The Tax Cuts and Jobs Act (“TCJA”) creates the need for tax planning with respect to several major life-changing activities individuals may encounter, including marriage, divorce, home ownership, casualty losses, medical expenses and parenting. More specifically, the TCJA makes major changes to the existing framework of personal exemptions and itemized deductions, the child tax credit, the tax treatment of alimony and spousal maintenance payments made as a result of divorce, and the alternative minimum tax (“AMT”).
The primary focus of this blog post is the provisions of the TCJA that significantly impact families and individuals. Many of these provisions have been exhaustively reviewed by other commentators in the past several weeks. In those instances, our discussion is brief. Rather, we decided to place the bulk of our discussion on the less obvious provisions of the TCJA that may have significant impact on families and individuals.
The Tax Cuts and Jobs Act (“TCJA”) creates, modifies or eliminates a number of employment and employee fringe benefit related provisions of the Code. Both employers and employees need to be aware of these changes. Accordingly, this installment of our ongoing review and analysis of the TCJA focuses on these employer and employee fringe benefit provisions.
“Neither a borrower nor a lender be…” or at least, if you insist on borrowing (and we understand the appeal), we are here to help you stay abreast of the new rules on deducting interest.
Interest on a business or investment related debt is, in most instances, a deductible expense of the borrower and taxed as income to the lender. With a few exceptions, such as mortgage interest on a personal residence, borrowers generally cannot deduct personal interest. A borrower’s deduction is subject to a number of limitations set forth in Code Section 163. The Tax Cuts and Jobs Act (“TCJA”) has changed some of these limitations.
Before the enactment of the TCJA, nondeductible interest included any interest on a taxpayer’s debt not arising from a trade or business, home mortgage, investment activity, or qualified student loans (in other words, interest arising from those debts was deductible).
The Tax Cuts and Jobs Act (“TCJA”) adopted a new 20% deduction for non-corporate taxpayers. It only applies to “qualified business income.” The deduction, sometimes called the “pass-through deduction,” is found in IRC § 199A. There has been a significant amount of media coverage of this new deduction. Rather than repeat what you have undoubtedly already read or heard, we chose to focus this blog post on the not so obvious aspects of IRC § 199A—the numerous pitfalls and traps that exist for the unwary.
Under IRC § 708(a), a partnership is considered as a continuing entity for income tax purposes unless it is terminated. Given the proliferation of state law entities taxed as partnerships today (e.g., limited liability companies and limited liability partnerships), a good understanding of the rules surrounding termination is ever important.
Prior to the Tax Cuts and Jobs Act (“TCJA”), IRC § 708(b)(1) provided that a partnership  was considered terminated if:
1. No part of any business, financial operation, or venture of the partnership continues to be carried on by any of the partners of the partnership; or
2. Within any 12-month period, there is a sale of exchange of 50% or more of the total interests of the partnership’s capital and profits.
Please join me on June 29, 2017 in Portland, Oregon, for what will be a dynamic presentation on the new partnership audit rules by Jerald August. Jerry is a Partner in the preeminent New York City-based boutique tax firm Kostelanetz & Fink, LLP. He has served as a chair of NYU's Institute on Federal Taxation for a number of years and specializes in federal and state income taxation, including taxation of pass-thru entities and tax controversy. Jerry is not only one of the brightest tax lawyers you will ever meet, he is an outstanding speaker. We are very fortunate to have him present at the Portland Tax Forum on this important topic. We all need to learn about the new partnership audit rules – they come into play on January 1, 2018.
As a general rule, in accordance with IRC § 162(a), taxpayers are allowed to deduct, for federal income tax purposes, all of the ordinary and necessary expenses they paid or incurred during the taxable year in carrying on a trade or business. There are, however, numerous exceptions to this general rule. One exception is found in IRC § 280E. It provides:
“No deduction or credit shall be allowed for any payment paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any state in which such trade or business is conducted.”
Congress enacted IRC § 280E as part of the Tax Equity and Fiscal Responsibility Act of 1982, in part, to support the government’s campaign to curb illegal drug trafficking. Even though several states have now legalized medical and/or recreational marijuana, IRC § 280E may come into play. The sale or distribution of marijuana is still a crime under federal law. The impact of IRC § 280E is to limit the taxpayer’s business deductions to the cost of goods sold.
On October 22, 2015, the U.S. Tax Court issued its opinion in Canna Care, Inc. v. Commissioner, T.C. Memo 2015-206. In that case, Judge Haines was presented with a California taxpayer that is in the business of selling medical marijuana, an activity that is legal under California law.
