ataxingmatter

Final Circular 230 Regulations

The IRS issued final rules under Circular 230 governing practice before the IRS on September 26 (T.D. 9359).  See this CCH description of the changes in the final rules.

The final regulations adopt the proposed change to the definition of practice before the Internal Revenue Service, so that it covers all matters connected with a presentation to the IRS or any of its officers or employees relating to a taxpayer's rights, privileges or liabilities under the tax laws administered by the IRS.  Even though some commentators had stated that the provision of tax advice could not, in and of itself, constitute practice before the IRS, the Treasury and IRS have concluded that providing written advice is practice before the IRS subject to Circular 230 when it is provided by a practitioner, and attorneys or CPAs who provide written advice covered under sections 10.35 or 10.37 of Circular 230 are not required to file a Form 2848 to the IRS before rendering covered advice.

The regulations change the proposed rules regarding contingent fees set forth in section 10.27.  The Preamble states that tax administrators "continue to believe that a rule restricting contingent fees for preparing tax returns supports voluntary compliance with the Federal tax laws by discouraging return positions that exploit the audit selection process.   The rules permit contingent fees for services in connection with the IRS examination of (i) an original tax return or an amended return or claim for refund or credit, where the amended return or claim was filed within 120 days of receipt of a written notice of exam or of a written challenge to the original tax return or (ii) interest and penalty reviews, or (iii) services rendered in connection with a judicial proceeding arising under the Code.

The final regulations also adopt the proposed amendments on conflict of interest with some modifications.  A practitioner has to obtain consent in writing from each client to represent conflicting interests.  Unlike the ABA model rule 1.7, a verbal consent followed by a confirmatory letter from the practitioner is insufficient--the client must countersign the confirmatory letter within 30 days of the verbal agreement. 

The final regulations do not conform the Circular 230 standards to the new Code standards for advice applicable to return positions under section 10.34.  The "Small Business and Work Opportunity Tax Act of 2007" applied the tax return preparer penalties to all tax return preparers, increased the penalty and altered the standard to avoid imposition of penalties to a more likely than not (MLTN) standard.  The IRS issued transitional relief under Notice 2007-54 for the section 6694 standards.  Therefore these regulations reserve section 10.34 (a) and (e) and a notice of proposed rulemaking is concurrently issued to amend this part to reflect the tax law changes. The regulations clarify that "a practitioner may not advise a client to submit a document to the IRS that contains or omits information in a manner that demonstrates an intentional disregard of a rule or regulation unless the practitioner also advises the client to submit a document showing a good faith challenge to the rule or regulation."

The Notice of Proposed Rulemaking  (REG-138637-07; RIN 1545-BH01) states that Treasury and IRS have concluded that section 10.34 of Circular 230 should conform to the civil penalty provisions in the Code, including the 2007 changes made to section 6694(a).  Therefor, a practitioner may not sign a tax return without a reasonable belief that the treatment of each position "would more likely than not be sustained on its merits, or there is a reasonable basis for each position and each position is adequately disclosed."  A similar standard applies to advice to a client to take a position on a return.  The NPRM also modifies the definitions of "more likely than not" and "reasonable basis" to reflect the understanding of these termms under the section 6662 penalty regulations.  Conforming wiht Notice 2007-54, these rules are proposed to apply when the regulations are finalized, but no earlier than January 1, 2008.

Patented Tax Strategies: new developments

Just months after the Treasury Department's July 31 release of final regulations on reportable transactions (T.D. 9350), it has released new proposed regulations treating patented tax strategies as reportable transactions and requiring reporting by both taxpayers and material advisors (Download patented_transactions_reportable_transactions_regs. 092607.doc ).  The regulations define patented transactions in two contexts, by focusing on a taxpayer's payment of a fee to use a patent in one case and on rights to payments from a taxpayer to a patent holder in the second case.  Settlements or damanges in infringement suits are taken into account in the latter but not in the former case.  Responding to concerns that tax planning methods that involve tax software should not be treated as problematic, the regulations define covered tax planning methods broadly  (as a plan, strategy, technique, or structure designed to affect Federal income, estate, gift, generation skipping transfer, employment, or excise taxes), but exclude mathematical calculations or mechanical assistance in the preparation of tax returns. The threshold dollar amounts for the material advisor determination are substantially lowered in the case of patented transactions--$250 instead of $50,000 for natural persons, and $500 instead of $250,000 otherwise.  Material advisors have a list maintenance obligation under section 6112.

