The Mirror Code Concept; Some Thoughts and Ruminations (5/27/13)

The United States has a "mirror code" system with certain of its territories -- including U.S. Virgin Islands, Guam and the Commonwealth of the Northern Mariana Islands (CNMI).  The mirror code concept treats the U.S. tax code as the tax law of each jurisdiction -- U.S.,on the one hand, and the other jurisdiction,on the other.  In effect, the two jurisdictions are treated as separate countries for purposes of the mirrored Code applied by each.  Double taxation is generally avoided by requiring a single filing to the jurisdiction in which the taxpayer resides.  If the U.S. citizen is a "bona fide resident." of the U.S. V.I., the U.S. resident reports and pays tax to the U.S. V.I. and not to the U.S.; If the U.S. taxpayer is resident anywhere else, he reports and pays his tax to the U.S.  By contrast, if the U.S. V.I. citizen is resident in the U.S., he reports and pays tax to the U.S.; if he is resident anywhere else,he reports and pays tax to the U.S. V.I.  In each of these cases, if the citizen pays tax in the noncitizenship country of residence -- i.e., U.S. citizens reports and pays tax in U.S. V.I. or U.S. V.I. citizen reports and pays tax in the U.S. -- the country receiving the tax will remit -- a process called "cover" -- the portion tax received that relates to income in the other country.

A pure mirror code system will result in the same tax regardless of where the return is filed and the tax paid.  The territories are, however, allowed to give tax breaks with respect to taxes paid on income source in the territories under the system.  Thus, if the reporting of U.S. V.I. sourced income is to U.S. V.I., the U.S. V.I. is permitted to give a tax break with respect to that tax.  If the reporting of U.S. V.I. sourced income is to the U.S., then the U.S. should cover that portion of the tax to the U.S. V.I., whereupon, from the tax thus remitted, it can given any break it otherwise allows.  Thus, at least in theory, wherever the return is filed, the same ultimate result should obtain.

The problem comes when, after the taxpayer has filed in good faith with the mirror code territory (e.g., the U.S. V.I.), the U.S. attempts to force the U.S. taxpayer to file in the U.S., despite being required under the treaty to make the single filing in U.S. V.I. The circumstances for double taxation are present if the U.S., through making a different sourcing determination, has no plan to cover the amount to the other country.

This battle was fought out in Appleton v. Commissioner, 140 T.C. ___, No. 14 (2013), here.  The IRS took the position that the taxpayer was required to file in the U.S., he had filed in U.S. V.I. rather than the U.S., and that, as a result, the IRS had an unlimited statute of limitations to send a notice of deficiency with respect to the tax.  The Court held that the single filing with the U.S. V.I. required under the mirror code scheme was a return filed under the Code and therefore the unlimited statute of limitations did not apply.

JCT Staff Report on Selected Tax Procedure and Administration Issues (4/26/13)

This blog entry was just also posted on my Federal Tax Crimes Blog, here.

The Staff of the Joint Committee on Taxation has published "Present Law And Background Information Related To Selected Tax Procedure And Administration Issues" dated April 14, 2013, available here.

The three principal topics are (as presented):

I.  Background and Federal Tax Provisions and Practices Implicated in Identity Theft Fraud
II.  Authority to Regulate the Conduct of Paid Tax Return Preparers.
III. Civil Tax Penalties as a Factor in Voluntary Compliance.

I focus here on the last item -- Civil Tax Penalties as a Factor in Voluntary Compliance.  The subtopics are:

A. Civil Assessment Process
B. Civil Tax Penalties
Overview of penalties
Legislative and other history
Selected Issues Raised by Practitioner Groups and Others

The first first of these subtopics -- A. Civil Assessment Process -- is short and probably already known to readers of this blog.  Hence, I do not dwell upon that portion of the Report.  The first two divisions of the second subtopic - B. Civil Tax Penalties -- is probably also known to readers, hence I focus only on the last (Selected Issues) and quote it in its entirety (footnotes omitted), although it too is cryptic.

