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IRS Changes Position on Approval for Assertion of Codified Economic Substance Doctrine

by | Apr 29, 2022 | ,

In March 2010, Congress codified the economic substance doctrine in Internal Revenue Code (Code) Section 7701(o). The codification clarified that a conjunctive analysis applies in determining if the doctrine applies. The codified economic substance doctrine applies when a transaction does not have economic substance or lacks a business purpose. When the doctrine applies, a taxpayer is subject to a 20% strict liability penalty (40% in the case of undisclosed transactions) on any underpayment attributable to the disallowed tax benefit claimed.

Congress acknowledged that the codified economic substance doctrine should be applied sparingly, and the Joint Committee on Taxation, in a report issued prior to the enactment of the doctrine, provided detailed guidance on when the doctrine should apply. The Internal Revenue Service (IRS) issued guidance shortly after the codification acknowledging these points. The IRS also put in place detailed procedures for examiners to follow in determining whether to assert the codified economic substance doctrine.

One of the procedures put in place was the approval by the Director, Field Operation before the codified economic substance doctrine could be formally asserted. An approval request was to be made after consultation with the revenue agent’s manager and local counsel. Additionally, taxpayers were to be provided “the opportunity to explain their position.”

On April 22, 2022, the IRS’s Large Business & International (LB&I) Division issued a memorandum—LB&I-04-0422-0014—to all LB&I and Small Business/Self Employed examination employees (Updated Guidance). The Updated Guidance removes the requirement to obtain executive approval before asserting the codified economic substance doctrine. The Updated Guidance states that this change aligns penalties for lack of economic substance with other assessable penalties which do not require executive approval. However, the changes do not remove the supervisory approval requirement under Code Section 6751.

In connection with the Updated Guidance, revisions are being made to the relevant provisions of the Internal Revenue Manual (IRM). The IRM revisions eliminate some of the considerations previously set forth in the four-step process that revenue agents were required to undertake in determining whether the doctrine should be applied.

Practice Points: Although the Updated Guidance has no impact on the substance of the codified economic substance doctrine itself, the change is disappointing news. As a result of the relaxed rules for the doctrine’s assertion, taxpayers can reasonably assume that the doctrine may more frequently be asserted on audit. Thus, it is now even more important to properly document transactions to demonstrate they have sufficient economic substance and a business purpose.



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An Update on Section 6751 Penalties

by and | Mar 23, 2022 | , , , , ,

Tax penalties are always a hot topic here. The Internal Revenue Service (IRS) has a large arsenal when it comes to grounds for asserting penalties on income tax deficiencies, ranging from the common 20% penalty under Internal Revenue Code (Code) Section 6662(a) to higher penalties ranging from 40% (gross valuation or basis misstatements and economic substance) to 75% (fraud).

However, before the IRS can assert most penalties against taxpayers, it must comply with the procedural requirement in Code Section 6751(b): That the “initial determination” to assert the penalty be “personally approved (in writing) by the immediate supervisor of the individual making such determination.” As the US Court of Appeals for the Second Circuit explained in Chai v. Commissioner, US Congress imposed this requirement because it “believes that penalties should only be imposed where appropriate and not as a bargaining chip” and “[t]he statute was meant to prevent IRS agents from threatening unjustified penalties to encourage taxpayers to settle.”

Over the past several years, there has been substantial litigation over the proper interpretation and application of Code Section 6751(b). The US Tax Court’s recent opinion in Oxbow Bend, LLC v. Commissioner is the latest development. In Oxbow Bend, the Tax Court rejected the taxpayer’s position that the “initial determination” was made on the date that the examining agent prepared a penalty lead sheet reflecting her recommendation to assert penalties and stated in a telephone conference with the taxpayer’s representative on that same day that penalties were being considered. Approximately three months later, the examining agent’s supervisor approved the penalty lead sheet, and the IRS issued a Notice of Final Partnership Administrative Adjustment asserting the penalties. The Tax Court, relying on its prior precedent, held that the word “determination”:

  1. “has an established meaning in the tax context and denotes a communication with a high degree of concreteness and formality”
  2. “signifies a consequential moment of IRS action”
  3. is not a “mere suggestion, proposal, or initial informal mention of penalties”
  4. “will be embodied in a formal written communication that notifies the taxpayer of the decision to assert penalties.”

