As of June 12, 2014, with the exception of what are commonly known as “Marketed Opinions,” tax advisors and their firms no longer need separate standards governing Written Advice. Section 10.35 of Circular 230 (“C230”) has been eliminated. Consequently, the crazy, overused C230 disclaimers can go in the trash bin. No more emails to mom, dad, children or other family members, and/or friends with a federal tax disclaimer. I bet that will be somewhat of a relief to these email recipients. No longer will they find themselves looking for tax advice as a result of the prominent disclaimer in a message that has absolutely nothing to do with taxes.
Representatives of the IRS and the Office of Professional Responsibility (“OPR”) have vocalized glee about the elimination of C230 disclaimers. Karen Hawkins, Director of the OPR, told participants at a tax conference in New York last week: “I’m here to tell you that jurat, that disclaimer off your emails. It’s no longer necessary.” IRS Chief Counsel, William Wilkins, echoed the same sentiments last week when he said: “The Circular 230 legend is not merely dead, it’s really most sincerely dead.”
Treasury estimates this amendment to C230 and the removal of the corresponding compliance burden on tax advisors “should save tax practitioners [and/or their clients] a minimum of $5,333,200.”
All Written Advice is now governed by Section 10.37 of C230. This provision does not contain specific disclosure rules. Consequently, unless Treasury further amends Section 10.37, the C230 disclaimers are no longer required on Written Advice.
Going forward, among other things specifically set forth in Section 10.37 of C230, tax advisors must:
- Base the written advice on reasonable factual and legal assumptions (including assumptions as to future events);
- Reasonably consider all relevant facts and circumstances that the practitioner knows or reasonably should know;
- Use reasonable efforts to identify and ascertain the facts relevant to written advice on each Federal tax matter;
- Not rely upon representations, statements, findings, or agreements (including projections, financial forecasts, or appraisals) of the taxpayer or any other person if reliance on them would be unreasonable;
- Relate applicable law and authorities to facts; and
- Not, in evaluating a federal tax matter, take into account the possibility that a tax return will not be audited or that a matter will not be raised on audit.
C230 still provides that any tax advisor with principal authority and responsibility for overseeing the firm’s tax practice must take reasonable steps to ensure that it has adequate procedures in place to ensure C230 compliance. Failure to take “reasonable” steps to ensure that the procedures are followed subjects the tax advisor and his or her firm to discipline.
As a result of the June 12, 2014 amendments to C230, tax advisors (with the exception of Marketed Opinions):
- Are no longer required to use disclaimers; and
- Are no longer required to describe in Written Advice all of the relevant facts, including assumptions and representations, the application of law to the facts, and any conclusions.
It is hard to dispute that specifically including in Written Advice all relevant facts, assumptions and representations, application of the law to the facts, and any legal conclusions, is a good and sound practice. Nevertheless, Section 10.37 of C230 now only requires that tax advisors consider the:
- Scope of the engagement;
- The type and specificity of the advice sought; and
- Appropriate facts and circumstances.
Based upon these factors, tax advisors are now required to determine the extent to which the relevant facts, application of the law to those facts, and the conclusions should be included in the Written Advice. This amendment to C230, in a lengthy and verbose manner, tells tax advisors that they are not subject to specific and rigid information inclusion requirements in all Written Advice any longer. Rather, they are required to look at all of the relevant facts and circumstances, giving due consideration to what they reasonably know or should know, to determine what should be included in Written Advice. No rigid, one-size-fits-all, requirement exists any longer. According to Karen Hawkins, the government amended this component of C230, purposely making it a broad principles-based rule. It gives both the government and tax advisors lots of flexibility, allowing them to use common sense and sound practice standards when rendering Written Advice.
It should be noted, written presentations provided to an audience solely for educational purposes are not considered Written Advice for purposes of C230. Be aware—if a presentation is made with any level of intent to market or promote transactions, more onerous requirements are required. The IRS has not lost sight of history – it is keeping its eye on Marketed Opinions and will continue to closely scrutinize them.