Whether penalties encourage voluntary compliance 

One criticism of the current regime is that many of the penalties which have been enacted, particularly over the past decade, seem to be designed for the purpose of raising revenue or punishing taxpayers rather than encouraging voluntary compliance. To support this assertion, practitioner groups and others have pointed to the strict liability penalty created under section 6662(b)(6) which imposes a penalty on transactions which lack economic substance and the strict liability penalty provided under section 6707A for failure to disclose reportable transactions. They argue that the lack of a reasonable cause defense under these provisions eliminates the opportunity, and the incentives, to remediate and to become compliant. Under section 6707A, for example, the penalty may be imposed even if the failure to disclose the transaction is not willful but instead inadvertent (perhaps because the taxpayer could not identify whether a transaction was a reportable transaction).

A Self-Proclaimed "Simple Man," "Utterly Uneducated" in Tax and Finance, but Still a Self-Made Multi-Millionaire Loses his Bullshit Tax Shelter Case (4/15/13)

JAT NOTE: This blog is the same as a blog posted earlier on my Federal Tax Crimes Blog.  See A Self-Proclaimed "Simple Man," "Utterly Uneducated" in Tax and Finance, but Still a Self-Made Multi-Millionaire Loses his Bullshit Tax Shelter Case (Federal Tax Crimes Blog 4/13/13), here.

In Kerman v. Commissioner, ___ F.3d ___, 2013 U.S. App. LEXIS 7032 (6th Cir. 2013), here, the Sixth Circuit rejected the Kerman's claim for tax benefits or, at least, relief from penalties from a bullshit tax shelter, this one of the Cards variety that has met with uniform rejection from the courts.  I just gave you the final result.  But the opinion starts this way (usually you can tell the result from the opening):

A tax shelter can be legitimate — if the reported transaction has economic substance. But the shelter Mark Kerman participated in lacked such substance. The transaction had no purpose other than the creation of an income tax benefit. After Kerman claimed the benefit on his tax return, the IRS disallowed the deduction and imposed a valuation misstatement penalty pursuant to 26 U.S.C. § 6662(e), which was increased to 40 percent of the unpaid tax pursuant to § 6662(h). The tax court affirmed the IRS's decision. Kerman appeals, contending that the shelter was legitimate and that, even if it was not, the penalty should not be imposed. Because the transaction lacked economic substance and Kerman lacked reasonable cause or good faith to believe that it did, we AFFIRM.
I
A
Mark Kerman is a college-educated multi-millionaire.

Toward the end of the opinion another key signal dot is connected as follows:

Finally, Kerman argues, the tax court gave him too much credit. He's just a simple man, "utterly uneducated in the complex tax arena — let alone the more byzantine tax-shelter realm." Appellant's Br. 48. Consequently, he was forced to rely on personal advisors. And, he argues, his reliance was reasonable even if his advisors had conflicts of interest.

So, what should I say about the opinion?  Prudence and respect for my readers time counsels that I should not say anything except the bullet points from the case.  So, I won't.

Estate Did Not Have Reasonable Cause For Failure to Timely File Estate Tax Return (4/11/13)

My immediately preceding blog entry is titled Estate Had Reasonable Cause for Failure to Timely File Estate Tax Return Based on Attorney's Advice (4/6/13), here.  I now present a new decision with the opposite result.  In Knappe v. United States, 713 F.3d 1164 (9th Cir. 2013), here, the executor received erroneous advice from his expert accountant regarding the extended due date for filing the estate tax return.  The case appears closer to the leading decision in the Supreme Court's Boyle case (United States v. Boyle, 469 U.S. 241 (1985)) than the Estate of Liftin decision discussed in the preceding blog.  Hence, in Knappe, the Ninth Circuit applied the Boyle result -- i.e., no relief from the penalties.  Why?

In Knappe, the executor was advised by a tax accountant with whom he had dealt previously that the estate could file for an extension of time to file the estate tax return and pay the tax.  The executor authorized the accountant to file the extension.  The extension requested was for six-months additional time to file the return and one year discretionary additional time to pay.  The IRS granted the extensions as requested -- 6 months and one year respectively.  However, for some reason, the accountant believed he had requested a one-year extension for both.  The return was then filed after the 6-month extended due date but before the one-year period.  The IRS imposed the late filing penalty.

