Trust Fund Taxes * Protesting Penalties * Offers in Compromise * Foreign Partnership Reporting Requirements

Editor:
Mark H. Ely, J.D., CPA
Partner
Washington National Tax
KPMG LLP
Washington, DC

Editor's note: Mr. Ely is the immediate past chair of the AICPA Tax Division's Relations with the IRS Committee. Ms. Jacobs and Messrs. Marchbein and Burke are committee members.

The Courts Look at Sec. 6672 TFRP

Courts have long been asked to determine who is a "responsible person" under the Code's Trust Fund Recovery Penalty (TFRP) provisions. The majority of recent decisions in some way held for the Government. Practitioners can use these results as a guide to the factors which go into sustaining—or avoiding—a TFRP assessment.

Background

Sec. 6672 provides that, "any person required to collect, truthfully account for, and pay over any tax imposed by this title who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof, shall, in addition to other penalties provided by law, be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over." Simply put, when a business withholds payroll tax deductions from its employees, and fails to pay these "trust funds" to the government, the Service can "pierce the corporate veil" and collect an equivalent amount of money directly from any "responsible person." This civil penalty, previously known as the 100% penalty, is now called the TFRP.

If more than one person is deemed liable, the amount of the penalty is not apportioned; each is assessed the same amount of the trust funds not paid for in the periods when they shared liability. When this happens, all parties receive credit for each other's subsequent payments. They also receive credit for any payments made by the collecting entity (the corporation), which reduce the unpaid trust fund amounts.

Assessment of a penalty is made after investigation and recommendation by a revenue officer. The recommendation can be appealed administratively to the IRS's Office of Appeals. However, an adverse decision by Appeals cannot be further appealed to the courts.

To obtain judicial review, a person must pay part of the assessment and then file a claim for a refund. The amount paid should be equal to the tax withheld from one employee for one calendar quarter; if this amount cannot easily be determined, a token amount, such as $100, is normally paid. When the individual's claim for refund is denied, he may bring a suit to recover the payment in either U.S. District Court or the U.S. Court of Federal Claims. This gives the court jurisdiction to determine the liability of the parties involved.

Court Tests

The courts look at two tests in determining whether to uphold an IRS assessment of the TFRP—was the individual a responsible person, and was the failure to pay over the funds willful?

In Doyle (1999), the Court of Federal Claims quoted various cases to define a responsible person. According to Slodov, 436 US 238 (1978), "the 'responsible person' must be under a duty to collect, truthfully account for, or pay over taxes." Per Greenberg, 46 F3d 239 (3rd Cir. 1994), "responsibility is a matter of status, duty or authority, not knowledge." Godfrey, 748 F2d 1568 (Fed. Cir. 1984), cautioned that, "the test of responsibility 'is a test of substance, not form.'"

Two cases hint at a possible exception for a taxpayer who only appears to have status, duty or authority. Referring to McCarty, 437 F2d 961 (Ct. Cl. 1971), the court noted, "if a person comprehensively delegates power and 'lacked the ultimate authority to withhold and pay the employment taxes in question,' then that person will not be held to be a 'responsible person.'" Additionally, "the basis for a responsibility finding is 'lacking...where the taxpayer assumes a title merely for the purpose of protecting his investment,'" according to O'Connor, 956 F2d 48 (4th Cir. 1992).

Interestingly, recent court cases focus more on the question of responsibility, giving much less attention to the question of willfulness. Despite the two-pronged test described, most cases turn on responsibility, while only a few are decided based on willfulness (when a person has already been determined to be responsible). Some taxpayers have been held to be responsible, but not willful. A question for future consideration might be whether it is possible to be willful, but not responsible.

Summary Judgment

Once a case goes to court, the Service usually seeks summary judgment. This is a finding by the court indicating that the government wins its case as a matter of law because there is no question about the case's facts. Taxpayers also often seek summary judgment, arguing that they were not responsible or willful as a matter of law—again, with no question as to the facts.

