On October 6, 2011, the Internal Revenue Service (IRS) announced that its July 15, 2011 field directive (the “directive”) pertaining to the codified economic substance doctrine (the “doctrine”) should not be viewed as legal precedent because the IRS reserves the ability to modify the directive at any time.

According to Mark Periwen, special counsel to the Associate Chief Counsel, the directive is “just that,” and therefore does not have the force of law.  Notably, the function of field directives issued to employees of the IRS is similar to the function of the Internal Revenue Manual (IRM), which directs IRS personnel in their day-to-day activities. Smith v. U.S., 478 F.2d 398 (5th Cir. 1973).  This does not follow, however, that field directives and the IRM will not be taken into consideration by reviewing courts.

Instead, as discussed in Griswold v. United States, 59 F.3d 1571, 1575 n. 8 (11th Cir. 1995), "[w]hile the IRS Manual does not have the force of law, the manual provisions do constitute persuasive authority as to the IRS’s interpretation of the statute and the regulations." (emphasis added).  Similarly, each field directive provides insight as to the IRS’s interpretation of the laws it is entrusted to enforce.

As we previously reported here, transactions shall be treated as having economic substance only if the transaction changes the taxpayer’s economic position in a meaningful way and the taxpayer has a substantial purpose for entering into the transaction. The doctrine only applies to a transaction entered into in connection with a trade or business or activity engaged in for income.

Taxpayers are concerned how the IRS will apply the doctrine due to the no-fault penalty of up to 40 percent. Tax practitioners speculate the issuance of the directive suggests the IRS wants to ensure that the doctrine is appropriately applied.  In fact, the directive specifically provides that agents should limit the assertion of penalties to transactions that implicate the doctrine and not a “similar rule of law” as provided in the statute.

The IRS’s original field directive regarding the application of IRC §7701(o) was issued on September 14, 2011 with the objective “to ensure consistent administration of the strict liability penalty related to the application of the doctrine.”  The July 15, 2011 field directive was issued to “instruct examiners and their managers how to determine when it is appropriate to seek the approval of the Director of Field Operations in order to raise the economic substance doctrine.”

As further elaborated in the directive:

Once an examiner determines that raising the doctrine may be appropriate, this directive sets forth a series of inquiries the examiner must develop and analyze in order to seek approval for the ultimate application of the doctrine in the examination.

The directive, which is publicly available to all Taxpayers, clearly provides the IRS’s interpretation of IRC §7701(o).  Although it may not be binding as legal precedent, it is nonetheless highly persuasive and will not be ignored by courts that are deciding issues pertaining to the application of the doctrine.

Fuerst Ittleman will continue to monitor the progress of cases where the doctrine may be an issue. Our professionals at are knowledgeable in the newly codified economic substance doctrine. If you believe you have been affected by the new law, please contact our professionals at contact@fuerstlaw.com.

In Healthpoint Ltd. v. Comr., T.C. Memo 2011-241 (10/3/11), available here, the Tax Court held that a company could not rely on a settlement agreement to recast a jury award and settlement to avoid paying taxes at ordinary income rates.

The taxpayer filed suit against a rival company and received a jury verdict of $16.47 million, awarding actual damages ($5 million), punitive damages ($3,174,515), disgorgement of profit ($1,640,000), and Lanham Act enhanced damages ($6,349,030). While litigation was pending, the taxpayer filed suit against the same company on different grounds, however, both parties agreed to settle both law suits for $12 million and $4.5 million, respectively.

The parties allocated damages in the settlement agreement differently than the jury’s allocation.  In particular, the settlement agreement provided for no punitive damages, even though the jury had awarded punitive damages in the first suit.  As a result, the taxpayer reported $14.5 million in long-term capital gain and $1.8 million in ordinary income. The IRS conceded that the Lanham Act enhanced damages, which totaled $6,349,030 for loss of goodwill, are taxable as long-term capital gain. However, the IRS challenged the remaining allocations in the settlement agreement.