Interestingly, both patent holders and taxpayers who use patented strategies can be "participants" in patented tax strategies under the regulations.  The definition of participation hinges on reflection of the patent ina return.  The NPRM explains it this way.

A taxpayer has participated in a patented transaction if the taxpayer's tax return reflects a tax benefit from the transaction (including a deduction for fees paid in any amount to the patent holder or patent holder's agent).  A taxpayer also has participated in a patented transaction if the taxpayer is the patent holder or patent holder's agent and the taxpayer's tax return reflects a tax benefit in relation to obtaining a patent for a tax planning method (including any deduction for amounts paid to the United States Patent and Trademark Office as required by title 35 of the United States Code and attorney's fees) or reflects income from a payment received from another person for the use of the tax planning method that is the subject of the patent.

Today, BNA reports a discussion at a National Association of Bond Lawyers seminar in which Treasury attorney John Cross III indicated that the proposed regulations that make patented tax strategies reportable transactions for purposes of sections 6011 and 6111 is  actually not the preferred solution within Treasury.  A ban, as proposed in the House version of Patent Reform legislation, would be preferable because of the problem that taxpayers may be misled into viewing patented strategies as carrying the imprimatur of correctness because of the Patent Office's approval of the patent.

"The proposal is very nuanced and if you are interested in it you should look at all the rules under it," Cross said. "But I think in the big picture Treasury would prefer a statutory ban on tax planning patents as is done under the existing House bill (H.R. 1908) rather than a regulatory approach, which by scope of authority is necessarily more limited. The base of concern is a fear by IRS and Treasury that when people run around saying ‘we have a patent,’ they will somehow imply that whatever the tax approach taken has been blessed in some way by the government."

Consolidated Return Regulations: intercompany obligations and insurance

The Federal Register tomorrow will carry new intercompany obligation and intercompany insurance regulations under section 1502 (1.1502-13(g) and 1.1502-13(e)), available on BNA at this link.

The preamble to the regulations discusses the consideration of eliminating the deemed satisfaction-deemed reissuance model of the current regulations for intercompany obligations.  After consideration of a matching and acceleration model, tax administrators concluded that the deemed satisfaction-reissuance model provides a better approach of minimizing the effects of intercompany obligations on a consolidated group's income and providing mechanisms closer to a single-entity approach.  The deemed satisfaction-deemed reissuance model maintains creditor and debtor items at their original site, matches  timing , and ensures correspondence between creditor and debtor for future amounts and timing of discount or premium.  The acceleration and matching rules, on the other hand, would have required a number of special rules to provide adjustments to the way original issue discount (OID) and other rules work in the consolidated return context.

The new regulations, however, are intended to simplify the mechanisms for satisfaction and reissuance for intragroup and outbound transactions, as follows.

In general, the new model deems the following sequence of events to occur immediately before, and independently of, the actual transaction: (1) the debtor is deemed to satisfy the obligation for a cash amount equal to the obligation’s fair market value; and (2) the debtor is deemed to immediately reissue the obligation to the original creditor for that same cash amount.  The parties are then treated as engaging in the actual transaction but with the new obligation. 

...

The new model operates to trigger all built-in items arising from the obligation, and then reissue the obligation with an issue price equal to its basis (and generally, its fair market value) before the actual transaction.  Thus, no further gain, loss, income, or deduction with respect to the obligation will result from the actual transaction.

