As with any investment, due diligence is required. Investing in an Opportunity Zone Fund (“OZF”) is not any different.
Historically, we have seen taxpayers go to great lengths to attain tax deferral. In some instances, the efforts have resulted in significant losses. With proper due diligence, many of these losses could have been prevented.
A TALE OF IRC § 1031 EXCHANGES GONE WRONG
Tax deferral efforts under IRC § 1031 have often resulted in significant losses for unwary taxpayers. The best examples of these losses resulted from the mass Qualified Intermediary failures we saw over the last two decades.
On November 2, 2015, the Bipartisan Budget Act (“Act”) was signed into law by President Barack Obama. One of the many provisions of the Act significantly impacts: (i) the manner in which entities taxed as partnerships will be audited by the Internal Revenue Service (“IRS”); and (ii) who is required to pay the tax resulting from any corresponding audit adjustments. These new rules generally are effective for tax years beginning after December 31, 2017. As discussed below, because of the nature of these rules, partnerships need to consider taking action now in anticipation of the new rules.
The Current Landscape
Entities taxed as partnerships generally do not pay income tax. Rather, they compute and report their taxable income and losses on IRS Form 1065. The partnership provides each of its partners with a Schedule K-1, which allows the partners to report to the IRS their share of the partnership’s income or loss on their own tax returns and pay the corresponding tax. Upon audit, pursuant to uniform audit procedures enacted as part of the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”), examinations of partnerships are conducted generally under one of the following scenarios:
- For partnerships with ten (10) or fewer eligible partners, examinations are conducted by a separate audit of the partnership and then an audit of each of the partners;
- For partnerships with greater than ten (10) partners and/or partnerships with ineligible partners, examinations are conducted under uniform TEFRA audit procedures, whereby the examination, conducted at the partnership level, is binding on the taxpayers who were partners of the partnership during the year under examination; and
- For partnerships with 100 or more partners, at the election of the partnership, examinations may be conducted under uniform “Electing Large Partnership” audit procedures, whereby the examination, conducted at the partnership level, is binding on the partners of the partnership existing at the conclusion of the audit.
Lawmakers believed a change in TEFRA audit framework was necessary for the efficient administration of Subchapter K of the Code. If a C corporation is audited, the IRS can assess an additional tax owing against a single taxpayer—the very taxpayer under examination—the C corporation. In the partnership space, however, despite the possible application of the uniform audit procedures, the IRS is required to examine the partnership and then assess and collect tax from multiple taxpayers (i.e., the partners of the partnership). In fact, the Government Accountability Office (the “GAO”) reported in 2014 that, for tax year 2012, less than one percent (1%) of partnerships with more than $100 million in assets were audited. Whereas, for the same tax year, more than twenty-seven percent (27%) of similarly-sized corporations were audited. The GAO concluded the vast disparity is directly related to the increased administrative burden placed on the IRS under the existing partnership examination rules.
Earlier this week, United States Tax Court Judge Richard T. Morrison ruled, in the case of Emmanuel A. Santos v. Commissioner, T.C. Memo 2016-100 (May 17, 2016), that the government will not pay the cost of a taxpayer obtaining a law degree.
This is a pro se case. While the record was not very clear, the taxpayer, Emmanuel A. Santos, claimed he earned a degree in accounting from Indiana University in 1988. Thereafter, he began a career as a tax return preparer. In 1996, he obtained a master’s degree in taxation. Eventually, Mr. Santos expanded his tax return preparer practice to include accounting and financial planning services.
Mr. Santos attended a law school in California, graduating in 2011. He was admitted to the California Bar Association and the United States Tax Court in 2014. In 2015, Mr. Santos and his father started Santos & Santos Law Offices LLP, a law firm offering attorney, tax planning, accounting and financial planning services.
On his 2010 federal income tax return, Mr. Santos deducted, in addition to various expenses, including laundry costs, $20,275 for law school tuition and fees. On audit, many of these deductions were denied.
After likely losing at the IRS Office of Appeals, Mr. Santos headed to the United States Tax Court. The sole issue in dispute was whether the deduction of $20,275 for law school tuition and fees was allowable under Code § 162 as an ordinary and necessary business expense.