The Tax Court held that damages were not to be allocated in accordance with the parties settlement agreement but, rather, in accordance with the jury verdict in the first law suit.  The Tax Court determined that proceeds of a settlement agreement attributable to goodwill or damage to reputation are taxable as capital gains, but those determined to be lost or disgorged profits and/or punitive damages are taxable as ordinary income.   The court stated that normally express allocations in settlement agreements will be followed in determining tax consequences.  However, there is an exception if the settlement agreement is not entered into in an adversarial context, at arm’s length, or not in good faith.

The Tax Court ultimately held that damages should be allocated in accordance with the jury verdict because the verdict accurately reflected the economic realities versus the settlement agreement.

The attorneys at Fuerst Ittleman, PL have extensive experience structuring settlement agreements and litigating against the IRS in the event that a settlement agreement is not respected.  If you can contact an attorney by emailing us at: contact@fuerstlaw.com.

In WFC Holdings Corp. v. U.S., No. 0:07-cv-03320 (D. Minn. 9/30/11) a refund claim based on capital loss deduction was disallowed because the underlying transaction was a tax shelter with no business purpose other than tax avoidance.

In the matter before the District Court, the taxpayer was the parent corporation of an affiliated group of corporations.   After a series of acquisitions, the taxpayer was left with a large quantity of excess leased space that it no longer needed, but which it was liable for (“underwater”).

KPMG marketed a tax product to clients called an “economic liability transaction.” The “economic liability transaction” involved a transfer of the “underwater” leases and a related stock sale to an investment bank. The taxpayer agreed to pay for KPMG’s work on the “economic liability transaction.”  KPMG’s employees developed the “economic liability transaction” with the understanding that a taxpayer needs a non-tax business purpose to justify the transaction.

The district court held that the transfer of “underwater” leases to a subsidiary and a related sale of stock was a sham tax shelter that the taxpayer had purchased from KPMG.  The court considered the lease restructuring transaction and, viewing the transaction as a whole, determined that the taxpayer had failed to establish a legitimate business purpose for the transaction other than tax benefits. The court concluded that the stock sale lacked economic substance and, moreover, did not accomplish the stated goal. The court stated that the lease restructuring transaction was designed, marketed, and implemented as a tax shelter, and the taxpayer’s actions indicated an absence of any real potential.

A full version of the opinion is available here.

The attorneys at Fuerst Ittleman, PL have extensive experience litigating against the IRS and the Department of Justice – Tax Division regarding tax shelters and transactions the IRS considers to lack business purpose. You can contact an attorney by emailing us at: contact@fuerstlaw.com.

Fifth Circuit Court of Appeals affirms District Court’s determination that Partnership Was a Sham

In Southgate Master Fund LLC v. U.S., No. 09-11166 (5th Cir. 9/30/11), the Court held that the loss claimed by the deducting partner was properly disallowed because the partnership was a sham.

The facts of the case are complex.  A Chinese-government-owned financial institution formed a single-member limited liability company (SMLLC).   As a wholly owned subsidiary, the SMLLC was created for the purpose of acting as its parent’s U.S. investment vehicle for nonperforming loans (NPLs) transactions. The parent company contributed to the SMLLC  a portfolio of NPLs.  The parent company contributed the NPLs to the SMLLC pursuant to a contribution which contained a series of warranties and representations stating that the parent company had not written off, compromised, or made a determination of worthlessness as to any of the NPLs.

The SMLLC and a related party formed and organized an S-corp.  Upon formation, the SMLLC contributed the NPLs to the S-corp. pursuant to a virtually identical contribution agreement. In exchange, the SMLLC received a 99% ownership interest in the S-corp.  The related party contributed cash and a promissory note in exchange for a 1% ownership interest in the S-corp. The related party was appointed as the S-corp.’s sole manager.

