the partnership’s contribution of assets in exchange for Complex Media’s stock as a transaction eligible for nonrecognition pursuant to section 351(a) and to treat Complex Media’s redemption of a portion of the shares issued to the partnership as a separate redemption of stock. On its corporate tax return for the year in which the section 351 exchange took place, Complex Media treated the transaction consistently with the manner in which it had agreed to do so (i.e., as a transaction eligible for nonrecognition pursuant to section 351(a) and as a separate redemption of some of the stock it had issued in the section 351 exchange) by reporting that it had taken a carryover basis in the acquired intangible assets pursuant to section 362(a). On its corporate tax returns for the subsequent three years, however, Complex Media effectively treated the two separate steps as a single section 351 exchange, reporting the cash and deferred payment obligation as section 351(b)(1) boot paid for a portion of the intangible assets of the partnership acquired in the exchange. Doing so allowed the taxpayer to step up its basis in the acquired intangible assets under section 362(a), leading to larger amortization deductions with respect to the intangibles under section 197. The taxpayer would not have been entitled to step up the basis in the intangible assets if the cash and deferred payment obligation were not boot in the section 351 exchange but instead were funds used to redeem some of the taxpayer’s stock issued in the section 351 exchange. Over the Service’s objection, the taxpayer argued, and the Tax Court (Judge Halpern) agreed, that the two steps could be treated as one, even if the taxpayer’s originally chosen form was a section 351 exchange of property solely for stock followed by a separate redemption of some of the stock issued in the section 351 exchange. Thus, with Judge Halpern’s blessing, the taxpayer in Complex Media was able to post hoc recast the taxpayer’s chosen form of a corporate acquisition to obtain a better tax result than as originally structured and agreed. We will spare the reader pages and pages of analysis regarding the relatively low bar the courts have set for the Service to recast a taxpayer’s chosen form of a transaction for tax purposes versus the much higher bar set for taxpayers to disavow their chosen form to achieve more favorable tax treatment. Suffice it to say that taxpayers rarely are allowed “do-overs” to report transactions for tax purposes in a manner inconsistent with their chosen form. Judge Halpern also agreed with Complex Media that the $300,000 deferred payment obligation granted to the partnership could be valued at its face amount rather than at a discount. Valuing the deferred payment obligation at face increased the section 351(b)(1) boot, thereby increasing subsequent amortization deductions taken by the taxpayer. Thus, Complex Media is an important and surprising case, albeit a Tax Court memorandum decision.
a. Although it took a while, the Service has decided to “disavow” Judge Halpern’s decision in Complex Media. The Service has announced that it will not follow Complex Media regarding a taxpayer’s ability to disavow the chosen form of a transaction for tax purposes, especially if the taxpayer “does not fully, properly, and consistently report the transaction.” Furthermore, the Service will not follow Complex Media in determining the fair market value of debt (i.e., the deferred payment obligation) for purposes of section 351(b)(1).
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
The Service has made permanent its fast-track program for private letter rulings solely or primarily under the jurisdiction of the Associate Chief Counsel (Corporate). The new program replaces, with minor changes, the pilot program established in Rev. Proc. 2022-10. If fast-track processing is available, then
the Service will endeavor to complete the processing of the letter ruling request and, if appropriate, to issue the letter ruling within the time period specified by the branch representative or branch reviewer. The specified period will be 12 weeks unless a shorter or longer period is designated by the branch reviewer …
The revenue procedure specifies that a taxpayer seeking fast-track processing must request a pre-submission conference and must submit required information before the conference, including the reason for requesting fast-track processing and the length of time requested (if other than 12 weeks). The revenue procedure strongly recommends that taxpayers submit fast-track requests as an encrypted e-mail attachment in order to avoid delays resulting from submitting requests by mail or by delivery in physical form. The new fast-track program is available for letter ruling requests received by the Service after July 26, 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
We previously have written about the entity-theory versus aggregate-theory dust-up between the Service and non-U.S. persons selling interests in partnerships conducting business in the U.S. For example, in Grecian Magnesite Mining, Industrial & Shipping Co., S.A. v. Commissioner, the Tax Court (Judge Gustafson) ruled against the Service (and against the Service’s position in Rev. Rul. 91-32) to hold that a non-U.S. person’s gain from the sale of an interest in a partnership conducting a U.S. trade or business is not U.S.-source income (because the partnership interest is personal property) and therefore is not subject to U.S. taxation unless such gain (i) is captured by section 897(g) (gain attributable to U.S. real property) or (ii) is captured by section 865(e)(2) (gain attributable to a U.S. office or fixed place of business). The Service in Grecian Magnesite had argued that a non-U.S. person’s gain from the sale of an interest in a partnership conducting business in the U.S. should be analyzed under the aggregate-theory of partnership taxation, meaning that the gain would be considered U.S. source income because it is attributable to the underlying U.S. assets held by the partnership. Nevertheless, Judge Gustafson declined to adopt the Service’s reasoning (labeling the Service’s analysis in Rev. Rul. 91-32 as “cursory”) and ruled for the taxpayer. Importantly, Grecian Magnesite did not address whether the result might be different if the partnership conducting business in the U.S. held inventory items subject to section 751.
a. Rawat Decision by Judge Gustafson. In Rawat v. Commissioner, Judge Gustafson got the chance to address the issue left open in Grecian Magnesite: whether gain from a non-U.S. person’s sale of an interest in a partnership holding inventory items and conducting business in the U.S. is considered U.S. source income by virtue of section 751 and the U.S. income-sourcing rules of sections 861-865. This time, the Tax Court (again, Judge Gustafson) adopted the Service’s aggregate-theory argument and held against the taxpayer. The taxpayer in Rawat was a Canadian citizen and nonresident of the U.S. during 2007 and 2008. In 2008, the taxpayer sold her interest in a partnership doing business in the U.S. in exchange for a promissory note with a face amount of $438 million. The principal of the promissory note was not payable until 2028. The Service sought to tax $6.5 million of the taxpayer’s gain (“inventory gain”) in 2008 because that amount was attributable to section 751 inventory items held by the partnership and allocable to the taxpayer’s partnership interest. The taxpayer argued that, because the inventory gain was realized and recognized prior to the enactment of section 864(c)(8) (see below), the Tax Court’s decision in Grecian Magnesite controlled. The Service disagreed, arguing that the inventory gain, unlike the gain in Grecian Magnesite, was subject to section 751, thereby rendering the gain as U.S. source income under sections 861-865 and the Service’s aggregate theory asserted in Grecian Magnesite. This time around, Judge Gustafson ruled for the Service and against the taxpayer. Judge Gustafson reasoned that, although section 751 is not a sourcing rule, the rule in section 741 generally treating the sale of a partnership interest as the disposition of a capital asset is expressly subject to the section 751 carve-out for inventory items. Then, examining the special sourcing rules under sections 861(a)(6) (sale or exchange of inventory property) and 865(b) (exception for inventory property), Judge Gustafson concluded that the taxpayer’s inventory gain from the sale of her partnership interest should be considered U.S.-source income subject to U.S. tax notwithstanding the Tax Court’s holding in Grecian Magnesite regarding more general section 741 gain.
b. The final word: 2017 Tax Cuts and Jobs Act Overturns Grecian Magnesite and Supports the Tax Court’s Holding in Rawat. Regardless of the Tax Court’s holdings in Grecian Magnesite and Rawat, readers may recall that the 2017 Tax Cuts and Jobs Act, section 13501, amended section 864(c) by adding section 864(c)(8) effective for dispositions after November 27, 2017. Section 864(c)(8) provides that gain or loss (after November 27, 2017) on the sale or exchange of all (or any portion of) a partnership interest owned by a nonresident alien individual or a foreign corporation in a partnership engaged in any trade or business within the U.S. is treated as effectively connected with a U.S. trade or business (and therefore taxable by the U.S. unless provided otherwise by treaty) to the extent that the transferor would have had effectively connected gain or loss had the partnership sold all of its assets at fair market value as of the date of the sale or exchange. The amount of gain or loss treated as effectively connected under this rule is reduced by the amount of such gain or loss that is already taxable under section 897 (relating to U.S. real property interests). Thus, section 864(c)(8) overturns the Tax Court’s holding in Grecian Magnesite effective for partnership-interest gain recognized after November 27, 2017, and is consistent with the Tax Court’s holding in Rawat for partnership-interest inventory gain recognized before or after November 27, 2017.
There were no significant developments regarding this topic during 2023.
The Ninth Circuit (holding for the Service) has reversed the Tax Court (which had held for the taxpayers) in a case in which the taxpayers were “sheltering” between the normal deficiency determination procedures of sections 6213 and 6214 and the now-repealed TEFRA “oversheltered return” procedures of section 6234 (hereinafter “TEFRA section 6234”). Essentially, prior TEFRA section 6234 provided a procedural solution in the unusual situation where (i) the taxpayer was contesting in the Tax Court (pursuant to sections 6213 and 6214) a proposed IRS individual-level deficiency assessment based upon items attributable solely to the taxpayer’s personal return for a taxable year or years (“non-partnership items”) and (ii) regardless of the outcome of the individual-level proceeding in Tax Court under sections 6213 and 6214, the taxpayer ultimately might not be found to have a “deficiency” for the taxable year or years due to pass-through losses claimed as a partner in a partnership subject to a pending TEFRA partnership audit for the same taxable year or years (“partnership items”). TEFRA section 6234(a) solved the problem by authorizing a special declaratory judgment action in the Tax Court concerning non-partnership items upon the taxpayer’s receipt of an IRS “notice of adjustment” if:
a taxpayer files an oversheltered return for a taxable year,
the Secretary makes a determination with respect to the treatment of items (other than partnership items) of such taxpayer for such taxable year, and
the adjustments resulting from such determination do not give rise to a deficiency (as defined in section 6211) but would give rise to a deficiency if there were no net loss from partnership items.
An “oversheltered return” was defined by TEFRA section 6234(b) as a partner’s return that showed no taxable income for a taxable year and showed a “net loss from partnership items.” The term “net loss from partnership items” was not defined in the statute. Lastly, as contemplated by TEFRA section 6234(c), the taxpayer eventually could file a petition in Tax Court seeking a readjustment of the taxpayer’s “deficiency” (as preliminarily determined in the TEFRA section 6234(a) declaratory judgment action) once the taxpayer’s allocable share of partnership items finally was determined in the TEFRA-partnership-level proceeding. (TEFRA section 6234 was enacted in 1997 to overturn the Tax Court’s 1989 decision in Munro v. Commissioner, in which the Tax Court held that claimed partnership losses must be “completely ignored” in a deficiency proceeding concerning the taxpayer’s non-partnership losses.)
Facts: In this case, taxpayers, a married couple, did not timely file federal income tax returns for the years 2006 through 2012. More precisely, and importantly for the outcome in the case, the taxpayers did not file any federal income tax returns whatsoever for 2007 and 2012 (because the returns provided were unsigned). The taxpayers filed late returns for 2006 and the years 2008 through 2011. None of the returns showed a federal tax liability because the taxpayers used current and carryforward losses from a TEFRA partnership in which they were partners to offset any gross income reported on their personal returns. After audit, the Service issued individual-level notices of deficiency to the taxpayers for the years in issue, asserting both back taxes and penalties. The taxpayers timely filed petitions in the Tax Court. Before trial, the Tax Court (Judge Halpern) granted the Service’s motion to dismiss for lack of jurisdiction so much of the case as related to partnership items and ordered the Service to provide recomputed deficiencies reflecting the dismissal of partnership items from the case. At trial, the taxpayers presented no evidence that any of the Service’s proposed recomputed deficiencies with respect to non-partnership items for the years in issue were erroneous. Presumably, the taxpayers were not concerned with the Service’s proposed non-partnership item adjustments because they had more than enough partnership-item losses (from the TEFRA partnership in which they were partners) to offset any such adjustments. Regardless, over the Service’s objection, Judge Halpern upheld only the Service’s proposed non-partnership item adjustments against the taxpayers for 2006 and 2008. Judge Halpern did not sustain the Service’s proposed non-partnership item deficiencies or penalties for the other years in issue (2007 and years 2009 through 2012), reasoning as follows:
The oversheltered return rules provided in [TEFRA section 6234] do not apply for petitioners’ 2007 and 2012 taxable years because they did not file returns for those years. And section 6234 does not apply for petitioners’ 2009, 2010, or 2011 taxable years because the adjustments in the notice of deficiency for each year would not result in a deficiency in petitioners’ joint income tax liability even if petitioners had not claimed a net loss from partnerships for the year.
The taxpayers appealed to the Ninth Circuit and the Service cross-appealed. The taxpayers’ appeal was dismissed for failure to prosecute, which resulted in the Service’s adjustments for 2006 and 2008 being upheld. Thus, only the Service’s proposed adjustments for 2007 and 2009 through 2012 were the subject of the Ninth Circuit’s decision.
Ninth Circuit: The Ninth Circuit, in an opinion by Judge Clifton, reversed and remanded the case to the Tax Court for redetermination of the taxpayers’ deficiencies and penalties for 2007 and years 2009-2012. With respect to tax years 2007 and 2012, the Ninth Circuit held that the unsigned, unfiled tax returns, on which the TEFRA partnership losses were reported by the taxpayers, were legally invalid because they had not been filed and executed under penalties of perjury. Therefore, those unsigned, unfiled returns could not be used to offset non-partnership item income in an individual deficiency proceeding with respect to those years. Furthermore, with respect to 2009-2011, the Ninth Circuit determined that the Tax Court erred by concluding that the oversheltered return rules of TEFRA section 6234 did not apply. Instead, the Ninth Circuit determined that Judge Halpern should have included in the calculation of “net loss from partnership items” (one of the requirements for triggering Tax Court jurisdiction under TEFRA section 6234) the portions of the net-operating-loss carryover deductions that were composed of eligible partnership losses in prior years. If Judge Halpern had done so, then the Tax Court would have had jurisdiction under TEFRA section 6234 to decide the Service’s proposed non-partnership item adjustments, if any, to the taxpayer’s returns for 2009-2011.
This memorandum opinion from the Tax Court affirms the applicability of Rev. Proc. 93-27 (partnership profits interest issued for services) in a tiered partnership structure, but the real dispute was whether there was a proper “book up” of the partners’ capital accounts. The authors discuss relatively few memorandum opinions of the Tax Court; however, this case is one which the authors believe is noteworthy—perhaps more so for what the opinion does not address than what it does. The ostensible dispute in the case concerned whether a partnership interest issued for services met the safe harbor of Rev. Proc. 93-27 As readers may recall, Rev. Proc. 93-27 (as clarified by Rev. Proc. 2001-43) generally provides that the receipt of a partnership interest for services is nontaxable to the recipient so long as the interest in question does not share in liquidation proceeds assuming a hypothetical liquidation of the partnership immediately following the grant of the partnership interest (i.e., that the partnership interest is a true “profits interest,” not a “capital interest”). If the requirements of Rev. Proc. 93-27 are met, then the Service will not contest that the issuance of a partnership profits interest in exchange for services is nontaxable. In this case, the Tax Court (Judge Weiler) held over the Service’s objection that Rev. Proc. 93-27 applied in the context of an intricate tiered partnership structure used in an acquisitive transaction. For details, see below.
Facts. The facts of the case are complex, and to fully appreciate the issues and arguments at stake, the intricacies of the tiered partnership structure must be understood. The ownership diagram provided by Judge Weiler is very helpful in this regard and easily worth a thousand words:
The tiered partnership structure depicted above related to the acquisition of a seventy-percent interest in a consumer loan portfolio held by Joshus Landy through a wholly-owned corporation, NPA, Inc. Oversimplifying to avoid writer’s cramp, the capital for the acquisition was provided by a group of outside investors (NPA Investors, LLC). Mr. Landy’s corporation, NPA, Inc., contributed its entire consumer loan portfolio to a second-tier partnership, IDS, LLC, which in turn contributed the portfolio to a first-tier partnership, NPA, LLC. Then, the investors, through NPA Investors, LLC, purchased a seventy-percent interest in the consumer loan portfolio by paying cash of roughly $21 million to the second-tier partnership, IDS, LLC, in exchange for a seventy-percent partnership interest in NPA, LLC. NPA, Inc., Mr. Landy’s corporation, retained the remaining thirty-percent interest in the consumer loan portfolio by holding the residual thirty-percent interest (valued at approximately $9 million) in the second-tier partnership, IDS, LLC. In connection with the acquisition, certain advisors to the transaction, as members of a third-tier partnership, ES NPA Holding, LLC, were issued a partnership interest in the second-tier partnership, IDS, LLC, in exchange for past and future services provided to the first-tier acquisition partnership, NPA, LLC. The central issue in the case was whether the partnership interest issued to the advisors via ES NPA Holding, LLC was in fact a “profits interest” qualifying as nontaxable under the safe harbor rules of Rev. Proc. 93-27.
