274 substantiation

I have no doubt that if the tax return in this case was prepared by a tax return preparer, the IRS would go aft the 6694(b) $5,000 penalties.

T.C. Summary Opinion 2009-84]
Kennie Blackmon v. Commissioner.

Docket No. 5165-07S . Filed May 28, 2009.


An individual who was a pipe fitter and maintenance worker was not entitled to deductions greater than the amount the IRS conceded for his mileage between his residence and work site or for his purchase of work clothes, boots and tools. He was unable to prove that his transportation to and from work was not a normal commuting expense. He was not entitled to any deduction for his alleged purchase of work clothes and boots because his uncorroborated testimony, in tandem with his admission that the dollar amount of his claimed deduction was a mere estimate, was insufficient to meet the Code Sec. 6001 substantiation requirements. In addition, he was not entitled to a deduction greater than the amount conceded by the IRS for his alleged purchase of tools because his uncorroborated testimony was insufficient to substantiate the additional amount. Finally, miscellaneous deductions conceded by the IRS were deductible only to the extent they exceeded two percent of his adjusted gross income. Since the conceded deductions did not exceed this amount, they did not affect the calculation of the deficiency.



PURSUANT TO INTERNAL REVENUE CODE SECTION 7463(b), THIS OPINION MAY NOT BE TREATED AS PRECEDENT FOR ANY OTHER CASE.









GUSTAFSON, Judge: This case was heard pursuant to the provisions of section 7463 1 in effect when the petition was filed. Pursuant to section 7463(b), the decision to be entered is not reviewable by any other court, and this opinion shall not be treated as precedent for any other case.



The Internal Revenue Service (IRS) determined a deficiency of $3,833 in the 2003 Federal income tax of petitioner Kennie Blackmon. After concessions, 2 the issue for decision is whether Mr. Blackmon is entitled to deductions under section 162 for (i) his mileage between his residence and his work site; and (ii) his purchase of work clothes, boots, and tools. On the facts proved at trial, Mr. Blackmon is not entitled to deductions under section 162 greater than respondent has conceded.





Background



Some of the facts have been stipulated and are so found. The stipulation of facts filed December 8, 2008, and the attached exhibits are incorporated herein by this reference. At the time that he filed his petition, Mr. Blackmon resided in North Carolina.




Mr. Blackmon's Residence and Place of Work


Mr. Blackmon is a pipe fitter and maintenance worker. He has resided in Chadbourn, North Carolina, for many years, but he has not worked in Chadbourn for many years. Since 1996 he has worked mostly, but not entirely, at a plant in Darlington, South Carolina, about 71 miles from his home (i.e., 142 miles round trip). During the year at issue (2003), Mr. Blackmon worked at the Darlington plant between January 1 and December 21.



On about three occasions from 1996 to 2003, there were layoffs at the Darlington plant, during which for periods of several months Mr. Blackmon worked at other jobs in Maxton, North Carolina (44 miles from Chadbourn, 88 miles round trip), Riegelwood, North Carolina (38 miles from Chadbourn, 76 miles round trip), and other locations that Mr. Blackmon could not recall at trial. These distances were not proved at trial, but we take judicial notice of them pursuant to rule 201(b) of the Federal Rules of Evidence. Because of these layoffs, Mr. Blackmon believes that his work in Darlington was "temporary". He testified: "I mean, you may go in tomorrow and be laid off, so I consider all jobs temporary."




Mr. Blackmon's 2003 Form 1040


Mr. Blackmon timely filed his 2003 Form 1040, U.S. Individual Income Tax Return, claiming the following "Job Expenses and Most Other Miscellaneous Deductions" on his Schedule A, Itemized Deductions: (i) unreimbursed employee expenses of $25,300; (ii) tax preparation fees of $181 (which respondent has conceded); and (iii) other expenses of $500.



Mr. Blackmon's claimed unreimbursed employee expenses consisted of the following: (i) vehicle expenses of $23,400, i.e., 65,000 business miles at the standard mileage rate of 36 cents per mile; and (ii) job expenses for "WORK CLOTHES AND BOOTS" of $1,900. Mr. Blackmon's claimed other expenses consisted entirely of an itemized deduction for "TOOLS" of $500, of which respondent has conceded $300, leaving only $200 still at issue.




Mr. Blackmon's Substantiation of His Expenses


With respect to his claimed deduction for vehicle expenses, Mr. Blackmon testified that during his employment at the Darlington plant in 2003, he drove to and from his residence and work site each workday. He presented no log, calendar, diary, work or leave record, or other written record to corroborate his mileage claim.



With respect to his claimed deduction for work clothes and boots, Mr. Blackmon testified that in his line of work as a pipe fitter, he worked in close proximity to welders, and that he purchased denim jeans, denim shirts, and boots to avoid getting burned by sparks from the nearby welding activity. He acknowledged that his claimed deduction of $1,900 for work clothes and boots was an estimate. With respect to his deduction for tools, Mr. Blackmon testified that he purchased a protracting level for $200 or $300, and "other stuff" that he could not recall in detail. However, he presented no receipts, credit card slips, canceled checks, or checkbook registers to substantiate the expenditures for work clothes, boots, or tools.





Discussion



At issue is Mr. Blackmon's entitlement to deductions that he claimed on his 2003 tax return for job-related expenses. Section 162(a) allows a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. Section 262, however, provides that no deduction is allowed for personal, living, or family expenses. Deductions are strictly a matter of legislative grace, and taxpayers must satisfy the specific requirements for any deduction claimed. See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Taxpayers are required to maintain records sufficient to substantiate their claimed deductions. See sec. 6001; sec. 1.6001-1(a), Income Tax Regs. (26 C.F.R.).




I. Vehicle Expenses


A. Personal Versus Business Purpose



Mr. Blackmon contends that he is entitled to deduct the standard mileage rate for the miles he drove between his residence in Chadbourn, North Carolina, and his work site in Darlington, South Carolina. However, in general, the cost of daily commuting to and from work is a nondeductible personal expense. See Commissioner v. Flowers, 326 U.S. 465, 473-474 (1946); sec. 1.162-2(e), Income Tax Regs. In order to prevail, Mr. Blackmon needed to prove that his transportation to and from work was not a normal commuting expense, but he was unable to do so.



Mr. Blackmon has not worked in Chadbourn, North Carolina, for many years. Rather, Mr. Blackmon must have other reasons, sufficient to him, for living in Chadbourn, North Carolina; and he is certainly free to live there and free to work wherever he pleases. However, it is clear that his reason for living in Chadbourn is not related to his reason for working 71 miles away in Darlington, South Carolina. Rather, personal reasons motivate that decision, and in 2003 he made his long drive to work each day for those personal reasons. Cf. Tucker v. Commissioner, 55 T.C. 783, 785-788 (1971).



