Federal Tax Bulletin - Issue 167 - April 2, 2018

President Signs $1.3 Trillion Spending Bill Featuring Extensive Technical Tax Corrections

On March 23, 2018, President Trump signed into law the Consolidated Appropriations Act of 2018 (CAA). In addition to funding the federal government through September 30, 2018, the $1.3 trillion spending bill also makes technical corrections to numerous tax bills enacted over the past fifteen years. Most notably, CAA fixes the Code Sec. 199A "grain glitch" that created a disparity between farmers marketing products to cooperatives versus farmers marketing products to non-cooperatives, enacts major changes to the centralized partnership audit regime rules, and makes extensive corrections to the PATH Act of 2015. Pub. L. 115-141.

I. Fixing the "Grain Glitch"

TCJA created a new deduction in Code Sec. 199A called the qualified business income deduction. As enacted, for tax years beginning after December 31, 2017, and before January 1, 2026, Code Sec. 199A provides a deduction to any specified agricultural or horticultural cooperative equal to the lesser of (1) 20 percent of the excess (if any) of the gross income of a specified agricultural or horticultural cooperative over the qualified cooperative dividends paid during the tax year for the tax year, or (2) the greater of 50 percent of the W-2 wages paid by the cooperative with respect to its trade or business, or the sum of 25 percent of the W-2 wages of the cooperative with respect to its trade or business plus 2.5 percent of the unadjusted basis immediately after acquisition of qualified property of the cooperative. The cooperative's Code Sec. 199A(g) deduction may not exceed its taxable income for the tax year.

A specified agricultural or horticultural cooperative is an organization to which Code Sec. 1381, Code Sec. 1382, and Code Sec. 1383 apply and that is engaged in (1) the manufacturing, production, growth, or extraction in whole or significant part of any agricultural or horticultural product, (2) the marketing of agricultural or horticultural products that its patrons have so manufactured, produced, grown, or extracted, or (3) the provision of supplies, equipment, or services to farmers or organizations described in the foregoing.

An unintended consequence of the provision in TCJA was that it created a disparity between marketing products to cooperatives versus non-cooperatives. This became known as the "grain glitch."

To resolve the "grain glitch," the Section 101 of CAA modifies the deduction for qualified business income of a specified agricultural or horticultural cooperative under Code Sec. 199A(g) to provide a deduction for qualified production activities income of a specified agricultural or horticultural cooperative that is similar to the deduction for qualified production activities income under former Code Sec. 199. The modification is effective as if originally included in TCJA, that is, for tax years beginning after December 31, 2017.

CAA provides a deduction from taxable income that is equal to nine percent of the lesser of the cooperative's qualified production activities income or taxable income (determined without regard to the cooperative's Code Sec. 199A(g) deduction and any deduction allowable under Code Sec. 1382(b) and Code Sec. 1382(c) (relating to patronage dividends, per-unit retain allocations, and nonpatronage distributions)) for the tax year. The amount of the deduction for a tax year is limited to 50 percent of the W-2 wages paid by the cooperative during the calendar year that ends in such tax year. For this purpose, W-2 wages are determined in the same manner as under the other provisions of section 199A, except that such wages do not include any amount that is not properly allocable to domestic production gross receipts.

In the case of oil related qualified production activities income, CAA provides that the Code Sec. 199A(g) deduction is reduced by 3 percent of the least of the cooperative's oil related qualified production activities income, qualified production activities income, or tax income (determined without regard to the cooperative's Code Sec. 199A(g) deduction and any deduction allowable under Code Sec. 1382(b) and (c) (relating to patronage dividends, per-unit retain allocations, and nonpatronage distributions)) for the tax year. For this purpose, oil related qualified production activities income for any tax year is the portion of qualified production activities income attributable to the production, refining, processing, transportation, or distribution of oil, gas, or any primary product thereof during the tax year.

In general, qualified production activities income is equal to domestic production gross receipts reduced by the sum of: 

(1) the cost of goods sold that are allocable to such receipts; and 

(2) other expenses, losses, or deductions that are properly allocable to such receipts. 

Domestic production gross receipts generally are gross receipts of the cooperative that are derived from any lease, rental, license, sale, exchange, or other disposition of any agricultural or horticultural product that was manufactured, produced, grown, or extracted by the cooperative in whole or in significant part within the United States. The cooperative is treated as having manufactured, produced, grown, or extracted in whole or significant part any agricultural or horticultural products marketed by the cooperative if such items were manufactured, produced, grown, or extracted in whole or significant part by its patrons.

Domestic production gross receipts do not include any gross receipts of the cooperative derived from property leased, licensed, or rented by the taxpayer for use by any related person. In addition, domestic production gross receipts do not include gross receipts that are derived from the lease, rental, license, sale, exchange, or other disposition of land.

CAA limits the definition of "specified agricultural or horticultural cooperative" to organizations to which Code Sec. 1381, Code Sec. 1382, and Code Sec. 1383 apply that (1) manufacture, produce, grow, or extract in whole or significant part any agricultural or horticultural product, or (2) market any agricultural or horticultural product that their patrons have so manufactured, produced, grown, or extracted in whole or significant part. The definition no longer includes a cooperative solely engaged in the provision of supplies, equipment, or services to farmers or other specified agricultural or horticultural cooperatives.

CAA repeals the special deduction for qualified cooperative dividends. In addition, CAA repeals the rule that excludes qualified cooperative dividends from qualified business income of a qualified trade or business. The proposal also clarifies that items of income excluded from qualified items of income, and thus excluded from qualified business income, do not include any amount described in section 1385(a)(1) (i.e., patronage dividends). Accordingly, qualified business income of a qualified trade or business includes any patronage dividend, per-unit retain allocation, qualified written notice of allocation, or any other similar amount received from a cooperative, provided such amount is otherwise a qualified item of income, gain, deduction, or loss (i.e., such amount is (i) effectively connected with the conduct of a trade or business within the United States, and (ii) included or allowed in determining taxable income for the taxable year).

In the case of any qualified trade or business of a patron of a specified agricultural or horticultural cooperative, the deductible amount determined under Code Sec. 199A(b)(2) for such trade or business is reduced by the lesser of (1) 9 percent of the amount of qualified business income with respect to such trade or business as is properly allocable to qualified payments received from such specified agricultural or horticultural cooperative, or (2) 50 percent of the amount of W-2 wages with respect to such qualified trade or business that are properly allocable to such amount.

CAA grants specific regulatory authority to the IRS to issue regulations under Code Sec. 199A(g) including regulations that prevent more than one cooperative taxpayer from being allowed a deduction with respect to the same activity (i.e., the same lease, rental, license, sale, exchange, or other disposition of any agricultural or horticultural product that was manufactured, produced, grown, or extracted in whole or in significant part within the United States). In addition, regulatory authority is provided to address the proper allocation of items of income, deduction, expense, and loss for purposes of determining qualified production activities income. CAA provides that the regulations be based on the regulations applicable to cooperatives and their patrons under former Code Sec. 199 (as in effect before its repeal).

Example: ABC Cooperative is a grain marketing cooperative with $5,250,000 in gross receipts during 2018 from the sale of grain grown by its patrons. ABC paid $4,000,000 to its patrons at the time the grain was delivered in the form of per-unit retain allocations and another $1,000,000 in patronage dividends after the close of the 2018 tax year. ABC has other expenses of $250,000 during 2018, including $100,000 of W-2 wages. ABC has domestic production gross receipts of $5,250,000 and qualified production activities income of $5,000,000 for 2018. ABC's Code Sec. 199A(g) deduction is $50,000 and is equal to the least of nine percent of qualified production activities income ($450,000), 9 percent of taxable income ($450,000), or 50 percent of W-2 wages ($50,000). ABC passes through the entire Code Sec. 199A(g) deduction to its patrons. Accordingly, ABC reduces its $5,000,000 deduction allowable under Code Sec. 1382(b) and (c) (relating to the $1,000,000 patronage dividends and $4,000,000 per-unit retain allocations) by $50,000.

Patron's grain delivered to ABC during 2018 is two percent of all grain marketed through ABC during such year. During 2019, Patron receives $20,000 in patronage dividends and $1,000 of allocated Code Sec. 199A(g) deduction from ABC related to the grain delivered to ABC during 2018. Patron is a grain farmer with taxable income of $75,000 for 2019 (determined without regard to section 199A) and has a filing status of married filing jointly. Patron's qualified business income related to its grain trade or business for 2019 is $50,000, which consists of gross receipts of $150,000 from sales to an independent grain elevator, per-unit retain allocations received from ABC during 2019 of $80,000, patronage dividends received from ABC during 2019 related to ABC's 2018 net earnings of $20,000, and expenses of $200,000 (including $50,000 of W-2 wages). The portion of the qualified business income from Patron's grain trade or business related to qualified payments received from ABC during 2019 is $10,000, which consists of per-unit retain allocations received from ABC during 2019 of $80,000, patronage received from ABC during 2019 related to ABC's 2018 net earnings of $20,000, and properly allocable expenses of $90,000 (including $25,000 of W-2 wages). Patron's deductible amount related to the grain trade or business is 20 percent of qualified business income ($10,000) reduced by the lesser of nine percent of qualified business income related to qualified payments received from ABC ($900)135 or 50 percent of W-2 wages related to qualified payments received from ABC ($12,500),136 or $9,100. As Patron does not have any other qualified trades or business, the combined qualified business income amount is also $9,100. Patron's deduction under Code Sec. 199A for 2019 is $10,100, which consists of the combined qualified business income amount of $9,100, plus Patron's deduction passed through from ABC of $1,000.

II. Changes to Partnership Audit Rules

CAA made major changes to the centralized partnership audit regime rules that were enacted in the Bipartisan Budget Act of 2015 (2015 BBA) and which apply generally to partnership tax years beginning after 2017. These changes are the subject of their own article in this issue of Parker's Federal Tax Bulletin. See "Appropriations Act Makes Major Changes to the Partnership Audit Rules" (PFTB 2018-03-30).

III. Other Technical Corrections

CAA includes technical corrections, other corrections, and clerical and deadwood corrections to recent tax legislation enacted before 2017. Except as otherwise provided, the amendments made by the technical corrections and other corrections take effect as if included in the original legislation to which each amendment relates.

Amendments Relating to the Protecting Americans from Tax Hikes (PATH) Act of 2015

Earned Income Tax Credit. With respect to the earned income credit PATH made permanent the $5,000 increase in the phaseout amount for married couples filing joint returns. PATH retained rules providing for the indexation of the prior-law $3,000 amount (notwithstanding that this amount had been repealed). CAA deletes references to the prior law amount and consolidates the inflation adjustment in one subsection.

