Tax Audit

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

Whose fraud is it anyway?

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In Murrin v. Commissioner, T.C. Memo. 2024-10, the court followed precedent and held that the normal three-year period of limitations on assessment may remain indefinitely open on account of fraud regardless of whose fraud it is, either the taxpayer’s or the preparer’s.

Murrin involved joint individual returns and partnership returns for tax years 1993 through 1999, all prepared by a return preparer who placed false or fraudulent entries on those returns without the knowledge of the taxpayers. And the court was careful to specify that the taxpayers themselves did not intend to evade tax. And only in 2019 did the IRS issue its notice of deficiency. In petitioning the Tax Court, Ms. Murrin sought to convince the court to find a prior opinion, Allen v. Commissioner, 128 T.C. 37 (2007), wrongly decided and to urge the adoption of the contrary stance taken by the Federal Circuit in BASR Partnership v. United States, 795 F.3d 1338 (Fed. Cir. 2015). But preferring to strictly construe the statute, section 6501(c), in favor of the Government, the court accordingly held against Ms. Murrin.

The opinion generated a considerable amount of agita, with many commentators condemning the Tax Court’s reasoning as well as the IRS’s “heavy-handed” approach. See https://www.forbes.com/sites/tomcullinan/2024/02/03/the-internal-revenue-service-is-being-heavy-handed/?sh=2dfd91a23f21. Advice given to taxpayers in this boat consisted solely in paying the tax and filing a claim in the Court of Claims as a favorable venue.

To provide some perspective, however, panic or paranoia may not be called for. While this was certainly a harsh result to Ms. Murrin, for those who know from IRS internal workings, the likely comment might be, “Wow, that must have been some darn fraud.” After all, to go back over 20 years, had to take some persuasive convincing of a higher-up pezzonovante, a chore most line employees are quite loath to undertake. (Perhaps unspoken too by the Tax Court was the potential for collusion between preparers and taxpayers.)

Now, concern may be justified if the IRS views this result as a handy club regarding any initiative to aggressively pursue Employee Retention Credit fraud. See ERC. Stay tuned.

Easy come, easy go: The D.C. Circuit reverses Tax Court on section 6038(b) penalty case

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Last year around this time, many international tax practitioners were still rejoicing over the text-driven opinion in Farhy v. Commissioner, 160 T.C. No. 6 (2023), where the Tax Court ruled that due to the lack of specific imprimatur, the IRS could not summarily assess penalties under section 6038(b) against an individual for failure to file the Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations.” Resort would therefore be necessary for the Department of Justice to sue to obtain judgment, a certainly more cumbersome route. So, in that Prague Spring, it seemed the zeitgeist might be shifting in the outbound taxpayer’s favor with regard to the “draconian” international penalty regime that is deplored even by the Taxpayer Advocate. See NTA Blog.

Alas, in Farhy v. Commissioner, 2024 U.S. App. LEXIS 10843, the Court of Appeals for the District of Columbia, turned to that old-time religion rooted in the assessment power as underlying the IRS’s self-help collection remedies. In particular, the circuit court observed: “It is the rare federal tax that can only be recovered through a government-initiated lawsuit.” The circuit court proceeded to find clear congressional intent in allowing the IRS to summarily assess the penalty.

As a consequence, the field of international tax penalties remains a minefield for outbound taxpayers, and one that should not be trod without proper advice. Check with Kim & Rosado before you leap. Don’t wait.

IRS Cranks Up Scrutiny on Micro-Captive Insurance: Key Changes and What They Mean for Businesses

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Often when the IRS suffers a setback in litigation, a tendency exists to prematurely declare victory on the issue. That was certainly the reflex when the Tax Court first blessed a midco tax shelter in Starnes v. Commissioner, T.C. Memo. 2011-63. But a dozen years and several definitive circuit court opinions later, that abusive scheme had been dispatched. Similarly, promoters of micro-captive insurance arrangements undoubtedly rejoiced at first news of the result in CIC Services, LLC v. IRS, 529 F. Supp. 3d 677, 687-88 (E.D. Tenn. 2022), vacating Notice 2016-66, which had targeted such deals. Ding-dong! The Witch is dead!

Without conceding the District Court’s ruling on the failure to observe the Administrative Procedures Act, the IRS last year issued a proposed regulation obsoleting Notice 2016-66 and providing that it will not enforce its disclosure requirements. REG-109309-22. But the IRS also sounded loud and clear that such obsoletion has no effect upon the merits of the transaction itself or upon any IRS action in that regard. So, advisors may need to dial back on any “irrational exuberance” inspired by the promoters and carefully parse the language of the proposed regulation in toto.

