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Tax Court Upholds Strict Adherence to Requirements for IRS Penalty Assessments as Result of Graev

  • Written by Kathleen M. Lach

mug lach kathleenA recent decision issued by the U.S. Tax Court in Graev v. Commissioner 1 could prove pivotal in cases where a practitioner has requested abatement of penalties for their client. While not yet applicable in every case for every penalty, the Court’s admonishment to the IRS that it must prove that it strictly adhered to statutory requirements for penalty assertion must be noted, and taken into consideration in all of your penalty challenges with the IRS.

Internal Revenue Code section 6751(b)(1)states: “No penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.” The exceptions to this provision only include penalties assessed under IRS sections 6651, 6654, or 6655, or automatically calculated through electronic means. 2 The exceptions relate primarily to late filing and late payment or federal tax deposit penalties, and estimated tax penalties, which are again, purely computational. A penalty is only considered to be “automatically calculated through electronic means” if no IRS human employee makes an independent judgment with respect to the applicability of the penalty. 3

In 1955, there were approximately 14 penalty provisions in the Internal Revenue Code. There are now more than ten times that number. 4 All options for penalty relief must be considered when requesting abatement for your client in any penalty situation.

In Graev, where the Court considered the appropriateness of accuracy related penalties under IRC §6662, it took a closer look at the requirements for imposition of the penalty, including written managerial approval, for the proposed assessment (in this deficiency case). The Court followed the Second Circuit in Chai v. Commissioner 5 which held that: “section 6751(b)(1) requires written approval of the initial penalty determination no later than the date the IRS issues the notice of deficiency (or files an answer or amended answer) asserting such penalty…” and that “compliance with § 6751(b) is part of the Commissioner’s burden of production and proof in a deficiency case in which a penalty is asserted.”

Following Graev, the Tax Court in Ford v. Commissioner held: “We do not …sustain the section 6662(a) accuracy-related penalties relating to negligence for the years in issue. Respondent failed to present any evidence that the penalties were personally approved (in writing) by the immediate supervisor of the individual making such determination.” 6 The Court did not uphold the proposed accuracy related penalty against the taxpayer.

While Graev takes a winding path down the road of strict adherence to the letter of the law contained in section 6751, 7 it lays down an important framework in reviewing penalty assessments and requests for abatement. When making your request for abatement of a penalty other than a computational penalty, discussed above, a demand for the managerial approval letter should be requested in every case. The approval must be in writing.

In considering requests for penalty abatement, this requirement is similar to the first time abatement provision in Internal Revenue Manual (IRM) 20.1.1.3.3.2.1. Relief is automatic if certain requirements are met: your client has filed, or filed a valid extension for, all required returns currently due, and has paid, or arranged to pay, any tax currently due. Additionally, there is a three-year look-back period for any prior penalties. If prior penalties have been assessed within that three-year period, there is no relief under this IRM section.

This is different of course from the reasonable cause provisions in the section 20 of the IRM. Determinations in reasonable cause requests become much more discretionary, and recently have become increasingly difficult to obtain, even where circumstances closely fit the requirements. The manual provides relief in cases where “death, serious illness, or unavoidable absence” occurs involving the taxpayer or an immediate family member. 8 This would seem like a fairly straightforward analysis in most cases, but it is not since the IRM section goes on to leave much to the discretion of the reviewing IRS employee in terms of considering why the delay in filing or payment occurred, when it occurred, how the event prevented compliance, etc. All of these considerations may be viewed differently depending on the reviewing employee. If that employee recently experienced a personal loss similar to that of the requesting taxpayer, it is conceivable that employee would be more sympathetic to that taxpayer. Different considerations such as how the event impacted the taxpayer’s ability to conduct business, or earn income, also affect the outcome of penalty determinations. Again, reasonable cause analyses are not “automatic” and are reviewed differently than those relief provisions discussed above.

