Kim & Rosado LLP

Positive News in International Penalties

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Knowing the room, on October 24th, at the UCLA Extension Tax Controversy Conference, IRS Commissioner Danny Werfel announced the IRS would cease automatically assessing penalties for late-filed Forms 3520 and would review the reasonable-cause statements attached to the forms before making a penalty determination. The resultant applause at the Beverly Hills Hotel (“such a lovely place”) was described by one attendee as “resounding.”

Required by I.R.C. § 6039F, the Form 3520, “Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts” is an information return, in part, as to foreign gifts and inheritances of more than $100,000, even where no tax is in fact due. But as has been candidly admitted by the IRS in its instructions to examiners: “Many taxpayers and representatives know that basic tenant of tax law [the non-taxable nature of gifts and inheritances] but are not aware of the requirement to report large foreign gifts and inheritances under I.R.C. § 6039F.” Voluntary Disclosure Practice Examiner Guide Paper, p. 44 (Rev:1/26/22) (Tax Notes Document Service, Doc. 2022-23495). Hence, unsophisticated taxpayers without advisors practiced in the foreign realm frequently incur the penalty, which can amount to twenty-five percent of the amount to be reported. I.R.C. § 6039F(c)(1)(B).

The harshness of the penalty structure has been a matter of distinct concern for some time with the IRS Taxpayer Advocate explaining in 2023 that her office was “aware of situations in which a foreign grandparent provided a gift to cover the cost of a U.S. grandchild’s living expenses while attending college. In this example, if the amount exceeded the $100,000 threshold, the grandchild has a filing obligation and could be penalized for up to 25 percent even though no U.S. tax liabilities may result from the gift. Similarly, if a U.S. person receives an inheritance from a foreign individual, the recipient is penalized if they do not file a Form 3520, even though the foreign individual may never have had a U.S. filing obligation or tax due.” See NTA Blog: International Information Return Penalties Impact a Broad Range of Taxpayers (August 22, 2023).

Congress likely authorized the penalty perhaps imagining it would catch nefarious high net-worth individuals with international connections. (Picture Dr. Evil.) But as noted by Ms. Collins’s office, such players typically have the legal assistance to easily sidestep the penalty or successfully obtain abatements. Instead, it is lower-income individuals, immigrants, and small businesses who receive a once-in-a-lifetime tax-free gift or inheritance and are unaware of their reporting requirement. But now at least, they have some respite, thanks to Ms. Collins’s diligent argumentation.

It’s halftime at the Rose Bowl game. Did you forget to tell FinCEN something?

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With New Year’s Day 2025 being right around the corner, it is becoming commonplace for commentators to assume the role of Cassandra in warning of the dangers of ignoring the Corporate Transparency Act filing deadline of January 1st for affected entities. And we feel no less obligated to jump on the bandwagon to remind advisors and principals of such entities over the need to disclose detailed information concerning their beneficial ownership to the Financial Crimes Enforcement Network (FinCEN).

Repeatedly, it is heard from practitioners that many clients bask in blissful ignorance of the law as applying to them; it only applies to those big companies, right? The reality is not quite that way at all as many large public corporations are, in fact, exempt.

Let’s mention one group that is chronically ignorant of regulatory niceties: Nonprofits. The law currently provides Exemption #19 for a “Tax-exempt entity,” which is one described in I.R.C. § 501(c), whether or not it has applied for tax-exempt status; one described in I.R.C. § 501(c) but which lost its tax-exempt status less than 180 days before; one exempt under I.R.C. § 527(a); or a trust described in I.R.C. § 4947(a)(1) or (2). A common belief of the people behind nonprofit organizations is that the good Lord will take care of them, and no need exists to contend with Caesar’s troublesome paperwork. Now, it is generous (and a little surprising) that under the CTA provisions, the purported tax-exempt entity need not have filed a Form 1023 or Form 1023-EZ. Nonetheless, nonprofit organizations should undertake an objective internal review to ensure that they, in fact, meet the requirements of the famous code section.

