December 2014 Newsletter
IRS Announces Post-Appeals Mediation For Offers In Compromise
In 2008, the IRS implemented a pilot program in certain cities for post-appeals mediation for offer in compromise and trust fund recover penalty cases. Revenue Procedure 2014-63 provides procedures that expand the program nationwide.
IRS Power To Regulate Tax Practitioners Slipping Away
The power of the Internal Revenue Service (IRS) Office of Professional Responsibility (OPR) seems to be draining away in the aftermath of Loving v IRS and Ridgely v Lew. What appears to be the latest drop comes in Sexton v Hawkins.
James Sexton used to be a practitioner representing taxpayers before the IRS. The words ‘used to be’ are applicable for two reasons. First, Sexton apparently once represented taxpayers before the IRS, since he is a lawyer licensed in South Carolina who also has an LLM in taxation. However, in 2005 he pled guilty in federal court to four counts of mail fraud and one count of money laundering. As a result, in 2008 the OPR suspended him from practice before the IRS for an indefinite period. Since then, he has made a living providing tax advice and return preparation services to taxpayers in Las Vegas.
Second, according to Loving, a person who does not actively represent taxpayers in proceedings with the IRS but merely prepares returns is not engaged in ‘practice before the IRS’ as that term is used in the applicable statute, 31 USC § 330(a). Therefore, Sexton contends that since his suspension by the OPR he has not been a practitioner before the IRS; and the rationale of Loving supports that claim. He has acknowledged that he prepares returns for clients; but again, he relies on Loving to contend that he is not thereby subject to regulation under Section 330.
The OPR apparently received a complaint that Sexton was engaged in practice before the IRS and in February 2013 it sent him an inquiry letter. It asked a number of questions about his practice and requested many documents related to his clients, such as copies of returns he had prepared, any documents he used or relied upon in preparing returns and any explanations of the tax law he had provided to clients. The OPR specifically relied on Circular 230 in its request letter, citing Section 10.20 as authority for its request and for his purported obligation to comply, and Sections 10.50 and 10.52 for sanctions that might apply. In May 2013 Sexton sued under the Administrative Procedure Act, seeking declaratory relief that he was not subject to OPR regulation and asking the court to enjoin the OPR request for information. The Justice Department moved to dismiss.
This dispute involves a number of paradoxes. First, Sexton (and perhaps the court) might have considered it strange that the OPR was threatening sanctions against someone whom it had already sanctioned once with an open-ended, indefinite suspension. Perhaps the only things left that the OPR could seek to do to Sexton now would be to disbar him permanently or impose some kind of monetary penalty on him. Further, while the OPR was arguing that Sexton was not authorized to practice before the IRS, it was relying on provisions of Circular 230 that apply only to practitioners before the IRS. Under the Loving rationale, return preparation is not practice; so perhaps the OPR was investigating to see whether Sexton was engaged in other activities that might constitute practice. But what is its authority to ask a return preparer (who, post-Loving, is by definition a non-practitioner) about that issue?
On the other hand, the OPR would presumably contend that it was merely investigating to see whether Sexton was in compliance with his previous sanction. Or it might argue that Sexton was still at least potentially an authorized practitioner by virtue of being a lawyer; that he was merely suspended, not disbarred; and that its inquiry was necessary to see whether an additional sanction was necessary. Either of these contentions would be consistent with the OPR’s position, repeated in various forms at every opportunity, which can be paraphrased as: “Once you’re in the system, you’re in for all purposes and the OPR has continuing jurisdiction over you.”
