Streamlined Filing Compliance Procedures

U.S. taxpayers are required to report foreign assets. For those who have not, the IRS has offered various options for addressing these failures. One such option is the Offshore Voluntary Disclosure Program (OVDP), which is now in its fourth iteration. The distinguishing characteristics of this program are relatively steep penalties that include a 20% understatement penalty and a 27.5% offshore penalty but the benefit of being able to “generally eliminate the risk of criminal prosecution for all issues relating to tax noncompliance and failing to file FBARs."

The other alternative is Streamlined Filing Compliance Procedures (SFCP), which are available to taxpayers who can certify that their "failure to report foreign financial assets and pay all tax due in respect of those assets did not result from willful conduct." On June 18, 2014, the IRS announced major changes in its offshore voluntary compliance programs, a key change being that for the first time, SFCP are available to certain U.S. taxpayers residing in the United States. Thus, SFCP now have two subsets, Streamlined Foreign Offshore Procedures (SFOP) and Streamlined Domestic Offshore Procedures (SDOP), which are available to foreign taxpayers and domestic taxpayers, respectively.

The decision between whether to use the OVDP or SFCP depends in part on the taxpayer’s level of concern regarding whether their failure to properly report could be viewed as willful. If SFCP are selected and the IRS discovers evidence of willfulness, it may open an investigation that could lead to civil fraud penalties, FBAR penalties, information return penalties, or even referral for criminal investigation. Once the OVDP or SFCP option has been pursued, the option not pursued becomes unavailable.

In order to participate in SFCP, taxpayers must file any delinquent FBARs for most recent 6 years according to special IRS instructions and file an amended U.S. tax return for most recent 3 years. Foreign individuals using SFOP can file an original return, but domestic individuals must have already filed. The returns must be filed at a specially-designated IRS address and include a statement certifying SFCP eligibility, that the FBARs have been filed, and that the failure to file was non-willful. Finally, the taxpayer must pay all taxes, penalties, and interest and individuals using SDOP must include the 5% the Miscellaneous Offshore Penalty. As this has been a high-level overview, consult with a competent tax adviser before undertaking any of these programs.

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Help with State Income Tax Audits

Just as the IRS conducts tax audits, so do the states. If you become involved in a state tax audit, keep in mind that Internal Revenue Code Section 6103 authorizes the IRS to share tax information with state governments for tax administration purposes. Among the information exchanged between the IRS and state taxation authorities is individual and business return information. One of the procedures that state taxing authorities use in selecting returns for audit is comparing the information (or the lack thereof) reported on an individual's federal income tax return with what is reported on their state income tax return.

With this in mind, one of the first steps in dealing with a state income tax audit is to gather all information on your account with the IRS. Basic information is readily available on a taxpayer's tax return transcript, a copy of which can be easily obtained through the IRS's Get Transcript webpage. Keep in mind that it will take around 10 days to receive your transcript. As mentioned below, this could potentially be different than the information on your tax return.

Once you have a copy of your IRS transcript, compare income and expense items with the corresponding items under review by your state tax commission. Many states use federal AGI as a key figure in the calculation of state income tax liability, so a difference in federal AGI reported by the IRS and federal AGI reported on your state income tax return could have triggered the audit.

If there are discrepancies, consider why that might be the case. Did you file your federal return but forget to file your state return (or vice versa)? Did the IRS make changes to your tax return? I've even seen a case of a false IRS return filed by a third party engaging in federal refund fraud that triggered a state income tax audit. Of course, you should always talk with a tax professional at the very earliest sign of an audit. With the right information and good advice, you can make any necessary changes to your returns and arrive at a fair resolution of your state income tax audit.

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IRS Notice 784 - Trust Fund Recovery Penalty

As mentioned in a previous post, the IRS pays out tax refunds (often constituting amounts an employer has withheld from an employee's paycheck in excess of that employee's income tax liability) before verifying if the employer has actually withheld those amounts or paid them to the IRS. This is a flawed method and helps explain why the IRS is extremely concerned that employers remit these withheld taxes, as well as social security and Medicaid taxes, to the IRS.

One enforcement mechanism is the Trust Fund Recovery Penalty (TFRP), which is described IRS Notice 784, which is referenced in the IRS's website and current Internal Revenue Manual. Since Notice 784 effectively explains the TFRP but does not appear to be generally available on the web, I quote it here:

Could You be Personally Liable for Certain Unpaid Federal Taxes?

