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IRS Industry Issue Focus Strategy • Schedule K-1 Reportable Transaction Disclosure Relief • Increased Correspondence Exam Coverage • The Power of Gifting Editor: Mr. Miller is a member of the AICPA Tax Division’s IRS Practice and Procedures Committee. Mr. Brennan is the chair, and Messrs. Snow and Tierney and Ms. Hodes are members, of that committee. For further information about this column, contact Mr. Miller at johnmillercpa@cox.net. IRS Launches New Industry Issue Focus Strategy To keep pace with changing business environments and cope with limited government resources, the IRS has implemented a new Industry Issue Focus (IIF) strategy to concentrate on high-risk tax issues. In recent years, the Service has begun to address issues associated with the dynamic nature of the global business environment in which some of its taxpayers operate. These taxpayers often retain sophisticated tax advisers who arrange very complex transactions in an effort to reduce their clients’ overall U.S. tax. With this challenge comes the realization that the IRS must make certain that specific industry issues are properly addressed. The IRS Large and Midsize Business Division (LMSB) has jurisdiction to examine business taxpayers with $10 million or more in assets. Fiscal-year 2006 statistics indicate that LMSB taxpayers paid approximately $206 billion in taxes and filed 175,862 returns, many of them thousands of pages long (see, e.g., “Industry Issue Focus (IIF) Fact Sheet—March 2007,” available at www.irs.gov/businesses/article/0,,id=168490,00.html (IIF Fact Sheet)). For example, the IRS announced that, on paper, General Electric’s e-filed return would have been approximately 24,000 pages long, the nation’s longest tax return; see IR-2006-84, available at www.irs.gov/newsroom/article/0,,id=157845,00.html. To examine these taxpayers and returns, the Service employs 5,132 revenue agents and LMSB specialists (this number does not include support personnel involved in these compliance efforts). The IRS believes that LMSB taxpayers deserve more attention, because government estimates for 2006 indicate that they account for $25 billion (7%) of the tax gap (the difference between estimates of taxes that should be paid and taxes actually collected). LMSB Tax Compliance As part of the new IIF strategy, the LMSB has implemented a system for prioritizing tax compliance issues. This system is designed to provide nationwide oversight on important designated issues to ensure consistency in issue resolution across industry lines; see “Industry Issue Focus,” available at www.irs.gov/businesses/article/0,,id=167377,00.html. The LMSB’s implementation of this strategy, which identifies and manages specific issues, should materially alter the Service’s approach to these issues during taxpayer examinations. In addition, the IRS recently published Internal Revenue Manual Section 4.51.5, Industry Focus and Control of LMSB Compliance Issues, which further describes the new strategy; see www.irs.gov/irm/part4/ch45s05.html. Under the updated procedures, Service field functions identify potential compliance issues from various sources, both internal (examinations) and external (outside stakeholders, new legislation, etc.). Issues are received from the Pre-Filing and Technical Guidance technical advisers, Industry Counsel, Schedule M-3 reviews and other specialist programs (international and field specialists). Known cross-industry issues are submitted for consideration to all affected industries by technical advisers or other submitters. In addition, industry directors, director field specialists and directors of field operations identify issues for each sub-industry through attendance at sub-industry meetings and field visits. The identified issues are then ranked and tiered based on their prevalence in the respective industry and relevance to compliance risk. Other factors include: 1. Visibility and uncertainty surrounding the issue’s tax treatment due to new legislation or litigation; 2. Materiality, in terms of affecting a large number of taxpayers, resulting in large audit adjustments or requiring significant time spent by agents examining the issue; and 3. Potential for abusive tax avoidance or promotion. A Compliance Strategy Council (CSC) reviews all proposed Tier I and Tier II issues. After the CSC approves an issue for a tier designation, it assigns ownership to an industry or specialty area. IRS management’s attention and resource deployment focus on those areas with the greatest risk. Other benefits engineered into the design of the tiered classification system include increased operational efficiency, ability to leverage technology, experience to identify and prioritize tiered issues, increased examination coverage and flexibility in resource deployment; see IIF Fact Sheet. Although designated issues can be classified into one of three tiers, at press time, the IRS has not designated any Tier III issues. According to Barry B. Shott, LMSB industry director for financial services, the Service is currently developing industry-related Tier III issues, which typically are those that should be considered by LMSB teams when conducting their risk analyses; see Tandon, “LMSB Releases Details on New Tiered System for Compliance Issues,” Tax Notes Today, 2007 TNT 49-2 (3/13/07). Tier III issues will be listed by industry on a centralized website along with Tier I and II issues; links will be provided to available guidance (e.g., audit technique guidelines) on industry or technical adviser websites to promote consistent development and resolution throughout the LMSB. For issues classified as Tier I