A taxpayer may deduct daily transportation expenses that he incurs in going between his residence and a work location that is temporary and that is outside the metropolitan area where he lives and normally works. Brockman v. Commissioner, T.C. Memo. 2003-3; Aldea v. Commissioner, T.C. Memo. 2000-136; Rev. Rul. 99-7, 1999-1 C.B. 361. However, Mr. Blackmon does not meet this exception, both because his work at the Darlington plant was not really temporary and because there was not a single metropolitan area where he both lived and normally worked.



Although Mr. Blackmon considers his work in the Darlington plant "temporary", the facts show otherwise. He worked in the Darlington plant for 11-1/2 months of 2003 and for most of the 7 years before. His testimony about the layoffs and his other employment was summary and vague. Those layoffs were few and brief during his long tenure at the Darlington plant, and it is clear that the Darlington plant was always his default work location --the one to which he intended to return and did return when the layoffs were over.



Even if Mr. Blackmon's 2003 work at the Darlington plant could be characterized as temporary, the temporary nature of a job is not, in and of itself, a sufficient basis to make transportation expenses deductible. Rather, that temporary work location must be outside the metropolitan area where he lives and normally works. If a taxpayer like Mr. Blackmon ordinarily works outside the metropolitan area in which he lives, then his transportation expenses to a temporary job that is also outside the metropolitan area where he lives are not deductible. See Aldea v. Commissioner, supra; Rev. Rul. 99-7, supra. From at least as early as 1996 through the year at issue, Mr. Blackmon did not ordinarily work in the metropolitan area of Chadbourn, North Carolina, in which he lived. Consequently, his decision to live apart from his work was a personal one; and even if his job or jobs were temporary, that fact would not render his daily transportation expense deductible. Rather, it remains a personal commuting expense.



B. Substantiation



Respondent contends that Mr. Blackmon's deduction of $23,400 under section 162 for vehicle expenses must be disallowed for the additional reason that he has not substantiated the mileage he claims to have driven between his residence and his work site. Section 274(d) imposes stringent substantiation requirements for claimed deductions relating to the use of "listed property", which is defined under section 280F(d)(4)(A)(i) to include passenger automobiles. Under this provision, any deduction claimed with respect to the use of a passenger automobile, like Mr. Blackmon's, will be disallowed unless the taxpayer substantiates specified elements of the use by adequate records or by sufficient evidence corroborating the taxpayer's own statement. See sec. 274(d); sec. 1.274-5T(c)(1), Temporary Income Tax Regs., 50 Fed. Reg. 46016 (Nov. 6, 1985).



The elements that must be substantiated to deduct the business use of an automobile are: (i) the amount of the expenditure; (ii) the mileage for each business use of the automobile and the total mileage for all uses of the automobile during the taxable period; (iii) the date of the business use; and (iv) the business purpose of the use of the automobile. See sec. 1.274-5T(b)(6), Temporary Income Tax Regs., 50 Fed. Reg. 46016 (Nov. 6, 1985).



Mr. Blackmon testified that each workday from January 1 to December 21 he drove 71 miles each way between his residence and his work site, and he claimed a deduction for 65,000 miles on his 2003 Form 1040. Mr. Blackmon has not corroborated his testimony with any records or other evidence to substantiate these claims or the other specified elements of his business use of his vehicle that are required by the regulations. Moreover, if he drove the 142-mile round trip 5 days each week during that 50-week period (i.e., 250 days), he would have driven only 35,500 miles, not the 65,000 miles alleged. Because of Mr. Blackmon's failure to present any records or other evidence to supplement his testimony, we find that he has not substantiated the required elements of his vehicle expense under section 274(d) and the regulations thereunder. Accordingly, we hold that Mr. Blackmon is not entitled to deduct his alleged vehicle expenses for transportation between his residence and his work site in 2003.




II. Purchase of Work Clothes and Boots


Respondent contends that Mr. Blackmon is not entitled to a deduction of $1,900 under section 162 for his estimated cost of work clothes and boots, 3 because he has not substantiated any such purchases during 2003. As is noted above, taxpayers are required to maintain records sufficient to substantiate their claimed deductions. See sec. 6001; sec. 1.6001-1(a), Income Tax Regs. However, Mr. Blackmon has not corroborated his testimony with any records or other evidence to substantiate his claimed deduction of $1,900. We find that Mr. Blackmon's uncorroborated testimony --in tandem with his admission that the dollar amount of his claimed deduction was a mere estimate --is insufficient to meet the substantiation requirements of section 6001. 4 Accordingly, we hold that Mr. Blackmon is not entitled to any deduction for his alleged purchase of work clothes and boots in 2003.




III. Purchase of Tools


On the basis of Mr. Blackmon's testimony at trial that he purchased a protracting level for use at his work site, respondent concedes that Mr. Blackmon is entitled to a deduction of $300 under section 162 for that purchase. However, respondent contends that Mr. Blackmon is not entitled to an additional deduction of $200 5 under section 162 for purchasing other tools, because he has not substantiated any purchases of other tools during 2003.



Mr. Blackmon has not corroborated the estimate given in his testimony with any records or other evidence to substantiate his deduction of $500 for the claimed purchase of tools, as the law requires. See sec. 6001; sec. 1.6001-1(a), Income Tax Regs. In making his concession that Mr. Blackmon is entitled to a deduction of $300 under section 162 for his purchase of a protracting level, respondent has generously construed section 6001 and has applied it liberally to concede the deductibility of Mr. Blackmon's purchase. We find that Mr. Blackmon's uncorroborated testimony is insufficient to substantiate the remainder of his claimed deduction for the purchase of tools under section 6001. Accordingly, we hold that Mr. Blackmon is not entitled under section 162 to a deduction greater than respondent has conceded for Mr. Blackmon's alleged purchase of tools.




IV. Respondent's Concessions


Respondent has conceded that Mr. Blackmon is entitled to miscellaneous deductions of $181 (for tax return preparation) plus $300 (for tools), totaling $481. However, such miscellaneous deductions are deductible only to the extent that they exceed 2 percent of the taxpayer's adjusted gross income (AGI). Sec. 67. Mr. Blackmon's AGI for 2003 was $38,799, so his miscellaneous expenses are deductible only to the extent they exceed $776 (i.e., 2 percent of $38,799). Since the conceded deductions of $481 do not exceed that amount, they do not affect the calculation of the deficiency. As a result, the IRS's determination of Mr. Blackmon's deficiency in income tax for 2003 will be sustained in full.



