Supplementing FBAR: New 2011 Foreign Asset Disclosure Requirements

       On March 18, 2010, the President signed into law the Hiring Incentives to Restore Employment (HIRE) Act that contains a provision that changes and supplements the FBAR filing requirement.  Section 511 of the HIRE Act added Section 6038D to the Internal Revenue Code which requires individual taxpayers with an aggregate balance of more than $50,000 in “specified foreign financial assets” to file a disclosure statement with his or her income tax return.  26 U.S.C. §6038D.  While an FBAR filing is only required to be filed for individuals who had financial interest in or signature or other authority over any foreign financial accounts if the aggregate value of these financial accounts exceeds $10,000 at any time during the calendar year, the new code section defines a "specified foreign financial asset" to include ownership of:  (1) any financial account maintained by a foreign financial institution;  (2) any stock or security issued by a non-U.S. person;  (3) any financial interest or contract held for investment that has a non-U.S. issuer or counterparty; and (4) any interest in a foreign entity.  The broad language makes the Section 6038D filing requirement more applicable than the FBAR filing.  Some taxpayers will be required to file both next year.

            Unlike FBAR information, which originates under Section 31 of the United States Code and is normally not permitted to be verified against a tax return or tax information due to privacy and disclosure concerns, the new provision under Section 6038D has none of these restrictions.  This change allows the IRS to use its arsenal of tools and resources to verify the information reported. 

The minimum penalty for failing to submit the required disclosure pursuant to Section 6038D  is $10,000, which increases by $10,000 for each 30-day period following receipt of notification of your failure to file from Treasury, with the maximum penalty being $50,000.  There is a 90-day grace period following notification from the Treasury before the additional $10,000 penalties accrue.  The penalty may be waived if the taxpayer is able to demonstrate that the failure to file was due to reasonable cause.  Furthermore, the HIRE Act amends Section 6662 to make the underpayment penalty applicable to understatements attributable to undisclosed foreign financial assets.  For such understatements, the penalty imposed by Section 6662 is 40 percent, rather than the normal penalty of 20 percent.

IRS Commissioner Doug Shulman called Section 6038D “the next big thing” in international tax compliance and enforcement.  He further noted that the President has authorized funding to hire 1600 new people for the IRS’ international operations over the next two years.  (“Tax From the Top: Q&A With IRS Commissioner Doug Shulman,” Journal of Accountancy, April 2010, page 16.)  The reporting requirements are effective beginning in the 2011 taxable year.  The IRS is eager to find assets abroad so remember to disclose these foreign assets or risk incurring a hefty IRS fine.

New Duty Imposed on IRS: Find My Address!

            This office believes a recent Fifth Circuit Court of Appeals opinion may have a broad impact on the policies and procedures of the Internal Revenue Service.  As explained below, the IRS may have a duty to perform due diligence when corresponding with taxpayers through the mail. 

The Fifth Circuit Court of Appeals reversed a Tax Court decision that an individual’s petition challenging the IRS’s denial of innocent spouse relief was untimely because it was filed more than 90 days after the IRS issued its determination.  The Fifth Circuit reinstated the case because it found the IRS was on notice that its determination was sent to the wrong address.  The Fifth Circuit found that the IRS has a duty to search for taxpayer’s correct addresses when sending correspondence.  Because the taxpayer acted within 90 days of receiving the determination at her correct address, the petition was timely.  

            The taxpayer in this case was Pamela R. Terrell who received an assessment for over $660,000 in unpaid taxes.  She filed a Request for Innocent Spouse Relief (Form 8857) on September 20, 2006 with the IRS pursuant to section 6015 of the Internal Revenue Code.  Under Section 6015(e)(1)(A), the Tax Court has jurisdiction over an individual’s request for innocent spouse relief if a petition is filed at any time after the earlier of the date:  (a) the IRS mails a notice of its final determination of relief available to the individual, or (b) 6 months after the date the request is made, and, in either case, not later than the close of the 90^th day after the date the IRS mails its notice of final determination.  

After Ms. Terrell submitted the Form 8857, she moved.  The IRS mailed two notices of determination to her old address denying relief and notifying Ms. Terrell she had 30 days to request a review from IRS Appeals.  The US Postal Service returned both notices as undeliverable.  After the IRS did not receive a request to review, it mailed to her old address a Notice of Final Determination on April 6, 2007 denying innocent spouse relief and stating she had 90 days to petition the Tax Court for review.  This notice was also returned to the IRS as undeliverable.  