Transit Parity. Under Code Sec. 132(f)(2) as in effect before the changes made by PATH, the monthly limit on the fringe benefit exclusion for employer-provided parking was $175, and the monthly limit on employer-provided benefits for mass transit and van pooling combined was $100. These monthly limits were indexed under Code Sec. 132(f)(6) using a base year determined by when the particular monthly limit became effective - a base year of 1998 for parking and 2001 for transit/vanpooling. Parity between the exclusions was provided on a temporary basis from 2009 through 2014. PATH created permanent parity in the exclusions by changing the monthly transit/vanpooling limit in Code Sec. 132(f)(2) to $175. However, PATH failed to include a conforming change to repeal the base-year rule in Code Sec. 132(f)(6) for transit/vanpooling. CAA repeals the transit/vanpooling base-year rule.

Research Credit. The alternative incremental credit expired in 2008. CAA clarifies that the alternative incremental credit is not reinstated by PATH, and makes conforming changes.

Bonus Depreciation. CAA clarifies that, among the criteria in PATH defining certain property having a longer production period that is treated as qualified property, the requirement that the property be acquired pursuant to a written contract before 2020 requires that the contract be a written binding contract. This corrects an unintended error that changed prior law. CAA also clarifies that the preproductive period under Code Sec. 168(k)(5)(B)(ii) is consistent with the preproductive period under Code Sec. 263A(e)(3).

CAA amends Code Sec. 168(k)(6), as in effect prior to the amendments made by section 13201 of PATH to provide the intended applicable percentages. Thus, CAA clarifies that in the case of longer production period property and certain aircraft acquired before September 28, 2017, and placed in service in 2018, 50 percent applies to the entire adjusted basis, and if placed in service in 2019, 40 percent applies to the entire adjusted basis.

CAA clarifies that if, for a tax year, a taxpayer makes both an election under Code Sec. 168(k)(7) not to claim bonus depreciation for all property in a particular class of property and an election under Code Sec. 168(k)(4) to claim AMT credits in lieu of bonus depreciation, Code Sec. 168(k)(4) does not apply to property in the particular class. This corrects an unintended error which changed prior law.

Election Out of Accelerated Recovery Periods for Qualified Indian Reservation Property. As amended by PATH, Code Sec. 168(j) permits taxpayers to elect out of the otherwise applicable accelerated recovery periods in the case of qualified Indian reservation property. In general, if Code Sec. 168(j) applies, there is no AMT adjustment. CAA clarifies that no AMT adjustment applies in the case of qualified Indian reservation property if the taxpayer makes the election out.

Failure to Furnish Correct Payee Statements. CAA clarifies Code Sec. 6722(c)(3)(A), relating to failure to furnish correct payee statements, to refer to the payee statement (rather than to information returns) that are furnished (rather than filed). A corresponding change in the effective date stated in PATH refers to statements that are furnished (rather than provided). Similarly-structured language in Code Sec. 6721(c)(3)(A) is conformed so that it refers to the information return (rather than to any information return).

Requirements for the Issuance of Individual Taxpayer Identification Numbers (ITINs). CAA clarifies that community-based Certifying Acceptance Agents are among the entities that are available to individuals living abroad who wish to obtain ITINs for purposes of meeting their U.S. tax filing obligations.

CAA clarifies that the expiration of ITINs that have not been used for three consecutive tax years is to occur on the date following the due date of the tax return for such third consecutive tax year. For ITINs issued prior to January 1, 2013, the ITIN will expire on the applicable date, or if earlier, the day following the due date of the tax return for the third consecutive tax year such ITIN was not used on a return. In the event that such an ITIN has not been used for three (or more) consecutive tax years on the tax return due date for the 2015 tax year, such ITIN will expire on the day following that date.

CAA clarifies that the effective date of PATH, which is effective for ITIN applications made after the date of enactment, does not prevent the provision relating to outstanding ITINs from taking effect.

Retroactive Claims of Credits. CAA conforms a reference in Code Sec. 24(e)(2) to the taxpayer identification number (not to the identifying number). The provisions remove special effective date rules in each of in certain PATH sections that have no practical effect.

Effective Date for Treatment of Credits for Certain Penalties. PATH inadvertently failed to state the effective date for the rule providing a reasonable cause exception for erroneous claims for refund or credit. CAA states that the effective date is for claims filed after the date of enactment of PATH.

Making American Opportunity Tax Credit Permanent. CAA reflects the permanent extension of the American Opportunity Tax Credit by eliminating deadwood and consolidating the provisions of Code Sec. 25A.

Section 529 Programs and Qualified ABLE Programs. For Section 529 qualified tuition programs, PATH repealed the rules providing that Section 529 accounts must be aggregated for purposes of calculating the amount of a distribution that is included in a taxpayer's income. Though PATH modified certain rules for qualified ABLE programs, it did not make a parallel change to the rules for distributions from ABLE accounts. CAA makes a parallel change that conforms the treatment of multiple distributions during a taxable year from an ABLE account in Code Sec. 529A to the treatment of multiple distributions during a tax year from a Code Sec. 529 account.

Restriction on Tax-free Distributions Involving Real Estate Investment Trusts. CAA clarifies that, for purposes of Code Sec. 355(h)(2)(B), control of a partnership means ownership of at least 80 percent of the profits interests and at least 80 percent of the capital interests. That is, control is not limited to exactly 80 percent ownership.

Ancillary Personal Property of a REIT. As amended by PATH, Code Sec. 856(c)(9) treats ancillary personal property as a real estate asset for purposes of the REIT 75 percent asset test to the extent that rents attributable to such ancillary personal property are treated, under a separate provision, as rents from real property. CAA makes two conforming changes with respect to the REIT income tests. First, the provision treats gain from the sale or disposition of such ancillary personal property as gain from the sale or disposition of a real estate asset for purposes of the REIT income tests. Second, the provision treats gain from the sale or disposition of certain obligations secured by mortgages on both real property and personal property as gain from the sale or disposition of real property for purposes of the REIT income tests.

Exception from Foreign Investment in U.S. Real Property Tax Act (FIRPTA) for Certain Stock of REITs. CAA restates provisions of Code Sec. 897(k) as amended, makes clerical conforming changes, and strikes a modification to a repealed provision. Further, under Code Sec. 897(k), as amended, the provision addresses the definition of a qualified collective investment vehicle that is eligible for benefits of a comprehensive income tax treaty with the United States that includes an exchange of information program. Specifically, the provision clarifies that the definition can be met only if the dividends article in the treaty imposes conditions on the benefits allowable in the case of dividends paid by a REIT.

The provision clarifies the effective date for the determination of domestic control by stating that the rule applies with respect to each testing period ending on or after the date of enactment (not that the rule takes effect on the date of enactment).

FIRPTA Exception for Qualified Foreign Pension Funds. As amended by PATH, Code Sec. 897(l)(1) provides that Code Sec. 897 does not apply (1) to any United States real property interest held directly (or indirectly through one or more partnerships) by, or (2) to any distribution received from a REIT by, a qualified foreign pension fund or an entity all the interests of which are held by a qualified foreign pension fund. CAA clarifies that, for purposes of Code Sec. 897, a qualified foreign pension fund is not treated as a nonresident alien individual or as a foreign corporation; in other words, in determining the U.S. income tax of a qualified foreign pension fund, Code Sec. 897 does not apply. The provision provides that, also for that purpose, an entity all the interests of which are held by a qualified foreign pension fund is treated as such a fund.

As amended by PATH, Code Sec. 897(l)(2) establishes a five-prong definition of the term "qualified foreign pension fund." CAA revises the second prong of the definition to clarify that a government-established fund to provide public retirement or pension benefits may qualify, as well as a fund established by more than one employer to provide retirement or pension benefits to their employees, such as a multiple-employer or multiemployer plan. In addition, the provision makes clarifying changes to the fourth and fifth prongs of the definition.

Election of Certain Small Insurance Companies to be Taxed Only on Taxable Investment Income. As amended by PATH, Code Sec. 831(b) requires that an otherwise eligible electing insurance company meet one of two diversification requirements. The first requires that no more than 20 percent of the company's net (or if greater, direct) written premiums for the taxable year is attributable to any one policyholder. The second, applicable if the first is not met, requires that no person holds (directly or indirectly) aggregate interests in the company that constitute a percentage of the entire interest in the company that is more than a de minimis percentage higher than the percentage of interests in specified assets with respect to the company held (directly or indirectly) by a specified holder.

CAA clarifies the first diversification rule to provide a look-through rule with respect to an intermediary (for example, an aggregate fund). Specifically, the provision provides that in the case of reinsurance or any fronting, intermediary, or similar arrangement, a policyholder means each policyholder of the underlying direct written insurance with respect to the reinsurance or arrangement.

The provision clarifies the determination of percentages under the second diversification rule by making the determination with respect to relevant specified assets. They are defined (with respect to any specified holder with respect to any insurance company) to mean the aggregate amount of the specified assets, with respect to the insurance company, any interest in which is held directly or indirectly by a spouse or specified relation. A specified relation is a lineal descendent (including by adoption) of an individual who holds, directly or indirectly, an interest in the insurance company, and the lineal descendant's spouse. Thus, for example, a specified relation of an individual includes the individual's step-children. The provision further clarifies that relevant specified assets do not include any specified asset that was acquired by the spouse or specified relation by bequest, devise, or inheritance from a decedent for a two-year period.

A specified holder is defined to include a lineal descendent (including by adoption) of an individual who holds, directly or indirectly, an interest in the insurance company, and the lineal descendant's spouse. Thus, a specified holder includes an individual's step-children. A specified holder is defined also to include a non-U.S.-citizen spouse of an individual who holds, directly or indirectly, an interest in the specified assets with respect to the insurance company. A non-U.S.-citizen spouse would generally not be an eligible recipient for purposes of the unified estate and gift tax marital deduction, for example, and so assets passing to such a spouse from such an individual would not be deductible for estate and gift tax purposes. By contrast, a U.S.-citizen spouse could receive assets from the individual without giving rise to estate tax or gift tax with respect to those assets.

CAA specifies that Treasury Department guidance under the provision may provide that factors such as ownership, premiums, gross revenue, and factors taken into account under applicable state law for assessing risk are taken into account, to the extent this is consistent with the purpose of the provision to accurately determine percentages based on the real economic arrangement among the parties.

Amendment Relating to the Consolidated Appropriations Act, 2016 (2016 CAA)

CAA clarifies that Code Sec. 199(c)(3)(C) applies for purposes of calculating qualified production activities income under Code Sec. 199(c) and for purposes of calculating oil related qualified production activities income under Code Sec. 199(d)(9), as in effect before the repeal of Code Sec. 199 as part of TCJA. CAA clarifies that an independent refiner may elect to apply Code Sec. 199(c)(3)(C) to its oil transportation costs for purposes of calculating its deduction under Code Sec. 199 (i.e., it is not required to apply the provision to its oil transportation costs). It is anticipated that the IRS will issue guidance prescribing the manner in which such election shall be made.