or II, an issue owner executive with nationwide jurisdiction is
assigned to coordinate the IRS’s examination efforts on the
individual issue. Once these issues are identified, issue
management teams, composed of personnel from many different
Service areas (e.g., counsel, technical advisers, appeals staff
and field representatives) develop guidance for examination teams
nationwide and provide instruction on the examination processing
of each issue. IRS Commissioner Mark Everson, in July 2006
testimony to the Senate Finance Committee, noted the formation of
issue management teams to provide executive oversight and focus
on high-risk areas (similar to the approach used by the Service
in formulating tax-shelter settlement initiatives over the past
several years); see “Written Testimony of Commissioner of
Internal Revenue Mark Everson before Senate Committee on Finance
on Compliance Concerns Relative to Large and Mid-size Businesses,
June 13, 2006,” available at
www.senate.gov/~finance/hearings/testimony/ Tier I Tier I addresses issues that the IRS has classified as having the utmost strategic importance and the most significant effect on one or multiple industries. After the Service categorizes an issue as Tier I, LMSB-wide coordination and executive oversight are required to ensure examination coverage, consistent development and issue resolution. At press time, the IRS had designated the following as Tier I issues (see “Industry Issue Focus—Tier I Issues,” available at www.irs.gov/businesses/article/0,,id=167379,00.html):
In addition, Tier I includes two tax-shelter transactions: distressed asset/debt and redemption bogus optional basis, and all currently listed transactions; see Notice 2004-67 and “Listed Abusive Tax Shelters and Transactions,” available at www.irs.gov/businesses/corporations/article/0,,id=120633,00.html. Tier II Tier II issues represent areas of potential high noncompliance and/or significant compliance risk to the LMSB or an industry. At press time, the following were designated as Tier II issues; see “Industry Issue Focus—Tier II Issues,” available at www.irs.gov/businesses/article/0,,id=167381,00.html:
Conclusions The tiered system allows the LMSB to resolve certain issues across industry lines. In particular, the Service desires consistency in issue resolution and enhanced oversight and accountability. Although the entire new IIF strategy has yet to be fully made public, it is apparent that the plan removes discretion from examination teams and places it under the centralized control of issue owner executives and issue management teams with nationwide influence for identification, development and resolution of designated issues that pose significant compliance risks. The discretion afforded examination teams in applying the guidance depends on the issue’s tier designation. Guidance developed for Tier I issues will be nondiscretionary: field personnel must implement the guidance determinations in all cases and may not use discretion when applying them. They will, however, be able to use discretion when applying guidance developed for Tier II (and most likely Tier III) issues, based on the facts and circumstances of each case. In response to these new initiatives, taxpayers need to be especially attentive in establishing their positions on tiered issues. If the IRS requests information about a designated issue, the taxpayer should be prepared to respond quickly with the relevant information. A prompt, effective and comprehensive response to the examination team may provide opportunities (such as alternative dispute resolution) for early and more taxpayer-favorable resolution of these issues than would have otherwise been available. Finally, given the IIF strategy’s clear purpose of promoting consistency and centralizing management control over the resolution of tiered issues, the migration of case control may further stretch Service resources. Many of the facts relevant to the designated issues are frequently developed during the examination stage. With nondiscretionary procedures for tiered issues that remove control from examination teams, one significant question is how the IRS will be able to continually exercise centralized management of these issues. From Scott E. Powers, J.D., LL.M., and James E. Brennan, CPA, Ernst & Young LLP, New York, NY Some Schedule