To reflect the foregoing,



Decision will be entered for respondent.


1 Unless otherwise indicated, all citations of sections refer to the Internal Revenue Code of 1986 (26 U.S.C.) in effect for the tax year at issue.

2 Respondent concedes that before application of the limitation imposed by section 67(a) (i.e., 2 percent of adjusted gross income), Mr. Blackmon is entitled to (i) a deduction of $300 under section 162 for the expense of tools, and (ii) a deduction of $181 for tax preparation fees under section 212(3).

3 It is unlikely that the costs of denim jeans and shirts would be deductible in any event, because they could be worn for general or personal purposes. Hynes v. Commissioner, 74 T.C. 1266, 1290 (1980).

4 The Court may estimate allowable expenses under Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930), but only if there is sufficient evidence in the record to provide a basis for the estimate, Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985), and the substantiation requirements under section 274(d) do not apply.

5 Mr. Blackmon claimed on his 2003 Form 1040 a deduction of $500 for the purchase of tools. The excess of that $500 claimed deduction over respondent's concession of a $300 deduction for a protracting level is the $200 that remains in dispute.

6694 penalty could justify practice injunction

Pursuant to 26 U.S.C. § 7407, if a district court finds that a tax return preparer has "(A) engaged in any conduct subject to penalty under [26 U.S.C. §§] 6694 or 6695," or "(D) engaged in any other fraudulent or deceptive conduct which substantially interferes with the proper administration of the Internal Revenue laws," it may enjoin that person from further engaging in that specific conduct. 26 U.S.C. § 7407(b)(1).

The injunction is obviously justified in the case below. Since 6694 penalties can apply for even non-negligent mistakes, it is a low threshold if the IRS wants a permanent injuction. Suppose, for example, a return preparer is hit with 5, 10 or more 6694 penalties in one year, why would the IRS not consider an injuction under the authority cited in this case?


United States of America, Plaintiff v. Deowraj Buddhu, individually and D/B/A/ Paradise Consulting, A/K/A Phoenix Consulting, and Sunita Buddhu, individually and D/B/A Paradise Consulting, A/K/A Phoenix Consulting and D/B/A Lotus Consulting, Defendants.

U.S. District Court, Dist. Conn.; Civ. 3:08-cv-0074 (CFD), May 12, 2009.

Related decision at 2008-2 USTC ¶50,408.



Two tax return preparers were permanently enjoined from preparing and filing federal income tax returns for others, providing tax-related advice to others, or promoting tax-fraud schemes. Injunctive relief was necessary because the individuals prepared and filed returns that understated their customers' tax liabilities based on unrealistic, frivolous and unreasonable positions and willfully engaged in fraudulent or deceptive conduct that substantially interfered with the proper administration of internal revenue laws. The preparers knowingly and repeatedly inflated and fabricated deductions on their customers' income tax returns and failed to provide their preparer identification number on the returns they prepared. These activities, would have caused irreparable harm to their customers, the government and the public. Moreover, the individuals failed to acknowledge any wrongdoing; thus, they failed to show that they would cease their unlawful conduct.







FINDINGS OF FACT AND CONCLUSIONS OF LAW


DRONEY, United States District Judge: The Government alleges that defendant Sunita Buddhu and her father, defendant Deowraj Buddhu, prepared and filed, on behalf of their clients, fraudulent tax returns for the years 2003 through 2007. The Government has moved for a permanent injunction under 26 U.S.C. §§ 7402(a), 7407 and 7408 prohibiting Sunita Buddhu and Deowraj Buddhu from filing tax returns. For the reasons stated below, the Court grants the Government's request for a permanent injunction.



I. Findings of Fact 1



A. Background

Prior to his incarceration on unrelated state charges in August 2005 and beginning in at least 2003, Deowraj Buddhu operated a tax return preparation business under the name Paradise Consulting Services ("Paradise"). Sunita Buddhu prepared tax returns for Paradise for the tax years 2004 and 2005. After her father's incarceration, Sunita Buddhu took over Paradise and began operating a tax return preparation business under the name of Lotus Consulting ("Lotus"). Since 2003, the Buddhus have prepared several thousand individual income tax returns. On June 5, 2008, the Court issued a preliminary injunction prohibiting Sunita Buddhu from filing tax returns. 2



B. IRS Investigation of the Buddhus

In early 2005, the Internal Revenue Service ("IRS") began a tax preparer investigation of Deowraj Buddhu after the IRS discovered large deficiencies in returns prepared by Paradise. This investigation was eventually expanded to include Sunita Buddhu.

In December 2006, Sunita Buddhu was interviewed by the Criminal Investigation Division of the IRS, and informed that she was the subject of a criminal investigation. Since then, Sunita Buddhu has been interviewed by the Criminal Investigation Division a number of times.



C. Improper Tax Preparer Conduct



1. Improper Schedules A, C and E

The IRS has determined that Deowraj Buddhu, doing business as Paradise Consulting, prepared 722 and 536 tax returns for the 2003 and 2004 tax years, respectively. The IRS has completed examinations on 186 of the 722 tax returns for the 2003 tax year prepared by Mr. Buddhu that had false business losses reported on Schedule C 3 and/or false deductions on Schedule E. 4

The IRS also determined that Deowraj Buddhu and/or Sunita Buddhu, doing business as Paradise Consulting, prepared 2090 tax returns for the tax years 2004 and 2005. The IRS has closed examinations on 278 of the 1087 returns for the 2004 tax year prepared by Paradise and all but one had false business losses reported on Schedule C and/or false deductions on Schedule E. The IRS has completed examinations on 151 of the 1003 returns filed by Paradise for the 2005 tax year that had false business losses reported on Schedule C and/or false deductions on Schedule E.