When Educational Expenses Are Considered Deductible (and When They Are Nondeductible)
Treas. Reg. § 1.162-5(a) is clear—educational expenses that either: (i) maintain or improve skills required by the taxpayer in his or her current employment; or (ii) are required by the taxpayer’s employer (or applicable law) as a condition to continued employment or rate of compensation, are deductible. On the other hand, certain types of educational expenses are expressly nondeductible, including expenses for education that qualify the taxpayer for a new trade or business. Treas. Reg. § 1.162-5(b)(1) provides examples of these nondeductible educational expenses. One of the examples set forth in the regulations specifically references a taxpayer practicing accounting who pursues a law degree. The costs of attending law school are nondeductible because the course of study qualifies the taxpayer for a new trade or business. The law degree is not required to continue practicing accounting.
Previous Tax Court Holdings
Judge Morrison cited numerous cases where the courts have held, consistent with the Treasury Regulations, a law degree qualifies a taxpayer for a new trade or business, and thus the cost of the degree is a nondeductible educational expense. This is true, even if the degree improves the taxpayer’s accounting and tax skills, and the taxpayer remains practicing accounting (i.e., never practices law). See e.g., Taubman v. Commissioner, 60 T.C. 814 (1973).
Despite the clear language of the Treasury Regulations and the numerous cases supporting the government’s position, Mr. Santos brought his case to the United States Tax Court. He appears to have argued that the holdings in the cases where the court relied upon the Treasury Regulations are incorrect because the regulations are invalid. Mr. Santos’s argument, at first blush, appeared intriguing to me. By gosh, I recently won an Oregon Tax Court case invalidating a long-existing administrative rule (which is akin to Treasury Regulations).
Shortly after Treasury promulgated Treasury Regulation § 1.162-5, the United States Tax Court ruled that it was valid. The Ninth Circuit Court of Appeals affirmed the tax court’s conclusion. See Weiszmann v. Commissioner, 52 T.C. 1106 (1969), aff’d 443 F.2d 29 (9th Cir. 1971).
Giving It the Old College Try
Mr. Santos argued that the court in Weiszmann employed the wrong standard to examine the validity of the regulation at issue. Unfortunately for him, the tax court quickly dismissed the argument without much discussion. Then, Mr. Santos asserted that Treasury failed to adequately respond to public comments before finalizing the regulations at issue, thus making the regulations invalid. Unfortunately, Mr. Santos did not raise that issue until after the trial had concluded. Consequently, the trial court record contained no evidence upon which the tax court could even evaluate his assertion. While his argument was creative and certainly intriguing, it never gained any traction. If he had offered evidence on the issue at trial, the tax court’s opinion would have been a much more interesting read. Who knows if any evidence exists to support his assertion of invalidity – Mr. Santos lost!
The clear take-away from this case is that: educational expenses are generally only deductible if they are incurred to maintain or improve the skills required for current employment or to retain current employment or current compensation. The costs of education required to prepare for a new trade or business are generally nondeductible.
The outcome of these cases is generally dependent upon the facts and circumstances. For example, if Mr. Santos had been a practicing tax lawyer (i.e., had already obtained his J.D. degree, had already passed the bar examination and was practicing as a tax lawyer), the costs of obtaining his LL.M. (taxation) may have been deductible.
Many nuances exist in this area of tax law. Consequently, careful analysis is required.
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
- "Tax Law Update for Family Law Practitioners," Oregon State Bar - Family Law Section 2019 Annual ConferenceSunriver, OR, 10.10.19-10.12.19
- "The Road Between Subchapter C and Subchapter S – It May Be a Well-Traveled Two-Way Thoroughfare, but It Isn’t Free of Potholes and Obstacles," New York University 78th Institute on Federal TaxationNew York, NY, 10.20.19-10.25.19
- "The Road Between Subchapter C and Subchapter S – It May Be a Well-Traveled Two-Way Thoroughfare, but It Isn’t Free of Potholes and Obstacles," Oregon Society of Certified Public Accountants (OSCPA) 2019 Northwest Federal Tax ConferencePortland, OR, 10.28.19
- "The Road Between Subchapter C and Subchapter S – It May Be a Well-Traveled Two-Way Thoroughfare, but It Isn’t Free of Potholes and Obstacles," New York University 78th Institute on Federal TaxationSan Francisco, CA, 11.10.19–11.15.19
- "The Oregon Corporate Activity Tax," Oregon Society of Certified Public Accountants (OSCPA) 2020 OSCPA State & Local Tax ConferencePortland, OR, 1.6.20