Larry's Tax Law

Taproot Administrative Services v. Commissioner, 133 TC 202 (2009), 679 F3d 1109 (9th Cir. 2012), is an S corporation shareholder eligibility case.  It was decided by the US Tax Court in 2009 and eventually made its way to the 9th Circuit Court of Appeals, where a decision was rendered in 2012.

Background

Prior to the enactment of the American Jobs Creation Act of 2004, only the following were eligible S corporation shareholders:

• • US citizens and resident individuals;
  • Estates;
  • Tax-exempt 501(c) charities and 401(a) retirement plans; and
  • Certain trusts, including QSSTs, ESBTs and grantor trusts

As a result of the lobbying efforts of family-owned rural banks, as of October 22, 2004 (the effective date of the American Jobs Creation Act), a new eligible shareholder was added to the list, IRAs, including Roth IRAs, provided two criteria are met:

• • The S corporation must be a bank, as defined in Section 581 of the Code; and
  • The shares must have been owned by the IRA on October 22, 2004, the enactment date of the American Jobs Creation Act.

As you might imagine, having an eligible IRA shareholder will be rare. The exception to the S corporation eligibility rules provided by the American Jobs Creation Act is quite narrow.

When tax advisors fail to follow the rules, it tarnishes our profession.  The bad behavior may subject them to discipline by the body governing their practice, the Office of Professional Responsibility and/or the criminal justice system.

Discipline may come in many flavors, depending upon the severity of the misconduct.  Sanctions generally consist of censureship, suspension, disbarment, financial penalties and imprisonment.

The stakes are high.  Tax advisors and their firms need to know and follow the rules, and implement systems to ensure compliance by the members of their firms.

Background

Effective June 30, 2005, Treasury issued final regulations amending Circular 230 (“2005 Regulations”).  The 2005 Regulations were specifically aimed at two goals:

• • Deterring taxpayers from engaging in abusive transactions by limited or eliminating their ability to avoid penalties via inappropriate reliance on advice of tax advisors; and

• • Preventing unscrupulous tax advisors and promoters from marketing abusive transactions and tax products to taxpayers based upon opinions that failed to adequately consider the law and the facts.

After the 2005 Regulations were issued, Treasury continued tinkering with the regulations to refine its approach, keenly keeping focus on these two goals.  Accordingly, we have seen numerous refinements to Circular 230 in the past nine (9) years, including:

• • Amendments to the 2005 Regulations published on May 19, 2005;

• • Broadened authority granted by lawmakers to Treasury to expand standards relating to written advice on October 22, 2004, with the passage of the American Jobs Creation Act of 2004 (“AJCA”).  In addition, the AJCA gave Treasury authority to impose monetary penalties against tax advisors who violate Circular 230;

• • Amendments to Circular 230 published on February 6, 2006, in proposed form, adopting, among other things, monetary penalties for Circular 230 noncompliance.  These regulations were finalized, effective September 26, 2007; and

• • Amendments to the written advice provisions of Circular 230 published on October 1, 2012 in proposed form.  These amendments were finalized on June 14, 2014.

Until 2005, Circular 230 was untouched for almost two decades.  An enormous storm awoke Treasury from a deep sleep, causing a loud roar to permeate among lawmakers, the IRS, Treasury and the tax community.  The result was the adoption of rules aimed at achieving the two goals set forth above.

The ultimate cause of the storm was the broad sweeping allegations of fraud and deception in the accounting and law professions which we saw in the early part of this millennium, including scandals involving ENRON, Global Crossing, imClone, WorldCom, Qwest, Tyco, HealthSouth and Aldelphia.  Further feeding the storm were the black clouds created by the collapse of Arthur Andersen and the financial penalties assessed against and the practice limitations imposed upon KPMG.  Last, but certainly not least, the investigations and lawsuits against tax advisors (and their firms) for developing and marketing abusive tax shelters, including the investigations and lawsuits leading to the demise of the large law firm of Jenkens & Gilchrist (“Jenkens”), added to these dark times.

On June 19, 2014, San Francisco tax attorney, James P. Kleier, entered into a plea agreement with the government for his failure to file tax returns and pay income taxes.  Per the agreement, Mr. Kleier will be imprisoned at the Atwater Federal Corrections Institution for 12 months commencing September 18, 2014.  Following release from prison, he will be subject to a 1-year supervised parole.  In addition, Mr. Kleier is required to pay the IRS a total $650,993.