The proposed regulation in fact raises the temperature in this area by identifying some deals as “listed transactions”; Notice 2016-66 had only classified its described deals as “transactions of interest.” From the IRS’s perspective, it might be said that the former category is more suggestive of abuse due to its attributes while the latter is less so but still subject to scrutiny. In any event, falling into either category means becoming subject to reporting requirements, under either I.R.C. §§ 6707, 6662A, or 6707A.

For a micro-captive “listed transaction,” the definition depends on either having a “financing factor” (financing by guarantee, loan, or other transfer of the captive insurance company’s capital), Prop. Treas. Reg. § 1.6011-10(c)(1), or a “loss ratio factor” below 65 percent, Prop. Treas. Reg. § 1.6011-10(c)(2). That test is met when total insured losses and claim administration expenses are less than 65 percent of total premiums earned less policyholder dividends. Thus, broadly, if an insurance company pays $60 in claims for every $100 in collected premiums, its loss ratio is 60 percent with a profit ratio of 40 percent. See michigan.gov/difs.) Under Notice 2016-66, the applicable marker was 70 percent.

Now the computation period during which such loss ratio is measured has been elongated under the proposed regulation supposedly to allow for some lenity. As the purpose of the proposed regulation is to “identify transactions involving circumstances inconsistent with insurance in the commonly accepted sense,” the pricing of premiums “far in excess of what is reasonably needed to fund insurance operations results in a lower loss ratio and is a strong indicator of abuse.” In the Federal Register explanation of the proposed regulation, the IRS accepts the possibility, however, that a captive insurance company with a loss history of fewer than ten taxable years could have a loss ratio below 65 percent, which result may not be due to abuse. Using a computation period of ten taxable years or greater in determining the loss ratio factor “allows Captives significant time to develop a reasonable loss history that supports the use of Captive for legitimate insurance purposes.”

Thus, for a captive insurance company in existence fewer than ten taxable years, including short taxable years and taxable years of predecessor entities, these “listed transaction” provisions do not apply. But while a captive insurance company in existence fewer than ten taxable years may avoid the definition of a micro-captive “listed transaction,” it may still default to a “transaction of interest,” because the applicable computation period is “the most recent nine taxable years, or the entire period of the Captive’s existence if Captive has been in existence for less than nine taxable years.” Prop. Treas. Reg. § 1.6011-11(b)(2).

The proposed regulation also expands on Notice 2016-66’s definition of a captive by providing that derivatives and interests in the assets of the captive are now to be taken into account in meeting the 20 percent related-interest threshold. Prop. Treas. Reg. §§ 1.6011-10(b)(1)(A)-(C) and 1.6011-11(b)(1). The IRS had found transactions were being structured so that the insured company, the owners, or related persons without a direct or indirect interest in the captive’s voting power or value or its outstanding stock or equity interests, were nonetheless obtaining substantially similar benefits and risk, and so improperly avoiding the 20 percent threshold.

Probably the most dramatic change in the proposed regulation is the creation of an exception for Consumer Coverage arrangements. Prop. Treas. Reg. §§ 1.6011-10(d)(2) and 1.6011-11(d)(2). According to the professional literature, the provision was primarily lobbied for by automobile dealer groups, and, hence, they are specifically mentioned in the text of the regulation, along with references to “extended warranties.” But the broad intent behind the exception appears to be that where the unrelated customer is the ultimate beneficiary, the risk of abuse is low. See IRS Hearing Transcript on Microcaptive Transactions, Tax Notes Today, July 19, 2023. But it is a good question of whether this exception is anything but a king-size “comfort ruling” dearly paid for by an industry group, as such covered scenarios would have likely fallen outside the general definitions anyway.

The IRS hinted that the proposed regulation would be finalized before the end of 2023, which did not come to pass. So, once again, taxpayers are in limbo, both the place and the game.

By the Numbers: The Corporate Transparency Act and the Probable Impact to IRS Global High Wealth Taxpayer Audits Beginning in 2024

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Back in 2009, the IRS formed the Global High Wealth (GHW) unit focusing on taxpayers who had elevated income and a complexity in their financials that warranted a “holistic approach.” From 2009 through 2022, our wise partner Tony Kim served as one of five IRS attorneys working to support this new unit. He found that understanding how a web of partnerships, domestic and foreign trusts, offshore accounts and corporations linked to reveal a GHW taxpayer’s true taxable income was no easy task. But, the IRS first had to find these dots to connect them.

