Does The IRS Want 1099s For Your Contributions?

I have been thinking about a recent IRS notice of proposed rulemaking. The IRS is proposing rules under its own power, arguing that it has the authority to do so under existing law.

This one has to do with charitable contributions.

You already know that one should retain records to back up a tax return, especially for deductions. For most of us that translates into keeping receipts and related cancelled checks.

Contributions are different, however.

In 1993 Congress passed Code section 170(f)(8) requiring you to obtain a letter (termed “contemporaneous written acknowledgement”) from the charity to document any donation over $250.  If you do not have a letter the IRS will disallow your deduction upon examination.

Congress felt that charitable contributions were being abused. How? Here is an example: you make a $5,000 donation to the University of Kentucky and in turn receive season tickets – probably to football, as the basketball tickets are near impossible to get. People were deducting $5,000, when the correct deduction would have been $5,000 less the value of those season tickets. Being unhappy to not receive 100 percent of your income, Congress blamed the “tax gap” and instituted yet more rules and requirements.

So begins our climb on the ladder to inanity.

Soon enough taxpayers were losing their charitable deductions because they failed to obtain a letter or failed to receive one timely. There were even cases where all parties knew that donations had been made, but the charity failed to include the “magic words” required by the tax Code.

Let’s climb on.

In October, 2015 the IRS floated a proposal to allow charities to issue Forms 1099s in lieu of those letters. Mind you, I said “allow.” Charities can continue sending letters and disregard this proposal.

If the charity does issue, then it must also forward a copy of the 1099s to the IRS. This has the benefit of sidestepping the donor’s need to get a timely letter from the charity containing the magic words.

Continue climbing: for the time-being charities have to disregard the proposal, as the IRS has not designed a Form 1099 even if the charity were interested.  Let’s be fair: it is only a proposal. The IRS wanted feedback from the real world before it went down this path.

Next rung: why would you give your social security number to a charity – for any reason? The Office of Personnel Management could not safeguard more than 20 million records from a data hack, but the IRS wants us to believe that the local High School Boosters Club will?

Almost there: the proposal is limited to deductible contributions, meaning that its application is restricted to Section 501(c)(3) organizations. Only (c)(3)s can receive deductible contributions.

But there is another Section 501 organization that has been in the news for several years – the 501(c)(4). This is the one that introduced us to Lois Lerner, the resignation of an IRS Commissioner, the lost e-mails and so on. A significant difference between a (c)(3) and a (c)(4) is the list of donors. A (c)(3) requires disclosure of donors who meet a threshold. A (c)(4) requires no disclosure of donors.    

You can guess how much credibility the IRS has when it says that it has no intention of making the 1099 proposal mandatory for (c)(3)s - or eventually extending it to also include (c)(4)s.

We finally reached the top of the ladder. What started as a way to deal with a problem (one cannot deduct those UK season tickets) morphed into bad tax law (no magic beans means no deduction) and is now well on its way to becoming another government-facilitated opportunity for identity theft.

The IRS Notice concludes with the following:

Given the effectiveness and minimal burden of the CWA process, it is expected that donee reporting will be used in an extremely low percentage of cases.”

Seems a safe bet.

UPDATE: After the writing of this post, the IRS announced that it was withdrawing these proposed Regulations. The agency noted that it had received approximately 38,000 comments, the majority of which strongly opposed the rules. Hey, sometimes the system works.

Vanguard's Whistleblower Tax Case

Can the IRS go after you for not making enough profit?

There is a whistleblower case against Vanguard, the mutual fund giant. Even though there is a tax angle, I had previously sidestepped the matter. Surely it must involve some mind-numbing arcana, and –anyway- why enable some ex-employee with a grudge? 

And then I saw a well-known University of Michigan tax professor supporting the tax issues in the whistleblower case.

Now I had to look into the matter.

My first reaction is that this case represents tax law gone wild. It happens. Sometimes tax law is like the person looking down at his/her cell phone and running into you in the hall. They are too self-absorbed to look up and get a clue.