The Service’s Arguments. The Service made two arguments as to why Rev. Proc. 93-27 did not apply. The Service’s primary argument was that Rev. Proc. 93-27 was inapplicable because the partnership interest issued to the third-tier partnership, ES NPA Holding, LLC, was granted by the second-tier partnership, IDS, LLC, not the first-tier partnership, NPA, LLC, for which the past and future services were performed. With respect to this argument, Judge Weiler held that Rev. Proc. 93-27 nonetheless applied because the Service’s reading of the ruling was too narrow. Specifically, Judge Weiler pointed to other language in Rev. Proc. 93-27 supporting a broader reading. Section 4.01 of Rev. Proc. 93-27 states that “if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the [Service] will not treat the receipt of such an interest as a taxable event for the partner or the partnership.” Judge Weiler held that the above-quoted language supported the broader reading of Rev. Proc. 93-27 advocated by ES NPA Holding, LLC, the recipient of the partnership interest. The Service’s alternative argument, and perhaps the Service’s real concern, was that the partnership interest issued by the second-tier partnership, IDS, LLC, to the third-tier partnership, ES NPA Holding, LLC, was in fact a “capital interest” because the consumer loan portfolio acquired by the first-tier partnership, NPA, LLC, was undervalued. The Service, supported by a valuation expert, contended that the consumer loan portfolio should have been valued at approximately $48.5 million, meaning that ES NPA Holding, LLC would receive as much as $12 million upon a hypothetical liquidation of the tiered partnership structure, not $0 as reflected in ES NPA Holding, LLC’s capital account in the second-tier partnership, IDS, LLC. In other words, the Service was arguing that the “book up” performed in connection with the formation of the tiered partnership structure was insufficient, so the service provider, ES NPA Holding, LLC, received a “capital interest” not a “profits interest” within the meaning of Rev. Proc. 93-27. Judge Weiler, though, disagreed, holding that the valuation used by the parties to the transaction—roughly $21 million purchased by the investors via NPA Investors, LLC plus approximately $9 million in value retained by Mr. Landy via NPA, Inc.’s thirty-percent interest in the second-tier partnership, IDS, LLC—was the best evidence of the valuation of the consumer loan portfolio. Hence, Judge Weiler concluded that Rev. Proc. 93-37 applied, and the service provider, ES NPA Holding, LLC, received a nontaxable partnership profits interest in connection with the transaction.
Comment: Perhaps the real import of ES NPA Holding is not that Rev. Proc. 93-37 applies in a tiered partnership structure. The authors believe that most practitioners have assumed as much. Instead, perhaps the most important lesson of the case is that partnerships issuing interests in exchange for the performance of services should take care to accurately substantiate capital account “book ups,” thereby safeguarding against an argument by the Service that the interest so issued was a taxable “capital interest” instead of a nontaxable “profits interest.”
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
There were no significant developments regarding this topic during 2023.
A well-hidden provision of the SECURE 2.0 Act amended Code 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 a 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, 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.
a. Safe harbor conservation easement deed language published by the Service with a short (now passed) deadline to file amended deeds. Notice 2023-30. As directed by Congress, the Service has published safe harbor deed language for extinguishment and boundary line adjustment clauses relating to conservation easements.
Extinguishment Clauses. Section 1.04 of the notice sets forth the Service’s litigating position with respect to extinguishment clauses in conservation easement deeds. The Service’s litigating position is that, upon destruction or condemnation of conservation easement property and the collection of any proceeds therefrom, Regulation section 1.170A-14(g)(6)(ii) (the “extinguishment regulation”) requires the charitable donee to share in the proceeds according to a “proportionate benefit fraction” set forth in the conservation easement deed. (Keep in mind, however, that the validity of the extinguishment regulation has been called into question. The Eleventh and Sixth Circuits have reached opposite conclusions regarding whether Treasury and the Service complied with the Administrative Procedures Act in promulgating the regulation.) The Service’s view of the allowed language in the conservation easement deed has been fairly narrow, requiring that the proportionate benefit fraction be fixed and unalterable as of the date of the donation according to the following ratio: the value of the conservation easement as compared to the total value of the property subject to the conservation easement. Therefore, according to the Service and as upheld by several court decisions, if the conservation easement deed either (i) allows the donor to reclaim from the charitable donee any portion of the donated conservation easement property in exchange for substitute property of equivalent value or (ii) grants the donor credit for the fair market value of subsequent improvements to the donated conservation easement property, the proportionate benefit fraction language in the deed is flawed and the charitable deduction must be disallowed. Section 4.01 of Notice 2023-30 then sets forth what the Service considers acceptable language regarding the proportionate benefit fraction as is relates to extinguishment clauses in conservation easement deeds.
Boundary Line Adjustment Clauses. Section 4.02 of Notice 2023-30 provides sample boundary line adjustment clause language. Unlike the background discussion relating extinguishment clauses in conservation easement deeds, the notice does not explain why Congress determined that the Service should publish sample boundary line adjustment clause language. The Service acknowledges in Notice 2023-30 that “[n]either the Code nor the regulations specifically address boundary line adjustments.”
Amendments. Section 3 of the Notice sets forth the process and timeline for amending an original “flawed” (in the eyes of the Service) conservation easement deed to adopt the Service-approved proportionate benefit fraction or boundary line adjustment language. Corrective, amended deeds must be properly executed by the donor and the donee, must be recorded by July 24, 2023, and must relate back to the effective date of the original deed.
The taxpayer waited too long to pull the trigger on a charitable donation of stock and ends up shooting himself in the foot. This fact-intensive and fact-sensitive case reminds us that the anticipatory assignment of income doctrine is alive and well, especially in connection with last-minute donations of stock to charity before closing. The idea in these transactions, of course, is to donate a portion of a taxpayer’s highly-appreciated, low-basis stock to charity in advance of a planned sale of the stock, claim the charitable contribution deduction for the fair market value of the donated stock, and then have the charity sell the donated stock (simultaneously with the sale of the donor’s retained stock) at the subsequent closing of the stock purchase transaction. The taxpayer thereby obtains a charitable contribution deduction for the fair market value of the donated stock while avoiding tax on the inherent capital gain in the contributed stock. The conventional wisdom in this area is that a taxpayer may wait to donate the stock to charity until after a letter of intent has been signed but should donate before the definitive stock acquisition agreement is executed. In this case, however, the Tax Court (Judge Nega) determined that the taxpayer nevertheless waited too late, even though he donated the stock sometime before the execution of the stock purchase agreement and the simultaneous closing. It did not help the taxpayer’s case that he had sent an email to his tax advisor stating “I do not want to transfer the stock until we are 99% sure we are closing.” The taxpayer apparently was concerned that if he gave away a portion of his stock too soon, his brothers, who owned the remaining stock in the corporation, might outvote him in connection with the anticipated sale. Furthermore, the documents and facts were unclear and there was a substantial dispute between the taxpayer and the Service as to the precise date of the transfer of the donated stock to the charity. Even worse, it appeared that some of the documents may have been backdated by the taxpayer. After a lengthy analysis of the facts, Judge Nega ultimately determined that the transfer of the donated shares took place two days before closing. It also did not help the taxpayer’s case that he and his brothers stripped the corporation of virtually all of its cash via a declared dividend (colloquially known as a “boot-strap” sale) one day before the closing, yet the charity, which according to the taxpayer received a stock certificate for the donated shares previously, received no portion of the dividend. In eventually holding for the Service regarding the anticipatory assignment of income issue, Judge Nega concluded:
To avoid an anticipatory assignment of income on the contribution of appreciated shares of stock followed by a sale by the donee, a donor must bear at least some risk at the time of the contribution that the sale will not close. On the record before us, viewed in the light of the realities and substance of the transaction, we are convinced that [the taxpayer’s] delay in transferring the [donated] shares until two days before closing eliminated any such risk and made the sale a virtual certainty.
Judge Nega also determined that the taxpayer, as argued by the Service, had not satisfied the qualified appraisal requirements of section 170(f)(11)(A)(i). Judge Nega therefore denied the taxpayer’s claimed charitable contribution deduction for the donated shares, even though the charity received a portion of the proceeds of the stock sale attributable to the shares it held as of closing. Ouch! We commend the case to readers who are advising taxpayers in connection with these transactions, but we decline to try to capture here and discuss the myriad factual nuances of a forty-nine-page Tax Court Memorandum decision.
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? 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 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 Service 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 Service’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 Service 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. 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 Service 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 Service 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 Service 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 Service 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. sections 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 Service 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 Service 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 Service 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 Service’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 IRS 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 IRS 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 Servicewould 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 Service 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 Service satisfies Section 6751(b) so long as a supervisor approves an initial determination of a penalty assessment before it assesses those penalties. Here, a supervisor approved Kroner’s penalties, and they have not yet been assessed. Accordingly, the Service 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 Service 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 Service’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 the 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, 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 Service 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.
c. Yes, the tide seems to be turning. The Tenth Circuit has held that, when the Service 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 no later than the date the Service issues the notice of deficiency formally asserting a penalty. In an unpublished order and judgment by Judge Tymkovich, the U.S. Court of Appeals for the Tenth Circuit has held that, when the Servicemust 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 on or before the date on which the Service issues a notice of deficiency.
The taxpayer in this case was indicted on two counts of tax evasion for the years 2000 and 2001. The taxpayer pleaded guilty with respect to the year 2000 and, in exchange, the government dismissed the count for 2001. Subsequently, the Service asserted deficiencies for 2000 and 2001 and section 6663 civil fraud penalties for both years. In 2010, a Service revenue agent visited the taxpayer in prison and obtained his signature on Form 4549, Income Tax Examination Changes, in which the Service proposed the deficiencies and penalties for 2000 and 2001. At that time, the agent’s supervisor had not approved the penalties. The taxpayer later requested that his agreement to the deficiencies and penalties be withdrawn. The Service agreed to the withdrawal and later issued a 30-day letter (Letter 950) asserting the same deficiencies and penalties. The 30-day letter was signed by the revenue agent’s supervisor. The Service later issued a notice of deficiency asserting the deficiencies and penalties for both years.
Tax Court’s Analysis. The taxpayer challenged the notice of deficiency by filing a petition in the U.S. Tax Court. The Tax Court (Judge Kerrigan) granted summary judgment in favor of the Service as to the deficiencies for both years and as to the fraud penalty for 2000. Following a trial, the Tax Court held that the Service was precluded from asserting the fraud penalty for 2001 by section 6751(b)(1). (The court also held that conviction for tax evasion on the 2000 count collaterally estopped the taxpayer from challenging the civil fraud penalty for 2000.) 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.
The Tax Court’s prior 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. In this case, the Tax Court held, the Service had failed to comply with section 6751(b)(1) because the Form 4549 the revenue agent presented to the taxpayer in prison was the initial determination of the penalties, and the Service had not secured the required supervisory approval before the agent presented the form to the taxpayer.
Tenth Circuit’s Analysis. On appeal, the U.S. Court of Appeals for the Tenth Circuit affirmed the Tax Court’s grant of summary judgment to the government as to the deficiencies for both years and as to the fraud penalty for 2000 but reversed the Tax Court’s decision as to the penalty for 2001. The court observed that the U.S. Courts of Appeal for the Ninth and Eleventh Circuits have disagreed with the Tax Court’s position that the supervisory approval before the Service first communicates to the taxpayer that it intends to assert penalties. The court agreed with the Ninth and Eleventh Circuits:
We agree with these assessments of section 6751(b)(1) and hold that its plain language does not require approval before proposed penalties are communicated to a taxpayer.
The Tenth Circuit then addressed the question of what timing requirement, if any, section 6751(b)(1) imposes on the government to obtain the necessary supervisory approval. The court analyzed the Second Circuit’s decision in Chai v. Commissioner, and agreed with the Second Circuit’s analysis:
We are persuaded by the Second Circuit’s reasoning and hold that with respect to civil penalties, the requirements of section 6751(b)(1) are met so long as written supervisory approval of an initial determination of an assessment is obtained on or before the date the Service issues a notice of deficiency.
Because the revenue agent’s supervisor had approved the 2001 civil fraud penalty before the Service issued the notice of deficiency, the Tenth Circuit reversed the Tax Court’s decision as to the 2001 penalty and remanded a determination of whether the taxpayer was liable for the penalty.
d. The turning tide now seems to have washed over the Tax Court—at least in this case appealable to the Ninth Circuit. This Tax Court decision presents an opportunity to synthesize for our readers the case law developments over the last few years (as detailed above) concerning the supervisory approval requirement of section 6751(b)(1). Readers will recall that section 6751(b)(1) requires the “initial determination” of the assessment of certain (but not all) federal income tax penalties be “personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.” The bare language of the poorly drafted statute is ambiguous, leaving room for various interpretations as evidenced by numerous recent court decisions.
The Tax Court. The Tax Court has taken an expansive view of section 6751(b)(1) regarding what constitutes the initial determination of the penalty in question. In a series of cases beginning with Graev v. Commissioner, the Tax Court reversed its earlier position that supervisory approval need only occur before assessment of the penalties subject to section 6751(b)(1). Instead, the Tax Court in Graev accepted the Second Circuit’s interpretation of section 6751(b)(1) as set forth in Chai v. Commissioner: “that section 6751(b)(1) requires written approval of the initial penalty determination no later than the date the Service issues the notice of deficiency (or files an answer or amended answer) asserting such penalty.” Then, in subsequent cases, the Tax Court has gone further, generally holding that:
The Circuit Courts. The Circuit Court interpretations of section 6751(b)(1) have not been as expansive as the Tax Court’s, but they have not been consistent either.
The Facts in Kraske. The Tax Court in Kraske, a case appealable to the Ninth Circuit, signaled that it may be reconsidering its expansive interpretation of section 6751(b)(1) and backing off its view that supervisory approval must come on or before the Service “formally communicates” proposed penalties to a taxpayer. On June 2, 2014, the examining agent within the Service’s Small Business and Self-Employed Division sent the taxpayer in Kraske a Letter 692 (15-day letter) proposing in part the imposition of accuracy-related penalties under section 6662. The 15-day letter further advised that if the taxpayer did not respond within 15 days, a notice of deficiency would be issued. Almost a month after the deadline passed for responding to the 15-day letter, the taxpayer on July 16, 2014, mailed the Service examining agent a letter disagreeing with the examining agent’s proposed tax adjustments and penalties. Coincidentally, on that same day, July 16, 2024, the examining agent, not having received a response to the 15-day letter from the taxpayer after having been promised it several times, closed the case as unagreed and forwarded it to the agent’s group manager, who was the agent’s immediate supervisor. On July 21, 2014, the group manager reviewed the case, signed approval forms regarding the agent’s assertion of accuracy-related penalties under section 6662, and approved the case for closure. The case was then forwarded to Appeals on July 24, 2014, immediately after the Service received on that date the taxpayer’s July 16, 2014, letter objecting to the proposed tax adjustments and penalties. IRS Appeals received the case on August 12, 2014, and after the taxpayer and Appeals were unable to settle matters, a notice of deficiency was issued to the taxpayer on July 28, 2015. Before the Tax Court, the taxpayer argued that imposition of any accuracy-related penalty under section 6662 was improper because the Service had not timely obtained supervisory approval under section 6751(b)(1).