The facts of this case are interesting. Bryan and Lanette Davies, facing significant financial setbacks and hefty educational costs for their six (6) children, turned to faith for a solution. After “much prayer,” Mr. Davies concluded that God wanted him to start a medical marijuana business. Unfortunately, it does not appear that he consulted with God or a qualified tax advisor about the tax implications of this new business before he and his wife embarked upon the activity.
The good news for the Davies is that their business blossomed. In fact, they employ ten (10) people in the business and have enjoyed financial success. They timely filed state and federal income tax returns, reported income and paid, what they believed, was the proper amount of taxes. The bad news for the Davies is the fact that the IRS did not agree with their computation of the tax liability.
The IRS issued a notice of deficiency. Not able to resolve the matter at IRS appeals, the Davies found themselves in the U.S. Tax Court. The sole issue in the case was whether the taxpayers’ business deductions were properly disallowed by the Service under IRC § 280E.
To no avail, the Davies presented numerous arguments as to why marijuana should no longer be a controlled schedule I substance. They also asserted that their new business created employment opportunities for others, cured their family’s financial woes, and allowed them to participate in civic and charitable activities.
Judge Haines quickly dismissed the Davies’ arguments, concluding the sale of marijuana is prohibited under federal law—marijuana is a schedule I controlled substance. Accordingly, IRC § 280E prevents taxpayers from deducting the expenses incurred in connection with such activity (other than the cost of goods sold).
Faced with a tax assessment exceeding $800,000, the Davies argued that their business does more than sell marijuana. In fact, it sells books, shirts and other items related to medical marijuana. Citing other cases, they argued that their expenses should be apportioned among the various activities (i.e., the sale of medical marijuana and the sale of other items), and that they should be able to deduct the expenses related to the sale of the non-marijuana items.
The court explained that, where a taxpayer is involved in more than one distinct trade or business, it may be able to apportion its ordinary, necessary and reasonable expenses among the different trades or businesses. Unfortunately for the Davies, they could not show that they operated two (2) or more trades or businesses. In this case, the facts indicated that the sale of shirts, books and other items was merely incidental to the sale of medical marijuana. There was not more than one (1) trade or business.
PRACTICE ALERT: Whether more than one (1) trade or business exists is a question of facts and circumstances. Under CHAMP v. Commissioner, 128 T.C. 182 (2007), if a taxpayer operates more than one (1) distinct trade or business, it may be allowed to apportion its expenses among the trades or businesses. If only one (1) of the businesses is impacted by IRC § 280E, only the expenses relating thereto should be denied. The key is establishing that more than one (1) trade or business exists, and reasonably be able to apportion the expenses among those trades or businesses. Keeping separate books and records, and accounting for business expenses in a separate manner, is likely the best approach. The more separation and distinction among the businesses the better the chances of showing more than one (1) trade or business exists. Maintaining separate entities or business names for each activity may be warranted.
The Davies lost the case and are now faced with a hefty tax bill. Unless IRC § 280E is amended, taxpayers involved in the sale of medical and/or recreational marijuana, despite state legalization, will be presented with the same dilemma faced by the Davies in Canna Care, Inc. v. Commissioner.
IRC § 6656(a) provides, in the case of any failure to timely deposit employment taxes, unless the failure is due to “reasonable cause and not due to willful neglect,” a penalty shall be imposed. The penalty is a percentage of the amount of underpayment.
- 2% for failures of five (5) days or less;
- 5% for failures of more than five (5) days, but less than 15 days;
- 10% for failures of more than 15 days; and
- 15% for failures beyond the earlier of: (i) 10 days after receipt of the first delinquency notice under IRC § 6303; or (ii) the day on which notice and demand is made under IRC §§ 6861, 6862 or 6331(a)(last sentence)(jeopardy assessment).
In addition to the “reasonable cause” exception contained in IRC § 6656(a), there are two other means by which taxpayers may avoid the imposition of the penalty.
1. Secretary has authority under IRC § 6656(c) to waive the penalty if:
- The failure is inadvertent;
- The return was timely filed;
- The failure was the taxpayer’s first deposit obligation or the first deposit obligation after it was require to change the frequency of deposits; and
- The taxpayer meets the requirements of IRC § 7430(c)(4)(A)(ii) [submits a request within 30 days and comes within certain net worth parameters].
2. The Secretary has authority under IRC § 6656(d) to waive the penalty if:
- The taxpayer is a first time depositor; and
- The amount required to be deposited was inadvertently sent to the Secretary instead of the appropriate government depository.