What sets this up is the management company: Vanguard Group, Inc. (VGI). Take a look at other mutual fund companies and you will see that the management company is separately and independently owned from the mutual funds themselves.  The management company provides investment, financial and other services, and in turn it receives fees from the mutual funds.  

The management company receives fees irrespective of whether the funds are doing well or poorly. In addition, the ownership of the management company is likely different from the ownership of the funds. You can invest in the management company for T. Rowe Price (TROW), for example, even if you do not own any T. Rowe Price funds.

Vanguard however has a unique structure. Its management company – VGI – is owned by the funds themselves. Why? It goes back to Jack Bogle and the founding of Vanguard: he believed there was an inherent conflict of interest when a mutual fund is advised by a manager not motivated by the same financial interests as fund shareholders.  Since the management company and the funds are essentially one-and-the-same, there is little motivation for the management company to maximize its fees. This in turn has allowed Vanguard funds to provide some of the lowest internal costs in the industry

My first thought is that every mutual fund family should be run this way.

VGI and all the funds are C corporations under the tax Code. The funds themselves are more specialized and are “registered investment companies” under Subchapter M. Because the funds own VGI, the “transfer pricing” rules of IRC Section 482 apply.

COMMENT: The intent of Section 482 is to limit the ability of related companies to manipulate the prices they charge each other. Generally speaking, this Code section has not been an issue for practitioners like me, as we primarily serve entrepreneurs and their closely-held companies. This market tends to be heavily domestic and unlikely to include software development, patent or other activity which can easily be moved overseas and trigger transfer pricing concerns. 

Practitioners are however starting to see states pursue transfer pricing issues. Take Iowa, with its 12% corporate tax rate as an example. Let’s presume a multistate client with significant Iowa operations. Be assured that I would be looking to move profitability from Iowa to a lower taxed state. From Iowa’s perspective, this would be a transfer pricing issue. From my perspective it is common sense.

Section 482 wants to be sure that related entities are charging arm’s-length prices to each other. There are selected exceptions for less-than-arm’s-length prices, such as for providing routine, ministerial and administrative services. I suppose one could argue that the maintenance and preparation of investor statements might fit under this exception, but it is doubtful that the provision of investment advisory services would.  Those services involve highly skilled money managers, and are arguably far from routine and ministerial.

So VGI must arguably show a profit, at least for its advisory services. How much profit?

Now starts the nerds running into you in the hall while looking down at their cell phones.

We have to look at what other fund families are doing: Janus, Fidelity, Eaton Vance and so on. We know that Vanguard is unique, so we can anticipate that their management fees are going to be higher, potentially much higher. An analysis of Morningstar data indicates as much as 0.5 percent higher. It doesn’t sound like much, until you consider that Vanguard has approximately $3 trillion under management. Multiply any non-zero number by $3 trillion and you are talking real money.

It is an interesting argument, although it also appears that the IRS was not considering Vanguard’s fact pattern when it issued Regulations. Vanguard has been doing this for 40 years and the IRS has not concerned itself, so one could presume that there is a détente of sorts. Perhaps the IRS realized how absurd it would be to force the management company to charge more to millions of Vanguard investors.

That might attract the attention of Congress, for example, which already is not the biggest fan of the IRS as currently administrated.

Not to mention that since the IRS issued the Regulations, the IRS can change the Regulations.

And all that presumes that we are correctly interpreting an arcane area of tax law.

The whistleblower is a previous tax attorney with Vanguard, and he argues that Vanguard has been underpaying its income taxes by not charging its fund investors enough.

Think about that for a moment. Who is the winner in this Alice-in-Wonderland scenario?

The whistleblower says that he brought his concerns to the attention of his superiors (presumably tax attorneys themselves), arguing that the tax structure was illegal. They disagreed with him. He persisted until he was fired.

He did however attract the attention of the SEC, IRS and state of New York.

I had previously dismissed the whistleblower argument as a fevered interpretation of the transfer pricing rules and the tantrum of an ex-employee bent on retribution.  I must now reevaluate after tax law Professor Reuven S. Avi-Yonah has argued in favor of this case.