Amendments Relating to the Fixing America's Surface Transportation Act (2015) (FAST)

Revocation or Denial of Passport in Case of Certain Unpaid Taxes. FAST provides for judicial review of the IRS's certification that an individual has a seriously delinquent tax debt, either in a U.S. district court or in the Tax Court. CAA clarifies that the party against whom a Tax Court petition is filed is the Commissioner of the Internal Revenue Service. CAA also provides a tie-breaker rule clarifying that the court first acquiring jurisdiction over CAAion has sole jurisdiction, and corrects a cross reference.

Amendments Relating to the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 (2015 Surface Transportation Act)

Consistent Value for Transfer and Income Tax Purposes. The 2015 Surface Transportation Act generally requires that, under Code Sec. 1014(f), an heir who acquires property from a decedent (whether or not reported on an estate tax return) claim a basis no greater than the final value of the property for estate tax purposes. Code Sec. 6662(b)(8) imposes a penalty in the case of an inconsistent estate basis. Under CAA, the term "inconsistent estate basis" means any portion of an underpayment attributable to the failure to comply with Code Sec. 1014(f). The penalty could have been viewed as applying when an heir claims a basis higher than the final estate tax value by reason of making basis adjustments relating to post-acquisition events (e.g., improvements to the property). This result is not intended. The provision modifies the definition of inconsistent estate basis to avoid this unintended result.

Mass Transit Account ("MTA") Financing. The 2015 Surface Transportation Act changes the taxation of liquefied natural gas (LNG) and liquefied petroleum gas (LPG) from a per-gallon basis to an energy-equivalent basis. That is, CAA provides that the tax is based on the LNG energy equivalent to a gallon of diesel (DGE) (24.3 cents per DGE, which is 6.06 pounds of LNG), and on the LPG energy equivalent to a gallon of gasoline (GGE) (18.3 cents per GGE, which is 5.75 pounds of LPG). Code Sec. 9503(e)(2) allocates 1.86 cents per gallon of LNG and 2.13 cents per gallon of LPG to the MTA of the Highway Trust Fund, but does not specifically conform the per-gallon basis to an energy-equivalent basis for purposes of the allocation. CAA conforms the per-gallon basis in Code Sec. 9503(e)(2) to the energy-equivalent basis, using DGE for LNG and GGE for LPG, to reflect the energy-equivalent basis used for the taxes imposed on LNG and LPG.

Amendments Relating to the Stephen Beck, Jr., ABLE Act of 2014 (ABLE Act)

The ABLE Act provides an annual inflation adjustment for fixed-dollar civil tax penalties in the case of: 

• Code Sec. 6651(a), failure to file a tax return; 
• Code Sec. 6652(c), failure to file or disclose information returns by exempt organizations and certain trusts;
• Code Sec. 6695, preparation of tax returns for other persons; 
• Code Sec. 6698, failure to file a partnership return, 
• Code Sec. 6699, failure to file an S corporation return;
• Code Sec. 6721, failure to file correct information returns; and 
• Code Sec. 6722, failure to furnish correct payee statements. 

The provision clarifies that the effective date of the annual inflation adjustments added to these civil penalties generally is for returns required to be filed, and statements required to be furnished, after December 31, 2014, and in the case of the annual inflation adjustment for penalties relating to preparation of tax returns for other persons, is for returns or claims for refund filed after December 31, 2014.

Amendment Relating to the American Taxpayer Relief Act of 2012 (ATRA)

CAA conforms a reference in Code Sec. 6211(b)(4)(A), relating to the definition of a deficiency, to a provision of the American Opportunity Tax Credit that was renumbered by the ATRA.

Amendment Relating to the United States - Korea Free Trade Agreement Implementation Act (2011)

CAA clarifies that the effective date of the Code Sec. 6695(g) penalty increase is for documents prepared (not returns required to be filed) after December 31, 2011.

Amendments Relating to the American Jobs Creation Act of 2004

Treatment of Certain Trusts as Shareholder of S Corporation. CAA clarifies that only the individual for whose benefit the trust is created is treated as "the shareholder."

Rural Electric Cooperatives. Code Sec. 501(c)(12) provides an income tax exemption for rural electric cooperatives if at least 85 percent of the cooperative's income consists of amounts collected from members for the sole purpose of meeting losses and expenses of providing service to its members. The Energy Policy Act of 2005 made permanent a rule to exclude from the 85 percent test income from transactions related to open access transmission if approved by the Federal Energy Regulatory Commission (FERC). FERC regulates transmission lines in all States except Alaska, Hawaii, and most of Texas. Because of an oversight, only transmission systems in Texas received the treatment accorded to FERC-regulated electric cooperatives. Electric cooperatives in Alaska are regulated by the Regulatory Commission of Alaska (RCA). Regulated utilities in Alaska with an RCA-approved open access transmission tariff modeled after FERC should have received the same tax treatment as their similarly situated counterparts in the other States. CAA clarifies that that such utilities in Alaska and Hawaii are treated the same as those in Texas for purposes of the exclusion from the 85-percent test.

IV. Changes to Low-Income Housing Credit Ceiling and Average Income Test

The low-income housing credit may be claimed over a 10-year credit period after each low-income building is placed in service. The amount of the credit for any tax year in the credit period is the applicable percentage of the qualified basis of each qualified low-income building. A state housing credit ceiling applies. For determining the current-year state dollar amount of the ceiling in any calendar year, the greater of (1) $1.75 multiplied by the state population, or (2) $2,000,000, is taken into account. These amounts are indexed for inflation. For calendar year 2018, the amounts are $2.40 and $2,760,000.

To be eligible for the low-income housing credit, a qualified low-income building must be part of a qualified low-income housing project. In general, a qualified low-income housing project is defined as a project that satisfies one of two tests at the election of the taxpayer. The first test is met if 20 percent or more of the residential units in the project are both rent-restricted and occupied by individuals whose income is 50 percent or less of area median gross income (the "20-50 test"). The second test is met if 40 percent or more of the residential units in the project are both rent-restricted and occupied by individuals whose income is 60 percent or less of area median gross income (the "40-60 test").

A unit occupied by individuals whose incomes rise above 140 percent of the applicable income limit shall continue to be treated as a low-income unit if the income of such occupants initially met such income limitation and such unit continues to be rent-restricted so long as the next available unit is occupied by a tenant whose income does not exceed such limitation. In the case of deep rent skewed projects, special rules apply. A deep rent skewed project is a project in which (1) 15 percent or more of the low-income units in the project are occupied by individuals whose incomes are 40 percent or less of area median gross income, (2) the gross rent with respect to each low-income unit in the project does not exceed 30 percent of the applicable income limit that applies to individuals occupying the unit, and (3) the gross rent with respect to each low-income unit in the project does not exceed one-half of the average gross rent with respect to units of comparable size that are not occupied by individuals who meet the applicable income limit.

CAA provides an increase in the state housing credit ceiling for 2018, 2019, 2020, and 2021. In each of those calendar years, the dollar amounts in effect for determining the current-year ceiling (after any increase due to the applicable cost of living adjustment) are increased by multiplying the dollar amounts for that year by 1.125.

CAA adds a third optional test to the 20-50 and 40-60 tests for a qualified low-income housing project. A project meets the minimum requirements of the average income test if 40 percent or more (25 percent or more in the case of a project located in a high cost housing area) of the residential units in such project are both rent-restricted and occupied by individuals whose income does not exceed the imputed income limitation designated by the taxpayer with respect to the respective unit. The taxpayer designates the imputed income limitation. The imputed income limitation is determined in 10-percentage-point increments, and may be designated as 20, 30, 40, 50, 60, 70, or 80 percent. The average of the imputed income limitations designated must not exceed 60 percent of area median gross income.

For purposes of the rental of the next available unit in a project with respect to which the taxpayer elects the average income test, if the income of the occupants of the unit increases above 140 percent of the greater of (1) 60 percent of area median gross income, or (2) the imputed income limitation designated by the taxpayer with respect to the unit, then the unit ceases to be treated as a low-income unit if any residential rental unit in the building (of a size comparable to, or smaller than, such unit) is occupied by a new resident whose income exceeds the applicable imputed income limitation. In the case of a deep rent skewed project, 170 percent applies instead of 140 percent, and other special rules apply.

The provision relating to the state housing credit ceiling is effective for calendar years beginning after December 31, 2017, and before January 1, 2022. The provision relating to the average income test is effective for elections made after March 23, 2018.

V. Extension of Airport and Airway Trust Fund Excise Taxes

Excise taxes are imposed on amounts paid for commercial air passenger and freight transportation and on fuels used in commercial and noncommercial (i.e., transportation that is not "for hire") aviation to fund the Airport and Airway Trust Fund. Most of the Airport and Airway Trust Fund excise taxes were scheduled to expire after March 31, 2018. Effective March 23, 2018, the taxes and expenditure authority that were scheduled to expire on March 31, 2018, are extended to September 30, 2018.

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Short Sale of Rental Property and Discharge of Mortgage Debt Resulted in No Gain or Loss

The Tax Court held that a short sale of real property that was converted to a rental property and that was purchased using nonrecourse debt was a single transaction in which the amount of the discharged debt had to be included in the amount realized for the purpose of determining gain or loss on the sale. The court noted that the amount realized was greater than the couple's loss basis in the property under Reg. Sec. 1.165-9(b)(2), but less than the couple's gain basis in the property and, because the property was sold for an amount between those bases, the court found there was neither a gain nor a loss on the sale. Simonsen v. Comm'r, 150 T.C. No. 8 (2018).

Facts

Karl and Christina Simonsen bought a townhouse in San Hose, California in 2005 for $695,000. They financed the purchase with a nonrecourse loan from Wells Fargo. The lived in the home until 2010, when they decided to convert the townhouse to a rental property and move to southern California. Due to the recession, the value of the townhouse had decreased, and its fair market value at the time of the conversion was only $495,000. By late 2011, the market had not rebounded and the Simonsens negotiated a sale with Wells Fargo and a third party buyer that yielded only $363,000. All the proceeds went to Wells Fargo to pay down the loan and cover closing costs. Wells Fargo forgave the remaining loan balance.

In January 2012, the Simonsens received two Forms 1099. Wells Fargo sent a Form 1099-C, Cancellation of Debt, showing that the bank had cancelled the Simonsens' remaining $219,000 debt. The Simonsens also received a Form 1099-S, Proceeds from Real Estate Transactions, from the title company reporting sale proceeds of $363,000.

Following the apparent form of the transaction, the Simonsens reported on their 2011 tax return a sale for $363,000 and cancellation of indebtedness (COI) income of around $219,000. They thought the sale resulted in a loss of $216,495, calculated as the difference between the sale price and their converted adjusted basis (reduced by depreciation) of $579,495. They excluded the COI amount based on Code Sec. 108(a)(1)(E).

Observation: The discharge of up to $ 2 million of indebtedness income for married taxpayers filing jointly related to a discharge of qualified principal residence debt was generally excludable from gross income under Code Sec. 108(a)(1)(E) for qualified principal residence debt discharged from 2008 through 2017.