The Tax Court’s Opinion in Kraske. In an opinion written by Judge Gale, the Tax Court acknowledged that under the court’s holding in Clay v. Commissioner, the supervisory approval obtained in Kraske would be considered untimely under section 6751(b)(1) because it came after a “formal communication” (i.e., the 15-day letter) of the proposed penalties was sent to the taxpayer. Judge Gale noted, however, that because the case was appealable to the Ninth Circuit, the Ninth Circuit’s decision in Laidlaw’s Harley Davidson Sales, Inc., must be considered. As noted above, Laidlaw’s Harely Davidson Sales, Inc. concerned an “assessable penalty,” not a penalty subject to deficiency procedures as in Kraske. Arguably, then, Laidlaw’s Harley Davidson Sales, Inc. was distinguishable, and the Tax Court was not necessarily bound to follow it under a strict application of Golsen v. Commissioner (holding that “better judicial administration. . .requires us to follow a Court of Appeals decision which is squarely in point where appeal from our decision lies to that Court of Appeals and to that court alone).” Judge Gale also noted, though, that the so-called Golson doctrine allows the Tax Court to examine not just the narrow holding of a binding Circuit Court decision, but also the underlying rationale of the decision. On this basis, Judge Gale determined that the Golson doctrine should apply in Kraske, resulting in the Tax Court ruling in favor of the government and against the taxpayer. Judge Gale wrote:
The rationale of the Ninth Circuit’s holding in Laidlaw’s Harley Davidson is clear regarding the timing of supervisory approval. The Ninth Circuit rejected outright our position in Clay that the supervisory approval required by section 6751(b)(1) is timely only if it is obtained before a formal communication to the taxpayer that penalties would be proposed, finding that our interpretation “has no basis in the text of the statute.” [Citation omitted.] Instead, the Ninth Circuit opined that approval is timely at any time before assessment, provided the supervisor retains discretion to give or withhold approval.
Judge Gale then ruled that the timeline for supervisory approval under section 6751(b)(1) in Kraske was “well within the parameters . . . found timely by the Ninth Circuit in Laidlaw’s Harley Davidson,” explaining further:
When the supervisor approved the penalties on July 21, 2014, it was more than a month past the deadline for [the taxpayer] to respond to the 15-day letter, and the [examining agent] had not received a written request for Appeals’ consideration from him. Although [the taxpayer] had mailed such a request on July 16, 2014, it was not received by the [examining agent] until July 24, 2014—three days after written supervisory approval had been given. The case was not received by Appeals until August 12, 2014—over three weeks after supervisory approval had been given. Thus, the [examining agent’s] immediate supervisor retained discretion to approve or to withhold approval of the penalties when she did so on July 21 because the case had not yet been transferred to Appeals (at which time the Small Business and Self-Employed Division’s jurisdiction over the case, and the supervisor’s discretion, may have terminated).
The Tax Court has held that there is no statutory authority for the Service to assess penalties imposed by section 6038(b) for failure to file information returns with respect to foreign business entities and that the Service therefore cannot proceed to collect the penalties through a levy. Section 6038(a) requires every United States person to provide information with respect to any foreign business entity the person controls (defined in section 6038(e)(2) as owning more than 50 percent of all classes of stock, measure by vote or value). The form prescribed for providing this information is Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. Section 6038(b)(1) imposes a penalty of $10,000 for each annual accounting period for which a person fails to provide the required information. In addition, section 6038(b)(2) imposes a continuation penalty of $10,000 for each 30-day period that the failure continues up to a maximum continuation penalty of $50,000 per annual accounting period. In this case, the taxpayer was required to file Form 5471 for several years with respect to two wholly-owned corporations organized in Belize but failed to do so. The Service assessed a penalty under section 6038(b)(1) of $10,000 and a continuation penalty of $50,000 for each of the years in issue. In response to a notice of levy, the taxpayer requested a collection due process (CDP) hearing. In the CDP hearing, the taxpayer argued that the Service had no legal authority to assess section 6038 penalties. Following the CDP hearing, the Service issued a notice of determination upholding the proposed collection action and the taxpayer changed this determination by filing a petition in the Tax Court. The Tax Court (Judge Marvel) agreed with the taxpayer and held that there is no statutory authority for the Service to assess section 6038 penalties. The Service argued that section 6201(a), which authorizes the Secretary of the Treasury to make the “assessments of all taxes (including interest, additional amounts, additions to the tax, and assessable penalties) imposed by this title” authorizes assessment of penalties imposed by section 6038. The court disagreed, however, and reasoned that the term “assessable penalties” in section 6201(a) does not automatically apply to all penalties in the Code. The court observed that (1) sections 6671(a) and 6665(a)(1) provide that penalties imposed by specified Code sections shall be assessed and collected in the same manner as taxes and (2) Code sections other than those specified by sections 6671(a) and 6665(a)(1) commonly provide that the penalty is a tax or assessable penalty for purposes of collection or are expressly covered by (or contain a cross-reference to) one of the specified Code sections. In contrast, the court explained, section 6038 is not one of the Code sections specified by sections 6671(a) and 6665(a)(1) and contains only a cross-reference to a criminal penalty provision. The court also rejected the Service’s argument that section 6038 penalties are “taxes” within the meaning of section 6201(a) and therefore subject to assessment. In short the court held, although section 6038(b) provides penalties for failure to provide the information required by section 6038(a), there is no statutory authority for assessment of those penalties and the Service therefore is unable to collect those penalties through a levy.
The court’s holding that there is no authority for assessment of section 6038 penalties suggests that (1) the Service would be precluded from exercising its other administrative collection powers, such as a lien or a refund offset, and (2) the mechanism for the Service to collect section 6038 penalties is a civil action under section 2461(a).
In a case of first impression, the Tax Court, in an opinion by Chief Judge Kerrigan, has determined that the $5,000 per taxable year frivolous return penalty of section 6702(a) can be imposed personally (apparently not limited to the trust’s assets) against a trustee filing and signing an IRS Form 1041 (U.S. Income Tax Return for Estates and Trusts) as an “authorized representative.” The case arose out of a collection due process hearing after the Service sent the taxpayer a notice of federal tax lien relating to the assertion of the section 6702(a) frivolous return penalty across multiple years. The taxpayer was the trustee of, in Judge Kerrigan’s words, a “grantor-type trust.” (The opinion does not elaborate on the precise federal income tax status of the trust—i.e., disregarded grantor trust within the meaning of Regulation section 1.671-4 or another type trust—except to state in a footnote that the Service disputed the validity of the trust, but the Tax Court assumed it was valid for purposes of the opinion.) The trust in question reported gross income across multiple years but simultaneously reported tax withheld for those years equal to or exceeding the amount of reported gross income. The returns reported that the trust had no tax liability and that it had made overpayments equal to the tax withheld. The Service previously announced in Section III(22) of Notice 2010-33, its position that such facially incorrect returns are considered frivolous within the meaning of section 6702. The trustee argued that the section 6702(a) frivolous return penalty should not apply to him personally, even if he filed and signed the multi-year returns as an “authorized representative of the trust, because the frivolous returns were returns of the trust, not the trustee as an individual. Judge Kerrigan disagreed, relying on the plain terms of section 6702(a) which states that a “person shall pay a penalty of $5,000 if (1) such person files [a frivolous return, as defined].” Judge Kerrigan reasoned further that nothing in the statute conditions the imposition of the penalty on a person’s filing of his or her personal return and that Congress, because it did not provide otherwise, must have considered it appropriate to impose the section 6702(a) penalty personally on a trustee who files a return on behalf of a trust.
There were no significant developments regarding this topic during 2023.
A dilatory taxpayer secures full concession from the Service for tax year 2014 after SCOTUS decision in 2022, but does not succeed in recovering almost $130,000 in litigation costs. Another apt headline for this case might be: “Sometimes for taxpayers it is better to be lucky than good.”
Facts. The case began in November of 2016, when the Service sent the taxpayer a notice of deficiency for unreported income relating to 2014. The taxpayer either never received or never responded to the notice of deficiency, and on April 17, 2017, the Service assessed back taxes, interest, and penalties against the taxpayer for 2014. Next, in February of 2018 the Service sent to the taxpayer a Notice of Federal Tax Lien Filing and Your Right to a Hearing Under Section 6320 (“NFTL”). In response, the taxpayer filed a request for a collection due process (“CDP”) hearing on March 2, 2018. At the CDP hearing, the taxpayer argued that the deficiency the Service assessed for 2014 was not attributable to her income, but instead to income realized by a business the taxpayer sold in 2009. The Service officer conducting the CDP hearing informed the taxpayer that she could not contest the underlying and assessed tax liability because the notice of deficiency was properly mailed and the taxpayer did not petition the Tax Court. The Service then sent the taxpayer a notice of determination under section 6330(d) sustaining the NFTL for 2014. The notice of determination was mailed to the taxpayer’s last known address on December 11, 2018. Under section 6330(d)(1), the taxpayer then had 30 days within which to file a petition in the Tax Court challenging the Service’s determination. This 30-day period expired on January 10, 2019. Nevertheless, almost nine months later, on October 8, 2019, the taxpayer filed a petition in the Tax Court challenging the notice of determination that upheld the NFTL. The taxpayer asserted (as she had in the CDP hearing) that the back taxes, interest, and penalties sought by the Service were not attributable to her but to the business she sold in 2009. Regardless, on March 25, 2020, the Tax Court, upon a motion made by the Service, dismissed the taxpayer’s petition as untimely. The Tax Court held that the 30-day time period prescribed by section 6330(d)(1) was jurisdictional, and because the taxpayer missed the deadline, the court had no jurisdiction to hear the taxpayer’s case regardless of the underlying merits. The taxpayer appealed to the U.S. Court of Appeals for the Second Circuit.
Second Circuit Appeal. The Second Circuit held the taxpayer’s appeal in abeyance pending the U.S. Supreme Court’s issuance of a decision in Boechler, P.C. v. Commissioner. 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 CDP hearing is not jurisdictional and is subject to equitable tolling. After Boechler was decided, the Second Circuit vacated the Tax Court’s earlier decision dismissing the taxpayer’s petition as untimely and remanded the case for further proceedings.
Back in Tax Court. Upon remand to the Tax Court, the Service and the taxpayer filed a stipulation of settled issues on November 8, 2022, wherein the Service completely conceded the case in favor of the taxpayer. (The opinion does not explain why the Service conceded the case.) The taxpayer, perhaps justifiably miffed but also incredibly lucky given her past delays in responding to the Service, filed a motion in the Tax Court pursuant to section 7430 on January 5, 2023, for an award of administrative ($5,601) and litigation ($129,750) costs. Along with other requirements and limitations, section 7430 allows a prevailing party to recover reasonable administrative and litigation costs in connection with the determination, collection, or refund of any tax, interest, or penalty if the government’s position was not substantially justified. The taxpayer thus argued that (i) she was the prevailing party, (ii) she had met the other requirements and limitations of section 7430 (which the Service conceded), and (iii) under Boechler and unspecified provisions of the Internal Revenue Manual, the Service’s litigating position was not substantially justified. The Service (for reasons that are not clear in the Tax Court’s opinion) conceded the taxpayer’s claim to $5,601 in administrative costs, but the Service contested whether the taxpayer was the prevailing party for purposes of a section 7430 award of litigation costs. Under section 7430(c)(4)(A)(i)(II), a taxpayer is not considered a prevailing party if the government establishes that its position was substantially justified. The Service thus argued that its pre-Boechler litigating position concerning the jurisdictional nature of the 30-day period prescribed by section 6330(d)(1) was substantially justified.
Tax Court Opinion. The Tax Court (Judge Kerrigan) agreed with the Service and rejected the taxpayer’s section 7430 claim for $129,750 in litigation costs. Judge Kerrigan first pointed out that the Service’s eventual concession of the case was not determinative of an award of litigation costs for the taxpayer under section 7430. Second, Judge Kerrigan noted that the question of whether the Service’s litigating position was substantially justified must be determined as of early 2020, when the Service filed its motion to dismiss the taxpayer’s untimely Tax Court petition. Third, emphasizing that Boechler was a case of first impression decided in 2022, Judge Kerrigan reasoned that “it was well established [prior to Boechler] that the 30-day period to file a petition for review of a collection due process determination was jurisdictional.” Lastly, Judge Kerrigan rejected the taxpayer’s additional argument that the Service’s litigating position was not substantially justified because the Service did not follow unspecified provisions of the Internal Revenue Manual. The Internal Revenue Manual, Judge Kerrigan wrote, is not “applicable published guidance” within the meaning of section 7430(c)(4)(B)(ii). Accordingly, Judge Kerrigan concluded that the taxpayer was not entitled to an award of litigation costs under section 7430.
There were no significant developments regarding this topic during 2023.
If you’re on “island time,” or think you might be, here’s why you might want to “meticulously” and “intentionally” file a U.S. federal income return even if you think you have $0 U.S. gross income and $0 U.S. tax liability. In a case with extremely narrow application, the Tax Court (Judge Pugh), in a unanimous, reviewed opinion, has held that filing a return solely with the U.S. Virgin Islands Bureau of Internal Revenue (“VIBIR”) does not trigger the limitations period under section 6501 for the Service to assess tax. The taxpayer in this case claimed to be a bona fide resident of the U.S. Virgin Islands (USVI) for tax years 2002 and 2003. Accordingly, pursuant to section 932(c) (coordination of U.S. and USVI income taxes), the taxpayer filed his Form 1040 for those years only with the VIBIR (the USVI’s counterpart to the Service). The Service audited the taxpayer and challenged his status as a bona fide resident of the USVI but did not issue a notice of deficiency until 2015. The taxpayer petitioned the Tax Court and moved for summary judgment on the grounds that the Service’s notice of deficiency was time-barred under section 6501(a), which generally provides that the Service can assess tax within three years after a return is filed. Nevertheless, the Tax Court held that the Service’s notice of deficiency was timely and that the section 6501 limitations period had not begun to run against the Service because the taxpayer did not show “meticulous compliance” by intentionally filing a return with the Service. In so holding, the Tax Court aligned itself with decisions of the Eighth and Eleventh Circuits.
Appleton and Hulett distinguished. The Tax Court distinguished its holding in Tice from its seemingly contrary holding in Appleton v. Commissioner. The taxpayer in Appleton also filed returns for 2002-2004 with the VIBIR only; however, the Service had subsequently received copies of the taxpayer’s USVI returns from the VIBIR. The Service had received the Appleton taxpayer’s USVI returns through the so-called “cover-over” process whereby the VIBIR requests that taxes paid to the U.S. by USVI residents be remitted (i.e., “covered over”) to the USVI. The VIBIR invokes the cover-over process by sending critical portions of a taxpayer’s return information to the Service. A cover-over request typically includes a partial or complete copy of a taxpayer’s USVI return. The Service conceded in Appleton that “the taxpayer’s subjective intent has no role to play” in determining whether a return has been properly filed. The taxpayer and the Service in Appleton also stipulated that the taxpayer was a bona fide resident of the USVI for the years in issue. Thus, the taxpayer contended, and the Tax Court in Appleton agreed, that the copies of the taxpayer’s USVI returns for years 2002-2004 transmitted to the Service started the section 6501 limitations period vis-à-vis the Service. The Hulett taxpayer made an argument similar to that made by the taxpayer in Appleton about the cover-over process triggering the section 6501 limitations period, and the lead Tax Court opinion in Hulett adopted this argument to hold for the taxpayer regarding the section 6501 limitations period. As noted above, however, the Eighth Circuit reversed the Tax Court’s decision in Hulett, holding that the VIBIR-IRS cover-over process is not sufficient to “meticulously comply with the requirements to file with the Service.” Similarly, the Eleventh Circuit in Commissioner v. Estate of Sanders, also rejected the cover-over argument, holding that “a taxpayer who files a return only with the VIBIR does not trigger the statute of limitations unless he actually is a bona fide resident of the USVI.” The taxpayer in Tice reserved making a similar argument as the taxpayer in Appleton (i.e., that VIBIR return copies sent to the Service start the statute of limitations against the Service under section 6501), so expect another Tax Court decision on this issue soon.