Thus, under the Tax Court’s analysis, an “initial determination” can only be made in a “written” document that is provided to the taxpayer.

Oxbow Bend is a memorandum opinion of the Tax Court and, therefore, is limited to its facts and technically not precedential, as we have discussed in the past. However, memorandum opinions are often cited by litigants, and the Tax Court does not disregard these types of opinions lightly. One has to wonder whether, under different facts where an examining agent makes an explicit oral statement to a taxpayer that penalties “will” be asserted, courts might reach a different result given Congress’s express intent that examining agents should not threaten penalties and use them as a bargaining chip for settlement purposes. Further, Code Section 6751(b) expressly requires that the supervisory approval be “in writing” but contains a written requirement for purposes of the [...]

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District Court Vacates, Sets Aside IRS Reportable Transaction Notice

by , and | Mar 23, 2022 | , , , ,

The fallout from taxpayer challenges to the Internal Revenue Service’s (IRS) “reportable transaction” regime continues. On March 21, 2022, the district court in CIC Servs., LLC v. IRS ruled in favor of the taxpayer, vacating Notice 2016-66 and ordering the IRS to return all documents and information produced pursuant to Notice 2016-66 to taxpayers and material advisors.

We previously posted about the Supreme Court of the United States’ decision in CIC Servs., LLC v. IRS, which allowed a pre-enforcement challenge to the IRS’s reportable transaction regime. On remand, the parties filed cross-motions for summary judgment. The district court, relying on Mann Construction, Inc. v. United States, explained that the “Sixth Circuit’s analysis in Mann Construction is binding on this Court and applies equally to the arguments advanced by the IRS regarding Notice 2016-66 in this case.” The court dealt the IRS another blow, holding that Notice 2016-66 had to also be set aside as an agency action that was arbitrary and capricious: “[s]imply including cases in the administrative record that suggest certain tax structures could be abusively employed is not synonymous with examining relevant facts and data in connection with issuing the Notice.” In determining the appropriate relief, the court rejected the IRS’s request to limit vacatur of the Notice to CIC, explaining that “vacating the Notice in its entirety is appropriate” and citing the US Court of Appeals for the Sixth Circuit’s prior statement that the IRS “do[es] not have a great history of complying with APA procedures, having claimed for several decades that their rules and regulations are exempt from those requirements” (See CIC Servs., LLC v. IRS, 925 F.3d 247, 258 (6th Cir. 2019) quoting Kristin E. Hickman & Gerald Kersa, Restoring the Lost Anti-Injunction Act, 103 Va. L. Rev. 1683, 1712-13 (2017)).

Practice Point: The assault on the IRS’s reportable transaction regime is far from over. We recently posted about the Sixth Circuit’s opinion in Mann Construction in which it held that Notice 2007-83, which required disclosure of listed transactions relating to certain employee benefit plans, violated the Administrative Procedure Act (APA). APA challenges continue to expand to other IRS notices that bypassed the notice-and-comment requirement, including Notice 2017-10, which identifies certain syndicated conservation easement transactions as listed transactions subject to disclosure to the IRS. These developments will certainly have a significant impact on taxpayers and material advisors’ responsibilities as we move into the tax filing season.



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IRS Proposes New Process for Post-Filing Disclosures to Replace Revenue Procedure 94-69

by and | Feb 28, 2022 | , ,

For many years, the Internal Revenue Service (IRS) has provided large corporate taxpayers who are under continuous audit to make affirmative disclosures at the start of an audit so they have an opportunity to disclose tax positions and avoid certain civil tax penalties. The procedure, outlined in Revenue Procedure 94-69, has been very popular with both taxpayers and IRS agents because it provides a mechanism that allows taxpayers to informally “amend” a return without filling out all of the paperwork. IRS agents also like the procedure because it allows them to focus the examination on the disclosed issues and incorporate the adjustments in the final computation from the audit. Indeed, the procedure has grown in practice to include the disclosure of affirmative and negative adjustments at the start of the examination and not just in the audits of taxpayers under the jurisdiction of the IRS’s Large Business & International division. However, as the continuous audit paradigm has ended, in 2020 the IRS questioned the continuing viability of this procedure and sought comments from taxpayers on if, and how, it should continue.

