Faxing A Return To The IRS

We recently prepared a couple of back California tax returns for a client.

The client had an accounting person who lived in California – at least on-and-off -for part of one year. The client itself is located in Tennessee and had little to do with California other than perhaps shipping product into the state. It is long-standing tax doctrine that having an employee in a state can subject a company to that state’s income tax, so I agreed that the client had to file for one year.

The second year was triggered by a one-off Form 1099 issued by someone in Los Angeles. The dollar amount was inconsequential, and I am still at a loss how California obtained this 1099 and why they burned the energy to trace it back to Tennessee. I am not convinced the client sold anything into California that second year. One could sell into Texas, for example, but have the check issued by corporate in Los Angeles.

The client did not care about the details. Just get California off their back.

California requested that we fax the returns to a unit rather than sending them through the regular system

And therein can exist a tax trap.

Let’s talk about it.

Seaview Trading LLC got itself into Tax Court for transacting in a tax shelter. The tax-gentle term is “listed transaction,” but you and I would just call it a shelter. At issue was a $35 million tax deduction, so we are talking big bucks.

The transaction happened in 2001.  The examination started in 2005. On July 27, 2005 the IRS sent Seaview a letter stating that it had never received its 2001 return.

Oh, oh.

This was a partnership, and for the year we are talking about there existed rather arcane audit rules. We will not need to get into the weeds about these rules, other than to say that failing to file a return was bad news for Seaview.

In 2005 Seaview’s accountant faxed a copy of the 2001 tax return to the IRS agent, stating that the return had been timely filed and that Seaview was providing a copy of what it had filed in 2002. He also included a certified mail receipt for the return.

The IRS maintained its position that it had never received the 2001 return. In 2010 the IRS issued its $35 million disallowance.

Fast forward to the Tax Court.

$35 million will do that.

The Court decided to review the case in two steps:

(1)  Did faxing the return to the agent in 2005 constitute “filing” the return?

(2)  If not, does the certified mail receipt constitute evidence of timely filing?

Personally, I would have reversed the order, as I consider certified mailing to be presumptive evidence of timely filing. That is why accountants recommend certified mail. It is less of an issue these days with electronic filing, but every now and then one may decide – or be required – to paper file. In that situation I would still recommend that one use certified mail.

The Court held that faxing the return to the agent did not constitute the filing of a return.

The tax literature observed and commented that faxing does not equal filing.

But there is a subtlety here: Seaview’s accountant indicated that he was supplying the agent a copy of a timely-filed 2001 return. By calling it a copy, the accountant was saying – at least indirectly – that the agent did not need to submit the return for regular processing. That said, it would be unfair for Seaview to later reverse course and argue that it intended for the agent to submit the return for processing.

The IRS won this round.

Now they go to round two: does the certified mail receipt provide Seaview with presumptive proof of timely mailing?

Seaview presents issues that we do not have with our client. We are not playing with listed transactions or obscure audit rules. California just wants its $800 minimum fee for a couple of years. They do not really care if our client actually owes. They want money.

Our administrative staff tried to fax the returns this past Friday but had problems with the fax number. I called the unit in California to explain the issue and discuss alternatives, but I never got to speak with an actual human being. I will try again (at least briefly; I have other things to do) on Monday. If California blows me off again, we will mail the returns.

I fear however that mailing the returns to general processing will cause issues, as the unit will probably issue some apocalyptic deathnote before gen pop routes the returns back to them. We will mail the returns to the specific unit and cross our fingers that not everyone there is “busy serving other customers.”

How I wish I had one of those jobs.

BTW, you can bet we will certify the mail.

A Tax Shelter In The Making

Have you ever heard of a “captive” insurance company?

They have become quite cachet. They have also drawn the IRS’ attention, as people are using these things for reasons other than insurance and risk management.

Let’s walk through this.  

Let’s say that you and I found a company manufacturing sat-nav athletic shoes

COMMENT: Sat-nav meaning satellite navigation. That’s right: you know you want a pair. More than one.