Reading between the lines and clarifying. It appears that, if in addition to the taxpayer’s USVI return filed with the VIBIR, the taxpayer had meticulously and intentionally filed a Form 1040 with the Service for 2002 and 2003—even if the return so filed listed $0 gross income, $0 deductions, and $0 tax—the statute of limitations of section 6501 would have run against the Service. Further, for USVI returns filed for 2006 and later tax years, Regulation section 1.932-1(c)(2)(ii) expressly provides that the section 6501 limitations period begins running against the Service based solely upon filing a return with the VIBIR in which the taxpayer takes the position that he or she is a bona fide resident of the USVI.
a. Wow! That was fast. In a case appealable to the Eleventh Circuit and with facts virtually identical to Tice, the Tax Court (Judge Buch), in a memorandum decision, refused to grant summary judgment to a taxpayer who argued that the cover-over process between the VIBIR and the Service triggers the section 6501 limitations period on assessment of tax for the Service. Instead, Judge Buch ruled that a genuine issue of material fact remained to be determined: whether the taxpayer “intended the VIBIR’s transmission of the cover-over requests to be the filing of his returns.” In both Tice and Estate of Tanner, the Service neither (i) conceded that the taxpayer’s subjective intent has no role to play in determining whether a return has been properly filed, nor (ii) stipulated that the taxpayer was a bona fide resident of the USVI. Thus, Judge Buch’s opinion noted that both Appleton and Hulett are distinguishable. Judge Buch further noted that the Estate of Tanner case is appealable to the Eleventh Circuit and governed by the Estate of Sanders decision mentioned above. Therefore, the Tax Court’s decision in Estate of Tanner also supports the conclusion that, if a taxpayer wishes to ensure the running of the section 6501 statute of limitations against the Service, the taxpayer would be well advised to file a return in the U.S. even if that return shows $0 gross income, $0 deductions, and $0 tax. Again, with respect to USVI returns filed for 2006 and later tax years, Regulation section 1.932-1(c)(2)(ii) expressly provides that the section 6501 limitations period begins running against the Service based solely upon filing a return with the VIBIR in which the taxpayer takes the position that he or she is a bona fide resident of the USVI.
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 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 directed 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, 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 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.
a. The Third Circuit disagrees. The 90-day period specified in section 6213(a) for filing a petition in the U.S. Tax Court is not jurisdictional and is subject to equitable tolling. In an opinion by Judge Ambro, the U.S. Court of Appeals for the Third Circuit 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 not jurisdictional and is subject to equitable tolling. Although the Third Circuit’s opinion does not provide specific dates, it states that the Service mailed a notice of deficiency to the taxpayers, a married couple, as well as a second notice of deficiency, both with respect to the taxable year 2015. The taxpayers filed a petition in the Tax Court seeking redetermination of the deficiency well outside the 90-day period specified in section 6213(a) for doing so. In an unpublished order, the Tax Court dismissed the taxpayers’ petition for lack of jurisdiction. On appeal, the taxpayers, backed by amicus curiae represented by the Legal Services Center of Harvard Law School, argued that the 90-day period provided by section 6213(a) is not jurisdictional and is subject to equitable tolling in appropriate circumstances. The court framed the issue in this way:
The central question in this appeal is whether the Culps’ late filing deprives the Tax Court of jurisdiction to consider their petition. Put another way, is section 6213(a)’s 90-day requirement jurisdictional or is it a claims-processing rule?
The court first analyzed the text of section 6213(a), which provides in part:
Within 90 days … after the notice of deficiency authorized in section 6212 is mailed …, the taxpayer may file a petition with the Tax Court for a redetermination of the deficiency.… The Tax Court shall have no jurisdiction to enjoin any action or proceeding or order any refund under this subsection unless a timely petition for a redetermination of the deficiency has been filed and then only in respect of the deficiency that is the subject of such petition.
The court concluded that the provision’s text did not indicate that the 90-day period specified in section 6213(a) is jurisdictional. The language Congress used, the court reasoned, does not link the 90-day deadline to the Tax Court’s jurisdiction. The statute provides that the Tax Court has no jurisdiction to enjoin actions or order a refund if the taxpayer’s petition is not timely filed, which indicates that “Congress knew how to limit the scope of the Tax Court’s jurisdiction.” But the provision does not similarly limit the Tax Court’s jurisdiction to review petitions that are not timely filed. Further, according to the court, neither the context of the statute nor the court’s own precedent interpreting section 6213(a) indicates that the 90-day period is jurisdictional.
After holding that the 90-day period specified in section 6213(a) is not jurisdictional, the court considered whether the period is subject to equitable tolling. According to the court, neither the text nor the context of the statute suggests that Congress intended the period not to be subject to equitable tolling. Accordingly, the court remanded the case to the Tax Court with instructions for the Tax Court to consider whether the taxpayers could demonstrate sufficient grounds for the 90-day period to be equitably tolled.
b. The Tax Court apparently will not follow the Third Circuit’s decision in Culp in cases appealable to other circuits. In a case decided after the Third Circuit issued its decision in Culp, the Tax Court refused to apply equitable tolling in a case appealable to the Tenth Circuit. Briefly, the taxpayer’s Tax Court petition arrived one day after the 90-day period of section 6213(a) had expired. Moreover, the “timely-mailed, timely-filed” rule of section 7502 did not apply because the taxpayer used FedEx Ground instead of one of the other FedEx delivery services permitted under section 7502 pursuant to Notice 2016-30, 2016-18 I.R.B. 676. The Tax Court (Judge Lauber) refused to apply equitable tolling principles and dismissed the taxpayer’s petition for lack of jurisdiction, stating in footnote 2 of the opinion:
Absent stipulation to the contrary this case is appealable to the Tenth Circuit, and we thus follow its precedent, which is squarely on point. See Golsen v. Commissioner, 54 T.C. 742, 756–57 (1970), aff’d, 445 F.2d 985 [27 AFTR 2d 71-1583] (10th Cir. 1971). The Tenth Circuit has long agreed with this Court’s holdings that the statutory period prescribed by section 6213(a) is a jurisdictional requirement. See Armstrong v. Commissioner, 15 F.3d at 973 n.2; Foster v. Commissioner, 445 F.2d 799, 800 [28 AFTR 2d 71-5210] (10th Cir. 1971). Thus, we need not address a recent ruling by the U.S. Court of Appeals for the Third Circuit that the statutory filing deadline in deficiency cases is a non-jurisdictional “claims-processing” rule. See Culp v. Commissioner, 75 F.4th 196, 205 [132 AFTR 2d 2023-5198] (3d Cir. 2023).
The Service explains and announces slightly longer look-back periods under section 6511 for filing claims for credit or refund relating to COVID-year postponed returns and payments of taxes. Appreciating this IRS Notice requires some knowledge of recent history as well as an understanding of section 6511 relating to claims for credit or refund of federal taxes paid. The bottom line, though, is good news for taxpayers. Note to self: You may want to mark May 17, 2024, on your calendar for individual clients who filed their 2020 federal income tax returns by the COVID-year postponed due date of May 17, 2021.
Background. As a result of the COVID pandemic, the Service exercised its authority under section 7508A to postpone the filing and payment deadlines for numerous types of federal tax returns and taxes due in 2020 and 2021. Although Notice 2020-23 and Notice 2021-21 postponed certain return filing and payment due dates, those notices did not extend the time for filing the returns because a postponement is not an extension. As a result, the postponements did not lengthen the so-called “lookback period” of section 6511(b), which limits a taxpayer to recovering only taxes paid within a specified look-back period.
Limitations periods of section 6511. Section 6511(a) generally requires claims for credit or refund of federal taxes paid to be filed by the later of (i) three years from the time the taxpayer’s return was filed or (ii) two years from the time the tax was paid. If the taxpayer fails to file the claim within one of these periods, then section 651l(b)(l) prohibits the Service from making the refund. Even if a taxpayer files a claim for refund within one of the periods prescribed by section 6511(a), the amount of tax that the taxpayer can recover may be limited by section 6511(b)(2). If the taxpayer files the claim within the three-year period of section 6511(a), then under section 651l(b)(2)(A) the taxpayer can recover only the portion of the tax paid during the period preceding the filing of the refund claim equal to three years plus any extension of time the taxpayer may have obtained for filing the return. If the taxpayer files the refund claim more than three years after the taxpayer filed the return, but within two years after the taxpayer paid the tax (so that the two-year period of section 6511(a) is satisfied), then under section 6511(b)(2)(B) the taxpayer can recover only the portion of the tax paid during the two years preceding the filing of the refund claim. Furthermore, for a calendar-year taxpayer, withheld and estimated income taxes are deemed paid on the due date of the tax return, generally April 15 of each year. The three-year lookback period of section 6511(b)(2)(A), particularly the deemed April 15 payment date for withheld and estimated taxes, is the subject of Notice 2023-21.
Notice 2023-21. Under the general rule of section 6511(b)(2)(A) described above, taxpayers who did not extend the time for filing their 2019 or 2020 federal returns must file a claim for credit or refund within three years of the normal due date for their returns (generally April 15, 2020, or April 15, 2021, respectively). Yet, Notice 2020-23 postponed until July 15, 2020, the due date for most 2019 federal tax returns, and Notice 2021-21 postponed until May 17, 2021, the due date for 2020 individual federal income tax returns. Technically, these “postponements” are not “extensions.” Therefore, absent relief, the three-year lookback period for filing claims for credit or refund of 2019 or 2020 taxes paid (or deemed paid) with returns timely-filed according to the postponed 2020 or 2021 filing dates would expire earlier than the full three years otherwise allowed by section 6511(b)(2)(A). Consequently, pursuant to section 7508A the Service has announced relief for any person (i) with a federal tax return filing or payment obligation that was postponed by Notice 2020-23 to July 15, 2020, or (ii) with a federal income tax return in the Form 1040 series that was postponed by Notice 2021-21 to May 17, 2021. Notice 2023-21 provides that, for taxpayers affected by Notice 2020-23, the period beginning on April 15, 2020, and ending on July 15, 2020, will be disregarded in determining the beginning of the lookback period for the purpose of determining the amount of a credit or refund under section 6511(b)(2)(A). Similarly, for taxpayers affected by Notice 2021-21 the period beginning on April 15, 2021, and ending on May 17, 2021, will be disregarded in determining the beginning of the lookback period for the purpose of determining the amount of a credit or refund under section 6511(b)(2)(A). The relief provided under section 7508A and announced in Notice 2023-21 is automatic. Affected taxpayers do not have to call the Service, file any form, or send letters or other documents to receive this relief.
Example. Taxpayer is a calendar-year filer with a 2019 federal income tax return due date of April 15, 2020. Taxpayer’s employer withheld income taxes from Taxpayer’s wages throughout 2019 and remitted the withheld income taxes to the Service. Pursuant to section 6513(b), these withheld income taxes are deemed paid on April 15, 2020. The due date for Taxpayer’s 2019 federal income tax return was postponed by Notice 2020-23 to July 15, 2020. Pursuant to the postponed due date, Taxpayer timely filed their return on June 22, 2020. Under section 6511(a), Taxpayer may timely file a claim for credit or refund until three years from the return filing date, or June 22, 2023. But if Taxpayer files a claim for credit or refund on June 22, 2023, absent the relief granted in Notice 2023-21, the amount of Taxpayer’s credit or refund would be limited to tax paid during the period beginning three years before the filing of the claim, or June 22, 2020. As a result, a credit or refund of Taxpayer’s withheld income taxes would be barred because they were deemed paid on April 15, 2020, outside of the lookback period in section 6511(b)(2)(A). This notice provides relief by disregarding the period beginning on April 15, 2020, and ending on July 15, 2020, in determining the beginning of the lookback period. Accordingly, under the relief provided by this notice, if Taxpayer files a claim for credit or refund on or before June 22, 2023, the lookback period extends three years back from the date of the claim, disregarding the period beginning on April 15, 2020, and ending on July 15, 2020. As a result, the limit to the amount of the credit or refund would include Taxpayer’s withheld income taxes deemed paid on April 15, 2020.
Partnership’s 2001 tax year remains open until 2010 because no original return was filed and neither a copy faxed to a Service agent in 2005 nor a second copy mailed to a Service attorney in 2007 started the three-year limitations period on assessment of tax. The procedural history of this case demonstrates the Tax Court’s and the Ninth Circuit’s struggles to determine the proper outcome. First, the Tax Court held for the Service. Then, a three-judge panel of the Ninth Circuit (by a two-to-one vote) reversed the Tax Court and held for the taxpayer. Finally, an en banc panel of the Ninth Circuit (by a ten-to-one vote) vacated the three-judge panel’s prior decision and held for the Service, affirming the Tax Court. Notwithstanding the procedural complexities, the facts of the case are relatively straightforward. Seaview Trading, LLC, a TEFRA partnership, mistakenly failed to file its original 2001 Form 1065 even though the return apparently had been timely prepared and signed. (Seaview’s return preparer may have mailed to the Service a related entity’s original tax return in the envelope that was meant to contain Seaview’s 2001 Form 1065.) In July of 2005, a Service agent in South Dakota notified the tax matters partner that there was no record of Seaview having filed a return for 2001. Next, in September of 2005, Seaview faxed a copy of its original return to the Service agent; however, the agent did not forward the faxed return to the IRS Service Center in Ogden, Utah, which was the proper place for filing Seaview’s 2001 return. Subsequently, in July of 2007 while an IRS audit was ongoing, Seaview mailed a copy of its original 2001 return to a Service attorney in Minnesota; but again, the attorney did not forward the copy to the Ogden Service Center. Lastly, in October of 2010, the Service issued a notice of final partnership administrative adjustment (“FPAA”) to Seaview disallowing a $35.5 million claimed loss for 2001. Seaview responded by filing a petition in Tax Court contending that the Service’s proposed adjustment was untimely. Seaview asserted that, under section 6229(a)(1), the Service has only three years from the time the partnership return is filed to assess tax, and that this period had expired no later than July 2010 (three years after the copy of the taxpayer’s return was mailed to the Service attorney in Minnesota and before the FPAA was received). The Service, of course, argued that the statute of limitations never began to run because Seaview did not properly file an original return with the Ogden Service Center. As the case wound its way through the Tax Court up to the Ninth Circuit, the record established that neither Seaview’s original 2001 Form 1065 nor a copy thereof was ever sent to or received by the Ogden Service Center. Thus, the only question before the Ninth Circuit was whether the Service’s FPAA, issued in October 2010, was issued before the three-year limitations period on assessment of tax had expired.
The Arguments. The Service argued that a return is properly “filed” for statute of limitation purposes only when it is submitted to, or eventually received by, the proper IRS Service Center, which in this case was in Ogden, Utah. The Service relied upon then-applicable regulations (Regulation section 1.6031(a)-1(e)) and instructions to the 2001 Form 1065, which designated the Ogden Service Center as the proper place for filing Seaview’s return. Seaview countered that the then-applicable regulations and instructions to the 2001 Form 1065 should be read to apply to returns filed on time, not late-filed returns or copies thereof delivered to a Service agent or attorney. For delinquent returns, Seaview argued, there is no specific instruction regarding where such returns should be filed in the Code, applicable regulations, or the instructions for Form 1065. Therefore, Seaview urged the Ninth Circuit to hold that its delinquent 2001 return on Form 1065 was “filed” no later than July 2007, when it was mailed to the Service attorney in Minnesota. In support of its position, Seaview cited IRS documents (a 1999 advice memorandum, the 2005 Internal Revenue Manual, and a 2006 policy statement) which permitted Service personnel to receive and “accept” delinquent returns during an examination. The 2005 Internal Revenue Manual went further to state that such accepted but delinquent returns should be forwarded “to the appropriate campus.” Seaview also cited as support for its position the Tax Court’s decision in Dingman v. Commissioner In Dingman, the Tax Court held that delinquent, original returns delivered to Service investigators, not an IRS Service Center, were considered properly “filed” when checks accompanying the delinquent returns were credited to the taxpayer’s account.
Ninth Circuit Majority. The Ninth Circuit majority was not persuaded by Seaview’s arguments. Judge Watford, writing on behalf of the ten-judge majority, reasoned that, although the Code, regulations, and instructions for Form 1065 did not dictate where delinquent tax returns (or copies thereof) should be filed, limitation statutes barring the collection of taxes are strictly construed in favor of the government. Thus, a taxpayer’s “meticulous compliance” with return filing requirements is necessary to start the statute of limitations running against the Service. The court reasoned that the failure of the Service agent and attorney to forward copies of Seaview’s 2001 Form 1065 to the Ogden Service Center according to Service policy did not relieve Seaview of its return filing obligations. Judge Watford concluded:
Because Seaview did not meticulously comply with the regulation’s place-for-filing requirement, it is not entitled to claim the benefit of the three-year limitations period. Having never properly filed its return, Seaview is instead subject to the provision allowing taxes attributable to partnership items to be assessed “at any time.”
