House Ways and Means Committee Chairman David Camp issued a discussion draft of the Tax Reform Act of 2014 earlier this year. The proposed legislation spans almost 1,000 pages.* One of its provisions repeals IRC § 1031 and taxpayers’ ability to participate in tax-deferred exchanges. The Obama Administration responded to Chairman Camp’s proposal. It wants to retain IRC § 1031, but limit its application to $1,000,000 of tax deferral per taxpayer in any tax year. Based upon the precise wording of the White House’s response to Chairman Camp’s proposal, it appears the $1,000,000 limitation would only apply to real property exchanges. So, personal property exchanges would be spared from the proposed limitation. Of course, there is always the possibility that lawmakers, if they take this approach, would expand the White House’s proposed limitation to apply to personal property exchanges. Only time will tell.
Despite this talk, many practitioners believe IRC § 1031 will survive tax reform unscathed. After reviewing a recent report issued by the Treasury Office of Tax Analysis (“OTA”), I am not convinced IRC § 1031 will remain unchanged in any tax reform legislation enacted by lawmakers.
In its report, Treasury points out that tax deferral under IRC § 1031 is not considered a tax expenditure for purposes of the federal budget. The Joint Committee on Taxation (“JCT”), however, does not adopt this approach. Rather, it considers the gain deferral from IRC § 1031 exchanges as a tax expenditure. For 2014, the JCT estimates IRC § 1031 will result in a federal tax expenditure of about $8.7 billion. That number is large enough to get the attention of lawmakers.
The OTA report primarily focuses on 2007. In that year, it found:
- Total IRC § 1031 tax deferral amounted to about $82.6 billion.
- $25.8 billion was claimed by C corporations.
- $35.6 billion was claimed by partnerships.
- $21.2 billion was claimed by individuals.
- Over one half of the tax deferral claimed by C corporations related to vehicle exchanges (e.g., car rental companies or businesses with large fleets of trucks and/or automobiles).
- Banks are a significant user of IRC § 1031 exchanges (primarily exchanges of automobile fleets).
- Real estate exchanges accounted for almost 90% of the exchanges conducted by partnerships.
- Nearly $10.6 billion of the gain deferred by individuals related to residential rental properties.
- Over 90% of all individual exchanges involved real estate.
- Tax deferral from real estate dramatically decreased from 2007 to 2010 due to the recession, but interestingly, during this same period, tax deferral by corporations increased by about $3.5 billion due to an increase in vehicle exchanges.
The OTA report makes one thing crystal clear--IRC § 1031 exchanges result in a significant amount of gain deferral. Accordingly, eliminating or limiting exchanges could be a significant source of tax revenue. Treasury is obviously closely analyzing IRC § 1031 for this very reason.
Tax practitioners that believe IRC § 1031 will remain unchanged, if and when we see tax reform, may be unrealistic. Given these huge numbers and the JCT’s view of exchanges (i.e., they result in a tax expenditure), it is not farfetched to conclude there is a high probability tax reform will result in the repeal of IRC § 1031 as Chairman Camp proposes or a significant limitation on the amount of tax deferral as the Obama Administration proposes. STAY TUNED!
*For a more detailed discussion of the proposed legislation, see: http://www.larrystaxlaw.com/2014/02/are-we-going-to-see-tax-reform-2014
Thomas v. Commissioner, TC Memo 2013-60 (February 26, 2013)
The saga of Michael and Julie Thomas started in the early part of this decade. Michael was the head of real estate acquisition for DBSI in Idaho. There, he met fellow DBSI employee Don Steeves, who was a CPA with seven (7) years of experience, primarily working in the real estate investment industry. When Michael started two real estate businesses, TIC Capital ("TIC") and TICC Property Management ("TICC"), he hired Steeves as an independent contractor to serve as CFO of TIC and as the managing partner of TICC. His compensation was incentive based—he received compensation which was based on the financial success of the two businesses. In good years, Steeves’ compensation was off the charts. In addition to acting as CFO for the two businesses, Steeves prepared Michael’s and Julie’s income tax returns. They relied upon him to oversee all aspects of accounting and tax compliance for both of the businesses and their personal affairs. They let him take total control of these functions.
TIC acquired real estate and then broke it into tenancy-in-common interests, and sold the interests to passive investors who were generally acquiring property through Section 1031 exchanges. In most cases, the acquisition and resale of the tenancy-in-common interests occurred simultaneously. After the properties were sold, TICC would manage the properties for the tenancy-in-common owners for a fee.
While the economy and the real estate markets were hot, both of the companies made significant profits. As we all know, the booming economy and real estate markets did not last forever.
In September 2007, Steeves resigned from the two businesses, but continued to perform bookkeeping work for both of the businesses, as well as for Michael and Julie, until about March 2008. He continued to prepare the Thomas’s tax returns until about 2009.
In late 2008, the IRS entered the picture. It audited the Thomas’s 2006 and 2007 income tax returns. Guess who appeared on IRS Form 2848 (Power of Attorney and Declaration of Representative) for the Thomas’s? You guessed correctly – CPA Don Steeves!