Mr. Kleier was a partner in the San Francisco law office of Preston Gates & Ellis LLP (now known as K&L Gates LLP) from 1999 to 2005.  Thereafter, he practiced law in the San Francisco office of Reed Smith LLP.  Both of these organizations are large prestigious international law firms.  According to the complaint filed by the government in the U.S. District for the Northern District of California, tax attorney Kleier failed to report income of more than $1.3 million while practicing law at these firms.  Specifically, he earned $624,923 in 2008; $476,088 in 2009; and $200,734 in 2010.  Nevertheless, he failed to file tax returns for these years and pay the taxes due and owing.

As of June 12, 2014, with the exception of what are commonly known as “Marketed Opinions,” tax advisors and their firms no longer need separate standards governing Written Advice.  Section 10.35 of Circular 230 (“C230”) has been eliminated.  Consequently, the crazy, overused C230 disclaimers can go in the trash bin.  No more emails to mom, dad, children or other family members, and/or friends with a federal tax disclaimer.  I bet that will be somewhat of a relief to these email recipients.  No longer will they find themselves looking for tax advice as a result of the prominent disclaimer in a message that has absolutely nothing to do with taxes.

Representatives of the IRS and the Office of Professional Responsibility (“OPR”) have vocalized glee about the elimination of C230 disclaimers.  Karen Hawkins, Director of the OPR, told participants at a tax conference in New York last week:  “I’m here to tell you that jurat, that disclaimer off your emails.  It’s no longer necessary.”  IRS Chief Counsel, William Wilkins, echoed the same sentiments last week when he said:  “The Circular 230 legend is not merely dead, it’s really most sincerely dead.”

Treasury estimates this amendment to C230 and the removal of the corresponding compliance burden on tax advisors “should save tax practitioners [and/or their clients] a minimum of $5,333,200.”

Treasury issues long-awaited amendments to Circular 230.  On June 9, 2014, Treasury published amendments to Circular 230 that we have been anticipating for the past several months.  It looks like the crazy email disclaimers, just like leisure suits, will be a thing of the past.  Among many changes to Circular 230, the final regulations eliminate or clarify the complex rules for written advice.  Based upon my first read of the regulations, it certainly appears Treasury has been listening to tax practitioners.

Stay tuned, I will be posting a summary of the amended regulations soon.

The Internal Revenue Service (“IRS” or “Service”) has repeatedly stated that, while its crackdown on the failure of taxpayers to report foreign financial accounts has been strong, it is reasonable in the application of the law. At least one taxpayer, Mr. Carl R. Zwerner, would likely debate that pronouncement.

On June 9, 2014, Bloomberg BNA Daily Tax Report (No. 110) revealed that a long and hotly-contested battle between Mr. Zwerner and the United States government has come to an end. This highly-publicized case is frightening. It illustrates that the IRS may not always be reasonable in the application of the foreign financial account reporting (“FBAR”) laws.

Mr. Zwerner, an 87-year old retired specialty-glass importer, is a United States citizen who resides in Coral Gables, Florida. He had a financial account in Switzerland. The account balance never exceeded $1.7 million. It appears the account was opened by Mr. Zwerner during 2004 in the name of a foundation. In 2007, he closed the original account and transferred the account balance to another Swiss account. The new account was opened in the name of yet another foundation. Mr. Zwerner controlled these accounts; he was undisputedly the beneficial owner of the accounts.

On June 11, 2013, the battle commenced when Assistant Attorney General Kathryn Keneally instituted a lawsuit against Mr. Zwerner in the United States District Court for the Southern District of Florida, seeking to collect almost $3.5 million in penalties from him for violating the FBAR rules. The assessment which the government was pursuing against Mr. Zwerner amounted to more than double the highest account balance of his Swiss financial account.

Montgomery v. Commissioner, T.C. Memo. 2013-151 (June 17, 2013) illustrates what appeared to be the obvious – neither a guaranty of the corporation’s debt by a shareholder nor an unpaid judgment against a shareholder for the S corporation’s debt creates basis.

In Montgomery, the taxpayers, Patrick and Patricia Montgomery, claimed a net operating loss on their 2007 joint return, which they carried back to 2005 and 2006.  In the calculation of their net operating loss, they included:  losses UDI Underground, LLC (“UDI”), incurred in 2007 that were passed through to Patricia Montgomery as a 40% member; and losses Utility Design, Inc., an S corporation (“Utility Design”), incurred in 2007 that were passed through to Patrick and Patricia Montgomery as shareholders.

The IRS challenged the amount of the net operating loss for 2007 on two grounds:

• •  First, the IRS asserted Patricia Montgomery did not materially participate in UDI during 2007.

• •  Second, the IRS asserted portions of the losses from Utility Design were disallowed under Section 1366(d)(1).

• •  The IRS asserted Patricia Montgomery’s share of the 2007 losses from UDI were losses from a passive activity.  Specifically, the IRS argued Patricia Montgomery did not materially participate in UDI.