Federal Rule of Civil Procedure 56 provides that a moving party (i.e., whoever asks for summary judgment) is entitled to win when there are no genuine issues of material fact in dispute, and when that moving party is entitled to judgment as a matter of law. To avoid summary judgment, the other party must make a sufficient showing of a material dispute as to an essential element of the case, meaning that the case must proceed to trial on the facts.

Recent cases primarily involved requests for summary judgment. Even though most of the decisions were to return the cases for trial, they are valuable for their discussions of the standards the courts use to determine liability.

Burden of Proof

As a side note, practitioners should be aware that all of the cases decided in the past year dealt with penalties assessed prior to July 22, 1998, the enactment date of the Internal Revenue Service Restructuring and Reform Act of 1998. Does the shift in the burden of proof provided for under Sec. 7491 apply to TFRP cases? While that question is beyond the scope of this item, it is instructive that one district court touched on the issue. In Hudson, DC Pa. (1999), the judge wrote, "with respect to assessments made prior to July 22, 1998, such as those here relevant, there is a rebuttable presumption in favor of the correctness of the assessment." This is one area that practitioners should watch.

Determining Responsibility

There is no uniform national standard used to determine responsibility. There are, however, elements that are common to all of the Federal appellate court decisions. No single element of any of the standards is recognized as being so important that its presence is enough to establish liability, or that its absence is enough to defeat liability. Instead, the courts tend to look at how many of the elements are present. This is important to know if a Revenue Officer tells the practitioner that a client is going to be held responsible, merely because he is a a corporate officer or signs checks.

Different courts of appeals have enumerated various lists of factors by which to judge responsibility. Practitioners should pay attention to these, particularly those within their own circuits. This will allow them to better structure their clients' individual situations to avoid potential future liability.

Factors to Be Considered

These are the factors, by circuit, which were cited by various cases in 1999. (Note the striking similarities.)

Second Circuit. Courts generally take a broad view of who qualifies as a responsible person. The core question is "whether the individual has significant control over the enterprise's finances."

For "significant control," the court considers whether a person:

1. Is an officer or member of the board of directors;

2. Owns shares or possesses an entrepreneurial stake in the company;

3. Is active in the management of day-to-day affairs of the company;

4. Has the ability to hire and fire employees;

5. Makes decisions regarding which, when and in what order outstanding debts or taxes will be paid;

6. Exercises control over daily bank accounts and disbursement records; and

7. Has check-signing authority.

See Hochstein, 900 F2d 543 (2nd Cir. 1990), and Fiataruolo, 8 F3d 930 (2nd Cir. 1993), quoted in Tarlow, DC NY (1999).

Third Circuit. "A responsible person is one with significant control over the company's finances. This control need not be exclusive, so long as it is significant...It is thus insufficient to defeat liability that another person has more control, or even has the final word, over the finances of the company. Courts in this circuit have considered the following factors in the analysis of section 6672 responsibility as well...":

1. Officer's duties as outlined by the corporate by-laws;

2. Individual's ability to sign corporate checks;

3. Taxpayer's signature on the employer's Federal employment or other tax returns;

4. Identity of the corportate officers, directors and shareholders;

5. Identity of the individuals who hired and fired employees; and

6. Identity of the individual(s) who was in charge of the corporation's financial affairs.

See Hudson, quoting Carrigan, 31 F3d 130 (3rd Cir. 1994).

Second and Fifth Circuits, cited by Fourth Circuit. The Fourth Circuit undertook a pragmatic, substance-over-form inquiry into whether an officer or employee "'participated in decisions concerning payment of creditors and disbursement of funds' that he effectively had the authority—and hence a duty—to ensure payment of the corporation's payroll taxes."

The court said that indicia of actual authority or ability to pay the taxes owed (in view of an employee's status within a corporation) include whether the employee:

1. Served as an officer of the company or as a member of its board of directors;

2. Controlled the company's payroll;

3. Determined which creditors to pay and when to pay them;

4. Participated in the day-to-day management of the corporation;

5. Possessed the power to write checks; and

6. Had the ability to hire and fire employees.

See Plett, 185 F3d 216 (1999), citing O'Connor, Landau, 155 F3d 93 (2nd Cir. 1998) and Barnett, 988 F2d 1449 (5th Cir. 1993).

