Category: Tax
Clear ResultsCommercial Litigation
United States Tax Court Delivers Important R&D Credit Win for Architectural Innovation
The United States Tax Court released its opinion today on Smith v. Commissioner, T.C. Memo. 2026-50, and it is a significant R&D credit win for taxpayers that perform sophisticated technical work for clients. I am particularly satisfied with the outcome, having had the privilege of litigating this case. This matter involved research credits claimed by Adrian Smith + Gordon Gill Architecture, LLP, or AS+GG, for research activities performed in connection with large scale architectural projects during the 2008, 2009, and 2010 tax years. AS+GG is known for ambitious, complex, and highly sustainable architectural design. The projects at issue involved supertall towers, zero carbon and low energy design concepts, wind studies, solar orientation analysis, structural and environmental performance issues, and other technical design challenges. This context matters, as the case was not about routine design work. The opinion describes a firm working at the edge of what architecture, engineering, and sustainable design could accomplish. In that respect, the case is a useful reminder that R&D credits are not limited to laboratories, software companies, or manufacturing floors. Innovation also happens in design studios, engineering meetings, building models, wind studies, and iterative technical problem solving. The IRS Conceded the Four-Part Test One of the most important features of the case is what was not in dispute by the time of trial. The IRS ultimately conceded that AS+GG’s claimed business components satisfied the four-part test for qualified research under section 41(d). That concession mattered, and it did not happen by accident. A significant part of the case was devoted to developing the factual record on the nature of AS+GG’s work. Through extensive discovery, the taxpayers built the record showing that the projects involved real technical uncertainty, a process of experimentation, and design work directed at performance, sustainability, structure, energy usage, wind behavior, solar orientation, and other technical objectives. By the time of trial, the government no longer tried the case on the theory that the work failed the four-part test. Instead, the IRS conceded that issue, and the trial focused on the funded research exclusion under section 41(d)(4)(H). That is a major point. For taxpayers in architecture, engineering, design, and other technical service industries, the concession reinforces something important: sophisticated client work can involve qualified research. The remaining fight was not whether AS+GG’s work was research. It was whether the funded research rules limited the credit. The Funded Research Issue The funded research exclusion is one of the most important limitations on R&D credits for companies that perform technical work under customer contracts. Section 41(d)(4)(H) excludes research “to the extent funded” by another person. The regulations generally ask two questions: First, was payment contingent on the success of the research Second, did the taxpayer retain substantial rights in the research The Court applied that familiar framework. The taxpayers argued that, after Loper Bright, the Court should not simply accept the regulatory test and should instead adopt a narrower reading of “funded.” The Court rejected that argument and held that the funded research regulations remain valid. That part of the opinion is important, but it should not obscure the practical taxpayer win. Even applying the regulatory framework urged by the government, the taxpayers prevailed on the central issue that mattered most for four of the six sample projects: substantial rights. The Taxpayer Win: Substantial Rights The heart of the opinion is the Court’s substantial rights analysis. The Court held that AS+GG retained substantial rights in the research performed on four of the six sample projects: Atrium City Tower, Masdar HQ, Atrium City Masterplan, and Plot R2. That holding matters because a taxpayer that retains substantial rights in the research may still claim R&D credits on a reduced basis, even if the Court concludes that payments were not contingent on success. The practical result is that AS+GG was not treated as having simply performed fully funded research for a customer on those projects with no credit available. Instead, the Court recognized that AS+GG retained meaningful rights to use the results of its research in its business. That is a significant result in a funded research case. It is also a lesson in contract drafting. The Court did not treat intellectual property provisions, copyright language, licenses, confidentiality clauses, settlement agreements, and use restrictions as boilerplate. It parsed the language project by project. On some projects, the language preserved enough rights for the taxpayer. On others, it did not. That project-by-project analysis is one of the most useful aspects of the opinion. It shows that small differences in contract language can produce very different R&D credit outcomes. Why this Matters for R&D Credit Taxpayers Smith is especially useful for architecture, engineering, construction, consulting, design, and other technical service businesses. Many of these companies assume that R&D credits are unavailable because they perform work for clients. That assumption is too broad. A customer contract does not automatically eliminate the credit. The funded research rules are more nuanced. The key questions are who bears the relevant risk and whether the taxpayer retains meaningful rights in the research. The opinion reinforces several important points. First, design and architecture can involve qualified research. The Court’s factual findings describe technical work involving sustainability, wind, energy, structure, geometry, performance, and environmental constraints. Those are exactly the kinds of uncertainties that can support R&D credit claims when properly documented. Second, substantial rights matter. A taxpayer does not necessarily lose the credit merely because the customer receives project rights, licenses, or deliverables. The question is whether the taxpayer retained meaningful rights to use the research results in its own business. Third, contracts matter. The funded research analysis is driven heavily by the agreement between the taxpayer and the customer. Taxpayers who wait until audit to think about substantial rights are often too late. Fourth, documentation still matters. The Court left the precise credit amounts to be determined through computation. That is a reminder that winning the legal issue is not enough. Taxpayers also need project level documentation and expense substantiation that allow the allowable credit to be calculated. A Strong, Reasonable Compensation Win The opinion also includes an important win on reasonable compensation, an issue I personally handled at trial, and one of the most satisfying parts of the case. AS+GG’s R&D credit included wage related qualified research expenditures attributable to the partners. The government challenged the partners’ 2008 compensation under section 174(e), arguing for a much lower reasonable compensation amount. At trial, a central part of the taxpayers’ case revealed that the government’s reasonable compensation theory did not fit the economics of the business. That point came through clearly in the expert testimony. The IRS expert advanced a much lower compensation number under a multifactor analysis, but his own independent investor analysis showed that, even after his adjustments, AS+GG generated a 939% return on equity. On that math, he concluded that the partners’ total compensation was not unreasonable. That was a powerful trial point. The government’s expert opinion, when tested against the controlling Seventh Circuit standard, supported the taxpayers. The Court agreed that the independent investor test applied because the case was appealable to the Seventh Circuit. Once that standard governed, the result followed: the partners’ 2008 compensation was reasonable under section 174(e). That holding is meaningful for owner-operated businesses where the people driving the research are also principals of the business. In those cases, the R&D credit often depends not only on whether the work qualifies, but also on whether compensation paid to key technical leaders can be included in wage QREs. Here, the Court accepted the taxpayers’ position and preserved an important component of the credit. Practical Takeaways The biggest takeaway from Smith is that R&D credit planning should begin before the contract is signed. Taxpayers performing technical work for customers should review their agreements for at least three things: First, what happens if the research fails Second, who owns the work product, technical information, drawings, designs, models, methods, and other research results Third, does the taxpayer retain the right to use what it learned and developed in future work Those questions should be addressed in the contract itself. They should not be left to implication, course of dealing, or after-the-fact argument. This case also highlights the importance of project-level documentation. Taxpayers should identify the business components, the technical uncertainties, the process of experimentation, the employees or principals performing qualified services, and the expenses tied to the research. Conclusion Smith v. Commissioner is a significant R&D credit decision and a gratifying taxpayer win. The IRS conceded that the work satisfied the four-part test. The Court held that AS+GG retained substantial rights in four of the six sample projects and allowed the taxpayers to claim research credits to the extent permitted by the funded research rules. The Court also accepted the taxpayers’ position on reasonable compensation, preserving an important wage QRE issue. For taxpayers in architecture, engineering, design, consulting, and other technical service businesses, the message is encouraging: customer contract work does not automatically defeat the R&D credit. But the contract language matters, the retained rights matter, and the record matters.
June 16, 2026
Tax
Cannabis Tax Relief Is Here — But IRS Risk Is Just Beginning
For years, cannabis operators have functioned under a fundamentally distorted tax regime. Section 280E denied deductions that every other business takes for granted, forcing companies to pay tax on something closer to gross income than net profit. That framework has now changed, at least for a significant portion of the industry. The federal government’s decision to reschedule state-licensed medical cannabis to Schedule III removes the § 280E limitation and allows qualifying businesses to deduct ordinary and necessary expenses under § 162. The headline is clear: tax relief is here. But the more important reality is this: the industry is transitioning from a regime of disallowance to a regime of interpretation, and that is where risk lives. A Structural Shift, Not Just a Tax Cut The removal of § 280E does more than reduce tax liability. It fundamentally changes how cannabis businesses are analyzed for tax purposes. For the first time, medical operators must think like every other taxpayer. They must evaluate what constitutes an ordinary and necessary expense, how costs are allocated across lines of business, and whether those positions are sustainable under IRS examination. This normalization introduces flexibility but also subjectivity. And subjectivity is where disputes begin. For operators with both medical and recreational activities, the issue is even more pronounced. Because recreational cannabis remains a Schedule I substance, § 280E still applies to that portion of the business. That creates an immediate need to develop defensible allocation methodologies between revenue streams, personnel, facilities, and shared overhead. These are not merely accounting questions, they are positions that will ultimately be tested. Timing, Transition, and Retroactivity Another layer of complexity lies in how the change is implemented. Treasury and the IRS have signaled that § 280E relief may apply to the entire taxable year that includes the effective date of rescheduling. If that approach holds, it creates a significant opportunity, but also risk. Businesses may take positions that maximize deductions across the full year, while the IRS may later challenge how those positions were calculated or documented. There is also the open question of retroactive relief. The possibility that prior years could be revisited raises strategic considerations around amended returns, refund claims, and statute of limitations issues. These decisions are not purely mechanical. They require a view of how the IRS is likely to respond. R&D Credits: A New Frontier for Cannabis Tax Strategy Perhaps the most underappreciated implication of rescheduling is access to the research and development credit under § 41. Cannabis businesses, particularly those engaged in cultivation, extraction, and product development, often perform activities that meet the technical requirements for qualified research. These include developing new strains, improving yield and consistency, refining extraction processes, and designing new delivery methods. Historically, many operators either avoided claiming the credit or took a conservative approach due to the overlay of § 280E and the lack of clear precedent in the industry. That restraint is likely to disappear quickly. The financial upside is real. Properly documented R&D credits can offset a meaningful portion of federal tax liability, and in some cases provide payroll tax offsets for earlier-stage businesses. But this is not low-risk territory. R&D credits are already an area of heightened IRS scrutiny, and the agency has become increasingly aggressive in challenging claims that lack contemporaneous documentation or rely on overly broad characterizations of qualifying activities. Cannabis businesses entering this space will be doing so under two compounding factors: new eligibility, and a tendency toward aggressive positioning. That combination is precisely what draws enforcement attention. The Inevitable Second Phase: IRS Scrutiny Tax law changes of this magnitude do not settle quietly. They move in phases. The first phase is what we are seeing now: rapid adoption of favorable positions. The second phase is where the IRS responds, often several years later, once patterns emerge and guidance is issued. That is when the real issues surface. The IRS will examine whether allocation methodologies between medical and recreational operations are reasonable, whether deductions claimed under § 162 are adequately substantiated, whether R&D credits meet the technical and documentation requirements, and whether positions taken during the transition period were overly aggressive. By the time these questions are asked, the financial stakes are often significant, and the factual record is already fixed. Why This Requires a Different Approach Most tax planning focuses on maximizing current benefit. In this environment, that is only part of the equation. The more important question is whether the positions being taken today will hold up under examination, appeals, or litigation. That requires thinking not just like an advisor, but like the IRS and, when necessary, like a litigator. Having spent nearly a decade inside the IRS Office of Chief Counsel and now representing clients in complex tax disputes, I have seen how these cases are developed from the government’s side. That perspective informs of a different approach. It means building allocation methodologies that are not just reasonable but defensible, structuring R&D credit claims with audit in mind from the outset, identifying positions that are likely to become enforcement targets, and preparing for disputes before they arise rather than reacting after the fact. In a transition like this, the strongest position is not the most aggressive one. It is the one that can survive scrutiny. The Bottom Line The rescheduling of medical cannabis is a turning point. It brings long-awaited tax relief and opens the door to planning opportunities that were previously unavailable. But it also moves the industry into a more complex and contested tax environment, one where interpretation, documentation, and defensibility matter as much as the underlying benefit. The businesses that come out ahead will not simply be the ones that claim the most. They will be the ones who approach this moment with a clear understanding of how those claims will be evaluated when it matters most. If you are navigating these issues, the question is not just whether you are taking advantage of the opportunity. It is whether you are positioned to defend it.