I am however reminded of my own experience. There is a trust tax provision that entered the Code in 1986. In the aughts I had a client with that tax issue. The IRS had not issued Regulations, 20 years later. The IRS had informally disclosed its internal position, however, and it was (of course) contrary to what my client wanted. I in turn disagreed with the IRS and believed they would lose if the position were litigated. I advised the client that taking the position was a concurrent decision to litigate and should be addressed as such.

I became extremely unpopular with the client. Even my partner was stressed to defend me. I was basing professional tax advice on chewing gum and candy wrappers, as there was nothing else to go on.

And eventually someone litigated the issue. The case was decided in 2014, twenty eight years after the law was passed. The taxpayer won.

Who is to say that Vanguard’s situation isn’t similar?

What does this tax guy think?

I preface by saying that I respect Professor Avi-Yonah, but I am having a very difficult time accepting the whistleblower argument. Vanguard investors own the Vanguard funds, and the funds in turn own the management company. I may not teach law at the University of Michigan, but I can extrapolate that Vanguard investors own the management company – albeit indirectly – and should be able to charge themselves whatever they want, subject to customary business-purpose principles. Since tax avoidance is not a principal purpose, Section 482 should not be sticking its nose under the tent.

Do you wonder why the IRS would even care? Any income not reported by the management company would be reported by fund investors. The Treasury gets its pound of flesh - except to the extent that the funds belong to retirement plans. Retirement plans do not pay taxes. On the other hand, retirement plan beneficiaries pay taxes when the plan finally distributes.  Treasury is not out any money; it just has to wait. Oh well.

It speaks volumes that someone can parse through the tax Code and arrive at a different conclusion. If fault exists, it lies with the tax Code, not with Vanguard.

Then why bring a whistleblower case? The IRS will pay a whistleblower up to 30% of any recovery, and there are analyses that the Vanguard management company could be on the hook for approximately $30 billion in taxes. Color me cynical, but I suspect that is the real reason.

Talking Expatriation (And A Little Latin)

A friend contacted me recently. He was calling to discuss the tax issues of expatriating. As background, there are two types of expatriation. The first is renouncing citizenship, which he is not considering. The second is simply living outside the United States. One remains an American, but one lives elsewhere.

It is not as easy as it used to be. 

I have, for example, been quite critical of Treasury and IRS behavior when it comes to Americans with foreign bank accounts. If you or I moved overseas, one of the first things we would do is open a bank account. As soon as we did, we would immediately be subject to the same regime as the U.S. government applies to the uber-wealthy suspected of stashing money overseas.  

Some aspects of the regime include:

(1) Having to answer questions on your tax return about the existence of foreign accounts. By the way, lying is a criminal offense, although filing taxes is generally a civic matter.

(2) Having to complete a schedule to your tax return listing your foreign financial and other assets. Move here from a society that has communal family ownership of assets and you have a nightmare on your hands. What constitutes wealthy for purposes of this schedule? Let’s start at $50,000, the price of a (very) nice pickup truck.

(3) Having to file a separate report with the Department of Treasury should you have a foreign bank account with funds in excess of $10,000. The reporting also applies if it is not your account but you nonetheless have authority to sign: think about a foreign employer bank account. It should be fun when you explain to your foreign employer that you are required to provide information on their account to the IRS.

(4) Requiring foreign banks to both obtain and forward to the IRS information about your accounts. Technically the foreign banks have a choice, but fail to make the “correct” decision and the IRS will simply keep 30% of monies otherwise going to them.

To add further insult, all this reporting has some of the harshest penalties in the tax Code. Fail to file a given tax form, for example, and take a $10,000 automatic penalty. Fail to file that report with the Treasury Department and forfeit half of your account to the government.

Now, some of this might be palatable if the government limited its application solely to the bigwigs. You know the kind: owners of companies and hedge fund managers and inherited wealth. But they don’t. There cannot be ten thousand people in the country who have enough money overseas to justify this behavior, so one is left wondering why the need for overreach. It would be less intrusive (at least, to the rest of us 320 million Americans) to just audit these ten thousand people every year. There is precedence: the IRS already does this with the largest of the corporations.