Dissenting opinion of Judge Bumatay. Judge Bumatay dissented, arguing that the majority’s decision “throws our tax system into disarray” by allowing “bureaucrats,” not law, to control when a return filing starts the statute of limitations running against the Service. Judge Bumatay reasoned that, in the absence of clear regulations or other published guidance, the Service should be bound by its stated policy directing Service personnel to forward “accepted” but delinquent returns to the appropriate IRS Service Center. Therefore, in Judge Bumatay’s view, a late partnership return should be considered “filed” for statute-of-limitations purposes:
when (1) a Service representative authorized to obtain and receive delinquent returns informs a partnership that a tax return is missing and requests that tax return, (2) the partnership responds by giving the Service representative the tax return in the manner requested, and (3) the Service representative receives the tax return.
A petition e-filed at 11:05 p.m. central time, which is 12:05 a.m. eastern time, was late and the Tax Court therefore had no jurisdiction to hear the matter. The taxpayers in this case received a notice of deficiency with respect to tax year 2019. The last day of the 90-day period specified by section 6213(a) within which the taxpayers could challenge the notice of deficiency by filing a petition in the U.S. Tax Court was July 18, 2022. The taxpayers, who resided in Alabama, e-filed their petition at 11:05 p.m. central time on July 18. The Service moved to dismiss for lack of jurisdiction on the basis that the taxpayers had not filed their petition by the last day of the 90-day period specified by section 6213(a). The Tax Court (Judge Buch) agreed with the government and granted the motion to dismiss. The court reasoned that “a petition is ordinarily ‘filed’ when it is received by the Tax Court in Washington, D.C.” In this case, the court observed, the Tax Court, which is in the Eastern time zone, had received the taxpayers’ petition at 12:05 a.m. on July 19, which was one day (by five minutes) late. Further, the court observed, the “timely mailing” rule of section 7502(a) does not apply to petitions filed electronically:
Under section 7502(a), a document that is mailed before it is due but received after it is due is deemed to have been received when mailed. But that rule applies only to documents that are delivered by U.S. mail or a designated delivery service. Because an electronically filed petition is not delivered by U.S. mail or a designated delivery service, the exception of section 7502 does not apply.
If the timely mailing rule does not apply, the court stated, then a taxpayer’s petition is filed when it is received by the Tax Court. In this case, the court reasoned, although it was still July 18 where the taxpayers resided and where they e-filed their petition, it was July 19 in the Eastern time zone and their petition therefore was filed one day late. Accordingly, the court granted the government’s motion to dismiss for lack of jurisdiction.
Observation: the court’s holding could work to the advantage of a taxpayer who resides abroad. (Keep in mind that taxpayers residing abroad normally have 150 days (rather than 90) to file their petitions.) If a U.S. citizen resides, say, in England, and the last day to file the petition is July 18, then, assuming a 5-hour time difference, the taxpayers presumably would have until 4:59 a.m. on July 19 to e-file their petition because the petition would be received by the Tax Court in the eastern time zone at 11:59 p.m. on July 18.
The taxpayer-promoter in this case was convicted of certain tax crimes in 2008 and sentenced to prison, where he remained until his release in 2014. In 2010 and within the three-year limitations period on assessment provided by section 6501, the Service assessed penalties against the taxpayer under section 6700 (promoting abusive tax shelters). Then, in 2011, the Service recorded a Notice of Federal Tax Lien (“NFTL”) against the taxpayer’s California property and delivered to the taxpayer a Letter 3172, Notice of Federal Tax Lien Filing and Your Right to a Hearing (“lien notice”). The letter instructed the taxpayer to submit his request for a collection due process (“CDP”) hearing by December 30, 2011. The taxpayer did not respond to the lien notice and did not request a CDP hearing. The Service then suspended collection activities against the taxpayer while he was incarcerated. Next, in 2017, approximately three years after the taxpayer was released from prison but within the ten-year collection period of section 6502, the Service issued a notice of determination to the taxpayer sustaining the collection action and delivered a Letter 1058, Notice of Intent to Levy and Your Right to a Hearing (“levy notice”) relating to the section 6700 penalties. Through his representative, the taxpayer requested a CDP hearing. In the CDP hearing, the Service Settlement Officer issued a notice of determination upholding the proposed collection action. The taxpayer challenged this determination by filing a petition in the Tax Court. The taxpayer first filed a motion to recuse and disqualify all Tax Court judges on separation of powers grounds. The Tax Court denied that motion in July 2019. Next, in December 2019, the Service filed a motion for summary judgment, and the taxpayer filed a cross-motion for summary judgment arguing alternatively that the statute of limitations had run against the Service under both section 6501 (three-year limit on assessment) and section 6502 (ten-year limit on collection). The Tax Court (Judge Lauber) decided in favor of the Service and issued its opinion sustaining the Service’s collection actions in October 2021. The taxpayer appealed to the D.C. Circuit.
Appeal: On appeal to the D.C. Circuit, the taxpayer again made his separation of powers and statute of limitations arguments. The D.C. Circuit, in an opinion by Judge Rogers, ruled two-to-one against the taxpayer on both arguments. We omit discussion of the taxpayer’s separation of powers argument. Concerning the taxpayer’s statute of limitations argument, Judge Rogers held for the Service noting that the D.C. Circuit is joining the Second, Fifth, and Eighth Circuits in holding that section 6501 does not apply to the assessment of promoter penalties under section 6700. According to Judge Rogers, the primary reason that the three-year limitation on assessment under section 6501 does not apply is because the section 6700 penalty turns on the promoter’s conduct, not the filing of a return by the promoter’s client. The taxpayer also made a statute of limitations argument under 28 U.S.C. 2462 which imposes a five-year limitation period on any action to enforce a “civil fine, penalty, or forfeiture.” With regard to this argument, Judge Rogers agreed with the Second and Eighth Circuits that 28 U.S.C. 2462 does not apply to section 6700 penalties because Congress “otherwise provided” for the ten-year limitation on collection in section 6502. The D.C. Circuit thus upheld the Tax Court’s summary judgment in favor of the Service and against the taxpayer.
Dissenting opinion of Judge Walker. In a dissenting opinion, Judge Walker indicated that he would remand the case to the Tax Court for further proceedings because he believed that the taxpayer’s statute-of-limitations argument “has some merit.” Judge Walker wrote: “Rather than deciding, as the majority does, that no return can ever trigger section 6501(a)’s statute of limitations in a tax-shelter-promotion case, I would let the Tax Court determine, on a case-by-case basis, whether a tax return has triggered the limitations clock.”
This was the conclusion of the Fourth Circuit, but the taxpayer nevertheless plausibly alleged that his claim for refund was physically delivered to the Service. The Service audited the taxpayer’s 2012 return. The audit revealed that the taxpayer was entitled to a refund but the Service mistakenly sent the taxpayer a letter stating that he owed additional tax and interest, which he paid. After the taxpayer’s accountant discovered the error, the taxpayer mailed a claim for refund for 2012 and, in the same envelope, mailed an amended return for 2013 claiming a refund for 2013 as a result of certain adjustments to his 2012 return. The taxpayer mailed the envelope containing the claims for refund for 2012 and 2013 by first class mail. After a great deal of effort on the taxpayer’s part, the Service issued the refund for 2012. But the Service took the position that it had never received the taxpayer’s claim for refund for 2013. The taxpayer brought this action for a refund in the U.S. District Court. Under section 7422(a), the jurisdiction of both U.S. District Courts and the U.S. Court of Federal Claims to hear tax refund actions is limited to those cases in which the taxpayer has “duly filed” a claim for refund with the Service. The issue in this case was how the taxpayer could prove that he had filed the necessary timely refund claim for 2013.
The taxpayer argued that he could rely on the so-called common-law mailbox rule developed and applied by some courts. Under the narrow version of this rule, if a taxpayer can show that a document was actually delivered, but can’t prove precisely when delivery occurred, a court can presume that physical delivery occurred within the ordinary time after mailing. Under a broader version of this rule adopted by some courts, proof of proper mailing (including by testimonial or circumstantial evidence) gives rise to a rebuttable presumption that the document was physically delivered to the addressee in the time the mailing would ordinarily take to arrive. In other words, the narrow version requires the taxpayer to prove delivery and assists the taxpayer only in establishing the time of delivery. The broader version of the rule requires the taxpayer only to prove timely mailing and, if timely mailing occurred, gives rise to a rebuttable presumption that the document was delivered.
The government moved to dismiss the taxpayer’s refund action for lack of jurisdiction and argued that the common-law mailbox rule, the court held, has been displaced by section 7502. Under section 7502(a) (which reflects the narrower version of the common-law mailbox rule), the postmark stamped on the cover in which a return or claim is mailed is deemed to be the date of delivery if the return or claim (1) is deposited in the mail in the United States within the time prescribed for filing in a properly addressed, postage prepaid envelope or other appropriate wrapper and bears a postmark date that falls within the time prescribed for filing, and (2) is delivered by United States mail after the prescribed time for filing to the agency with which it is required to be filed. In section 7502(c)(1), the statute also reflects the broader version of the common law mailbox rule and provides that, if the return or claim is mailed by United States registered mail, the date of registration is treated as the postmark date and the registration is prima facie evidence that the return or claim was delivered to the agency to which it was addressed. Section 7502(c)(2) authorizes the Secretary of the Treasury to issue regulations providing the same treatment of returns or claims sent by certified mail, which Treasury and the Service have done. Section 301.7502-1(e)(2)(i) of the regulations further provides that, except for direct proof of actual delivery, proof of proper use of registered or certified mail (or a designated private delivery service) is the exclusive means to establish prima facie evidence of delivery and that “[n]o other evidence of a postmark or of mailing will be prima facie evidence of delivery or raise a presumption that the document was delivered.”
The Fourth Circuit agreed with the Service that the common-law mailbox rule has been displaced by section 7502. Because the taxpayer had not sent his claims for refund by registered or certified mail, he could not rely on the presumption of delivery provided by section 7502(c). In reaching this conclusion, the court did not give deference to Regulation section 301.7502-1(e)(2)(i) under the two-step analysis of Chevron. The court concluded that the statute was not ambiguous on this question (Chevron step one) and that giving deference to the regulation was therefore unnecessary.
According to the Fourth Circuit, however, this did not end the inquiry:
Is Pond out of luck just because he cannot rely on a presumption of delivery? No. He can still proceed if he has plausibly alleged that his claim was physically delivered to the Service.
The court concluded that the taxpayer had plausibly alleged that his claim was physically delivered to the Service and had supported his claim with three factual allegations. The taxpayer had alleged: (1) that the envelope containing the 2013 claim was postmarked on a specific date, which suggests that the document made it to its destination; (2)that his 2012 and 2013 claims were sent in a single envelope, and the Service paid his 2012 claim; and (3) that the letter he received from the IRS denying his 2013 claim listed the “date of claims received” as a specific date.
Therefore, according to the Fourth Circuit, the District Court, in ruling on the government’s motion to dismiss, should have drawn all reasonable inferences in the light most favorable to the taxpayer. The District Court had not done so and therefore erred in granting the government’s motion. The court remanded for further proceedings.
Use separate envelopes, and for God’s sake, use registered or certified mail when a deadline is approaching! This decision provides two valuable lessons to those filing documents with the Service when a deadline is approaching. First, although it might be easier to send multiple filings in a single envelope, doing so runs the risk that the Service will perceive the envelope as containing only one item. It is much better practice to mail one item per envelope. Second, if a deadline is approaching, it is imperative to send the document to the Service using registered or certified mail. Doing so will provide prima facie evidence of mailing and will give rise to a statutory presumption that the document was delivered.
A petition e-filed eleven seconds after midnight is late, so the Tax Court lacks jurisdiction to hear the case. The 90-day deadline under section 6213 for this pro se taxpayer to file a petition in the Tax Court was midnight on December 12, 2022. The Tax Court’s DAWSON e-filing system was available and fully operational at all relevant times on December 12, 2022, during which the taxpayer sought to e-file his petition. The taxpayer initially attempted to use his mobile telephone to e-file his petition on the evening of December 12, 2022; however, the taxpayer encountered technological problems using his mobile telephone. Next, after gaining access to a computer shortly before midnight, the taxpayer logged into the Tax Court’s DAWSON e-filing system at 11:57 p.m. on December 12, 2022, and began the e-filing process. Several steps must be completed under the DAWSON system to e-file, and the taxpayer did not complete those steps prior to midnight. In fact, due to no fault of the DAWSON system, the upload process for the taxpayer’s e-filed petition did not begin until 12:00:09 am on December 13, 2022, and the petition was not electronically received by the Tax Court until 12:00:11 am on December 13, 2022, eleven seconds late. Because the taxpayer’s petition was filed eleven seconds late, the Service filed a motion to dismiss for lack of subject matter jurisdiction. The taxpayer objected, arguing that the Tax Court should treat his petition as timely filed when the taxpayer logged into the DAWSON system at 11:57 pm and began the filing process. Essentially, the taxpayer argued that logging into the DAWSON e-filing system at 11:57 p.m. on December 12, 2022, to meet the 90-day deadline under section 6213 was equivalent to timely mailing a petition prior to midnight on December 12, 2022, under the special mailbox rule of section 7502. The Center for Taxpayer Rights, represented by the Tax Clinic at the Legal Services Center of Harvard Law School, filed an amicus brief supporting the taxpayer’s position. The Tax Court (Judge Buch) nonetheless ruled that e-filing a petition to meet the 90-day deadline under section 6213 is not equivalent to mailing a petition under section 7502 prior to the 90-day deadline. Judge Buch reasoned that the mailbox rule of section 7502 is a limited exception to the general rule that a Tax Court petition is not filed until it is received, citing Nutt v. Commissioner, discussed above in this outline. Furthermore, Judge Buch determined that another special rule under section 7451(b) that tolls the deadline for filing a Tax Court petition when “a filing location is inaccessible or otherwise unavailable to the general public” did not apply because the DAWSON system was functioning normally at all relevant times on December 12, 2022. According to Judge Buch, the courts have consistently held that “inaccessibility” under section 7451(b) does not extend to “user error or technical difficulties on the user’s side.” Finally, Judge Buch noted that equitable tolling does not apply to the filing of a Tax Court petition in a deficiency case. The filing deadline under section 6213 is jurisdictional, and the Tax Court must enforce it “regardless of equitable considerations.”
If I’m high on cannabis and forget the 30-day deadline, will “equitable tolling” get me a few extra days to file my collection due process hearing request with IRS Appeals? Maybe. À la Boechler, the Tax Court, in a reviewed opinion (14-0-3), introduces “equitable tolling” to the 30-day deadline under section 6320(a)(3)(B) for requesting a collection due process (“CDP”) hearing with IRS Appeals, overruling Kennedy v. Commissioner. Recall that in Boechler, the Supreme Court of the United States held that the 30-day period specified in section 6330(d)(1) for requesting judicial review in the Tax Court of a notice of determination following a CDP hearing with IRS Appeals is not jurisdictional and is subject to equitable tolling. In this case, the taxpayer missed the 30-day deadline in another provision, section 6320(a)(3)(B), which permits a taxpayer to request an administrative hearing with IRS Appeals after receiving a notice of the filing of federal tax lien (“NFTL”) under section 6323(a). More specifically, the taxpayer, a single-member LLC subsidiary that had elected subchapter C status, had unpaid tax for three years: 2010, 2011, and 2018. The Service issued notices of federal tax lien filings to the taxpayer for all three years. For tax years 2010 and 2011, the taxpayer timely requested a CDP hearing with IRS Appeals within the 30-day period under section 6320(a)(3)(B). For some reason, however, the taxpayer’s section 6320(a)(3)(B) request for a CDP hearing with IRS Appeals for 2018 was filed one day late. IRS Appeals determined that the taxpayer’s hearing request for 2018 was untimely and provided an equivalent hearing under Treasury Regualtion section 301.6320-1(i)(1). Ultimately, IRS Appeals issued an adverse notice of determination to the taxpayer for 2010 and 2011 and an adverse decision letter for 2018. The taxpayer then filed a petition in Tax Court seeking review for all three years. In response, the Service moved to dismiss the taxpayer’s Tax Court petition with respect to 2018 for lack of jurisdiction, arguing that IRS Appeals did not make a “determination” for the Tax Court to review under section 6330(d)(1). The taxpayer argued that the 30-day period for requesting a CDP administrative hearing with IRS Appeals under section 6320(a)(3)(B) should be equitably tolled, similar to SCOTUS’s ruling in Boechler under section 6330(d)(1) for a judicial hearing in Tax Court. The Tax Court, in a thirty-one-page opinion written by Judge Goeke reached the following holdings:
The Tax Court then remanded the case to IRS Appeals to determine if the taxpayer’s circumstances warranted equitable tolling.