The IRS examinations included interviews with taxpayers who used the Buddhus' services to prepare their income tax returns. During the interviews, the IRS discovered that many of these taxpayers should not have had a Schedule C included with their tax returns because they were wage earners and were not self-employed in any capacity. During their interviews, many taxpayers indicated that they did not tell the Buddhus that they were self-employed, and did not provide the Buddhus with a factual basis for claiming amounts as either business losses, or employee business expenses. The Buddhus encouraged some clients to list hobbies as businesses. 5

After learning of the IRS examinations, Sunita Buddhu began preparing and filing Form 1040X, Amended Individual Income Tax Returns, on behalf of clients whose returns had been examined. In these amended tax returns, Sunita Buddhu eliminated the disallowed Schedule C business losses, and replaced these losses with corresponding amounts for employee business expenses on Schedule A. 6 Sunita Buddhu prepared 922 federal income tax returns under the name of Lotus Consulting for the 2006 tax year. To date, the IRS has completed eighteen examinations of returns Sunita Buddhu prepared for the 2006 tax year and determined that all eighteen returns contained false employee business expenses reported on Schedule A. There are currently 126 ongoing examinations of 2006 returns that contain suspect employee business expenses. Sunita Buddhu also prepared tax returns that contained fraudulent charitable deductions.



2. False Preparer Information

The Buddhus prepared federal income tax returns for their customers listing false preparer identifications numbers.



3. Frivolous Tax Arguments

Sunita Buddhu represented to her clients that the IRS does not have authorization or jurisdiction to conduct examinations of Connecticut residents' tax returns. Sunita Buddhu also prepared letters for her clients to submit to the IRS stating this unfounded position.



D. Recent Activity

During the 2007 federal income tax filing season, Sunita Buddhu electronically filed 542 federal income tax returns that she prepared for customers. These returns are currently subject to examination by the IRS.

As recently as March 11, 2008, over a year after she learned that she was the subject of a criminal investigation and almost three months after this case was filed, Sunita Buddhu filed a Form 1040X Amended U.S. Individual Tax Return for one of her clients. In the past, Sunita Buddhu has filed numerous Forms 1040X, Amended U.S. Individual Tax Returns for clients after April 15 of the calendar year when the deadline for filing a timely federal income tax return has passed.



E. Damage Caused

684 fraudulent returns prepared by the Buddhus resulted in $3.5 million in tax harm, not including penalties and interest, to the IRS. The Connecticut office of the IRS has spent more than 3000 hours to examine these 684 tax returns.

The Buddhus' customers are responsible for paying all additional taxes, interest and penalties that are assessed after they have paid the Buddhus to prepare their tax returns. Some of their clients have had to borrow money or suffered other hardships to pay the additional tax assessments.



II. Conclusions of Law 7



A. Legal Standard

When an injunction is expressly authorized by statute, the standard injunction test does not apply. SEC v. Mgmt. Dynamics, Inc., 515 F.2d 801, 808 (2d Cir. 1975) ("As the issuance of an injunction in cases of this nature has statutory sanction, it is of no moment that the plaintiff has failed to show threatened irreparable injury or the like, for it would be enough if the statutory conditions for injunctive relief were made to appear"). Instead, the Court must look to the "statutory conditions for injunctive relief," and may issue an injunction if it is clearly established that those conditions are met. Id. at 808.

Sections 7407 and 7408 of Title 26 of the Unites States Code contain express statutory conditions for issuance of an injunction. United States v. Broccolo, No. 06-cv-2812, 2006 WL 3690648 (S.D.N.Y. Dec. 13, 2006) (applying statutory conditions set forth at 26 U.S.C. § 7407 and 7408). However, "in deciding whether to grant injunctive relief [in such a case], a district court is [still] called upon to assess all those considerations of fairness that have been the traditional concern of equity courts." SEC v. Manor Nursing Centers, Inc., 458 F.2d 1082, 1102 (2d Cir. 1972).

Section 7402(a) authorizes injunctive relief, but does not provide "statutory conditions." Accordingly, the traditional equitable considerations must be applied. United States v. Broccolo, No. 06-cv-2812, 2006 WL 3690648.



B. Internal Revenue Code § 7407

Pursuant to 26 U.S.C. § 7407, if a district court finds that a tax return preparer has "(A) engaged in any conduct subject to penalty under [26 U.S.C. §§] 6694 or 6695," or "(D) engaged in any other fraudulent or deceptive conduct which substantially interferes with the proper administration of the Internal Revenue laws," it may enjoin that person from further engaging in that specific conduct. 26 U.S.C. § 7407(b)(1). If a court finds that the preparer's misconduct is continual or repeated, and that a narrower injunction prohibiting only the specific conduct would not be sufficient to prevent a preparer's interference with the proper administration of the internal revenue laws, 26 U.S.C. § 7407 authorizes the court to enjoin the preparer from preparing returns altogether.

Section 6694(a) of the Internal Revenue Code penalizes a return preparer if she understates a customer's liability based on a position for which there is no realistic possibility of being sustained on the merits, if the return preparer knew or reasonably should have known of the unrealistic position and the unrealistic position was not disclosed or was frivolous.

Section 6694(b) of the Internal Revenue Code penalizes a return preparer who wilfully attempts to understate a taxpayer's liability or who understates a taxpayer's tax liability due to reckless or intentional disregard of rules and regulations.

Section 6695(c) of the Internal Revenue Code penalizes a return preparer who fails to provide an identifying number to secure the proper identification of the tax return preparer.

The Government has sufficiently established that Deowraj Buddhu and Sunita Buddhu engaged in conduct subject to penalty under 26 U.S.C. § 6694(a) by preparing returns that understated their customers' tax liabilities based on positions for which there was no realistic possibility of being sustained on the merits. Specifically, there is strong evidence that the Buddhus have continually and repeatedly prepared returns that contain false deductions on Schedules A, C and E. Also, the Buddhus knew or should have known that the positions taken in the returns they prepared and filed for customers were unrealistic, frivolous and without a reasonable basis.

The Government has sufficiently established that Deowraj Buddhu and Sunita Buddhu violated 26 U.S.C. § 6694(b) because their understatement of their customers' tax liabilities was willful or due to reckless or intentional disregard of internal revenue rules and regulations.

The Buddhus also failed to provide a correct identifying number on the returns that they prepared that would secure their proper identification as the tax return preparer.

Deowraj Buddhu and Sunita Buddhu have engaged in fraudulent or deceptive conduct that substantially interfered with the administration of the internal revenue laws by inflating or fabricating deductions on Schedules A, C and E. Sunita Buddhu also wrote letters on behalf of her clients for submission to the Internal Revenue Service that assert that the Internal Revenue Service has no authority to conduct an examination of her clients' tax returns.

Deowraj Buddhu and Sunita Buddhu's continual, repeated violations of 26 U.S.C. §§ 6694 and 6695 and their fraudulent, deceptive conduct fall within the provisions of 26 U.S.C. 7407(b)(1)(A) and (D), and are subject to injunction under § 7407. A narrow injunction prohibiting only specific misconduct would not prevent their continued interference with the proper administration of the internal revenue laws.