And otherwise, any corporation, limited liability company, partnership, S-corporation, or another entity created by the filing of a document with a secretary of state or any similar office in the U.S. may be required to report information about its beneficial owners. Futher, trusts registered with a state may be so required. Reporting requirements even extend to a foreign company formed under the law of a foreign country that is registered to do business in the U.S. by the filing of a document with a secretary of state or any similar office.

Still unsure or scared? We recommend that you work with qualified attorneys to meet your beneficial ownership information filing requirements. Experienced counsel at Kim & Rosado LLP can assist you meet these new filing requirements: Request a Consultation.

(N.B. On March 1st, 2024, the U.S. District Court for the Northern District of Alabama held that the CTA unconstitutional for exceeding the Constitution’s limits on Congress’s power. Nat’l Small Bus. United v. Yellen. The ruling permanently enjoined FinCEN from enforcing the CTA against the plaintiffs, the National Small Business Association (NSBA), a group that represents over 65,000 businesses and entrepreneurs in all 50 states. FinCEN filed an appeal to the 11th Circuit Court of Appeals, which appeal is still pending as of this writing, and announced it would continue enforcement of the CTA but that the named plaintiffs and members of the NSBA would not be required to report beneficial ownership under the CTA at this time.)

The Tax Law After Moore v. U.S.

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Congress is constantly tinkering with the tax code. With the 2025 expiration of many aspects of the Tax Cuts and Jobs Act, expect significant changes in the near future. But just how far does Congress’s authority to tax its citizens extend?

The U.S. Constitution, specifically Article I and the Sixteenth Amendment to the U.S. Constitution, provide Congress with near unlimited authority to tax in certain circumstances. Article I, Section 8 provides that “[t]he Congress shall have power to lay and collect taxes, duties, imposts and excises[.]” There are narrow constraints on Congress when passing taxes that fall within its Article I authority.  Article I, Section 8 merely states that such taxes should be “to pay the Debts and provide for the common Defense and general Welfare of the United States” and that all such taxes be uniform throughout the United States. The Sixteenth Amendment to the U.S. Constitution similarly grants Congress broad authority to tax income: “[t]he Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

The significant restraint to Congress’s taxing authority is a limitation on its ability to impose “direct taxes.” Article I, Section 9 provides that “[n]o Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or enumeration herein before directed to be taken.” Therefore, Congress has broad authority when imposing “indirect taxes,” with the exception of the general welfare clause and the uniformity requirement.

But because direct taxes must be apportioned amongst the States according to each State’s population, such taxes are difficult for Congress to pass. The Supreme Court gives the following example of what apportionment entails:

So if Congress imposed a property tax on every American homeowner, the citizens of a State with five percent of the population would pay five percent of the total property tax, even if the value of their combined property added up to only three percent of the total value of homes in the United States. To pay five percent, the tax rate on the citizens of that State would need to be substantially higher than the tax rate in a neighboring State with the same population but more valuable homes.

Moore v. United States, 602 U.S. __ (2024). The Court goes on to note that Congress does not appear to have attempted to pass a direct tax since the Civil War. Id.

Within those broad general contours lie many uncertainties. For example, what is a direct tax and what is an indirect tax? And, going back to the Sixteenth Amendment, what is an income tax, and what, if any, limitations apply to Congress’s authority to tax income?

The Supreme Court has rarely addressed Congress’s taxing authority, especially since the New Deal. And Congress has steadily written countless lines of tax law. But a reconstituted Court now seems interested in delineating Congress’s authority to tax. A recently decided Supreme Court case, Moore v. U.S., raises many of these questions, yet, as we will see, fails to provide many definitive answers.