Concurring and dissenting opinion of Judge Jones. In a concurring and dissenting opinion by Judge Jones (joined by Judges Buch and Foley), Judge Jones dissented from the majority’s holding that the Regulations under section 6320 do not preclude equitable tolling and would have held for the Service and against the taxpayer on that basis.
Despite the availability of electronic filing, if the office of the clerk of the Tax Court is inaccessible on the last day for filing a Tax Court petition, then under section 7451(b), the 90-day period for filing the petition is tolled for the number of days of inaccessibility plus an additional 14 days. The taxpayer received a notice of deficiency that stated the last day to file a petition with the Tax Court was Friday, November 25, 2022, which was the day after Thanksgiving. The Tax Court was administratively closed on that day. The taxpayer, who resided in Colorado, mailed his petition to the court on Monday, November 28, 2022. The court received the petition on December 1, 2022. The Service filed a motion to dismiss for lack of jurisdiction on the basis that the taxpayer had filed the petition late. The Tax Court (Judge Buch) held that the taxpayer had timely filed the petition and denied the Service’s motion. Section 7451(b), added to the Code in 2021 by the Infrastructure Investments and Jobs Act, tolls the period for filing a Tax Court petition if a filing location is inaccessible. Section 7451(b)(1) provides:
Notwithstanding any other provision of this title, in any case (including by reason of a lapse in appropriations) in which a filing location is inaccessible or otherwise unavailable to the general public on the date a petition is due, the relevant time period for filing such petition shall be tolled for the number of days within the period of inaccessibility plus an additional 14 days.
Section 7451(b)(2) defines the term “filing location” as either “(A) the office of the clerk of the Tax Court, or (B) any on-line portal made available by the Tax Court for electronic filing of petitions.” The court reasoned that, because the office of the clerk of the Tax Court, which is a filing location, was inaccessible on November 25, 2022 (the date the petition was due), section 7451(b) tolled the period for filing the taxpayer’s petition by one day (the period of inaccessibility) plus an additional 14 days. Accordingly, the taxpayer had until December 10, 2022, to file the petition. Further, because December 10, 2022, was a Saturday, under section 7503, the taxpayer had until Monday, December 12, 2022, to file the petition. The taxpayer’s petition was filed on December 1, 2022, the date on which it was received by the Tax Court, and therefore was timely. Although the taxpayer could have filed the petition at any time through Dawson, the court’s electronic filing system, the court concluded that, because “a fling location” was inaccessible on November 25, 2022, “the availability of the Court’s electronic filing system is immaterial.”
There were no significant developments regarding this topic during 2023.
Such posts are “newly discovered evidence” within the meaning of section 6015(e)(7) and therefore admissible even if they existed before the taxpayer requested innocent spouse relief. The Taxpayer First Act, enacted in 2019, amended Code section 6015 to clarify the scope and standard of review in the Tax Court of any determination with respect to a claim for innocent spouse relief, i.e., any claim for relief under section 6015 from joint and several liability for tax liability arising from a joint return. Among other changes, the legislation added section 6015(e)(7), which provides:
Any review of a determination made under this section shall be reviewed de novo by the Tax Court and shall be based upon—
A. the administrative record established at the time of the determination, and
B. any additional newly discovered or previously unavailable evidence.
The amendment was generally consistent with the Tax Court’s holding in Porter v. Commissioner, but resolved conflicting decisions in cases in which the taxpayer sought equitable innocent spouse relief under section 6015(f), some of which had held that the Tax Court’s review was limited to the administrative record and that the Tax Court’s standard of review was for abuse of discretion.
Procedural history. In this case, the taxpayer filed joint returns with her husband for the years 2012, 2013, and 2014 but some of the tax liability reported on those returns remained unpaid. Her husband died in 2016. The taxpayer submitted to the Service a request for innocent spouse relief for those years, which the Service denied. The taxpayer responded by filing a petition in the Tax Court seeking review pursuant to section 6015(e) and asking the court to determine that she was entitled to innocent spouse relief under section 6015(f). At trial, the Service sought to introduce into evidence Exhibit 13-R, which consisted of a series of blog posts from the taxpayer’s personal blog. These posts ranged in date from November 2, 2016, to January 5, 2022. The taxpayer moved to strike all blog posts that existed before September 8, 2020, the date on which the taxpayer submitted her administrative request for innocent spouse relief, on the ground that the posts had not been in the administrative record and were not “newly discovered evidence” within the meaning of section 6015(e)(7).
Tax Court’s analysis. In a unanimous, reviewed opinion by Judge Toro, the Tax Court concluded that the blog posts were “newly discovered evidence” within the meaning of section 6015(e)(7). The court began with the language of the statute and concluded that section 6015 does not define the term “newly discovered evidence.” Accordingly, the court reasoned, “[w]e must therefore discern the ordinary meaning of that phrase in 2019.” The court turned to the dictionary definition of the phrase “newly discovered” and concluded that the ordinary meaning of the phrase as of 2019 “was ‘recently obtained sight or knowledge of for the first time.’” The court concluded that the blog posts the Service sought to introduce into evidence were “newly discovered evidence” because the Service had first discovered them by searching the internet after the taxpayer had filed her petition in the Tax Court. In reaching this conclusion, the court rejected the taxpayer’s argument that section 6015(e)(7)(B) should be read to incorporate an additional limitation similar to that in Federal Rule of Civil Procedure (FRCP) 60(b)(2). Rule 60(b)(2) provides that a court can relieve a party from a final judgement, order, or proceeding on the basis of “newly discovered evidence that, with reasonable diligence, could not have been discovered in time to move for a new trial.” (emphasis added). The taxpayer argued that the Service could have discovered the blog posts that existed before September 8, 2020, once she had submitted her administrative request for innocent spouse relief on that date and that they therefore should not be considered “newly discovered evidence.” The court rejected this argument. The court reasoned that Congress had not included a reasonable diligence standard in the language of section 6015(e)(7)(B) and, in fact, the statute’s use of the phrase “any additional newly discovered evidence” counseled against reading such a limitation into the statute. The court also observed that the statute’s specification that the Tax Court’s standard of review of an Service determination concerning innocent spouse relief is de novo (rather than an abuse-of-discretion standard) supported “the conclusion that evidence unknown to a participant in the innocent spouse administrative proceeding should be admissible if that participant (now a party in our Court) offers it in the proceedings before us.” Finally, the court noted that section 6015(e)(7) applies in a context entirely different from that of FRCP 60(b)(2). When a party moves for relief from a judgment under FRCP 60(b)(2), both parties have had an opportunity to conduct discovery and introduce evidence at trial. In contrast, “in the context of section 6015(e)(7), the Court considers a case for the first time following a relatively limited administrative proceeding.” Accordingly, the court concluded that the blog posts offered into evidence by the Service were admissible.
Concurring opinion of Judge Buch. In a concurring opinion joined by Judges Ashford and Copeland, Judge Buch emphasized that, although the court’s holding was faithful to the language of section 6015(e)(7), that language “may not have captured what Congress intended.” Specifically, Judge Buch reasoned that the statute’s language permitting the introduction of “newly discovered or previously unavailable evidence” might be a one-way street that benefits only the government. Judge Buch gave an example of a spouse who is abused by her husband, posts about the abuse on social media, and submits an administrative request for innocent spouse relief that does not mention the social media posts. Such a spouse might be precluded from introducing the social media posts at trial in a subsequent Tax Court proceeding because she created the posts and therefore it might be difficult for her to establish that the posts were “newly discovered or previously unavailable” to her. This problem, he observed, is not limited to social media posts but could apply to “a vast array of evidence” that could be helpful to a requesting spouse to prove entitlement to innocent spouse relief.
Isn’t there some sort of fundamental right to travel? Don’t pack your bags just yet. Section 7345, which addresses the revocation or denial of passports for seriously delinquent tax debts, was enacted in 2015 as section 32101(a) of the Fixing America’s Surface Transportation Act (FAST Act). It provides that, if the Service certifies that an individual has a “seriously delinquent tax debt,” the Secretary of the Treasury must notify the Secretary of State “for action with respect to denial, revocation, or limitation of a passport.” In general, a seriously delinquent tax debt is an unpaid tax liability in excess of $50,000 for which a lien or levy has been imposed. A taxpayer who seeks to challenge such a certification may petition the Tax Court or bring an action in a 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.
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 Service 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 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, 26 U.S.C. section7421(a) (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.
a. This taxpayer apparently didn’t get the memo about Franklin or Ruesch (see above and below), but regardless, the Tax Court determines that its jurisdiction under section 7345 is limited to deciding whether the Service’s certification is erroneous and does not extend to hearing substantive challenges to assessed taxes or constitutional claims. The taxpayer in this case owed more than $1.2 million in federal income taxes, penalties, and interest accumulated across eight taxable years. The taxpayer failed to file federal income tax returns for the relevant years, and the Service prepared substitute returns for each year under section 6020(b). The Service also filed a notice of federal tax lien for each year under section 6323(f) and had notified the taxpayer of his right to a collection due process (CDP) hearing under section 6320. The taxpayer did not request a CDP hearing for any of the years in issue and the time for doing so had passed. The Service’s subsequent collection efforts against the taxpayer failed, so the Service issued the certification (via the Treasury Department) under section 7345(a) to the Secretary of State for purposes of denying, revoking, or limiting the taxpayer’s passport. Later, the taxpayer apparently lost his passport and applied to the State Department for a replacement. The Secretary of State refused to issue a replacement passport due to the outstanding section 7345 certification of the taxpayer’s “seriously delinquent tax debt” and so notified the taxpayer. Thereafter, the taxpayer petitioned the Tax Court, as permitted under section 7345(e)(1), to determine if the Service’s certification was erroneous. The taxpayer made two arguments that the Service’s section 7345 certification was erroneous. The taxpayer’s first argument was that he did not have a “seriously delinquent tax debt” because “as a matter of law [the Service] has failed to prove that any of the taxes [for the relevant years] were properly assessed.” Giving the pro se taxpayer the benefit of the doubt, the Tax Court liberally construed the taxpayer’s first argument to raise two alternative positions: (1) that he should be allowed to substantively challenge his tax liabilities underlying the section 7345(a) certification in Tax Court or (2) that section 7345 requires the underlying tax liabilities to be “properly assessed,” not merely “assessed,” before the Service certification can be issued. The Tax Court (Judge Toro) held that, as determined in Ruesch v. Commissioner, the Tax Court lacks jurisdiction under section 7345(e)(1) to review the tax liabilities underlying the certification of a “seriously delinquent tax debt.” Moreover, Judge Toro noted that plain language of section 7345(e)(1), which allows the taxpayer to petition the Tax Court, only requires that the tax liability be “assessed” by the Service. Here, the Service clearly had “assessed” the tax liabilities against the taxpayer. Furthermore, the taxpayer had ample prior opportunity (either via a deficiency proceeding or a collection due process hearing) to substantively challenge the IRS’s assessment. The taxpayer’s second argument was identical to the taxpayer’s argument in Franklin v. United States, but again Judge Toro relied upon the plain language of section 7345(e)(1). Judge Toro reasoned that section 7345(e)(1) does not grant the Tax Court jurisdiction to hear constitutional challenges relating to the refusal of the Department of State to issue a passport. Given its limited jurisdiction, the Tax Court does not have authority over the Secretary of State. Only a federal district court potentially has jurisdiction to hear the taxpayer’s constitutional arguments against section 7345 and possibly compel the Department of State to issue a passport notwithstanding the Service certification. Instead, the Tax Court’s jurisdiction is limited, as section 7345(e)(1) provides, to correcting an erroneous IRS certification of a “seriously delinquent tax debt.” Judge Toro did note, though, that a constitutional challenge to section 7345 was unsuccessful in Franklin.
b. ♪♫”Let’s call the whole thing off.”♫♪ Yet another Tax Court reviewed decision concerning section 7345. In this case under section 7345, the taxpayer applied for renewal of her passport after the Service had certified (via the Treasury Department) to the Secretary of State that she had a “seriously delinquent tax debt.” Accordingly, the Department of State declined to renew the taxpayer’s passport. Thereafter, the pro se taxpayer petitioned the Tax Court under section 7345(e)(1). After clearing some procedural hurdles, the Service moved for summary judgment against the taxpayer. The taxpayer never responded to the Service’s motion, even after two separate Tax Court orders were issued for her to do so. Eventually, the taxpayer filed a motion to dismiss her case, but failed to indicate whether the requested dismissal was with or without prejudice. The Service initially objected to the taxpayer’s motion to dismiss, but then consented. The Tax Court (Judge Copeland) construed the taxpayer’s motion as one to dismiss without prejudice; however, the court then had to determine whether, as a matter of first impression, a taxpayer is permitted to withdraw without prejudice a petition filed under section 7345(e)(1). On the one hand, Judge Copeland noted that, in deficiency proceedings under section 6213, the Tax Court cannot grant taxpayer motions to dismiss without prejudice. On the other hand, Judge Copeland reasoned that, where the Tax Court’s jurisdiction has been expanded, taxpayer motions to dismiss without prejudice have been allowed. Judge Copeland then looked to the Federal Rules of Civil Procedure for further guidance. The Federal Rules of Civil Procedure generally allow courts to grant motions to dismiss without prejudice unless dismissal would inflict “clear legal prejudice” on the non-moving party. Because the Service consented to the dismissal, Judge Copeland determined that the Service would not be harmed, and therefore granted the taxpayer’s section 7345(e)(1) motion to dismiss without prejudice. Finally, Judge Copeland ruled that the Service’s prior summary judgment motion was moot and should be dismissed as well.
But at least we think we know the law until Congress says otherwise: $10,000 max penalty per year for non-willful violations, but the greater of $100,000 or 50 percent of each foreign account for willful violations. The Bank Secrecy Act provides in part that U.S. persons owning an interest in foreign accounts with an aggregate balance of more than $10,000 in deposits must file an annual disclosure report. The annual disclosure is filed on the Financial Crimes Enforcement Network’s (“FinCEN”) Form 114 — Report of Foreign Bank and Financial Accounts (“FBAR”). Failure to properly file FinCEN Form 114 may result in varying penalties under 31 U.S.C. 5321(a)(5) depending upon whether the failure was willful or non-willful. We have reported below on the numerous cases decided under 31 U.S.C. 5321(a)(5) regarding the controversy surrounding the FBAR penalty for willful violations of 31 U.S.C. 5314. Generally, however, the United States Courts of Appeal addressing the issue agree that the FBAR penalty for willful violations is the greater of $100,000 or 50 percent of each offending account. With regard to non-willful FBAR violations, there has been a split between the Ninth and Fifth Circuits. In United States v. Boyd, the Ninth Circuit held for the taxpayer that the FBAR penalty for non-willful violations of 31 U.S.C. 5314 should be limited to $10,000 per annual filing of FinCen Form 114 regardless of the number of foreign accounts the taxpayer failed to properly report. In United States v. Bittner, the Fifth Circuit disagreed and held for the government that the FBAR penalty for non-willful violations is determined on a per-offending-account basis, similar to the FBAR penalty for willful violations. SCOTUS granted certiorari in United States v. Bittner, to resolve the split between the circuits.