May 8, 2026
Commercial Litigation
Defeating the IRS at Trial: Lessons from the Taxpayer Victory in Ankner v. United States
After successfully trying Ankner v. United States and defeating a multi-million-dollar promoter-penalty assessment, Matthew S. Reddington analyzes what the verdict means for the government’s burden of proof under IRC § 6700—and for taxpayers and advisors facing promoter investigations. In Ankner v. United States, a federal jury rejected the Internal Revenue Service’s attempt to impose approximately $4 million in promoter penalties under IRC § 6700 against a captive insurance manager. Janine Campanaro and I served as trial counsel for the taxpayer and successfully tried the case to verdict in the United States District Court for the Middle District of Florida. The decision offers an important reminder for businesses, advisors, and professionals facing promoter-penalty investigations: even in industries the IRS has publicly targeted, the government must still prove each statutory element of § 6700 at trial. When the government cannot meet that burden, the penalties cannot stand. As the trial record and jury verdict in Ankner illustrate, promoter-penalty disputes frequently turn not on sweeping policy debates about the legitimacy of an industry, but on far more specific evidentiary questions. The government must prove that materially false statements were made regarding the tax benefits of the transaction and that the alleged promoter knew or had reason to know those statements were false. When those elements are carefully examined through witness testimony, documentary evidence, and expert analysis, the government’s theory does not always hold. § 6700 Promoter Penalties Require the Government to Prove Specific Elements Internal Revenue Code 6700 authorizes the IRS to impose substantial penalties on individuals or businesses that promote abusive tax shelters. The statute permits penalties equal to 50% of the gross income derived from the promotional activity, which can quickly result in multi-million-dollar assessments. Despite the severity of the penalty, the government must still establish specific statutory elements when the penalty is challenged in court. In particular, the government must prove: A False or Fraudulent Statement The promoter made false or fraudulent statements regarding the tax benefits of a transaction. Knowledge or Reason to Know The promoter knew, or had reason to know, that the statements were false. In practice, the knowledge requirement frequently becomes the most contested issue in promoter-penalty litigation. A Federal Jury Found the Government Failed to Meet That Burden in Ankner Ankner v. United States arose from the government’s investigation of a captive insurance manager who assisted small businesses in forming insurance companies intended to qualify under IRC § 831(b). Rather than focusing exclusively on promotional statements regarding tax benefits, the government argued that the underlying captive insurance arrangements did not constitute legitimate insurance companies. Based on that premise, the government asserted that the captive manager and related entities made false statements regarding the tax consequences of participating in the arrangements. After paying a portion of the assessed penalties permitted in promoter-penalty disputes, the taxpayer filed suit challenging approximately $4 million in penalties related to tax years 2010 through 2016. Following the trial, the jury concluded that the government failed to carry its burden of proof, and the taxpayer was not liable for the penalties. Although jury verdicts are necessarily fact-specific, the case underscores an important point: even in areas the IRS has identified as enforcement priorities, the government must still prove each element of § 6700. Traditional Promoter-Penalty Cases Often Involved Clear Tax-Avoidance Schemes Historically, many litigated § 6700 cases involved blatantly abusive tax-avoidance schemes, where the government’s evidentiary burden was comparatively straightforward. For example, in United States v. Schulz, the defendants promoted materials instructing taxpayers how to stop withholding and paying federal income taxes. The court concluded that the promoters knowingly advanced positions repeatedly rejected by the courts. Similarly, in United States v. RaPower-3 LLC, the government successfully pursued promoter penalties against a company marketing solar-energy technology that was incapable of producing electricity. Participants were promised tax benefits tied to equipment that never functioned as represented. In Tarpey v. United States, the Ninth Circuit affirmed an $8.5 million promoter penalty related to a timeshare-donation scheme, emphasizing the broad scope of § 6700 when determining the gross income derived from the promotional activity. These cases involved clear factual records demonstrating knowingly false representations. By contrast, more recent promoter-penalty investigations increasingly involve legitimate industries and complex transactions, where the relevant facts and legal standards are far more nuanced. The IRS Is Expanding the Use of Promoter Penalties Across Multiple Industries The significance of Ankner must also be viewed against the backdrop of expanding IRS enforcement initiatives. In recent years, the IRS has increasingly relied on promoter penalties as a mechanism to deter activity in industries it believes involve aggressive tax planning. Current enforcement efforts have focused on areas such as: Micro-captive insurance arrangements Syndicated conservation easements Employee Retention Credit (“ERC”) promotions Certain partnership basis-adjustment transactions The IRS’s Office of Promoter Investigations has become particularly active in these matters, and promoter-penalty assessments are frequently pursued alongside broader civil or criminal investigations. Given the scale of potential penalties, these disputes can carry significant financial and reputational consequences for businesses and advisors. For Taxpayers and Advisors Facing § 6700 Investigations, Litigation Strategy Matters For taxpayers, captive managers, tax advisors, and other professionals facing promoter-penalty investigations, Ankner highlights an important strategic point: § 6700 cases ultimately turn on proof of statutory elements—not simply the IRS’s view of the underlying transaction. Promoter-penalty disputes often begin with extensive government investigations that focus heavily on the perceived legitimacy of the transaction itself. While those issues may form part of the broader context, the government must ultimately prove far more specific facts at trial—namely, that false statements were made and that the alleged promoter knew, or had reason to know, those statements were false. In practice, those evidentiary requirements can present meaningful challenges for the government. Because promoter-penalty cases frequently involve complex industries, expert testimony, and extensive factual records, early strategic guidance is critical. Decisions made during the investigative stage—often long before litigation begins—can substantially influence how the case develops if it proceeds to court. For that reason, businesses and advisors confronting potential § 6700 exposure should consider engaging counsel with significant experience litigating complex tax disputes through trial. Promoter-penalty cases are not merely technical tax controversies; they are fact-intensive litigation matters that require careful development of the evidentiary record and a disciplined focus on the government’s burden of proof.
March 23, 2026
Tax
ERC Refund Claims Are Running Out of Time: Why Waiting on the IRS Could Cost Businesses Their Credit
The Employee Retention Credit may be closed to new filings, but the controversy surrounding unpaid and disallowed claims is very much alive. For many businesses, the real risk in 2026 is no longer just whether the IRS will eventually act. The real danger is that waiting too long may eliminate a taxpayer’s ability to force action and recover the refund at all. That risk is becoming acute. The IRS’s own ERC disallowance guidance states that once a Letter 105C is issued, the taxpayer generally has two years from the date of that letter to file suit. Requesting an administrative appeal does not extend that deadline. In other words, a protest can sit comfortably in the IRS administrative queue while the clock on your right to sue keeps ticking away. This is not a theoretical concern. In its Annual Report to Congress, the National Taxpayer Advocate warned that the IRS issued roughly 28,000 ERC disallowance notices during the summer of 2024. By the time the report was published, many of those taxpayers had fewer than six months remaining on the two-year period to file suit. That should get the attention of any business with an unresolved ERC dispute. The practical message is straightforward. A taxpayer cannot assume that “waiting on appeals” preserves the claim. It does not. Nor can a taxpayer assume that the IRS will affirmatively safeguard the deadline. And while TAS has reportedly set up a universal email address where taxpayers and practitioners can send Form 907s that need immediate attention, there is no clear definition of what “immediate” means or how submissions with be prioritized. That is if you can get one signed. Practitioners have widely reported that the IRS has a directive to deny any requests for extensions. For businesses stuck in the administrative process or waiting out IRS inaction, that is not encouraging news. Just as troubling is the disconnect between official reporting and what many practitioners are seeing on the ground. The Government Accountability Office (“GAO”) reported in February 2026 that the IRS told GAO it had closed all ERC claims, except for the 41,000 still in examination or appeal. BUT the IRS did not provide documentation for that figure, did not define what it meant by a “closed” claim, and had not publicly updated ERC processing status since October 2024. That lack of transparency matters. A claim that the IRS internally considers “closed” may not feel closed at all to the business that has received no payment, no final resolution, no meaningful movement in the administrative process, and no clear explanation of what happens next. And practitioners, who have direct knowledge about how many ERC claims remain unresolved or pending for their clients, are scratching their heads at the IRS’s numbers. When the government’s statistics and the real-world experience of taxpayers diverge this sharply, the problem usually isn’t arithmetic. It’s visibility. The disconnect could be driven by resource constraints. The IRS is attempting to manage complex amended return inventories, controversy matters, and operational changes at the same time its workforce has shrunk significantly. According to the National Taxpayer Advocate’s 2026 report, the IRS workforce fell from 102,113 to 75,702 over the prior year, with major reductions in taxpayer services, small business and self-employed functions, and information technology. A workforce reduction of that magnitude inevitably affects how quickly and effectively disputes are resolved. All of this to say: businesses should not treat delay as harmless. Put differently, this is not an environment in which a company should confidently assume its case will be resolved through the ordinary administrative process before a limitations problem arises. When the statute of limitations is involved, time does not merely fly, it sprints. For businesses with ERC claims, 2026 should be treated as a decision year, not a waiting year. If your claim has been denied, you should determine the date on the denial letter and calculate the two-year suit deadline now. Many businesses will find that deadline is coming this July. If your protest is pending, you should evaluate immediately whether the statute is still running and whether action is necessary to preserve your rights. If your claim remains unresolved after prolonged inaction by the IRS, you should assess whether court action is appropriate rather than assuming the administrative process will eventually resolve itself. Businesses that filed ERC claims in good faith should not lose their recovery rights because the IRS process is slow, opaque, and under-resourced. They should not lose a legitimate tax credit simply because a handful of aggressive promoters created skepticism around the program. Yet that is precisely the position many taxpayers now face. One of the important nuances of filing for a refund is that it takes it out of the hands of the Office of Chief Counsel (IRS in-house attorneys) and thrusts it into the arms of the DOJ. At a time when the DOJ has defunded its tax division and spread its specialized attorneys amongst its various criminal and civil litigation divisions, perhaps an abundance of filings creating pressure will cause the DOJ to push the IRS into action and resolution. Who knows. But there’s only one way to find out. Either way, the window to act is narrowing, particularly for taxpayers who received ERC disallowance letters in the summer of 2024 and assumed their protest would preserve the claim. It may not. If your company has an unpaid ERC claim, a pending protest, or a disallowance letter that has been sitting for months, now is the time to review the file, confirm the applicable deadlines, and determine whether litigation or other protective action is necessary. You still have options today, but that may not be true for long. Waiting for the IRS to move first may be the very thing that costs you the chance to recover.
March 16, 2026
Tax
When Will the IRS Compromise Tax Liability?
We have all seen the television commercials hawking tax relief with “satisfied clients” shilling for the promoter. But will the IRS really compromise a tax liability? If so, when, how, and why? There are four grounds on which the IRS is authorized to compromise a tax liability: (1) Effective tax administration on grounds of equity or public policy; (2) Effective tax administration on grounds of economic hardship; (3) Doubt as to liability; and (4) Doubt as to collectability. Because the business is the taxpayer, a request to compromise must be made in the name of the business. This means that partners in a partnership cannot compromise an individual’s portion of a partnership tax debt. The partnership must submit its own offer in compromise based upon the partnership’s and the individual partner’s ability to pay. The Internal Revenue Manual (IRM) is the IRS’s internal policies and procedures manual and contains a wealth of information regarding how the IRS evaluates offers in compromise (among many other topics). To see what factors the IRS considers and how it evaluates offers in compromise as set forth in the IRM, click here. Effective Tax Administration on Grounds of Equity or Public Policy This means there is no doubt the tax liability is owed, and that the full amount could be collected. In this case, compelling public policy or equity considerations exist, such that collection of the full liability would undermine public confidence that the tax laws are administered in a fair and equitable manner. Not to say the IRS has never compromised a tax debt on these grounds, but a successful result is almost unprecedented. Effective Tax Administration on Grounds of Economic Hardship Like its sibling, a compromise on grounds of public policy, this exception also means there is no doubt the tax liability is owed and that the full amount could be collected. This ground would apply where full collection would cause severe economic hardship, such as an inability to pay basic, reasonable living expenses. Most efforts to compromise a tax debt under this exception fail because other, more common grounds exist. Doubt as to Liability This means there is a genuine dispute whether the amount of the assessed tax is correct or whether the assessment is correct. Tax protester arguments, i.e., the Income Tax Act is unconstitutional, the income tax is a voluntary tax, wages are not income, the sovereign citizens theory, and a plethora of other arguments do not constitute a genuine dispute. In fact, all these tax protester arguments have been repeatedly characterized as frivolous, which, if made, will subject the person making them to possible sanctions under IRC § 6673(a). For information on tax protester arguments (and the consequences) click here. Doubt as to liability frequently arises in cases involving innocent spouse relief, but may arise in other areas as well. Doubt as to liability can arise in a number of circumstances such as a missed notice from the IRS resulting in the IRS disallowing all deductions, which, assuming the time for correction has not expired, can be proven and credited, mistaken or incorrect reporting such as when a payroll service reports (and pays) employment taxes for one affiliate when it should have been the other affiliate, or the IRS examiner made a mistake in applying the law or in calculating a tax liability. It happens. Doubt as to liability could arise when the IRS seeks to impose a Trust Fund Recovery penalty—the Trust Fund Recovery penalty, or TFR for short, is a 100% penalty— on a corporate official for not making payroll tax deposits and a genuine issue exists whether the person is a “responsible party” for purposes of withholding, collecting, and remitting payroll taxes. In virtually all the litigated tax cases, the issue is doubt as to liability. In each case, the determination of whether there is any doubt as to liability will be made on the totality of the facts and circumstances. To raise the issue of doubt as to liability, several conditions must be met: (1) there cannot be a final court determination regarding the tax liability; (2) there must be a legitimate dispute regarding the tax liability (no tax protester arguments); and (3) you must have supporting documentation. Typically, doubts as to liability are resolved well before the offer in compromise stage; but if not, an offer in compromise on the basis of doubt as to liability is made using Form 656-L. The last category, doubt as to collectability, is the most often used ground for compromising a tax debt. Doubt as to Collectability This means the IRS does not think it can collect the full amount of the tax liability through forced collection, so it would rather have something rather than nothing. Before the Service will consider compromising a tax debt due to doubt as to collectability, it will require the taxpayer to submit Form 433-B, Collection Statement for Businesses (for individuals, there is Form 433-A). Form 433-B requires a business to list extensive financial information. Though it may seem intrusive at first blush, the purpose of Form 433-B is to determine what the IRS can achieve through force collections. After all, the IRS will not compromise a tax debt for doubt as collectability where the full amount can be paid through available assets or income, either in full immediately or through an installment agreement. Though some may be tempted to understate assets and overstate liabilities on Form 433-B, this is a very bad idea. Form 433-B, like all forms submitted to the IRS, is signed under penalty of perjury. Intentionally understating assets or overstating liabilities on a Form 433-B is a 1001 violation (a crime punishable by up to five years imprisonment) just as if the person signing the form had lied to a federal agent. As thorough as Form 433-B is, it is just numbers on a piece of paper. To maximize the chances of getting the IRS to compromise a business tax debt, the business’s story needs to be told, in writing, ideally accompanying Form 433-B. An offer in compromise (OIC) for doubt as to collectability is made on Form 656-B. If the taxpayer can demonstrate that it is unlikely that the IRS will collect the full amount through forced collection and the offer in compromise reflects the taxpayer’s reasonable collection potential (RCP), the IRS will likely accept the offer and compromise the tax debt.
