Larry's Tax Law

In March 2014, I reported on the all-out battle that was ensuing in the U.S. Tax Court between the IRS and the Estate of Michael Jackson over the value of the late pop singer’s estate. It began in 2013, when the estate petitioned the court, alleging that the Service’s assessment, based upon the assertion that the estate underreported its estate tax obligation by more than $500 million, was incorrect. In addition, the estate challenged the IRS’s additional assessment of almost $200 million in penalties. Keep in mind that although these numbers are staggering, they do not include the estate’s potential state of California estate tax obligations.

On November 2, 2015, the Bipartisan Budget Act (“Act”) was signed into law by President Barack Obama. One of the many provisions of the Act significantly impacts: (i) the manner in which entities taxed as partnerships[1] will be audited by the Internal Revenue Service (“IRS”); and (ii) who is required to pay the tax resulting from any corresponding audit adjustments. These new rules generally are effective for tax years beginning after December 31, 2017. As discussed below, because of the nature of these rules, partnerships need to consider taking action now in anticipation of the new rules.

The Current Landscape

Entities taxed as partnerships generally do not pay income tax. Rather, they compute and report their taxable income and losses on IRS Form 1065. The partnership provides each of its partners with a Schedule K-1, which allows the partners to report to the IRS their share of the partnership’s income or loss on their own tax returns and pay the corresponding tax. Upon audit, pursuant to uniform audit procedures enacted as part of the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”), examinations of partnerships are conducted generally under one of the following scenarios:

• • For partnerships with ten (10) or fewer eligible partners,[2] examinations are conducted by a separate audit of the partnership and then an audit of each of the partners;

• • For partnerships with greater than ten (10) partners and/or partnerships with ineligible partners, examinations are conducted under uniform TEFRA audit procedures, whereby the examination, conducted at the partnership level, is binding on the taxpayers who were partners of the partnership during the year under examination; and

• • For partnerships with 100 or more partners, at the election of the partnership, examinations may be conducted under uniform “Electing Large Partnership” audit procedures, whereby the examination, conducted at the partnership level, is binding on the partners of the partnership existing at the conclusion of the audit.

Lawmakers believed a change in TEFRA audit framework was necessary for the efficient administration of Subchapter K of the Code. If a C corporation is audited, the IRS can assess an additional tax owing against a single taxpayer—the very taxpayer under examination—the C corporation. In the partnership space, however, despite the possible application of the uniform audit procedures, the IRS is required to examine the partnership and then assess and collect tax from multiple taxpayers (i.e., the partners of the partnership). In fact, the Government Accountability Office (the “GAO”) reported in 2014 that, for tax year 2012, less than one percent (1%) of partnerships with more than $100 million in assets were audited. Whereas, for the same tax year, more than twenty-seven percent (27%) of similarly-sized corporations were audited. The GAO concluded the vast disparity is directly related to the increased administrative burden placed on the IRS under the existing partnership examination rules.

Come join me at the NYU Summer Institute In Taxation this July in New York City.  I am honored to be presenting a paper on qualified S corporation subsidiaries on July 28 as part of the “Wealth Planning for High Net-Worth Individuals and Owners of Closely-Held  Companies” panel.  The program looks terrific this year.  You can pick and choose which panel sessions you would like to attend.  The conference brochure and registration details are available here.  I hope to see you in New York City.

Larry

Earlier this week, United States Tax Court Judge Richard T. Morrison ruled, in the case of Emmanuel A. Santos v. Commissioner, T.C. Memo 2016-100 (May 17, 2016), that the government will not pay the cost of a taxpayer obtaining a law degree.

Case Background

This is a pro se case. While the record was not very clear, the taxpayer, Emmanuel A. Santos, claimed he earned a degree in accounting from Indiana University in 1988. Thereafter, he began a career as a tax return preparer. In 1996, he obtained a master’s degree in taxation. Eventually, Mr. Santos expanded his tax return preparer practice to include accounting and financial planning services.

As reported in my November 2014 blog post, President Obama’s administration wants to limit taxpayers’ ability to defer income under IRC § 1031. In response to former House Ways and Means Committee Chairman David Camp’s proposed Tax Reform Act of 2014, which would have eliminated IRC § 1031 altogether, the Obama administration proposed to retain the code section, but limit deferral with regard to real property exchanges to $1 million per taxpayer each tax year. Personal property exchanges, under the President’s proposal, would go unscathed.

In 2015, President Obama expanded his proposal relative to IRC § 1031 to limit personal property exchanges by excluding certain types of property from the definition of “like kind.” The excluded personal property included items such as collectibles and art. The President’s proposed $1 million real property exchange limitation was left intact.

Every year, around the April 15 individual tax return filing deadline, a story appears in the press highlighting the tax woes of famous people.  The Government undoubtedly issues these press releases to encourage taxpayers to comply with their tax filing and tax payment obligations.  The list of famous people who have been the subject of this news over the years is lengthy.  It includes:  Abbott & Costello, Spiro Agnew, Chuck Berry, Richard Pryor, Martha Stewart, Darryl Strawberry, Nicholas Cage, Heidi Fleiss, Pete Rose, Wesley Snipes and Willie Nelson.

As reported in my November 2015 blog post, in accordance with Internal Revenue Code (“Code”) Section 280E, taxpayers (for purposes of computing federal taxable income) are prohibited from deducting expenses related to the production, processing or sale of illegal drugs, including marijuana.

A Bit of Welcome Relief?

Measure 91, officially called the Control, Regulation, and Taxation of Marijuana and Industrial Hemp Act, passed by Oregon voters, appears to have alleviated some of the impact of Code Section 280E as it relates to Oregon taxable income. Specifically:

As reported in my November 2013 blog post, for tax years beginning in 2015 or later, under ORS 316.043, applicable non-passive income attributable to certain partnerships and S corporations may be taxed using reduced tax rates.  The reduced tax rates are as follows:

• • 7 percent for taxable income of $250,000 or less;

• • 7.2 percent for taxable income greater than $250,000 but less than or equal to $500,000;

• • 7.6 percent for taxable income greater than $500,000 but less than or equal to $1,000,000;

• • 8 percent for taxable income greater than $1,000,000 but less than or equal to $2,500,000;

• • 9 percent for taxable income greater than $2,500,000 but less than or equal to $5,000,000; and

• • 9.9 percent for taxable income greater than $5,000,000.

The Department of the Treasury estimates the annual federal “tax gap” (the difference between what taxpayers should have paid and what they actually paid on a timely basis) exceeds $450 billion. IR-2012-4 (January 6, 2012).  This figure correlates with a voluntary tax compliance rate of just shy of 86 percent.

Studies conducted by the National Research Program (“NRP”) conclude that the $450 billion “tax gap” is comprised of three components, namely non-filing of tax returns ($28 billion), underreporting of income ($376 billion) and underpayment of taxes ($46 billion).

Dear Readers:

It is hard to believe that 2015 is almost at an end.  Although this year has gone by quickly, it has proven to be an interesting year in the world of tax law.  During the past twelve months, we have explored numerous tax topics and developments, including tax extender legislation, IRS budget cuts, leadership changes at OPR, IRC Section 1031 exchanges, tax reform, taxation of cannabis, and offshore voluntary disclosure programs.

I feel especially blessed this year.  The support that I have received from the legal, tax and accounting professions has been overwhelming.  In June, the Oregon State Bar bestowed upon me the Taxation Section Award of Merit.  Then, in September, I was elected to the American College of Tax Counsel.  Without your help, these accolades would not have been attainable.  Thank you.