Fifth Circuit. Factors to consider in determining a responsible person are whether that person:

1. Is an officer or member of the board of directors;

2. Owns a substantial amount of stock in the company;

3. Manages the day-to-day operations of the business;

4. Has the authority to hire or fire employees;

5. Makes decisions as to the disbursement of funds and payment of creditors; and

6. Possesses the authority to sign company checks.

See Barnett, cited in Logal, 195 F3d 229 (5th Cir. 1999).

Seventh Circuit. To be responsible, the court considered whether the person:

1. Had an entrepreneurial stake in the company;

2. Was a corporate office;

3. Had authority to disburse funds on the company's behalf;

4. Had the ability to take out loans on the company's behalf; and

5. Had the ability to hire and fire employees.

See Charlton, 2 F3d 237 (7th Cir. 1993), cited in Johnson, DC Ill (1999).

Ninth Circuit. "Factors to consider when determining whether an individual is a 'responsible person' are whether the individual...":

1. Is an owner, an officer, or a director of the corporation;

2. Manages the day-to-day operations of the corporation;

3. Makes decisions as to the disbursement of funds and payment of creditors;

4. Has check-signing authority;

5. Has authority to sign corporate tax returns; and

6. Can hire and fire employees.

See Alsheskie, 31 F3d 837 (9th Cir. 1994), cited in Larson, DC Wa (2000).

Eleventh Circuit. Indicia of a responsible person include:

1. Holding a corporate office;

2. Controling financial matters;

3. Having authority to disburse corporate funds;

4. Owning stock in the company; and

5. Having authority to hire and fire employees.

See George, 819 F2d 1008 (11th Cir.), cited in Harris, 175 F3d 1318 (1999).

While these lists of factors vary from circuit to circuit, certain factors are common to all. The ability to hire and fire employees, the authority to disburse funds (as distinguished from the authorization to sign checks) and the holding of a corporate office are viewed by all of the circuits above as important indicators of liability for the TFRP. No factor, however, is ever considered determinative on its own.

Conclusion

What does this mean to a person who is involved with a corporation not paying its payroll taxes? A person who has apparent (but not actual) authority is at-risk for a TFRP assessment. Courts have looked to documentation as a means of establishing actual authority, according to the facts and circumstances of each case. Corporate by-laws, written directions as to what obligations and taxes are to be paid, memoranda of conversations, internal e-mails and meeting minutes can all be used to help establish who exercised authority that would hold that person liable. It is clear that the courts look beyond mere appearances and consider the actual operation of a corporation when determining liability. Any evidence that sheds light on how a corporation makes decisions furthers the goal of properly and fairly assessing the TFRP.

From Harriet A. Jacobs, CPA, MST, Michael Silver & Co., Skokie, IL and John C. Domke, MSIR, Skokie, IL

Protesting Penalties Asserted by the Service Center

Clients routinely receive notices from IRS Service Centers. It is not unusual for these notices to assert penalties, such as those for failures to file or pay. Other common penalties include additions to tax for not making timely deposits of payroll taxes and not using the Electronic Federal Tax Payments System for making payments. Penalties are sometimes also proposed for not filing information returns in a timely manner or not filing forms through the use of magnetic media.

On receipt of these notices, many clients tend to pay the assessments without considering whether the penalties are applicable in the first instance. However, sometimes the assessments are not correct or the penalties are not warranted due to reasonable cause.

