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IRS Changes Position on Approval for Assertion of Codified Economic Substance Doctrine

In March 2010, Congress codified the economic substance doctrine in Internal Revenue Code (Code) Section 7701(o). The codification clarified that a conjunctive analysis applies in determining if the doctrine applies. The codified economic substance doctrine applies when a transaction does not have economic substance or lacks a business purpose. When the doctrine applies, a taxpayer is subject to a 20% strict liability penalty (40% in the case of undisclosed transactions) on any underpayment attributable to the disallowed tax benefit claimed.

Congress acknowledged that the codified economic substance doctrine should be applied sparingly, and the Joint Committee on Taxation, in a report issued prior to the enactment of the doctrine, provided detailed guidance on when the doctrine should apply. The Internal Revenue Service (IRS) issued guidance shortly after the codification acknowledging these points. The IRS also put in place detailed procedures for examiners to follow in determining whether to assert the codified economic substance doctrine.

One of the procedures put in place was the approval by the Director, Field Operation before the codified economic substance doctrine could be formally asserted. An approval request was to be made after consultation with the revenue agent’s manager and local counsel. Additionally, taxpayers were to be provided “the opportunity to explain their position.”

On April 22, 2022, the IRS’s Large Business & International (LB&I) Division issued a memorandum—LB&I-04-0422-0014—to all LB&I and Small Business/Self Employed examination employees (Updated Guidance). The Updated Guidance removes the requirement to obtain executive approval before asserting the codified economic substance doctrine. The Updated Guidance states that this change aligns penalties for lack of economic substance with other assessable penalties which do not require executive approval. However, the changes do not remove the supervisory approval requirement under Code Section 6751.

In connection with the Updated Guidance, revisions are being made to the relevant provisions of the Internal Revenue Manual (IRM). The IRM revisions eliminate some of the considerations previously set forth in the four-step process that revenue agents were required to undertake in determining whether the doctrine should be applied.

Practice Points: Although the Updated Guidance has no impact on the substance of the codified economic substance doctrine itself, the change is disappointing news. As a result of the relaxed rules for the doctrine’s assertion, taxpayers can reasonably assume that the doctrine may more frequently be asserted on audit. Thus, it is now even more important to properly document transactions to demonstrate they have sufficient economic substance and a business purpose.




IRS Continues Focus on Hiring and Modernization of Technology

We previously discussed the Internal Revenue Service’s (IRS) efforts to adjust to a remote environment by offering video meetings and secure messaging systems in order to maintain an efficient audit process. We also previously shared the IRS Office of Chief Counsel’s plan to hire up to 200 additional lawyers to assist with litigation matters.

On March 16, 2022, the IRS announced it was continuing its hiring and modernization efforts via a plan to hire more than 200 additional technologists to help further modernize its technology. The announcement states, in part:

The IRS has undergone a significant technology transformation over the last several years as part of a large-scale enterprise modernization plan to transform the taxpayer experience, upgrade core service and enforcement systems, build a more sustainable technology infrastructure and enhance cybersecurity.

 

The agency is seeking to expand its pool of experts in hybrid and multi-cloud environments, no/low-code enterprise platforms and applications, data and analytics, artificial intelligence and machine learning, IT service management leading practices and networks management. Additional career opportunities include joining the integrated technical team modernizing the Individual Master File, the agency’s core tax processing system, and the Enterprise Case Management initiative modernizing IRS case management applications, services and associated processes. These are just some of the modernization efforts that the new hires will be working on.

This latest update comes on the heels of the IRS’s announcement last week that it plans to fill more than 5,000 positions in its processing centers located in Austin, Texas; Kansas City, Missouri and Ogden, Utah.

Practice Point: The IRS’s efforts to increase its workforce and update its technology is a step in the right direction as the agency faces numerous challenges with unprocessed returns, out-of-date computer systems and compliance challenges. As the IRS obtains newer and better equipment, we expect to see it use these new tools in its tax compliance mission.




Weekly IRS Roundup February 27 – March 5, 2022

Presented below is our summary of significant Internal Revenue Service (IRS) guidance and relevant tax matters for the week of February 27, 2022 – March 5, 2022. Additionally, for continuing updates on the tax impact of COVID-19, please visit our resource page here.

March 1, 2022: The IRS issued final regulations increasing the user fees for the special enrollment examination for enrolled agents and eliminating the user fees for the special enrollment examination for enrolled retirement plan agents.

March 1, 2022: The IRS issued proposal regulations increasing the renewal fee for enrolled agents and enrolled retirement plan agents.