Background: The Moores Pay a Bit More Tax Than Expected

In 2006, Charles and Kathleen Moore invested $40,000 in a (greater than 50%) American-controlled foreign corporation (CFC) located in India. The Moores’ investment bought them a 13-percent interest in the CFC. While profitable, the CFC never distributed any of its income to its shareholders, including the Moores. But in 2017, American shareholders of CFCs were subject to a one-time tax, titled the “Treatment of Deferred Foreign Income Upon Transition to Participation Exemption System of Taxation,” known colloquially as the Mandatory Repatriation Tax (MRT).

To prevent Americans from avoiding U.S. taxes by keeping earnings offshore, the U.S. has long taxed U.S. shareholders of CFCs. For purposes of those tax provisions, a CFC is a foreign corporation that is more than 50% owned by U.S. shareholders. A U.S. shareholder is a U.S. person that owns at least 10% of a foreign corporation’s shares.

Prior to 2017, the U.S. only taxed CFC’s Subpart F income, mainly consisting of passive income. CFCs’ active business income from overseas business activity were generally untaxed. By 2015, according to the federal government, CFCs had accrued $2.6 trillion in untaxed offshore earnings. And this is where things stood with the Moores and their CFC – it had accrued overseas earnings since 2006, but neither the CFC nor the Moores were subject to tax on that income in the United States.

In 2017, the Tax Cuts and Jobs Act (TCJA) was passed and signed into law. The TCJA made significant changes to the taxation of both domestic corporations and CFCs. As relevant here, the MRT was passed as part of the TCJA. Under the MRT, CFCs’ accumulated earnings going back to 1986, which have not been taxed, must be included in Subpart F income in the last tax year before 2018 (generally 2017). Therefore, shareholders holding at least 10% of a CFC must include in income up to 30 years of accumulated corporate earnings (this does not appear to have been the case with the Moores who appear to have owned the company from its inception in 2005 or 2006).

The Parties’ Arguments

The taxpayers questioned whether the Sixteenth Amendment authorizes Congress to tax unrealized sums without apportionment among the states. The important concept here is realization. The taxpayers contended that another taxpayer – their CFC – earned income, but because such income was not distributed to the taxpayers, they never realized it. Without realization, there can be no income.

The taxpayers contended that the MRT is a property tax in that it taxed their ownership interest in the CFC rather than their income from the CFC. Since the MRT is a property tax rather than an income tax, the taxpayers contended that it was a direct tax subject to apportionment. Since the MRT was not apportioned among the states, the taxpayers contended that the MRT was unconstitutional.

The government argued that the MRT is an income tax. Congress has, even before the enactment of the Sixteenth Amendment, taxed shareholders on undistributed corporate earnings. In this context, the MRT appears indistinguishable from Subpart F. Further, significant portions of the tax code are based on taxing owners on undistributed business income, including taxation of partnerships and S corporations.

The government also contended that there is no realization requirement in the Sixteenth Amendment to the U.S. Constitution. It cannot be read into the Sixteenth Amendment term “income,” which encompasses all economic gain. And it cannot be based on the Sixteenth Amendment phrase “from whatever source derived.”

As a secondary, argument, the government asserted that the MRT was constitutional as an excise tax. Prior Supreme Court precedent (Flint v. Stone Tracy Co., 220 U.S. 107 (1911)) upheld a tax on a corporation’s income as an excise tax on the privilege of doing business.

The Court’s View

The Court upheld the MRT as a constitutional income tax. Congress may attribute an entity’s realized and undistributed income to the entity or to its shareholders or partners. Here, rather than attributing the corporation’s income to the entity, Congress instead attributed it to its shareholders. The Court stressed that this was a narrow holding, stating that: (i) taxation of the shareholders of an entity, (ii) on the undistributed income realized by the entity, (iii) which has been attributed to the shareholders, (iv) when the entity itself has not been taxed on that income is constitutional.

The Court’s holding was supported by five justices (Justices Kavanaugh, Kagan, Sotomayor, Jackson, and Roberts). Justices Barrett and Alito concurred in the judgment only on technical grounds. Justices Thomas and Gorsuch dissented.