Mrs. Simonsen, who completed the return, determined that although the couple was not currently living in the townhouse, it was their principal residence at the time of the sale because they had lived there for at least two of the last five years as required under Code Sec. 121. Mrs. Simonsen is a lawyer but has no tax background. She reviewed the IRS's instructions before concluding that none of the COI income was taxable and that no basis adjustment was required before determining gain or loss because they no longer owned the property. She used TurboTax to prepare the return like she had every year since 2002.

The IRS audited the Simonsens and sent a notice of deficiency in 2014, indicating a deficiency of just under $70,000 and an accuracy related penalty of $14,000. The Simonsens petitioned the Tax Court, arguing that Code Sec. 108(a)(1)(E) changed the treatment of short sales by requiring the tax consequences of the sale to the determined first, before calculating the cancellation of debt. The IRS argued that the short sale was a single transaction and that the COI amount should have been added to the Simonsens' amount realized to calculate the gain or loss. Any gain realized would be taxable gains derived from dealings in property, and not excludable COI income, according to the IRS. Even if there were two transactions, the IRS argued that the Simonsens would not be entitled to exclude the COI income because the townhouse was not their principal residence at the time of the sale.

Analysis

The Tax Court agreed with the IRS that the short sale was one transaction and that the Simonsens should have included the COI income in their amount realized to determine their gain or loss. The court observed that there were cases holding that a nonrecourse loan satisfied at less than the full amount owed produced COI income, but found that such cases were exceptional, and the more common outcome was that a disposition of encumbered property is a sale or exchange in which the nonrecourse debt is included in the amount realized. The court agreed with the Simonsens that the townhouse was their principal residence when they sold it because during the five years before they sale they had lived in it as their principal residence for three years and ten months. However, that finding was not determinative because the court found that the sale was only one transaction and no COI income arose.

The sale was a single transaction, in the court's view, primarily because Wells Fargo's willingness to cancel the debt depended entirely on the Simonsens' willingness to turn over the proceeds from the sale of their home. The court found that the IRS's position was consistent with the obvious realities of the transactionthat Wells Fargo had to reconvey the deed of trust in order for the sale to close, and that it could dictate the terms of the sale as long as it retained the deed of trust. Other factors that suggested a single transaction were that Wells Fargo facilitated the short sale and received the sale proceeds, that Wells Fargo accepted the sale the amount even though it was insufficient to completely pay off the mortgage, and that the debt forgiveness occurred when the sale closed.

However, the Tax Court had a problem in determining the amount of gain or loss on the sale because the amount realized was $555,960, which fell between the basis the court would use to calculate a loss ($495,000) and the basis the court would use to calculate a gain ($695,000). The court noted that, where such a transaction involves a short sale, there was no guidance and the closest analogy it could find was to look at what happens to bases in property that one person gives another. The court looked to Code Sec. 1015(a) and Reg. Sec. 1.1015-1(a)(1) which provides that when one person gifts property to another, the donee uses the lower fair market value to compute a loss but the donor's basis to compute a gain. And, as far as what to do when a donee sells the gift at a price between those two possible bases, the court found the answer in Reg. Sec. 1.1015-1(a)(2): there is no gain or loss. Thus, the court held that the couple realized no gain or loss on the sale of their property

With respect to the accuracy related penalty, the Tax Court found that the IRS produced no evidence that it complied with the written approval requirement under Code Sec. 6751(b)(1) in assessing the penalty. However, even if the IRS had met its burden of production, the court found that the Simonsens acted with reasonable cause and good faith because they were not tax professionals and their reporting of the transaction was consistent with the information returns they received. The court noted that Mrs. Simonsen had used TurboTax for almost a decade, and although the receipt of COI income was new to her, she consulted the IRS's instructions before filing the return. The court also noted that there were no regulations under Code Sec. 108(a)(1)(E) and that caselaw was scarce. The court concluded that the Simonsens' error was the result of an honest misunderstanding of a complex area of the law, so they had therefore acted in good faith.

For a discussion of the tax treatment of short sales of real estate, see Parker Tax ¶72,375. For a discussion of the rules relating to the calculation of gain or loss on the sale of a residence converted to rental property, see Parker Tax ¶86,150.

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Doctor's Royalty Income from Patent Is Ordinary Income, Not Capital Gain

The Third Circuit affirmed a Tax Court ruling that a doctor's royalty income from a patent that he received under a licensing agreement was ordinary income, not capital gains, because by retaining the right to decide how the technology was used, the doctor had failed to transfer substantially all rights to the patent. The Third Circuit also found that the doctor's argument on appeal was waived because it depended on a different legal theory and different facts than the argument he made before the Tax Court. Spireas v. Comm'r, 2018 PTC 83 (3d Cir. 2018).

Background

Spiridon Spireas is a pharmaceutical scientist who invented "liquisolid technology," a set of drug delivery techniques meant to facilitate the body's absorption of water-insoluble molecules taken orally. The technology is not one-size-fits-all. Each application is specific to a particular drug, and creating a clinically useful liquisolid formulation of a given drug requires creating, through trial and error, a process specific to the substance involved.

Because each formulation was unique, commercializing the technology was complex process. Before a drug could go to market in liquisolid form, a specific formulation had to progress from conception to prototyping to extensive further development. Like many inventors, Spireas could not develop the technology alone, so in June 1998 he signed a licensing agreement with Mutual Pharmaceutical Co., an established drugmaker.

Spireas's agreement with Mutual established a comprehensive framework for licensing liquisolid technology to Mutual, selecting prescription drugs to develop, developing and selling those drugs, and paying Spireas royalties out of the proceeds. Mutual received exclusive rights to use the technology, but only to develop liquisolid drug products that were unanimously selected by written agreement between Mutual and Spireas. The parties memorialized their selections of which products to develop in formal engagement letters. Once an agreement was made, the process continued with the development of a practical liquisolid formulation, clinical testing, FDA approval, and marketing. As sales were made and funds were received, Mutual would pay Spireas a 20 percent royalty on the gross profits.

In March 2000, Spireas and Mutual signed an engagement letter to develop a generic version of a blood pressure drug called felodipine. Spireas put forth considerable efforts to adapt the technology to felodipine and completed his efforts in a relatively short amount of time. When he signed the engagement letter, he had completed roughly 30 percent of the work that ultimately resulted in the liquisolid formulation of felodipine that he finished inventing sometime after May 2000. The FDA approved felodipine and Mutual marketed it to great success.

Spireas's royalties for 2007-2008, the years at issue, totaled just over $40 million, which he reported as capital gains on his tax returns. In 2013, the IRS sent a notice of deficiency stating that the royalties were ordinary income, and it assessed around $5.8 million in additional tax. Spireas petitioned the Tax Court for a redetermination.

Analysis

Royalty payments received under a license agreement are generally taxed as ordinary income. However, Code Sec. 1235(a) provides a transfer of all substantial rights to a patent is treated as a sale or exchange of a capital asset held for more than one year. Under Reg. Sec. 1.1235-2(b)(1), "all substantial rights" means all rights to a patent which are of value at the time the rights are transferred.

An inventor must transfer property rights that the inventor actually possesses at the time of the grant, and to possess a transferable property interest the inventor generally must have reduced it to actual practice. Under Reg. Sec. 1.1235-2(e), an invention is reduced to actual practice when it has been tested and operated successfully under normal operating conditions.

Before the Tax Court, the IRS argued that Spireas failed transfer all of his rights to liquisolid technology as required under Code Sec. 1235 because Mutual could only sell those products that it and Spireas unanimously selected. Spireas acknowledged that he had retained valuable rights in the overall technology but emphasized that he had transferred away all of his rights to the liquisolid formulation of felodipine, and that the transfer took place sometime in 2000 or 2001, after the felodipine formulation was invented.

The Tax Court agreed with the IRS, finding that Spireas could not have transferred the rights to any particular liquisolid products in 1998 because no products existed at that time. According to the Tax Court, the only rights Spireas could have granted in 1998 were the rights to use the liquisolid technology and to make and sell any products using the technology. The Tax Court held that, since Spireas had granted far less than all substantial rights to the overall liquisolid technology, the royalty payments he received in 2007 and 2008 did not satisfy the requirements of Code Sec. 1235 and were therefore taxable as ordinary income.

Spireas appealed to the Third Circuit. On appeal, he argued that the transfer of his rights occurred in 1998 with the execution of the licensing agreement, which he claimed prospectively assigned to Mutual his rights to liquisolid felodipine. The IRS responded that Spireas had waived that argument by not presenting it to the Tax Court. The IRS claimed that under Third Circuit precedent, Spireas's argument on appeal had to be based on the same legal rule and facts as the argument he made before the Tax Court, and that his new argument failed this test.

The Third Circuit affirmed the Tax Court and held that Spireas had waived his argument that he prospectively transferred the rights. The court explained that the under the waiver rule, Spireas's argument on appeal had to depend on the same legal rule and the same material facts as the argument he presented to the Tax Court.

The Third Circuit found the legal theory Spireas presented to the Tax Court was that he acquired a property interest in liquisolid felodipine when the invention was complete, either in 2000 or 2001. In the Third Circuit's view, that determination implied a finding by the Tax Court that the formulation had been reduced to actual practice at that time. Thus, the Third Circuit found that Spireas's original theory was that he made a post-invention transfer of his rights to Mutual around May 2000, which is the time that he acquired a property interest in the invention.

The Third Circuit found that Spireas abandoned that theory on appeal, and instead had argued that he prospectively transferred his rights in 1998, two years before the invention of liquisolid felodipine. According to the Third Circuit, Spireas's argument for a prospective transfer could not depend on a theory of "actual reduction to practice" because it depended on a different legal standard for when the formulation became property than his argument to the Tax Court. The Third Circuit also reasoned that the prospective transfer could not depend on the same facts (including the timing of felodipine's invention) as those supporting his Tax Court argument.

For these reasons, and because Spireas offered no reasons why the court should excuse his waiver, the Third Circuit declined to evaluate his new argument on appeal and affirmed the Tax Court's decision.

Observation: In a dissenting opinion, one judge would have held that Spireas's arguments before the Tax Court and on appeal were consistent. In the view of the dissenting judge, Spireas consistently argued that the physical delivery of the formulation occurred in 2000 pursuant to the 1998 transfer of the legal rights to the formulation, and that such rights were the consideration for the royalty payments Spireas received. The dissent also disagreed with the majority's view that an invention must be reduced to practice in order for Code Sec. 1235 to apply, and reasoned that by the logic of the majority opinion, the 2000 engagement letter could not have transferred the rights because it also predated the felodipine formulation's reduction to practice.

For a discussion of the taxation of gain or loss from the transfer of patents, see Parker Tax ¶117,110.

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Appropriations Act Makes Major Modifications to the Partnership Audit Rules

The Consolidated Appropriations Act of 2018 (CAA), which was signed into law on March 23, 2018, contains numerous modifications, corrections, and clarifications relating to the centralized partnership audit regime rules that were enacted in the Bipartisan Budget Act of 2015 (2015 BBA) and which apply generally to partnership tax years beginning after 2017. Among the many changes, CAA revises the definition of a partnership adjustment and adds a new term - "partnership-related item." Under CAA, a new procedure is introduced - a "pull-in" procedure - as an alternative procedure to filing amended returns relating to an imputed underpayment of tax. The changes to the partnership audit regime rules are effective as if included with the partnership audit provision enacted in the 2015 BBA. Pub. L. 115-141.