Clients should contact their CPAs on receipt of notices from the Service. When a client receives a penalty notice and it is determined that the penalty may not be warranted or has been incorrectly computed, the CPA should obtain a Form 2848, Power of Attorney and Declaration of Representative, authorizing representation before the IRS for the matter at hand. A letter should then be sent to the Service Center carefully and fully explaining the facts and circumstances, citing applicable Code sections, regulations, caselaw and IRS guidance or policies, and requesting abatement of the penalty. Many sections of the Code that impose penalties generally provide for no such additions if failure to timely comply was due to reasonable cause and not willful neglect. The "Internal Revenue Manual Penalty Handbook," the procedural book of the Service, beginning at IRM [120.1] 1.3, provides guidelines for relief from penalties. The Handbook discusses the guidelines for relief due to reasonable cause, statutory exceptions, administrative waivers and correction of IRS error.

If the abatement request is denied, the Service Center will send a notice explaining the reasons for denial and requesting payment of the assessment. The notice will also advise that, if the representative still believes the penalty is not warranted, a statement of facts and position should be sent to the Penalty Appeals Coordinator at the Service Center. This statement should request that, if the abatement request is denied by the Coordinator, the matter should be referred to the Appeals Office.

If the Coordinator will not abate the penalty, the file is transferred to the Appeals Office closest to the Service Center. An Appeals Officer will phone the representative and discuss the issues. Appeals may sustain the penalty or recommend abatement in full or in part. The mission of Appeals is to fairly resolve issues, and it has the authority to do so on an intermediate basis. Thus, the penalty amount, if not fully abated, may be partially reduced. If the penalty is not abated to the taxpayer's satisfaction, the amount must be paid and a claim for refund filed to seek relief through the usual administrative channels and, if necessary and appropriate, the courts.

From Joe Marchbein, CPA, RBG & Co., LLP, St. Louis, MO

IRS Revises Offers in Compromise

The Service has made significant procedural and substantive changes to its Offer in Compromise Program. These changes are reflected in the IRS's revised Form 656, Offer in Compromise, which was issued in January 2000.

The first change that practitioners will notice is that the Service has adopted a procedure of returning to taxpayers or their representatives all Forms 656 that were in progress on Jan. 1, 2000. As part of this procedure, the IRS will request that taxpayers execute the revised form and file it with the Service. The apparent reason for this procedure is a change in IRS policy that no longer requires interest payments on accepted offers in compromise that include multiple payments. Previous policy required interest to be paid for the time period between the acceptance of an offer and the final payment.

The Form 656 revisions are extensive and include the changes mandated by the Internal Revenue Service Restructuring and Reform Act of 1998.

The revised form includes three grounds for an acceptable offer:

• Doubt as to liability;
• Doubt as to collectibility; and
• Effective tax administration.

The third criterion is predicated on the Service's view that an offer should be accepted to promote "effective tax administration." The rules for determining if an acceptable offer is based on effective tax administration are included in Temp. Regs. Sec. 301.7122-1T; an offer will be acceptable when, "collection of the full liability will create economic hardship, or, regardless of the taxpayer's financial circumstances, there may be such exceptional circumstances that collection of the full liability would be detrimental to voluntary compliance by taxpayers."

Factors supportive of a claim of economic hardship include whether a taxpayer is incapable of earning a living because of a long-term illness, or a liquidation of the taxpayer's assets would leave him unable to pay basic living expenses. Temp. Regs. Sec. 301.7122-1T also includes an example of a business that exercised reasonable care over its financial matters and was subject to a defalcation of funds, including its payroll taxes. The defalcation significantly impaired the company's viability. In the example, the IRS finds that a historically compliant taxpayer that is sufficiently profitable to make payments less than the full tax amount owed will qualify for an offer.

An offer will not be accepted if it would undermine compliance by taxpayers with the tax laws. The Service has listed three factors that it will consider in making this determination:

1. The taxpayer has a history of noncompliance with the Code's filing and payment requirements;

2. The taxpayer has taken deliberate actions to avoid the payment of taxes; and

3. The taxpayer has encouraged others to refuse to comply with the tax laws.

Revised Form 656 also includes three options for payment: (1) a cash offer, defined as payable in 90 days or less; (2) a short-term deferred payment offer (payable in more than 90 days but within two years); and (3) a deferred payment offer (payable over the life of the collection statute). IRS policy allows taxpayers who cannot meet their obligations within the statute of limitations by way of a traditional installment agreement to enter into deferred payment offers (see IR-1999-105 (12/12/99), in which the Service announced a new, fixed monthly payment option for taxpayers unable to meet their obligations under a traditional installment agreement).