March 11, 2026
Commercial Litigation
When Hypothetical Liquidations Become “Illogical”: Otay Project LP v. Commissioner
The Tax Court’s recent decision in Otay Project LP v. Commissioner, T.C. Memo. 2026-21, is likely to become one of the most discussed partnership cases of the year — not because it announces a new doctrine, but because it quietly rewrites how § 743(b) is expected to operate in large tiered partnerships. At issue was a familiar structure. A real estate development partnership underwent ownership changes that triggered a technical termination under pre-2018 § 708(b)(1)(B). Because the partnership had a § 754 election in effect, the termination required a basis adjustment under § 743(b). The partnership computed that adjustment using the regulatory hypothetical liquidation framework in Treas. Reg. § 1.743-1(d), which assumes a fully taxable disposition of partnership assets at fair market value. That hypothetical recognition of embedded gain — including large deferred income under long-term contract accounting — produced a substantial negative “previously taxed capital” amount and therefore a large positive § 743(b) adjustment. The IRS disallowed the deduction, and the court ultimately agreed. But the court did not reject the adjustment primarily on economic substance grounds. Instead, it concluded the calculation itself was “illogical,” pointing to the resulting balance sheet, which reflected negative partner capital and a basis adjustment far larger than the partnership’s book of equity. That reasoning deserves scrutiny. The Problem with the Court’s Analytical Frame Section 743(b) is mechanical. When a partnership interest is transferred, and a § 754 election exists, the statute requires the partnership to adjust inside basis so that the transferee partner’s share of inside basis matches its outside basis. Congress did not condition the adjustment on accounting symmetry, economic parity, or a positive capital account. The statute simply compares two numbers. Treasury regulations likewise adopt a mechanical approach. Treas. Reg. § 1.743-1(d) defines a transferee partner’s share of partnership basis using a “hypothetical transaction”; an immediate sale of all partnership assets for cash equal to fair market value. The regulation expressly requires gain recognition in that hypothetical liquidation. In a development partnership using the completed contract method, such a hypothetical sale necessarily accelerates large amounts of deferred income. The resulting negative capital is not anomalous — it is the direct product of the regulatory model. The purpose of § 743(b) is precisely to prevent that phantom gain from being taxed to the transferee partner a second time. The court, however, treated the result as evidence that the computation must be wrong rather than evidence that the regulation is working as intended. Negative Capital Is Not a Defect The opinion implicitly assumes that inside basis cannot produce a negative capital allocation. But neither the statute nor the regulations impose that limitation. To the contrary, § 743(b) adjustments routinely arise when outside basis exceeds a partner’s share of inside basis — especially in partnerships holding appreciated property or deferring income. The regulatory hypothetical liquidation is not a balance-sheet exercise; it is a tax allocation exercise. Its purpose is to determine how much gain would be allocated to the transferee partner if the partnership sold all of its assets immediately after the transfer. If that hypothetical gain exceeds the partner’s liquidation proceeds, negative capital necessarily follows. Calling that result “illogical” effectively replaces the regulation with a net-equity test that does not appear anywhere in subchapter K. The Liability Expansion Issue The government also argued that additional liabilities — including construction obligations — should reduce the § 743(b) adjustment. The court appeared receptive to this position. That approach risks blurring an important doctrinal boundary. Section 752 governs partnership liabilities. It does not treat executory performance obligations as liabilities simply because the partnership must perform under a contract. Real estate developers frequently have future performance obligations, but those obligations do not automatically create recourse liabilities for basis purposes. If performance obligations are treated as § 752 liabilities in order to neutralize § 743(b), the liability rules cease to be administrable. A Practical Consequence The most significant implication of Otay is not confined to pre-2018 technical terminations. The reasoning threatens routine partnership transactions: family succession transfers upper-tier partnership restructurings real estate development partnerships using CCM any partnership with a large built-in gain and a § 754 election Under the decision’s logic, a § 743(b) adjustment may be disregarded whenever the result is large enough to appear economically disproportionate. That converts a mechanical statute into a facts-and-circumstances inquiry — exactly what subchapter K historically sought to avoid. What the Case Really Reflects The opinion appears less concerned with statutory interpretation than with scale. The partnership reported substantial deferred income and an offsetting basis deduction attributable to the prior § 743(b) adjustment. The court viewed the magnitude as incompatible with economic reality. But subchapter K has never limited tax consequences by magnitude. Congress allowed long-term contract deferral. Congress allowed § 754 elections. Congress required § 743(b) adjustments to maintain parity between inside and outside basis. Large numbers are sometimes the inevitable consequence of those interacting provisions. Courts traditionally police abusive transactions through economic substance or anti-abuse doctrines. Here, however, the court did something more consequential, it recast a regulatory computational rule into an equitable limitation. Why the Decision Matters The importance of Otay lies in its methodological shift. Instead of asking whether the statute and regulations were followed, the court asked whether the result looked sensible on a balance sheet. That is not how subchapter K operates. Partnership taxation depends on predictability. Taxpayers make structural decisions — § 754 elections in particular — based on mechanical consequences. If courts can override those consequences whenever hypothetical liquidation math produces large disparities, then § 743(b) becomes unreliable as a planning tool. In short, Otay Project does not merely deny a deduction. It introduces uncertainty into one of the most fundamental coordination rules in partnership taxation: the alignment of inside and outside basis. The case will likely be remembered not for its facts, but for its implication that regulatory mechanics yield to judicial intuition. For partnerships relying on § 754 elections, that is a far more significant development than the adjustment at issue in the case itself.
March 4, 2026
Tax
Treasury and IRS Issue Interim Guidance on Prohibited Foreign Entity Rules with New Safe Harbors Under Notice 2026‑15
On February 12, 2026, the Department of the Treasury and the Internal Revenue Service released Notice 2026-15, the first substantive regulatory action implementing the prohibited foreign entity ("PFE") provisions enacted by the One, Big, Beautiful Bill Act ("OBBBA") on July 4, 2025. The Notice provides interim guidance on restrictions to the Section 45Y clean electricity production credit, the Section 48E clean electricity investment credit, and the Section 45X advanced manufacturing production credit, with respect to sourcing from a PFE. It establishes temporary safe harbors and reliance rules for determining whether a facility, energy storage technology ("EST"), or eligible component includes "material assistance from a PFE," while previewing how Treasury and the IRS intend to approach related concepts, including effective control, in forthcoming proposed regulations. Unlike the domestic content bonus credit, which merely offered an incremental adder, these rules are binary: a facility that fails is ineligible for the tech-neutral ITC or PTC entirely with potentially devastating consequences for project capital stack. The Statutory Framework The OBBBA added new Sections 45Y(b)(1)(E), 48E(b)(6) and (c)(3), and 45X(c)(1)(C) to the Code, providing that the terms "qualified facility," "energy storage technology," and "eligible component" do not include items that incorporate material assistance from a PFE. The OBBBA simultaneously amended Section 7701 to add new paragraphs (a)(51) and (a)(52), defining a "prohibited foreign entity" and "material assistance from a prohibited foreign entity," respectively. Under Section 7701(a)(52), "material assistance from a PFE" is present when a facility's, EST's, or eligible component's material assistance cost ratio ("MACR") falls below the applicable threshold percentage. The threshold percentages phase in over time based on the calendar year during which construction of a qualified facility or EST begins (for Sections 45Y and 48E) or the calendar year during which an eligible component is sold (for Section 45X). For example, a qualified facility beginning construction in calendar year 2026 must achieve a Clean Electricity MACR of not less than 40% (for qualified facilities) or 55% (for ESTs), and a solar energy component sold during calendar year 2026 must achieve an Eligible Component MACR of not less than 50%. Calculating the MACR: A Two-Track System Notice 2026-15 establishes a detailed framework for calculating the MACR, distinguishing between two tracks: the "Clean Electricity MACR" (for qualified facilities and ESTs under Sections 45Y and 48E) and the "Eligible Component MACR" (for Section 45X eligible components). Clean Electricity MACR For qualified facilities and ESTs, the Clean Electricity MACR equals the taxpayer's total direct costs attributable to all manufactured products ("MPs") and manufactured product components ("MPCs") incorporated into the facility or EST, minus the total direct costs attributable to MPs and MPCs that were mined, produced, or manufactured by a PFE, divided by the total direct costs. The calculation requires a taxpayer to: (a) identify MP and MPC types; (b) track relevant characteristics of each MP and MPC; (c) determine direct costs; and (d) determine PFE direct costs. A separate Clean Electricity MACR must be calculated for each qualified facility or EST placed in service during a taxable year. Eligible Component MACR For Section 45X eligible components, the Eligible Component MACR substitutes "total direct material costs" for "total direct costs," focusing on the constituent elements, materials, or subcomponents ("Constituent Materials") incorporated into or consumed in the production of the eligible component. The relevant costs are those paid or incurred by the taxpayer for direct materials under Section 1.263A-1(e)(2)(i)(A), including freight-in and tariffs. Interim Safe Harbors: The Core of the Notice The most consequential aspect of Notice 2026-15 is its three-tiered interim safe harbor framework, which is intended to significantly simplify the compliance burden. Identification Safe Harbor The Identification Safe Harbor allows taxpayers to use the 2023–2025 domestic content safe harbor tables (from Notices 2023-38, 2024-41, and 2025-08) as the exclusive and exhaustive list of MPs and MPCs (or Constituent Materials) for purposes of identifying what must be tracked and costed. Components not appearing in the tables are disregarded entirely and do not factor into the MACR calculation. This is material compliance relief, it obviates the need for deeper upstream tracing that many in the industry feared and instead limits the inquiry to a discrete, published list of components. However, this pathway is available only for projects and components listed in the safe harbor tables. Facility types without specified tables, such as nuclear, fuel cells, or geothermal, cannot use this safe harbor. Likewise, facilities relying on the incremental production rule cannot use the Cost Percentage Safe Harbor. The Treasury has acknowledged these industries’ interest in obtaining updated tables, but guidance remains forthcoming. Cost Percentage Safe Harbor Building on the Identification Safe Harbor, the Cost Percentage Safe Harbor permits taxpayers to use the Assigned Cost Percentages from the safe harbor tables in lieu of tracking actual direct costs. The taxpayer sums the Assigned Cost Percentages for each listed MP and MPC (the "Total Percentage"), sums the Assigned Cost Percentages attributable to PFE-produced MPs and MPCs (the "Total PFE Percentage"), and calculates the MACR as: (Total Percentage – Total PFE Percentage) / Total Percentage. Structural steel and iron are excluded entirely from the MACR calculation, consistent with their treatment under the domestic content rules. Used property in facilities qualifying under the 80/20 rule is also disregarded; only the costs of new MPs and MPCs count toward the calculation. The Notice’s examples, particularly the PV facility illustration walking through both safe harbors, will be invaluable in standardizing the calculation methodology. Certification Safe Harbor The Certification Safe Harbor provides an alternative pathway allowing taxpayers to rely on supplier certifications to determine direct costs, PFE direct costs, and PFE status. Three certification forms are available, tracking the statutory framework in Section 7701(a)(52)(D)(iii)(II)(bb): (AA) an attestation that the property was not produced or manufactured by a PFE and the supplier has no knowledge of PFE involvement in the upstream chain; (BB) for Section 45X, a statement of total direct material costs not produced or manufactured by a PFE; or (CC) for Sections 45Y/48E, a statement of total direct costs attributable to non-PFE manufactured products. Importantly, pathways (BB) and (CC) do not facially require the supplier to possess knowledge of the entire upstream chain, as does pathway (AA). Certifications must include the supplier's employer identification number (or foreign equivalent), be signed under penalties of perjury, be retained for at least six years by both the supplier and the taxpayer, and be produced upon IRS request. A taxpayer may rely on a certification unless it "knows or has reason to know" the certification is inaccurate. The “reason to know” standard is the most significant area of ambiguity in the Notice and is driving intense market discussions. Early practice suggests a tiered diligence approach: baseline certifications with PFE-status checklists from established suppliers, supplemented for higher-risk Tier 2 suppliers and battery storage components by third party supply chain audits. Suppliers offering compliance packages, including legal memoranda and compliance presentations, are gaining a competitive edge. Tracking and Averaging Flexibility The Notice provides meaningful flexibility in how taxpayers track components to specific facilities or eligible components. Three tracking methods are available: Individual tracking. The default approach requiring each MP or MPC to be traced to the specific facility or EST into which it is incorporated. De minimis assignment-based tracking. Allows MPs or MPCs of the same type to be assigned across qualified facilities or ESTs placed in service during the same taxable year without individual tracing, provided the assigned components represent less than 10% of the Total Direct Costs of each facility. Average-cost tracking for small ESTs. For ESTs of the same type, each under 1 MW, placed in service during the same taxable year, taxpayers may use averaged costs and PFE Production Percentages over specified periods within the taxable year. Section 45X manufacturers may use a similar averaging system for Constituent Materials incorporated into eligible components during specified time periods. Binding Written Contract Election A notable feature of the statutory framework, addressed in the Notice, is the elective grandfather provision under Section 7701(a)(52)(D)(iv). Upon a taxpayer's election, MPs, eligible components, or Constituent Materials acquired or manufactured pursuant to a binding written contract entered into before June 16, 2025, and placed in service before January 1, 2030 (or January 1, 2028 for applicable wind facilities) in a facility where construction began before August 1, 2025, may be excluded from the MACR calculation entirely. For Constituent Materials, the item must be used in a product sold before January 1, 2030 (or January 1, 2027 for Section 45X). Treasury has been granted anti-abuse authority to prevent stockpiling of components during any period prior to the application of the PFE requirements. Qualified Interconnection Property The Notice addresses the separate treatment of qualified interconnection property under Section 48E with a nuanced approach. A taxpayer seeking to include interconnection property expenditures in its qualified investment must calculate a separate Clean Electricity MACR for the interconnection property, apart from the facility itself. Each project component: solar, storage, and interconnection, qualify independently; failure on one does not disqualify the others. However, the safe harbors are unavailable for interconnection property, requiring the direct cost method, with practitioners view as significantly more invasive and more susceptible to error. Effective Control and Anti-Abuse Provisions Notice 2026-15 previews forthcoming regulatory action on two important fronts. First, the Notice clarifies that effective control under the foreign-influenced entity provisions of Section 7701(a)(51)(D) is determined independently under each prong of the statute. Notably, any licensing agreement for intellectual property with respect to a qualified facility entered into or modified on or after July 4, 2025, constitutes effective control, even absent any of the other enumerated prohibited provisions, such as limits on IP usage. Second, Treasury and the IRS intend to propose regulations to prevent entities from evading, circumventing, or abusing the PFE restrictions, including through temporary lapses of restricted foreign ownership or control. Suppliers restructuring ownership of supply chains mid-stream to achieve compliance raise particularly difficult questions, as the rule lack specificity on the timing of qualification relative to procurement and delivery. Enhanced Penalty and Statute of Limitations Framework The OBBBA established a robust penalty regime supporting the PFE rules. New Section 6662(m) lowers the substantial understatement threshold to 1% (from 10%) for credit disallowances attributable to overstating the MACR. New Section 6501(o) extends the statute of limitations to six years for deficiencies attributable to MACR determination errors. New Section 6695B imposes a separate penalty on suppliers who provide certifications they know or should have known to be inaccurate, equal to the greater of 10% of the resulting underpayment or $5,000, though a reasonable cause defense is available. Reliance and What Comes Next Taxpayers may rely on the guidance in Sections 3 and 5.01 of the Notice for projects that begin construction after December 31, 2025, and continue through 60 days after publication of the forthcoming proposed regulations. The Section 4 safe harbors may be relied upon through 60 days after publication of the forthcoming safe harbor tables under Section 7701(a)(52)(D)(iii)(I), which must be issued by December 31, 2026. While Notice 2026-15 resolves several of the most pressing compliance questions confronting the clean energy tax credit market, particularly around supply-chain depth, cost allocation methodology, and certification standards, it expressly defers comprehensive guidance on the PFE definitional framework, constructive ownership mechanics, and long-term recapture rules to forthcoming proposed regulations. Stakeholders should use the comment period strategically and begin integrating the safe harbor frameworks into project and deal structures without delay. The early market consensus is that Notice 2026-15, while demanding increased diligence and documentation relative to the domestic content regime, provides workable and solvable rules. Storage remains the highest-risk area given the battery supply chain’s continued dependence on Chinese components. Stakeholders should engage counterparties and advisors early, integrate the safe harbor frameworks into deal structures without delay, and prepare for escalating MACR thresholds in future years.