The Tax Court disagreed, holding Patricia Montgomery did materially participate in UDI.  In 2007, Patricia Montgomery handled all of the office functions, managed payroll, prepared documents, met with members of the company and attended business meetings.  Additionally, she continuously worked on company matters and daily discussed the company's business with Patrick Montgomery.  The court ultimately concluded Patricia Montgomery participated in UDI for more than 500 hours during 2007 and her participation was regular, continuous, and substantial.  Thus, Patricia Montgomery’s UDI activity was a non-passive activity.

IRC § 6656(a) provides, in the case of any failure to timely deposit employment taxes, unless the failure is due to “reasonable cause and not due to willful neglect,” a penalty shall be imposed.  The penalty is a percentage of the amount of underpayment.

• • 2% for failures of five (5) days or less;

• • 5% for failures of more than five (5) days, but less than 15 days;

• • 10% for failures of more than 15 days; and

• • 15% for failures beyond the earlier of:  (i) 10 days after receipt of the first delinquency notice under IRC § 6303; or (ii) the day on which notice and demand is made under IRC §§ 6861, 6862 or 6331(a)(last sentence)(jeopardy assessment).

In addition to the “reasonable cause” exception contained in IRC § 6656(a), there are two other means by which taxpayers may avoid the imposition of the penalty.

1.  Secretary has authority under IRC § 6656(c) to waive the penalty if:

• • The failure is inadvertent;

• • The return was timely filed;

• • The failure was the taxpayer’s first deposit obligation or the first deposit obligation after it was require to change the frequency of deposits; and

• • The taxpayer meets the requirements of IRC § 7430(c)(4)(A)(ii) [submits a request within 30 days and comes within certain net worth parameters].

2.  The Secretary has authority under IRC § 6656(d) to waive the penalty if:

• • The taxpayer is a first time depositor; and

• • The amount required to be deposited was inadvertently sent to the Secretary instead of the appropriate government depository.

As the exceptions are limited in application, most taxpayers seeking abatement of the penalty are required to pursue the “reasonable cause” exception.

Acts of dishonesty can cost a tax practitioner his or her ability to practice before the IRS.  Charles M. Edgar (“Edgar”), formerly a licensed CPA and attorney in Massachusetts, recently learned this lesson.

On May 1, 2014, the Service issued a news release (“IR-2014-58”), announcing the disbarment of Edgar.  While the saga of Edgar is long and somewhat convoluted, it illustrates a significant point—failure to act honestly in matters before the IRS constitutes a violation of Circular 230.  It will cost you severely.

Background 

The Secretary of Treasury has express authority to regulate practice before the IRS, including the power to suspend or disbar an individual from practice before the Service for failing to comply with Circular 230.  In such instances, the practitioner must be provided notice and an opportunity for a hearing before an administrative law judge.

Circular 230 grants the Director of the Office of Professional Responsibility authority to bring proceedings to suspend or disbar practitioners from practice before the Service.  Generally, an administrative law judge, not the Office of Professional Responsibility, determines the appropriate sanction, if any, taking into consideration all relevant facts and circumstances.

Circular 230 specifically provides that a practitioner may be sanctioned for giving “false or misleading” information to the Treasury or any officer or employee thereof.  For this purpose, “information” means any facts or statements made in testimony, on federal tax returns, financial statements, and other documents or statements (written or oral).

Circular 230 also provides that a practitioner may be sanctioned if he or she is disbarred or suspended from practice as an attorney, CPA, PA, or actuary.

On April 9, 2014, Oregon Governor John Kitzhaber signed into law House Bill 4138 (“HB 4138”).  Effective June 8, 2014, the methodology by which an “Interstate Broadcaster” apportions its business income for purposes of the Oregon corporate excise tax changes in at least two (2) ways:

           1.        Method of Apportionment.  Prior to June 8, 2014, an Interstate Broadcaster included in the numerator of the “sales factor” gross receipts from broadcasting in the ratio that its audience and subscribers located in Oregon bear to its total audience and subscribers located within and without Oregon.  On or after June 8, 2014, Interstate Broadcasters will no longer use this method of apportionment.  Rather, they will include in the numerator of the “sales factor” only those gross receipts from customers (i.e., advertisers and licensees) that have their commercial domicile in Oregon, or (in the case of individuals) who are residents of Oregon.

            2.        Definition of Interstate Broadcasters.  HB 4138 amends the definition of “Interstate Broadcaster” to include anyone engaging in the for-profit business of broadcasting to persons located within and outside of Oregon.   Prior law referred to broadcasting to subscribers or to an audience.  I am not sure this change to the law is significant other than it reduces the verbiage by four (4) words.