March 1, 2022: The IRS issued a news release reminding taxpayers of the obligation to report certain types of income, such as gig economic earnings, earnings from virtual currency transactions and foreign-source income.

March 2, 2022: The IRS issued a news release announcing the release of a Fact Sheet containing answers to frequently asked questions regarding the 2021 Earned Income Tax Credit.

March 3, 2022: The IRS issued a news release providing an update to a Fact Sheet containing answers to frequently asked questions regarding the paid leave tax credits under sections 3131 through 3133 of the Code, enacted as part of the American Rescue Plan Act of 2021 (ARPA).

March 3, 2022: The IRS issued a news release providing an update to a Fact Sheet containing answers to frequently asked questions regarding the paid leave tax credits enacted as part of the Families First Coronavirus Response Act.

March 3, 2022: The IRS issued a news release announcing that it was aware of technical difficulties encountered by taxpayers attempting to electronically file Form 7203, S Corporation Shareholder Stock and Debt Basis Limitations, in advance of the March 1, 2022, filing deadline for taxpayers with income from a farming or fishing business. The IRS stated in the news release that a notice would be forthcoming providing an extended filing deadline for certain taxpayers.

March 4, 2022: The IRS issued Notice 2022-10, providing the 2022 table of housing expense limitations with respect to various foreign locations, for purposes of calculating the excludible/deductible housing cost amount under section 911(c) of the Code.

March 4, 2022: The IRS issued a news release announcing the creation of a new administrative division, the Taxpayer Experience Office, focused on improving the customer service experience for taxpayers.

March 4, 2022: The IRS issued a news release reminding taxpayers that free face-to-face tax preparation assistance will be provided at Taxpayer Assistance Centers around the country on Saturday, March 12, 2022.

March 4, 2022: The IRS released its weekly list of written determinations (e.g., Private Letter Rulings, Technical Advice Memorandums and Chief Counsel Advice).

Special thanks to Le Chen in our DC office for this week’s roundup.




Sixth Circuit Sides with Taxpayer in APA Challenge to Reportable Transaction Regime

We previously posted about the US Supreme Court’s opinion in CIC Servs., LLC v. IRS, which allowed a pre-enforcement challenge to the Internal Revenue Service’s (IRS) “reportable transaction” regime. In that post, we noted the district court opinion in Mann Construction, Inc. v. United States, No. 1:20-cv-11307 (E.D. Mich. 2021), holding that an IRS Notice requiring disclosure of listed transactions was not subject to the Administrative Procedure Act’s (APA) notice-and-comment requirement, and identified unanswered questions and potential future disputes over IRS enforcement strategies.

The US Court of Appeals for the Sixth Circuit has now reversed the district court in Mann Construction, holding that the IRS’s process for issuing Notice 2007-83—which designates certain employee-benefit plans featuring cash-value life insurance policies as listed transactions—violated the APA. Specifically, the court found that Notice 2007-83 was a legislative rule under the APA because it had the force and effect of law. The Sixth Circuit relied on CIC Services, explaining that Notice 2007-83 “defines a set of transactions that taxpayers must report, and that duty did not arise from a statute or a notice-and-comment rule…failure to comply comes with the risk of penalties and criminal sanctions, all characteristics of legislative rules.” The court further found that Congress did not expressly exempt the IRS from the APA’s notice-and-comment requirements with respect to the reportable transaction regime. The Sixth Circuit explained that there was an absence of any express deviation from the APA’s notice-and-comment procedures, and “any exceptions to the sturdy protections established by the APA’s notice-and-comment requirements must come from Congress, not us and not the IRS.”

What now? Mann Construction is a heavy blow to the IRS’s reportable transaction regime, and similar APA attacks are underway against other Notices imposing non-statutory reporting obligations. One example is Notice 2017-10, which identifies certain syndicated conservation easement transactions as listed transactions subject to disclosure to the IRS.

Practice Point: In 2011, the Supreme Court announced in Mayo Found. for Med. Educ. & Rsch. v. United States, that “we are not inclined to carve out an approach to administrative review good for tax law only.” The last 10 years have seen numerous APA challenges in the tax world, some successful and others unsuccessful. CIC Services and Mann Construction are two important cases for taxpayers subject to non-statutory reporting obligations. Taxpayers and practitioners should carefully consider the impact of these cases in similar reporting situations in determining whether to initiate APA challenges.