March 3, 2026
Tax
Tariff Litigation & Section 122 Tariffs
On February 20, 2026 the U.S. Supreme Court issued a landmark decision in Learning Resources, Inc. v. Trump holding that the International Emergency Economic Powers Act (IEEPA) does not authorize the President to impose tariffs. The decision invalidates the reciprocal tariffs and trafficking/immigration tariffs imposed in 2025 under IEEPA and confirms that the power to impose tariffs lies with Congress. The Court did not prescribe a refund mechanism; that responsibility now falls to the U.S. Court of International Trade (CIT) and U.S. Customs and Border Protection (CBP). Within hours of the decision, the Administration imposed a new 10% tariff under Section 122 of the Trade Act of 1974 (now 15%), effective February 24, 2026, and limited to 150 days (absent congressional action). This creates two immediate opportunities: Refund claims for prior IEEPA tariffs (available to domestic and foreign companies) Advisory and planning work related to new Section 122 tariffs and potential replacement regimes (Section 232/301) What Changed: 1. IEEPA Tariffs Invalidated The Supreme Court ruled that IEEPA does not authorize tariff imposition. IEEPA tariffs imposed in 2025 are unlawful ab initio. Refunds are not automatic. Importers must act. 2. Section 122 Tariffs Now in Effect 15% tariff on most imports entered on or after February 24, 2026 Limited to 150 days (approx. expires July 24, 2026 unless extended) USMCA-qualified goods excluded “Goods on the water” exception for certain shipments loaded before Feb 24 and entered before Feb 28 This is a temporary bridge. Section 232 (tariff imposed for national security) and 301 (tariffs imposed on foreign products to counter unfair trade practices) actions may follow. Who May Have a Refund Claim: Those who: Imported goods between February 2025 and February 24, 2026 Paid additional IEEPA ad valorem duties Are the importer of record Have entries that are unliquidated or recently liquidated Did not yet file a protective Court of International Trade (CIT) action Refund claims are available to domestic and foreign companies – the controlling factor: who is the Importer of Record on the customs entry Important: Only IEEPA duties are refundable — not Section 232 or 301duties. Downstream buyers may have contract-based reimbursement claims. Areas Where Offit Kurman Can Assist You: 1. Tax Litigation / Customs Litigation Refund analysis and quantification Protest filings Protective CIT litigation Federal Circuit appeals Strategic coordination of administrative and judicial remedies 2. Transactional Tax Tariff deductibility analysis Accounting method considerations Timing of refund recognition Contingent asset treatment Structuring to mitigate future tariff exposure 3. Corporate & Business Structuring Restructuring importer-of-record status Creating new import entities Evaluating transfer pricing implications Risk allocation between affiliates Supply chain realignment 4. Commercial Contracts Review of tariff pass-through clauses Reimbursement rights for downstream buyers Force majeure and change-in-law provisions Supplier renegotiation strategy Indemnification enforcement 5. Commercial Litigation Claims between buyers and suppliers over tariff allocation Breach of contract actions Indemnity disputes Class or coordinated actions among distributors 6. Restructuring & Insolvency Tariff-driven liquidity pressure Claims valuation in bankruptcy Recovery of tariff refunds as estate assets Documents You Should Be Gathering: Entry summaries (CF 7501) Duty payment records Liquidation dates PSC filings Contracts allocating tariff responsibility ACE and ACH refund account status SKU lists affected by Section 122 Bottom Line: IEEPA refunds are potentially significant. Deadlines are running. Section 122 tariffs create immediate planning needs. If you import goods, manufacture overseas, distribute foreign products, or rely on cross-border supply chains, connect with Offit Kurman for consultation.
March 2, 2026
Tax
Top Audit Red Flags Businesses Shouldn’t Ignore
My recent blog, So, The IRS Has Selected Your Return for Audit, discussed the four types of IRS audits. What factors may trigger an audit of a business’s income tax return? The presence of multiple red flags in a business’s income significantly raises the likelihood of an audit. Round Numbers While rounding 49 cents up to 50 cents is not problematic—the IRS instructs you to round cents up or down for whole dollar amounts—reporting $10,000 of income from a customer instead of the actual $10,089 or reporting depreciation of $7,500 instead of $7,448 is. The algorithms the IRS uses to select returns for audit are programmed to identify rounding like this because the IRS knows (as we all do) that transactions are rarely in exact round amounts. Claiming Excessive Expenses The IRS compares your deductions against deductions for similarly situated businesses, using figures from returns filed by businesses similar in size and industry sector. The IRS has a bell curve for each category of expense. These figures are tweaked by the Taxpayer Compliance Measurement program. Similarly, your business expenses must be ordinary and necessary. Ordinary means the expense is a type common in your business’s industry sector. Necessary means the expense is helpful for your trade or business. If your business’s figures are excessive as measured against the IRS’s figures or the types of expenses are different than what the IRS routinely sees for businesses of your size or type, the chance of your return being audited increases. The more categories your figures are above the norm or are different from what the IRS usually sees, the greater the chances of an audit. It is also a matter of degree. Being slightly high in several categories is not necessarily an audit flag, but being very high in a few categories is a red flag. It is important to mention business use of automobiles. As a result of changes to the law in the Tax Cut and Jobs Act of 2017, the ability of employees to deduct unreimbursed business expenses was all but eliminated. However, self-employed persons (which includes partners in an entity classified as a partnership for federal income tax purposes) can still deduct business use of automobiles. Claiming 100% business use is a red flag. Likewise, because of accelerated depreciation associated with heavy SUVs and large trucks, the IRS may look twice at purchases near the end of the tax year. So, take advantage of that year-end sale but have the records to substantiate the business purpose and use. Misreporting Income First, beyond rounding cents, don’t round. Second, just because you didn’t receive a 1099 doesn’t mean the payor didn’t file the 1099 with the IRS. If you know you are missing a 1099, call the payor and ask for it otherwise this brings up the next flag. Large Cash or Large Numbers of Cash Transactions Some businesses naturally have large cash transactions or large numbers of cash transactions. If a cash transaction is over $10,000, financial institutions are required to file a currency transaction report (CTR). Breaking a cash transaction into smaller transactions to avoid the CTR threshold is known as structuring and is a crime under federal law. If your business deals in cash, keeping an accurate record of all transactions and documentation is essential in the event of an audit. Real Estate Rental Losses The IRS has strict rules regarding the ability to deduct losses from real estate rental against other income. For those who are not real estate professionals, which means you spend more than 50% of your working hours and more than 750 hours each year materially participating as a developer, landlord, or agent, you must own at least 10% of the value of all interests in the activity (spousal interests are combined for this threshold test) and you must actively participate in the operations of the rental property in the year in which the loss is claimed and in the year in which you seek recognition of the loss. If you meet these requirements, then you may deduct $25,000 of losses from real estate rental activity. This deduction phases out beginning with an adjusted gross income (AGI) of $100,000 and is completely phased out once AGI reaches $150,000. Deducting Hobby Losses Only losses incurred in a trade or business are deductible, which means you are engaging in the activity with the reasonable expectation of making a profit and you conduct the activity in a business-like manner. If your activity three out of every five years (two out of seven years for breeding horses), the IRS presumes that the activity is for profit. If not, whether the activity is for profit depends on the facts and circumstances. If you claim losses year after year, which is common among start-up businesses, your business will likely be audited. As with other areas, substantiation of expenses is imperative. Misclassification of Employees Whether a worker is an independent contractor, in which case your business issues them a 1099 at year end, or an employee, in which case your business issues the worker a W-2, is a hot bed item with the IRS and the U.S. Department of Labor. If a worker is misclassified as an independent contractor, then your business (and potentially you personally) owe employment taxes and withholding, plus interest and penalties. As with other areas, proper documentation (which includes agreements setting forth the worker’s independent contractor status) are essential. If your workers are employees (W-2) consistently filing and paying payroll taxes (941s) will also trigger additional scrutiny that likely will result in an audit. Claiming the R&D Tax Credit The R&D credit is great—if your business qualifies and if your business substantiates the credit. The One Big Beautiful Bill Act (OBBBA) reversed a 2022 law that required businesses to amortize research and development expenses over a five-year period. Businesses are now permitted to expense R&D costs immediately. The OBBBA also provided additional relief for small businesses that applied the new rule retroactively for the 2022 through 2024 tax years. Unscrupulous promoters (for a fee that is a percentage of the R&D credit) offer to analyze a business’s records to see if the business can claim the R&D credit retroactively. Often these promoters try to persuade a business to claim routine expenses as R&D activities to qualify for the R&D credit (which increases the promoter’s fee). Activities that are not eligible for the R&D credit include modifying an existing product, customer-funded research, research after commercial production, or research on a product about which there is no doubt about the expected result (this merely confirms what the company already knows). With proper substantiation costs for these activities still are deductible, just not eligible for the R&D credit. Growing and Selling Mary Jane Despite the current administration’s proposed rescheduling of marijuana, it is still a controlled substance at the federal level. It does not matter to the IRS that marijuana is legal in your state. Because it is illegal, expenses (other than cost of goods sold) incurred in the production, distribution, and sale, even if permitted under state law, are not deductible. Here is the real burn—you must still report and pay taxes on the income generated from your marijuana business. Because marijuana is illegal at the federal level, it also means if you invest in a marijuana business you can’t deduct investment losses. It also means you cannot use your self-directed IRA to invest in marijuana businesses. Bummer man. Home-Office Expense Deduction If you can take the home-office deduction (see Claiming Excessive Expenses above regarding restrictions on the ability to deduct unreimbursed business expenses incurred by employees), to claim the deduction you must use the space exclusively and regularly as your principal place of business. Guest bedroom, bonus room where the kids watch TV or play X-Box? Nope. Exclusive means exclusive. In the IRS’s eyes, returns that claim the home-office deduction is a target rich environment. Don’t paint a bullseye on your back. In the end, avoiding an audit is not about fear—it is about diligence. By keeping accurate records, understanding which expenses truly are allowed, and steering clear of overly aggressive tax positions, businesses can reduce their audit risk significantly. Most importantly, thoughtful documentation and consistent business practices provide the strongest defense should the IRS come knocking.
February 25, 2026
Commercial Litigation
When the Chicken Does Come Before the Egg: The Taxpayer-Friendly Takeaways from George v. Commissioner, Plus a Few ‘Egg-cellent’ Judicial Puns
Some tax court opinions are dry. Others are dense. And then there are the rare decisions where the court clearly enjoyed the assignment. George v. Commissioner, T.C. Memo. 2026-10 falls squarely in the third category. From its opening pages, the court signals both the seriousness of the R&D credit issues at stake and its willingness to have a little fun along the way. As Judge Greaves famously framed the dispute: “Forget the proverbial chicken or the egg; today we are called to answer which came first, the research or the research credit?” Clever turn of phrase aside, the opinion delivers something far more important for taxpayers, particularly those in agriculture and other operationally complex industries: a roadmap for how real-world innovation can qualify for the R&D credit when done correctly. The Big Win: The Court Acknowledged That Agriculture Innovates. Full Stop. Before we get to the substance, it’s worth pausing on tone. Over the course of 80+ pages, the court peppers the opinion with references to “ruling the roost,” “sunny-side up,” and other poultry-themed flourishes. That levity is notable because it accompanies a very serious acknowledgment: modern agriculture is technologically sophisticated. The opinion’s humor is not accidental. By leaning into chicken metaphors, the court subtly reinforces its understanding of the industry it is judging. From a litigation perspective, that tone is telling. Courts don’t joke about industries they don’t take seriously. The takeaway? The court was engaged, informed, and analytical, not dismissive. That is good news for future taxpayers who bring better-structured R&D claims to the table. This is reinforced by the court repeatedly recognizing that poultry production involves: Complex biological systems Evolving disease pressures Feed chemistry and nutrient optimization Genetic performance tradeoffs Data-driven decision-making at massive scale Indeed, the court emphasizes that even “small changes having dramatic impacts on profitability” are central to the industry, noting that producers may earn “approximately one penny of profit per pound.” That framing matters. The court did not dismiss these activities as routine farming. Instead, it treated them as legitimate candidates for R&D analysis, rejecting the outdated notion that innovation only happens in laboratories. What the Taxpayer Got Right (and the Court Agreed) Despite ultimately limiting the credits claimed, the court credited the taxpayer with confronting real technological uncertainty, a foundational requirement under §41. The opinion details extensive efforts to address: Disease outbreaks with no clear industry solution Antibiotic-free production pressures Feed efficiency and nutrient absorption challenges Vaccine administration methods and dosage questions Genetic line performance under different conditions The court acknowledged that these efforts involved trial-and-error, failed approaches, and iterative refinement, classic hallmarks of experimentation. In fact, the court goes as far as rejecting the IRS’s argument that data collected by George was “routine” and thus excluded from consideration. Instead, the court rejected the ‘routine’ argument the IRS has been fighting hard to revive. Likewise, the court rejected IRS attempts to repurpose the adaptation exclusion, definitively stating that an improved business component is a different business component. That distinction leaves the door wide open for taxpayers who document their experimentation contemporaneously and intentionally, even when data used for testing is collected during standard production. Practical Lessons the Court Practically Hands to Taxpayers If you read the opinion with an eye toward future claims, the lessons are unmistakable: When possible, articulate uncertainty before acting. This helps avoid the IRS assertion that a company reverse-engineered the research narrative. Design experiments with intent, though they don’t have to look like laboratory work. Document while the feathers are flying. Production data is helpful, but technical reasoning is essential. Separate experimentation from execution. Rolling out a solution is not the same as proving it works. Assume IRS scrutiny and prepare accordingly. The IRS will ask whether the “research” existed before the credit study. Courts will too. These lessons don’t clip the wings of the R&D credit. They strengthen it. The Broader Takeaway: Courts Want Better R&D Claims, Not Fewer For all the poultry puns, George v. Commissioner delivers a serious, taxpayer-friendly message: Section 41 remains viable for real-world businesses that innovate intentionally and document rigorously. The court did not narrow the statute. It did not exclude agriculture. And it did not demand laboratory conditions. It simply required that the research come first—and the credit follow honestly. Final Thought If nothing else, George proves that even an R&D case about chickens can be meaty. Matthew Reddington served as counsel in this matter and played a primary role in securing the favorable outcome for the taxpayers.