After receiving due diligence reports that the loans were valid and worth between $44.67 million (3.9% of face value) and $111.8 million (9.76% of face value), the taxpayer agreed to purchase a portion of the Chinese parent company and the SMLLC’s interest in the S-corp.

The taxpayer formed its own single-member LLC, (TSMLLC), through which he would invest in the S-corp. The taxpayer executed a series of transactions which resulted in the taxpayer becoming a direct 89.1% owner of the S-corp. The taxpayer then took the position that the series of transactions had increased his outside basis in the S-corp. by $180.6 million. The taxpayer ultimately took a $210.5 million deduction on his tax return because of losses from the NPLs.

The IRS issued a final partnership administrative adjustment (FPAA) pertaining to its partnership return. The partnership filed a petition for review in federal district court. The district court upheld the FPAA’s disallowance of the claimed losses on the ground that the partnership was a sham for tax purposes. However, the district court disallowed the imposition of penalties on the ground that the partnership had established reasonable cause and good faith and thus had a complete defense to any accuracy-related penalties. Both parties appealed the adverse determinations.

The Fifth Circuit held that the partnership was a sham, the deduction should be disallowed, and disallowed the accuracy-related penalties.  The Fifth Circuit applied a totality-of-the-facts-and-circumstances test to determine whether the partnership was a sham. Ultimately the Court determined that the partnership was “a meaningless and unnecessary incident” inserted into the chain of entities, transactions, and agreements through which the NPL acquisition took place. The partnership served no legitimate purpose whose accomplishment was not already assured by other means or could not have been equally well assured by alternative, less tax-beneficial means.  The full text of the opinion can be found here.

On September 28, 2011, Florida’s Second District Court of Appeal (“2nd DCA”) asked the Florida Supreme Court to rule on the constitutionality of Florida’s Drug Abuse Prevention and Control law, § 893.13 Fla. Stat. in the case of State v. Adkins. A copy of the 2nd DCA’s opinion can be read here. As we previously reported, on July 27, 2011, Judge Mary Scriven of the United States District Court for the Middle District of Florida declared the law unconstitutional under the United States Constitution as a violation of due process because it eliminated mens rea as an element of felony delivery of a controlled substance thus making the law a strict liability offense.

The federal court’s decision has opened the floodgates to litigation in pending drug cases in Florida and has led to uncertainty for criminal defendants for two main reasons. First, because the United States and Florida are separate sovereigns, the rulings of federal courts other than the U.S. Supreme Court are generally not binding on state courts. Second, because neither the Florida Supreme Court nor any District Court of Appeal has ruled on the constitutionality of § 893.13, the Circuit Courts of Florida (the tribunals responsible for adjudicating felony criminal cases) have no binding precedent to rely upon in determining whether § 893.13 is constitutional.

As a result, the Circuit Courts have split on the issue as to whether § 893.13 violates the 14th Amendment. In fact, as noted in the 2nd DCA’s Certification Order, in certain circuits, such as the Eleventh Judicial Circuit in Miami-Dade County, conflict exists within the different felony divisions with some judges adopting Judge Scriven’s opinion and declaring the statute unconstitutional while others finding the Middle District of Florida’s rationale unpersuasive because the precedent relied upon by that court was distinguishable.

In certifying the question of whether § 893.13 is constitutional, the 2nd DCA stated that because it would be the only district court of appeals to have ruled on the constitutionality of the drug law, its “decision would be binding statewide and could affect literally thousands of past and present prosecutions throughout the state.” The 2nd DCA noted that while the Florida Supreme Court prefers to resolve cases after multiple district courts have issued opinions, given the volume of the cases involved and the fact that the issue has been “fully briefed and thoroughly discussed” in trial court proceedings, it would be appropriate for the Supreme Court to decide this issue.

Although the 2nd DCA certified the question to the Supreme Court as one of ”great public importance” pursuant to Fla. R. App. P. 9.125, it should be noted that because the Florida Supreme Court is a court of limited jurisdiction, the Court can choose not to decide the issue under  Article V § 3 of the Florida Constitution as jurisdiction over such certified questions is not mandatory.