The IRS quickly learned the tax returns did not comport to the Thomas’s business records. Upon learning this, Mr. Thomas demanded CPA Steeves produce accounting records to support the entries he placed on their tax returns. Apparently, CPA Steeves did not comply with the Service’s request.
Mr. Thomas hired a CPA named Dave Stewart to take over the audit. Mr. Stewart, who had thirty-four (34) years of experience, quickly learned that CPA Steeves did a very poor job of maintaining the accounting records for Michael and Julie and likely misappropriated funds. He worked with the auditor and they ultimately agreed to a tax deficiency for both years under review.
Michael and Julie eventually turned the matter over to the Boise Police Department; they alleged CPA Steeves had committed theft, fraud, and misappropriation of their funds. Also, they sued Don Steeves in a civil suit for more than $1.2 million.
This case focused on the applicability of the Code Section 6662 accuracy-related penalty.
Under Code Section 6662(a), a taxpayer is liable for a 20% penalty on any under-payment of tax attributable to:
- negligence; or
- disregard of rules or regulations; or
- a substantial underpayment of a tax. For this purpose, a substantial underpayment of tax is an underpayment which is more than the greater of: 10% of the tax required to be shown; or $5,000.
There is a major exception to the application of this penalty. The penalty does not apply to any portion of an underpayment of tax if it is shown the underpayment was due to reasonable cause and the taxpayer acted in good faith.
In this case, Michael and Julie Thomas alleged they relied upon Don Steeves, an experienced tax advisor. They turned all accounting and tax matters over to him. Accordingly, they argued that they acted with reasonable cause and in good faith. They had no reason to believe that Mr. Steeves was other than competent and honest.
Reliance on the advice of a tax professional may establish reasonable cause and good faith. In accordance with Treasury Regulation Section 1.6664-4(b)(1), if a taxpayer relies upon the professional judgment of a competent tax advisor who has been provided all of the necessary and relevant information, the taxpayer will generally be cleared of an accuracy-related penalty.
To prove “reasonable reliance,” the taxpayer must jump over three hurdles:
Hurdle #1: The tax advisor must have sufficient experience or expertise to justify reliance;
Hurdle #2: The taxpayer must have provided the advisor with the necessary and accurate information; and
Hurdle #3: The taxpayer must have relied in good faith on the tax advisor’s guidance.
Here, Don Steeves was a CPA; he had 7 years of experience in the real estate industry. Mr. Thomas knew CPA Steeves from his work with DBSI. According to testimony at trial, Mr. Thomas provided Mr. Steeves with all documents and information he requested, including mortgage and interest records.
So, the court concluded Hurdle #1 and Hurdle #2 were met. Steeves had sufficient experience and expertise. Also, the taxpayers provided him with all of the information required to accurately prepare the tax returns. The ultimate question came down to whether the Thomas’s reliance upon CPA Steeves was in good faith.
In this case, Michael and Julie Thomas gave CPA Steeves their power of attorney at the outset of the audit. It was not until the IRS uncovered the numerous return problems that Mr. Thomas terminated Mr. Steeves, instituted a civil lawsuit against him, and went to the police so criminal action could be pursued. Before that, Michael and Julie believed in Don Steeves and they relied upon him.
Judge Gerber of the US Tax Court concluded that Michael and Julie Thomas met their burden and showed they had acted in good faith and with reasonable reliance on the advice of a professional tax advisor. Consequently, the Code Section 6662 penalty was tossed out.
This is a textbook case for applying the reasonable reliance defense to a Code Section 6662 penalty. The Tax Court clearly and thoughtfully reviewed the elements of the reliance defense. So, this decision should serve as a good textbook reference if you come across a case where the defense may be viable. The take-away is simple: The accuracy-related penalty does not apply to any portion of an underpayment of tax where the taxpayer acted with reasonable cause and in good faith. A reasonable cause determination takes into account all of the relevant facts and circumstances. The taxpayer claiming reliance on a tax professional must prove that:
- The tax adviser was a competent professional who had sufficient expertise to justify reliance;
- The taxpayer provided necessary and accurate information to the tax adviser; and
- The taxpayer actually relied in good faith on the tax adviser’s judgment.
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
- "S Corporation Distributions – The Ins and Outs," New York University 77th Institute on Federal TaxationNew York, NY, 10.21.18-10.26.18
- "Developments in the World of IRC Section 1031 Exchanges, including the Impact of the Tax Cuts and Jobs Act," IRS Tax Practitioners ForumPortland, OR, 10.31.18
- Portland, OR, 11.5.18
- "The Tax Cuts and Jobs Act – What It May Mean to Your Clients," Estate Planning Council of Portland Mini-SeminarPortland, OR, 11.7.18
- "What a Family Law Practitioner Needs to Know About the Tax Cuts and Jobs Act," Clackamas County Bar Association Fall ConferenceOregon City, OR, 11.8.18
- "S Corporation Distributions – The Ins and Outs," New York University 77th Institute on Federal TaxationSan Diego, CA, 11.11.18-11.16.18