The Second Circuit has identified several factors a court may evaluate to determine the appropriateness of a permanent injunction. See SEC v. Manor Nursing Ctrs., Inc., 458 F.2d 1082, 1100 (2d Cir. 1972) ("The critical question for a district court in deciding whether to issue a permanent injunction in view of past violations is whether there is a reasonable likelihood that the wrong will be repeated."). Factors to be considered in assessing the probability of future infractions include: (1) the degree of scienter involved, (2) the isolated or recurring nature of the fraudulent activity, (3) the defendant's appreciation of his wrongdoing, and (4) the defendant's opportunities to commit future violations." S.E.C. v. Softpoint, Inc., 958 F. Supp. 846 (S.D.N.Y. 1997); S.E.C. v. Commonwealth Chemical Securities, Inc., 574 F.2d 90 (2d Cir. 1978); see also United States v. Broccolo, No. 06-cv-2812, 2006 WL 3690648 (evaluating the factors in the context of a preliminary injunction under 26 U.S.C. § 7407).

In this case, the enumerated factors support injunctive relief. First, even though the Buddhus may have believed that the IRS is not authorized to collect taxes, they knew their tax preparations on behalf of their clients did not comport with the Internal Revenue Code. Second, the Buddhus' conduct was recurring in nature, as they filed thousands of tax returns for the tax years 2003-2007. Further, Sunita Buddhu continued to assist clients into 2008, after this lawsuit was filed and while she was under criminal investigation. Third, the Buddhus do not appear to appreciate their wrongdoing and continue to dispute the IRS's authority to collect taxes. Finally, if the Court does not issue an injunction, nothing will stop the Buddhus from committing further violations. An injunction permanently barring Deowraj Buddhu and Sunita Buddhu from acting as tax return preparers or providing tax advice to others is warranted.



C. Internal Revenue Code § 7408

Section 7408 of the Internal Revenue Code authorizes a district court to enjoin a person from engaging in conduct subject to penalty under 26 U.S.C. § 6701 if injunctive relief is appropriate to prevent recurrence of that conduct. 26 U.S.C. § 7408(b) & (c)(1).

Section 6701 imposes a penalty on any person who aids or assists in, procures or advises with respect to the preparation or presentation of a federal tax return, refund claim, or other document knowing (or having reason to believe) that is will be used in connection with any material matter arising under the internal revenue laws and that if it is so used it would result in an understatement of another person's tax liability. 26 U.S.C. § 6701(a).

The Government has presented strong evidence that Deowraj Buddhu and Sunita Buddhu knowingly inflated and fabricated deductions on their customers' federal income tax returns. They have engaged in conduct that is subject to penalty under § 6701, and an injunction under 26 U.S.C. § 7408 is appropriate to prevent them from engaging in such conduct in the future.



D. Internal Revenue Code § 7402(a)

Section 7402(a) of the Internal Revenue Code authorizes a court to issue injunctions as may be necessary or appropriate for the enforcement of the internal revenue laws, even if the United States has other remedies available for enforcing the internal revenue laws. The standard for granting a permanent injunction is the same as that for a preliminary injunction, except that the moving party must demonstrate actual, rather than likely, success on the merits of its claim. See Amoco Prod. Co. v. Vill. of Gambell, Alaska, 480 U.S. 531, 546 n. 12 (1987).

The Court finds the United States has presented persuasive evidence that it, the public, and the Buddhus' clients will suffer irreparable harm if they are not enjoined. As discussed above, the United States has also presented sufficient evidence to succeed on the merits. Further, the United States has presented evidence that the public interest will be served by granting this injunction. While the Buddhus will be denied the right to earn a livelihood preparing income tax returns, the harm to them is substantially outweighed by the harm to which their clients are subjected by having fraudulent tax returns prepared in their names. The Court therefore finds an injunction is also appropriate under 26 U.S.C. § 7402.



III. Conclusion

The Government's motion for a permanent injunction against Deowraj Buddhu and Sunita Buddhu [Dkt. # 54] is GRANTED. Deowraj Buddhu and Sunita Buddhu shall be and are hereby precluded from:


1. preparing federal income tax returns, amended federal income tax returns and other related documents and forms for others;



2. representing customers before the Internal Revenue Service;



3. advising, assisting, counseling, or instructing anyone about the preparation of a federal tax return;



4. owning, managing, controlling, working for, or volunteering for a tax-return-preparation business; and



5. from promoting tax-fraud schemes.


The defendants' motion to dismiss the Government's motion for a permanent injunction [Dkt. # 56] is DENIED. The Government's motion for a preliminary injunction against Deowraj Buddhu [Dkt. # 53] is DENIED as moot in light of the permanent injunction.

SO ORDERED this 12th day of May 2009, at Hartford, Connecticut.

1 The following findings of fact are based on the April 2, 2008 Declaration of Supervisory Tax Specialist Lucille Jessey; Jessey's May 1, 2008 Declaration; Jessey's November 13, 2008 Declaration; testimony by Jessey; testimony by Richard Ferrara, Danielle Andrews, and Elestine Nicholson (three of the Buddhus' former clients); testimony by Diana Leyden (counsel for Ferrara and other former clients of the Buddhus); testimony by Cookie Newell Young (former Internal Revenue Service employee and enrolled agent who assisted ten of the Buddhus' former clients); and the documents filed with the Court by the Buddhus. The Buddhus chose not to testify at the evidentiary hearings and did not submit evidence challenging the factual assertions made by the Government's witnesses (beyond cross examining these witnesses at the evidentiary hearings).

2 The Government did not at that time seek a preliminary injunction against Deowraj Buddhu because he was incarcerated. Deowraj is currently out of state custody and the Government has moved for a preliminary injunction against him, which the Court now denies as moot in light of the permanent injunction.

3 Schedule C is used to report profit or loss from a sole proprietorship.

4 Schedule E is used to report supplemental income and loss including income and loss from rental real estate, royalties, partnerships, S corporations, estates, or trusts.

5 The Buddhus maintain that all information included on returns prepared by them was provided by their clients. However, the Buddhus admit that they "explained to the clients that they are only required to pay Social Security and Medicare tax under Subtitle C and no income tax under Subtitle A, because they do not live and work in a foreign country and they were not non-resident aliens."

6 Schedule A is used to itemize deductions, including employee expenses.

7 The Buddhus argue that the IRS is not authorized to collect taxes on the wage-based income of United States citizens residing in Connecticut. Because it is beyond cavil that the IRS has such authority, the Court will not address each of the Buddhus' arguments on this point, although it has considered each argument.