Fuerst Ittleman will continue to track the progress of this matter with a keen eye as its final resolution could affect all strict liability offenses. The white collar criminal defense lawyers at Fuerst Ittleman are experienced in handling even the most complex cases where clients are facing allegations of criminal actions. The attorneys of Fuerst Ittleman have defended clients in cases involving numerous general intent and strict liability offenses including money laundering violations found at 18 U.S.C. § 1957, the operation of unlicensed money transmitting businesses found at 18 U.S.C. § 1960, and violations of the FDCA under 21 U.S.C. §§ 331 and 333 as well as prosecutions of corporate officials for FDCA violations under the Park Doctrine. For more information regarding Fuerst Ittleman’s white collar criminal defense practice, contact an attorney today at contact@fuerstlaw.com.

On September 16, 2011, President Obama signed into law the Leahy-Smith America Invents Act (the “Act”) (H.R. 1249) which drastically reforms the U.S. patent system. Among other effects that the Act will have on the patent system, the Act prevents the granting of “tax strategy” patents. Since 1998, the U.S. Patent and Trademark Office (USPTO) has granted more than 160 tax strategy patents in the areas of real estate, charitable giving, retirement planning, and stock options.

Pursuant to the Act, “strateg[ies] for reducing, avoiding, or deferring tax liability” are considered to be a “prior art” and are thus not patentable. Applicants can no longer rely on the novelty or non-obviousness of a tax strategy to distinguish their claims over prior art pursuant to 35 U.S.C. § 101. The Act defines “tax liability” as any liability for a tax under any Federal, State, or local law imposed by statute, rule, regulation, or ordinance. However, the Act excludes methods, apparatus, technology, and computer programs that are used solely for tax preparation. The Act further states that existing tax strategy patents will not be affected yet, pending applications will be deemed prior art.

Proponents of the Act claim that it will bring fairness to the patent system and deter the use of tax shelters. Opponents, however, state that the ability to patent tax strategies creates an incentive to interpret existing tax law and disseminate it among the government and taxpayers as public knowledge. Opponents further say that the Act will force developers to keep new tax strategies as trade secrets.

If you have any questions or concerns related to this or any other tax issue, feel free to email an attorney at Fuerst Ittleman at contact@fuerstlaw.com.

On September 27, 2011, the U.S. Supreme Court granted certiorari to determine whether an understatement of gross income attributable to an overstatement of basis in property is an "omi[ssion] from gross income" that can trigger the Internal Revenue Service’s (IRS) six-year statute of limitations.

Generally, the IRS has three years to assess additional tax if the Agency believes that the taxpayer’s return has understated the amount of tax owed. I.R.C. § 6501(a). However, the assessment period is extended to six years if the taxpayer "omits from gross income an amount properly includible therein . . . in excess of 25 percent of the amount of gross income stated in the [taxpayer's] return." I.R.C. § 6501(e)(1)(A).

The case currently before the Supreme Court, U.S. v. Home Concrete & Supply, LLC, will hopefully clear up inconsistent lower court rulings regarding the amount of time the IRS has to challenge a tax shelter technique known as “Son-of-BOSS” (Bonds and Options Sales Strategy). The IRS argues that it should have six years to challenge Son-of-BOSS shelters. The Seventh, Federal, Tenth, and D.C. Circuits held that the six year statute of limitation applies, while the Fourth, Fifth, and Ninth Circuits have held that the three year statute of limitations applies.

The disputed Son-of-BOSS shelter was designed to artificially inflate the cost basis of an asset when sold, often through partnerships, allowing taxpayers to claim little to no capital gains. According to IRS estimates, this technique was used by more than 1,900 taxpayers leading to more than $6 billion in unpaid taxes.