The Ninth Circuit first laid out the Code's background (footnote omitted):

An estate-tax return, Form 706, must be filed within nine months of the decedent's death. 26 U.S.C. § 6075(a); 26 C.F.R. § 20.6075-1. An executor may apply for an automatic six-month extension of time to file Form 706 by filing Form 4768 on or before the due date of the return and checking the appropriate box. 26 C.F.R. § 20.6081-1(b). While the IRS "may grant a reasonable extension of time for filing any return," "no such extension shall be for more than 6 months" except in the case of taxpayers who are abroad. 26 U.S.C. § 6081(a). 

Extensions of the deadline to pay the estate tax operate differently. Treasury Department regulations specify that the IRS may grant an extension of time to pay estate taxes, at the written request of the executor, "for a reasonable period of time, not to exceed 12 months." 26 C.F.R. § 20.6161-1(a)(1).

Estate Had Reasonable Cause for Failure to Timely File Estate Tax Return Based on Attorney's Advice (4/6/13)

In Estate of Morton Liftin v. United States, 110 Fed. Cl. 119 (2013), here, the Court of Federal Claims, Judge Miller, held that the estate's failure to timely file the estate tax return because it was waiting for the surviving spouse to obtain citizenship, thus qualifying  bequests to her for the marital deduction, constituted reasonable cause sufficient to prevent the application of the late filing penalty.  Readers who have only a passing familiarity with the Supreme Court's holding in United States v. Boyle, 469 U.S. 241 (1985) may think the holding inconsistent.  It is not, as the Judge Miller explained.  I quote the relevant portion of the opinion (some case, page citations and quotation marks omitted for readability):

To avoid a penalty for a late-filed return, the taxpayer bears the "heavy burden" of proving its failure to file timely was due to reasonable cause and not willful neglect. Boyle, 469 U.S. at 245 (citing I.R.C. § 6651(a)(1)). In order to prove "reasonable cause," a taxpayer must show that it "exercised 'ordinary business care and prudence' but nevertheless was 'unable to file the return within the prescribed time.'" "Willful neglect" requires a "conscious, intentional failure or reckless indifference." 

In Boyle, the Supreme Court observed that "[c]ourts have differed over whether a taxpayer demonstrates 'reasonable cause' when, in reliance on the advice of his accountant or attorney, the taxpayer files a return after the actual due date but within the time the adviser erroneously told him was available." The Court's decision in Boyle did not resolve those differences. The Court did state, however, that: 

When an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice. Most taxpayers are not competent to discern error in the substantive advice of an accountant or attorney. To require the taxpayer to challenge the attorney, to seek a "second opinion," or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place. "Ordinary business care and prudence" do not demand such actions. 

By contrast, one does not have to be a tax expert to know that tax returns have fixed filing dates and that taxes must be paid when they are due. In short, tax returns imply deadlines. Reliance by a lay person on a lawyer is of course common; but that reliance cannot function as a substitute for compliance with an unambiguous statute. Among the first duties of the representative of a decedent's estate is to identify and assemble the assets of the decedent and to ascertain tax obligations. Although it is common practice for an executor to engage a professional to prepare and file an estate tax return, a person experienced in business matters can perform that task personally. It is not unknown for an executor to prepare tax returns, take inventories, and carry out other significant steps in the probate of an estate. It is even not uncommon for an executor to conduct probate proceedings without counsel.

Majority of Circuits Hold that the Bankruptcy Automatic Stay Does Not Apply to Tax Court Proceedings (4/5/13)

In Schoppe v. Commissioner, ___ F.3d ___, 2013 U.S. App. LEXIS 6266 (10th Cir. 2013), here, the Tenth Circuit held that the automatic stay provision in 31 U.S.C. § 362(a)(1), here, does not stay a Tax Court proceeding (including the appeal from the Tax Court involved in Schoppe).  In so doing, the Court discussed a circuit court split on the issue and sided with the majority of the circuits.  I commend the decision for its discussion of the competing authorities.

I have added the following to my Federal Tax Procedure Book (footnotes omitted):

2. The filing of bankruptcy will impose an automatic stay of: 

the commencement or continuation, including the issuance or employment of process, of a judicial, administrative, or other action or proceeding against the debtor that was or could have been commenced before the commencement of the case under this title, or to recover a claim against the debtor that arose before the commencement of the case under this title. 