As the exceptions are limited in application, most taxpayers seeking abatement of the penalty are required to pursue the “reasonable cause” exception.
On April 4, 2014, the Chief Counsel’s Office issued Chief Counsel Advice 201414017 (CCA). The CCA offers guidance on this topic. Unfortunately, the guidance reflects the Service’s position that the “reasonable cause” exception under IRC § 6656(a) is narrow.
In the CCA, the taxpayer was subjected to a IRC § 6656(a) penalty when it failed to timely deposit employment taxes as the result of some of its employees exercising nonqualified stock options. The taxpayer claimed “reasonable cause” existed because its failure to timely deposit employment taxes was the error of its third-party payroll service. The taxpayer bolstered its position with two important facts.
- Its deposits had always been timely filed in the past; and
- The taxpayer immediately remedied the failure upon learning of it and
instituted procedures to avoid future repetition of the failure.
The Service commended the taxpayer for its historic compliance and its prompt remedial efforts. It concluded, however, that “[t]hese actions may amount to the exercise of ordinary business care that the reasonable cause defense requires and to the absence of willful neglect. The reasonable cause defense, however, also requires the taxpayer to demonstrate that despite its exercise of ordinary business care and prudence, it was ‘rendered unable to meet its responsibilities.’” The General Counsel’s Office ultimately concluded the taxpayer was liable for the penalty. It stated that the taxpayer’s reliance on its third-party payroll service provider is insufficient to obtain a penalty waiver as the reliance did not render it unable to otherwise meet its responsibilities.
Next, the General Counsel’s Office looked at whether the taxpayer could raise the first-time depositor defense under IRC § 6656(c) on examination rather than be required to wait until an assessment has been issued. It concluded, on the basis of administrative efficiency, the defense may be raised by the taxpayer on audit and the examiner should grant the request when appropriate.
The moral to the story is two-fold. First, the “reasonable cause” exception may be difficult to obtain. Whether it exists requires a facts and circumstances analysis. The burden of proof is on the taxpayer.
Reliance on third parties alone is generally insufficient. Likewise, failures due to mistake, ignorance of the laws or forgetfulness will not carry the day. Also, a taxpayer’s financial problems alone will generally not constitute “reasonable cause.”
The “reasonable cause” exception is narrow. Failures resulting from matters totally outside the taxpayer’s control appear to be required in order to obtain this penalty waiver. Examples of qualifying “reasonable cause” likely include situations where an otherwise compliant taxpayer, with adequate payroll procedures in place, encounters a natural disaster (e.g., fire, flood, storm), rendering it unable to process payroll and make the required deposits in a timely manner. Other examples of “reasonable cause” may include: (i) the death or serious illness of the taxpayer or the taxpayer’s immediate family; (ii) inability of the taxpayer to obtain necessary records due to no fault of the taxpayer; or (iii) embezzlement by the bookkeeper when and only when the taxpayer has reasonable protections in place.*
Second, taxpayers should raise the first time depositor defense, if applicable, on audit. The examiner should be able to accept the defense if the taxpayer qualifies. As confirmed by General Counsel’s Office, taxpayers are not required to wait for an actual assessment before raising this defense.
The courts presented with the “reasonable cause” exception to the imposition of a penalty under IRC § 6656(a) have taken varying positions—some more taxpayer friendly than others. The Service, however, is clearly taking a narrow view of the exception, leading to less taxpayer friendly results. Caution is advised.
*Reliance on a bookkeeper who embezzled funds from the taxpayer was not reasonable cause because the taxpayer did not have adequate checks and balances in place to prevent the embezzlement. Leprino Foods Co. v. U.S., 85 AFTR 2d 2000-1729 (D. Colo. 2000). Financial difficulties when adequate funds existed, but the taxpayer decided to use the funds for other things, trumped a reasonable cause defense. Van Camp & Bennion, P.S. v. U.S., 251 F.3d 862 (9th Cir. 2001). Failure of the bookkeeper delegated the responsibility of making deposits does not constitute reasonable cause when the bookkeeper was supervised by the owners of taxpayer and the outside CPA. Janet Nesse v. IRS, 93AFTR 2d 2004-1022 (DC MD 2004).
On March 3, 2014, the Internal Revenue Service published Announcement 2014-13 (“Announcement”). The Announcement sets forth the disciplinary actions the Office of Professional Responsibility (“OPR”) recently took against practitioners.
The OPR is responsible for interpreting and applying the Treasury Regulations governing practice before the Internal Revenue Service (commonly known as “Circular 230”). It has exclusive responsibility for overseeing practitioner conduct and implementing discipline. For this purpose, practitioners include attorneys, certified public accountants, enrolled agents, enrolled actuaries, appraisers, and all other persons representing taxpayers before the Internal Revenue Service.