If you are an employer, you must withhold federal income, social security (or railroad retirement), and Medicare taxes from your employee’s wages or salaries. If you provide communication or air transportation services, you also may have to collect certain excise taxes from people who paid you for the services. (Get Pub. 510 for more information on excise taxes.) These taxes are called trust fund taxes and must be paid to the Internal Revenue Service through tax deposits or as payments made with the applicable returns.

The trust fund recovery penalty. – If trust fund taxes willfully aren’t collected, not truthfully accounted for and paid, or are evaded or defeated in any way, we may charge a trust fund recovery penalty. This penalty is equal to the amount of the trust fund taxes evaded, not collected, not accounted for, or not paid to IRS. We also charge interest on the penalty.

Who has to pay the penalty? – The trust fund recovery penalty may apply to a person or persons IRS decides is responsible for collecting, accounting for and paying the trust fund taxes and who acted willfully in not doing so. If IRS can’t immediately collect the taxes from the employer or business, we will decide who the responsible person or persons are and who acted willfully.

“Willfully” means voluntarily, consciously, and intentionally. A responsible persons acts “willfully” if this person knows that the required actions are not taking place for any reason. Paying other business expenses instead of trust fund taxes is considered willful behavior.

Any person who had responsibility for certain aspects of the business and financial affairs of the employer (or business) may be a responsible person. A responsible person may be an officer or employee of a corporation, or a partner or employee of a partnership. This category may include accountants, trustees in bankruptcy, members of a board, banks, insurance companies, or sureties. The responsible person can even be another corporation, a volunteer director/trustee, or employee of a sole proprietorship. Responsible persons may include those who direct or have authority to direct the spending of business funds.

If we charge you this penalty, we may take your assets (except exempt assets) to collect the amount owed.

Avoid the penalty. – You can avoid the trust fund recovery penalty by making sure that all taxes are collected, accounted for, and paid to IRS when required. Make your tax deposits and payments on time. IRS employees are available to assist you if you need information on tax deposits and payments. You may telephone the IRS tax information number in your area for help. Pub. 937, Employment Taxes and Information Returns, Pub. 15, Employer’s Tax Guide, and Form 941, Employer’s Quarterly Federal Tax Return, are also helpful and available from IRS.

Source: Bloomberg BNA, Tax and Accounting Center, links added by me.

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Tax Protester Arguments Work, Until They Don't

Certain individuals and groups insist that portions of the Internal Revenue Code do not apply to them. The reasoning in support of this position is generally based upon words and phrases in statutes and cases taken out of context. Many of these arguments have been deemed "frivolous" by the IRS, the making of which subjects the "tax protester" to additional penalties.

Because the U.S. tax system depends, in large part, on voluntary compliance, tax protesters can point to various circumstances as "proof" that the techniques "work," at least temporarily. The IRS may accept tax returns with obviously understated income or overstated expenses and may pay out refunds as well. This "works," as Peter J. Reilly, writing for Forbes, pointed out, "if you are just about maximizing your current lifestyle rather than accumulating net worth and entirely amoral when it comes to meeting tax obligations."

Collection due process affords taxpayers a chance to appeal to the Tax Court, a process I outlined in a previous post. All tax protester arguments fail at Tax Court, the result being a judgment against the taxpayer for taxes due and probably penalties. While most Tax Court judges don't bother writing an opinion in tax protester cases, Judge Ronald L. Buch, a new Tax Court judge, took the opportunity to write a very detailed opinion in a recent one. The discussion section of the opinion beings with this, which should cause would-be tax protesters to reconsider their course of action:

This case has occupied an inordinate amount of the Court’s time. The Court could have disposed of the entire matter summarily by reference to Crain v. Commissioner or any number of 6 other cases that stand for the proposition that we need not address frivolous arguments (citing Crain v. Commissioner, 737 F.2d 1417, 1417 (5th Cir. 1984) ("We perceive no need to refute these arguments with somber reasoning and copious citation of precedent; to do so might suggest that these arguments have some colorable merit.")

The case, Waltner v. Commissioner, TC Memo 2014-35, is a good read for anyone who thinks they may have found a book or website promoting a loophole in the Internal Revenue Code. Judge Buch had a clear intent to "inform the public of the court’s analysis" of frivolous positions of tax protesters. Hopefully, some will listen.

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Captive Insurance Companies

Insurance does two things: First, it shifts a risk from an insured to the insurance company. Second, it distributes the risk taken on by the insurance company among a pool of like risks with a predictable number of risks that will materialize. In other words, from the insured’s perspective, insurance shifts risks; and from the insurer’s perspective, insurance distributes risk.