On April 11, 2007, Terrell filed her 2006 tax return listing her new address.  After it received the returned Notice of Final Determination, the IRS searched its database and found her new address from her filed tax return. The IRS then re-mailed the Notice of Final Determination to her new address.  She then filed a petition with the Tax Court on July 13, 2007.

The Tax Court dismissed the petition because it was not filed within 90 days of the date of the Notice of Final Determination- April 6, 2007.  It held that Terrell had not carried her burden of demonstrating that the Notice was not sent to her “last known address.”  The Court stated Ms. Terrell had to file her petition by July 5, 2007, and because she did not file until July 13, 2007, it lacked jurisdiction to hear her claim.  Ms. Terrell appealed. 

The Fifth Circuit held that, absent a subsequent, clear and concise notification of an address change, the IRS may consider the address on the taxpayer’s most recently filed return as her “last known address.”  But this does not dispense with the requirement that the IRS must use reasonable diligence to determine the taxpayer’s address in light of all relevant circumstances. 

In this case, when the IRS sent its Notice of Final Determination on April 6, 2007, it should have already known that Terrell’s address on file was incorrect because three separate mailings had been returned as undeliverable.  Although the IRS had not received clear and concise notification that her address had changed, the Fifth Circuit found that the IRS could not rely on a lack of notification once it was on notice that its address on file was incorrect. 

Because the IRS failed to take any steps to determine Ms. Terrell’s address after receiving the undeliverable mail and before mailing the Notice, the Fifth Circuit found that the IRS did not exercise reasonable diligence.  It noted the IRS could have done a search through the Department of Motor Vehicles, contacted Ms. Terrell’s employer, searched using her social security number, or undertaken any number of actions that might have revealed her new address.  

The Court went on to hold that because the Notice was not sent to her “last known address,” the Notice was null and void.  The statutory petition period began only when the IRS re-sent the Notice to Ms. Terrell’s correct address on May 14, 2007.  Because Ms. Terrell filed her petition within 90 days of this date, the Tax Court erred in finding itself without jurisdiction to hear the merits. 

To read the complete opinion, see Terrell v. Commissioner of Internal Revenue, ---F.3d ---, 2010 WL 4276021 (5th Cir., November 1, 2010).

Economic Substance: A Strict Diagnosis

       The new Health Care and Education Reconciliation Act of 2010 passed this year may have some very unhealthy consequences for unwitting small businesses and individual taxpayers in the form of strict liability tax penalties. With close to 150 million federal income tax filers in the country, taxpayers are given no comfort in the revelation that Congress enacted yet another strict liability penalty for transactions that lack “Economic Substance.” The weight of the Economic Substance penalty is sure to be borne by small businesses and individuals, not the large corporations that can afford the costs of engaging in controversy with the IRS.

       With the enactment of the strict liability penalty, the IRS apparently seems unable to learn from its past mistakes. Section 6707A was enacted to impose strict liability for the failure to disclose and report tax shelters to the IRS. Although the penalties reaching $300,000 per year were intended for large corporations, Section 6707A victimized many small businesses for attempting to do good deeds such as establishing employee benefit plans. Laura Saunders, Small-Business Owners Fret Over Large IRS Fines, The Wall Street Journal, September 19, 2009 at B1.

       As word spread of the damage being caused to small businesses by Section 6707A’s strict liability, senators and congressmen from around the country pleaded with the IRS to cease its imposition. What resulted was a moratorium on the collection of the penalty until Congress created a solution. Letter from Max Baucus, Chairman, Senate Committee on Finance, Charles Grassley, Ranking Member, Senate Committee on Finance, John Lewis, Chairman, House Committee on Ways & Means, and Charles W. Boustany Jr., Ranking Member, House Committee on Ways & Means, to Douglas H. Shulman, Commissioner, Internal Revenue Service (June 12, 2009) (available at the U.S. Senate Committee on Finance website). Even the National Taxpayer Advocate Nina Olson accused the fine of being unconstitutional in her yearly report. Taxpayer Advocate Service, 2008 Annual Report to Congress, vol. 1, p. 421. Congress has not fixed 6707A’s unintended damages but, nonetheless, the IRS marches forward with strict liability penalties for transactions that it unilaterally deems to lack economic substance.

       By way of reference, a strict liability penalty is one for which there exists no reasonable cause defense under Section 6664. Even if the taxpayer had a reasonable basis for the position by relying on a tax professional in good faith and discloses the transaction to the IRS, the penalty still applies. See 26 U.S.C. §6707A(a); Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152, 124 Stat. 1029 (to codify “economic substance” at 26 U.S.C. §7701(o)(1)). Thus, the only defense is to convince the IRS that the transaction in fact has economic substance. Good luck.