We make a million of them, and we have back orders for millions more. We are on the cover of Inc. magazine, meet Jim Cramer and get called to the White House to compliment us for employing America again.

Sweet.

Then tax time.

We owe humongous taxes.

Not sweet.

Our tax advisor (I am retired by then) mentions a captive.

LET’S EXPLAIN THIS: The idea here is that we have an insurable risk. Rather than just buying a policy from whoever-is-advertising-during-a-sports-event, we set up our own (small) insurance company. Granted, we are never going to rival the big boys, but it is enough for our needs. If we can leap through selected hoops, we might also get a tax break from the arrangement.

What risks do you and I have to insure?

What is one of those shoes blows out or the satellite-navigation system shorts and electrocutes someone? What if it picks up contact from an alien civilization – or an honest political journalist? We could get sued.

Granted, that is what insurance is for. The advisor says to purchase a policy from one of the big boys with a $1.2 million deductible. We then set up our own insurance company – our “captive” – to cover that $1.2 million.

We are self-insuring.

There is an election in the tax Code (Section 831(b) for the incorrigible) that waives the income tax on the first $1.2 million of premiums to the captive. It does pay tax on its investment income, but that is nickels-to-dollars.

You see that I did not pick the $1.2 million at random.

Can this get even better?

Submitted for your consideration: the You & Me ET Athletic Shoe Company will deduct the $1.2 million as “Insurance Expense” on its business return.

We skip paying tax on $1.2 million AND we deduct it on our tax return?

Easy, partner. We can still be sued. We would go through that $1.2 million in a heartbeat.

Is there a way to MacGyver this?

Got it. Three ways come quickly to mind, in fact:

(1) Let’s make the captive insurance duplicative. We buy a main policy with a reputable insurance company. We then buy a similar – but redundant -  policy from the captive.  We don’t need the captive, truthfully, as Nationwide or Allstate would provide the real insurance. We do get to stuff away $1.2 million, however – per year. We would let it compound. Then we would go swimming in our money, like Scrooge McDuck from the Huey, Dewey and Louie comics.

(2) A variation on (1) is to make the policy language so amorphous and impenetrable that it is nearly impossible to tell whether the captive is insuring whatever it is we would submit a claim for. That would make the captive’s decision to pay discretionary, and we would discrete to not pay.

(3) We could insure crazy stuff. Let’s insure for blizzards in San Diego, for example. 

a.    Alright, we will need an office in San Diego to make this look legitimate. I volunteer to move there. For the team, of course.

The tax advisor has an idea how to push this even further. The captive does not need to have the same owners as the You & Me ET Athletic Shoe Company. Let’s make our kids the shareholders of the captive. As our captive starts hoarding piles of cash, we are simultaneously doing some gifting and estate tax planning with our kids.

Heck, we can probably also put something in there for the grandkids.

To be fair, we have climbed too far out on this limb. These things have quite serious and beneficial uses in the economy. Think agriculture and farmers. There are instances where the only insurance farmers can get is whatever they can figure-out on their own. Perhaps several farms come together to pool risks and costs. This is what Section 831(b) was meant to address, and it is a reason why captives are heavily supported by rural state Senators.

In fact, the senators from Wisconsin, Indiana and Iowa were recently able to increase that $1.2 million to $2.2 million, beginning in 2017.

Then you have those who ruin it for the rest of us. Like the dentist who captived his dental office against terrorist attack.

That nonsense is going to attract the wrong kind of attention.

Sure enough, the IRS stepped in. It wants to look at these things. In November, 2016 the IRS gave notice that (some of) these captive structures are “transactions of interest.” That lingo means that – if you have one – you must file a disclosure (using Form 8886 Reportable Transaction Disclosure Statement) with the IRS by May 1, 2017.

If this describes you, this deadline is only a few months away. Make sure that your attorney and CPA are on this.

Mind you, there will be penalties for not filing these 8886s.