Related Article: CAA also contains numerous technical tax corrections, including a change to fix the "grain glitch." See "President Signs $1.3 Trillion Spending Bill That Includes Technical Tax Corrections", also in this issue of Parker's Federal Tax Bulletin (PFTB 2018-03-30).

I. Scope of Adjustments Subject to Audit Rules

CAA clarifies the scope of the partnership audit rules. It eliminates references to adjustments to partnership income, gain, loss, deduction, or credit, and instead refers to partnership-related items, defined as any item or amount with respect to the partnership that is relevant in determining the income tax liability of any person, without regard to whether the item or amount appears on the partnership's return and including an imputed underpayment and an item or amount relating to any transaction with, basis in, or liability of, the partnership. Thus, the partnership audit rules are not narrower than the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) partnership audit rules, but rather, are intended to have a scope sufficient to address those items described as partnership items, affected items, and computational items in the TEFRA context in regulations in 301.6231(a)(3), 301.6231(a)(5), and 301.6231(a)(6), as well as any other items meeting the statutory definition of a partnership-related item.

For example, because a partnership-related item includes an item or amount relating to any transaction with the partnership, an item or amount relating to a partner's transaction with a partnership other than in his capacity as a member of the partnership (which is considered as occurring between the partnership and one who is not a partner under Code 707) is a partnership-related item. As another example, because a partnership-related item includes an item or amount relating to basis in the partnership, an item or amount relating to the determination of the adjusted basis of a partner's interest in the partnership or relating to the basis of the partnership in partnership property is a partnership-related item. As a further example, because a partnership-related item includes an item or amount relating to liability of the partnership, an item or amount relating to the determination of partnership liabilities or to the effect on a partner of a decrease or increase in a partner's share of partnership liabilities is a partnership-related item.

CAA clarifies that the partnership audit rules do not apply to taxes imposed, or to amounts required to be deducted or withheld, under Code chapters 2 (tax on self-employment income) or 2A (tax on net investment income), 3 (withholding tax on nonresident alien individuals or foreign corporations), or 4 (withholding tax for certain foreign accounts), except as otherwise specifically provided. However, any partnership adjustment determined under the income tax is taken into account for purposes of determining and assessing tax under these chapters of the Code to the extent that the partnership adjustment is relevant to the determination. The period for assessing any tax under chapter 2 or 2A that is attributable to a partnership adjustment does not expire before the date that is one year after (1) in the case of an adjustment pursuant to the decision of a court in a proceeding brought under Code Sec. 6234, such decision becomes final, or (2) in any other case, 90 days after the date on which the notice of final partnership adjustment is mailed under Code Sec. 6231.

CAA applies a specific timing rule in the case of any tax imposed, including any amount that is required to be deducted or withheld, under chapter 3 (withholding tax on nonresident alien individuals or foreign corporations) or 4 (withholding tax for certain foreign accounts). In these cases, the tax is determined with respect to the reviewed year. The tax is imposed with respect to the adjustment year; similarly, the amount required to be deducted or withheld is deducted or withheld with respect to the adjustment year. The reviewed year and the adjustment year are defined in Code Sec. 6225(d).

In determining the amount of any deficiency, adjustments to partnership-related items are made only as provided under the partnership audit rules, except to the extent otherwise provided. Thus, CAA clarifies that the court has jurisdiction to determine all partnership-related items of the partnership for the partnership tax year to which the notice of final partnership adjustment relates, the proper allocation of such items among the partners, and the applicability of any penalty, addition to tax, or additional amount for which the partnership may be liable. For example, because partnership-related items include items or amounts with respect to (1) Code Sec. 707 transactions; (2) liabilities of the partnership and the partners' shares of the liabilities; and (3) the basis of a partnership interest or of partnership property, determination of these items or amounts is within the scope of judicial review.

II. Netting in the Determination of Imputed Underpayments

When the IRS makes adjustments to any partnership-related item with respect to the reviewed year of a partnership, if the adjustments result in an imputed underpayment, the partnership pays an amount equal to the imputed underpayment, and if the adjustments do not result in an imputed underpayment, the adjustments are taken into account by the partnership in the adjustment year and passed through to the adjustment year partners. CAA clarifies this rule by conforming the language referring to partnership-related items and by striking erroneous references to separately stated income or loss.

CAA also clarifies the manner of netting items to determine the amount of an imputed underpayment of a partnership. It clarifies that items of different character (capital or ordinary), for example, are not netted together in determining the amount of an imputed underpayment. Rather, an imputed underpayment of a partnership with respect to a reviewed year is determined by the IRS by appropriately netting partnership adjustments for that year and by applying the highest rate of individual or corporate tax in effect for the reviewed year. In the case of partners' distributive shares, like items within categories under Code Sec. 702(a)(1)-(8) are separately netted.

In determining an imputed underpayment, any adjustment that reallocates the distributive share of any item from one partner to another is taken into account by disregarding any part of the adjustment that results in a decrease in the amount of the imputed underpayment. For example, this rule could be implemented by disregarding the decrease in any item of income or gain and disregarding the increase in any item of deduction, loss, or credit.

Limitations that would apply at the direct or indirect partner level are treated as applying, unless otherwise determined. Under the provision, if an adjustment would decrease the imputed underpayment, and could be subject to a limitation or not be allowed against ordinary income if the adjustment were taken into account by any person, then the adjustment is not taken into account in determining the imputed underpayment of the partnership, except to the extent the IRS otherwise provides.

For example, if an adjustment would increase the amount of a partnership loss allocable to partners, but the loss could be subject to the passive loss rule of Code Sec. 469 in the hands of direct and indirect partners of the partnership, then the IRS does not take into account the adjustment increasing the loss in determining the amount of the partnership's imputed underpayment, unless the IRS provides otherwise. For example, the IRS may provide otherwise if the partnership supplies accurate information that all direct and indirect partners of the partnership are publicly traded domestic C corporations not subject to the passive loss rule.

Adjustments to credits are separately determined and netted as appropriate. Adjustments to credits are not multiplied by the tax rate, but rather, adjustments to items of credit are taken into account as an increase or decrease in determining the amount of the imputed underpayment.

III. Alternative Procedure for Seeking Modifications to Imputed Underpayments

CAA clarifies the procedures under Code Sec. 6225(c)(2) that permit a partnership to seek modification of an imputed underpayment. These procedures allow reviewed-year partners to take adjustments into account so that the partnership's imputed underpayment can be determined by the IRS without regard to that portion of the adjustments. Like other modification procedures in Code Sec. 6225(c), these procedures take place within the period ending 270 days after the date the notice of proposed partnership adjustment is mailed, unless the period is extended with the consent of the IRS, as provided in Code Sec. 6225(c)(7).

Amended Returns of Partners

CAA clarifies the requirements for reviewed-year partners filing amended returns with payment of any tax due. First, the amended return procedure requires the partner to file returns for the taxable year of the partner that includes the end of the partnership's reviewed year, as well as for any tax year with respect to which any tax attribute of the partner is affected by reason of any adjustment to a reviewed-year partnership-related item. Second, the amended returns are required to take into account all such adjustments that are properly allocable to the partner, as well as the effect of the adjustments on any tax attributes. Third, payment of any tax due is required to be included with the amended returns. As is the case for other amended returns, the IRS may require the payment of interest, penalties, and additions to tax (for example, by billing the partner as under present practice).

If the requirements are satisfied, then the partnership's imputed underpayment amount is determined without regard to the portion of the adjustments taken into account by such partners. The amended return modification procedure does not require the participation of all reviewed year partners of the partnership. Direct and indirect reviewed-year partners may participate. The amended return procedure is not intended to cover adjustments to items on an amended return of a partner that do not correspond to adjustments to a reviewed-year partnership-related item and the effect of the adjustments on tax attributes.

Pull-In Procedure - Alternative Procedure to Filing Amended Returns

CAA sets forth an alternative procedure to filing amended returns. The alternative procedure is referred to as the pull-in procedure. Under the pull-in procedure, the IRS determines the partnership's imputed underpayment as reduced by the portion of the adjustments to partnership-related items that direct and indirect reviewed-year partners take into account and with respect to which those partners pay the tax due, provided the requirements of the pull-in procedure are met.

Under pull-in, reviewed-year partners pay the tax that would be due with amended returns, make binding changes to their tax attributes for subsequent years, and provide the IRS with the information necessary to substantiate that the tax was correctly computed and paid. However, the partners file no amended returns. Thus, there are generally no corollary effects on the partners' returns beyond the effects on tax attributes, in other taxable years, of the adjustments to partnership-related items.

Pull-in, as well as the amended return modification procedure, is available generally to direct and indirect reviewed-year partners, in the case of tiered partnerships. The pull-in procedure generally does not require the participation of all direct and indirect reviewed-year partners of the partnership.

Pull-in requires the participating partner to pay the tax that would be due under the amended return filing procedure. The partner is responsible for remitting the payment unless the IRS provides that another person, such as the partnership or a third party, may remit the payment on the partner's behalf. Payment is due within the period ending 270 days after the date the notice of proposed partnership adjustment is mailed (unless the period is extended with the IRS's consent).

Pull-in requires that the partner agree to take into account, in the form and manner required by the IRS, the adjustments and the effects on the partner's tax attributes of the adjustments to partnership-related items properly allocable to the partner.

Pull-in requires that the partner provide, in the form and manner specified by the IRS, such information as the IRS may require to carry out the pull-in procedure. This requirement can include information in the same form as on an amended return, if the IRS so specifies. The information is to be provided within the period ending 270 days after the date the notice of proposed partnership adjustment is mailed (unless the period is extended with the IRS's consent).

If all of the requirements are satisfied, the imputed underpayment can be modified. In the event that a partner provides the required information, but does not make the required payment, for example, the imputed underpayment of the partnership is not modified with respect to those adjustments.

Rules Applicable Both to the Amended Returns of Partners and to the Pull-in Procedure

If an adjustment involves reallocation of an item from one partner to another, the opportunity to modify the imputed underpayment under amended return procedure (Code Sec. 6225(c)(2)(A)) or pull-in procedures (Code Sec. 6225(c)(2)(B)) is available only if the requirements of one or the other of the amended return or pull-in procedures are satisfied with respect to all partners affected by the adjustment involving reallocation.

For purposes of the amended return and pull-in procedures, tax relating to adjustments to a reviewed-year partnership-related item and the effect of the adjustments on tax attributes may be determined and assessed without regard to the otherwise applicable statute of limitations of Code Sec. 6501 and Code Sec. 6511. For example, if a notice of proposed partnership adjustment is mailed to a partnership by the IRS more than three years after a partner filed his or her return for the year including the end of the reviewed year, the three-year statute of limitations under Code Sec. 6501 or Code Sec. 6511 does not preclude the filing of an amended return, the assessment and payment of the partner's tax due for that year, or the proper crediting or refund of an amount paid by a partner, but these results apply only with respect to adjustments to partnership-related items for the reviewed year (and the effect of such adjustments on any tax attributes).