In U.S. v. Home Concrete & Supply, LLC, a group of North Carolina taxpayers entered into a short sale of U.S. Treasury bonds and moved the transaction into a partnership which they subsequently sold.  In 2006, the IRS issued a Notice of Final Partnership Administrative Adjustment (FPAA) concluding that the taxpayers had improperly used a pass-through company to increase their cost basis, leaving them with a $69,000 gain on a sale of more than $10 million and requiring the taxpayers to pay $1.4 million. The taxpayers brought suit alleging the FPAA was barred by the general three-year limitations period in I.R.C. § 6501(a) and are seeking a refund.

Fuerst Ittleman will continue to monitor the progress of the abovementioned case along with new developments in tax law.  See our previous blogs on Son-of-BOSS tax shelters posted on February 21, 2011 and February 28, 2011. For more information, please contact us at contact@fuerstlaw.com.

On September 21, 2011, the Internal Revenue Service (IRS) announced that starting 2012, it will require certain tax preparers to undergo fingerprinting as part of the Return Preparer Initiative.  For more information regarding the Return Preparer Initiative please see our previous posting here. 

Pursuant to Notice 2011-08, registered tax return preparers will be required submit their fingerprints when renewing their Preparer Tax Identification Numbers (PTIN) annually as part of a suitability check.  The IRS also published proposed regulations (REG-116284-11) pertinent to fingerprinting user fees.

Additionally, prior to issuing PTINs to new applicants, the IRS intends to conduct suitability checks requiring applicants to submit fingerprints to the Federal Bureau of Investigation (FBI).  With these fingerprints, the FBI will conduct a database search as part of the applicants suitability review.

At this time, the IRS does not require attorneys, certified public accountants, enrolled agents, enrolled retirement plan agents, and enrolled actuaries to be fingerprinted.  These individuals, however, must meet all other suitability requirements set forth by the IRS. Additional requirements for those who are currently exempt will be set forth in future guidance. 

If you have any questions regarding the Return Preparer Initiative or any other tax provision, please contact Fuerst Ittleman, PL at contact@fuerstlaw.com.

In January 2011, President Obama issued Executive Order 13563, Improving Regulation and Regulatory Review, requiring agencies to review current regulations and determine if they are necessary and effective. On August 22, 2011, the Internal Revenue Service (IRS) and the U.S. Department of Labor (DOL) released their final plans for regulatory review. The IRS and DOL final plans for regulatory review aim to assist distressed sponsors and help retirement plans.

According to a White House fact sheet, the IRS is in the process of reviewing regulations pertaining to retirement plans to determine whether “any modifications could better achieve the objective of promoting retirement security by facilitating the offering of benefit distribution options in the form of retirement income.” This initiative plans to reduce administrative burdens for retirement plan sponsors looking to expand employees’ retirement income options.

Additionally, the IRS is considering providing relief to employers facing financial difficulty from requirements under the existing regulations pertaining to safe harbor contributions to 401(k) plans. The IRS proposal would provide flexibility to plan sponsors by allowing them to suspend required contributions based on financial health. According to the White House, the proposed regulations are in response to concerns raised by employers experiencing economic hardship and incapable of meeting certain safe harbor contributions under their plans.

The DOL Employee Benefits Security Administration (EBSA) will propose revisions to 401(k) plans that have been abandoned by their sponsors to reflect changes in the U.S. Bankruptcy Code. The proposed regulation would provide a streamlined program to terminate plans, including those for businesses involved in bankruptcy liquidations, with little EBSA involvement. Expanding the program to cover plans in liquidation would allow bankruptcy trustees to use the streamlined termination process to better discharge its obligations. The proposal is expected to be published in December 2011.

The attorneys at Fuerst Ittleman are current and knowledgeable on today’s pressing tax issues. If you have any tax concerns, email an attorney at contact@fuerstlaw.com.

The Internal Revenue Service has announced that it has eliminated the two-year limit for filing innocent spouse claims under IRC §6015(f), giving spouses of those accused of tax evasion more time to file their claims. 