That is how the IRS looks at things. It is good to be king.

The IRS is not saying that captives are bad. Not at all. What it is saying is that some people are using captives for other than their intended purpose. The IRS has a very particular set of skills, skills it has acquired over a very long career. Skills that make the IRS a nightmare for people like this. If these people stop, that will be the end of it. If they do not stop, the IRS will look for them, they will find them, and they will ….

Ahem. Got carried away there.

When this is over, we can reasonably anticipate the IRS to say that certain Section 831(b) structures and uses are OK, while others are … unclear. The IRS will then upgrade the unclear structures and uses to “reportable” or “listed” status, triggering additional tax return disclosures and potential eye-watering penalties.

In the old days, listed transactions were called “tax shelters,” so that will be nothing to fool with.

Do You Have to Disclose That?

I was recently talking with another CPA. He had an issue with an estate income tax return, and he was wondering if a certain deduction was a dead loser. I looked into the issue as much as I could (that busy season thing), and it was not clear to me that the deduction was a loser, much less a dead loser.

He then asked: does he need to disclose if he takes the deduction?

Let’s take a small look into professional tax practice.

There are many areas and times when a tax advisor is not dealing with clear-cut tax law.

Depending upon the particular issue, I as a practitioner have varying levels of responsibility. For some I can take a position if I have a one-in-five (approximately) chance of winning an IRS challenge; for others it is closer to one-in-three.

There are also issues where one has to disclose to the IRS that one took a given position on a return. The concept of one-in-whatever doesn’t apply to these issues. It doesn’t have to be nefarious, however. It may just be a badly drafted Regulation and a taxpayer with enough dollars on the line.

Then there are “those” transactions.

They used to be called tax shelters, but the new term for them is “listed transactions.” There is even a subset of listed transactions that the IRS frowns upon, but not as frowny as listed transactions. Those are called “reportable transactions.”

This is an area of practice that I try to stay away from. I am willing to play aggressive ball, but the game stays within the chalk lines. Making tax law is for the big players – think Apple’s tax department – not for a small CPA firm in Cincinnati.

Staying up on this area is difficult, too. The IRS periodically revises a list of transactions that it is scrutinizing. The IRS then updates its website, and I – as a practitioner – am expected to repeatedly visit said website patiently awaiting said update. Fail to do so and the IRS automatically shifts blame to the practitioner.

No thanks.

I am looking at a case involving a guy who sells onions. His company is an S corporation, which means that he puts the business numbers on his personal return and pays tax on the conglomeration.

His name is Vee.

He got himself into a certain type of employee benefit plan.

A benefit plan provides benefits other than retirement. It could be health, for example, or disability or severance. The tax Code allows a business to prefund (and deduct) these benefits, as long as it follows certain rules. A general concept underlying the rules is risk-taking and cost-sharing – that is, there should be a feel of insurance to the thing.

This is relatively easy to do when you are Toyota or General Mills. Being large certainly makes it easier to work with the law of large numbers.

The rules however are problematic as the business gets smaller. Congress realized this and passed Code Section 419A(f)(6), allowing small employers to join with other small employers – in a minimum group of ten – and obtain tax advantages  otherwise limited to the bigger players.

Then came the promoters peddling these smaller plans. You could offer death and disability benefits to your employees, for example, and shift the risk to an insurance company. A reasonable employer would question the use of life insurance. If the employer needed money to pay benefits, wouldn’t a mutual fund make more sense than an illiquid life insurance policy? Ah, but the life insurance policy allows for inside buildup. You could overfund the policy and have all kinds of cash value. You would just borrow from the cash value – a nontaxable transaction, by the way – to pay the benefits. Isn’t that more efficient than a messy portfolio?

Then there were the games the promoters played to diminish the risk of joining a group with nine others.

Vee got himself into one of these plans.

He funded the thing with life insurance. He later cancelled the plan, keeping the life insurance policy for himself.

The twist on his plan was the use of experience-rated life insurance.