Numerous commentators (including the American Bar Association Section of Taxation and Tax Executives Institute, Inc.) recommended that the IRS keep this post-filing disclosure procedure in place, citing the following points in support:

  • The procedure avoids the need to file a formal amended return, a burdensome process on large taxpayers.
  • Requiring formal amended returns can be a significant strain on taxpayer resources, including the potential need to deal with state and local tax filings.
  • All mistakes can be fixed at one time (i.e., avoiding multiple amended returns).
  • The procedure eases reporting issues with Schedules K-1 that are issued after the original tax return is filed.
  • The procedure allows incorporating carryover adjustments from prior examinations.
  • There’s potential to avoid strict liability for penalties relating to transfer pricing adjustments.

On February 25, 2022, the IRS announced that it will standardize the process for making post-filing disclosures so that eligible taxpayers and IRS agents have consistent guidelines for determining what constitutes an adequate disclosure. To that end, the IRS has published a new draft form, Form 15307, Post-Filing Disclosure for Specified Large Business Taxpayers, to be used by eligible taxpayers seeking to make a post-filing disclosure. Taxpayer comments on the new draft form can be submitted here.

The draft Form 15307, which must be signed under penalties or perjury, requires that the taxpayer identify the number of disclosures and provide specific information about each disclosure, including:

  • Adjustment type
  • Timing
  • Effect of carryover
  • Description
  • Increase/decrease to taxable income or tax credits
  • Explanation of the item being disclosed

Examples of acceptable and unacceptable descriptions and disclosures are provided in the instructions to the draft form. Generally, netting of adjustments is not permitted, however, where the facts and circumstances of an item are identical and represent a high volume of low dollar amounts, the disclosures can be netted. The [...]

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Revoking Your Power of Attorney Status

by and | Jan 28, 2022 | ,

To represent a taxpayer before the Internal Revenue Service (IRS), you need a valid power of attorney (POA). This is accomplished by preparing and submitting a properly completed Form 2848, Power of Attorney and Declaration of Representative pursuant to the Instructions for Form 2848. At some point, the representation will end (or it ends for certain matters and years but not for others). However, absent affirmative steps by the representative prevents the IRS from knowing that you no longer represent the taxpayer, and you may continue to receive IRS correspondence. This creates a potential issue because representatives should not be receiving taxpayer information if they no longer represent or provide legal advice to said taxpayer.

To avoid this, a representative can notify the IRS that they no longer represent the taxpayer and do not wish to receive any further correspondence, either for all matters and years or just certain ones. This is done by revoking your POA with the IRS. Revocation can be done in one of two ways. The first way is to mail or fax a copy of the POA to the IRS with the word “REVOKE” written across the top of the first page with a current signature and the date below this annotation. Alternatively, if the representative does not have a copy of Form 2848 or wishes to revoke several POAs at the same time, they can send the IRS a statement of revocation that indicates that the authority granted by the POA is revoked, lists the matters and years and lists the name and address of each recognized representative whose authority is revoked. If the representative is completing revoking authority, they can write “revoke all years/periods” instead of listing the specific matters and years.

For representatives who represent multiple taxpayers before the IRS, it may be difficult to recall all of the POAs they have filed with the IRS. However, a listing of all your POAs can be obtained by submitting a Freedom of Information Act request for a copy of the Centralized Authorization File (CAF)/Representative/Client listing. It’s a simple process, and the IRS provides the following Sample CAF Client Listing Request on its website:

Sample CAF Client Listing Request

 

Practitioner or company name Practitioner or company address Phone number (optional)

 

Date

 

Dear Disclosure Manager:

 

This is a request under the Freedom of Information Act. I request that a copy of the CAF Representative/Client Listing be provided to me. I do not wish to inspect the documents first.

 

In order to determine my status for the applicability of fees, you should know that I am an “Other” requester seeking information for non-commercial or personal use. I am a tax professional and my CAF number is XXXXXXX. (This is not your Enrolled Agent Number)

 

I am including a valid photo identification which includes my signature as proof of identity.

 

Send listing as a paper document. I am willing to pay [...]

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IRS Chief Counsel Signals Increased Tax Enforcement

by , and | Jan 27, 2022 | , , , , ,

The Internal Revenue Service (IRS) Chief Counsel is the chief legal advisor to the Commissioner of Internal Revenue on all matters pertaining to the interpretation, administration and enforcement of the Internal Revenue Laws. In this regard, the IRS Office of Chief Counsel is responsible for litigating cases in the US Tax Court. Such cases can arise from examinations conducted by different divisions within the IRS, such as the Large Business & International (LB&I), Small Business/Self Employed (SB/SE), Tax Exempt & Government Entities (TE/GE) and Wage & Investment (W&I) Divisions.