The taxpayer in Bittner v. United States, had 61 foreign bank accounts in 2007, 51 in 2008, 53 in 2009 and 2010, and 54 in 2011. The government acknowledged that the taxpayer’s failure to properly file FinCEN Forms 114 for the numerous accounts held over the five-year period was non-willful. Nevertheless, the government sought to impose an FBAR penalty of $2.72 million on the taxpayer due to the number of offending accounts over the five-year period. Therefore, the question before the U.S. Supreme Court was whether the taxpayer owed $2.72 million in FBAR penalties or only $50,000 ($10,000 per year). Justice Gorsuch wrote the opinion for the majority (Gorsuch, Roberts, Alito, Kavanaugh, and Jackson), holding that the FBAR penalty under 31 U.S.C. 5321(a)(5) should be limited to $10,000 per year for non-willful violations of 31 U.S.C. 5314. Justice Gorsuch reasoned that 31 U.S.C. 5314 “does not speak of accounts or their number,” but instead refers to a duty to file annual “reports.” Justice Gorsuch was not persuaded by the government’s argument that because the penalty for willful violations of 31 U.S.C. 5321(a)(5) is determined on a per-offending-account basis, so should the lower penalty for non-willful violations. Instead, applying the expressio unius est exclusio alterius maxim of statutory construction (i.e., the use of different terms within a single statute implies a different meaning), Justice Gorsuch concluded that Mr. Bittner’s maximum FBAR penalty for non-willfully violating 31 U.S.C. 5314 over five years should be only $50,000 ($10,000 per year). Justice Barret wrote for the dissenters (Barrett, Thomas, Sotomayor, and Kagan), arguing that although expressio unius est exclusio alterius is a general rule of statutory interpretation, it gives way where context suggests otherwise. In Justice Barrett’s view, the FBAR penalties permitted under 31 U.S.C. 5321(a)(5), whether for willful or non-willful violations, only make sense if they are determined on a per-account basis. Otherwise, dissenting Justice Barrett wrote, the maximum annual penalty that the government may impose for a non-willful violation of 31 U.S.C. 5314 is $10,000 whether the taxpayer has one offending foreign bank account or one hundred such accounts.
Especially if you have a puzzling STD—not what you think—plan. The plaintiff in this case, a photojournalist, was an employee of the defendant, Turner Broadcasting Systems, Inc. (TBS) when the plaintiff injured his back in late 2012 loading camera equipment while at work. Thereafter, the plaintiff remained on the TBS’s payroll and was paid certain amounts under the defendant’s short-term disability (“STD”) plan. Puzzlingly, though, TBS’s STD plan consisted of two distinct policies. The first policy, J.A. 388, was for “job-related” injuries or illnesses and paid an injured employee a predetermined amount (or such greater amount as required by applicable workers’ compensation law) over the 26-week period following the injury. After the 26-week period, TBS’s workers’ compensation insurance carrier funds any payments to an injured or ill employee. The second policy, J.A. 383, was for employees “absent from work due to [their] own medical needs.” The predetermined payments to be made to injured or ill employees under either J.A. 388 or J.A. 383 were largely the same, except that J.A. 383 did not provide for increased payments due to workers’ compensation law). (The court’s opinion does not indicate whether payments under J.A. 383 continued beyond the 26-week period following injury.) TBS apparently considered all disability-related payments made to the plaintiff as falling under its J.A. 383 policy (non-workers’ compensation portion of its STD plan), while the plaintiff believed that the disability-related payments he received fell under J.A. 388 (workers’ compensation portion of STD plan). The distinction was important because any workers’ compensation payments made to the plaintiff would be excludable from gross income under section 104(a)(1); however, employer-funded disability payments to an employee that are not workers’ compensation are not excludable from gross income by the employee. TBS apparently believing that the payments to the plaintiff were not workers’ compensation payments, reported all amounts paid to the plaintiff during the years in issue as gross income on the Forms W-2 issued to the plaintiff. The plaintiff alerted TBS to the alleged error, but TBS either did not agree with the plaintiff or did not fully appreciate the significance of issuing inaccurate Forms W-2. Subsequently, the plaintiff sued TBS in federal district court under section 7434, which authorizes a private civil action for damages against “any person [who] willfully files a fraudulent information return with respect to payments purported to be made to any other person.” Section 7434 applies to information returns listed in section 6724(d)(1)(A), including Forms W-2, 1099-MISC, 1099-INT, and 1099-DIV among others. The district court had granted TBS’s motion for summary judgment, ruling that the Forms W-2 issued to the plaintiff were not fraudulent under any of three theories: (i) that the Forms W-2 filed by the defendant had the accurate gross amount of payments to the plaintiff, even if some portion of the payments should have been designated as excludable from gross income; (ii) that no reasonable jury could conclude that the plaintiff’s payments were workers’ compensation; or (iii) that the defendant’s error was not intentional and thus lacked the specific intent to deceive required for willfulness under section 7434. The U.S. Court of Appeals for the D.C. Circuit reversed and remanded the case for further proceedings, concluding that the District Court had erred under all three of its theories for granting summary judgment to TBS. In an opinion by Judge Wilkins, the D.C. Circuit held (i) that an information return may be false under section 7434 even if the gross amount of the payment is correct; (ii) that the confusion surrounding TBS’s STD plan, consisting of a workers’ compensation policy (J.A. 388) and non-workers’ compensation policy (J.A. 383), could lead a reasonable jury to find that the payments the plaintiff received were workers’ compensation; and (iii) that a knowing or reckless action, as opposed to specific intent to deceive, is sufficient to meet the willfulness requirement of section 7434. Of course, because the case was remanded to the federal district court for further proceedings, we do not know if the plaintiff ultimately will prevail in his section 7434 action for damages against the defendant. Nevertheless, the case is instructive regarding the care an employer (or its agent) should take in preparing and filing information returns subject to section 7434.
The taxpayers in this case were a married couple. The husband, Om, was experienced in business and established several businesses with large accounting and finance departments. His wife, Anjali, took care of the home and relied on her husband to handle all financial and tax matters. According to the opinion of the Tax Court (Judge Copeland), Anjali was reluctant to sign documents because a family member had forged her father’s signature to steal money, and she therefore was “leary of signing documents and made it an ordeal to get her signature on any document.” Again according to the Tax Court’s opinion, she
chose to not take part in the financial matters of the home, including tax matters. Since the time of their marriage, Anjali has never signed a tax return or asked anyone to sign a tax return for her. She did not pay attention to tax issues.
The 2004 return and proceedings in the Tax Court. The taxpayers’ tax returns were prepared by an accounting firm. The returns for the years 1999-2003 and for 2005-2015 were joint returns. For the year in question, 2004, the firm prepared a joint return, which Om signed. Although their son often signed his mother’s name on documents, including tax-related documents, the record was unclear as to who signed Anjali’s name on the 2004 return. The parties stipulated on appeal, however, that Anjali did not personally sign the 2004 return. On the 2004 return, the taxpayers deducted a loss of over $1.7 million from a subchapter S corporation in which Om held an ownership interest. Following an audit, the Service disallowed the loss deduction because, according to the Service, the taxpayers had failed to provide documentation to establish their basis in the S corporation’s stock. The Service issued a notice of deficiency asserting that the taxpayers were jointly and severally liable for additional tax of $642,629 and a late-filing penalty under section 6651(a)(1) of $28,835. The taxpayers filed a petition in the Tax Court, where they argued that the return filed for 2004 was not a valid joint return. In an amended answer, the Service asserted that the taxpayers also were liable for an accuracy-related penalty under section 6662 of $128,526. The Tax Court concluded that, although Anjali had not personally signed the return, it was nevertheless a valid joint return. Judge Copeland concluded that Anjali had tacitly consented to filing a joint return for 2004 because she had “approved or at least acquiesced in the joint filing of their 2004 return.”
Second Circuit’s Analysis. In an opinion by Judge Cabranes, the U.S. Court of Appeals for the Second Circuit affirmed the Tax Court’s decision. The court relied on its prior decision in O’Connor v. Commissioner, in which the court had provided guidance on the determination of whether a return is a joint return. According to O’Connor, a determination that a return is a joint return “is a factual issue of the intention of the parties and must be affirmed unless clearly erroneous.” Although normally a presumption of correctness attaches to the Service’s determination that a return is a joint return, that presumption does not apply if one spouse has not signed a purported joint return. When one spouse has not signed, the Service bears the burden of proving that the intent of the parties was to file jointly. The court in this case observed that four circumstances present in O’Connor, in which the court had concluded that the return was a joint return, were also present here. First, the non-signing spouse knew that a return had to be filed because the evidence showed that Anjali was aware that a return had to be filed and simply chose not to engage. Second, the non-signing spouse knew of the signing spouse’s expert knowledge concerning preparing and filing tax returns because Anjali knew of Om’s expert knowledge and relied on him to handle the family’s finances, including the filing of tax returns. Third, the parties filed a joint petition in the Tax Court. Fourth, the taxpayers asserted only a delayed challenge to the return’s characterization as a joint return because they had not disavowed its joint status until trial. The court also noted that the taxpayers had filed joint returns for every other year from 1999 through 2003 and from 2005 through 2014. Accordingly, the court concluded that the Tax Court had not clearly erred in in finding that the taxpayers intended to file a joint return.
Other issues. The taxpayers also argued that the three-year limitations period on assessment of tax provided by section 6501(a) had expired before the Service issued the notice of deficiency. The notice of deficiency for the year in question, 2004, was issued on March 12, 2015. The Service received a total of eight consents to extend the limitations period on assessment on Form 872, which ostensibly had been signed by the taxpayers or by their CPA, Mr. Grossman. The taxpayers argued that the consents were invalid for a variety of reasons, such as their contention that they had not signed a power of attorney on Form 2848 authorizing Grossman to act on their behalf and that he had forged Om’s signature on the power of attorney, and therefore any consents executed by him on their behalf were invalid. The Second Circuit affirmed the Tax Court’s decision that the period of limitations on assessment had not expired before the notice of deficiency was issued. The court affirmed the Tax Court’s finding that Om had signed the power of attorney on Form 2848 and its conclusion that both Om and Anjali had authorized Grossman to act on their behalf in consenting to extend the limitations period on assessment. Finally, the court affirmed the Service’s imposition of the late-filing penalty and the accuracy-related penalty because the taxpayers had not established a reasonable cause defense to the penalties.
There were no significant developments regarding this topic during 2023.
Calling someone a limited partner in a state-law limited partnership does not necessarily exempt that person from self-employment tax on their distributive share of partnership income. The petitioner in this case, Soroban Capital Partners LP (Soroban), is a limited partnership that, for the years in question, was subject to the former TEFRA unified audit and litigation procedures. Soroban had one general partner (a limited liability company) and three individual limited partners, Messrs. Mandelblatt, Kapadia, and Friedman. On the one hand, Soroban included in net earnings from self-employment on its partnership tax returns for 2016 and 2017 the guaranteed payments received by the three limited partners and the general partner’s distributive share of the partnership’s ordinary business income. On the other hand, Soroban excluded from net earnings from self-employment the limited partners’ distributive shares of the partnership’s ordinary business income. Following an audit, the Service issued Notices of Final Partnership Administrative Adjustment for 2016 and 2017 in which the Service proposed increasing net earnings from self-employment by the limited partners’ distributive shares of the partnership’s ordinary business income. On behalf of the partnership, the general partner filed a petition in the Tax Court challenging this adjustment. In the Tax Court, Soroban filed a motion for summary judgment asking the court to determine as a matter of law that the limited partners’ shares of the partnership’s ordinary business income were excluded from net earnings from self-employment or, alternatively, that any inquiry into the roles of the limited partners in the partnership’s business did not concern a partnership matter and therefore could not be resolved in this TEFRA partnership-level proceeding. The government filed a motion for partial summary judgment asking the court to determine as a matter of law that an inquiry into the limited partners’ roles could be determined in this partnership-level proceeding. The Tax Court (Judge Buch) denied Soroban’s motion and granted the government’s motion. Under section 1402(a), a partner’s distributive share of partnership income generally is treated as net earnings from self-employment, but section 1402(a)(13) excludes from this treatment “the distributive share of any item of income or loss of a limited partner, as such …” (other than guaranteed payments for services). The court reviewed the legislative history of section 1402(a)(13) and the government’s issuance of proposed regulations in 1997 that sought to define the scope of this limited partner exception and that led to a congressional moratorium on the issuance of regulations. The court also reviewed prior judicial interpretation of the limited partner exception in section 1402(a)(13), including the court’s previous decision in Renkemeyer, Campbell & Weaver, LLP v. Commissioner. In Renkemeyer, the court held that partners in a law firm organized as a limited liability partnership were subject to self-employment tax on their distributive shares of partnership income because that income was derived from legal services performed by the partners in their capacity as partners, and therefore “they were not acting as investors in the law firm.” The Tax Court had not previously addressed whether a limited partner in a state law limited partnership is automatically a “limited partner, as such” within the meaning of section 1402(a)(13) or instead must satisfy a functional analysis test like the one applied in Renkemeyer to be entitled to the limited partner exception. The partnership, Soroban, argued that, because Soroban was a state law limited partnership and its Limited Partnership Agreement identified Messrs. Mandelblatt, Kapadia, and Friedman as limited partners, section 1402(a)(13) was satisfied. The court, however, disagreed and concluded that “[a] functional analysis test should be applied when determining whether the limited partner exception under section 1402(a)(13) applies to limited partners in state law limited partnerships.” Because this test requires analysis of the functions and roles of the limited partners, which are factual determinations, the court denied the partnership’s motion for summary judgment. The court also held that this examination of the roles of the limited partners is a partnership item that the court had jurisdiction to determine in this TEFRA partnership-level proceeding.
There were no significant developments regarding this topic during 2023.
This 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, signed by the President on August 16, 2022, imposes a 15 percent alternative minimum tax (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.
The SECURE 2.0 Act increases the age at which required minimum distributions must begin, modifies the rules regarding catch-up contributions, and makes many other significant changes that affect retirement plans. The Consolidated Appropriations Act, 2023, signed by the President on December 29, 2022, includes the SECURE 2.0 Act of 2022, which increases the age at which required minimum distributions (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.
In this federal estate tax case, the U.S. Court of Appeals for the Eighth Circuit had to decide whether corporate-owned life insurance proceeds were includable in the estate tax value of a deceased shareholder’s redeemed shares or should be excluded from such value as the Eleventh Circuit had held in Estate of Blount v. Commissioner. Two brothers owned all 500 outstanding shares of stock of Crown C Corporation (“Crown”), a building-materials company located in St. Louis. One brother owned a majority (385.9 shares or 77.18%) of Crown’s outstanding stock, while the other brother owned a minority (114.1 shares or 22.82%) of Crown’s outstanding stock. Crown and the two brothers had entered into a stock purchase agreement that would take effect upon the death of either brother. Under the agreement, the surviving brother had an option to purchase the deceased brother’s shares, or if the surviving brother declined the option, the corporation, Crown, was obligated to redeem the deceased brother’s shares. The agreement set the price for the decedent’s shares via either (i) a contemporaneous “Certificate of Agreed Value” executed between the brothers each year or (ii) an appraisal process if the brothers failed to execute a “Certificate of Agreed Value” for the relevant year. Furthermore, Crown owned separate $3.5 million insurance policies on the life of each brother to facilitate a redemption of stock upon the death of either brother. When the brother owning the majority of Crown’s shares died in 2013, the surviving brother’s and Crown’s rights under the stock purchase agreement were triggered. No “Certificate of Agreed Value” had been executed between the brothers for 2013 (or, for that matter, ever), and the surviving brother declined to exercise his purchase option. Therefore, Crown proceeded to redeem the deceased brother’s shares (385.9 shares or 77.18%) for $3 million, funded by the $3.5 million corporate-owned life insurance policy on the decedent’s life, with Crown retaining the $500,000 excess of life insurance proceeds over the redemption price. Rather than the redemption price being set by the agreement itself, however, the deceased brother’s son and the surviving brother, as executor of the deceased brother’s estate, had agreed to the $3 million value for the deceased brother’s shares as part of an “amicable and expeditious” settlement of several estate-administrative matters. Not surprisingly, the decedent’s estate reported the value of the redeemed stock at $3 million for federal estate tax purposes. On audit, the Service challenged the reported $3 million estate tax value of the decedent’s shares, arguing that Crown’s overall fair market value, including the $3.5 million in life insurance proceeds, was $6.86 million ($3.36 million exclusive of the $3.5 million in life insurance proceeds). The Service further argued that the higher company-level value informs the estate tax value of the decedent’s stock, not merely the $3 million redemption price agreed to by the decedent’s son and the surviving brother. The Service (supported by expert testimony) thus set the value of the deceased brother’s shares at about $5.3 million (77.17% x $6.86 million) and assessed a $1 million estate tax deficiency against the decedent’s estate. The estate paid the deficiency and filed a refund suit in U.S. District Court, where the lower court held for the Service. The estate then appealed to the Eighth Circuit.