February 12, 2026
Tax
So, The IRS Has Selected Your Return for Audit
The Internal Revenue Service (“IRS”) audits 1% to 2% of small business income tax returns annually for one of two reasons: (1) something about the return (or information reported on the return) flagged the return for a closer review and the revenue agent reviewing the return decided an audit was appropriate; or (2) (bad) luck of the draw – the return was randomly selected for audit. The first reason – a red flag – is far more common than a random audit. The IRS publishes Audit Technique Guides for use by revenue officers. These guides can be found on the IRS’s website here and provide insight into what the IRS checks for and hopes to discover. Regardless of the reason or type (more on that below), the IRS never emails you and never calls without first sending you correspondence BY MAIL (not email). There are Four Types of Audits There are four types of audits, listed from least to most intrusive. Correspondence Audit The first (and most common) is a correspondence audit, which constitutes about three-quarters of all audits. With correspondence audits, you never meet with a revenue agent face-to-face because everything is done through the mail. In the simplest of audits, the IRS asks for information only regarding certain specific entries on your return. For example, if your return reported sales of stock and the return failed to indicate the basis, the IRS will write and request you to provide them with basis information (how much you paid for the stock you sold). Once you supply the requested information, the audit may be over (assuming the information provided matches the gain or loss reported on the return). Office Audit The second form of audit is an office audit, which takes place at their office, not yours. Office audits arise when a return is too complex for a correspondence audit but does not meet the threshold for a field audit. Often, office audits are over itemized deductions, rental incomes and losses, or Schedule C filers. During an office audit, the examiner will ask you questions in an attempt to find other areas to examine. Often, the examining agent will ask for more information, usually documents, and will give you a reasonable amount of time to gather and supply the requested information. Field Audit The third form of audit is a field audit. This audit takes place at your office, not theirs. During a field audit, the examiner will frequently ask for additional information and expect you to provide it reasonably quickly, after all, they are at your office where (in their mind) the records should reside. Line-By-Line Audit The fourth form of audit is a line-by-line audit, otherwise known as a Taxpayer Compliance Measurement Program (TCMP) audit. In this audit, the IRS reviews the returns of lucky taxpayers, line-by-line. The stated purpose of the audit is to build and refine the data points used to tweak the algorithms that determine whether a return should be selected for audit. Still, it is an audit, nonetheless. No matter the type of audit, the IRS’s starting position is to count all income and deny all deductions. For example, in our correspondence audit example, if you claimed a loss on the sale of stock, unless and until the IRS receives the requested supporting documentation, they will deny the loss, adjust your return accordingly, and send you a tax bill with interest and penalties. Office, field, and TCMP audits are the same way. The IRS wipes out your deductions and makes you build them back, providing reasonable substantiation for each type and amount of deduction. All audits begin the same way regardless of the type: the IRS sends you a letter, often by certified mail, advising you of the audit. The letter always has a response date. Do not ignore this date. If you ignore the date and do not respond, the IRS will either escalate the audit or issue a 30-day letter in which the IRS tells you what changes they propose and how much additional tax, interest, and penalties you will need to pay. If you ignore the 30-day letter, the IRS will issue a Statutory Notice of Deficiency (SNOD), and you will have ninety (90) days to file suit in the United States Tax Court to contest the IRS’s findings. When Do You Need a Tax Lawyer Certainly, for office and field audits. During office and field audits, the audit examiner will be asking you questions. Audits are unpleasant, and many people simply think that if they answer all the examiner’s questions the audit will be over quicker. WRONG. The examiner is asking questions because they are looking for additional areas to audit. Equally important, statements you make to the examiner fall under 18 USC § 1001, more commonly known as a “1001 violation.” 18 USC § 1001 criminalizes knowingly and willfully making materially false, fictitious, or fraudulent statements or representations made to a federal agent. This is the statute under which Martha Stewart was convicted. What she lied about was not a crime, but lying about it to a federal agent was (and still is) a crime under 18 USC § 1001. Whether an incorrect answer is merely the fault of a bad memory or may be considered lying to a federal agent is a question over which reasonable minds can and do differ. Just as I often told baseball teams I coached, never put the calling of a close pitch a ball or strike in the hands of an umpire; you shouldn’t leave the decision whether it was your bad memory or something worse to an IRS agent. A tax lawyer can help keep this from happening. When Should You Call a Tax Lawyer The minute you get the notice in the mail advising you that your return has been selected for audit. An experienced tax controversy lawyer can meet with the audit examiner on your behalf and provide information in a limited, organized manner, which will help limit the scope of the audit. The audit examiner will address questions to your attorney, not you. Tax lawyers’ answers are measured and designed to keep the audit as limited as possible. Even with a correspondence audit, your best solution may be to engage a tax lawyer to respond on your behalf or, at the very least, guide your response. Professional counsel can make a significant difference in the outcome, so leave the DIY to other areas.
February 9, 2026
Business
USPS Postmark Changes Could Impact Tax Filing Deadlines
A couple of years ago, I wrote a blog about the importance of sending any correspondence to the Internal Revenue Service via Registered or Certified Mail or by an approved overnight courier, rather than relying solely on the regular USPS First-Class postmark to determine timely mailing. I like to know the IRS receives what I send. On more than a few occasions, the IRS loses mail, and the only evidence of receipt is the return receipt or proof of delivery. Recently, the USPS announced an upcoming change to its postmark date system, effective December 24, 2025. This change makes it even more critical that taxpayers and their representatives use Registered or Certified mail, or an approved overnight courier, when filing a federal tax return. Here is why this change matters. “Postmarks are generally applied by the Postal Service via automation on machines in originating processing facilities but may also be applied manually by Postal Service personnel at those facilities, or by a Postal Service employee at a retail unit when a customer presents a mailpiece at a retail counter and requests a postmark.” FR Doc. 2025-20740. Under the USPS’s current system, the postmark reflects the date the mail is given to the USPS, i.e., handed to a USPS employee at a USPS counter or placed in an official USPS mailbox. Under IRC § 7502, a return is considered timely filed if it is postmarked on or before the due date of the return. For example, in 2025, the filing deadline for an individual taxpayer who did not request an automatic extension was April 15, 2025. Under the USPS’s current system, if the taxpayer mailed the return on April 15, 2025 by depositing the return, with sufficient postage, in an official USPS mailbox prior to the last mail pickup posted on the USPS mailbox, the return would have been postmarked April 15, 2025. It would be considered timely filed even if the return was not received by the IRS until days or weeks later. However, under the soon to be implemented USPS change, a machine-applied postmark indicates the date of the "first automated processing operation" at a processing facility, which may be later than the date the mail was dropped off, which could happen anytime but particularly during periods of high volume, i.e., April 15 (March 15 for calendar year tax year corporate and partnership taxpayers). With this change, even if the return were deposited into a USPS official mailbox, the return may not be postmarked with the official USPS postmark until after the filing deadline when the return was processed in a processing facility. Still, because most postmarks are applied at processing facilities, the postmark does not represent either the place or date on which the USPS first accepted possession of the mailed return. This means the return would not be considered timely filed, and failure to file penalties and interest would be assessed by the IRS. With this USPS change, an ounce of prevention is worth more than a pound of cure. Mail returns, Register or Certified mail, and get a hand-cancelled receipt, or use an approved overnight courier with an approved level of service. And just in case you were wondering, the postmark on the office postage machine is never sufficient. The views expressed herein are solely those of the author, are not intended as, and do not constitute legal or tax advice.
December 18, 2025
Business
Unexpected Tax Penalties in Talent Contracts: Could Your Motion Picture, Recording, or Sports Contract be Subject to IRC Section 409A?
Could your motion picture agreement, recording agreement, or sports contract be a non-qualified deferred compensation arrangement? You may think it unlikely, but a non-qualified deferred compensation arrangement refers to any agreement under which an employee or independent contractor—i.e., a “service provider”—may receive a payment in a taxable year later than the year in which the service provider had a legal right to the payment. There are specific rules governing non-qualified deferred compensation arrangements: Code Section 409A of the Internal Revenue Code of 1986, as amended. Failure to comply with the detailed requirements of Code Section 409A can trigger the immediate taxation of deferred income and impose an additional 20% penalty tax on that income. Any contract providing for the provision of services that provides that some payments may be made after the year that the contract was entered into may be a non-qualified deferred compensation arrangement. This is because the Internal Revenue Service takes the position that a service provider first has a legal right to payment when the contract is entered into, and this applies even if the contract requires the service provider to provide services and the services have not yet been provided. Entertainment Industry Examples: How Code Section 409A May Apply Motion picture contracts frequently provide top talent with a percentage of the box office as compensation for services. In recording contracts, a new artist is generally given an advance to deliver a master recording to a record company. The record company owns the master recording, but the agreement provides the artist receives a “royalty” equal to a certain percentage of sales that will be offset against the advance that the artist received. Since the artist does not have a property right in the master recording, the “royalties” are compensation and will be subject to Code Section 409A, unless an exception applies. Sports contracts often provide for deferred compensation in a colloquial sense. Since the payment to be received by the athlete is not a payment under a qualified retirement plan governed by ERISA, the deferred compensation will be subject to Code Section 409A unless an exception applies. One exception to Code Section 409A is the short-term deferral exception. A payment qualifies as a short-term deferral if the payment must be made by March 15 (for a calendar year service recipient) of the year following the year in which the payment becomes vested or is no longer “subject to a substantial risk of forfeiture.” In this case, this is a short-term deferral and Code Section 409A does not apply. Permissible Payment Events Under Code Section 409A If a payment constitutes non-qualified deferred compensation, then there are only certain events on which the payment can be made: An objectively determinable time or schedule set forth in the agreement (e.g., on January 1 of a certain year or the athlete’s 50th birthday) Death or disability Separation from service (with a very specific definition) Change of control (also a very special definition) Unforeseen emergency Once the payment terms are set forth in an agreement, the terms cannot change, except in very limited circumstances. The payment can never be accelerated by more than 30 days, and there are very strict rules regarding further deferral of the payment. One of those rules is that if a payment is deferred, it must be deferred by more than 5 years from the original payment date. Consequences of Violating Section 409A If Code Section 409A applies and is violated, the penalties are generally imposed on the service provider. These penalties include acceleration of recognition of income for all payments to be made under the agreement in the year in which the violation occurs. Additionally, the service provider is required to pay a 20% penalty tax, as well as ordinary income tax on these accelerated payments. Code Section 409A is complex and often overlooked in entertainment and sports agreements. But if your contract includes future payments tied to services performed now, it is worth asking whether these rules apply. Careful planning can help avoid unexpected taxes and penalties.
May 5, 2025
Tax
New Jersey Law Permits Pass Through Entities to Bypass the Federal Cap on State and Local Tax Deductions
Originally posted on 2/20/2020, no content changes New Jersey has passed legislation to limit the impact of the $10,000 cap on state and local tax (“S.A.L.T.”) deductions created by the 2017 federal implement Tax Cuts and Jobs Act. The bill creating the New Jersey law, known as The Pass-Through Business Alternative Income Tax Act (A-4807/S-3246) was signed by the governor of New Jersey on Jan. 13, 2020 and was previously passed by the New Jersey legislature on December 16, 2019 (“NJ Act”).[1] The NJ Act creates an optional entity-level tax on pass-through businesses. The NJ Act permits New Jersey pass-through entities, such as “S” corporations, partnerships and LLCs to elect to pay income taxes at the entity level as a business expense instead of at the personal income tax level. Paying the tax individually subjects the tax payer to the limitation for federal deductibility of state and local taxes of $10,000. By structuring as a deductible business expense/tax at the entity level, the pass-through entity’s taxable income is reduced by the amount of the tax and the flow through income to the owner is so reduced. Under the NJ Act the “pass-through entity” must have at least one member who is liable for tax on distributive proceeds pursuant to the “New Jersey Gross Income Tax Act” in a taxable year. The NJ Act defines “distributive proceeds” as the income, dividends, and gain of a pass-through entity, derived from or connected with sources within the State of New Jersey, and upon which tax is imposed and due on a member of the pass-through entity pursuant to the “New Jersey Gross Income Tax Act” in a taxable year. The New Jersey Society of Certified Public Accountants (“NJCPA”) welcomed the signing of the NJ Act: “We are grateful to the Governor, the Legislature and all those who supported the bill. Their dedication to assisting small businesses in New Jersey does not go unrecognized.” The NJCPA noted that the NJ Act is estimated it would save New Jersey business owners $200 to $400 million annually on their federal tax bills. The NJ Act was sponsored by Assemblymen Daniel Benson and Roy Freiman in response to federal changes to S.A.L.T that “have had a great impact on homeowners and businesses”, according to Benson. Benson further opined that “[t]his tax payment option could save business owners $450 million annually without costing the state any money in lost revenues. Protecting New Jersey businesses against sweeping federal changes ensures New Jersey’s economy stays on the right track and business owners continue to thrive.” Other states, such as New York, have also attempted to implement a state law to circumvent the federal S.A.L.T. limits through contributions to state-run charitable funds. However, the Internal Revenue Service (“IRS”) issued regulations that eliminate the benefits of the New York law. The New Jersey approach has not been expressly barred by the IRS as of the writing of this article. As such, the NJ Act is effective for pass through entities for tax years beginning after January 1, 2020. The option to pay the tax at the entity level is made for each tax year by an authorized person(s) for the entity. Moreover, the tax rates imposed at the entity level are different from those imposed on individuals. The practical import of the NJ Act is that tax advisors for businesses should advise their New Jersey flow through entity clients of the change in New Jersey law, risk/benefit tradeoff of making such an election, as well as careful consideration of taking advantage of this change in the law by paying estimated taxes at the entity level (i.e. reducing their draws/distributions) instead of at their individual level. Additional considerations should include that the option to pay the tax at the entity level is made annually by the entity and the tax rates imposed at the entity level differ from the rates imposed on individuals. Owners of pass through entities must consult their lawyers and tax advisors prior to making any decisions. [1] The NJ Act supplements Title 54A of the New Jersey Statutes and amends N.J.S.54A:4-1 and P.L.1993, c.173. The text of the NJ Act can be found at https://legiscan.com/NJ/text/S3246/id/1829428
November 1, 2023
Tax
IRS Proposes to Make Monetized Installment Sales a List Transaction
I know. I know. Your reaction is probably, “Huh? Do what? I don’t even know what a monetized installment sale is, why should I care.” As my partnership tax professor, Theodore Seto always says, “To understand the rule, you have to know the game that is being played.” The Problem and the Game: Here’s what a monetized installment sale is and how it works. Peggy Sue has a low basis, high-value asset. For our example, we assume a tax basis of $10,000 and a sales price of $1,010,000 so she has a taxable gain of $1,000,000. If Peggy Sue sells it straight up, unless she has other offsetting losses elsewhere, will have a lot of gain she must recognize and for which she must pay tax. Let’s say instead of selling it for a lump sum, she sells it in an installment sale payable in ten equal annual installments. Under IRC 453 she would allocate and pay tax on the pro rata portion of the gain each payment represents, so she would pay tax on 100k of gain each year over the ten-year period ($1,000,000 gain ÷ 10 years = 100k gain per year). If Peggy Sue has no other income, spreading the gain over 10 years will prevent a bracket run and result in less of a tax bite. The interest component of each payment will be taxable as ordinary income in the year of Peggy Sue’s receipt of each payment. Now here comes the game (greatly simplified for brevity): What if Peggy Sue sells to Elvis and takes back a 30-year, interest-only balloon note? Well, the interest is ordinary income, but Peggy Sue won’t recognize any gain until the balloon payment. This defers gain, but Peggy Sue still doesn’t have her money, only the interest payments. But what if Peggy Sue can find a lender who will lend Peggy Sue say 95% of the sale amount (and coincidentally, the payment terms and interest Peggy Sue pays the lender is the same rate as Elvis’s note to her). In other words, the interest received and interest paid cancel out each other. And because a loan ordinarily is not a taxable event, Peggy now gets 95% of the sales price to invest and grow for 30 years. When Elvis pays her the balloon payment in 30 years she pays the lender. Money for nothing and checks for free. Sweet deal, isn’t it? The Rule (Proposed): Too sweet, actually. So, the IRS has proposed making this and its variants a listed transaction. Being a “listed transaction” means you have to tell the IRS you are doing it, i.e. flag it on your return, so they can decide if it is legit or not (for a very narrow class of assets-farm land-it actually might work, but even then there are limits and restrictions). Also, if the proposed regulation goes into effect anyone who engaged in a monetized installment in a prior year for which the period of assessment is still open (generally three years from the latter of the due date or the date the return was filed) must send the IRS a disclosure of the transaction. Failure to list (“disclose”) the transaction can result in a penalty equal **TO** 75% of the tax savings the transaction produced, together with understatement penalties and interest. And it gets better. If you were required to disclose a listed transaction but didn’t, the period for assessment is extended until one year after the date of disclosure. Now, until the proposed regulation becomes final, this is all somewhat speculative. But if I were a betting man, I would look for a final version of the regulation this fall. Forewarned is forearmed. Scott Tippett is a principal at Offit Kurman PA where he concentrates his practice on tax planning, tax mitigation, and tax controversy in corporate, partnership, executive compensation, and employee benefit matters. He is a member of the firm’s Business Law Transactions and Intellectual Property groups. Offit Kurman PA is a national law firm providing clients with guidance in intellectual property, business, and tax matters. The views expressed herein are solely those of the author, are not intended as, and do not constitute legal or tax advice.
