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On June 19, 2014, San Francisco tax attorney, James P. Kleier, entered into a plea agreement with the government for his failure to file tax returns and pay income taxes.  Per the agreement, Mr. Kleier will be imprisoned at the Atwater Federal Corrections Institution for 12 months commencing September 18, 2014.  Following release from prison, he will be subject to a 1-year supervised parole.  In addition, Mr. Kleier is required to pay the IRS a total $650,993.

Mr. Kleier was a partner in the San Francisco law office of Preston Gates & Ellis LLP (now known as K&L Gates LLP) from 1999 to 2005.  Thereafter, he practiced law in the San Francisco office of Reed Smith LLP.  Both of these organizations are large prestigious international law firms.  According to the complaint filed by the government in the U.S. District for the Northern District of California, tax attorney Kleier failed to report income of more than $1.3 million while practicing law at these firms.  Specifically, he earned $624,923 in 2008; $476,088 in 2009; and $200,734 in 2010.  Nevertheless, he failed to file tax returns for these years and pay the taxes due and owing.

Mr. Kleier is not a novice attorney.  He is a seasoned tax practitioner and has handled several significant high-profile tax cases.  For example, Mr. Kleier represented the City of San Francisco in its battle with Macy’s over a significant property tax matter, and he represented Microsoft in a hotly-contested California unitary tax case.  Also, attorney Kleier has taught tax courses at both Golden Gate University and the Hastings College of Law.  In addition, he is the author of several articles on tax matters.

For his bad deeds, attorney Kleier made the infamous list of the top 250 delinquent California taxpayers.  According to California public records, he now joins the ranks of prominent taxpayers like singer Dionne Warwick and actor Burt Reynolds.  Also, as stated above, he now owes the government over $650,000 in taxes, interest and penalties.  In addition, he will be spending a year in the slammer.

IRS Special Agent-in-Charge José M. Martinez said, when interviewed about the case:  “The prosecution of individuals who brazenly attempt to avoid their tax filing and payment obligations and prevent the IRS from performing its mission is necessary to maintaining public confidence in our tax system.”  No doubt, the fact that the taxpayer in this case was a prominent tax attorney, played a role in the outcome.

The morale to the story is simple:  Tax practitioners should know better!  It is quite likely that a tax practitioner who finds himself or herself in this predicament will not be treated leniently.  Mr. Kleier is proof of this hypothesis.

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.

 

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.

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Larry Brant
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Larry J. Brant is a Shareholder in Garvey Schubert Barer, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; New York, New York; Washington, D.C.; 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.

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