Justices Barrett, Alito, Thomas, and Gorsuch found that there is a realization requirement within the Sixteenth Amendment. In the context of a taxpayer taxed as a corporation, these Justices would require a shareholder to receive a dividend or sell shares to have a realization event subject to income tax. Though two of these Justices concurred in the result of this case, the concurrence was on very narrow grounds – ultimately, four Justices signaled that they felt that the MRT was unconstitutional.

Justice Jackson, in concurrence, indicated that she does not read a realization requirement into the U.S. Constitution. The other four Justices did not state their view on whether there is a realization requirement, finding that this issue did not need to be addressed to resolve this case.

Though it did not appear to be raised or implicated in this case, the majority noted that there are due process limitations on who can be taxed on income. The Court stated that these limits are based on the taxpayer’s relationship to the underlying income. The Due Process Clause prohibits the arbitrary attribution of income. Remember, the MRT it imposes taxable income on a shareholder even if the shares were purchased long after the income was earned. A taxpayer who owned the shares as the CFC earned the income, but who sold before the trigger date, would pay no tax. This did not appear to be the case with the Moores, but perhaps another taxpayer could attack the MRT on these grounds.

On the distinction between direct and indirect taxes, the Court pointed to prior precedent that indicated that direct taxes include taxes on persons and property. The Constitution specifically references capitation taxes (a head tax or a poll tax). Such taxes are what the Court refers to as a tax on persons. Previous Court precedent provides that a tax on real property is a direct tax. Decisions prior to 1895 limited direct taxes to capitation taxes and real property taxes. See Hylton v. United States, 3 U.S. 171 (1796). Taxes on personal property were not included in the definition of direct taxes. But Pollock expanded direct taxes to include taxes on personal property and income from property. See Pollock v. Farmers’ Loan & Trust Co., 158 U.S. 601 (1895). The Court did not say that it would consider a tax on personal property a direct tax, but it signaled that it would.

What’s Next?

There are other portions of the tax code that appear to impose tax without a realization requirement, without the distinction of whether income is merely being imposed on the entity or its owners. I.R.C. § 475 mark-to-market accounting and the I.R.C. § 877A taxation of covered expatriates – known as the “Exit Tax” – are two such provisions. Both of these provisions require a taxpayer to treat certain assets as having been sold on a specific date without any such sale actually having taken place. These provisions do not appear to fit within the narrow holding of Moore.

The case also left unaddressed Congress’s authority to impose a wealth tax. Such a tax could be structured as a mark-to-market tax similar to sections 475 or 877A. It could also be designed as a mere tax on a taxpayer’s net worth. The current Court would likely find the latter tax to be a direct tax on personal property, making such a tax unworkable. But we will have to wait to see how the Court views mark-to-market taxes.

Lastly, this was a narrow decision, and any future change to the composition of the Court could result in a different result. As the majority stated, the MRT is similar to Subpart F, Subchapter K, Subchapter S, and many other tax provisions that provide for a significant portion of the government’s revenue. A different result could fundamentally change the U.S. tax code.

Recent Tax Court Cases Addressing the “Augusta Rule”

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Occasionally, self-proclaimed tax evangelists pop up on my Instagram feed hawking the benefits of a special tax loophole called the “Augusta” rule. So, let’s discuss the latest Tax Court rulings on this seemingly hot Instagram topic.

Let’s start by covering the basics of this rule. Section 280A(a) provides the general rule that no deduction is allowed for expenses related to the use of a “dwelling unit” by a taxpayer as a residence. Section 280A(g) provides a specific exception to the general rule which states that if a taxpayer rents out their home for 14 days or fewer in a year, they do not have to report the rental income, and they cannot deduct any expenses related to the rental. This provision is particularly beneficial for homeowners who rent out their homes during high-demand events, such as the Masters golf tournament in Augusta, Georgia, which is where the rule gets its nickname. A Google search shows that you can rent a home for 7 nights during the 2025 during Masters week for the tidy sum of $75,000. https://rentlikeachampion.com/Augusta-GA?game=The-Masters-2025&p=1. It’s a safe bet that the owner of this home will not agree to rent this same home in 2025 for any more than an additional 7 nights, so they don’t have to report the rent received income.