Experience-rated does not pay well with the idea of cost-and-risk sharing. If I am experience rated, then my insurance cost is based on my experience. My insurance company does not look at you or any of the other eight employers in our group. I am not feeling the insurance on this one.

Some of these plans were outrageous. The employer would keep the plan going for a few years, overpay for the insurance, then shut down the plan and pay “value” for the underlying insurance policy. The insurance company would keep the “value” artificially low, so it did not cost the employer much to buy the policy on the way out. Then a year or two later, the cash value would multiply ten, twenty, fifty, who-knows-how-many-fold. This technique was called “springing,” and it was like finding the proverbial pot of gold.

The IRS had previously said that plans similar to Vee’s were listed transactions.

This meant that Vee had to disclose his plan on his tax return.

He did not.

That is an automatic $10,000 penalty. No excuses.

He did it four times, so he was in for $40,000.

He went to Court. His argument was simple: the IRS had not said that his specific plan was one of those abusive plans. The IRS had said “plans similar to,” but what do those words really mean? Do you know what you have forgotten? What is the point of a spice rack? Does anybody really know what time it is?

Yea, the Court felt the same way. The plan was “similar to.” They were having none of it.

He owed $40,000.

He should have disclosed.

Even better, he should have left the whole thing alone.

The 6707A Tax Penalty Is Outrageous

I have attached a penalty notice to this blog. Take a look . The IRS is assessing $14,385 for the 2008 tax year, and the description given is a “Section 6707A” penalty.

This is one of the most abusive penalties the IRS wields, in my opinion. As too often happens, it may have been hatched for legitimate reasons, but it has degenerated into something else altogether.

Let’s time travel back to the early aughts. The IRS was taking a new direction in its efforts against tax shelters: mandatory disclosure.  There was a time when tax shelters involved oil and gas or real estate and were mostly visible above the water line, but the 1986 changes to the tax Code had greatly limited those schemes. In their place were more sophisticated – and very hard to understand – tax constructions. The planners were using obscure tax rules to separate wealth from its tax basis, for example, with the intent of using the orphaned basis to create losses. 

The IRS promulgated disclosure Regulations under Section 6011. At first, they applied only to corporations, but by 2004 they were expanded to include individual taxpayers. The IRS wanted taxpayers to disclose transactions that, in the IRS’ view, were potentially abusive. The IRS quickly recognized that many if not most taxpayers were choosing not to report. There were several reasons for this, including:

·       Taxpayers could consider a number of factors in determining whether a transaction was reportable

·       The gauzy definition of key terms and concepts

·       The lack of a uniform penalty structure for noncompliance

The IRS brought this matter to Congress’ attention, and Congress eventually gave them a new shiny tax penalty in the 2004 American Jobs Creation Act. It was Section 6707A.

One of the things that the IRS did was to disassociate the penalty from the taxpayer’s intent or purpose for entering the transaction. The IRS published broad classes of transactions that it considered suspicious, and, if you were in one, you were mandated to disclose. The transactions were sometimes described in broad brush and were difficult to decipher. Additionally, the transactions were published in obscure tax corners and publications. No matter, if the IRS published some transaction in the Botswana Evening Cuspidor, it simply assumed that practitioners – and, by extrapolation, their clients – were clued-in.

If the IRS decided that your transaction made the list, then you were required to disclose the transaction on every tax return that included a tax benefit therefrom. If the IRS listed the transaction after you filed a tax return but before the statute of limitations expired, then you had to file disclosure with your next tax return. You had to file the disclosure with two different offices of the IRS, which was just an accident waiting to happen. And the disclosure had to be correct and complete. If the IRS determined that it was not, such as if you could not make heads or tails of their instructions for example, the IRS could consider that the same as not filing at all. There were no brownie points for having tried.

There’s more.