Unlike the current regulations, however, these regulations determine the amount of the deemed satisfaction and reissuance based on fair market value rather than through application of the OID rules.  However, if the transaction is not an intragroup transaction and the creditor's amount realized differs from the fair market value, the amount used will be the amount realized by the creditor.

A number of further special rules are provided, and of course intergroup insurance transactions are treated.  This appears to be a regulatory project that both clarifies and simplifies in ways that most taxpayers will find reasonable.

Cancellation of Debt Income on Mortgage Loans: Offsets

Yesterday, I discussed the current House bill that permanently excludes mortgage debt discharge income.  See Cancellation of Debt Income on Mortgage Loans: H.R. 3648.  The House Ways and Means Committee approved the bill yesterday on a voice vote, in spite of its inclusion of an offset provision which Republicans have typically objected to. 

The cost of the mortgage loan forgiveness exclusion is about $2 billion.  The revenue provision in the bill  offsets that cost by reducing the gain exclusion on sales of principal residences under section 121.  Under the offset, the gain that can be excluded from income on a sale or exchange of a principal residence is reduced proportionately for periods that do not relate to use as the taxpayer's principal residence.  Here's the description of the offset provision provided by Ways and Means in the short summary of the legislation.

The bill amends the current law exclusion of up to $250,000 ($500,000 if married filing a joint return) of gain realized on the sale or exchange of a principal residence. Under current law, the sale of a home will qualify for this exclusion if the home is a taxpayer’s principal residence for at least two of the five years ending on the sale or exchange. This exclusion applies even if the home was initially purchased as a second home. Under the bill, if a taxpayer moves their principal residence to a second home, the taxpayer will only be able to utilize this exclusion to the extent that it relates to the period of time when the home was first used as a principal residence. The bill grandfathers use before 2008. This proposal is estimated to raise $2.005 billion over 10 years.

If Congress does enact a mortgage debt discharge exclusion, it should enact an appropriate offset and the gain exclusion provision may well be the right one to consider.  Clearly, the current section 121 rules permit a form of gamesmanship whereby taxpayers with second homes that they intend to sell can move their principal residence to those homes for a period of two years, sell the home, and exclude the entire amount of gain, which may relate almost entirely to the period of ownership before the house was used as a principal residence.  A nifty tax avoidance mechanism that should be prevented.  The offset provision does prevent the avoidance: excludible gain would be limited to the appreciation during the period of use as a principal residence and would not include the appreciation (which might be the most substantial portion) during the period of use as a vacation home prior to conversion to principal residence status.

Thus, while the provision adds another complication to the Code, and will undoubtedly disappoint homeowners who foresaw being able to play this game several times over the years and enjoy constant upgrades in their vacation properties at no tax cost, it seems to be a good idea independently of the mortgage debt discharge provision.

Cancellation of Debt Income on Mortgage Loans: HR 3648

The House Ways and Means Committee will consider tomorrow H.R. 3468, Download mortgage_loans_cancellation_of_debt_income. HR3468.billtext.pdf , to exclude discharge of indebtedness income in respect of a home mortgage loan.

The exclusion provision would be added as a new subparagraph (E) under the current section 108(a)(1) list of types of debt discharge that are excluded from gross income.  The type of home mortgage loans excluded would be "qualified principal residence indebtedness"  under section 163(h)(3)(B), without the application of subparagraph (ii).  That provision defines a category of mortgage loan called "acquisition indebtedness" as a loan that is incurred to acquire, construct or substantially improve a  "qualified residence" that secures the loan, where a "qualified residence" is either the taxpayer's principal residence or another residence (e.g., a second home or vacation home).  For interest deduction purposes, the aggregate amount that can be treated as acquisition indebtedness is limited to $1,000,000, but for purposes of the discharge of indebtedness exclusion provision, that limitation would not apply.  Accordingly, forgiveness of a multimillion dollar mortgage debt would be eligible for this exclusion.