The question has arisen whether this automatic stay applies to Tax Court proceedings.  The Circuit Courts are split on the issue based on differing interpretations of the nature of Tax Court proceedings with respect to the textual requirement that the stayed proceeding be a proceeding “against the debtor.”  Courts focusing on the taxpayer as the initiator of the Tax Court proceeding itself, hold that the Tax Court proceeding is not a case “against the debtor” and thus deny the stay.  This is the majority holding.  The Ninth Circuit, however, takes a broader view of the Tax Court case as being a continuation of a tax assessment proceeding commenced by the IRS against the debtor via the audit and imposes the stay.

The authorities cited in my footnotes (omitted here) are contained in the Schoppe decision linked above.

Transferee-of-Transferee Liability (4/4/13)

In Frank Sawyer Trust of May 1992 v. Commissioner, 712 F.3d 597 (1st Cir. 2013), here, the First Circuit recognized that something suspicious had gone on in the "Midco" transaction case.  The quintessential circumstance that give rise to the Midco transaction is a closely-held C corporation that has sold all of its appreciated assets at a substantial gain, thus having only cash and a potential tax liability coming due at the end of the year.  For example, assume a sale of a $150,000,000 asset with $100,000,000 gain arising from the sale.  Assume a tax liability that likely would arise from the sale of $20,000,000.  The net value of the corporation is $130,000,000 -- i.e., $150,000,000 cash (the net sales proceeds) less $20,000,000 tax.  The shareholders can realize that value  by liquidating the corporation after paying the tax.  Or they can sell the stock to a third party who, logically, would be willing to pay only $130,000,000 because that is all the buyer would realize by taking the cash out of the corporation, provided that the corporate level tax were paid.  I am sure readers see an opening here.  What if the buyer could do something to cause the corporation to pay less tax? Then so long as the buyer can do that at less cost than the tax savings, then the buyer might be willing to pay more than $130,000,000.  For example, assume that the buyer could put an asset into the corporation that has a built-in loss of $100,000,000 and then use that loss to offset the $100,000,000 gain, so that there is no corporate level tax and thus there is $150,000,000 cash available for the buyer to take out.  Sweet.  And, what if the loss asset was phony, but the buyer stripped the $150,000,000 cash out of the company before the IRS realized the loss was phony and came looking for its $20,000,000 tax, plus penalties and interest?  And, what if the buyer through some complicated transactions, stripped the cash out in a way that the IRS cannot recover from the buyer (say the buyer spent it all or disappeared).

Now, go back and focus on the seller's side.  In a logical world, the seller might still sell the corporate stock for $130,000,000, for that is all that it is worth.  Why would the seller demand more?  All the seller has is corporate stock worth $130,000,000.  So, at least in theory, why would a buyer -- even one who thinks he can cause the tax liability to disappear -- pay much more than $130,000,000?  Presumably, in such a case, the logical buyer might pay just enough more to the seller that seller would have some incentive to fool with the buyer.  For example, in this case, the seller might insist upon $130,500,000 (that is a $500,000 sweetener to sell to the buyer rather than liquidate and get $130,000,000).  But that is not the way these deals -- at least the abusive ones -- get done.  The buyers put in a real sweetener -- that is they split the pot of gold, the tax of $20,000,000 -- between the buyer and seller.  For example purposes, let's say that the buyer agrees to pay $140,000,000 cash, meaning that the buyer gets $10,000,000 otherwise going to tax and the seller gets $10,000,000 otherwise going to tax.  (In the case, the deal was described as:  "a price equal to the value of the companies' assets (which by that point consisted only of cash) minus 50% of the value of the companies' tax liabilities.")  Sweet deal for both.

Is the Traditional Formulation of Seminole Rock and Auer Deference in Play? (3/28/13)

The Supreme Court's decision in Chevron U. S. A. Inc. v. Natural Resources Defense Council, Inc., 467 U. S. 837 (1984) has been the most important administrative decision in modern times.  Through deference, it cedes to an administrative agency -- the IRS included -- great power, through regulation, to control how courts must apply the statutes the agency administers.  In effect, the agency can determine what the law is, so long as the statute has some ambiguity requiring interpretation and the agency's interpretation in the regulation is not unreasonable (i.e. arbitrary, capricious and manifestly contrary to the statute's text (and presumably intent)).  But the regulation itself may have some ambiguity requiring further interpretation.  When the ambiguity is recognized, the agency can amend the regulation to make the clarification.  But, the agency will often attempt the clarification by some lesser form of agency pronouncement (in the case of the IRS, by such a pronouncement as a Revenue Ruling or Notice).  Indeed, the IRS may attempt to state its interpretation of the regulation in a brief in litigation.  The question is what authority such interpretations of the regulations should be accorded.  This is obviously a hot-button issue in the tax law and well as in other areas of the law administered by federal agencies.