In essence, Circular 230 sets forth the “rules of the road” for tax practice before the Service. Circular 230 cases generally revolve around a practitioner’s fitness to practice.
The OPR is comprised of three major divisions:
- Office of the Director;
- Legal Analysis Branch; and
- Operations and Management Branch.
The Director, currently Karen Hawkins, has primary supervisory responsibility for OPR. She reports to the Commissioner and Deputy Commissioner of the Internal Revenue Service. Ms. Hawkins’ authority includes oversight and control of OPR policy decisions.
The Legal Analysis Branch is tasked with the interpretation and application of Circular 230 in the cases involving practitioners. Jack Manhire is currently the Chief of the Legal Analysis Branch.
The Chief of the Operations and Management Branch is currently Robert Johnson. This group manages OPR’s administration, communications, budgetary and personnel functions.
OPR’s authority and case determinations are independent of the Internal Revenue Service enforcement functions. Referrals to OPR, alleging practitioner violations of Circular 230, typically come from two sources:
- Internal sources (e.g., Internal Revenue Service Examination Division); and
- External sources (e.g., taxpayers, boards of accountancy, practitioners, etc.).
Following receipt of a referral, the OPR is tasked with determining, based upon the facts and circumstances, whether a violation of Circular 230 occurred, whether the violation is one which calls into question the practitioner’s fitness to practice, and the appropriate sanction, if any. The life of a referral generally takes the following path:
- The OPR performs a preliminary investigation of the facts and circumstances to determine whether it is likely a violation of Circular 230 occurred.
- If the OPR determines that a violation of Circular 230 likely occurred, it notifies the practitioner and gives the practitioner an opportunity to present evidence to support his or her case.
- After taking into consideration its investigatory findings and information presented by the practitioner, the OPR determines the level of discipline, if any, to apply to the case.
- If the OPR and the practitioner do not agree to an appropriate sanction, OPR prepares a complaint and refers the matter to the General Legal Services Division of the Office of Chief Counsel.
- The Office of Chief Counsel will generally attempt to work with the practitioner, giving him or her another opportunity to resolve the matter. If a resolution is not reached, however, the Office of Chief Counsel files the complaint so that the matter is presented to an administrative law judge (“ALJ”) in accordance with the Administrative Procedures Act.
- The parties can always settle the case during the pendency of the ALJ proceeding.
- If the case is not resolved, a hearing before the ALJ will occur. The ALJ, after hearing the case, issues a decision commonly referred to as the “Initial Decision and Order.”
- Either the OPR or the practitioner may appeal the ALJ decision to the Treasury Appellate Authority. In such event, the Treasury Appellate Authority reviews the case and issues what is commonly referred to as the “Final Agency Decision.” The text of the Final Agency Decision is made available to the public.
- The practitioner may appeal a Final Agency Decision to the U.S. District Court. The proceeding is not, however, a trial de novo. Consequently, the court will only review the findings of fact on the record in the ALJ proceeding and will only set aside the decision if it was arbitrary or capricious, contrary to law, or an abuse of discretion.
- The burden of proof in these cases is on the OPR. It must show the practitioner willfully violated Circular 230 by “clear and convincing evidence.”
- The sanctions against a practitioner in these cases generally include: disbarment or suspension of practice before the Internal Revenue Service; censure (public reprimand); and/or imposition of monetary penalties.
The types of matters referred to the OPR include, without limitation, practitioners involved in promoting abusive tax shelters, preparing and filing frivolous tax returns, willfully attempting to evade any federal tax, diverting taxpayer refunds, repeated patterns of misconduct, and willful violations of Circular 230.
As reflected in the Announcement, during the last half of 2013, three enrolled agents, seven CPAs, three unenrolled preparers, and three attorneys were subjected to OPR discipline. This included 11 suspensions and 5 disbarments.
The Announcement illustrates the high stakes. Practitioners must pay careful attention to Circular 230 and their obligations thereunder.
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.
Upcoming Speaking Engagements
- Palm Beach, FL, 4.13.18-4.15.18
- "What Family Law Practitioners Need to Know About the New Tax Laws," American Academy of Matrimonial Lawyers 9th Bi-Annual Continuing Legal Education ProgramPortland, OR, 4.20.18
- "Planning Using IRC Section 1031 Exchanges," Oregon Society of Certified Public Accountants (OSCPA) Forest Products ConferenceEugene, OR, 6.22.18