IRS Proposes New Process for Post-Filing Disclosures to Replace Revenue Procedure 94-69

For many years, the Internal Revenue Service (IRS) has provided large corporate taxpayers who are under continuous audit to make affirmative disclosures at the start of an audit so they have an opportunity to disclose tax positions and avoid certain civil tax penalties. The procedure, outlined in Revenue Procedure 94-69, has been very popular with both taxpayers and IRS agents because it provides a mechanism that allows taxpayers to informally “amend” a return without filling out all of the paperwork. IRS agents also like the procedure because it allows them to focus the examination on the disclosed issues and incorporate the adjustments in the final computation from the audit. Indeed, the procedure has grown in practice to include the disclosure of affirmative and negative adjustments at the start of the examination and not just in the audits of taxpayers under the jurisdiction of the IRS’s Large Business & International division. However, as the continuous audit paradigm has ended, in 2020 the IRS questioned the continuing viability of this procedure and sought comments from taxpayers on if, and how, it should continue.

Numerous commentators (including the American Bar Association Section of Taxation and Tax Executives Institute, Inc.) recommended that the IRS keep this post-filing disclosure procedure in place, citing the following points in support:

  • The procedure avoids the need to file a formal amended return, a burdensome process on large taxpayers.
  • Requiring formal amended returns can be a significant strain on taxpayer resources, including the potential need to deal with state and local tax filings.
  • All mistakes can be fixed at one time (i.e., avoiding multiple amended returns).
  • The procedure eases reporting issues with Schedules K-1 that are issued after the original tax return is filed.
  • The procedure allows incorporating carryover adjustments from prior examinations.
  • There’s potential to avoid strict liability for penalties relating to transfer pricing adjustments.

On February 25, 2022, the IRS announced that it will standardize the process for making post-filing disclosures so that eligible taxpayers and IRS agents have consistent guidelines for determining what constitutes an adequate disclosure. To that end, the IRS has published a new draft form, Form 15307, Post-Filing Disclosure for Specified Large Business Taxpayers, to be used by eligible taxpayers seeking to make a post-filing disclosure. Taxpayer comments on the new draft form can be submitted here.

The draft Form 15307, which must be signed under penalties or perjury, requires that the taxpayer identify the number of disclosures and provide specific information about each disclosure, including:

  • Adjustment type
  • Timing
  • Effect of carryover
  • Description
  • Increase/decrease to taxable income or tax credits
  • Explanation of the item being disclosed

Examples of acceptable and unacceptable descriptions and disclosures are provided in the instructions to the draft form. Generally, netting of adjustments is not permitted, however, where the facts and circumstances of an item are identical and represent a high volume of low dollar amounts, the disclosures can be netted. The [...]

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Recent Tax Developments Concerning Staking Rewards

Stakers—taxpayers involved in proof of stake (PoS) validation of blockchain transactions—continue to operate in uncharted tax waters. PoS blockchains represent over half of the $1.68 trillion cryptocurrency market capitalization, with five of the top 10 PoS blockchains having a stake rate greater than 50%. Despite the remarkable growth of the PoS market in the last two years, there is no government guidance about the tax treatment of staking rewards.

In a closely followed case in the US District Court for the Middle District of Tennessee, Jarrett v. United States, No. 3:21-cv-00419 (M.D. Tenn.), a taxpayer paid tax on staking rewards and sued for a refund. The question before the district court is whether the receipt of staking rewards generates taxable income at the date the rewards are received.

On February 3, 2022, it was reported that the Internal Revenue Service (IRS) offered to refund the taxpayer’s money for taxes paid on staking rewards. The taxpayer rejected the IRS’s offer to receive a definitive ruling that will be binding on the IRS.

In this article, we look at the issue before the district court and address the significance of the recent offer by the IRS to refund the taxpayer’s tax payment.

VIRTUAL CURRENCY STAKING

In PoS systems, stakers are chosen by combinations of random selection plus the amount of units making up their stake and/or the amount of time they agree to lock up the stakes in a specific digital wallet. Staked units support the blockchain operations by validating transactions on the blockchain and earning rewards. Unlike the mining activities of proof of work (PoW) blockchain miners, stakers validate new blocks by forging the next block on the blockchain without mathematical computations. Certain platforms participate in staking by pooling their customers’ tokens and sharing the staking rewards.

Although each blockchain protocol is different, PoS protocols require stakers to hold (for an agreed amount of time) and post a minimum number of units (stake) to participate in the validation process. Stakers receive, as staking rewards, a specified number of units. These reward units can redistribute ownership stakes away from computers (nodes) that do not put up a stake to those nodes that do put up stakes.

The IRS has addressed the tax treatment of PoW blockchain miners but has not addressed the tax treatment of staking rewards. This means that taxpayers must consider general tax principles that apply to property transactions and adopt a tax methodology they believe is supportable on audit, subject to judicial and administrative review.