August 11, 2023
Tax
Operating Agreements: The Power of the Partnership Representative
Recently, a colleague asked me to review an operating agreement (not one that my colleague had drafted) from a tax standpoint. The LLC was classified as a partnership for federal income tax purposes. Setting aside the tortured regulatory allocations (it was a service partnership, distributions were pro rata, and there was no 704(c) property (property with a built-in gain or loss at the time the property was contributed to the LLC)), it was fairly straightforward. But therein lies the problem. The often-overlooked section designating a partnership representative needed substantial work. Wait, what!? The Bipartisan Budget Act ("BBA") of 2015 made the centralized partnership audit regime applicable to all partnerships for tax years beginning after December 31, 2017. I frequently encounter many older operating agreements that refer to a "Tax Matters Manager," which came about under the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982. If your operating agreement is one of these, for the reasons discussed below, it needs to be updated. Under TEFRA, before the effective date of the centralized regime, partnerships could elect the centralized audit regime or have each individual partner audited. Obviously, large partnerships preferred the centralized regime, while smaller ones frequently elected to have an audit at the partner, not the partnership level. The BBA changed all that by taking away the election and making the centralized regime mandatory for partnerships with more than one hundred (100) partners, while partnerships with one hundred (100) or fewer partners can opt out of the centralized audit regime. IRC § 6221(b); Treas. Reg. § 301.6221(b)-1(b). Sadly, I have seen many small partnerships, or, more appropriately, the lawyer drafting the operating agreement, simply copy these provisions from an operating agreement they thought looked good without ever giving a moment's thought to the impact and consequences of these provisions. In fact, the LLC whose operating agreement prompted this particular column had less than ten (10) members. And as Professor Ted Seto, my partnership tax professor, drilled into us, partnership tax is the one area of tax law where the Code and Regs dictate the business deal. The power of the partnership representative is august, cannot be overstated, and definitely should not be overlooked. Under the BBA, the partnership representative is the sole person with authority to act on behalf of the partnership and its partners! Treas. Reg. § 301.6223-2(a). Further, "no partner, or any other person, may participate in an administrative proceeding without the permission of the IRS." Treas. Reg. § 301.6223-2(d). So, even if you wanted to participate, absent the Service's permission, you can't. The partnership representative's decisions are binding on each partner of the partnership. Treas. Reg. § 301.6223-2(a). Disagree with a decision made by the partnership representative in an audit? Tough. You're bound. Can't we limit the power of the partnership representative by including provisions in our operating agreement? As far as the Service goes, no. In fact, any such limits are prohibited by Treas. Reg. § 301.6223-2(c)(1), which states, "[n]o state law, partnership agreement, or other document or agreement may limit the authority of the partnership representative or the designated individual as described in section 6223 and this section." Yikes! The partnership must designate a partnership representative separately for each tax year, and the designation is effective only for the tax year for which it is made. Treas. Reg. § 301.6223-1(c)(1)). The designation is made on the partnership's tax return (IRS Form 1065) and is effective when the return is filed. Treas. Reg. § Regs. Sec. 301.6223-1(c)(2). The partnership representative need not be a partner. Also, the partnership representative does not have to be a person, though if the partnership representative is an entity, it is required to have a "designated individual" so the Service has an actual human being as its point of contact. Clearly, the regs say plenty of things a partnership can't do, which begs the question, what can a partnership do? What you can do is include provisions in your operating agreement that: (1) require the partnership representative to acknowledge it acts in a fiduciary capacity with respect to the partners; (2) requires the partnership representative to provide notice to each partner immediately upon the receipt of any notice (and provide a copy of any such notice) the partnership representative receives from the Service that seeks to make any adjustment or impose any penalty with respect to the partnership or its partners; (3) requires the partnership representative to employ experienced tax counsel to represent the partnership in connection with any audit or investigation of the partnership by the Service and in connection with all subsequent administrative and judicial proceedings arising out of such audit; (4) requires the partnership representative to get approval from the partners before taking any position or action with the Service, including but not limited to any decision: (i) to enter into a settlement agreement which purports to bind the partners other than the partnership representative (which, as noted above any decision will); (ii) to file a petition or request contemplated in Section 6227(a) of the Code; (iii) to enter into an agreement extending the period of limitations as contemplated in Section 6235(b) of the Code. Finally, under the BBA, the partnership can either pay an assessment or penalty at the entity level or pass it down to the partners to be paid pro rata by each partner. This election can be made with respect to each separate assessment or penalty, so to provide the most flexibility, the operating agreement should permit this decision to be made by the partners on a case-by-case basis, then communicated to the Service through the partnership representative. What's in your operating agreement? Scott Tippett is a principal at Offit Kurman, PA, where he concentrates his practice on corporate, partnership, and employee benefit tax matters. He is a member of the firm's Business Law Transactions and Intellectual Property groups. Offit Kurman PA is a national law firm that provides simple, clear solutions to complex business and tax issues. The views expressed herein are solely those of the author, are not intended as, and do not constitute legal or tax advice.
May 24, 2023
Tax
Virtual Currency and Virtual Transactions – Real Tax Issues in Real Dollars
Recently the IRS released a draft form of Form 1040 for the upcoming tax year. The biggest change is a more detailed question about virtual currency transactions. The new draft form asks, “At any time during 2022, did you: (a) receive (as a reward, award, or compensation); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset),” followed by a “Yes” or “No” box. You can see a copy of the draft form here. Although not as bad as some expected (Line A-How much did you make last year? Line B-How much do you have left? Line C-Send Line B.), this change shows the Service is increasing its scrutiny of virtual currency transactions and, not coincidentally, subjecting taxpayers to false statement penalties if they are not truthful in their answer. Although the question asking about virtual currency did not appear on the 1040 until 2020, as seen here, the Service began issuing guidance on virtual currency and transactions as early as 2014, as seen in Notice 2014-21. Five years later, in Rev. Rul. 2019-24, the Service issued further guidance to address “hard forks” and “airdrops.” So, what are the rules? First, despite the moniker, virtual currency or cryptocurrency, the Service considers virtual currency (Bitcoin, Dogecoin, Ethereum, as well as all other cryptocurrencies) to be personal property, not currency. Setting aside currency arbitrage transactions, the basis of currency is the face value of the currency. If I receive a $100.00 bill, my basis in that Benjamin is always $100.00 (I can’t depreciate it), and when I dispose of it (use it to buy, say $100.00 of Dogecoin), I have no gain or loss on the disposition of that bill. Now, because Dogecoin is treated as property and not currency if my $100.00 of Dogecoin grows to $300.00 and I use it to buy something else for $300.00, I have taxable gain, in this case, $200.00. Because my Dogecoin is considered property, not currency, the gain will be taxed either as ordinary income or as a capital gain. Whether the gain is taxed as a capital gain depends on whether the Dogecoin is a capital asset in my hands. See Q &A No. 7, Notice 2014-21. If I do not hold the Dogecoin in inventory for sale to others but hold it as an investment, much like stocks, bonds, and other investments, it should be treated as a capital asset and taxed at capital gains rates. If I satisfy the long-term capital holding period (more than one year, i.e., a year and a day), then I get the favorable long-term capital gain rates, which generally are lower than short-term capital gain rates. Let’s take the flip side. What if someone pays me in virtual currency? What is my basis in the virtual currency with which I was paid? My basis is the fair market value of the virtual currency on the date of receipt. See Q & A No. 4, Notice 2014-21. Transactions using virtual currency must be reported in U.S. dollars for U.S. tax purposes. If the virtual currency is traded on an exchange, the value can be determined simply by looking at the exchange rate on the date of receipt or payment. Where the virtual currency is not traded on an exchange, the taxpayer still must determine the fair market value based on all the facts and circumstances. What if I receive virtual currency in payment for services? If I am an independent contractor (I receive a 1099), the receipt of virtual currency is considered self-employment income, which means it is subject to self-employment tax. This also means that payment to an independent contractor using a virtual currency is subject to information reporting, i.e., reporting to the IRS payments of $600 or more in the same tax year to the same person, and the attendant penalties for not filing information returns. If I am an employee (I receive a W-2 from my employer), the payment of wages in virtual currency is subject to federal income tax withholding and, if I am the employer, to the employer’s share of employment taxes. If I am an employer, I must pay the taxes withheld and the employer’s share of employment taxes in U.S. currency, not Dogecoin or any other virtual currency. What if I “mine” virtual currency? If I mine virtual currency, the fair market value of the virtual currency as of the date of my receipt of it is included in gross income. What if I “mine” virtual currency as a trade or business? If I mine virtual currency for my own trade or business or as an independent contractor, the net earnings from that activity constitute self-employment income, but I am entitled to deduct my ordinary and necessary business expenses in determining my net income. You said something about hard forks and airdrops; tell me more. (For those unfamiliar with soft forks and hard forks, click here to read an Investopedia article containing a brief explanation). Typically, and grossly general terms, a hard fork results in the creation of a new cryptocurrency. After a hard fork, transactions involving the new cryptocurrency are recorded on a new distributed ledger, while transactions involving the old or legacy virtual currency continue to be recorded on the old legacy ledger. An airdrop is a way of distributing units of virtual currency to the distributed ledger addresses of multiple taxpayers. Hard forks are often, but not always, followed by airdrops. Generally, a virtual currency is received from an airdrop on and at the date and time it is recorded on the distributed ledger. For U.S. tax purposes, whether the taxpayer received the virtual currency on and at that date and time is determined by the dominion and control test. If the taxpayer has dominion and control over the virtual currency on the date and at the time it was airdropped, then the taxpayer, if on the cash basis of accounting, has gross income under IRC § 61(a)(3) on and at the date and time of receipt. On the other hand, if the hard-forked virtual currency is airdropped into a wallet managed by an exchange that does not support the newly created (hard forked) virtual currency, which means the taxpayer cannot transfer, sell, exchange, or otherwise dispose of it, then the taxpayer does not have dominion and control over the new hard fork airdropped virtual currency, and it would not be included in the taxpayer’s gross income unless and until the taxpayer later acquired dominion and control over it. The use of virtual currencies and transactions using virtual currencies can create real tax issues. If these tax issues result in federal tax liability, those liabilities must be paid with the U.S., not virtual, currency. If in doubt regarding the tax consequences of buying, selling, using, or mining virtual currency, taxpayers should consult their tax advisor regarding the implications of buying, selling, and using virtual currencies. Offit/Kurman PA counsels clients on intellectual property matters such as virtual currency and NFTs, including the tax aspects and effects of those matters. The views expressed herein are solely those of the author, are not intended as, and do not constitute, legal or tax advice.