Tax advisors and their firms need to have a good understanding of C230, as amended, and implement policies to ensure compliance therewith. In light of the possibility of censorship, suspension or disbarment from practice before the IRS, the stakes are high.
The Service’s new arsenal is strong. The 2014 amendments to C230 redirect the tax world back toward normalcy. Nevertheless, given the sanctions for noncompliance, C230 is still something tax advisors and their firms need to take seriously and strive to comply therewith.
The takeaways are threefold:
1. No longer may tax advisors place disclaimers on Written Advice that say things like “the IRS requires that we tell you…………………” or “we are required under Circular 230 to tell you” that you may not rely upon this advice to avoid federal tax penalties. Those types of statements are no longer accurate and should be removed from Written Advice. No longer does the IRS or C230 require such a statement.
2. A good understanding of C230 is required by all tax advisors. Firms should have a C230 Committee that adopts good practice standards and policies, and educates, monitors, and ensures C230 compliance by, members of the firm.
3. Marketed Opinions are still being closely scrutinized by the IRS. Compliance with Section 10.37 of C230 is required.
For C230 compliance issues, or to learn more about C230, feel free to contact me.
Treasury issues long-awaited amendments to Circular 230. On June 9, 2014, Treasury published amendments to Circular 230 that we have been anticipating for the past several months. It looks like the crazy email disclaimers, just like leisure suits, will be a thing of the past. Among many changes to Circular 230, the final regulations eliminate or clarify the complex rules for written advice. Based upon my first read of the regulations, it certainly appears Treasury has been listening to tax practitioners.
Stay tuned, I will be posting a summary of the amended regulations soon.
The Internal Revenue Service (“IRS” or “Service”) has repeatedly stated that, while its crackdown on the failure of taxpayers to report foreign financial accounts has been strong, it is reasonable in the application of the law. At least one taxpayer, Mr. Carl R. Zwerner, would likely debate that pronouncement.
On June 9, 2014, Bloomberg BNA Daily Tax Report (No. 110) revealed that a long and hotly-contested battle between Mr. Zwerner and the United States government has come to an end. This highly-publicized case is frightening. It illustrates that the IRS may not always be reasonable in the application of the foreign financial account reporting (“FBAR”) laws.
Mr. Zwerner, an 87-year old retired specialty-glass importer, is a United States citizen who resides in Coral Gables, Florida. He had a financial account in Switzerland. The account balance never exceeded $1.7 million. It appears the account was opened by Mr. Zwerner during 2004 in the name of a foundation. In 2007, he closed the original account and transferred the account balance to another Swiss account. The new account was opened in the name of yet another foundation. Mr. Zwerner controlled these accounts; he was undisputedly the beneficial owner of the accounts.
On June 11, 2013, the battle commenced when Assistant Attorney General Kathryn Keneally instituted a lawsuit against Mr. Zwerner in the United States District Court for the Southern District of Florida, seeking to collect almost $3.5 million in penalties from him for violating the FBAR rules. The assessment which the government was pursuing against Mr. Zwerner amounted to more than double the highest account balance of his Swiss financial account.
In the past five to six years, the United States Justice Department has filed over 75 criminal cases against taxpayers for failure to report foreign financial accounts. In these cases, the penalties sought by the government have usually been 50 percent of an account’s maximum balance, or less. While the government has authority to pursue multiple penalties, pursuit of penalties aggregating more than 50 percent of the maximum account balance has been rare. Mr. Zwerner’s case raises the issue of whether collection of more than an account’s highest balance constitutes a violation of the Eighth Amendment to the United States Constitution.
Pursuant to the Eighth Amendment, the amount of a penalty must bear a relationship to the gravity of the offense; it cannot be excessive. Is a penalty of the magnitude imposed on Mr. Zwerner excessive?
The facts of this case appear to be as follows:
Mr. Zwerner was required to report the foreign financial account from 2004 through 2007 by filing an FBAR on or before June 30 of each following year. He only filed an FBAR, however, in October 2008 (delinquent for 2007). Further, he did not report any income from the account before 2008.