In any event, the discretionary aspect of “reasonable cause” makes it critical that, when you are preparing requests for penalty abatement for your client, you routinely take into consideration automatic abatement provisions. This includes first time abatement, and the recently emphasized written managerial approval requirement discussed in Graev, and followed in the Ford case.

1 149 T.C. No. 23 (Dec. 20, 2017)
2 IRC §6751(b)(2)
3 IRM 20.1.1.2.3(5)
4 IRM 20.1.1.1.1(1)
5 851 F.3d 190, 221 (2d Cir. 2017), aff'g in part, rev'g in part T.C. Memo. 2015-42.
6 Ford v. Commissioner, T.C. Memo. 2018-8, January 25, 2018
7 In Graev, the Court opines on whether a new penalty may be proposed within an already pending Tax Court deficiency case by IRS counsel, and whether the approval process in such a situation meets the requirements of section 6751. In that case, the Court determined the approval requirements were met.
8 IRM 20.1.1.3.2.2.1


Kathleen M. Lach is a Partner in the Tax and Litigation Departments of Arnstein & Lehr LLP. She represents clients before a variety of different tax authorities, including the Internal Revenue Service, the Illinois Department of Revenue, and the Illinois Department of Employment Security.

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Is Crowdfunding Easy Money or Tax Trap for the Unwary?

  • Written by Kathleen M. Lach

mug lach kathleenIt has become fairly common these days for individuals and businesses to raise funds for various purposes through a mechanism referred to now as “crowdfunding.” Whether for a charitable cause such as a medical need or to raise funds for a start-up business, social media has made it easy to reach a broad range of people in order to request money for a cause.

To initiate a crowdfunding effort, the individual or entity generally enlists the assistance of an established platform, such as Kickstarter or GoFundMe. During the set-up process, the fund raiser will in most cases be asked to complete tax forms which will be provided to the IRS, such as a W-9 or W-8. At the conclusion of this effort, Form 1099-K will be issued from the payment processor to the platform, if certain thresholds are met, and a Form 1099-K may be issued to the fund raiser, if certain thresholds are met. At the end of the day, your client will come to you with the Form 1099-K and ask you why he received it, and now, how does this impact his tax obligations.

A determination on whether funds raised during this effort are taxable turns, of course, on the purpose of the effort. If the funds are raised in connection with a business start-up, or to determine the feasibility of a business venture, there may be tax consequences, depending on what consideration is given for the contribution. If the funds are contributed for a charitable cause, taxability depends on the amount of the contribution, and to whom the funds were given. In certain circumstances, funds may be contributed directly to a certified charitable organization on behalf of an individual, which may result in a contribution deduction for the donor, and no impact on the individual.

There is little IRS guidance available specifically on the issue of taxability of funds received though crowdfunding. The IRS did issue Information Letter 2016-36 (IL) in response to a taxpayer’s request for guidance in the business contribution arena. The IL generically refers to the general tax law principles of IRC §61: “Gross income includes all income from whatever source derived.” It goes on to say:

“In general, money received without an offsetting liability (such as a repayment obligation), that is neither a capital contribution to an entity in exchange for a capital interest in the entity nor a gift, is includible in income. The facts and circumstances of a particular situation must be considered to determine whether the money received in that situation is income. What that means is that crowdfunding revenues generally are includible in income if they are not 1) loans that must be repaid, 2) capital contributed to an entity in exchange for an equity interest in the entity, or 3) gifts made out of detached generosity and without any “quid pro quo.” However, a voluntary transfer without a “quid pro quo” is not necessarily a gift for federal income tax purposes. In addition, crowdfunding revenues must generally be included in income to the extent they are received for services rendered or are gains from the sale of property.”

So generally, if the funds raised are for a charitable purpose such as a medical need, funeral, or other personal need of an individual or family, there are no tax consequences if the individual “gifts” are below the IRS threshold for the gift tax annual exclusion. In these cases, the contributor expects nothing in return for his contribution.