The innocent spouse rule allows spouses who signed joint returns with their partners to avoid sharing the responsibility of paying taxes and penalties as a result of their partner’s wrongful actions.  Under Treas. Reg. §1.6015-5(b)(1), the IRS required innocent spouse claims to be filed within two years after the first attempt to collect.  About 50,000 innocent spouse requests are filed per year and about 2,000 are automatically rejected by the IRS because of the two-year rule.  Nina Olson, an Ombudsman at the IRS, said that the two-year rule did not work because, in many cases, taxpayers were unaware that the collection process had started.  Also, many taxpayers may have had legitimate reasons for missing the two-year deadline – including domestic abuse, divorce, fraud, and death.  (See blog entry Relaxed Restrictions for Tough “Innocent Spouse Relief” Rules, July 1, 2011).  However, despite legitimate reasons for taxpayers missing the deadline, the IRS has been unyielding in a number of especially sensitive situations.  Commissioner Douglas Shulman stated that the rule was too restrictive and not “flexible and compassionate” in its treatment of innocent spouses. 

The strictly-enforced deadline triggered an outcry of criticism from lawmakers and legal aid attorneys.  Whether Treas. Reg. §1.6015-5(b)(1) was a valid exercise of the IRS’s rulemaking authority has been challenged and several courts of appeal have upheld the validity of the two-year deadline (see, e.g., Lantz v. Commr., 607 F.3d 479 (7th Cir. 2010); Mannella v. Commr., 631 F.3d 115 (3d Cir. 2011); Jones v. Commr., 642 F.3d 459 (4th Cir. 2011)).  While the IRS has been defending the validity of the two-year rule in court, members of Congress have been urging the IRS to reconsider it.  Representatives Jim McDermott and Pete Stark, senior members of the House Ways and Means Committee, wrote a letter to Commissioner Shulman stating that Congress had not specifically included a statute of limitations for filing innocent spouse claims under IRC § 6015.  Regarding the new rule, McDermott says that the new rule makes the IRS rules consistent with congressional intent.  Representative Michele Bachman, a former IRS attorney, introduced a bill in April preventing the IRS from imposing a time limit on filing innocent spouse claims.

The new rule is effective immediately and will apply to certain cases pending before the IRS or in Tax Court.  Notice 2011-70 provides guidance regarding the new rule and several transitional rules pending formal modification of the regulations removing the two-year time limit. 

Future Requests.  Individuals may request equitable relief under IRC §6015(f) without regard to when the first collection activity occurred. The request must be filed within 10 years of the IRS’s assessment under IRC §6502.

Requests Pending with the IRS.  Innocent spouse requests that have already been submitted under IRC §6015(f) and are currently under consideration by the IRS will be honored, even if they were submitted more than two years after the first collection activity occurred.  They will be honored as long as the applicable period of limitation under IRC §6502 or IRC §6511 was open when the request was filed.

Requests that were Denied Solely for Untimeliness and not Ligitated.  Individuals whose IRC §6015(f) requests were denied solely because they were untimely and were not litigated may reapply for IRC §6015(f) relief by filing a new Form 8857, Request for Innocent Spouse Relief. 

Requests in Litigation.  For cases currently in litigation, the IRS will take appropriate action with regard to the timeliness issue and no reapplication for relief is required.

Requests that were in Litigation and the Case is now Final.  The IRS will take no further collection activity with respect to an individual who sought equitable relief under IRC §6015(f) in a judicial proceeding in which the validity of the two-year deadline was at issue and the decision in the case is final.  The collection relief provided under Notice 2011-70 applies only to those liabilities for which equitable relief would have been granted under IRC §6015(f).

Notice 2011-70 may be relied upon until final regulations modifying the two-year rule are published in the Federal Register or other published guidance is issued.  

The attorneys at Fuerst Ittleman are experienced in making and defending innocent spouse claims.  If you have any questions regarding the innocent spouse rule or any other provision of the Internal Revenue Code, please contact us at contact@fuerstlaw.com.