       In theory, the IRS’s stated policy is against strict liability. Policy Statement 20-1 provides that the “Service will demonstrate the fairness of the tax system to all taxpayers by … providing every taxpayer against whom the Service proposes to assess penalties with a reasonable opportunity to provide evidence that the penalty should not apply; giving full and fair consideration to evidence in favor of not imposing the penalty, even after the Service’s initial consideration supports imposition of a penalty; and determining penalties when a full and fair consideration of the facts and the law support doing so.” Perhaps Congress should reexamine the IRS stated policies when deciding whether to enact strict liability penalties that strip the taxpayer’s right to full and fair consideration. In addition, the penalties are not insignificant.

       The Economic Substance penalty is 20 percent of the taxpayer’s understatement if the transaction is disclosed and 40 percent if the transaction is not disclosed under Section 6662. In addition, the Section 6662A penalty is also stacked on top of it, which is another 20 percent. Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152, 124 Stat. 1029 (to be codified at 26 U.S.C. §6662(b)(6)).  

       If a potential 60 percent penalty is not daunting enough, the economic substance doctrine is one of the most fluid and facts-and-circumstances based “test” in the Code and is a judicially created vehicle whose standard varies from circuit to circuit. In general, the Economic Substance Doctrine stands for the idea that anticipated tax benefits from a transaction may be denied, even if the transaction completely complies with the technical aspects of the Internal Revenue Code, if the transaction otherwise does not result in a meaningful change to the taxpayer’s economic position other than a reduction in federal income tax. See Rice’s Toyota World, Inc. v. Comm’r, 752 F.2d 89 (4th Cir. 1985); see also ACM P’ship v. Comm’r, 157 F.3d 231 (3d. Cir. 1998). The codification does not provide further clarity.

       Section §7701(o) states that “[i]n the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.” The only defined term relating to Section 7701(o) is “economic substance doctrine,” which is defined as the “common law doctrine [under which certain tax treatment may be disallowed if the transaction does not have economic substance].” Simply adopting a common law doctrine that varies from circuit to circuit implants ambiguity in the statute.

       Congress also failed to define terms such as “transaction to which the economic substance doctrine is relevant”; “changes”; “meaningful way”; “taxpayer’s economic position”; and “substantial purpose.” The codification provides no further assistance in determining any red flags that may trigger a transaction’s disallowance. In fact, Congress seems to have codified the judicial doctrine and inserted some new, undefined terminology that will keep the litigation lively.

       The issue with the application of the Economic Substance doctrine is that it is usually applied to transactions that occurred many years ago, and then the IRS makes a decision to aggressively attack the transaction. One such transaction of late would be stock loan transactions consisting of non-recourse loans individuals and businesses took on a stock portfolio. Many taxpayers’ advisors agreed with the loan treatment under the Internal Revenue Code. Even though law existed to support the loan treatment and the taxpayer did actually transfer stock to the lending entity, the courts agreed with the IRS that the transactions lacked economic substance. Nagy v. United States, Slip Copy, 2009 WL 5194996 (Dec. 22, 2009). These taxpayers would be subject to a 60 percent penalty because the loan proceeds would not have been disclosed on the return, and the return preparer may be subject to preparer penalties.

       In the future, what could keep the IRS from taking the position that the discounts related to the transfer of Family Limited Partnership interests funded with stock, bonds and other liquid assets lack economic substance?  I am sure that every tax practitioner could think of a client who engaged in a transaction in the past that may lack economic substance.

        By codifying this ambiguous, strict liability economic substance penalty, Congress is undoubtedly placing an insurmountable burden on small businesses and individuals. The IRS will not consider any documentation, CPA’s advice, tax opinions or other facts and circumstances that could support a reasonable cause defense before imposing this penalty. There is no defense to this penalty on the administrative level unless you can convince the IRS that the transaction does have economic substance. Should the IRS remain unconvinced, the only option left is to litigate the economic substance issue, which is a fact intensive and expensive process, especially when facing the litigation resources of the United States. Jasper L. Cummings, Jr., Making Litigation Complex, Tax Notes, June 28, 2010.  

       Congress seems intent on implementing harsher and harsher penalties to raise revenue at the expense of small businesses and individual taxpayers.

       Check out this article on the web, along with other publications from South Carolina Tax Reports Fall 2010.

As If You Should Have to Ask: “Plain Writing” Rule Becomes Law

           “Huh?” has become the typical response of people who receive and are forced to read notices, pamphlets, and other government published materials.  IRS notices alone can cover several pages, front and back, with relatively no instructions.  Much to our relief, President Obama signed the Plain Writing Act of 2010 into law on October 13, 2010.