In the case of adjustments taken into account on an amended return of a partner or in a pull-in with respect to a partner, the effects of these adjustments on tax attributes are binding. This binding effect applies for the tax year of the partner that includes the end of the reviewed year of the partnership and any taxable year for which a tax attribute is affected by such an adjustment. Any failure to take into account the effects of adjustments on tax attributes is treated for all Federal tax purposes in the same manner as a failure by a partner to treat a partnership-related item consistently with the treatment of the item on the partnership return (as provided in Code Sec. 6222). For example, if a partner who files an amended return or provides information in a pull-in fails to take into account in other taxable years the effect on tax attributes of adjustments to partnership-related items that are properly allocable to the partner, any underpayment attributable to the failure may be assessed under math error procedures as provided in Code Sec. 6222(b).

The provision clarifies the rules applicable in the case of partnerships and S corporations in tiered structures when a partner files an amended return and pays, or provides information to the IRS and pays in a pull-in. Specifically, in the case of any partnership, any partner of which is a partnership, the amended return and pull-in rules of Code Sec. 6225(c)(2)((A) and (B) apply with respect to any partner (the "relevant partner") in the chain of ownership of such partnerships, provided that certain requirements are met. As a practical matter, this rule generally permits the filing of amended returns even if some, but not all, of the partners (or S corporation shareholders treated as partners for this purpose) file amended returns. Similarly, this rule generally permits some but not all partners to participate in a pull-in, provided requirements are met.

Requirements applicable to both the amended return procedure and the pull-in procedure include the requirement that such information as the IRS may require be furnished to the IRS for purposes of administering the amended return or pull-in rules in the case of tiered structures. In this context, the IRS may require information with respect to any chain of ownership of the relevant partner. The IRS may require that each partnership in the chain of ownership between the relevant partner and the audited partnership must satisfy the requirements for filing amended returns or for participating in the pull-in, so that all partnerships in the chain of ownership between the relevant partner and the audited partnership either meets the requirement of filing an amended return, or meets the requirements for supplying information in a pull-in.

Example: An audited partnership has three partners, A, B, and C, each of which is a partnership. Partnership B in turn has two partners, D and E, each of which is a partnership. Partnerships A, C, D, and E each have only 5 partners. Individual Q is a partner in partnership E, and agrees to participate in a pull-in, pay the tax due, and provide information as required by the IRS (including information similar to that which would be supplied on an amended return of Q, and information with respect to the chain of ownership between Q as the relevant partner and the audited partnership). The provision does not contemplate that the IRS may require Q to supply information about the chain of ownership between the audited partnership and upper-tier partners of partnerships A, C, or D. However, partners of A, C, or D that file amended returns or participate in the pull-in may be required to supply information on the chain of ownership between themselves and the audited partnership, as well as information on their own chains of ownership should they be partnerships or S corporations.

Other Modification Procedures: References to Adjustments

CAA clarifies the operation of modification procedures under Code Sec. 6225(c)(3) (relating to tax-exempt partners), Code Sec. 6225(c)(4) (relating to applicable highest tax rates), and Code Sec. 6225(c)(5) (relating to certain passive losses of publicly traded partnerships). In each of these modification procedures, the provision clarifies that the determination of the imputed underpayment is made without regard to the adjustment or portion of the adjustment being described (not without regard to a portion of the imputed underpayment).

Other Modification Procedures: Adjustment Not Resulting in an Imputed Underpayment

CAA states specifically that the modification procedures are available if adjustments to partnership-related items do not result in an imputed underpayment. Under Code Sec. 6225(c)(9), information relating to a modification may be offered by the partnership in the case of adjustments that do not result in an imputed underpayment, and such adjustments may be modified by the IRS as the IRS determines appropriate.

IV. Other Changes to Partnership Audit Rules

Push-Out Treatment of Passthrough Partners in Tiered Structures

CAA addresses the situation of a partnership (or an S corporation, which is treated similarly to a partnership under this rule) that is a direct or indirect partner of an audited partnership which has elected to push out adjustments of partnership-related items to partners (or S corporation shareholders, which are treated similarly to partners under this rule) under Code Sec. 6226. The provision sets forth requirements applicable to such partners and the time frame for satisfying these requirements.

If a partner that receives a statement in a push-out is a partnership, that partner must satisfy two requirements. First, the partner must file with the IRS a partnership adjustment tracking report that includes information required by the IRS. For example, the required information may include identifying the partner's own partners or shareholders, describing and quantifying adjustments necessary to determine partnership-related items or the equivalent in the hands of those partners or shareholders, or other information necessary or appropriate to assessment and collection from tiers of partners in a push-out.

Second, that partner is required to furnish statements to its partners under rules similar to Code Sec. 6226(a)(2), or, if no such statements are furnished, to compute and pay its imputed underpayment under rules similar to Code Sec. 6225 (other than certain modification-related rules). That is, the partnership must push out the adjustments to its partners, or if not, it must compute and pay its imputed underpayment. If such a partnership computes and pays its imputed underpayment, the rules of Code Sec. 6225 apply (other than the modifications provided in Code Sec. 6225(c)(2) (amended returns and pull-in), 6225(c)(7) (270-day period for modifications), and Code Sec. 6225(c)(9) (modification of adjustment not resulting in imputed underpayment). The imputed underpayment of the partnership is determined by appropriately netting all partnership adjustments on the statement (taking into account limitations to which adjustments that decrease the imputed underpayment could be subject) and applying the highest rate of tax in effect for the reviewed year under section 1 or 11, as provided in Code Sec. 6225. The partnership pays its imputed underpayment as so determined.

The due date for the payment of the imputed underpayment or furnishing of partner statements and the filing of the partnership adjustment tracking report is the return due date (including allowable extensions) for the adjustment year of the audited partnership. That is, the partnership adjustment tracking report must be filed with the IRS, and the imputed underpayment paid or statements furnished to partners or S corporation shareholders (or if not so furnished, an imputed underpayment must be paid), not later than the due date for the adjustment year of the audited partnership. In the case of a partner that is not a partnership or an S corporation and that receives a statement in a push-out, the partner's tax is increased for the partner's taxable year that includes the date of the statement, as provided in Code Sec. 6226(b). In the case of partner that is a trust and that receives a statement in a push-out, regulatory authority to provide any necessary rules is set forth.

CAA defines an audited partnership for purposes of the push-out treatment of passthrough partners in tiered structures under Code Sec. 6226(b)(4). With respect to a partner that is a partnership or an S corporation and that receives a statement in a push-out, the audited partnership is the partnership in the chain of ownership originally electing the application of Code Sec. 6226.

Failure of Partnership or S Corporation to Pay Imputed Underpayment

Under CAA, if, following an assessment, a partnership fails to pay an imputed underpayment within 10 days after the date of notice and demand by the IRS, the applicable interest rate increases, and assessment and collection against adjustment-year partners for their proportionate shares may be made. The interest rate under the provision is the underpayment rate as modified, that is, the rate is the sum of the federal short-term rate (determined monthly) plus 5 percentage points. An S corporation and its shareholders are treated like a partnership and its partners under this provision.

The provision applies if, within 10 days of notice and demand for payment, a partnership fails to pay an imputed underpayment under Code Sec. 6225 or any interest or penalties under Code Sec. 6233. For example, the increased interest rate applies and assessment and collection from adjustment year partners may be made in the case of a partnership that has not elected under Code Sec. 6226 to push out adjustments to partners nevertheless fails to pay within 10 days of notice and demand.

The provision also applies if any specified similar amount (or interest or penalties with respect to the amount) have not been paid. A specified similar amount arises if a partner that is an upper-tier partnership or S corporation in a push-out fails to pay an imputed underpayment under Code Sec. 6226(b)(4)(A)(ii) (including any failure to furnish statements that is treated as a failure to pay an imputed underpayment under Code Sec. 6651(i)). A specified similar amount also includes an amount required to be paid by former partners (including partners that are themselves partnerships) of a partnership that has ceased to exist or terminated (not including a technical termination) as well as interest or penalties with respect to the amount.

The date of the notice and demand for payment initiates a two-year period in which the IRS may assess against the adjustment-year partners (or former partners). The two-year period of limitations also applies to a proceeding begun in court without assessment with respect to a partner. The period may be extended by agreement.

CAA expands the present-law Code Sec. 6501(c)(4) rule permitting extension by agreement between the IRS and the taxpayer of the time period for assessment. As a result, that rule permitting extension by agreement is not limited to assessment periods prescribed in Code Sec. 6501, but rather, applies more broadly to assessment periods and in particular applies to the period for assessment against partners in the case of failure of a partnership to pay an imputed underpayment after notice and demand under Code Sec. 6232(f).

If a partnership has ceased to exist or terminated (not including a technical termination) within the meaning of Code Sec. 6241(7), the provision applies with respect to the former partners of the partnership. For example, the former partners of the partnership may be the partners for the most recent period before the partnership ceased to exist or terminated, such as the partners for purposes of the last return filed by the partnership.

A partner is liable for no more than the partner's proportionate share of the imputed underpayment, interest, and penalties, measured as the IRS determines on the basis of the partner's distributive share of items. For example, the distributive shares set forth in the partnership agreement, or as determined for purposes of Schedule K-1, may serve as a measure of a partner's proportionate share. The IRS is required to determine partners' proportionate shares so that the aggregate proportionate shares so determined total 100 percent. Thus, no partner is required to pay more than the partner's proportionate share of the imputed underpayment, interest, and penalties.

Partner payments under this provision reduce the partnership's liability to pay. The partnership's liability is not reduced by partner payments if such payments are made after the date on which the partnership pays, however.

Example: If Partnership ABC's liability is $100, and partner payments aggregating $60 before July 15 reduce ABC's liability to $40, and ABC pays $40 on July 15, a partner payment of $40 on August 1 does not reduce ABC's liability. ABC may not receive a credit or refund for any part of the partner payment of $40; the partner, however, may.

The IRS may assess the tax, interest, and penalties on the proportionate share of each partner (as of the close of the adjustment year) of the partnership without regard to the deficiency procedures generally applicable to income tax. Under the provision, assessment may not be made (or proceeding in court begun without assessment) after the date that is two years after the date on which the IRS provides notice and demand.

Amendment of Statements (Schedule K-1s) to Partners

CAA clarifies that a partnership that has validly elected out of the partnership audit rules under Code Sec. 6221(b), and therefore is not subject to the partnership audit rules, may amend partner statements (Schedule K-1s) after the due date of the partnership return to which the statements relate.