I am still not persuaded that a broad provision like this is necessary.  As I've said before, homeowners who lose their homes to foreclosures and face bankruptcy or insolvency are already protected by the existing provisions of the Code (section 108(a)(1)(A), (B).  There is a group beyond those already insolvent that we might rightly want to protect--those whom we have failed to protect by adequately regulating credit providers who pressure them to take on high-interest loans beyond their capacity to pay and those who are struggling at the brink of insolvency to retain their homes and stay afloat in a difficult economy and weak job market.   But this bill goes far beyond that.  It will provide the most relief to taxpayers who are in neither of these categories-- e.g., to millionaires who have bought multi-million dollar vacation homes that they now realize are too big a debt burden or to taxpayers who have expensive homes that they need to sell quickly in order to facilitate their career move to another locale.  To the extent they can talk the bank into taking a below mortgage amount (a so-called "short sale"), this bill would relieve them of any obligation to pay taxes on the benefit they received from the initial mortgage of which they are now relieved, even when they are fully able to pay. 

I understand that many people think of debt relief as "phantom" income.  If they used the loan to buy a piece of property, they don't think of themselves as ever having the cash, just the property.  And if the property has gone down in value since its purchase, they feel like they got a raw deal already and tax liabilities for debt discharge just add to the rawness of the deal.  But then why are we elevating this debt relief to the level of meriting a particular tax law provision providing relief, rather than debt relief connected with major health expenditures or debt relief connected with large education loans or similarly valued societal needs that are often funded with debt that often cannot be repaid?   Is it just because of the current housing crunch?  Or the vocal realtor lobbies?  Or is the pervasiveness of housing debt simply a more pressing problem than the pervasiveness of catastrophic medical bills?

I also wonder if anyone has thought through the corollaries of passing this bill.  After all, one of the loud supporters of some such legislation is the National Association of Realtors, whose numbers increased during the housing boom but have already started decreasing during the current bust.  One suspects that realtors think this bill will help their business by making homes sell more easily at lower, below-mortgage prices.  That may be good for the country--people will buy the housing they need at a lower price, and realtors will continue to get their commission on the deal.  Or will this provision, as a permanent part of the Code, have a perverse effect on the housing bubble by encouraging taxpayers to purchase higher-priced homes, because of their knowledge that this tax liability won't apply if they should eventually succeed in having their lender write off part of the debt?   Will lenders tend to provide credit more freely than they should under the assumption that this provision eases the way for debtors who ultimately cannot pay and thereby relieves pressure that might otherwise apply to them for having lent too freely for the loans that do go sour?  ( Note that loosely regulated credit markets are a factor in the bursting housing bubble that has caused the concern about tax liabilities for discharged debt on written off mortgage loans.)   I don't have a crystal ball, but sometimes, just sometimes, I wish I did.....

GAO Report on I.R.C. Penalties

The GAO issue a report in August on tax compliance and the efficacy of the penalty provisions of the Code, entitled Tax Compliance: Inflation has Significantly Decreased the Real Value of Some Penalties.  GAO undertook the study to assess whether the failure to index civil tax penalties for inflation undercut the effectiveness of the penalties.  The many different penalty provisions in the Code utilize a range of mechanisms--some are a percentage of the tax liability, others are a fixed dollar or a fixed maximum or minimum amount that is not adjusted for inflation.  Using IRS data on civil penalties and interviews with IRS employees and tax practitioners, the GAO assessed to what extent adjusting penalties for inflation would impact amounts assessed and collected and the nature of the administrative burden to be expected from making the adjustments.

Its conclusions were straightforward.  Adjusting penalties for inflation could yield tens of millions annually in additional IRS collections (estimated at $38 milion to $61 million per year from 2000 to 2005) without a very heavy administrative burden, whereas failure to adjust could result in weakening deterrent effect of the penalty provisions. 

A few interesting snippets of facts and thought from the report are noted herein.