This is the view of insurance from a tax perspective and helps explain why historically, the IRS challenged "captive" insurance companies, or insurance companies owned by the insured. The IRS argued that true risk shifting and distribution could never occur within the same "economic family" and that as such, deductible premiums by the insured were really non-deductible contributions to a reserve fund.

Beginning with the case of Humana v. Commissioner, 88 T.C. 197 (1987), which was discussed at length in the recent case of Rent-A-Center, Inc. v. Commissioner, 142 T.C. No. 1 (2014), the IRS started consistently losing this argument. Eventually, in Rev. Rul. 77-316, the IRS announced that it would no longer rely on its economic family argument. Currently, there are a few safe harbors that taxpayers can rely upon to obtain the expected tax treatment of their captive insurance companies and payments made thereto. However, as Rent-A-Center makes clear, the IRS can still litigate based on facts and circumstances of individual scenarios.

Rev. Rul. 2002–89 and Rev. Rul. 2002-90 stand for the following two safe harbors: If a captive insurance company either (1) receives at least 50% of its income from a non-parent or (2) provides insurance for at least twelve subsidiaries, with no subsidiary accounting for less than 5% or more than 15% of the total risk underwritten, the IRS will normally concede that adequate risk shifting and distribution has occurred and not challenge the captive arrangement. 11 Mertens Law of Fed. Income Tax'n § 44:24.

Firms who market and help clients establish captive insurance companies can help clients pool with third parties in order to meet these requirements. The viability of this strategy assumes that the captive is operated as a bona fide insurance company in every respect.

While captive insurance companies provide clear asset protection benefits, the tax benefits are substantial as well. If the captive qualifies and elects to be taxed as a "small company" under section 831(b) of the Internal Revenue Code, it will be taxed only on taxable investment income, not underwriting income. A captive insurance company can receive up to $1.2 million in annual premiums and still qualify under section 831(b). Effectively, this means that by establishing a captive insurance company, a taxpayer can reduce taxable income by deducting premiums of $1.2 million, while recognizing no taxable income to the captive. Assuming a good claims history, the premiums accumulate tax-deferred and are available to be withdrawn later as dividends or long term capital gains.

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The IRS Audit and Appeals Process

After taxpayers file their tax returns, the IRS computer system analyzes the returns to verify that income, deduction, gain, and loss amounts reported to the IRS by third parties are properly reported on the taxpayers' returns. The system also gives each return a numeric score based on certain factors that the IRS has identified as indicative of error. Returns that have a high probability of error are screened by IRS personnel and in this manner, selected for audit. The first step in an audit is a letter from the IRS to the taxpayer providing notification that the return has been selected.

Examinations can be conducted through the mail or face-to-face. A taxpayer can represent themselves, but it is wise to have a good CPA or tax attorney assist. Hiring a reputable professional to assist with tax return filing and significant transactions in the first place can often prevent the kinds of problems that trigger IRS scrutiny of a tax return in the first place.

At the end of the audit, the IRS will provide the taxpayer a written explanation of any proposed changes to the tax return. If the audit results in a lower assessed tax (which is possible), the taxpayer will get a refund. If not, and the IRS takes the position that additional tax is owed, the taxpayer has a choice: Pay the additional tax, or contest the proposed changes.

If the audit meeting takes place at an IRS office, the taxpayer can immediately request a meeting with the examiner's supervisor. If the meeting takes place elsewhere or no agreement with the supervisor can be reached, the examiner will forward the case for processing. The IRS will prepare an examination report detailing the proposed adjustments as well as a "30 day letter."

The 30 day letter will inform the taxpayer of their right to an appeal from within the IRS to an independently-operated IRS Appeals office. A written request must be filed with the IRS office indicated in the letter in order to have the matter brought before the IRS appeals officer. Many matters can be settled with an IRS appeals officer, although the taxpayer can take the matter to court without IRS appeals.

If the taxpayer does not respond to the 30-day letter or an agreement cannot be reached, the IRS will send a Notice of Deficiency, or 90 day letter. The Notice of Deficiency gives the taxpayer 90 days to file a petition with the U.S. Tax Court. If no petition is filed, the IRS assesses the proposed tax and bills the taxpayer for the deficiency. Alternatively, the taxpayer can pay the disputed tax in full and file a claim for refund with the IRS. If the refund is denied, the taxpayer can file suit for refund in a Federal District Court or the Court of Federal Claims.

Throughout this process, there are a number of resources and options available, such as Taxpayer Advocate Service, Offers in Compromise, installment agreements, Alternative Dispute Resolution, etc. After the taxpayer's protest options have been exhausted, and if they are unable to pay, the collections process will commence. That will be the topic of a future post.

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