K-1 Recipients Get Reportable Transaction Disclosure Relief Taxpayers that discover after filing their returns that they indirectly participated in a reportable transaction through a passthrough entity may be able to rely on Prop. Regs. Sec. 1.6011-4(e)(1) to avoid reportable transaction penalties. The preamble to the proposed regulations (REG-103038-05, 11/2/06) provided that this relief was effective immediately. Reportable Transaction Basics Currently, under Regs. Sec. 1.6011-4(b), there are five categories of reportable transactions: listed transactions, confidential transactions, transactions with contractual protection, Sec. 165 loss transactions and transactions with a brief asset-holding period. Taxpayers that have participated in one of these are required to disclose it on Form 8886, Reportable Transaction Disclosure Statement, attached to their federal income tax return. The first time a taxpayer discloses the transaction, a copy of Form 8886 must also be sent to the Office of Tax Shelter Analysis (OTSA); see Regs. Sec. 1.6011-4(d). For partnerships, S corporations and trusts, the entity and the interest holder must each separately determine whether the taxpayer has participated in a reportable transaction and, thus, whether the taxpayer is required to disclose it on Form 8886. Instructions for Schedule K-1 require passthrough entities to provide interest holders with information so that the latter can determine if they have a disclosure obligation (see, e.g., p. 13 of the Instructions to Form 1065, U.S. Return of Partnership Income, Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., under the heading “Code Q, Other Information”). Based on these rules, it is possible for a partner to have a disclosure obligation even though the partnership does not or, alternatively, for a partnership to have a disclosure obligation even though its partners do not. Example: In 2007, Partnership X has a $10 million Sec. 165 loss that is not a Sec. 988 loss. Partners A (a corporation) and B (an individual) each have a 50% allocable share of the loss. Under the reportable transaction regulations, X has a disclosure obligation, because the loss exceeds the $2 million reporting threshold for Sec. 165 losses for partnerships under Regs. Sec. 1.6011-4(b)(5)(i)(C). In addition, B has a disclosure obligation, because his allocable share of the loss, $5 million, exceeds the $2 million reporting threshold for individuals under Regs. Sec. 1.6011-4(b)(5)(i)(C). However, A does not have a disclosure obligation, because the loss does not meet the $10 million reporting threshold for corporations under Regs. Sec. 1.6011-4(b)(5) (i)(A). Penalties: In 2004, Congress enacted Sec. 6707A, which provides a penalty for failure to disclose a reportable transaction, and Sec. 6662A, which provides a special accuracy-related penalty for listed transactions and reportable transactions with a significant purpose of avoiding or evading Federal tax. For listed transactions, the Sec. 6707A penalty is $200,000 for corporations and $100,000 for other taxpayers; it may not be waived or rescinded. For other reportable transactions, the penalty is $50,000 for corporations and $10,000 for other taxpayers; it may be waived or rescinded only in limited circumstances (see Sec. 6707A(d) and Rev. Proc. 2007-21). In general, the accuracy-related penalty under Sec. 6662A is 20% of the reportable transaction understatement. The penalty increases to 30% if the reportable transaction is not disclosed. Under Sec. 6664(d), a strengthened reasonable cause exception may be available to avoid the Sec. 6662A penalty, but no defense is available if the transaction was not disclosed. Thus, a taxpayer that fails to disclose timely a reportable transaction is potentially exposed to significant penalties whose effect is exacerbated by the limited defenses available. Although there are no statutory provisions to forgive unintentional errors resulting in a failure to disclose, the Service has provided limited relief for certain passthrough-entity interest holders, permitting them additional time to file Form 8886 while still avoiding the Sec. 6707A penalty. A taxpayer can correct a failure to disclose a transaction for purposes of the Sec. 6662A accuracy-related penalty, by filing a qualified amended return meeting the requirements of Temp. Regs. Sec. 1.6664-2T. However, a qualified amended return cannot be used to correct a failure to disclose a transaction for purposes of avoiding the Sec. 6707A penalty. Timing Dilemma Partners, shareholders and beneficiaries struggle to report accurately the allocable share of income from passthrough entities, primarily because the extended due date for Schedule K-1 coincides with or is later than the extended due date for federal income tax returns. This may also prevent a Schedule K-1 recipient from timely disclosing indirect participation in a reportable transaction through ownership of a passthrough entity that participated in one. If the interest holder receives a