If funds raised, for example, are for a start-up business, and the contributor receives an equity interest in the enterprise, the funds may be treated as a capital contribution. If the contributor receives something in exchange for the funds, there will likely be income tax consequences, as well as state sales tax consequences for the fund raiser. These situations most commonly arise in connection with test marketing a product through a crowdfunding platform.

The issuance of Form 1099-K as a result of the type of revenue generating activity discussed above is governed by IRC §6050W, “Returns relating to payments made in settlement of payment card and third party network transactions.” A Form 1099-K must be filed under the following circumstances: “A payment settlement entity (PSE) must file Form 1099-K for payments made in settlement of reportable payment transactions for each calendar year. A PSE makes a payment in settlement of a reportable payment transaction, that is, any payment card or third party network transaction, if the PSE submits the instruction to transfer funds to the account of the participating payee to settle the reportable payment transaction.” irs.gov.

It is apparent that there are a myriad of scenarios surrounding crowdfunding activities, and the potential tax implications of these activities. This note only scratches the surface of the various ways people are trying to raise money on-line through the use of social media, using different platforms that make it easy to do so. It may be advantageous to add as a best practice, at a minimum to any business client questionnaire, whether they engage in on-line crowdfunding. It is important to secure the specific facts surrounding the activity to use as a guide as you determine any tax consequences of such activity, how to handle your client’s Form 1099-R, and also in advising clients who are contemplating fund raising of this type. This issue is of growing importance in the area of taxability of on-line transactions, and we will look for more guidance from the IRS, as well as state tax agencies for sales tax implications, on handling these transactions in the months to come.


Kathleen M. Lach is a Partner in the Tax and Litigation Departments of Arnstein & Lehr LLP. She represents clients before a variety of different tax authorities, including the Internal Revenue Service, the Illinois Department of Revenue, and the Illinois Department of Employment Security.

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Qualified Business Income Deduction Clarified

  • Written by Sidney Kess, CPA, J.D., LL.M.

kess sidneyThe Tax Cuts and Jobs Act of 2017 introduced a new write-off for owners of pass-through entities that runs from 2018 through 2025. This deduction doesn’t require any cash outlay or special action to be eligible for it, but using it reduces the effective tax rate on business income. There is much confusion about this new deduction and some clarification will need IRS guidance. Here is what is clear so far, how it impacts CPAs and attorneys, and what needs IRS and/or Congress to explain further.

What is the new deduction?
Under new Code Section 199A there is a 20% deduction for qualified business income from a sole proprietorship or a pass-through entity.

Where is the deduction taken?
The deduction is not a business deduction used to reduce profits subject to tax; it does not reduce net earnings for self-employment tax purposes. It is not a reduction to gross income taken in the Adjusted Gross Income section of Form 1040. It is a deduction from adjusted gross income much like the standard deduction or itemized deductions used to reduce taxable income.

Terminology

What is a pass-through entity for purposes of Code Sec. 199A?
Many business owners may be eligible to take the deduction on their personal returns, including:

• Schedule C filers: Sole proprietors, independent contractors, and single-member limited liability companies (LLCs).
• Schedule E filers: S corporation shareholders, partners, members in multi-member LLCs, real estate investors, beneficiaries of trusts and estates, owners of REITs, and those with interests in qualified cooperatives.
• Schedule F filers: farmers and ranchers.

What is qualified business income?
The deduction applies to this income, but it isn’t merely the owner’s share of net income from the business. It is the net amount of income, gain, deduction, and loss from a qualified U.S. trade or business (including Puerto Rico). It does not include investment items, such as short-term and long-term capital gains and losses, dividends, and interest other than what’s allocable to the business. And it doesn’t include reasonable compensation or guaranteed payments to owners. But it does include most REIT dividends and income from publicly traded partnerships.

What is a specified service trade or business?
This is a business where the owner must reduce the amount of qualified business income on which the deduction is taken (explained below). It includes any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services, as well the performance of services that consist of investing and investment management, trading or dealing in securities, partnership interests or commodities. It also includes any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.