August 24, 2022
Tax
Harvesting Tax Credits Is Legitimate Business for Tax Purposes
If the sole purpose of a partnership is to harvest tax credits, is that a legitimate business for tax purposes? According to the Tax Court and the D.C. Circuit Court of Appeals, yes. In Refined Coal, LLC. V. Commissioner, No. 20-1015, (D.C. Cir. August 5, 2022), the answer is a resounding yes. But first, some background. In 2004, to stimulate the production of refined coal, which produces fewer emissions when burned, Congress created a tax credit for the production and sale of refined coal. But there was a catch – a producer could only receive the credit if it sold refined coal for 50% more than the market value of unrefined coal. Well, surprise, surprise, this went nowhere, so in 2008 Congress removed the 50% restriction and lo-and-behold, it worked. To take advantage of this change (and resulting tax credit), AJG Coal, Inc. launched a coal-refining facility at a power plant on Santee Cooper in South Carolina. Under the agreement, AJG, through a subsidiary, signed a lease that allowed it to build a coal refining facility inside the power plant. Next, the subsidiary entered into an agreement with the power plant to buy unrefined coal from the power plant, refine it, and sell it back to the power plant at $.75 less per ton. Finally, the sub entered an agreement with its parent to license the coal-refining technology. Wait a minute; they are reselling refined coal to the company from which they bought it for less money!? How could this ever make good business sense? The answer? Tax credits. The only possible way this was only profitable was through the application of the tax credit for refined coal. And we are not talking peanuts here. AJG projected that the sub would realize a $140 million after-tax profit over a ten-year period. Sadly, profits were much less than projected. In fact, the project had several lengthy shutdowns. Finally, in 2012, Santee shut down the coal-refining operation because of insufficient demand for local power, which caused two of the partners to suffer $ 2.9 million and $700,000 after-tax losses, which they wrote off on their respective federal income tax returns. Not so fast, the IRS said. To be a legitimate business, i.e., to write off expenses and losses, you must have a profit motive, and operating a business solely to harvest tax credits do not count, so the partnership was not a bona fide partnership; therefore, the losses are not deductible. Au contraire mon frère said the Tax Court. Yes, harvesting tax credits is a legitimate business purpose, and if the business would not be profitable, but for the tax credits, that is okay. It is still a legitimate business. Not content with the Tax Court, the Service appealed to the D.C. Circuit Court. The D.C. Circuit Court noted that due to special benefits the tax code affords partnerships, there is the ever-present temptation for an entity to appear as a partnership, even if it is not. The Court noted there are two requirements to be a partnership. The first requirement is the partners must intend to carry-on business as a partnership, i.e., the business must be undertaken for profit or other legitimate nontax purposes. Factors examined include the duration of the partnership and the business rationale for forming a partnership. The Court observed, “Taxpayers that structure their dealing to receive tax benefits afforded by statute are entitled to those benefits, no matter their subjective motivations.” The second requirement is the partners must intend to share in the profits or losses or both; that is, the partners’ interests must have the prevailing character of equity. If a partner is insulated from the upside and downside risks of the business, that partner looks more like a secured creditor, not a true partner. Applying these factors, the D.C. Circuit Court found the partnership was a true partnership and dismissed the Service’s objection that the partnership had no pre-tax profit motive and, therefore, was not a true partnership. The Court noted a partnership’s pursuit of after-tax profit, even one only made possible by tax credits, is a legitimate business activity. Finally, the Court held that even transactions that are only profitable on a post-tax basis can still have a nontax business purpose. The decision by the D.C. Circuit Court was unanimous. So, where does that leave us? Consider for a minute all the tax credits provided by the tax code. The Refined Coal decision confirms and affirms that a partnership organized solely to harvest tax credits is a legitimate business for tax purposes. The question is, what tax credits can your business harvest? Offit/Kurman PA counsels clients on business matters, including the formation and structuring of entities to maximize tax savings and tax credits. The views expressed herein are solely those of the author, are not intended as, and do not constitute, legal or tax advice.
August 19, 2022
Tax
Pass-Through Entities in Bankruptcy-Beware of Phantom Income
Recently I discussed the tax issues created by the inadvertent inclusion of partnership tax provisions in an operating agreement for a LLC taxed as an S-corp. Today we have a different problem – not following what the operating says regarding dissolution and the potentially serious adverse tax consequences that can create. This is a bankruptcy case with important income tax lessons for members of pass-through entities. LeClairRyan PLLC was a law firm in Virginia that was taxed as an S-corporation for federal and state income tax purposes. In 2019 LeClairRyan filed bankruptcy (initially Chapter 11 (reorganization) but converted to Chapter 7 (liquidation). On July 29, 2019, the firm voted to dissolve. On July 31, 2019, Mr. LeClair terminated his employment with the firm. Three years later, he was in bankruptcy court, asking the court to order the bankruptcy trustee to remove his name from the list of equity security holders (members of the law firm) on the ground he had terminated his interest. Under Virginia’s LLC act, an LLC “is bound by its operating agreement, which regulates the conduct of its business and the relations of its members.” Most, if not all, state LLC acts contain similar provisions. Here, the law firm’s operating agreement provided that a member’s interest terminated on the date the member’s employment with the firm ceased. For Mr. LeClair, this was July 31, 2019. But the firm’s operating agreement also provided that as long as a member-owned shares (instead of a membership interest, the law firm used common and preferred shares), no member could withdraw prior to dissolution and winding up of the [law firm]. Because the law firm voted to dissolve on July 29, 2019, two days before Mr. LeClair attempted to terminate his employment, the bankruptcy court ruled Mr. LeClair’s termination was ineffective based on this provision of the operating agreement. Had it been the other way around, that is, had Mr. LeClair terminated his employment before the firm voted to dissolve, then he would not have been a member as of the date of dissolution. So why was Mr. LeClair trying to do this, and what difference does all this really make? The reason: Taxes. The difference it makes: Potentially a big one, and here’s why. Under the Bankruptcy Code, when an individual files bankruptcy, the bankruptcy estate is its own tax entity, meaning it, not the debtor (the individual who filed bankruptcy), is responsible for paying any taxes associated with the income from the bankruptcy estate. See IRC § 1398. However, this rule does not apply to corporations or partnerships. IRC § 1399. In the case of a C-corporation, this is no big deal because C-corporations are separate tax-paying entities anyway. But…where a pass-through entity (PTE) is involved (entity taxed as an S-corporation or partnership)…it can be a big (taxable) problem for the partners/shareholders/members. Recall, with PTEs, items of profit and loss flow through to and are taxed at the shareholder/member/partner level. In bankruptcy, if the PTE has assets that continue to produce income, the bankruptcy estate–not the shareholders/members/partners–gets the income, but and this is a BIG BUT because the income flows through to the individual shareholders/members/partners, they, not the PTE, must pay the taxes associate with that income. Ouch!! So, coming back to Mr. LeClair’s case, that meant that as the bankruptcy trustee collected the law firm’s receivables (which are income), the bankruptcy trustee got to keep the money to pay the firm’s creditors, but for tax purposes, the income was allocated to the members of the now bankrupt firm who had to pay income taxes on money they never received. I know what some of you are thinking. Would the result have been different if the firm had made an election to pay tax at the entity level instead of at the shareholder/member/partner level? After all, Virginia has adopted pass-through entity tax (PTET) as a SALT workaround. Highly doubtful. PTET legislation, at least in Virginia as well as most states, does not create or define a property interest (IRS looks to state law to determine whether a taxpayer has a property interest, then federal law governs how that interest is taxed). Maybe a closer call in Connecticut, where PTET is mandatory but still doubtful, in my opinion. Let this be a cautionary tale that if you are a shareholder/member/partner of a PTE that is contemplating bankruptcy, you should seek not only competent bankruptcy counsel but competent tax counsel as well, lest you wind up with phantom income for which you, not your now defunct PTE, will have to pay income taxes. Offit/Kurman PA counsels clients on bankruptcy and insolvency matters, including the tax aspects and effects of those matters. The views expressed herein are solely those of the author, are not intended as, and do not constitute, legal or tax advice.
August 16, 2022
Tax
Self-Employed and Deducting Car Expenses? – Document or Else!
An internet search of “Schedule C filers” will yield a bevy of sites warning of the increased audit risk and audit red flags for Schedule C filers. As a reminder, Schedule C of Form 1040 is used by sole proprietors, and LLCs taxed as disregarded entities. The recent Tax Court case of Eze v. Commissioner, T.C. Memo. 2022-083 (Aug. 4, 2022) serves as a potent reminder of the need for taxpayers not only to document their business expenses but, when it comes to cars and trucks, to make sure the strict substantiation requirements of IRC § 274(d) and Temp. Treas. Reg. § 1.274-5T(c) are satisfied. Plain English, please. This means keeping records of car and truck expenses, i.e., where you go, the purpose of the trip, miles traveled, who you saw, etc… and make those records close in time to when the expenses were incurred. In Eze, the taxpayer, who’s return was selected for audit (this means the automated system flagged it because his expenses were so high), created his records months, if not years after the fact, created and used a calendar solely for the purpose of the IRS examination, offered no clear explanation when he made the entries, and could not explain how he could have remembered the minute details months and years after the fact. Other things the Tax Court had trouble believing: (1) the taxpayer made the same trip to the same client on the same day of each year; (2) recorded mileage was inconsistent (some trips from his home to New York he recorded as 354 to 362 miles, others he recorded as 448 to 450). There may have well been good reason for that. If I travel to our home office in Baltimore, my mileage each way, will range from 329 to 383, depending on the route. Like most others, I map the route when I am leaving and take the one that suits me the best. But if the taxpayer did that here, he did not offer a plausible explanation why. With the other issues involving his auto expenses records, the Court found the taxpayer’s testimony was not credible. Other things the Tax Court had trouble believing: (1) he took four round trips to Buffalo, New York, and three round trips to Charleston, South Carolina (the taxpayer lived in or around Baltimore, Maryland), all in one month, but could not explain why he needed to visit the same client that many times in one month; and (2) In 2015 the taxpayer showed some personal mileage, but none in 2016. Consistency matters! So, if you are entitled to deduct business mileage, keep accurate records. At a minimum, this should include: (1) miles driven; (2) date; (3) place; and (4) business purpose. These records should be made close in time to when the miles were driven. Have trouble remembering to do that? There’s an app (actually several) for that. Just remember to do period downloads or printouts so if your return is selected for audit, you can substantiate your business mileage deduction. Offit/Kurman PA counsels clients in business and corporate matters, including tax planning and advocacy. The views expressed herein are solely those of the author, are not intended as, and do not constitute legal or tax advice.
August 11, 2022
Tax
Legal Fees – Deductible as Ordinary Business Expenses or Capitalized?
This is the question currently on appeal from the Tax Court to the Third Circuit. In Myland, Inc. v. Commissioner of Internal Revenue (Case No. 22-1193, 1194 & 1195) the IRS appealed the Tax Court’s ruling that Mylan (the taxpayer) was entitled to deduct, as an ordinary business expense under IRC § 162(a), approximately $50 million in legal expenses it incurred to defend patent infringement actions in connection with its manufacture of generic drugs. The Service contended Mylan’s $50 million in legal expenses should be capitalized under IRC § 263(a) because, in its mind, the expenses were related to the acquisition of a capital asset. Okay, so what difference does this make? A big one. If Mylan establishes the legal fees were ordinary business expenses, it gets to deduct those fees as they are incurred (which they did on their timely filed tax returns for the years at issue). If not, Mylan must recover its legal fees over a fifteen-year period, through amortization and depreciation deductions (Ouch!). Because Mylan deducted the fees currently as an ordinary business expense, if the Service ultimately prevails and those deductions are denied, Mylan will also incur interest and penalties (salt in the wound). What is it, an ordinary business deduction or a capital expense? The answer all depends on whether the expense either: (1) creates or enhances a separate and distinct asset; or (2) otherwise generates significant benefits for the taxpayer extending beyond the current taxable year. Yep. About as clear as mud. To provide clarity the Service promulgated Treas. Reg. § 1.263 to provide additional guidance. Without getting too deep into the weeds, if a taxpayer incurs expenses (including legal fees) to create or improve an intangible asset, which includes “rights obtained from a governmental agency,” i.e., trademark, trade name, copyright, license, permit, franchise, or similar right granted by that governmental agency,” those expenses are capital expenses that may only be recovered over the useful life of the asset through amortization and depreciation deductions. Treas. Reg. § 1.263(a)-4(d)(9)(l). Although most businesses do not have patents, many do have other intangibles such as trademarks, trade names, and copyrights, to name a few. The deductibility of legal expenses depends on the nature of the underlying claim for which the legal expenses were incurred, so businesses must look to the substance of the claim or transaction that gave rise to the legal fees to determine whether the expenses are ordinary business expenses (and, therefore currently deductible) or a capital expenditure, recoverable over the useful life of the asset. With intellectual property becoming ever more important and valuable to businesses of all types and sizes, business owners need to be mindful of how and when legal fees (and other expenses) incurred to create or defend rights in intellectual property are treated for federal income tax purposes-deductible currently as an ordinary business expense or capitalized over the life of the asset. As for how the Third Circuit will rule? My money is on Mylan. Offit Kurman PA counsels clients on creating, enhancing, and protecting intellectual property, including the tax aspects and effects of those transactions. The views expressed herein are solely those of the author, are not intended as, and do not constitute legal or tax advice.
August 5, 2022
Tax
Operating Agreements – One Size Does Not Fit All
A recent private letter ruling highlights the danger of using a form or template blindly. PLR 202219005 involved a limited liability company (the “Company”) that sought, but failed, to be taxed as an S-corporation. On the effective date of the Company’s organization, the Company duly adopted a written operating agreement. The problem was the written operating agreement contained provisions appropriate for partnerships but not S-corporations. Specifically, one provision of the operating provided, “the proceeds from liquidation will be allocated to members with positive balances in their respective capital accounts, pro-rata, in proportion to the positive balances in those capital accounts.” Provisions like this one are seen routinely in operating agreements for entities taxed as partnerships for federal income tax purposes but are wholly inappropriate for entities taxed as S-corporations. Recall an S-corporation may have only one class of stock. While an S-corporation can have voting and non-voting shares, all shares must have identical rights to distribution and liquidation proceeds. The problem is partnership allocation provisions, such as the one at issue here, do not confer identical rights to distribution and liquidation proceeds. More of a problem among the DIY community who grab forms off the internet; this also can happen with attorneys who create limited liability companies (and operating agreements for those LLCs) without understanding what the agreements actually say and do. The allocation and distribution provisions of an operating agreement are the meat of the agreement because these provisions determine how members get money (or don’t get it) (distributions) and how they are taxed on money (or not taxed) (allocations). You don’t go to your dentist for heart surgery, and you don’t go to your cardiologist to fill a tooth. Lawyers are the same. When setting up a new company, turn to a lawyer well-versed in business and tax matters. The PLR does not discuss how the operating agreement came to contain partnership tax allocation provisions, only that it did. This PLR serves as a cautionary tale – do not use forms blindly. With operating agreements, one size DOES NOT fit all. Each operating agreement should be tailored to the facts and circumstances of the particular transaction and the parties’ intended tax treatment. In the case the Company was fortunate, the Service granted relief. Still, the need for (and cost of) a PLR easily could have been avoided had the taxpayer carefully reviewed the operating agreement. Scott Tippett is a member of Offit Kurman, where he focuses his practice on business and tax planning. Offit Kurman counsels business owners on strategic business, tax, and risk management techniques. The views expressed herein are solely those of the author’s and do not constitute and are not intended as legal or tax advice.