The instructions for the revised form include an area of legal controversy; they state that taxpayers are ineligible to file an offer based on doubt as to collectibility or effective tax administration if "involved in an open bankruptcy proceeding." The instructions, which presumably reflect IRS policy, are contrary to two recent bankruptcy court holdings — Mills, Bankr. Ct. W. Va. (6/23/99), and Chapman, Bankr. Ct. W.Va.(6/23/99). In these cases, the courts held that the Service's policy of refusing to consider offers from debtors in bankruptcy proceedings violates Bankruptcy Code provisions prohibiting discrimination against persons who have filed bankruptcy. In these matters, the courts required the IRS to consider offers filed by taxpayers who had filed bankruptcy.

Timothy J. Burke, J.D., CPA, Burke & Associates, Braintree, MA

New Foreign Partnership Reporting Requirements

The Taxpayer Relief Act of 1997 (TRA '97) significantly modified and dramatically altered the focus and basis on which informational reporting is required for foreign partnerships. Shifting the purview from Sec. 6031 to Sec. 6038 and from the partnership to partner level, there was a need for specific guidance on requirements for compliance. Following the issuance of proposed regulations in 1998 and follow-up commentary from the professional community, final regulations were promulgated in 1999 for several important aspects of reporting by U.S. persons in connection with certain foreign partnerships. The final regulations attempted to address some of the concerns and eliminate some of the burdens and duplication inherent in the earlier proposed regulations.

While many of the burdensome reporting requirements are applicable only to qualifying U.S. persons and reportable events for tax years ending on or after Dec. 31, 2000, certain property transfers occurring in 1999 and earlier tax years are currently reportable. To carry out these filing requirements, Form 8865, Report of U.S. Persons With Respect to Certain Foreign Partnerships, was finally released by the IRS in December 1999. A separate Form 8865 is required for each foreign partnership.

Background

Information reporting requirements for foreign partnerships were generally controlled by Secs. 6038, 6038B and 6046A. Sec. 6031, which governed the earlier reporting for foreign partnerships, required filing when U.S. persons were allocated 25% or more of certain items by the foreign partnerships. As amended by TRA '97 Section 1141, foreign partnerships are now required to file a Form 1065 only if the partnership has gross income from sources within the U.S. or gross income effectively connected with a U.S. trade or business. Similarly, TRA '97 Section 1142 amended Sec. 6038 to require informational reporting by certain U.S. persons with direct or indirect interests in controlled foreign partnerships. Additionally, TRA '97 Section 1143 amended Sec. 6046A to require informational reporting only when the interest acquired, disposed of or substantially changed is at least a 10% or greater interest in the partnership. Finally, the TRA '97 also significantly altered the required reporting of property transfers to foreign partnerships, by imposing general informational reporting for such transfers (TRA '97 Section 1144), while repealing the previous 35% excise tax imposed under Secs. 1491 through 1494 on the built-in gain associated with the transferred property (TRA '97 Section 1131(a)).

The rules discussed below evolved out of a desire to put foreign partnerships and their partners (particularly when control exists) on parity with the long-standing informational reporting requirements applicable to controlled foreign corporations and their shareholders.

Required Current Filings—Property Transfers

The recently enacted regulations contain many important provisions that could greatly affect certain taxpayers almost immediately:

• Regs. Sec. 1.6038B-2 requires a U.S. person to report a property transfer (including cash), other than certain stock and securities, to a foreign partnership as a contribution in exchange for a partnership interest, when such U.S. person either holds (immediately after the transfer), directly or indirectly, a 10% or greater interest in the partnership or the value of all property transferred within a 12-month period ending on the transfer date exceeds $100,000. A U.S. person is defined under Sec. 7701(a)(30) as a U.S. citizen or resident, a domestic partnership, a domestic corporation and any estate or trust that is not foreign. Thus, for major partners or partnerships (or both), which by today's standards make even "minimal" contributions to the capital of foreign reportable.