The TCJA deleted engineering and architecture, but the IRS could still view such businesses as a qualified service business based on the “reputation or skill” clause.

Deduction Amount

What is the deduction amount?
Technically the deduction is the sum of:

• The lesser of (1) the individual’s combined qualified business income or (2) 20% of the excess of taxable income over net capital gain plus qualified cooperative dividends
• The lesser of (1) 20% of cooperative dividends or (2) taxable income reduced by net capital gains.

Essentially, the deduction is 20% of qualified business income. But due to the technical definition of the deduction, it means that the 20% deduction is based on taxable income if it is less than qualified business income.

Who can claim the full 20%-of-qualified-business-income deduction?
An individual who has taxable income below set levels can apply the 20% deduction against qualified business income. This is so whether or not the taxpayer is in a qualified service business. For 2018, the taxable income limit is $315,000 for a married couple filing a joint return and $157,500 for any other filer. These taxable income thresholds are where the 24% tax brackets end and the 32% tax brackets begin for 2018. The taxable income limit will be adjusted for inflation after 2018. Thus, an attorney or accountant with taxable income below the applicable threshold amount for his or her filing status would be able to claim the deduction with respect to income from a practice.

Limitations

What is the W-2 limitation?
If the owner’s taxable income is above the threshold, then a limitation comes into play. The deduction is the lesser of:

• 20% of qualified business income, or
• The greater of (1) 50% of W-2 wages for the qualified business, or (2) 25% of the W-2 wages with respect to the business plus 2.5% of the unadjusted basis (immediately before acquisition) of qualified property.

If the amount of qualified business income is greater than the taxpayer’s taxable income, then the 20% applies only to the extent of taxable income as explained earlier.

W-2 wages are amounts reported as such to the Social Security Administration for owners and other employees. Payments to independent contractors do not factor in. For partners, LLC members, and S corporation owners, the allocations of W-2 wages and the unadjusted basis of property are made in the same way as the allocation of qualified business income, and likely will have to be reported on Schedule K-1.

What is the limitation for a qualified service business?
For purposes of figuring the W-2 limitation, the owner of a qualified service business with taxable income above the threshold reduces the amount of qualified business income to which the deduction applies. The reduction is a percentage derived from the ratio of taxable income for the year in excess of the threshold over $100,000 on a joint return or $50,000 for all other filers. In effect, if taxable income for the owner of a qualified service business who files jointly is $415,000 or over in 2018 (or $207,500 for other filers), then no deduction can be claimed because there is no qualified business income on which to apply the deduction. Thus, CPAs and attorneys with taxable income over $415,000, or $207,500, depending on filing status, cannot claim any deduction.

If an individual above the taxable income threshold owns a qualified service business as well as a nonqualified service business, it is not yet clear whether the deduction can be taken with respect the nonqualified service business even though he or she phases out for the deduction on the qualified service business income.

What is a Section 199A loss and how does it impact the deduction?
If the net amount of income, gain, deduction, and loss is less than zero, the net amount is treated as a loss in the succeeding year.

It is not clear whether the loss is carried forward only to the following year or continues to be carried forward indefinitely until used up. And it’s not clear whether the loss is used to offset only income in the subsequent year from the business that generated it or must be used to offset income from all of a taxpayer’s businesses.

Conclusion

As is clear from the questions and answers above, much is not clear. Additional guidance from the IRS may not be immediately forthcoming from the recent tax filing season. Once this is done, then business owners can decide on what to do, including changing their form of entity, deciding whether to add independent contractors to the payroll, or taking other actions.

 


Executive Editor Sidney Kess is CPA-attorney, speaker and author of hundreds of tax books. The AICPA established the Sidney Kess Award for Excellence in Continuing Education in his honor, best-known for lecturing to over 700,000 practitioners on tax. Kess is senior consultant for Citrin Cooperman, consulting editor to CCH and Of Counsel to Kostelanetz & Fink.