The IRS alleged in its complaint that Mr. Zwerner, on October 13, 2008, filed a delinquent FBAR, reporting the account for 2007. At that time, he also filed an amended 2007 income tax return, reporting the account’s income. On March 27, 2009, Mr. Zwerner filed delinquent FBARs, reporting the account for 2004, 2005, and 2006. At that time, he also filed amended income tax returns for those years, reporting the account’s income.
The government asserted Mr. Zwerner’s failure to report for 2004, 2005, 2006 and 2007 was willful. It pointed out the following facts in support of this position:
• The account was placed in the name of two separate foundations to disguise the identity of the true owner.
• On Mr. Zwerner’s original income tax returns for 2004, 2005, 2006 and 2007, he specifically reported on Schedule B that he held no interest in a foreign financial account.
• For the years at issue, Mr. Zwerner reported to his CPA on a tax organizer that he had no interest or signatory authority over a foreign financial account.
• Mr. Zwerner admitted he was aware of the FBAR rules.
Based upon the above facts, the IRS assessed penalties against Mr. Zwerner relating to each tax year for “willful” failure to comply with the FBAR rules. Pursuant to 31 USC 5321(a)(5), the penalties are equal to the greater of $100,000 or 50 percent of the account balance as of the date of violation. Consequently, for 2004, 2005, 2006 and 2007, these penalties, with interest, exceeded $3.45 million or over twice the account’s highest balance. Despite demand, Mr. Zwerner failed to pay the assessment. As a result, the lawsuit resulted.
The facts do not sound good. There are, however, some mitigating facts.
About four months after filing a late FBAR for 2007, and amending his 2007 income tax return, reporting the foreign financial account income, and paying the tax, in February 2009 Mr. Zwerner’s legal counsel approached the IRS Criminal Investigative Division. Without disclosing Mr. Zwerner’s identity, the lawyer inquired about his particular situation for tax years 2004, 2005 and 2006. The IRS issued a letter stating that no criminal action in the hypothetical case presented by the lawyer would be pursued. So, Mr. Zwerner, at counsel’s advice, filed the delinquent FBARs and amended his income tax returns, reporting the income. At that time, he also paid all income tax due and owing. It is important to note, Mr. Zwerner was not under exam when he took corrective action. In 2010, the Service began an examination of Mr. Zwerner’s income tax returns. Mr. Zwerner’s attempt at voluntary compliance pre-dated by a few months the formal FBAR voluntary disclosure programs.
Unfortunately for Mr. Zwerner, his case proceeded to trial in May 2014. The jury returned a verdict, finding Mr. Zwerner’s violations of the FBAR rules were “willful” for tax years 2004, 2005 and 2006. It found, however, any violation of the FBAR rules for 2007 was not willful. This verdict left Mr. Zwerner faced with penalties of about $2.2 million.
Mr. Zwerner’s counsel filed a motion with the court to dismiss or reduce the verdict on the ground that the penalty was excessive and violated the Eighth Amendment of the United States Constitution. The court was set to hear arguments on the motion this month. The parties, however, settled the matter. So, this important issue remains open.
Several takeaways exist:
• Until the courts look at this issue, it remains unclear whether FBAR penalties in excess of an account’s highest balance are excessive and constitute a violation of the Eighth Amendment.
• When a taxpayer goes to the Service, even on an anonymous basis, and obtains guidance, the Service may still bombard the taxpayer with noncompliance penalties.
• Despite rhetoric about its reasonable approach to FBAR enforcement, it appears the government will continue to use its strong arsenal of penalties to obtain compliance.
This area of law continues to be complex and full of traps for unwary taxpayers and their advisors. The Service continues to tell us that it intends to apply the FBAR rules in a reasonable manner. Time will tell. Tax advisors must be careful so that they do not walk their clients, without full disclosure of the risks, into the penalty assessment gauntlet.
Montgomery v. Commissioner, T.C. Memo. 2013-151 (June 17, 2013) illustrates what appeared to be the obvious – neither a guaranty of the corporation’s debt by a shareholder nor an unpaid judgment against a shareholder for the S corporation’s debt creates basis.