Even though section 280A(g) bars the taxpayer/lessor from claiming any expenses related to the rental of his Georgia home, it’s a nice tax break to avoid reporting any rental income. But what if there was more tax benefit to extract here? What if a different taxpayer, say an S corporation, decides to rent out a dwelling unit for 14 days to hold business meetings? Well, then, the S corporation is allowed a deductible business under section 162 and the homeowner is still allowed to exclude the rental income for the 14-day period under section 280A(g). Win-win? The facts present a slippery tax scenario especially if the taxpayer/lessor also is a shareholder of the S corp/lessee of the residential property. But the tax code permits this double benefit – deduction for the rent paid by the S corp/lessee and exclusion of the rent received by the taxpayer/lessor – unless there’s sloppy execution.

In Sinopoli v. Commissoner, T.C. Memo. 2023-105, the Tax Court agreed with the IRS when the agency challenged an S corporation’s deduction of rental expenses paid for use of shareholders’ home to hold business meetings. Below are the critical takeaways from the court’s decision:

  • Rental price – Petitioners failed to obtain an independent third-party appraisal of the rental value of their residence as meeting space. Instead, one shareholder of the S corporation provided his independently researched rental rate for meeting space in the same locality. The IRS conducted its own market research for local meeting space and determined that $500 for a full or half day was the market rate.
  • Business conducted at meetings – Petitioners failed to produce any credible evidence (minutes, agendas or calendars) of the business conducted at such meetings.
  • Additional facts – occasionally, the spouses or other family members who were not shareholders of the S corporation attended the meetings. Petitioners’ testimony was not credible as to the frequency of the meetings held during the years at issue.

Based on the lackadaisical execution by the petitioners in Sinopoli and the fact the business meetings appeared more like family gatherings, the Tax Court agreed with the IRS that “it seems that petitioners adopted a tax savings scheme to distribute [the S corporation’s] earnings to petitioners through purported rent payments, claim rent deductions, and exclude the rent from their gross income relying on section 280A(g).” Despite the Court’s view that the petitioners engaged in a tax savings scheme, it nonetheless held that rental expenses were allowed to the extent conceded by the IRS. The IRS didn’t advance a harsh position and the Tax Court reluctantly (it seems) acceded to the result.

When a taxpayer’s execution of the Augusta rule moves from lackadaisical to fecklessness, then we have the result in Jadhav v. Commissioner, T.C. Memo. 2023-140. In Jadhav, the Tax Court addressed the same section 162/280A(g) tax play involving an S corporation that claimed rental expense deductions for use of petitioners/shareholders’ residential property for allegedly business purposes. Unlike Sinopoli, however, the Tax Court in Jadhav disallowed all rental expenses claimed by the petitioners for failing the reasonableness requirement under section 162. Why such a harsh result in Sinopoli from a very sympathetic jurist in Judge Vasquez? Finding that the payments by the S corporation for use of the residence was for “something other than rent,” the Tax Court focused on the petitioners’ sole reliance on the daily rental price for their residence presented in a tax plan prepared by a tax strategy firm rather than a third-party appraisal/report or the petitioners’ own investigation. In other words, the petitioners in Sinopoli engaged in such little effort (actually no effort beyond securing a tax plan) as to dare the IRS and the Tax Court to take action. It seems that the petitioners in Sinopoli played the audit lottery and lost.

Executing the Augusta rule is not complicated or particularly risky unless you decide to thumb your nose at the required execution.

The Franchise Tax Board and like-kind exchanges

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It is common knowledge that the FTB is more active in pursuing audits of section 1031 transactions than is the IRS, and that determined agency certainly gets into the weeds regarding that notoriously weedy statute. (Revenue & Taxation Code § 18031 conforms California Personal Income Tax Law to I.R.C. § 1031(a).)