The Estate’s Arguments. The estate of the deceased brother made two arguments that the $3 million redemption price for the decedent’s shares was proper for estate tax purposes. The estate’s first argument was that the stock purchase agreement complied with section 2703(b) and therefore sets the value of the deceased brother’s shares for estate tax purposes. Section 2703(a) generally provides that the estate tax value of property is determined without regard to any agreement restricting the property’s sale or setting the property’s price at less than fair market value. Section 2703(b), though, provides an exception, thereby potentially allowing an agreement to set the estate tax value of property via agreement if three requirements are met: (i) it is a bona fide business arrangement; (ii) it is not a device to transfer property among family members for less than full and adequate consideration; and (iii) its terms are comparable to arms’ length transactions entered into by unrelated persons. The estate’s second argument was that the $3 million price set for the deceased bother’s shares reflected the stock’s fair market value exclusive of the $3.5 million of life insurance proceeds, which is the proper result under Estate of Blount v. Commissioner. The Eleventh Circuit in Blount held under similar circumstances that the estate tax value of a decedent’s shares subject to a stock purchase agreement at death should not include corporate-owned life insurance proceeds used to redeem the decedent’s shares. The Eleventh Circuit reasoned that any such life insurance proceeds have no net effect on the value of the redeemed shares because the proceeds received by the corporation are offset by a concomitant liability to purchase the decedent’s stock. The Eleventh Circuit stated in Blount, “To suggest that a reasonably competent business person, interested in acquiring a company, would ignore a $3 million liability strains credulity and defies any sensible construct of fair market value.”
The Eighth Circuit’s Opinion. The Eighth Circuit rejected both arguments by the estate and accepted the Service’s position that Crown’s overall fair market value upon the decedent’s death was $6.86 million, resulting in the deceased brother’s shares being valued at approximately $5.3 million for estate tax purposes, inclusive of the $3.5 million of corporate-owned life insurance proceeds. In an opinion by Chief Judge Smith, the Eighth Circuit reasoned that the estate’s first argument concerning section 2703 was flawed because the stock purchase agreement did not contain a fixed price or formula to set the value of the deceased brother’s shares for estate tax purposes. Courts, including the Eleventh Circuit in Blount, have recognized that, under Regulation section 20.2031-2(h), a stock purchase agreement must contain a fixed or determinable price if it is to be binding for estate tax valuation purposes. Regulation 20.2031-1(h) provides in part that “[l]ittle weight will be accorded a price” in an agreement where the decedent was “free to dispose of” stock at any price during the decedent’s lifetime. Section 2703 was enacted against the backdrop of Regulation section 20-2031-2(h), and thus the courts have applied the two in tandem to control the determination of value for estate tax purposes. Chief Judge Smith thus concluded that the stock purchase agreement at issue in Connelly could not establish the estate tax value of the decedent’s shares under section 2703 or Regulation section 20.2023-2(h) because, in the absence of a pre-determined and binding “Certificate of Agreed Value” or a compulsory appraisal, the agreement had no fixed or determinable method for setting the stock’s redemption price as of the decedent’s death. The Eighth Circuit also declined to adopt the estate’s second argument that Blount controlled to exclude the $3.5 million of corporate-owned life insurance proceeds from the determination of the estate tax value of the deceased brother’s shares. Chief Judge Smith cited as support both the general willing buyer/willing seller rule of Regulation section 20.2031-2(a) and the more specific rule of Regulation section 20.2031-2(f)(2), which states that in valuing shares of a closely-held corporation for estate tax purposes “consideration shall also be given to nonoperating assets, including proceeds of life insurance policies payable to or for the benefit of the company.” Chief Judge Smith emphasized this latter point by noting that the $500,000 of excess life insurance proceeds not used to redeem the decedent’s shares benefitted Crown and augmented its overall fair market value. Chief Judge Smith wrote further:
The Service has the better argument. Blount’s flaw lies in its premise. An obligation to redeem shares is not a liability in the ordinary business sense . . . A buyer of Crown would therefore pay up to $6.86 million [for all of Crown’s outstanding stock], having “taken into account” the life insurance proceeds, and extinguish [the stock purchase agreement] or redeem [the deceased brother’s shares] as desired. On the flip side, a hypothetical willing seller of Crown holding all 500 shares would not accept only $3.86 million knowing that the company was about to receive $3 million in life insurance proceeds, even if those proceeds were intended to redeem a portion of the seller’s own shares. To accept $3.86 million would be to ignore, instead of “take[ ] into account,” the anticipated life insurance proceeds.
Chief Judge Smith also wrote of the estate’s argument and the court’s decision not to follow Blount:
To further see the illogic of the estate’s position, consider the resulting windfall to [the surviving brother]. If we accept the estate’s view and look to Crown’s value exclusive of the life insurance proceeds intended for redemption, then upon [the deceased brother’s] death, each share was worth $7,720 before redemption. After redemption, [the deceased brother’s] interest is extinguished, but [the surviving brother] still has 114.1 shares giving him full control of Crown’s $3.86 million value. Those shares are now worth about $33,800 each. Overnight and without any material change to the company, [the surviving brother’s] shares would have quadrupled in value. This view of the world contradicts the estate’s position that the proceeds were offset dollar-by-dollar by a “liability.” A true offset would leave the value of [the surviving brother’s] shares undisturbed.
Comment. Never leave it to clients to mutually agree to the value stock on an annual basis as part of a stock purchase agreement triggered by a stockholder’s death, especially if they are related. Moreover, consider having any life insurance policies that are intended to fund the purchase of a deceased shareholder’s stock being held outside the corporation, such as in a trust or a partnership that is a party to the stock purchase agreement.
a. The U.S. Supreme Court affirmed the decision in Connelly, resolving the conflict between the Eleventh Circuit’s decision in Connelly and that of the Eighth Circuit in Estate of Blount. Oral arguments took place March 27, 2024, and the Court issued its opinion on June 6, 2024, immediately before this Article went to press. The Supreme Court opinion will be discussed in next year’s Annual Update.
There were no significant developments regarding this topic during 2023.
The taxpayer in this case, who resided in Pennsylvania, was diagnosed with “an endstage medical condition” in early September 2015. On September 6, 2015, the taxpayer’s son, acting under a power of attorney, wrote eleven checks on the taxpayer and spouse’s investment account. Ten of the eleven checks were intended as annual exclusion gifts to family members ($14,000 per donee in 2015 under section 2503, which allowed the taxpayer and his wife to pay $28,000 per donee), while one check for $240,000 was payable to a “savings plan.” (The opinion does not elaborate, but the authors assume the $240,000 check was payable to a section 529 college savings plan for the benefit of multiple family members). The eleven checks were either delivered personally or mailed to the payees by the taxpayer’s son. The taxpayer died five days later, on September 11, 2015. Seven of the eleven checks, totaling $366,000, had not cleared the drawee bank before the taxpayer’s death. Even though the seven checks totaling $366,000 had not cleared the drawee bank as of the taxpayer’s death, the estate did not include the $366,000 represented by the seven uncleared checks in the taxpayer’s federal gross estate under section 2031. On audit, the Service asserted an estate tax deficiency based upon the estate’s failure to include the $366,000 in the taxpayer’s gross estate. The Service’s position was that the seven uncleared checks were incomplete gifts because the taxpayer retained the power under Pennsylvania law to stop payment on the checks until his death. The Tax Court (Judge Jones) agreed with the Service that the $366,000 represented by the seven uncleared checks should have been included in the taxpayer’s gross estate. The estate appealed to the U.S. Court of Appeals for the Third Circuit and argued that the seven delivered but uncleared checks were made in contemplation of death and, therefore, under Pennsylvania’s “in causa mortis” doctrine, were completed gifts excludable from the taxpayer’s gross estate. The Third Circuit acknowledged that, under Pennsylvania law, donative transfers “prompted by the [donor’s] belief . . . that his death is impending, and made as a provision for the donee if death ensues” are considered gifts “in causa mortis” complete at the time of delivery even if the check does not clear the drawee bank until after the donor’s death. Nevertheless, in an opinion written by Judge Shwartz, the Third Circuit affirmed the Tax Court’s decision, determining that the taxpayer had not produced evidence to show that Pennsylvania’s “in causa mortis” doctrine applied. Other than the circumstances surrounding the taxpayer’s demise (i.e., the taxpayer’s “endstage medical condition diagnosis” in early September 2015 followed shortly thereafter by the taxpayer’s death on September 11, 2015) and the fact that annual gifts to family members generally were given in December rather than September, the estate had not provided specific evidence that the taxpayer’s gifts made via his son’s power of attorney were motivated by the taxpayer’s anticipated death. The taxpayer had pre-authorized his son in the power of attorney to make annual exclusion gifts on the taxpayer’s behalf, but the estate presented no evidence that the taxpayer actually had directed his son to make such gifts in September of 2015. Accordingly, the court ruled, the $366,000 represented by the seven uncleared checks should have been included in the taxpayer’s gross estate.
A relatively common estate-planning strategy involves the use of a so-called “intentionally defective grantor trust” (“IDGT”). An IDGT exploits the mismatch between subchapter J (income taxation of trusts and estates) of chapter 1 of the Code and subtitle B (estate and gift taxes) of chapter 11 of the Code. Through an IDGT, a grantor can make a completed gift of property for estate and gift tax purposes under subtitle B, chapter 11 of the ode but still be taxed on the income from the property under subchapter J chapter 1 of the Code. More specifically, Rev. Rul. 2023-2 postulates the following facts:
In Year 1, A, an individual, established irrevocable trust, T, and funded T with Asset in a transfer that was a completed gift for gift tax purposes. A retained a power over T that causes A to be treated as the owner of T for income tax purposes under subpart E of part I of subchapter J of chapter 1 (subpart E). A did not hold a power over T that would result in the inclusion of T’s assets in A’s gross estate under the provisions of chapter 11. By the time of A’s death in Year 7, the fair market value (FMV) of Asset had appreciated. At A’s death, the liabilities of T did not exceed the basis of the assets in T, and neither T nor A held a note on which the other was the obligor.
Normally, of course, when property is acquired from a decedent via a bequest or devise, section 1014(a) allows a step-up in basis equal to the value of the property includable in the decedent’s gross estate under chapter 11 of the Code. Apparently, some taxpayers have taken the position that property acquired from an IDGT after the grantor’s death is entitled to a basis step-up under section 1014(a). Rev. Rul. 2023-2 asserts the contrary, reasoning that the “Asset” (see above) was not acquired or passed from A (the decedent) within the meaning of section 1014(a) as elaborated in subsections (b)(1)-(10). Instead, Rev. Rul. 2023-2 holds that the “Asset” was acquired from the IDGT, which was not includable in A’s estate under section 2031 or otherwise under chapter 11. Notably, Rev. Rul. 2023-2 distinguishes an older ruling, Rev. Rul. 84-139, where a non-citizen, non-resident person devised non-U.S. real property to a U.S. citizen. The non-U.S. real property was not subject to chapter 11 (estate and gift taxation) because it was owned by a non-US person. Nevertheless, Rev. Rul. 84-139 held that the non-U.S. property was “acquired from a decedent” under section 1014(b)(1) and thereby entitled to a basis step-up under section 1014(a).
“The gain disappearing act the [taxpayers] attribute to the CRATs is worthy of a Penn and Teller magic show. But it finds no support in the Code, regulations, or caselaw.” Four married couples (collectively, the Gerhardts) had their cases consolidated in the Tax Court. In each case, the taxpayers contributed real property with a high value and a low basis to a charitable remainder annuity trust (CRAT). Shortly after contribution, each CRAT sold the real property and used the sale proceeds to purchase a single-premium immediate annuity (SPIA) owned by the CRAT. Pursuant to the terms of the trust, each CRAT paid to the taxpayers the payments received from the SPIA. The taxpayers took the position that the distributions from the CRAT were not taxable except to the extent of a small amount of interest income earned by the CRAT. For example, one couple contributed real properties with a total adjusted basis of $97,517 to their CRAT and the CRAT sold the properties for approximately $1.7 million. Their CRAT purchased a SPIA that would make five annual payments to the couple of $311,708. The CRAT distributed $311,708 to the couple in 2016 and again in 2017, the years at issue in the Tax Court. The CRAT issued Schedules K-1 to the couple in each year reporting only interest income of $4,052 (2,026 per person). Following an audit, the Service asserted that the gain the CRAT realized on the sale of the real property was ordinary income pursuant to section 1245. The Service also asserted that the $311,708 distribution to the couple in each year was fully included in their gross income and was ordinary income. The Service issued a notice of deficiency to each couple for 2016 and 2017 and each couple filed a petition in the Tax Court.
Background on CRATs. A CRAT is a common estate planning tool. Generally, to establish a CRAT, a grantor transfers cash or property to an irrevocable trust. The terms of the trust provide for specified payments, made at least annually, to the grantors or another noncharitable beneficiary for life or for a specified period of up to twenty years. Whatever remains in the trust is transferred to or held for the benefit of one or more qualified charitable organizations. At the time of the contribution to the CRAT, the grantor is entitled to a charitable contribution deduction equal to the value of the contributed property less the present value of the annuity payments to be received (and limited to the present value of the trust’s remainder interest). The grantor does not recognize gain from the transfer of appreciated property to the CRAT. The CRAT takes the same basis in the contributed property that the grantor had. The CRAT is tax-exempt and does not pay tax on any gain realized from its sale of contributed property. Nevertheless, gain realized by the CRAT on the sale of contributed property must be tracked and affects the tax treatment of distributions from the CRAT. Under section 664(b), distributions from the CRAT to its income beneficiaries are treated as distributed in the following order with the following character:
(1) as ordinary income, to the extent of the CRAT’s current and previously undistributed ordinary income;
as capital gain, to the extent of the CRAT’s current and previously undistributed capital gain;
as other income, to the extent of the CRAT’s current and previously undistributed other income; and
as a nontaxable distribution of trust corpus.
Tax Court’s analysis. In the Tax Court, the taxpayers argued that any gain realized by a CRAT on the sale of contributed property effectively disappears and therefore does not make taxable any distributions by the CRAT that are funded with proceeds from the sale. The Tax Court (Judge Toro) rejected this argument. The court noted that it had considered and rejected this argument in Furrer v. Commissioner, and that the same advisers who advised the taxpayers in this case had been involved in Furrer. The court invited the Gerhardts to distinguish Furrer but, according to the court’s opinion, their briefs failed to mention the case. The court summarized the taxpayers’ argument as follows:
As best we can tell, the Gerhardts maintain that the bases of assets donated to a CRAT are equal to their fair market values. … Section 1015 flatly contradicts their position. Section 1015(a) governs transfers by gift, and section 1015(b) governs transfers in trust (other than transfers in trust by gift). Under either provision, the basis in the property “shall be the same as it would be in the hands of the donor” under section 1015(a) or “in the hands of the grantor” under section 1015(b).
The court upheld the Service’s position that the CRATs involved had realized ordinary income from the sale of the contributed properties that resulted in the distributions from the CRATs to the Gerhardts being fully taxable and characterized as ordinary income. As the court put it, “[t]he gain disappearing act the Gerhardts attribute to the CRATs is worthy of a Penn and Teller magic show. But it finds no support in the Code, regulations, or caselaw.”
Issue concerning gain recognition in like-kind exchange. In a separate transaction in 2017, one couple exchanged property (the Armstrong Site) for other property. The Armstrong site “comprised hog buildings and equipment as well as raw land.” The couple treated this exchange as a like-kind exchange that qualified for nonrecognition of gain under section 1031. The service took the position that, although the exchange qualified under section 1031, the property exchanged was section 1245 property and section 1245 required the couple to recognize gain characterized as ordinary income on the exchange. The court agreed with the service. The flush language of section 1245(a)(1) provides that gain from the disposition of section 1245 property “shall be recognized notwithstanding any other provision of this subtitle.” And Regulation section 1.1245-6(b) explicitly provides that section 1245 overrides section 1031. Acordingly, the court held that the couple had to recognize the gain realized from the exchange and that the gain was ordinary income.