• In connection with indirect transfers through a domestic partnership, Regs. Sec. 1.6038B-2(a)(2) sets out an extremely important principle. In substance, it fully embraces the otherwise applicable attribution rules and indicates that the partners of a domestic partnership are considered to have transferred a proportionate amount of a property to a foreign partnership. Thus, it is entirely possible to have multiple reporting of the same contribution. Notwithstanding this, in an apparent effort to eliminate duplicative filings, the final regulations provide that a domestic partnership can satisfy the obligation of all its partners by filing Form 8865. Thus, it is inferred that the first U.S person actually making the contribution to a foreign partnership can satisfy each partner's filing obligation. However, the proportionate contribution is still considered in evaluating whether a simultaneous or subsequent direct contribution to a foreign partnership by a U.S. partner of the domestic partnership also meets the filing requirement.

Example (4) of Regs. Sec. 1.6038B-7 illustrates its application. B, a U.S. citizen, owns 60% of XYZ, a domestic partnership that contributes $200,000 to a foreign partnership, FP, on March 1, 2000. While B is considered to have contributed $120,000 (60% of $200,000), if XYZ reports the contribution, B is not required to report the $120,000 contribution to FP. On the other hand, a subsequent contribution of $5,000 by B directly to FP in June 2000 must be reported. B is considered to have contributed more than $100,000 within the 12-month period ending on the date of that contribution by virtue of the earlier $120,000 contribution.

• The requirement to report transfers in exchange for partnership interests was effective for transfers occurring after Aug. 5, 1997. For U.S. persons who have not fulfilled this obligation, all is not lost; transfers that occurred between Aug. 5, 1997 and Jan. 1, 1999, will be considered timely if reported on either (1) Form 8865, filed for the first tax year beginning after 1998 or (2) Form 8865, attached to an amended return for the transfer year and filed no later than Sept. 15, 2000. This deadline is extremely important, because there are severe penalties imposed for noncompliance, including failing to timely file and/or providing inaccurate or incomplete information or both. Moreover, under the regulations, the effect is twofold:

1. Absent reasonable cause, the penalty is equal to 10% of the fair market value (FMV) of the contributed property at the time of the contribution, limited to $100,000 (unless due to intentional disregard).

2. Gain must also be recognized as if the property had been sold at its FMV at the time of the contribution. While not a penalty per se, the acceleration of the gain and the payment of an associated tax liability is certainly a harsh result for noncompliance, even though the amount of the gain is reduced by any gain recognized by the transferor for such property after the transfer (e.g., if the property was subsequently disposed of by the partnership before the failure to file or comply was discovered).

Adjustments to a partnership's basis in a contributed property or the partner's basis in a partnership, as a result of gain recognition, are made as if the gain were recognized in the year the failure to report was finally determined.

• The information required to be reported on a timely filed Form 8865 includes the following:

1. Name, address and taxpayer identification number (TIN) of the U.S. person making the transfer.

 

2. Certain information about the other partners in the foreign partnership, including names, addresses, etc. For years beginning after 1999, this applies only to 10% direct owners and certain related parties.

 

3. Description of the percentage interest received in the partnership, including a change in partnership interest.

 

4. Description of the property transferred, including the type of property and transfer date. For Sec. 704(c) property or built-in-gain property (i.e., the FMV exceeds the property's adjusted basis when contributed), the partner must provide the FMV, adjusted basis, realized gain, etc., when transferring the property to the partnership.

 

5. When appreciated property that would be subject to Sec. 704(c) allocation rules is contributed, the partner must provide the method to be used by the partnership to properly make the required Sec. 704(c) allocations. The partner must also report when the appreciated property (or any replacement property with a substituted basis acquired in a nonrecognition transaction) is disposed of by the foreign partnership, provided that the U.S. person is still a partner (direct or indirect). This latter requirement enables the Service to track whether built-in gains have been properly allocated.