One example of that doggedness concerns challenges to the fair market values of the replacement properties. In the typical forward exchange, the transfer of the relinquished properties occurs, and the replacement properties must be identified and “unambiguously described” within 45 days. If the exchange party has not decided on the replacement properties, they have the choice of (1) identifying up to three properties regardless of fair market value, Treas. Reg. § 1.1031(k)-1(c)(4)(i)(A), or (2) identifying any number of properties as long as the aggregate fair market value does not exceed 200 percent of the aggregate fair market value of the relinquished properties, Treas. Reg. § 1.1031(k)-1(c)(4)(i)(B).

Presumably, the policy behind these requirements is to force the exchange party to “focus.” After all, if the rationale for nonrecognition behind section 1031 is that the seller is not truly “cashing out” but is rather simply transforming their investment, the onus should therefore be on the exchange party to be somewhat “particular” about what the future investment will be and not simply throw spaghetti against the wall in the form a laundry list of possible properties.

One vulnerability that the FTB has recently been exploiting in this regard is when an exchange party is attempting to rely on that any number of properties provision, and the FTB challenges the fair market values as being understated, causing the aggregate amount to run afoul of the 200-percent rule. In one case, the exchange party quite sensibly and practically utilized the equity buy-in amounts for interests in certain Delaware Statutory Trusts as provided by the sponsor, yet the FTB disregarded those amounts in favor of performing its own valuation of the interests, in other words substituting its own business judgment of what the fair market value should over that proffered by a “willing seller.” (And mind you, the FTB did not even bother to allege collusion between the exchange party and the DST sponsor.)

As a result, it would behoove any exchange party to take special pains as to documenting such fair market values, since the FTB’s determination is presumptively correct. See In the Matter of the Appeal of: Donald M. Jinks and Sandra Jinks, 2014 Cal. Tax LEXIS 128, *19. And as most practice guides in this area recommend, seek to stay well away (by a county mile) from the 200-percent marker.

For further section 1031 trouble spots, see: https://www.linkedin.com/pulse/hurley-burley-section-1031-gordon-gidlund/?trackingId=EnWt0kRuSrS4pt%2FFJrA32w%3D%3D

Action Item: Prepare a Written Information Security Plan

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Periodically, the IRS will remind tax professionals of the critical need to safeguard client information. And most recently, on August 9th, it was announced that Publication 5708, “Creating a Written Information Security Plan for your Tax & Accounting Practice” had been updated. That document provides a template for a Written Information Security Plan (bearing the unfortunate acronym WISP) that is designed to help tax professionals, particularly smaller practices, in minding their responsibilities. Publication 5708 is produced by the Security Summit, a partnership of the Internal Revenue Service, state tax agencies, private-sector tax groups as well as tax professionals. Not surprisingly, the update is intended to respond to increasing levels of identity theft and data breaches.

Since 1999, with the enactment of the Gramm-Leach-Bliley Act, tax and accounting professionals have been statutorily obligated to protect client data. In its implementation of this law, the Federal Trade Commission issued measures required to keep customer data safe, and one requirement is implementing a WISP. Despite the decades, many practitioners remain blissfully unaware of the requirement to develop a written plan that describes how their firm is prepared to protect clients’ nonpublic Personally Identifiable Information (PII), including Social Security numbers, dates of birth, employment data, driver’s license number, income data, asset ownership data, Investment data, financial account numbers, personal identification numbers or passwords, email addresses, and non-listed phone numbers.

The update includes best practices for implementing multi-factor authentication for any individual accessing any information system. Further, it is recommended the WISP include a data theft response strategy, which includes alerting of the Federal Trade Commission and the IRS Stakeholder Liaison after a security incident involving the theft or loss of PII affecting 500 or more people.

While the official pronouncements express hope of making the process of developing a WISP easier, no one should be deceived into thinking it will be a simple cut-and-paste affair. The template is twenty-eight pages of rather detailed requirements. It will take more than a Friday afternoon.