Did you know that – if you fail to provide the above information – the IRS will deem your tax return to be “frivolous?” You will be lumped in there with tax protestors who believe that income tax is voluntary and, if not, it only applies to residents of the District of Columbia.

There is yet another penalty for filing a frivolous return: $5,000. That would be on top of all the other penalties, of course. It’s like a party.

Many practitioners, including me, believe this is one of the reasons why record numbers of Americans overseas are turning-in their citizenship. There are millions of American expats. Perhaps they were in the military or foreign service. Perhaps they travelled, studied, married a foreign national and remained overseas. Perhaps they are “accidental” Americans – born to an American parent but have never themselves been to the United States. Can you imagine them having a bank close their account, or perhaps having a bank refuse to open an account, because it would be too burdensome to provide endless reams of information to a never-sated IRS? Why wouldn’t the banks just ban Americans from opening an account? Unfortunately, that is what is happening.

So I am glad to see the IRS lose a case in this area.

The taxpayer timely filed his 2011 tax return. All parties agreed that he correctly reported his interest and dividend income. What he did not do was list every interest and dividend account in detail and answer the questions on Schedule B (that is, Interest and Dividends) Part III. He invoked his Fifth Amendment privilege against self-incrimination, and he wrote that answering those questions might lead to incriminating evidence against him.

Not good enough. The IRS assessed the penalty. The taxpayer in response requested a Collections Due Process Hearing.

Taxpayer said he had an issue: a valid Fifth Amendment claim. The IRS Appeals officer did not care and upheld the penalty.

Off to Tax Court they went.

And the Court reviewed what constitutes “frivolous” for purpose of the Section 6702 penalty:

(1) The document must purport to be a tax return.

(2) The return must either (i) omit enough information to prevent the IRS from judging it as substantially correct or (ii) it must clearly appear to be substantially incorrect.

(3) Taxpayer’s position must demonstrate a desire to impede IRS administration of the tax Code.

The first test is easy: taxpayer filed a return and intended it to be construed as a tax return.

On to the second.

Taxpayer failed to provide the name of only one payer. All parties agreed that the total was correct, however. The IRS argued that it needed this information so that it may defend the homeland, repair roads and bridges and present an entertaining Super Bowl halftime show. The Court asked one question: why? The IRS was unable to give a cogent reply, so the Court considered the return as filed to be substantially correct.

The IRS was feeling froggy on the third test. You see, the IRS had previously issued a Notice declaring that even mentioning the Fifth Amendment on a tax return was de facto evidence of frivolousness. Faciemus quod volumus [*], thundered the IRS. The return was frivolous.

The Court however went back and read that IRS notice. It brought to the IRS’ attention that it had not said that omitting some information for fear of self-incrimination was frivolous. Rather it had said that omitting “all” financial information was frivolous. You cannot file a return with zeros on every line, for example, and be taken seriously. That however is not what happened here.

The IRS could not make a blanket declaration about mentioning the Fifth Amendment because there was judicial precedence it had to observe.  Previous Courts had determined that a return was non-frivolous if the taxpayer had disclosed enough information (while simultaneously not disclosing so much as to incriminate himself/herself) to allow a Court to conclude that there was a reasonable risk of self-incrimination.

The Court pointed out the following:

(1) The taxpayer provided enough information to constitute an accurate return; and

(2) The taxpayer provided enough information (while holding back enough information) that the Court was able to conclude that he was concerned about filing an FBAR. The questions on Schedule B Part III could easily be cross-checked to an FBAR. Given that willful failure to file a complete and accurate FBAR is a crime, the Court concluded that the taxpayer had a reasonable risk of self-incrimination.

The Court dismissed the penalty.

The case is Youssefzadeh v Commissioner, for the at-home players.

I am of course curious why the taxpayer felt that disclosure would be self-incrimination. Why not just file a complete and accurate FBAR and be done with it? Fair enough, but that is not the issue. One would expect that an agency named the Internal “Revenue” Service would task itself with collecting revenue. In this instance, all revenue was correctly reported and collected. With that backdrop, why did the IRS pursue the matter? That is the issue that concerns me. 

[*] Latin for “we do what we want”