1. About 99% of the increased collections would be attributable to four areas (some of which have penalties that were set decades ago):  failure to file tax return; failure to file correct information return; failure to file partnership returns and; various penalties on returns by exempt organizations and trusts.
2. In 1990 Congress passed a law requiring most civil penalties to be adjusted for inflation to maintain their deterrent effect, but there were a few exceptions:  the Internal Revenue Code penalties, the Social Security Act penalties, the Tariff Act of 1930, and the Occupational Safety and Health Act of 1970.
3. Of the penalties that are collected, approximately 85% of penalties are collected in the three years following assessment.
4. The penalty for failure to file a partnership return was set at $50 in 1979, and has a real value of only $18 today.
5. Not adjusting penalties for inflation results in inconsistent treatment of similarly situated taxpayers, as the fine decreases in value over time.
6. If the cost to impose penalties stays constant while the penalty amount declines in value, penalties may become disfavored as a means to enforce compliance.

Apparently, Congress is attentively reading GAO reports.  BNA reported today that Senator Baucus  said he intended to work on legislation to deal with this problem.

Partnerships and Carried Interest: American Enterprise Institute

The BNA reported on a September 19 discussion of carried interest at the American Enterprise Institute involving Vic Fleisher (Illinois), David Weisbach (Chicago) and AEI scholar Alan Viard.  Weisbach stated his position against the proposed bill for taxing carried interest, asserting that the capital gains distinction is too "vague" and so it would be inappropriate to change the taxation of carried interest on the claim that it represents something more like ordinary income than caital gains.  Vic Fleisher reiterated his position (with which I agree) that carried interest earned by managers of private equity firms (whether buyout or venture capital) is compensation and should be taxed at ordinary rates.  See also Vic's post on conglomerate blog on the question of separating out venture capital firms for special treatment as the national association has requested.

Weisbach's point about the difficulty of distinguishing capital gains from ordinary income is on point in this respect--the categorization is easy at the extremes of a person who has been a passive investor in stocks who sells stocks held for many years (capital gains) and a person who has no financial assets other than a bank account who is a construction worker paid an hourly wage for hours actually worked (ordinary income).  We say that an entrepreneur who establishes a business with a little bit of money and a lot of sweat equity earns capital gains when he sells the business after a number of years. The entrepreneur should receive a salary from the business profits as the business develops, so that the capital gain represents the appreciation on his original investment.  In contrast, a sculptor who builds a masterpiece with a little bit of money and a lot of sweat equity earns ordinary income when he sells the product of his labor.   

Money managers do not seem to raise particularly hard issues.  The only cause for thinking they may be entitled to capital gains treatment on some of their carried interest is because of the use of the partnership form, which allows profits interests to be received tax free and allows allocations of capital gain income to that profits interest in the same way that it is allocated to a partner who has actually contributed capital rather than performing services.  What is problematic is the concept of a profits interest in a partnership that can be received for performing services without being taxed as services income.

Jackson Hewitt pays $1.5 million

Jackson Hewitt, the tax preparer firm under investigation by the IRS because of alleged misconduct by 125 of the firm's offices (see this news item of the IRS involvement in the Justice Dept investigation and this earlier ataxingmatter posting), filed a Form 8-k with the SEC on September 20.  According to the securities filing, the firm has made a voluntary compliance payment of $1.5 million to the IRS to settle the franchise matters under investigation.  The firm suffered losses in its first quarter earnings report due in part to its internal review costs.  See this item from RTT News, 9/6/07.  A few days later, the firm announced that it had completed its internal review (led by former IRS commissioner Fred Goldberg) and concluded that none of its corporate employees were involved in the fraudulent activities of its franchisees.  See this item.

In an interesting juxtapositioning of news items, a Miss Ezell, who had worked at H&R Block before working at Jackson Hewitt, was sentenced on September 19 to 21 months in prison and ordered to pay restitution of almost $83,000 in connection with aiding in the presentation and filing of fraudulent tax returns claiming false deductions for medical expenses, charitable contributions, and business expenses, and false claims for child credits and dependents at both firms.  See this press release. 