Additional Reporting and Filing Requirements—2000 and Beyond

On Dec. 28, 1999, final regulations were promulgated for two important aspects of additional general informational reporting by U.S. persons applicable in connection with certain foreign partnerships.

Controlled Foreign Partnerships

• When U.S. persons, at any time during the partnership's tax year-end, possess a 10%-or-greater ownership interest in either capital, profits, deductions or losses (including constructive ownership), and such persons own more than a 50% interest in a foreign partnership, such partnership is deemed a controlled foreign partnership. By virtue of this, Regs. Sec. 1.6038-3 provides that each controlling 50% partner and controlling 10% partner must annually file Form 8865, although the information reported by each varies (see Exhibit 1). One of the goals of the final regulations was to eliminate duplication when possible. Therefore, Regs. Sec. 1.6038-3(a)(2) provides that when there is a "controlling fifty-percent partner," at any time during the tax year, an otherwise 10% partner is not deemed a "controlling ten-percent partner" and, therefore, has no obligation to file Form 8865.

• The final regulations also provide several other exceptions to the general filing obligations and required disclosures:

 

1. A U.S. person who does not have a direct interest but would otherwise be required to file Form 8865 because of the constructive ownership rules is not required to file if all of the following requirements are satisfied (see the constructive ownership exception under Regs. Sec. 1.6038-3(c)(2)):

 

(i) A statement is filed with its tax return, entitled "Controlled Foreign Partnership Reporting," which contains the following: (a) a representation that the indirect partner was required to file Form 8865, but is not doing so pursuant to the constructive ownership exception; (b) the names and addresses of the U.S. persons whose interests are constructively owned; (c) the name and address of the foreign partnership for which Form 8865 would have been filed; and (d) any other information ultimately required by the final Form 8865; and

 

(ii) The U.S. person whose interest is constructively owned reports all of the information otherwise required.

 

2. When there is more than one controlling 50% partner (through direct and indirect interests), only one of these partners is required to file Form 8865 (see the multiple controlling 50% partner exception rule under Regs. Sec. 1.6038-3 (c)).

 

A statement, titled "Controlled Foreign Partnership Reporting," must be filed by that person with his tax return. The statement must contain the following: (a) a statement that the partner was required to file Form 8865, but is not doing so pursuant to the multiple controlling 50% partner exception; (b) the name and address of the controlling 50% partner filing the form; (c) the name, address and TIN of the foreign partnership for which Form 8865 would have been filed by it as a controlling 50% partner; (d) a representation that the filing requirement has been (or will be) satisfied; and (e) any other information required by the final Form 8865.

Example 1: On Jan. 1, 2001, A, a U.S. person, contributes property to acquire a 40% interest in foreign partnership X. No other person has a direct or indirect interest in X. A is not a controlling 50% partner, because he held only 40%. Moreover, A is not a controlling 10% partner. U.S. persons owning 10%-or-greater interests do not control X (more than 50%). A has no obligation to file Form 8865 under Sec. 6038. (There may, however, be a Sec. 6046 reporting of the transfers discussed below).

On Jan. 1, 2002, B, another U.S. person, acquires a 15% interest in X from a foreign owner. Neither A nor B is a controlling 50% partner, because neither had over 50%. However, now more than 50% is controlled by U.S.-20% partners, such that each would be a controlling 10% partner and, thus, obligated to file Form 8865.

 

If on Jan. 1, 2003, C, A's brother, acquires 50% of a foreign corporation's stock, which, in turn, owned 20% of X, under the attribution rules, C is deemed to own 10% of the foreign partnership (i.e., 50% of its 20% interest). This interest is attributed to A. However, A is not considered to be a controlling 50% partner, because the interest is not greater than 50% (i.e., A owns 40% directly and 10% indirectly through attribution). A, B and C must each file Form 8865 because X is a controlled foreign partnership (i.e., 40% + 15% + 10% = 65%) and each is a controlling 10% partner.