The penalty applied regardless of whether taxpayer’s underlying tax treatment was ultimately sustained. In fact, the IRS was publishing reportable transactions BEFORE proving in Court that any of the transactions were illegal or abusive. If you took the IRS to Court and won, the IRS said it could still apply the penalty. There was no exception to the imposition of the penalty, even if you could demonstrate reasonable cause and good faith.  

But there was some mercy. Although you could not take the penalty to Court, you could request the IRS Commissioner for rescission if it would “promote compliance … and effective tax administration.” Oh please.

Can this get worse? You bet.

Let’s decouple the penalty from any possible tax benefit you may have gotten. If the transaction was particularly suspicious (termed “listed’), the penalty was $100,000. Double that if you were a company. What if the transaction occurred in your S corporation and then on your personal income tax return because of the K-1 pass-through? Well, add $200,000 plus $100,000 for a penalty of $300,000. Per year. What if the tax benefit was a fraction of that amount? Tough. 

This was a fast lane to Tax Court. Wait, the penalty could not be appealed. Think about that for a moment. The IRS has a penalty that cannot be appealed. What if the system failed and the IRS assessed the penalty abusively or erroneously?  Too bad.  

The Taxpayer Advocate publicly stated that the 6707A penalty should be changed as it “raises significant constitutional concerns, including possible violations of the Eight Amendment’s prohibition against excessive government fines and due process protections.”

In response to public clamor and pressure from Congress, the IRS issued moratoriums on 6707A enforcement actions. It wound up reducing the penalty for years after 2006 to 75% of the decrease in tax resulting from the transaction. There was finally some governor on this runaway car.

My client walked into Section 6707A long before I ever met him/her. How? By using a retirement plan.

Yep, a retirement plan.

The plan is referred to as a 412(i), for the Code section that applies. A company would set up a retirement plan and fund it with life insurance. Certain rules relaxed once one used life insurance, as it was considered a more reliable investment than the stock market. I was a fan of these plans, and I once presented a 412(i) plan to a former client who is (still) a sports commentator at ESPN.

Then you had the promoters who had to ruin 412(i)) plans for everyone else. For example, here is what I presented to the ESPN person. We would set up a company, and the company would have one employee and one retirement plan. The plan would be funded with life insurance. The plan would have to exist for several years (at least five), and - being a pension plan - would have to be funded every year. Because life insurance generally has a lower rate of return than the stock market, the IRS would allow one to “over” fund the plan. After five years or more, we would terminate the plan and transfer the cash value of the insurance to an IRA.

The promoters made this a tax shelter by introducing “springing” life insurance. They were hustling products that would have minimal cash value for a while – oh, let’s say … the first five years. That is about the time I wanted to close the plan and transfer to an IRA. Somehow, perhaps by magic, all that cash value that did not previously exist would “spring” to life, resulting in a very tidy IRA for someone. Even better, if there was a tax consequence when the plan terminated, the cost would be cheap because the cash value would not “spring” until after that point in time.

I thought a 412(i) plan to be an attractive option for a late-career high-income individual, and it was until the promoters polluted the waters with springing insurance nonsense. It then became a tax shelter, triggering Section 6707A.

My client got into a 412(i). From what I can tell, he/she got into it with minimal understanding of what was going on, other than he/she was relying on a professional who otherwise seemed educated, sophisticated and impartial. The plan of course blew up, and now he/she is facing 6707A penalties – for multiple tax years.

And right there is my frustration with penalties of this ilk. Perhaps it makes sense if one is dealing with the billionaires out there, but I am not. I am dealing with businesspeople in Cincinnati who have earned or accumulated some wealth in life, in most cases by their effort and grit, but nowhere near enough to have teams of attorneys and accountants to monitor every fiat the government decides to put out. To say that there is no reasonable cause for my client is itself abusive. He/she could no more describe the tax underpinnings of this transaction any more than he/she could land a man on the moon.

What alternative remains to him/her? To petition the Commissioner for “rescission?” Are you kidding me? That is like asking a bully to stop bullying you. I have ten dollars on how that exercise will turn out.