Treasry (Green Book) 2010 Fiscal Year Tax Proposals

Treasury Department General Explanations of the Administration's Fiscal Year 2010 Revenue Proposals (Green Book)

May 12, 2009

Treasury Department : Treasury Green Book : Fiscal year 2010 : Revenue proposals : General explanations .


General Explanations of the Administration's Fiscal Year 2010 Revenue Proposals

Department of the Treasury

May 2009

This document is available in Adobe Acrobat format on the Internet at: http://www.treas.gov/offices/tax-policy/library/grnbk09.pdf

The free Adobe Acrobat Reader is available at: http://get.adobe.com/reader/


Table of Contents 1


TAX CUTS FOR FAMILIES AND INDIVIDUALS
Provide the "Making Work Pay" Credit

Expand the Earned Income Tax Credit (EITC): Provide Marriage Penalty Relief and Enhamced Benefits for Larger Families

Expand the Refundability of the Child Tax Credit: Make Permanent the $3,000 Earnings Threshold and Eliminate Indexing

Expand the Saver's Credit and Provide for Automatic Enrollment in IRAs

Provide the American Opportunity Tax Credit

TAX CUTS FOR BUSINESS
Eliminate Capital Gains Taxation on Investments in Small Business Stock

Make the Research & Experimentation (R&E) Tax Credit Permanent

Expand Net Operating Loss Carryback

MODIFY FEDERAL AVIATION ADMINISTRATION FINANCING

CONTINUE CERTAIN EXPIRING PROVISIONS THROUGH CALENDAR YEAR 2010

OTHER REVENUE CHANGES AND LOOPHOLE CLOSERS
Reinstate Superfund Excise Taxes

Reinstate Superfund Environmental Income Tax

Tax Carried (Profit) Interests as Ordinary Income

Codify "Economic Substance" Doctrine

Repeal the Last-In, First-Out (LIFO) Method of Accounting for Inventories

Reform U.S. International Tax System

Reform Business Entity Classification Rules for Foreign Entities

Defer Deduction of Expenses, Except R&E Expenses, Related to Deferred Income

Reform Foreign Tax Credit: Determine the Foreign Tax Credit on a Pooling Basis

Reform Foreign Tax Credit: Prevent Splitting of Foreign Income and Foreign Taxes

Limit Shifting of Income Through Intangible Property Transfers

Limit Earnings Stripping by Expatriated Entities

Prevent Repatriation of Earnings in Certain Cross-Border Reorganizations

Repeal 80/20 Company Rules

Prevent the Avoidance of Dividend Withholding Taxes

Modify the Tax Rules for Dual Capacity Taxpayers

Combat Under-Reporting of Income Through Use of Accounts and Entities in Offshore Jurisdictions

Require Greater Reporting by Qualified Intermediaries Regarding U.S. Account Holders

Require Withholding on Payments of FDAP Income Made Through Nonqualified Intermediaries

Require Withholding on Gross Proceeds Paid to Certain Nonqualified Intermediaries

Require Reporting of Certain Transfers of Money or Property to Foreign Financial Accounts

Require Disclosure of FBAR Accounts to be Filed with Tax Return

Require Third-Party Information Reporting Regarding the Transfer of Assets to Foreign Financial Accounts and the Establishment of Foreign Financial Accounts

Require Third-Party Information Reporting Regarding the Establishment of Offshore Entities

Negative Presumption for Foreign Accounts with Respect to Which an FBAR has not Been Filed

Negative Presumption Regarding Failure to File an FBAR For Accounts with Nonqualified Intermediaries

Negative Presumption Regarding Withholding on FDAP Payments to Certain Foreign Entities

Extend Statute of Limitations for Certain Reportable Cross-Border Transactions and Foreign Entities

Double Accuracy-Related Penalties on Understatements Involving Undisclosed Foreign Accounts

Improve the Foreign Trust Reporting Penalty

Require Information Reporting for Rental Property Expense Paymentss

Eliminate Oil and Gas Company Preferences

Levy Tax on Certain Offshore Oil and Gas Production

Repeal Credit for Enhanced Oil Recovery (EOR) Projects

Repeal Credit for Production from Marginal Wells

Repeal Expensing of Intangible Drilling Costs

Repeal Deduction for Tertiary Injectants

Repeal Passive Loss Exception for Working Interests in Oil and Gas Properties

Repeal Percentage Depletion

Repeal Domestic Manufacturing Deduction for Oil and Gas Production

Increase the Amortization Period for Geological and Geophysical Costs to Seven Years

Eliminate the Advanced Earned Income Tax Credit

UPPER-INCOME TAX PROVISIONS DEDICATED TO DEFICIT REDUCTION
Reinstate the 39.6-Percent Rate

Reinstate the 36-Percent Rate for Taxpayers with Income Over $250,000 (Married Filing a Joint Return) and $200,000 (Single)

Reinstate the Limitation on Itemized Deductions for Taxpayers with Income Over $250,000 (Married Filing a Joint Return) and $200,000 (Single)

Reinstate the Personal Exemption Phase-Out (PEP) for Taxpayers with Income Over $250,000 (Married Filing a Joint Return) and $200,000 (Single)

Impose a 20-Percent Rate on Dividends and Capital Gains for Taxpayers with Income Over $250,000 (Married Filing a Joint Return) and $200,000 (Single)

USER FEES
Preserve Cost-Sharing of Inland Waterways Capital Costs

OTHER INITIATIVES
Implement Unemployment Insurance Integrity Legislation

Restructure Assistance to New York City

Provide Tax Incentives for Transportation Infrastructure

Levy Payments to Federal Contractors with Delinquent Tax Debt

Improve Debt Collection Adminstrative Procedures

Increase Levy Authority to 100 Percent for Vendor Payments

REVENUES DEDICATED TO THE HEALTH REFORM RESERVE FUND
Limit the Tax Rate at Which Itemized Deductions Reduce Tax Liability to 28 Percent

REDUCE THE TAX GAP AND MAKE REFORMS

Expand Information Reporting

Require Information Reporting for Private Separate Accounts of Life Insurance Companies

Require Information Reporting on Payments to Corporations

Require a Certified Taxpayer Identification Number From Contractors and Allow Certain Withholding

Require Increased Information Reporting for Certain Government Payments for Property and Services

Increase Information Return Penalties

Improve Compliance by Business

Require E-Filing by Certain Large Organizations

Implement Standards Clarifying When Employee Leasing Companies can be Held Liable for Their Clients' Federal Employment Taxes