The above intriguing questions – which may eventually be resolved by the Sexton court – are not addressed in the opinion just issued. However, the opinion is interesting in its own right for other reasons. First, over the government’s motion to dismiss, the court held that it had jurisdiction under Section 702 of the Administrative Procedure Act, because the OPR investigation constituted a “final agency action for which there is no other adequate remedy in a court”. It may seem strange (especially to the OPR) to characterize a mere inquiry letter as a final agency action. But to that, the court essentially responded that the OPR was hoist by its own petard. It found that the OPR’s assertion of jurisdiction over Sexton and his business was itself a final agency action that had consequences, among which was application of the very provisions that the OPR cited – that is, the obligation under Section 10.20 to respond to its inquiry and the possibility of additional sanctions under Section 10.50. Other consequences might also ensue: Sexton claimed that the OPR threatened to withdraw his ability to e-file returns if he failed to respond to the inquiry letter, and the opinion points out that the letter required him immediately to turn over otherwise confidential client records and returns. The OPR’s position, the court stated, “elides the important distinction between a mere investigation, which is likely not final, and the instant demand for documents under color of law and threat of consequences, which is”. The court found that there was no adequate remedy to prevent the harm that could flow from that action, pointedly noting the Justice Department’s concession at oral argument that there was “no possible administrative remedy or process for contesting the production of the material”.
In a second holding, and largely for the same reasons, the court found that Sexton had adequately asserted a claim for relief. The issues it described include whether Sexton was a ‘practitioner’, whether OPR jurisdiction extends to a ‘former practitioner’ and his business and, most interestingly, “whether the giving of tax advice is beyond the scope of the regulatory authority” of the OPR. That the court even appears intent on deciding that third issue, which has been the subject of much speculation since Loving, should give the government some pause.
Third and finally, the court entered a preliminary injunction, again based mainly on the lack of any other adequate remedy. It noted that once the requested documents are produced, they cannot be ‘unproduced’ (its word), and specifically found that the production itself could constitute irreparable injury, whereas there would be no hardship to the IRS or adverse impact on the public from waiting. The court thus specifically enjoined the production of documents – but not the entire investigation – and prohibited the IRS from suspending Sexton’s ability to e-file for failing to produce those documents.
There are many other thought-provoking asides and comments in the opinion, which warrants careful review by interested parties. While the final outcome of the case remains to be seen, it seems to be at least another temporary setback for the OPR. The government has now suffered three consecutive losses in its effort to reach return preparation activities, whether conducted by non-practitioners (Loving), former practitioners (Sexton) or even current certified public accountants (Ridgely). Given the court’s comments and holdings in this initial opinion, a final loss in Sexton could further seriously undercut the OPR’s authority.
Moreover, the court’s conclusion that there is no potential harm to the public from letting a convicted felon and suspended practitioners continue to prepare returns seems questionable. It is certainly inconsistent with the findings of the IRS’s return preparation study, the regulations overturned in Loving and the views of the organized tax bar and accounting profession. Many believe that additional legislative authority is required and urge a thorough rewriting of Section 330; although it is hard to believe a Republican-controlled Congress will be inclined give the IRS new and expansive regulatory powers.
So the most likely result may just be continued fights over – and possibly further erosion of – the OPR’s authority.
Ten Year-End Tax Tips
As January 1, 2015 rapidly approaches, individuals and businesses are reviewing their gains and losses in 2014 in an effort to determine what can be done to improve in fiscal 2015. However, 2014 is not over yet and there is still time to take advantage of certain last minute tax and estate planning techniques and to ensure that certain tax elections have not “slipped through the cracks.” The following is a checklist of some year-end tax and estate planning tips to consider.
Income Tax Planning
• Income Tax Deferral- We are approaching the second anniversary of the enactment of the American Taxpayer Relief Act (“ATRA”) which increased the top individual income tax rate to 39.6% and the top capital gains rate to 20%. In addition to increasing the top income tax rates, ATRA also enacted the 3.8% tax created by the Affordable Health Care and Patient Protection Act (commonly known as “Obamacare”). As we approach the close of another year under ATRA, individuals should evaluate whether it makes “tax sense” to defer or postpone the recognition of income to next year. If an individual is contemplating whether to sell certain assets, he or she may have the ability to delay the sale so that the income is recognized in a future year. This strategy could be beneficial not only if the taxpayer expects to be in a lower tax bracket in future years, but allows deferral of the payment of the taxes on that gain by a year.