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New ‘Qualified Opportunity Zone’ Guidance

  • Written by Micah W. Bloomfield, Mayer Greenberg, Michelle M. Jewett, Kevin Matz, Brian J. Senie, and Jeffrey D. Uffner at Stroock & Stroock & Lavan LLP in New York

newEarlier today the Internal Revenue Service released the first set of proposed regulations[1] (the “Proposed Regulations”) and a revenue ruling (the “Revenue Ruling”) clarifying certain aspects of the Qualified Opportunity Zone (“QOZ”) provisions added by the tax reform legislation enacted in December 2017. The IRS indicated that it expects to issue additional guidance before the end of 2018,[3] and the IRS has requested comments on a number of provisions in the Proposed Regulations. The Proposed Regulations state that they may apply to transactions occurring before the finalization of such regulations, provided they are applied consistently. We are preparing a more detailed bulletin to provide further comments, but want to highlight some of the key aspects of the Proposed Regulations in this Stroock Special Bulletin:
 


Only Capital Gains Eligible for Reinvestment
 


The Proposed Regulations provide that only capital gains may be “rolled over” into a QOZ investment. This would preclude ordinary income from the sale of inventory (and possibly would preclude gain recharacterized as ordinary income under certain “recapture” rules).
 


Partners in Pass-Through Entities May Reinvest

Share of Entity’s Gains From Asset Sales
 
 The Proposed Regulations include special provisions by which gain recognized by a partnership may (except to the extent the partnership elects to rollover the gain itself) flow through to the partners and be reinvested by such partners into qualified opportunity funds (“QOFs”). It was previously unclear whether the partner or the partnership had to make such reinvestment.
 


Additionally, there is the potential for such partners to have an increased period during which to reinvest gain into a QOF. The partnership’s 180-day period begins on the date of its sale, but if the gain flows through to the partners, the partners’ 180-day period begins on the last day of the partnership’s taxable year. Partners may instead elect to use the partnership’s 180-day period if they so desire (e.g. if the desired investment is already lined up).
 


Qualified Opportunity Funds Always Tested at End of Calendar Year
 


The Proposed Regulations clarify that, while the initial testing date for a QOF (for purposes of the 90% asset test, discussed below) may be as long as six months after the QOF’s start date, there is always a testing date on the last day of the calendar year. Accordingly, QOFs that are formed near the end of a calendar year may need to meet the 90% asset test sooner than expected.[4]
 


The Proposed Regulations do, however, provide flexibility for QOFs to select the date on which they begin to qualify (although QOFs must qualify as such prior to receiving investments for such investments to qualify under the QOZ provisions), and for taxpayers to use pre-existing entities as QOFs.
 


LLCs Likely Permitted
 


The Proposed Regulations state that QOFs may include entities treated as partnerships for federal income tax purposes, which would presumably permit the use of limited liability companies.
 


Investors May Hold Investments Past Expiration of QOZ Designation
 


Although the statute provides that the QOZ designations expire after 10 years, the Proposed Regulations permit investors seeking to take advantage of the 10-year rule to hold their investments for an additional 20-year period — until December 31, 2047 — and still receive the benefit of the exclusion from income of all post-acquisition appreciation.[5]
 


Treatment of Land
 


The Proposed Regulations and Revenue Ruling provide that land is treated separately from the improvements thereon for purposes of the substantial improvement test, and provide several important clarifications regarding the treatment of land.
 


The Revenue Ruling provides that land, given its permanence, may never be treated as originally used by a QOF in a QOZ. However, the examples in the Revenue Ruling indicate that the land may qualify as QOZ Business Property if the improvements thereon qualify, even if such land is not improved. Accordingly, for the substantial improvement test, a QOF need only substantially improve the building on a parcel of acquired land in order for the entire parcel to qualify for the 90% asset test.
 