Schedule K-1 reporting an allocable share of a reportable transaction close to or after its filing due date (which often occurs even if the interest holder has requested an extension), the interest holder will likely not even know that there is a disclosure obligation resulting from ownership of an interest in the passthrough entity. However, the interest holder is still required to disclose the transaction if it “participated” in the transaction and may be exposed to potential penalties for failure to do so. Unlike accuracy-related penalties, the penalty for failure to disclose a reportable transaction can be waived (rescinded) only in extremely limited circumstances (if at all). Thus, even though a taxpayer may be able to establish reasonable cause to avoid an accuracy-related penalty under Sec. 6662 (e.g., due to receipt of a Schedule K-1 after the taxpayer filed a return), that relief would not excuse a failure to disclose a reportable transaction on the original filed return, which is subject to the Sec. 6707A penalty. Limited Relief Prop. Regs. Sec. 1.6011-4 provides limited relief for passthrough-entity interest holders who receive Schedules K-1 close to their return filing due date. Under Prop. Regs. Sec. 1.6011-4(e)(1), relief is provided if a partner, an S shareholder or a beneficiary receives a timely Schedule K-1 less than 10 calendar days before the due date of the taxpayer’s return (including extensions). If, in those situations, the taxpayer determines (based on the Schedule K-1) that it participated in a reportable transaction, the disclosure will be deemed timely if filed with the OTSA within 45 calendar days of the return due date (including extensions). Under this relief provision, filing with the OTSA is sufficient, and no amended return is required. The preamble to the proposed regulations explains that even though they are not final, taxpayers may currently rely on this relief. Determining Whether Relief Is Available The relief provided to passthrough-entity interest holders in the proposed regulations is very limited. To be eligible, three requirements must be met: 1. Schedule K-1 received less than 10 days before return due date: To be eligible, a Schedule K-1 must be received less than 10 calendar days before the due date of the taxpayer’s return (including extensions). A reportable transaction reported on a Schedule K-1 received on the tenth calendar day before the due date of the recipient’s return is not eligible for relief. The arbitrary choice of 10 days means that eligibility will depend on when the passthrough entity completes its Schedules K-1 and on the mail system. It is likely that issues will arise about when the recipient received the Schedule K-1. How will a taxpayer be able to prove receipt for purposes of determining eligibility for this relief? 2. Schedule K-1 is timely: Even if Schedule K-1 is received on the ninth calendar day before the return’s due date (including extensions), relief will not apply if the Schedule K-1 is not timely. This criterion is patently unfair to the interest holder, because the passthrough entity, not the interest holder who needs relief, is the one required to satisfy it. If the interest holder is unaware that it has participated in a reportable transaction indirectly through the passthrough entity, it is likely that the interest holder also has little control over the timeliness of the Schedule K-1. 3. File with the OTSA within 45 calendar days of the return due date: The disclosure must be made to the OTSA within 45 calendar days of the return’s due date, including extensions. This time seems sufficient (provided the taxpayer actually receives a timely Schedule K-1). In addition, the government created a more administrable rule by requiring disclosure to the OTSA only, rather than also requiring the taxpayer to amend its return. Recommendations Passthrough-entity interest holders welcome this relief, but many commentators have requested broader help with the reportable transaction requirements. The IRS and Treasury should reconsider the need for duplicate filings by partnerships and partners, giving special consideration to eliminating disclosure requirements for partners who have de minimis interests in a partnership or who own interests in widely held investment vehicles. In these cases, the interest holders have no decisionmaking authority. Thus, whether these interest holders participate in a reportable transaction is in the control of the passthrough entity, not the partner. Until the Service and Treasury issue broader relief, the relief provided in the proposed regulations should be extended to late Schedules K-1, because their timeliness is generally outside the control of the passthrough-entity interest holder. To avoid abuses, this extended relief could be limited to taxpayers with a de minimis ownership interest or control in the passthrough entity. From Rochelle Hodes, PricewaterhouseCoopers LLP, Washington, DC IRS Increases Correspondence Exam Coverage The federal