 

On Jan. 1, 2004, A acquires an additional 1% direct interest. A will now be a controlling 50% partner on the basis of his 41% direct interest and 10% indirect interest through C. A is therefore required to file Form 8865 on this basis. Because A is a controlling 50% partner, B and C are no longer viewed as controlling 10% partners and do not have to file Form 8865.

The penalties imposed for noncompliance are quite harsh. For a failure to timely file or provide accurate or complete information (or both), the penalty is $10,000. For each 30-day period, the penalty increases by an additional $10,000 (up to a maximum of $50,000), for each failure to comply that has not been cured within 90 days after receipt of notification of such failure from the IRS. In addition, in some instances, available foreign taxes eligible for credit are reduced by 10% on the occurrence of a failure to comply. Further, the amount of the reduction also increases by an additional 5% for each three-month

Reporting by U.S. Persons Acquiring or Disposing of Foreign Partnership Interests and Changes of Proportional Interests

Regs. Sec. 1.6046A provides that Form 8865 must be filed in the case of certain reportable events for foreign partnerships that occur during a U.S. person's tax year. For this purpose, Regs. Sec. 1.6046A-1(b) defines a reportable event to include the following:

Acquisitions: A U.S. person who did not hold a 10%-or-greater direct interest (again, in capital, profits, deductions or losses) before the acquisition and after the acquisition has a 10%-or-greater direct interest in the foreign partnership. This also includes an increase by at least 10% when compared to the direct interest held at the last reportable event.

Dispositions: A U.S. person who owned a 10%-or-greater direct interest before the disposition and after the disposition owns less than a 10% direct interest in the foreign partnership. This also includes a decrease by at least 10% when compared to the direct interest held at the last reportable event.

Change in proportional interest: When compared to the direct proportional interest at the last reportable event, a U.S. person's proportional interest has increased or decreased by at least the equivalent of a 10% interest. Particular attention must be paid to this, because a change may result from a withdrawal of another partner from the partnership or a change in the partner's interest under the partnership agreement.

Example 2: Foreign partnership XYZ is owned by foreign corporations XY and YZ, which own 40% and 60%, respectively. On Jan. 1, 2000, A, a U.S. person, acquires 100% of YZ's stock. A has acquired an indirect 60% interest in XYZ. A is not required to report this, because A does not have a direct interest of 10% or greater. Here, A has no direct interest. (However, the transaction may be reportable under the controlled foreign partnership reporting rules discussed above.)

On June 1, 2000, A purchases a 5% direct interest in XYZ from XY. A did not own a 10%-or-greater direct interest before the acquisition and has only a 5% direct interest afterward. A is not obligated to report the transaction.

On Sept. 15, 2000, A purchases an additional 7% direct interest from XY. This is a reportable transaction, because A did not own a 10%-or-greater direct interest before the acquisition but, in fact, owned a 12% direct interest afterward. The September acquisition must be reported on Form 8865.

On Dec. 1, 2000, A acquires another 4% direct interest from XY, increasing his direct interest from 12% to 16%. Because the direct interest has not increased by at least 10%, this is not reportable.

On April 1, 2001, A acquires another 6% direct interest from XY, increasing his direct interest to 22%. This acquisition is reportable, because there has been a 10% increase (from 12% to 22%) since the last reportable event in September 2000.

If XY were to withdraw from XYZ, YZ and A's interests would increase proportionally by more than 10%. This withdrawal would create a reportable event and Form 8865 would be required.

The penalties imposed for noncompliance, whether attributable to a failure to file Form 8865 or to provide accurate or complete information, are imposed under Sec. 6679. In substance, these penalties for controlled foreign partnerships are identical to those set forth immediately above.

Given the far-reaching implications of the new regulations and the significant penalties imposed for noncompliance, Form 8865 must be accurately and timely filed.

From Richard D. Nichols, CPA, J.D., LL.M., American Express Tax & Business Services, New York, NY