Treatment of Partnership Adjustments that Result in a Decrease in Tax in Push-Out

As an alternative to a partnership payment of the imputed underpayment in the adjustment year, the audited partnership may elect to furnish to the IRS and to each partner of the partnership for the reviewed year a statement of the partner's share of any adjustments to partnership-related items as determined by reference to the final determination with respect to the adjustment. In this situation, Code Sec. 6225, requiring the audited partnership to pay the imputed underpayment, does not apply. Instead, each reviewed-year partner takes the adjustments into account for the taxable year that includes the date of the statement and pays the tax as provided in Code Sec. 6226 (taking into account Code Sec. 6226(b)(4)).

The provision provides that in taking into account adjustments to determine a partner's tax in a push-out, decreases as well as increases in the partner's tax are taken into account. The provision clarifies that in a push-out, the partner's tax for the taxable year that includes the date of the statement is adjusted by the aggregate of the correction amounts (not adjustment amounts).

The correction amount for a particular taxable year of a partner takes into account both decreases and increases. That is, the correction amount for the partner's taxable year that includes the end of the reviewed year is the amount by which the income tax would increase or decrease if the partner's share of adjustments were taken into account for that year. Similarly, the correction amount for any taxable year of the partner after that year, and before the year that includes the date of the statement, is the amount by which the income tax would increase or decrease if the partner's share of adjustments were taken into account for that year. The present-law treatment of mathematical or clerical errors applies with respect to correction amounts and aggregate correction amounts.

Clarification of Assessment of Imputed Underpayments

CAA clarifies that the assessment of any imputed underpayment is not subject to the deficiency procedures. Rather, they are assessed and collected in accordance with the rules of Code Sec. 6221 through Code Sec. 6235. Any imputed underpayment (including an imputed underpayment under Code Sec. 6226(b)(4)(A)(ii) of a partnership or S corporation that is a direct or indirect partner of an audited partnership in a push-out) is assessable under the provision.

The provision clarifies that in the case of an administrative adjustment request to which Code Sec. 6227(b)(1) applies, the underpayment must be paid, and may be assessed, when the request is filed.

A reference in Code Sec. 6232(b) to the assessment of a deficiency is corrected to refer to the assessment of an imputed underpayment. Generally, then, an imputed underpayment of a partnership may not be assessed or collected before the close of the 90th day after the day on which a notice of final partnership adjustment was mailed, and if a petition is filed under Code Sec. 6234 with respect to the notice, the decision of the court has become final.

However, the restrictions on assessment and collection of an imputed underpayment provided generally under Code Sec. 6232(b) do not apply in the case of any specified similar amount within the meaning of Code Sec. 6232(f)(2). As a result, the restrictions do not apply to the imputed underpayment of partner that is a partnership or S corporation in a push-out. A specified similar amount means the amount described in Code Sec. 6226(b)(4)(A)(ii)(II), including an failure to furnish statements to partners or S corporation shareholders that is treated as a failure to pay that amount under Code Sec. 6651(i). A specified similar amount also means any amount assessed on a partner that is a partnership or S corporation. Thus, for example, these restrictions do not apply to assessment and collection of an imputed underpayment of a partnership or S corporation that receives a statement in a push-out and neither timely furnishes statements to its partners or shareholders nor pays its imputed underpayment.

Time Limit for Notice of Proposed Partnership Adjustment

CAA clarifies that a notice of proposed partnership adjustment must be mailed within the applicable period of limitations on making adjustments under the partnership audit rules. The notice of proposed partnership adjustment cannot be relied upon to revive an otherwise expired limitations period under Code Sec. 6235. For purposes of determining whether or not a notice of proposed partnership adjustment is timely, the applicable limitations period is determined under Code Sec. 6235, determined without regard to Code Sec. 6235(a)(2) (relating to the period for modification of an imputed underpayment under Code Sec. 6225(c)(7)), and without regard to Code Sec. 6235(a)(3) (relating to the 330-day period (or the period as extended) for making an adjustment after the date of a notice of proposed partnership adjustment).

CAA does not alter the Code Sec. 6231(b)(2) prohibition against mailing any notice of final partnership adjustment earlier than 270 days after the date on which the notice of proposed partnership adjustment is mailed (except to the extent the partnership elects to waive the prohibition).

Statute of Limitations on Making Adjustments

CAA clarifies several rules relating to the period of limitations on making adjustments. CAA makes clear that the period of limitations on making adjustments under subchapter C of chapter 63 does not limit the period for notification of the IRS and redetermination of tax under Code Sec. 905(c). CAA corrects a cross reference so that it refers to the partnership audit regime rules (rather than to a nonexistent subpart). CAA clarifies a reference to the penalty for substantial omission of income to incorporate a reference to constructive dividends, not just to other omitted items. CAA also clarifies that the time for making any adjustment under the partnership audit regime rules with respect to any tax return, event, or period does not expire before the date determined under Code Sec. 6501(c)(8) (relating to the failure to notify the IRS of certain foreign transfers), that is, generally, the date that is three years after the date on which the IRS is furnished the information required to be reported. CAA clarifies that the time for making any adjustment under the partnership audit regime rules with respect to a listed transaction described in Code Sec. 6501(c)(10) does not expire the date determined under Code Sec. 6501(c)(10), that is, generally, the date that is one year after the earlier of the date on which the IRS is furnished the information required to be reported or the date on which a material advisor meets certain applicable requirements. The provision is clarified by striking Code Sec. 6235(d), a provision included in prior law that has no effect under the partnership audit regime rules.

U.S. Shareholders and Certain Other Persons Treated as Partners

CAA clarifies the treatment under the partnership audit regime rules of U.S. shareholders and certain other persons treated as partners. Generally, in the case of a controlled foreign corporation that is a partner of a partnership, each U.S. shareholder is treated under the partnership audit regime rules as a partner in the partnership. For this purpose, except as otherwise provided by the IRS, the distributive share with respect to the partnership equals the U.S. shareholder's pro rata share with respect to the controlled foreign corporation, determined under rules similar to the rules for determining its pro rata share of subpart F income under Code Sec. 951(a)(2). CAA also addresses the treatment under the partnership audit regime rules of a passive foreign investment company (PFIC) that is a partner in a partnership and that is a qualified electing fund with respect to a taxpayer pursuant to the taxpayer's election under Code Sec. 1295.

Penalties Relating to Administrative Adjustment Requests and Partnership Adjustment Tracking Reports

CAA clarifies existing penalty provisions to ensure that they address compliance with the partnership audit rules. A partnership adjustment tracking report required to be filed pursuant to a Code Sec. 6226 election is treated as a return for purposes of penalties relating to failure to file a partnership return, frivolous position submissions, and preparation of tax returns for other persons. A failure to comply with Code Sec. 6226(b)(4)(A)(ii)(II), relating to the requirement to furnish statements in a push-out, is treated as a failure to pay an imputed underpayment for purposes of the penalty relating to failure to file a tax return or to pay tax. An administrative adjustment request under Code Sec. 6227 is treated as a return for purposes of penalties relating to frivolous position submissions and the preparation of tax returns for other persons. However, CAA clarifies that neither an administrative adjustment request under Code Sec. 6627 nor a partnership adjustment tracking report under Code Sec. 6226(b)(4)(A) is treated as a return for purposes of the partner amended return modification procedure of Code Sec. 6225(c)(2)(A).

Statements to Partners (Adjusted Schedules K-1) Treated as Payee Statements

The provision clarifies that for purposes of the penalty for failure to furnish correct payee statements and the penalty for failure to file correct information returns, statements required to be furnished to partners in a push-out under Code Sec. 6226(a)(2), or statements required to be furnished to partners under rules similar to Code Sec. 6226(a)(2), are treated as payee statements. Statements required to be furnished to partners under rules similar to Code Sec. 6226(a)(2) include statements furnished to partners pursuant to an administrative adjustment request under Code Sec. 6227.

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Supreme Court: Tax Obstruction Conviction Requires Awareness of Pending Proceeding

The Supreme Court reversed the Second Circuit and held that, in order to secure a conviction under Code Sec. 7212(a) for interference with the administration of the Internal Revenue Code, the government must show a nexus between the taxpayer's obstructive conduct and a particular administrative proceeding, such as an investigation, audit, or other targeted administrative action. The Court found that broadly applying the statute to the routine administration of the Code, including the processing and review of tax returns, would conflict with the language, history, and context of the statute and fail to give taxpayers fair warning of what conduct is subject to criminal prosecution. Marinello v. U.S., 2018 PTC 77 (U.S. 2018).

Background

Between 2004 and 2009, the IRS investigated the tax activities of Carlo Marinello, the owner of a courier business. In 2012, Marinello was charged with violating several criminal tax statutes including the "omnibus clause" of Code Sec. 7212(a), which makes it a felony to corruptly or by force obstruct or impede the due administration of the Internal Revenue Code. The government claimed Marinello failed to maintain corporate books and records, failed to provide his tax accountant with complete and accurate tax information, destroyed business records, hid income, and paid employees with cash.

Marinello was tried before a jury. After the trial, the judge instructed the jury on the elements of the omnibus clause. However, the jury was not told that it had to find that Marinello knew he was under investigation and intended to corruptly interfere with the investigation. The jury subsequently convicted Marinello on all counts.

Taxpayer and Government Arguments

Marinello appealed to the Second Circuit. He argued that under Code Sec. 7212(a), the government had to show that he tried to interfere with a pending IRS proceeding, such as a particular investigation. The Second Circuit disagreed, holding that the omnibus clause does not require awareness of a particular IRS action or investigation. Marinello petitioned for certiorari and, in light of a split among the circuits courts, the Supreme Court granted Marinello's petition.

The government argued that the administration of the Code referred to in Code Sec. 7212(a) includes not just a specific investigation of a taxpayer but the routine work of the IRS, including the processing and review of tax returns. According to the government, the need to prove that the obstructive conduct was done "corruptly" would cure any overbreadth problem in the statute. It also argued that the scope of the statute would be effectively narrowed by prosecutorial discretion. The omnibus clause had been used sparingly, the government said, and where more punitive and less punitive criminal provisions both applied, charges were typically brought under the more punitive provision. The government further argued that previous Supreme Court cases interpreting obstruction provisions, including U.S. v. Aguilar, 515 U.S. 593 (1995), should be ignored because of differences in the language and history of those statutes.

Supreme Court's Decision

The Supreme Court agreed with Marinello and held that to secure a conviction under the omnibus clause, the government must prove the taxpayer was aware of a pending tax proceeding, such as a particular investigation or audit, or could reasonably foresee that such a proceeding would begin. The Court began by analyzing its decision in Aguilar, where it interpreted the obstruction of justice provision under 18 U.S.C. Sec. 1503. In that case, which involved an attempt to mislead an investigating agent, the Court found that the statute required a nexus between the defendant's act and judicial proceedings. The Court set forth two reasons for finding that such a nexus was required. First, it felt compelled to defer to the prerogatives of Congress. Second, the Court was concerned that fair warning should be given of what the law intends to do if a certain line is crossed.