Additionally, the example in the Revenue Ruling involves the conversion of a factory building into residential real property. As the building was already in existence and is being modified (rather than a new one being constructed), it must meet the substantial improvement test rather than the original use test. The example also seems to confirm that residential real property does indeed qualify as potential QOZ property.[6]


Working Capital Safe Harbor
 


The Proposed Regulations provide certain safe harbors relating to working capital and asset composition of a QOF. Specifically, the “reasonable working capital” safe harbor of Section 1397C(e)(1) of the Internal Revenue Code now also extends to QOFs for a period of 31 months.
 


QOZ Business “Substantially All” Requirement to Mean at Least 70%


QOFs may own QOZ businesses (rather than directly owning qualified opportunity zone property), with the requirement that a QOZ business have “substantially all” of its assets be qualified opportunity zone property. The Proposed Regulations provide that, solely for this purpose, “substantially all” means at least 70%. Accordingly, a QOF that owns a QOZ business may have as little as 63% of its capital invested in qualified opportunity zone property (90% in the QOZ business, per the 90% asset test, times 70% of the business’s property). This may provide additional flexibility as to the timing of capital investments into a QOF and the use of such capital.

[1] REG-115420-18.
[2] Rev. Rul. 2018-29.
[3] See https://home.treasury.gov/news/press-releases/sm530
[4] Note, however, that the negative impact of this rule may be mitigated by the working capital provisions discussed infra.
[5] It would seem that the QOF must continue to qualify as such, solely but for the expiration of the QOZ designation, but this does not appear to be entirely clear from the regulations.
[6] This, although already thought by many to be the correct result, nevertheless helpfully rebuts a technical point raised by some regarding the incorporation of certain definitions from Section 1397C of the Internal Revenue Code.

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Sales Tax After Supreme Court Overrules Physical Presence Standard

  • Written by Andrea Turner, CPA and Wayne Danneman, CMI

Turner AndreaDanneman WayneIn the 5-4 decision of South Dakota v. Wayfair, Inc., the Supreme Court of the United States ruled South Dakota’s economic nexus law constitutional. The decision has the potential to require online retailers and other remote sellers to collect and remit sales tax to states in which they do business, regardless of their physical presence within those states.

The decision overturned the physical presence standard established in the 1992 decision of Quill Corp v. North Dakota. That decision barred states from requiring out-of-state businesses to collect sales tax on purchases delivered to state residents unless those businesses had a physical presence within the state.

In the absence of Quill, the first question is whether the sales tax applies to an activity with substantial nexus with the taxing state. Such nexus is established when the seller avails itself of the privilege of carrying on significant business in the taxing jurisdiction. The Supreme Court’s decision found that large, national companies with an extensive virtual presence in South Dakota are engaging in a significant quantity of business within the state. The South Dakota statute applies only to sellers who exceed the thresholds of $100,000 in gross revenue or 200 remote transactions with in-state consumers on an annual basis. The Court found this quantity of business could not have occurred unless the seller availed itself of the privilege of carrying on substantial business in South Dakota.

The Court remanded the case to determine whether the South Dakota law violates other elements of the Commerce Clause. The Commerce Clause is a constitutional principle that prohibits states from passing legislation that discriminates against interstate commerce. However, the Court noted in their decision that several features of the law prevent discrimination including the economic thresholds, no retroactive application and South Dakota’s participation in the Streamlined Sales and Use Tax Agreement and simplification efforts.

The implications and scope of the Court’s decision are still uncertain, but it is likely that additional states will enforce and enact economic thresholds and may repeal collection laws related to physical presence.

Next steps include:

• Reviewing existing activities and the geographic footprint for those activities
• Reviewing product and service offerings to develop taxability determinations
• Ensuring proper exemption documentation is collected, retained, and regularly renewed
• Reviewing and considering whether technology investments are warranted
• Monitoring state and local sales/use tax updates, including developments regarding economic nexus thresholds
• Preparing for increased audit activity by state and local taxing jurisdictions


Andrea Turner, CPA and Wayne E. Danneman, CMI are partners at RubinBrown.

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