On January 21, 2022, the IRS Office of Chief Counsel announced plans to hire up to 200 additional attorneys to assist with litigation efforts. The announcement specifically notes that new hires are necessary “to help the agency combat syndicated conservation easements, abusive micro-captive insurance arrangements and other tax schemes.” They will also help the IRS manage its increasing caseload as part of its multiyear effort to combat what it believes are abusive schemes and to ensure that the appropriate taxes and penalties are paid. The new hires will be located around the country and focus on audits of complex corporate and partnership issues.

Additionally, there are a significant number of cases before the Tax Court that involve conservation easements and micro-captive insurance arrangements. The IRS’s attack on the donation of conservation easements is well known in the tax world. To date, the IRS has largely been successful in these cases based on non-valuation arguments that easement deeds do not comply with the applicable regulations. However, in the recent Hewitt v. Commissioner case, the US Court of Appeals for the Eleventh Circuit dealt a significant blow when it held that the IRS’s interpretation of Treas. Reg. § 1.170A-14(g)(6)(ii) was arbitrary and capricious and violated the Administrative Procedure Act because the US Department of the Treasury failed to respond to significant comments submitted during the notice-and-comment process. Many conservation easements are within the Eleventh Circuit’s jurisdiction and other appellate courts are expected to weigh in soon, which could result in the IRS and taxpayers proceeding to trial on valuation issues. Valuation issues are inherently fact intensive and will require the IRS to utilize substantial resources to litigate.

Practice Point: Much has been written about the trend of decreased enforcement by the IRS over the past several years, owing in part to decreased or stagnant funding from US Congress. Tax litigation, particularly in fact intensive cases involving valuation issues and transactions the IRS (but not necessarily the courts) deemed abusive, requires the expenditure of substantial resources by the IRS. The IRS has signaled that it is ready to reverse the trend. All IRS tax controversies start with the examination of the taxpayer’s positions on the return. We have seen an increase in IRS audit activity in the last year or so, especially with medium-sized businesses and high-net-worth individuals. The Chief Counsel is assembling his “army” to litigate positions developed during the examination. It’s a good time for taxpayers [...]

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National Taxpayer Advocate’s Report Highlights Tough Times for Tax Administration

by and | Jan 18, 2022 | , , , ,

On January 12, 2022, the National Taxpayer Advocate released a report to US Congress concerning the state of tax administration in 2021. The report highlights the struggles the Internal Revenue Service (IRS) has been having in the wake of the COVID-19 pandemic, including how the IRS is substantially behind in processing returns, the breakdown of the IRS call center, delays in processing responses to IRS notices sent to taxpayers and a myriad of other issues. (There is indeed a backlog for processing millions of tax returns!)

The Taxpayer Advocate Service (TAS) can be a helpful and powerful tool for taxpayers looking to resolve their tax issues with the IRS. We have provided information on this resource in earlier submissions. (See Taxpayer Advocate Service: Not Just for Low-Income Taxpayers.)

Practice Point: For those who are having difficulties interacting with the IRS and unable to achieve reasonable or satisfactory responses or explanations, seeking assistance from TAS can go a long way in resolving tax issues. The process is free to taxpayers and starts with the filing of Form 911 with the appropriate TAS office. If you seek assistance in the near future, be mindful that TAS is currently flooded with requests for help but will work your case—if it meets the relevant criteria—as soon as possible. A dose of patience will be needed to work through this resource to obtain a successful resolution of your tax issue.



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Extending the Statute of Limitations for Assessing Federal Tax

by and | Jan 14, 2022 | , ,

We previously provided an overview of the time limits imposed on the Internal Revenue Service (IRS) for assessing federal tax. The general rule is that the IRS must assess tax within three years from the later of the due date of the original tax return or the date it was filed. If the IRS does not assess tax during this period, it is foreclosed from doing so in the future. Note that the filing of an amended return does not restart or extend the limitations period. There are numerous exceptions to this rule, including if there is a substantial omission of income, fraud, failure to file a return, extension by agreement and failure to provide certain information regarding foreign transactions. We discussed many of these exceptions in Seeking Closure on Tax Positions: A Look at Tax Statutes of Limitation and Omitted Subpart F and GILTI Income May Be a Statute of Limitations Trap for the Unwary. Below, we discuss the rules and considerations for consenting to extending the time to assess federal tax.