Stakers take a wide range of positions with respect to the tax character and tax timing of staking rewards. For example, some stakers take the position that the receipt of staking rewards result in taxable income from the performance of services, while others assert that staking rewards are not taxable until they sell, exchange or otherwise dispose of the rewards. The policy considerations behind each of these positions vary as well, with the timing of taxation on staking rewards currently being litigated in Jarrett v. United [...]

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Revoking Your Power of Attorney Status

To represent a taxpayer before the Internal Revenue Service (IRS), you need a valid power of attorney (POA). This is accomplished by preparing and submitting a properly completed Form 2848, Power of Attorney and Declaration of Representative pursuant to the Instructions for Form 2848. At some point, the representation will end (or it ends for certain matters and years but not for others). However, absent affirmative steps by the representative prevents the IRS from knowing that you no longer represent the taxpayer, and you may continue to receive IRS correspondence. This creates a potential issue because representatives should not be receiving taxpayer information if they no longer represent or provide legal advice to said taxpayer.

To avoid this, a representative can notify the IRS that they no longer represent the taxpayer and do not wish to receive any further correspondence, either for all matters and years or just certain ones. This is done by revoking your POA with the IRS. Revocation can be done in one of two ways. The first way is to mail or fax a copy of the POA to the IRS with the word “REVOKE” written across the top of the first page with a current signature and the date below this annotation. Alternatively, if the representative does not have a copy of Form 2848 or wishes to revoke several POAs at the same time, they can send the IRS a statement of revocation that indicates that the authority granted by the POA is revoked, lists the matters and years and lists the name and address of each recognized representative whose authority is revoked. If the representative is completing revoking authority, they can write “revoke all years/periods” instead of listing the specific matters and years.

For representatives who represent multiple taxpayers before the IRS, it may be difficult to recall all of the POAs they have filed with the IRS. However, a listing of all your POAs can be obtained by submitting a Freedom of Information Act request for a copy of the Centralized Authorization File (CAF)/Representative/Client listing. It’s a simple process, and the IRS provides the following Sample CAF Client Listing Request on its website:

Sample CAF Client Listing Request

 

Practitioner or company name Practitioner or company address Phone number (optional)

 

Date

 

Dear Disclosure Manager:

 

This is a request under the Freedom of Information Act. I request that a copy of the CAF Representative/Client Listing be provided to me. I do not wish to inspect the documents first.

 

In order to determine my status for the applicability of fees, you should know that I am an “Other” requester seeking information for non-commercial or personal use. I am a tax professional and my CAF number is XXXXXXX. (This is not your Enrolled Agent Number)

 

I am including a valid photo identification which includes my signature as proof of identity.

 

Send listing as a paper document. I am willing to pay [...]

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IRS Chief Counsel Signals Increased Tax Enforcement

The Internal Revenue Service (IRS) Chief Counsel is the chief legal advisor to the Commissioner of Internal Revenue on all matters pertaining to the interpretation, administration and enforcement of the Internal Revenue Laws. In this regard, the IRS Office of Chief Counsel is responsible for litigating cases in the US Tax Court. Such cases can arise from examinations conducted by different divisions within the IRS, such as the Large Business & International (LB&I), Small Business/Self Employed (SB/SE), Tax Exempt & Government Entities (TE/GE) and Wage & Investment (W&I) Divisions.

On January 21, 2022, the IRS Office of Chief Counsel announced plans to hire up to 200 additional attorneys to assist with litigation efforts. The announcement specifically notes that new hires are necessary “to help the agency combat syndicated conservation easements, abusive micro-captive insurance arrangements and other tax schemes.” They will also help the IRS manage its increasing caseload as part of its multiyear effort to combat what it believes are abusive schemes and to ensure that the appropriate taxes and penalties are paid. The new hires will be located around the country and focus on audits of complex corporate and partnership issues.

Additionally, there are a significant number of cases before the Tax Court that involve conservation easements and micro-captive insurance arrangements. The IRS’s attack on the donation of conservation easements is well known in the tax world. To date, the IRS has largely been successful in these cases based on non-valuation arguments that easement deeds do not comply with the applicable regulations. However, in the recent Hewitt v. Commissioner case, the US Court of Appeals for the Eleventh Circuit dealt a significant blow when it held that the IRS’s interpretation of Treas. Reg. § 1.170A-14(g)(6)(ii) was arbitrary and capricious and violated the Administrative Procedure Act because the US Department of the Treasury failed to respond to significant comments submitted during the notice-and-comment process. Many conservation easements are within the Eleventh Circuit’s jurisdiction and other appellate courts are expected to weigh in soon, which could result in the IRS and taxpayers proceeding to trial on valuation issues. Valuation issues are inherently fact intensive and will require the IRS to utilize substantial resources to litigate.