• Harvest Tax Losses- While the overall economy is in better shape now than it was a few years ago, many taxpayers continue to have capital losses from prior years that can be used to offset current capital gains. While capital losses in general can only be utilized to offset capital gains, if capital losses exceed capital gains, an individual can utilize the excess capital losses to offset $3,000 of ordinary income. Unused capital losses can be carried forward and used in future years.
• Accelerating Deductions- Another way for an individual to reduce their 2014 tax liability is to accelerate certain deductions so the deduction can be claimed in 2014. If a taxpayer had a high income tax year in 2014, the taxpayer may consider prepaying property taxes or state income taxes by December 31 in order to accelerate the deduction.
• 3.8% Obamacare Tax- Many high net worth individuals will be subject to the 3.8% healthcare surcharge on net investment income. The 3.8% tax applies to individual taxpayers whose modified adjusted gross income exceeds $200,000 or $250,000 for taxpayers who are married filing jointly. Net investment income includes, but is not limited to, certain capital gains, dividends, interest and royalties. In general, the 3.8% tax applies to certain passive activities in which the taxpayer does not materially participate. Deferring the recognition of certain income taxes and harvesting tax losses (both discussed above) are two ways of potentially reducing a taxpayer’s exposure to the 3.8% tax. Additionally, a taxpayer may consider gifting certain assets that would otherwise be subject to the 3.8% tax to family members in lower tax brackets, as only those taxpayers in the highest income tax brackets are subject to the 3.8% tax.The 3.8% tax also applies to trusts when the adjusted gross income of the trust exceeds $12,150. Therefore, trustees of irrevocable trusts should evaluate whether making distributions of trust income to beneficiaries (if the terms of the trust permit) who have income below the $200,000 or $250,000 threshold would remove the 3.8% tax liability.
• Charitable Planning – In addition to satisfying an individual’s philanthropic endeavors, year-end charitable planning may be able to provide significant income tax benefits. Many individuals make annual charitable gifts in cash without first considering whether or not there may be other tax-advantaged ways of giving to charity. For example, instead of giving cash to charity to obtain an immediate income tax deduction, an individual should consider gifting appreciated securities. By gifting appreciated securities, the individual would get an income tax deduction equal to the fair market value of the asset gifted and avoid the capital gains tax with respect to the appreciated asset. Gifting to charity may also assist taxpayers is avoiding the federal Alternative Minimum Tax (“AMT”) and the 3.8% Obamacare Tax discussed above. Although beyond the scope of this Tax Alert, there are many additional charitable planning techniques available to leverage an individual’s charitable intent as well as advance their estate plans, including the use of charitable lead trusts (for significant income tax deductions) and charitable remainder trusts (to defer significant capital gain).
Estate and Gift Tax Planning
• Estate and Gift Tax Exemption Gifts- In addition to introducing many income tax changes in early 2013, ATRA also provided a certain amount of stability to the federal estate and gift tax. ATRA increased the maximum estate, gift and generation skipping transfer (“GST”) tax rate from 35% to 40% and maintained the maximum exclusion amount for estate, gift and GST taxes at $5,000,000 per individual, indexed for inflation. Due to the inflation adjustments, the estate, gift and GST tax exclusion amount is $5,340,000 per individual for 2014 (and is scheduled to increase to $5,430,000 in 2015). Although ATRA was enacted less than two years ago, President Obama’s fiscal year 2014 and fiscal year 2015 budgets have included provisions to again reduce the estate, gift and GST tax exclusion amounts. Utilizing an individual’s exclusion amount allows an individual to remove the value of an asset, along with any appreciation on the asset, out of the individual’s estate for federal estate tax purposes. Those taxpayers who may be subject to the federal estate tax on death may still want to consider utilizing their full exemption amount during their lifetime.