Internal Revenue Code (Code) Section 6501(c)(4) provides that, except in the case of estate taxes, taxpayers (or their duly authorized representative) and the IRS may consent in writing to an extension of the limitations period for assessment. Importantly, such an agreement must be executed before the limitations period expires. In other words, assuming no other exception applies to the general three-year rule, an agreement to extend the limitations must be executed within the later of three years from the date the tax return was due or filed. If executed after that date, the consent is invalid. Thus, a late-filed consent cannot revive an otherwise closed limitations period. Under Code Section 6511(c), extending the statute of limitations on assessment also extends the period for filing a claim for credit or refund to six months after the expiration of the extended assessment period.

Form 872, Consent to Extend the Time to Assess Tax, is generally used to effectuate an agreed extension to a certain date, however, other versions of the form may be used for different types of taxpayers or issues (e.g., Form 872-M, Consent to Extend the Time to Make Partnership Adjustments, is used for partners subject to the centralized partnership audit regime under the Bipartisan Budget Act of 2015). Form 872-A, Special Consent to Extend the Time to Assess Tax, may be used to extend the limitations period for an indefinite period (referred to as an Open-Ended Consent). An Open-Ended Consent ends 90 days after the mailing by the IRS of written notification of termination or receipt by the IRS of written notification of termination from the taxpayer (both actions are accomplished through the use of Form 872-T, Notice of Termination of Special Consent to Extend the Time to Assess Tax), or the mailing of a notice of deficiency. The IRS’s views on Open-Ended Consents are summarized in
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IRS Audit Update: Communicating Via Video Meetings and Secure Messaging

by and | Nov 5, 2021 |

The traditional audit experience for taxpayers large and small has, like many things, been impacted by COVID-19. Taxpayers and the Internal Revenue Service (IRS) have been forced to navigate audits in a remote environment, causing issues related to exchanging documents, engaging in discussions and even filing tax returns and other documents. The IRS has worked hard to adjust to the pandemic and made significant strides in maintaining an efficient audit process.

The key to a well-organized and just audit process is communication between taxpayers and the IRS. In a welcome development, the IRS Large Business & International (LB&I) Division recently announced that effective October 18, 2021 (and expiring October 18, 2023), IRS employees must grant an LB&I taxpayer’s request for a video meeting in lieu of an in-person or telephone discussion. The video meeting must be through IRS-approved solutions, which is currently WebEx and ZoomGov with a future phase-in of Microsoft Teams planned. Screen sharing is permitted but files may not be transferred on these platforms.

Additionally, the IRS has been offering the Taxpayer Digital Communications (TDC) secure messaging system as another communication method. The TDC system avoids the need to send documents to the IRS via facsimile and allows the transfer of files of up to one gigabyte in a secure messaging environment. The IRS is also working with corporate taxpayers on third-party virtual reading rooms that permit IRS employees to review documents without downloading them.

Practice Point: The use of video meetings and the TDC system are two ways that the IRS and taxpayers can continue to communicate effectively and efficiently in a remote working environment. The IRS is continuing to roll out new programs and initiatives in this area and the McDermott tax team will continue to provide updates as they become available.



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Show Me the Money: IRS Introduces Webpage for Large Refunds Subject to JCT Review

by and | Sep 23, 2021 | , ,

When we previously wrote about the Joint Committee on Taxation’s (JCT) process for reviewing refund claims granted by the Internal Revenue Service (IRS), we explained that the IRS generally must submit proposed refunds in excess of $5 million for corporate taxpayers and $2 million for all other taxpayers to the JCT before any such refunds can be paid. However, getting through the JCT review process can be difficult and time-consuming in some situations—and sometimes taxpayers are left in the dark.

On September 22, 2021, the IRS announced the launch of its new webpage that provides information to taxpayers whose large refunds are subject to JCT review. Topics covered include general information about how a JCT review matter arises and how the IRS handles a JCT review case.

Practice Point: The IRS’s new webpage provides a helpful general overview of the JCT review process but does not provide any new information on it. A more detailed discussion of the JCT review process can be found in our prior post and in the JCT’s 2019 process overview.



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