Practice Point: Much has been written about the trend of decreased enforcement by the IRS over the past several years, owing in part to decreased or stagnant funding from US Congress. Tax litigation, particularly in fact intensive cases involving valuation issues and transactions the IRS (but not necessarily the courts) deemed abusive, requires the expenditure of substantial resources by the IRS. The IRS has signaled that it is ready to reverse the trend. All IRS tax controversies start with the examination of the taxpayer’s positions on the return. We have seen an increase in IRS audit activity in the last year or so, especially with medium-sized businesses and high-net-worth individuals. The Chief Counsel is assembling his “army” to litigate positions developed during the examination. It’s a good time for taxpayers [...]

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What You Need to Know About the Taxation of NFTs

Non-fungible tokens (NFTs) are today’s hottest digital assets. They are also completely ignored by the Internal Revenue Service—to date, at least—even in the agency’s pronouncement on the taxation of cryptocurrencies.

In this series of articles, we’ll start cracking the NFT code: what they are, how they are created, bought and sold, how they might be taxed by the IRS, and the use of NFTs for charitable contributions and fundraising purposes.

1. Introduction to NFTs – As today’s hottest digital assets, non-fungible tokens (NFTs) have taken the arts and investment worlds by storm. But what are they, exactly, and how are they to be treated for tax purposes? This article provides an overview of need-to-know information regarding these exciting—and potentially risky—assets. Read more.

2. Taxation of NFT Creators – NFTs offer artists, musicians, celebrities, influencers and other creators an opportunity to develop, market and control the future of many types of digital content that they produce. Less understood is how these assets will be categorized and taxed by the Internal Revenue Service. This article reviews how creators of NFTs will likely be treated by the IRS and what that means for them. Read more.

3. Taxation of the Purchase and Sale of NFTs – Given a lack of guidance on the tax treatment of non-fungible tokens (NFTs), taxpayers can be forgiven for experiencing a certain level of uncertainty with respect to how the Internal Revenue Service (IRS) will apply its tax rules to purchases and sales of these assets. IRS reasoning on other asset classes, however, sheds some light on this otherwise uncharted territory. This article reviews the various factors that are likely to play a role in determining the classification and treatment of NFT transactions for tax purposes. Read more.

4. NFTs and Charitable Fundraising: Navigating Tax Hurdles – As the creation of and transactions involving non-fungible tokens (NFTs) have increased dramatically, so has interest in using NFTs as donations to charitable organizations and for other charitable fundraising tools. Given the lack of guidance from the IRS on such gifts, donors and recipient charities face a number of tax uncertainties. This article examines the tax hurdles involved in using NFTs for charitable fundraising purposes and offers suggestions for compliance with recordkeeping and tax reporting requirements. Read more.

Andrea (Andie) Kramer is a recognized thought leader on tax related cryptocurrency matters. She was named the 2020 Go-To Thought Leader in Virtual Currency Tax by the National Law Review and a 2021 Readers’ Choice Top Author in cryptocurrency taxation by JD Supra for her article series on cryptocurrency tax.




National Taxpayer Advocate’s Report Highlights Tough Times for Tax Administration

On January 12, 2022, the National Taxpayer Advocate released a report to US Congress concerning the state of tax administration in 2021. The report highlights the struggles the Internal Revenue Service (IRS) has been having in the wake of the COVID-19 pandemic, including how the IRS is substantially behind in processing returns, the breakdown of the IRS call center, delays in processing responses to IRS notices sent to taxpayers and a myriad of other issues. (There is indeed a backlog for processing millions of tax returns!)

The Taxpayer Advocate Service (TAS) can be a helpful and powerful tool for taxpayers looking to resolve their tax issues with the IRS. We have provided information on this resource in earlier submissions. (See Taxpayer Advocate Service: Not Just for Low-Income Taxpayers.)

Practice Point: For those who are having difficulties interacting with the IRS and unable to achieve reasonable or satisfactory responses or explanations, seeking assistance from TAS can go a long way in resolving tax issues. The process is free to taxpayers and starts with the filing of Form 911 with the appropriate TAS office. If you seek assistance in the near future, be mindful that TAS is currently flooded with requests for help but will work your case—if it meets the relevant criteria—as soon as possible. A dose of patience will be needed to work through this resource to obtain a successful resolution of your tax issue.




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