The IRS’s Data Book shows that the agency struggled with GHW audits. IRS Data Book Table 17. As of fiscal year 2010, 13,322 tax returns were filed by taxpayers who had total positive income of $10,000,000 or more – that’s the range to fall within this GHW population. IRM 4.52.1.2. From that number, 21.5% of the returns were audited with an average recommended adjustment of $610,397. Fast forward to fiscal year 2019, where the number of GHW tax returns filed grew to 24,457, resulting in just 10.2% audit coverage with an average recommended adjustment of $49,805. If the GHW division was a stock, we’d probably sell and take a loss. Before we do, let’s look under the hood for a moment.

In building a GHW case, the IRS prepares a review a “yK-1 analysis” for each taxpayer to gain an overview of the taxpayer enterprise that includes the taxpayer’s Form 1040 and all related entities. From this interactive link analysis of the GHW taxpayer and all of their web of entities, the IRS could then review the entire enterprise and consider how to build the case. IRM 4.52.1.1.5(1); IRM 4.52.1.3. The trouble with building this yK-1 analysis is that the IRS needs information on a GHW taxpayer’s web of entities. And, a GHW taxpayer’s ownership information in various entities is elusive.

The GHW unit’s audit results may increase dramatically in the coming years due to the recently enacted Corporate Transparency Act (CTA). Congress added the CTA section, 31 U.S.C. § 5336, to the Bank Secrecy Act to address the broader objectives of beneficial ownership transparency. The CTA requires certain types of domestic and foreign entities, called “reporting companies,” to submit specified beneficial ownership information (BOI) reports to the Financial Crimes Enforcement Network (FinCEN), a bureau of the U.S. Treasury, that is charged with safeguarding the U.S. financial system from money laundering and promote national security through the collection, analysis, and dissemination of financial intelligence. All of the information that connects GHW taxpayers to their holdings so critical to a yK-1 analysis will soon become available to the IRS beginning in 2024 when taxpayers are required to file BOI reports with FinCEN. The CTA provides, “[b]eneficial ownership information shall be accessible for inspection or disclosure to officers and employees of the Department of the Treasury . . . .” Couple the CTA with the additional funding provided by Congress in the Inflation Reduction Act that will lead to the hiring of more revenue agents and you have the stage set for quite a dramatic change to the landscape of GHW taxpayer audits beginning in 2024.

Reliance on CPA for penalty defense? Sorry, not this time

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In John R. Johnson et al. v. Commissioner, T.C. Memo. 2023-116, the respondent had determined that the petitioners had applied a seven-year depreciation period instead of the correct 39-year period to commercial property, had double-counted mortgage interest, and had inadequately claimed the charitable contribution of a “building.” The petitioners conceded those adjustments but disputed the negligence penalty due to the reasonable cause and good faith exception. Their sole defense was reliance on their CPA. But for a taxpayer to so reasonably rely on the advice of a professional, one obvious element is reliance in good faith. See Neonatology Assoc., P.A. v. Commissioner, 115 T.C. 43, 99 (2000).

In what must have been a cringe-worthy spectacle to sit through at trial, the CPA took the stand, but apparently, nothing could be elicited as to what she told her clients. Further, the petitioner-husband’s testimony about the supposed advice received was dismissed as “not credible.” In sum, the petitioners simply failed to establish that they received any advice at all about the matters at hand.

And it got worse. The petitioners asserted the mere fact of a CPA having prepared their returns entitled them to the reasonable cause and good faith exception. The court emphasized the nondelegable duty of taxpayers to review returns for accuracy. And particularly with such a sophisticated taxpayer as the petitioner-husband (over 50 years’ real estate experience), the court was unpersuaded that he would have missed all the errors on his returns had he “conducted even a cursory review.”

One commentator piquantly noted the odd aspect of the finding in the Johnson opinion that the CPA was “competent,” another required element under the Neonatology test. Bryan Camp, When ‘My CPA Did It’ Is No Defense To Penalties,  TaxProf Blog (September 18, 2023). Perhaps the judge was being gracious. But certainly, the CPA’s blasé conduct implicated section 10.22 of Circular 230 regarding due diligence. Not applying the correct depreciation period, entering the same amount of mortgage interest ($44,806) twice, and failing to appreciate the need for a qualified appraisal of a donated building (and not just an old jalopy) all add up to a disturbing picture. The Office of Professional Responsibility may not be so gracious.