• Annual Exclusion Gifts – Notwithstanding the $5,340,000 estate, gift and GST tax exclusion afforded to taxpayers, each individual is permitted to make a tax-free gift of $14,000 to an unlimited number of individuals every year. Each $14,000 “annual exclusion gift” does not reduce an individual’s overall $5,340,000 lifetime exclusion amount. However, annual exclusion gifts must be made by December 31 and any unused amount does not carry over to 2015. Utilizing an individual’s annual exclusion gifts is a simple way to transfer wealth to future generations. In addition, individuals are also permitted to make payments for another individual’s educational and medical needs without using the annual exclusion and without incurring gift tax or reducing the donor’s $5,340,000 exclusion amount if the payments are made directly to educational institutions or to healthcare providers.
• Funding 529 Plans- 529 plans have become popular vehicles for individuals who are looking to help family members save for college. In general, 529 plans are state-sponsored savings accounts that are exempt from federal income tax. Income accumulated in a 529 plan can grow income tax free provided that the account assets are used for the educational expenses of the beneficiary for whom the account was established. Contributions to a 529 plan are however subject to federal gift tax. Therefore, it is common for taxpayers to make gifts of their annual exclusion amounts (described above) to 529 plans in order to avoid any gift tax liability. An added benefit of a 529 plan is a special rule that permits the donor to contribute five years’ worth of annual exclusion gifts (or $70,000 in 2014) to the plan. If a donor chooses to “front-load” the plan using five years’ worth of annual exclusion gifts then the donor may not make any annual exclusion gifts to the plan beneficiary for the next four years. Contributions to a 529 plan must be deposited by December 31 in order to utilize the donor’s annual exclusion amount.
• IRA Distributions- Upon attaining the age of 70½, an individual must begin taking annual distributions (“required minimum distributions” or “RMDs”) from his/her retirement account. The amount required to be withdrawn is based on the age of the individual receiving the distribution. If an individual fails to withdraw the full amount or fails to take their RMDs by December 31, the amount not withdrawn will be subject to a 50% penalty tax. If the individual turned age 70½ in 2014, he/she can defer the first RMD to April 1, 2015. If an individual chooses to defer their first RMD until April 1, 2015, he/she will still be required to receive next year’s RMD by December 31, 2015.Note that at the end of 2013, a special rule expired that allowed taxpayers who had attained the age of 70½ to make direct contributions from an IRA to the charity of their choice in an amount not to exceed $100,000. The amount distributed to charity directly from the IRA was not required to be included in the taxpayer’s income for the year of the distribution. Congress has discussed re-enacting this rule. However, as of December 1, 2014 no action has been taken. Taxpayers and their advisors should be monitoring this and prepared to act quickly in the event Congress passes legislation prior to year end.
• Roth Conversion- Converting traditional IRAs to Roth IRAs has become a popular strategy for those whose annual income precludes them from making direct contributions to Roth IRAs. In fact, individuals can also convert other retirement plan accounts, such as a 401(k) to a Roth IRA. A Roth conversion triggers an income tax realization event for the taxpayer, as the taxpayer must pay tax on the amount converted. Therefore, conversion may make sense in a year where the taxpayer otherwise has a low amount of taxable income, but the means to pay any income tax generated by the conversion. Roth IRAs offer taxpayers significant benefits including tax-free distributions, tax-free growth of assets and no required minimum distributions. Please note, however, that different rules apply for inherited Roth IRAs. For those taxpayers looking to take advantage of a Roth conversion, the conversion must be completed by December 31.
Year-end is generally a good time to review your overall estate and financial plan. As described above, a number of tax-related decisions must be made by December 31 in order to take advantage of certain benefits. However, individuals are often inclined to procrastinate and postpone the discussion to the last minute. Estate planning and personal income tax planning are often intertwined, and now is a great time to not only take advantage of certain basic tax-related techniques but also to review your overall estate plan.
President Obama Signs Tax Increase Prevention Act Of 2014: Provides Temporary “Extenders”
Increase Prevention Act of 2014. This legislation retroactively extends multiple tax provisions that were set to expire at the end of 2013. The plan achieves what lawmakers called the “bare minimum” package needed to avoid delaying tax refunds.