Turning to Code Sec. 7212(a), the Court noted that although the language of the omnibus clause is neutral, the choice of words and legislative history showed that Congress did not intend for the clause to apply to every administrative task undertaken by the IRS. The Court reasoned that the statute refers specifically to efforts to intimidate or impede any officer or employee of the United States. In that context, the omnibus clause is a catchall for such obstructive conduct, and not for every violation that interferes with the administration of the Code. The Court also reviewed the legislative history and found that Congress was concerned with threatening acts against agents, officers and other employees of the IRS; nothing in the statute's history suggested to the Court that Congress intended the omnibus clause to apply to routine processing of tax returns.

The Court also found that the government's broad reading of the omnibus clause was unwarranted when considered in the broader context of the Code. The Court reasoned that the Code creates numerous misdemeanors, such as willful failure to furnish statements to employees and failure to keep required records. A broad reading of the omnibus clause could potentially transform many if not all of these misdemeanor provisions into felonies, in the Court's view. The Court recognized that some overlap and redundancy in criminal provisions is inevitable. But the Court found no cases interpreting a statutory provision that would create overlap and redundancy to the degree that would result from the government's broad reading of Code Sec. 7212, especially considering that other provisions of the same statute would be rendered superfluous.

The Court also found that a broad interpretation would create the same fair warning problem that was identified in Aguilar. According to the Court, a taxpayer who paid a babysitter in cash without withholding taxes, or failed to keep receipts for every charitable donation, might believe that an IRS rule had been violated, but the Court doubted that such a taxpayer would expect a felony prosecution for tax obstruction. In the Court's view, if Congress intended that outcome it would have spoken with more clarity than it did in Code Sec. 7212(a).

The Court was not persuaded that the government's need to prove the obstructive conduct was done "corruptly" would cure the overbreadth problem, and was likewise skeptical that prosecutorial discretion could be relied on to narrow the statute's scope. While the government argued that "corruptly" means acting with specific intent to obtain an unlawful advantage, the Court struggled to imagine a scenario where a taxpayer would willfully violate the Code without intending to obtain an unlawful advantage for him or herself or another. The Court further reasoned that trusting prosecutorial discretion to narrow the statute would place great power in prosecutors and could result in nonuniform enforcement. The Court found that it had traditionally exercised restraint in assessing the reach of a federal criminal statute for these reasons.

The government's argument that previous decisions interpreting similar statutes narrowly should be ignored due to differences in statutory language and history was also rejected. The Court pointed out that Congress relied on the language of 18 U.S.C. Sec. 1503 when it enacted Code Sec. 7212, and found that given the similarity between the two statutes it was helpful to consider how the former had been interpreted.

The Court concluded with a clarification that, in addition to the nexus requirement, the government must show that the proceeding was pending or at least foreseeable when the taxpayer engaged in the obstructive conduct. According to the Court, it is not enough for the government to claim the taxpayer knew the IRS might eventually catch on to the unlawful scheme.

In a dissenting opinion, Justices Thomas and Alito would have held that, based on the statute's plain language, the omnibus clause applies to all efforts to obstruct the administration of the Code and is not limited to a particular proceeding.

For a discussion of the criminal penalty for interference with administration of the Code, see Parker Tax ¶265,148.

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Case Against IRS Involving Phone Call Broadcast on Howard Stern Show Moves Forward

A district court held that it was the proper venue for an action against the IRS for unauthorized disclosure of tax information in a case involving an IRS agent whose conversation with a taxpayer was inadvertently broadcast on the Howard Stern radio show. However, the court dismissed the taxpayer's negligence and invasion of privacy claims against the IRS because they were not authorized under the Federal Tort Claims Act, and found that the taxpayer failed to state a claim with respect to her intention infliction of emotional distress claim against the radio show. Barrigas v. U.S., 2018 PTC 63 (D. Mass. 2018).

Judith Barrigas called an IRS customer service center in May 2015 to discuss whether her tax refund for 2014 had been incorrectly applied to her 2011 and 2012 tax liabilities, which were already subject to a repayment agreement. Barrigas's call was routed to IRS agent Jimmy Forsythe who, without Barrigas's knowledge, was on hold on another phone line with the Sirius XM satellite radio program The Howard Stern Show. At some point during Forsythe's conversation with Barrigas, Forsythe was taken off hold. Apparently unaware that he was on the air, Forsythe continued to speak to Barrigas and, toward the end of their conversation, mentioned her phone number.

The show segment captured only Forsythe's side of the conversation; Barrigas's voice was not audible during the broadcast. The call between Barrigas and Forsythe lasted around 45 minutes but only about three minutes of the conversation aired. While Forsythe's side of the conversation was on air, Stern and his cohost commented on the complexity of the subject matter and expressed disinterest in Forsythe's work. They also commented that the person he was talking to did not "need to ask all those questions" and should "pay the bill," and that Forsythe should just give them "the bottom line" and "stop going through all the math."

Barrigas found out about Forsythe's call into the Howard Stern Show when she began receiving harassing text messages and telephone calls from unknown people in the days following the broadcast. She reported the incident to the IRS and to the show, but the IRS took action only after she reported it to a local news station. The show did not respond to her communications about the incident and a recording of the broadcast was allegedly available on the show's website for weeks after the incident. Barrigas claimed she suffered anxiety and difficulty sleeping and eating and sought treatment as a result of the incident. She also said that the broadcast had detrimentally affected her ability to find employment.

Barrigas sued the IRS and the Howard Stern Show in a district court. Her claims against the IRS included negligence and invasion of privacy under the Federal Tort Claims Act (FTCA) and disclosure of tax return information in violation of Code Sec. 7431. Barrigas brought tort claims against the Howard Stern Show including negligence, invasion of privacy, and intentional infliction of emotional distress. Barrigas argued that the broadcast of Forsythe's statements concerning her tax information and her phone number violated her right to privacy, that the show had a duty of reasonable care to avoid disseminating private information about her, and that the show's hosts either knew or should have known that emotional distress would result from their actions.

The IRS filed a motion to dismiss, arguing that Barrigas's tort claim against it was not permitted under the FTCA. The IRS also argued that the district court was not the proper venue for the Code Sec. 7431 claim. The Howard Stern Show filed a motion to dismiss arguing that Barrigas had failed to state a claim against it.

The district court held that it was the proper venue for Barrigas's Code Sec. 7431 claim because Barrigas claimed she lived in Massachusetts since filing her complaint and the government did not oppose her on that issue. However, the district also granted the IRS's motion to dismiss Barrigas's claim under the FTCA and dismissed all of her claims against the Howard Stern Show.

The district court determined that it did not have jurisdiction over Barrigas's tort claims against the IRS because the government had not waived its sovereign immunity under the FTCA. The FTCA provides a limited waiver of sovereign immunity to allow claims against the U.S. for damages caused by the negligent or wrongful acts of a federal government employee. However, under the tax exception, the waiver does not apply to any claim relating to the assessment or collection of taxes. As the court explained, the tax exception has been interpreted broadly, and courts have found that a wide range of IRS activity arises in respect of tax collections and assessments. The court agreed with Barrigas that Forsythe's call to the Howard Stern Show was beyond the scope of his duties but reasoned that the tax exception is meaningless if it does not cover activities that fall outside the scope of an IRS agent's employment.

The court also rejected Barrigas's tort claims against the Howard Stern show. The court found that there was no intentional dissemination of her private information because she was never named and her phone number was not disclosed until the final seconds of her and Forsythe's conversation. It was unclear to the court how Forsythe's on-air statements, which vaguely discussed the tax amounts and repayment terms of an unspecified third party, could be an intentional invasion of the third party's privacy. Even if the show's hosts acted intentionally, the court found that there was no serious intrusion into highly personal information because Barrigas's name, social security number, address or other identifying information were not disclosed and her voice could not be heard. The only disclosure was her phone number, which Barrigas admitted was publicly listed.

Barrigas's negligence claim against the show was rejected because the court characterized it as a claim for negligent invasion of privacy, which it found was not recognized under Massachusetts state law. Regarding Barrigas's emotional distress claim, the court found that Barrigas had not shown that the show's hosts had the requisite intent. The court reasoned that their on-air comments were mostly directed at Forsythe, not Barrigas, and those that did concern Barrigas were nondescript, general and not malicious. The court reasoned that it did not see how the broadcasting of limited tax-related information about an unidentified individual and the show's failure to remove a recording of the segment from its website for several weeks could be considered extreme or outrageous as required for an intentional infliction of emotional distress claim.

For a discussion of penalties relating to the unauthorized disclosure of tax return information, see Parker Tax ¶265,145.

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IRS Tax Lien Applied Only to Taxpayer's Half Interest in Former Marital Home

A district court held that an IRS tax lien encumbered only half of an interest in real property that the taxpayer previously held as a joint tenant with his now-deceased wife because the couple's divorce agreement provided that the property was to be sold with the proceeds divided equally and that agreement thus severed the joint tenancy that previously existed. The district court certified the question of the divorce agreement's effect on the joint tenancy under Georgia law to the Georgia Supreme Court, which found that the agreement, as a whole, evidenced the parties' intent to sever the joint tenancy. Estate of Cahill v. U.S., 2018 PTC 66 (N.D. Ga. 2018).

Robert Hall and Cathleen Mary Cahill were married in 1999. At the time, Hall owned a house on Old Course Drive in Roswell, Georgia. In 2005, he quitclaimed the property to himself and Cahill as joint tenants with a right of survivorship. The couple occupied the house as their marital home until they separated.

Cahill and Hall divorced in 2008. Under a settlement agreement, Cahill was given the exclusive use and possession of the Old Course Drive property, but both parties were to remain on the title until the property was sold and both agreed that the settlement resolved all issues as to equitable division of property. The property was to be placed on the market when Cahill reached age 66 and the net proceeds from the sale would be divided equally. Cahill lived in the house until her death in April 2015, two months after her 66th birthday. The property was never listed for sale or transferred after the April 2005 quitclaim deed that created the joint tenancy.

After the divorce, Hall failed to fully pay his income taxes. In 2013, the IRS filed a notice of tax lien against all property and rights to property belonging to Hall, including the Old Course Drive property. Cahill's estate sued the IRS in a district court, arguing that the divorce severed the joint tenancy and that Hall had only a half interest in the Old Course Drive property. Thus, only half of that property could be encumbered by the lien. The IRS countered that that Hall acquired a full interest in the property on Cahill's death.

The district court certified to the Georgia Supreme Court the question of what effect the divorce agreement, which purported to resolve all issues as to equitable division of property but made no express reference to severance or retention of the joint tenancy, had on the joint tenancy and right of survivorship under Georgia law. The Georgia Supreme Court held that the provision of the divorce agreement addressing the Old Course Drive property, when read in conjunction with the agreement as a whole, evidenced the parties' intent to sever the joint tenancy. The district court therefore concluded that the tax lien against Hall encumbered only half of the Old Course drive property.

For a discussion of IRS tax liens, see Parker Tax ¶260,530.