Perhaps these tax preparation firms need to spend more time ensuring that all employees, whether corporate employees or franchise employees, are properly trained and screened to ensure that they understand that fraudulent creation of deductions or dependents is simply not acceptable.

Tax in the News

Ways and Means Chair Rangel is staking out a number of tax positions for the late fall tax wrangle.

1. On tax simplification, Rangel says he is considering ways to lower corporate tax rates in order to help US corporations compete globally.  There are two major problems with this proposal:

(i) half of US publicly traded corporations pay no federal income tax already, so lowering the corporate tax shifts the federal tax burden from corporate taxpayers who pay little to the corporate fisc to individuals; and

(ii) the mantra about lowering US taxes to help corporations compete globally seems to be continuing to gain credibility even though the competition may be with other US corporations (so lowering the US tax burden has nothing to do with increasing US corporations' ability to compete globally) and even though US corporations' effective taxes are alreaady at the bottom of the tax burden for OECD countries. 

2. on home mortgage loan relief, Rangel indicated that Democrats had decided for permanent relief from cancellation of debt income in connection with home mortgages.  Again, it is not clear why this bill is marching so fast to passage.  Taxpayers who are in financial straits already have relief available through the bankruptcy and insolvency exceptions.  Taxpayers who flip houses and take on too much risk don't merit a bailout by the rest of the taxpayers, nor do those with substantial assets who overbought luxury properties but can afford the tax obligation.  The real estate industry and financial institutions must be lobbying fast and furious on this one.

3. on carried interest, the lobbying by the hedge and equity fund industry hasn't yet gotten Rangel to back away from taxing managers' "carried interest" received for services as compensation income subject to tax at ordinary income rates.  He says he will "listen" but doesn't yet see any justification for the disparity between hedge fund managers' compensation income and others who provide services for a wage. 

Time to change taxpayer standard for reporting on tax returns?

Congress recently adopted a more-likely-than-not standard for tax return preparers under Internal Revenue Code section 6694.  Various groups representing accountants and lawyers who advise about taxes have complained about that change. See, e.g., AICPA

Now Congress is considering whether to also raise the standard for taxpayer reporting.  The current standard for undisclosed positions is "substantial authority"--that is, taxpayers who do not specifically disclose an uncertain position are required to have substantial authority for the position taken on their return.  A position may have substantial authority even when it is not in accord with the predominant weight of authority. 

Congress is now considering whether to raise the taxpayer standard to the more-likely-than-not standard.  I have argued for this position because I think that it will counter the prevailing tax minimization norm that encourages taxpayers and tax advisers to take more and more aggressive positions on returns.  When standards for reporting are too low, it is easier for tax advisers and taxpayers to rely on hyperliteral interpretations to create tax-saving loopholes.  A more-likely-than-not standard, in contrast, should encourage structurally coherent interpretations of the tax laws. 

This spring, I spoke at a conference in Wisconsin as keynoter on a panel that included among others a national manager from a large accounting firm.  His response to my proposal for a more-likely-than-not standard was strongly negative: he argued that substantial authority was the appropriate standard, because it permits taxpayers to interpret statutes, where there is considerable uncertainty, to support their desired objective rather than the government's.  A more-likely-than-not standard implies that ties break in favor of the government.  That is the right result, I argued, because the taxpayer can always challenge the result through litigation.  The adversarial process is intended to bring out the relevant information and lead to an appropriate decision.  On the contrary, with a substantial authority standard that encourages more aggressive filing (sometimes based solely on the taxpayer's reasoned interpretation of a statute), the taxpayer has the advantage of the audit lottery and may never have to defend the aggressive interpretation.

The Tax Executives Institute has reacted quickly to the discussion of higher standards by sending a letter to the Senate Finance Committee today urging Congress not to change the taxpayer standard.  See this link on BNA.  Instead, they argue for "tightening" the substantial authority standard, which suggests at least an implied acknowledgment that tax advisors and taxpayers have treated that standard rather loosely in filing under aggressive interpretations of the Code.