Previously, there had been a tentative deal between House Ways and Means Committee Chairman Dave Camp, R-Mich., and Senate Majority Leader Harry Reid, D-Nev., that would have extended some of the expiring provisions permanently, including the research tax credit and Section 179 expensing for small businesses, and renewed the remainder of these provisions for another two years. However, this preliminary deal had to be reworked when President Obama threatened to veto the package.
The benefits in this bill are short lived however, because the bill serves only as a one-year patch for many beneficial provisions that otherwise would have expired at the end of 2013. Because the enacted law is a one-year extension, each provision at issue is scheduled to expire again – this time on December 31, 2014. While reliable planning may be limited due to the timing of the legislation’s enactment, there are planning opportunities available to taxpayers in many industries. This Alert identifies some of the more widely applicable tax provisions addressed in the new law. However, because the 2014 Legislation extends more than 50 diverse tax benefits for businesses and individuals, taxpayers are well-advised to review the new law carefully with tax counsel.
The following section outlines some of the major business tax provisions that were extended to apply to 2014:
• R&D Credit. This is a tax credit for increasing research activities. Readers should note that the research credit allowed normally is equal to 20% of the amounts by which of qualified research expenses for the tax year exceed a base amount (unless the taxpayer elects the alternative simplified research credit). The rules, which are complex, remain consistent with the rules that were applicable in the law that was set to expire at the end of 2013.
• Low-income Housing Credit. This is a tax credit rate for newly constructed non-federally subsidized buildings.
• The new markets tax credit. The provision would authorize the allocation of an additional $3.5 billion of new markets tax credits for 2014.
• Accelerated depreciation of qualified leasehold improvement, restaurant, and retail improvement property, of motorsports entertainment complexes, and of business property on Indian reservations.
• Bonus depreciation allowed in the year property is acquired equal to 50% of the depreciable cost of the property was extended to apply to property placed in service before January 1, 2015. This change prevents many unexpected tax increases for business in capital intensive industries.
• Section 179 Expense. The increased expensing allowance for business assets, computer software, and qualified real property (i.e., leasehold improvement, restaurant, and retail improvement property) was extended to allow property with a cost of up to $500,000 to be expensed currently (with a limit of $2,000,000 in total property placed in service before the Section 179 limit would be reduced). This change avoided the Section 179 Expense amount being reduced to $25,000 (with a limit of $200,000 in total property placed in service limit). Tax rules relating to payments between related foreign corporations and dividends of regulated investment companies. The provision would extend through 2014 provisions allowing for the pass-through character of interest-related dividends and short-term capital gains dividends from regulated investment companies to non-resident aliens.
• The subpart F income exemption for income derived in the active conduct of a banking, financing, or insurance business.
• Exclusion of 100% of gain on certain small business stock.
• The reduction of the recognition period for the built-in gains of S corporations. The provision would extend, to sales of assets occurring during 2014, the rule reducing to five years (rather than 10 years) the period for which an S corporation must hold its assets following conversion from a C corporation to avoid the tax on built-in gains.
The following section outlines some of the major individual tax provisions that were extended to apply to 2014 activities:
• The tax deduction of expenses of elementary and secondary school teachers.
• The tax exclusion of imputed income from the discharge of indebtedness for a principal residence.
• The tax deduction of mortgage insurance premiums.
• The tax deduction of state and local general sales taxes in lieu of state and local income taxes.
• The tax deduction of qualified tuition and related expenses.
• The tax exemption of distributions from individual retirement accounts for charitable purposes.
The new law signed by President Obama also includes the Achieving a Better Life Experience Act of 2014, or ABLE Act. This Act allows each state to set up tax-advantaged accounts for the care of persons with disabilities. Income earned by the accounts, which have a limit of $14,000, would be tax-free. The House passed the ABLE Act as a separate bill the same day it passed the extenders legislation, and the two were later combined.
It bears repeating that these extenders are only available through December 31, 2014. While there is certainty for tax year 2014, watch for additional updates from Dykema’s Taxation Practice in 2015 as the uncertainty for future tax years continues and tax bills – both temporary “patches” and real reform bills – likely will be introduced as 2015 progresses.