            The law requires the federal government to write its documents in simple, easy to understand language.  The law itself defines “plain writing” as writing that is clear, concise, well-organized, and follows other best practices appropriate to the subject or field and intended audience. “Americans lose time and money because government instructions, forms, and other documents are too complicated,” Senator Daniel Akaka of Hawaii, the bill’s co-sponsor said.  “The Plain Writing Act will require agencies to write documents which are clear, well organized, and understandable, leading to fewer customer service questions and increased compliance, making the government more efficient.” 

            One possible hiccup in the mandate: no punishment.  Each federal agency is stuck with the task of training and educating its employees on what constitutes “plain language,” and agency heads will issue annual reports on compliance.  However, there is no provision in the law for its violation.

Here are two examples of changes already made:

            The Department of Health and Human Services took a six-page article and replaced it
            with a single brochure:

Before
The Dietary Guidelines for Americans recommends a half hour or more of moderate physical activity on most days, preferably every day. The activity can include brisk walking, calisthenics, home care, gardening, moderate sports exercise, and dancing.
 

After
Do at least 30 minutes of exercise, like brisk walking, most days of the week.


The Medicare Beneficiary Services took standard correspondence and cut it down to two sentences:

Before

Investigators at the contractor will review the facts in your case and decide the most appropriate course of action. The first step taken with most Medicare health care providers is to reeducate them about Medicare regulations and policies. If the practice continues, the contractor may conduct special audits of the provider’s medical records. Often, the contractor recovers overpayments to health care providers this way. If there is sufficient evidence to show that the provider is consistently violating Medicare policies, the contractor will document the violations and ask the Office of the Inspector General to prosecute the case. This can lead to expulsion from the Medicare program, civil monetary penalties, and imprisonment.

After

We will take two steps to look at this matter: We will find out if it was an error or fraud.  We will let you know the result.

For other comparisons and examples of the new “plain writing,” visit www.plainlanguage.gov. 

Strapped for Cash? Try Checking Out Your Old Tax Returns.

            In a recent article featured in the Wall Street Journal, attorney Barbara Weltman discussed how old tax returns still have value.  Individuals and businesses can seek to amend past returns in order to receive tax refunds.  Reviewing old tax returns may also serve as a reminder to take other deductions or carryovers on this year’s return.  For business owners, here are some important things to check when reviewing your old returns:

·        Home Office Deductions:  The deduction for home office expenses cannot exceed the gross income from the home office activity in any taxable year.  However, any excess may be carried forward and used to offset gross income at any time in the future.

·        Net Operating Losses (NOLs):  Losses relating to your business that are not used on a current year’s tax return may be carried back for two years and carried forward for up to 20 years. 

·        Tax Credits:  Tax credits as a part of the general business credit (meaning the overall limitation of a combination of business credits) may be carried back for one year and forward for up to 20 years.  This year, small businesses may carry back credits for up to five years.

These are just a few of the ways you can squeeze more pennies out of your tax return.  For the complete article, visit www.wsj.com.

Changes for Small Businesses under the Small Business Jobs Act of 2010

       As mentioned in our September 30^th blog, President Obama’s Small Business Job Act contains many new tax breaks and incentives for businesses.  Below is a highlight of some of these new provisions. 

·        Enhanced Small Business Expensing (Section 179 Expensing).  To help small businesses quickly recover the cost of capital outlays, small business taxpayers can elect to write off these expenditures in the year they are made instead of recovering them through depreciation.  Under the old rules, taxpayers could generally expense up to $250,000 of qualifying property—including machinery, equipment and software—placed in service in during the tax year.  This annual limit was reduced by the amount by which the cost of property placed in service exceeded $800,000. Under the Small Business Jobs Act, the $250,000 limit is increased to $500,000 and the investment limit to $2,000,000 for tax years beginning in 2010 and 2011.  The Small Business Jobs Act also makes certain real property eligible for expensing.  Thus, for property placed in service in any tax year beginning in 2010 or 2011, the $500,000 amount can include up to $250,000 of qualified leasehold improvement, restaurant and retail improvement property.

·        Extension of 50% Bonus First-Year Depreciation. Before the Small Business Jobs Act, Congress allowed businesses to rapidly deduct capital expenditures of most new tangible personal property placed in service in 2008 or 2009 by permitting the first-year write-off of 50% of the cost.  The Small Business Jobs Act extends the first-year 50% write-off to apply to qualifying property placed in service in 2010 (as well as 2011 for certain aircraft and long production period property).