In Montgomery, the taxpayers, Patrick and Patricia Montgomery, claimed a net operating loss on their 2007 joint return, which they carried back to 2005 and 2006. In the calculation of their net operating loss, they included: losses UDI Underground, LLC (“UDI”), incurred in 2007 that were passed through to Patricia Montgomery as a 40% member; and losses Utility Design, Inc., an S corporation (“Utility Design”), incurred in 2007 that were passed through to Patrick and Patricia Montgomery as shareholders.
The IRS challenged the amount of the net operating loss for 2007 on two grounds:
- First, the IRS asserted Patricia Montgomery did not materially participate in UDI during 2007.
- Second, the IRS asserted portions of the losses from Utility Design were disallowed under Section 1366(d)(1).
- The IRS asserted Patricia Montgomery’s share of the 2007 losses from UDI were losses from a passive activity. Specifically, the IRS argued Patricia Montgomery did not materially participate in UDI.
The Tax Court disagreed, holding Patricia Montgomery did materially participate in UDI. In 2007, Patricia Montgomery handled all of the office functions, managed payroll, prepared documents, met with members of the company and attended business meetings. Additionally, she continuously worked on company matters and daily discussed the company's business with Patrick Montgomery. The court ultimately concluded Patricia Montgomery participated in UDI for more than 500 hours during 2007 and her participation was regular, continuous, and substantial. Thus, Patricia Montgomery’s UDI activity was a non-passive activity.
Next, the Tax Court considered whether the taxpayers’ portion of the net operating loss attributable to Utility Design was limited by Section 1366(a). Section 1366(a) requires an S corporation shareholder, when calculating his or her taxable income for the year, to take into account his or her pro rata share of the S corporation's items of income, loss, deduction, or credit for the S corporation's tax year that ends in the tax year of the shareholder. However, the S corporation's loss taken into account by a shareholder cannot exceed the limitation amount calculated under Section 1366(d)(1), which is equal to the shareholder’s adjusted basis in the S corporation stock increased by the shareholder’s adjusted basis of any indebtedness of the S corporation to the shareholder.
The Tax Court concluded Patrick Montgomery’s basis in the Utility Design stock was zero at the beginning of 2007. It then considered basis adjustments. In 2006 and 2007, Utility Design borrowed the following amounts: $1 million from SunTrust Bank on August 25, 2006, (which was personally guaranteed by the taxpayers); $60,000 from Patrick Montgomery on September 26, 2007; $30,000 from Patrick Montgomery on October 5, 2007; and $15,000 from Patrick Montgomery on November 13, 2007.
In 2008, Utility Design defaulted on the $1 million loan. The bank proceeded to pursue claims against the taxpayers on the personal guarantees. The taxpayers failed to pay the debt under the guarantees, despite repeated demand and the filing of a lawsuit against them. Ultimately, in November 2009, a judgment was entered in favor of the bank against them for $425,169.54. The taxpayers took the position that their basis in the Utility Design shares was increased by the amount of the judgment (i.e. $425,169.54).
The IRS contended the judgment amount did not increase the taxpayers’ stock basis. When an S corporation shareholder guarantees a loan of the corporation, no debt has been created between the S corporation and the shareholder. However, once the shareholder pays the bank pursuant to the guarantee, the S corporation becomes indebted to the shareholder and the shareholder obtains basis.
Accordingly, the court held that, because the taxpayers, Patrick and Patricia Montgomery, did not make any payments under the guarantee, their guarantee did not increase share basis. To put salt on the wound, the court upheld the Service’s imposition of a Code Section 6651(a)(1) penalty against the taxpayers for late filing.
The moral to this story is simple: You do not get basis merely by guaranteeing the corporation’s debt. Also, unless you pay the debt, a judgment against you will not give you basis. Last, but certainly not least, failure to follow these clear rules could result in penalties.
Larry J. Brant
Larry J. Brant is a Shareholder in Foster Garvey, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; Washington, D.C.; New York, New York, Spokane, Washington; and Beijing, China. Mr. Brant practices in the Portland office. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long-term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.