The standard holding of the Supreme Court has been that such interpretations are entitled to deference.  Justice Kennedy states the standard holding in the majority opinion in Decker v. Northwest Environmental Defense Center, ___ U.S. ___, 2013 U.S. LEXIS 2373 (3/20/13), here, a nontax case, as follows:

It is well established that an agency’s interpretation need not be the only possible reading of a regulation—or even the best one—to prevail. When an agency interprets its own regulation, the Court, as a general rule, defers to it “unless that interpretation is ‘plainly erroneous or inconsistent with the regulation.’” 

This deference is commonly referred to as "Seminole Rock" or "Auer" deference." See Bowles v. Seminole Rock & Sand Co., 325 U. S. 410 (1945); and Auer v. Robbins, 519 U. S. 452 (1997).

This broad deference to agency interpretations is not without its critics, even on the Supreme Court.  In Decker, the issue surfaced again.  Justice Scalia took the opportunity to swipe at it in detail in a dissent, and Chief Justice Roberts, with Justice Alito joining, in a concurring opinion, suggested that the issue might be reconsidered in another case.  I first cover Chief Justice Roberts' short discussion and then cover Justice Scalia's full-throated -- is there any of way with Justice Scalia? -- criticism.

Ethicist Question About Tax Professionals Exploiting Loopholes (3/24/13)

Note to readers, I posted this entry on my Federal Tax Crimes Blog, here, and offer it hear because it relates as well to Federal Tax Procedure.

In this blog, I usually discuss tax crimes and matters related to tax crimes.  At least for tax professionals, there are parallel ethical issues.  The ethical issues certainly are recognized or should be recognized by tax professionals whose conduct approaches the criminal tax line -- that line where they cross over into intentionally violating a known legal duty, the mens rea standard for tax crimes.

The Ethicist, a column in the New York Times, addressed a facet of the ethical issue, in a context that does not necessarily implicate a tax crime.  Chuck Klosterman, A Tax Lawyer's Quandary (NYT Ethicists 3/22/13), here.  The question the anonymous tax lawyer asks is:

I am a tax lawyer. Is advising wealthy companies of ways to reduce their tax bills through sophisticated legal structures ethically permissible? The structures take advantage of legal loopholes in the tax legislation. 

The Ethicist answer, very short, is:

The ethics of specific professions create unique realms of responsibility. In the same way that a defense attorney is ethically obligated to give his client the best possible defense — even if he’s convinced of the individual’s guilt — your principal responsibilities lie with the company hiring you. You need to do your job to the best of your abilities, within the existing rules. You should, however, voice your moral apprehension about the use of such loopholes to the company you represent.

For a good, short general discussion, I suppose this works.

Availability of Jack's Federal Tax Procedure Book (3/22/13)

I have posted my Student Edition of my Federal Tax Procedure book on SSRN here.  The Student Edition has no footnotes and includes only the key statutory provisions and other authorities in the text.  Anyone may download that edition free here.

I also offer for purchase an footnoted edition suitable for practitioners.  The text is the same in both editions.  The footnotes contain citations to authority in support of the statements in the text and further discussion of nuance.  By way of contrast, the 2013 Student Edition is 533 pages, with (obviously) no footnotes.  The 2013 Practitioner Edition is 726 pages, with 2,336 footnotes.  This Practitioner Edition is available for purchase here.

By way of example, the following includes the text of the discussion on informal refund claims which is in both editions and the footnotes for that text which is in the practitioner edition only:

(2) Informal Claims.

The statute requires a claim for refund.  Administrative necessity reflected in the regulations requires that the claim be formally presented.  Accordingly, claims should be presented with the proper forms (discussed above) and, where required by procedures, with any required accompanying information. n731  However, from time to time, courts will recognize informal claims as satisfying the statutory predicate for a claim for refund where the taxpayer has in fact presented a claim to the IRS and, in the court's view, the IRS did or should have considered the claim.  These cases are rare and are driven by unusual facts and equities. n732