·        Boosted Deduction For Start-Up Expenditures. The Small Business Jobs Act allows taxpayers to deduct up to $10,000 in trade or business start-up expenditures for 2010.  The amount that a business can deduct is reduced by the amount by which startup expenditures exceed $60,000.  Previously, the limit of these deductions was capped at $5,000, subject to a $50,000 phase-out threshold.

·        General Business Credits of Eligible Small Businesses for 2010 Get Five-Year Carryback.  Generally, a business's unused general business credits can be carried back to offset taxes paid in the previous year, and the remaining amount can be carried forward for 20 years to offset future tax liabilities.  Under Small Business Jobs Act, for the first tax year of the taxpayer beginning in 2010, eligible small businesses can carry back unused general business credits for five years instead of just one.  Eligible small businesses are sole proprietorships, partnerships and non-publicly traded corporations with $50 million or less in average annual gross receipts for the prior three years.

·        General Business Credits of Eligible Small Businesses Not Subject to AMT for 2010.  Under the AMT, taxpayers can generally only claim allowable general business credits against their regular tax liability, and only to the extent that their regular tax liability exceeds their AMT liability.  A few credits, such as the credit for small business employee health insurance expenses, can be used to offset AMT liability.  The Small Business Jobs Act allows eligible small businesses to use all types of general business credits to offset their AMT in tax years beginning in 2010.

·        Deductibility of Health Insurance for the Purpose of Calculating Self-Employment Tax.  The Small Business Jobs Act allows business owners to deduct the cost of health insurance incurred in 2010 for themselves and their family members in calculating their 2010 self-employment tax.

·        Cell Phones No Longer Listed Property.  This means that cell phones can be deducted or depreciated like other business property, without onerous recordkeeping requirements.

·        S-Corporation Holding Period for Appreciated Assets Shortened to Five Years.  Generally, a C corporation converting to an S corporation must hold onto any appreciated assets for 10 years or face a built-in gain tax at the highest corporate rate of 35%.  The 2010 Small Business Jobs Act temporarily shortens the holding period of assets subject to the built-in gains tax to 5 years if the 5th tax year in the holding period precedes the tax year beginning in 2011.

·        New Tax Break for Long-Term Contract Accounting.  The Small Business Jobs Act provides that in determining the percentage of completion under the percentage of completion method of accounting, bonus depreciation in 2010 is not taken into account as a cost.  This prevents the bonus depreciation from having the effect of accelerating income.

·        Limitation on Penalty for Failure to Disclose Certain Reportable Transactions.  The Small Business Jobs Act generally limits the Section 6707A penalty to 75% of the decrease in tax resulting from the transaction, retroactively to penalties assessed after Dec. 31, 2006.  Minimum and maximum penalties apply.

·        Revenue Raisers.  These tax breaks come at a cost.  To mention a few of these unfavorable provisions, information reporting will generally be required for rental property expense payments made after Dec. 31, 2010, and increased information return penalties will be imposed.

Entrepreneurs Can Escape Capital Gains

       As a part of the Small Business Bill signed into law on September 23^rd, section 1202 of the Internal Revenue Code will be amended to provide for an exclusion of capital gains on small business qualified stock held for more than five years.  In sum, certain investors in startup companies will pay no tax on the disposition of the stock.  Indeed, the current administration is providing a huge tax break to entrepreneurs looking for an exit strategy. 

       In order to qualify, the stock must be held by the taxpayer by January 1, 2011.  So if you already own the stock don’t worry.  But if you are contemplating the startup of a new company, closing the transaction and issuing the stock within the next three months will provide for 100% exclusion on capital gains and an exclusion from the alternative minimum tax on these gains if the stock is sold after five years. 

       Additionally, the exclusion is available for taxpayers who received eligible stock from its original issuance, and the corporation meets the requirements that it actively conducts a qualified trade or business and its aggregate gross assets do not exceed $50 million.  To be considered a “qualified” corporation, it must be a C-corporation other than a (1) DISC; (2) a regulated investment company; (3) a real estate investment trust; (4) a real estate mortgage investment conduit; (5) a financial asset securitization investment trust; (6) a cooperative; or (7) a corporation electing the Puerto Rico and possessions tax credit.   

        More limitations are written into the code section, including the requirement that the corporation use at least 80% by value of its assets in the active conduct of a qualified trade or business.  While the requirements may seem overwhelming, entrepreneurs seeking funds now have an excellent marketing tool to entice investors.  And for investors, this might be the incentive to finally write that check.  President Obama estimated that the measure would drive “capital to as many as one million small firms across America.”  President Obama might be right about this excellent benefit.