Strengthen Tax Administratio

Allow Assessment of Criminal Restitution as Tax

Revise Offer-In-Compromise Application Rules

Expand IRS Access to Information in the National Directory of New Hires for Tax Administration Purposes

Make Repeated Willful Failure to File a Tax Return a Felony

Facilitate Tax Compliance with Local Jurisdictions

Extension of Statute of Limitations where State Tax Adjustment Affects Federal Tax Liability

Improve Investigative Disclosure Statute

Expand Required Electronic Filing by Tax Return Preparers

Expand Penalties

Clarify that the Bad Check Penalty Applies to Electronic Checks and Other Payment Forms

Impose a Penalty on Failure to Comply with Electronic Filing Requirements

Make Reforms to Close Tax Loopholes

Financial Institutions and Products

Require Accrual of Income on Forward Sale of Corporate Stock

Require Ordinary Treatment for Certain Dealers of Equity Options and Commodities

Modify Definition of Control for Purposes of the Section 249 Deduction Limit

Insurance Companies and Products

Modify Rules that Apply to Sales of Life Insurance Contracts

Modify Dividends-Received Deduction for Life Insurance Company Separate Accounts

Expand Pro Rata Interest Expense Disallowance for Corporate-Owned Life Insurance (COLI)

Tax Accounting Methods

Deny Deduction for Punitive Damages

Repeal Lower-Of-Cost-Or-Market Inventory Accounting Method

Modify Estate and Gift Tax Valuation Discounts and Make Other Reforms

Require Consistency in Value for Transfer and Income Tax Purposes

Modify Rules on Valuation Discounts

Require Minimum Term for Grantor Retained Annuity Trusts (GRATs)

Modify Alternative Fuel Mixture Credit

APPENDIX: EXTENDING CURRENT POLICIES

TABLES OF REVENUE ESTIMATES


TAX CUTS FOR FAMILIES AND INDIVIDUALS




PROVIDE THE "MAKING WORK PAY" CREDIT



Current Law

In 2009 and 2010, individual taxpayers are eligible for a refundable tax credit of 6.2 percent of earned income up to a maximum credit of $400 ($800 for joint filers). Thus, workers receive a credit on the first $8,065 of earned income ($16,130 for joint filers). The credit phases out at a rate of 2 percent for taxpayers with modified adjusted gross income in excess of $75,000 ($150,000 for joint filers). Dependent filers are not eligible for the credit. Neither the maximum credit amount nor the beginning of the phase-out range is indexed for inflation.

The IRS withholding schedules are modified to reflect the Making Work Pay (MWP) credit, with reconciliation of overwithholding and underwithholding on annual income tax returns.



Reasons for Change

The MWP credit partially offsets the regressivity of the Social Security payroll tax. It effectively raises the income of workers eligible for the credit, which encourages individuals to enter the labor force. Permanency and indexing the beginning of the phase-out range for inflation would ensure that workers continue to receive some of the benefits of the credit and low-income workers continue to receive a work incentive. In addition, the MWP credit could be extended to more people by raising the phase-out range.

The MWP credit contributes to the high marginal tax rates faced by workers in the phase-out range. Lowering the phase-out rate would produce fewer distortions.



Proposal

The proposal would make the MWP credit permanent and index the beginning of the phase-out range for inflation. In addition, the phase-out rate would be reduced to 1.6 percent.

The proposal is effective for tax years beginning after December 31, 2010.



EXPAND THE EARNED INCOME TAX CREDIT (EITC): PROVIDE MARRIAGE PENALTY RELIEF AND ENHANCED BENEFITS FOR LARGER FAMILIES



Current Law

Low and moderate-income workers may be eligible for a refundable earned income tax credit (EITC). Eligibility for the EITC is based on the presence and number of qualifying children in the worker's household, adjusted gross income (AGI), earned income, investment income, filing status, age, and immigration and work status in the United States. The amount of the EITC is based on the presence and number of qualifying children in the worker's household, AGI, earned income, and filing status.

The EITC has a phase-in range (where each additional dollar of earned income results in a larger credit), a maximum range (where additional dollars earned or AGI have no effect on the size of the credit), and a phase-out range (where each additional dollar of the larger of earned income or AGI results in a smaller total credit). The EITC for childless workers is much smaller and phases out at a lower income level than does the EITC for workers with qualifying children. The EITC is larger for workers with more qualifying children, reaching a maximum amount at three qualifying children. The phase-out range for joint filers begins at a higher income level than for an individual with the same number of qualifying children who files as a single filer or as a head of household. The width of the phase-in range and the beginning of the phase-out range are indexed for inflation. Hence, the maximum amount of the credit and the end of the phase-out range are effectively indexed. The following chart summarizes the EITC for 2009.


_____________________________________________________________________________________
Childless
Taxpayers Taxpayers with Qualifying Children


___________________________________________________
One Child Two Children Three or More

_____________________________________________________________________________________
Phase-in rate 7.65% 34.00% 40.00% 45.00%

_____________________________________________________________________________________
Minimum earnings $5,970 $8,950 $12,570 $12,570
for maximum
credit

_____________________________________________________________________________________
Maximum credit $457 $3,043 $5,028 $5,657

_____________________________________________________________________________________
Phase-out rate 7.65% 15.98% 21.06% 21.06%

_____________________________________________________________________________________
Phase-out begins $7,470 ($12,470 $16,420 ($21,420 $16,420 ($21,420 $16,420 ($21,420
joint) joint) joint) joint)

_____________________________________________________________________________________
Phase-out ends $13,440 ($18,440 $35,463 ($40,463 $40,295 ($45,295 $43,279 ($48,279
joint) joint) joint) joint)

_____________________________________________________________________________________


To be eligible for the EITC, workers may have a maximum of $3,100 of investment income. (This amount is indexed for inflation.)

In 2009 and 2010, the beginning of the phase-out range for joint filers is $5,000 higher than for other filers. (The amount will be indexed in 2010.) Under current law, beginning in 2011 the EITC for workers with the same number of qualifying children will phase-out over the same income range regardless of filing status. Under the assumption that certain provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) are made permanent, the additional $5,000 for married filers will revert in 2011 to $3,000 indexed from 2007.

In 2009 and 2010, the EITC phases in at a faster rate for workers with three or more qualifying children than for workers with two qualifying children (45 and 40 percent, respectively). The accelerated phase-in rate results in a higher credit and a longer phase-out range. This provision expires after 2010, at which point workers with three or more qualifying children will receive the same EITC as similarly situated workers with two qualifying children.