June 22, 2022
Tax
North Carolina Enacts Pass – Through Entity Tax
Recently the North Carolina General Assembly changed the law to permit pass-through entities (partnerships and s-corporations) to pay entity-level tax, thereby joining a majority of states (29 at last count) in doing so. The change is effective for tax years beginning January 1, 2022. As with most states, paying tax at the entity level is optional (mandatory in Connecticut). If a partnership pays tax at the entity level, the tax paid is a separately allocable item to the individual partners, so the net effect is the same, which begs the question, then why pay tax at the entity level. Originally pass-through entity tax (PTET) laws came about as a workaround for the state and local tax (SALT) limitations imposed by the Tax Cut and Jobs Act of 2017 (TCJA). Recall the TCJA limits deductions of state and local taxes to ten thousand ($10,000) annually, but taxes paid y an entity are business expenses, not subject to the 10K cap. There are two potential drawbacks of PTET. First, not all states give their residents credit for PTET paid in other states. Second, in some states, PTET is paid at a state’s top marginal rate (or more), so the advantage may be illusory at best. But let me suggest an additional aspect of PTET – asset protection. In the traditional model, a partnership would, at a minimum, make distributions to its partners to cover the taxes for the income allocated to each partner. Within the partnership, and here we are talking about a limited liability company taxed as a partnership, not a true general partnership, assets held within the LLC are beyond the reach of an individual partner’s creditors. However, when a tax distribution is made, the funds out of the LLC and into the individual partners’ bank accounts where the funds then become subject to set-off by the bank, garnishment by a judgment-creditor, withdrawal by a joint account holder, not to mention subject to the joint account holder’s judgment creditors, or, in extreme cases, prejudgment attachment. Depending on the amount of income allocated to a partner, the tax distribution could be substantial. Imagine the disgruntled, secretly planning to separate spouse who waits until the tax deposit is made to drain the joint bank account, leaving the partner/member without immediate liquid assets with which to pay tax liabilities. On the other hand, if the entity elects PTET, then the funds never leave the entity and are paid by the entity directly to the relevant tax authorities and the tax paid is allocated to the individual members/partners as though the tax distribution had been made to them and they, in turn, paid their respective tax obligations. No doubt, neither the North Carolina General Assembly nor any other state legislative body that enacted a PTET did it for asset protection purposes, but every now and then, life has its little bonuses. Scott Tippett is a member of Offit Kurman, where he focuses his practice on business and tax planning. Offit Kurman counsels business owners on strategic business, tax, and risk management techniques. The views expressed herein are solely those of the author’s and do not constitute and are not intended as legal or tax advice.
June 16, 2022
Tax
Excess Compensation and Disguised Dividends – Take Care and Beware!
Yesterday I wrote about a case involving constructive dividends. Today it is disguised dividends. The issue in Clary Hood, Inc. v. Comm.,T.C. Memo. 2022-15, was whether the salary and bonus paid to the company’s president (Mr. Hood) was excessive under IRC 162(a)(1) and was therefore a disguised dividend. Recall that compensation, if reasonable and not excessive, is a deductible business expense for the company, but dividends are not. In this case the company was a C-corporation, which, because of the double layer of taxation (first at the corporate level, then again at the shareholder and employee level), had every incentive to characterize the payment as compensation, not as a dividend. The company’s story is the great American success story, and the opinion is well worth the read for this story alone. Starting with little money and used equipment in 1980, the company, largely through the efforts of Mr. Hood, who, together with his wife owned all the stock and were the only directors of the company, became a multimillion-dollar company by 2016 with revenues in excess of 60 million dollars. Along the way Mr. Hood did what many small business owners do when starting out – he often did not draw a salary, so the business had enough money to pay its other employees and creditors. When things finally began to turn around, Mr. Hood and his wife, as the company’s directors, decided to pay a bonus to Mr. Hood in the company’s 2015 and 2016 fiscal years. For the 2015 bonus, the company engaged its outside accountants to perform a salary survey. Based on the accountants’ recommendations, the company paid Mr. Hood a bonus of 5 million dollars in 2015. The company paid Mr. Hood the same bonus in 2016 but did so without engaging the company’s accountants to perform another salary survey. Without going through the math, the difference in the Hoods’ pocket between the company declaring and paying a dividend to the Hoods for 5 million (not deductible by the company) or paying the Hoods a 5 million bonus (deductible by the company) was about one million dollars. The substantial increase on Line 12 of the company’s return caught the watchful eye of the Service. Audits and notices of deficiencies promptly followed, including accuracy related penalties under 6662 for substantial understatement of income. The company put on several experts to demonstrate Mr. Hood’s bonus was calculated reasonably and the Service put on one expert. Based on deficiencies in their reports, the Tax Court placed little value in the company’s experts. On the other hand, the Service’s expert’s report did not have the same deficiencies and the Tax Court found that expert (who concluded Mr. Hood’s bonus was excessive) credible. The Tax Court determined reasonable compensation for Mr. Hood was $3,681,269 for tax year 2015 and $1,362,831 for tax year 2016. Further the Tax Court abated the substantial understatement penalty for 2015, based on the company’s engagement of and reliance upon its outside accountants, but did not waive the penalty for 2016 because the company essentially relied on the 2015 accountant report and performed no new study. Among the issues the Tax Court considered in ruling the bonus was excessive and therefore a disguised dividend, were the following: (1) Mr. Hood had no employment contract with his company; (2) other company executives did not receive bonuses comparable to Mr. Hood’s bonus and the company had no policy in place for setting non-shareholder employee compensation; (3) Mr. and Mrs. Hood were the sole shareholders and sole directors of the company, who, as such, had sole authority to review and approve the bonus amount; and (4) in its entire history, the company had never paid a dividend to its shareholders. Although every tax case is highly fact specific, things the company and Mr. Hood could have done differently that might have affected the outcome include: (1) had a written employment agreement with Mr. Hood specifying how salary and bonuses would be determined; (2) had a written compensation and bonus eligibility policy for all employees (and followed it); (3) had outside directors and perhaps even an independent compensation committee that reported to the board; (4) had a history of paying some dividends as approved by the board of directors. For practitioners, this case has an excellent discussion of the “independent investor” test versus the “multi-factor” test for excessive compensation. It also provides a detailed road map for what expert reports should include to be deemed credible. Offit Kurman counsels business owners on strategic business, tax, and risk management techniques, including the design and implementation of executive compensation packages. The views expressed herein are solely those of the author’s and do not constitute and are not intended as legal or tax advice.
March 11, 2022
Tax
S-Elections Gone Wrong
The IRS just released four separate Private Letter Rulings (“PLRs”) addressing the inadvertent termination of a taxpayer’s S-election. It is often said the devil is in the details, which is demonstrated aptly by these four PLRs. Fortunately for the taxpayer, in each case the Service found that the terminations were inadvertent, which means the taxpayer was allowed to correct the issues and be treated as though the S-election was never terminated, likely saving the taxpayer untold thousands of dollars in taxes, penalties, and interest. Although PLRs may be relied upon only by the taxpayer who obtained the PLR and may not be cited by other taxpayers in similar positions, PLRs reveal how the IRS approaches certain issues, in this case inadvertent termination of S-elections. Recall, a small business entity (100 or fewer equity owners) may elect to have the entity taxed as a S-corporation, rather than the default classification of partnership, corporation (meaning C-corporation), or disregarded entity). Depending on the revenue flow, it is often advantageous for a limited liability company (“LLC”) that would otherwise be taxed as a partnership or disregarded entity to elect to be taxed a S-corporation. This would permit the entity to receive the asset benefits of being structured as a LLC, and receive the tax benefits of being taxed as a S-corporation. Similarly, small businesses that are set up as corporations may wish to be taxed as S-corporations, not C-corporations, which is the default classification assigned by the Service (C-corporations have two layers of tax-one at the corporate level and one at the shareholder level, while S-corporations have just one level of tax-the shareholder level). In either case, the taxpayer and the taxpayer’s owners must qualify and make an affirmative election by filing certain forms in a timely manner with the Service. In PLR 2022090001 the taxpayer was a corporation that converted to a LLC, but failed to read or did not understand the operating agreement it adopted. This happens with some regularity, typically with DIY entities or when done by an advisor who simply relies on “a form” operating agreement without reading or understanding the tax provisions contained in the operating agreement. In this case the taxpayer’s operating agreement was one designed for a LLC taxed as a partnership, the provisions of which created interests with different rights, which violated the single class of stock rule applicable to all entities taxed as S-corporations (a S-corporation may only have one class of stock so every owner has the same dividend and liquidation rights. Non-voting shares are permitted if the non-voting shares have the same dividend and liquidation rights). The Service noted the operating agreement “included provisions in contemplation of Company being treated as a partnership for federal income tax purposes (inclusion of capital account rules under Treas. Reg. § 1.704(1)(b))(analysis supplied); however, the applicability of those provisions was not limited to such a situation…,” meaning that even though the entity was not seeking to be taxed as a partnership, it could under its operating agreement. In this case the taxpayer failed to make sure the operating agreement was drafted correctly for an entity to be taxed as a S-corporation (failure to remove the capital account provisions among other things). PLRs 202209003 and 202209005 each concerned trusts as owners of S-corporation stock that failed to make appropriate and timely elections. Only certain types of trusts may be S-corporation shareholders, and one of the steps a trust must take to be an eligible shareholder include making the affirmative election to be an electing small business trust (ESBT) under the requirements set forth in IRC § 1361(e). In PLR 2022090003, the trust at issue failed to do that. Similarly, in PLR 2022090005, the trust qualified as an ESBT within the meaning of § 1361(e), but the trustee failed to make an election under § 1361(e)(3) to treat the trust as an ESBT. In other words, make sure you dot your “I” and cross your “T.” Finally, PLR 2022090010, which also involved a LLC that sought to be taxed as a S-corporation, the entity’s owner (there was only one) failed to sign the required consent to be taxed as a S-corporation. As noted above, to be taxed as a S-corporation the entity and its owners must make an affirmative election to be taxed as a S-corporation. Here it appears the entity signed and timely submitted the requisite consent to the Service, but the entity’s owner failed to sign the consent. Although PLRs never mention specific dates actions were taken, it is possible that the S-election was submitted near the end of the allotted time for making the election so by the time the taxpayer became aware of the oversight the time for electing S-corporation treatment for that tax year had passed. PLRs are highly fact specific, and there is no assurance the Service would come to a taxpayer friendly resolution in a different case. To avoid making similar mistakes, business owners should make sure their business advisors understand the tax ramifications of the business documents being used, and are aware of the steps that must be taken and the time for taking those steps for the entity to make a valid S-election. Offit Kurman counsels business owners on strategic business, tax, and risk management techniques, including the design and implementation of executive compensation packages. The views expressed herein are solely those of the author’s and do not constitute and are not intended as legal or tax advice.
March 10, 2022
Tax
Ipads, iPhones, and Barter Transactions
From the hardly noticed case of Sherwin Community Painters, Inc. v. Commissioner, T.C. Memo. 2022-19, come some interesting tidbits. First, just the facts. Sherwin Community Painters, Inc. is a C-corporation with a single shareholder. As its name implies, Sherwin was a painting contractor. The case arose from the Service’s disallowance of certain business deductions claimed by Sherwin and the Service’s attempt to characterize the disallowed deductions as a constructive dividend. The Service also asserted accuracy related penalties against both taxpayers under IRC 6662(a) and a late filing penalty against the shareholder under IRC 6651(a)(1). All issues were limited to the taypayers’ 2016 tax year and returns for that year. Among the deductions Sherwin claimed were deductions for office equipment (iPads, iPhones, a speaker, accessories, and service contacts), office supplies, gas, entertainment (remember this was 2016 and entertainment expenses were deductible back then), and a business deduction for a coding course the company paid for that was taken by the shareholder’s soon to be son-in-law. After the coding course the soon to be son-in-law, using the skills acquired in the course, updated Sherwin’s website and made numerous changes to the website. PSA No.1 – File a timely request for an extension. The shareholder’s 2016 return was filed on October 12, 2017, three days before the automatic extension deadline of October 15, 2017 (actually four days because that year October 15th fell on a Sunday). Had the taxpayer timely filed an extension for the 2016 return, with the extension the return would have been timely filed and no late filing penalty would have been asserted. PSA No.2 – iPads, iPhones, speakers, and accessories are deductible provided they are ordinary and necessary under IRC 162(a). The Tax Court wasted little time in allowing this deduction noting the taxpayer properly substantiated the deduction. PSA No. 3 – Document your barter transactions! Sherwin argued that its tuition payment to the educational institution for the coding course was essentially a barter transaction in exchange for website design services. The Tax Court did not dispute Sherwin’s assertion that the soon to be son-in-law performed web design services, but did take issue with the lack of any documentation. The Court noted the soon to be son-in-law was not an employee of Sherwin and there was no agreement that the web design services were in consideration of payment of the tuition. It seems Sherwin was arguing an after-the-fact quid pro quo. Had Sherwin documented (in writing) the arrangement contemporaneously, that deduction would probably have been allowed. Finally, the Service attempted to argue the disallowed deductions were constructive dividends to the shareholder, which if true, would have been includible in the shareholder’s gross income under IRC 61(a)(7). Apparently the Service thought Sherwin made a loan to the shareholder and this was the basis for its constructive dividend claim. The records showed just the reverse-a loan from the shareholder to Sherwin. Refusing to give up the constructive dividend claim, the Service then argued the disallowed business expenses were a constructive dividend. You can almost see the Court scratching its head looking at counsel for the Service and saying “REALLY!?” Noting “Respondent [IRS] refuses to concede his error and instead argues on brief that the disallowed business expenses should be treated as a constructive dividend,” the Court held there was no relation between disallowed business expenses and a constructive dividend. All taxpayers should make sure they file an extension request in a timely manner to avoid a late filing penalty. All business owners should make sure expenses they deduct are ordinary and necessary, and are properly substantiated in case those expenses are later challenged. Finally, in the gig economy barter transactions have become more prevalent. To make sure businesses can deduct these expenses, businesses need to be sure to document such arrangements in writing, contemporaneously. Offit Kurman counsels business owners on strategic business, tax, and risk management techniques, including the design and implementation of executive compensation packages. The views expressed herein are solely those of the author’s and do not constitute and are not intended as legal or tax advice.
March 10, 2022