tax gap has received much attention in the past two years. In her 2006 Annual Report to Congress, National Taxpayer Advocate Nina Olson identified it as “one of the most serious problems facing taxpayers today”; see www.irs.gov/advocate/article/0,,id=165806,00.html. In an effort to address this growing concern, the IRS has been increasing the use of correspondence examinations. In a 2006 report to Congress, Treasury Inspector General for Tax Administration J. Russell George reported that during fiscal years 2002–2005, face-to-face examinations increased by 25%, while correspondence examinations increased 170%. Correspondence examinations account for more than 70% of the Service’s total audit coverage, involving more than one million audits annually. The IRS has a number of limited-contact programs in addition to correspondence audits, including programs on mathematical/clerical error abatement, unallowable items, information returns and the earned income credit; see Saltzman, IRS Practice and Procedure (Warren, Gorham & Lamont, 2d ed., 1991). Under these programs, Service Centers look for readily identifiable problems that can be resolved via correspondence. For example, under the unallowable items program, the Service questions items on individual returns that appear to be unallowable by law. Taxpayers whose returns are identified as containing unallowable items under this program are contacted by correspondence, and corrections are made to the return. Tax advisers should note that the IRS does not consider correspondence to a taxpayer under one of these programs to be an examination of a return, regardless of whether the return was changed or accepted as filed; see Internal Revenue Manual Section 1.2.1.4.1. As such, the Service is not precluded from future examinations of the taxpayer’s return and is not subject to the second-inspection prohibition of Sec. 7605(b). CP-2000 With the increase in IRS correspondence compliance initiatives, practitioners should clearly understand the types of correspondence a client has received and respond promptly. For example, the most common IRS correspondence to taxpayers is CP-2000, Notice of Underreported Income (in effect, a 30-day letter). Failure to respond timely or in accordance with the notice’s instructions will result in the Service Center issuing a Notice of Deficiency (90-day letter) and could also subject the client to backup withholding under Sec. 3406(a)(1)(C). An amended return is rarely required; filing one at this point could result in more notices (requiring more responses) and a significant delay in resolving the issue. Due Diligence Practitioners should give a correspondence examination the same due diligence and attention as an office examination. The tax adviser should first file Form 2848, Power of Attorney and Declaration of Representative. Next, he or she should review the issues raised by the Service Center to determine if they can be reasonably responded to by correspondence. If the matters are too complex to be addressed properly without a face-to-face discussion with an examiner, the practitioner should request that the case be forwarded to the area office for examination. Converting the case to an office examination increases the possibility that the examiner will review the entire return or at least raise additional issues. The tax adviser should consider this when deciding how to proceed. Should he or she elect a correspondence examination, the response should include detailed explanations of each issue, including copies of supporting documentation, reconciliations or any other corroborating evidence that the taxpayer’s position on the return is correct. Documentation As with a face-to-face examination, the practitioner should document the examination process. Responses and supporting documentation should be sent via certified mail, return receipt requested. Telephone conferences with the Service should be documented (1) in the practitioner’s files, identifying the agent’s name and badge number and the date and results of the conversation; and (2) by a written response to the IRS contact, outlining the practitioner’s understanding of the issues discussed and the resolutions agreed to. Concluding a correspondence examination is similar to the office examination process. The Service will either accept the return as filed or issue a 30-day letter. The taxpayer then either accepts the IRS’s changes and pays the additional tax or files an appeal. Failure to respond or to file an appeal in 30 days will result in the issuance of a deficiency notice. More Changes Needed To address more completely the tax gap, additional informational reporting will be required. An Aug. 3, 2006 staff report by the Joint Committee on Taxation, “Additional Options to Improve Tax Compliance,” contains a number of proposals, including basis reporting by brokerage firms for sales of publicly traded securities and state and local government reports of real estate taxes paid; see http://finance.senate.gov/press/Gpress/2005/prg101906.pdf. This increase in informational reporting will allow the Service to enhance its correspondence compliance programs. Tax advisers should know the appropriate procedures for addressing Service Center correspondence. Just as important, however, they should minimize IRS correspondence to their clients by providing return information in a manner that allows the Service to reconcile the return with third-party information reporting. From Danny R. Snow, CPA, Thompson Dunavant PLC, Memphis, TN Prospects for repeal of the estate tax became less likely after the November 2006 elections; as a result, gifting continues to be a powerful estate planning tool. Maximizing use of the annual gift tax exclusion, using the $1 million lifetime gift tax exemption and gift-splitting by married couples, can help reduce the size of a taxable estate. The younger the individual using these tools, the better the results. Current Exclusion/Exemption Amounts The current annual gift tax exclusion is $12,000 per donee, under Sec. 2503(b)(1). This amount is indexed for inflation under Sec. 2503(b)(2) and could rise in the future. Any annual gift tax exclusion not used in a calendar year is lost; there is no carryover. The current lifetime gift tax exemption is $1 million, under Sec. 2505. This amount had been tied to the estate tax exemption, but currently is fixed at $1 million, even though the estate tax exemption is scheduled to change in the future (currently under Sec. 2010(c), $2 million for 2007 and 2008; $3.5 million for 2009; full exemption in 2010; and $1 million in 2011). Reducing the Estate Annual gift tax exclusion: Making a $12,000 gift will likely reduce the donor’s estate by more than $12,000 (because had the gift not been made, the asset would likely have increased in value). Example 1: X, a 50-year-old, makes a $12,000 gift in 2007; there is no gift tax because of the annual exclusion. If X lives to age 70, the $12,000 would otherwise have grown to $38,486, assuming a 6% annual rate. Thus, a $12,000 gift made 20 years before death would decrease the total estate by $38,486 (more than 3.2 times the original gift amount). If the gift were made 10 years before death, the estate reduction would be $21,490, approximately 1.8 times the original gift. However, because the $12,000 exclusion is available each year, a consistent gifting plan could result in a significant reduction to X’s eventual estate. Estate tax exemption: The $1 million estate tax exemption can be used now or later. To the extent that it is used during life to reduce taxable gifts, it is not available for estate tax purposes, making it somewhat less valuable than the annual gift tax exclusion. However, as with annual-exclusion gifts, asset growth from the gift date until death is removed from the estate. Example 2: Y, 50 years old, makes a $1 million gift in 2007 and elects to use his estate tax exemption; thus, he will not be subject to tax on that gift in 2007. If Y did not make the gift, but left the funds in his estate until death 20 years later, at 6% annually the amount would grow to $3,207,135. However, if Y used his $1 million exemption, the exemption available to the estate would be reduced. The net reduction in the estate would be $2,207,135 (more than 2.2 times the gift amount). If the gift were made only 10 years before Y’s death, the net reduction to the estate would be $790,848, almost 0.8 times the gift amount. Gift-Splitting Married couples can double their exclusion and exemption amounts, as each spouse is entitled to both a $12,000 annual gift tax exclusion and a $1 million estate tax exemption. If gifted assets are owned jointly, a gift would be deemed made one-half by each spouse, if the spouses meet Sec. 2513’s requirements. If an intended gift asset is not owned jointly, there are two options. The asset’s owner could transfer a one-half interest to the other spouse before a gift is made to a third party. This would be gift tax free, because transfers between spouses are exempt from gift tax, under Sec. 2523. Alternatively, the nonjoint property could be gifted outright to a third party. The non-owning spouse could elect to split the gift for gift tax purposes, thus being able to use the annual exclusion and/or $1 million exemption. The splitting election requires the spouses to file a gift tax return. Thus, the dollar amounts of estate reduction in Examples 1 and 2 above would double if both spouses maximized use of their annual exclusions and exemptions. Conclusion While there are many nontax considerations in making gifts, individuals who project a taxable estate would be well served to take advantage of the exclusion, exemption and splitting provisions in the gift tax rules. The sooner that individuals eliminate the future growth of gifted assets from inclusion in the eventual estate, the more beneficial the results. From Thomas G. Tierney, CPA, University of Wisconsin–Madison, Madison, WI |
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