Reasons for Change

The beginning of the phase-out range for joint filers is higher than for other workers with the same number of qualifying children in order to reduce the "EITC marriage penalty." This marriage penalty occurs because the income of both spouses is counted toward eligibility for joint filers, but the income of only the "head of household" filer is considered if the individuals are not married. Extending marriage penalty relief improves fairness and removes financial impediments to marriage for some low-income households.

Families with many children face larger expenses related to raising their children than do smaller families and as a result have higher poverty rates. The steeper phase-in rate and larger maximum credit for workers with three or more qualifying children helps them meet their expenses while maintaining work incentives.



Proposal

The proposal would make permanent the $5,000 (indexed) increase in the beginning of the phase-out range for joint filers relative to other individuals.

Furthermore, the proposal would make permanent the expansion of the EITC for workers with three or more qualifying children. Specifically, the phase-in rate of the EITC for workers with three or more qualifying children under the American Recovery and Reinvestment Act of 2009 (ARRA) would be maintained at 45 percent, resulting in a higher maximum credit amount and longer phase-out range.

The proposal would be effective for tax years beginning after December 31, 2010.



EXPAND THE REFUNDABILITY OF THE CHILD TAX CREDIT: MAKE PERMANENT THE $3,000 EARNINGS THRESHOLD AND ELIMINATE INDEXING



Current Law

An individual may claim a $1,000 tax credit for each qualifying child. A qualifying child must meet the following four tests:
(1) Relationship - The child generally must be the taxpayer's son, daughter, grandchild, sibling, niece, nephew, or foster child.

(2) Residence - The child must live with the taxpayer in the same principal place of abode for over half the year.

(3) Support - The child must not have provided more than half of his or her own support.

(4) Age - The child must be under the age of 17.

For purposes of the child tax credit, a qualifying child must be a citizen, national, or resident of the United States. The child tax credit is phased out for individuals with income over certain thresholds, 1 and is partially refundable.

In 2009 and 2010, individuals may be eligible for a refundable amount (the additional child tax credit) equal to the lesser of 15 percent of earned income in excess of $3,000 and any child credit unclaimed due to insufficient tax liability. 2 Under the assumption that certain provisions of EGTRRA are made permanent, in 2011 the earned income threshold reverts to an amount indexed from $10,000 in 2000.

Families with three or more children may determine the additional child tax credit using an alternative formula based on the extent to which a taxpayer's social security taxes exceed the taxpayer's EITC.



Reasons for Change

Because the wages of low-income families have failed to keep up with inflation, continued indexing will result in a decreasing number of low-income families able to take advantage of the credit each year and smaller credits for the families who receive the credit.

Furthermore, if the threshold increases to $12,700 in 2011 as scheduled, an estimated 11 million low-income families would have a tax increase as a result.



Proposal

The proposal would make permanent the $3,000 earnings threshold for refundability of the child credit. In addition the earnings threshold would no longer be indexed for inflation.

The proposal would be effective for tax years beginning after December 31, 2010.



EXPAND THE SAVER'S CREDIT AND PROVIDE FOR AUTOMATIC ENROLLMENT IN IRAS



Expand the Saver's Credit



Current Law

A nonrefundable tax credit is available for eligible individuals who make voluntary contributions to 401(k) plans and other retirement plans, including IRAs. The maximum annual contribution eligible for the credit is $4,000 for married couples filing jointly and $2,000 for single taxpayers or married individuals filing separately, resulting in maximum credits of $2,000 and $1,000, respectively. The credit rate is 10 percent, 20 percent or 50-percent, depending on the taxpayer's adjusted gross income (AGI) (the amount of which is adjusted each calendar year based on the cost-of-living adjustment). In 2009, "eligible individuals" who may claim the credit are
 Married couples filing jointly with incomes up to $55,500;

 Heads of households with incomes up to $41,625; and

 Married individuals filing separately and singles with incomes up to $27,750,

who are 18 or older, other than individuals who are full-time students or claimed as a dependent on another taxpayer's return.

The credit is available with respect to an eligible individual's "qualified retirement savings contributions." These include (i) elective deferrals to a section 401(k) plan, section 403(b) plan, section 457 plan, SIMPLE, or simplified employee pension (SEP); (ii) contributions to a traditional or Roth IRA; and (iii) other voluntary employee contributions to a qualified retirement plan, including voluntary after-tax contributions and voluntary contributions to a defined benefit pension plan. The eligible individual may direct that the amount of any refund attributable to the credit may be directly deposited by the IRS into an IRA or certain other accounts.

The credit is nonrefundable and, therefore, offsets regular tax liability or minimum tax liability. The credit is in addition to any deduction or exclusion that would otherwise apply with respect to the contribution.



Reason for Change

The saver's credit should be amended to more effectively encourage moderate- and lower-income individuals to save for retirement. Because it is currently nonrefundable, the saver's credit only offsets a taxpayer's income tax liability and therefore gives no saving incentive to tens of millions of households without income tax liability. In addition, the current three-tier credit rate structure should be simplified, the eligibility income threshold should be raised to increase the number of households eligible for the credit, and the credit rate should be increased for most eligible households. Finally, making the saver's credit more like a matching contribution would enhance the likelihood that the credit would be saved and would increase the salience of the incentive by framing it as a match similar to the familiar employer matching contributions to 401(k) plans.



Proposal

The proposal would make the saver's credit fully refundable and would provide for the credit to be deposited automatically in the qualified retirement plan account or IRA to which the eligible individual contributed. Making the saver's credit more like a matching contribution would enhance the likelihood that the credit would be saved and would increase the salience of the incentive by framing it as a match similar to the familiar employer matching contributions to 401(k) plans. The proposal would offer a meaningful saving incentive to tens of millions of additional households while simplifying the current three-tier credit structure and raising the eligibility income threshold to cover millions of additional moderate-income taxpayers.

In place of the current 10-percent/20-percent/50-percent credit for qualified retirement savings contributions up to $2,000 per individual, the proposal would match 50-percent of such contributions up to $500 per individual (indexed annually for inflation beginning in taxable year 2011). The eligibility income threshold would be increased to $65,000 for married couples filing jointly, $48,750 for heads of households, and $32,500 for singles and married individuals filing separately, with the amount of savings eligible for the credit phased out at a 5-percent rate for AGI exceeding those levels.

The proposal would be effective December 31, 2010.



Automatic Enrollment in IRAS



Current Law

A number of tax-preferred, employer-sponsored retirement savings programs exist under current law. These include section 401(k) cash or deferred arrangements, section 403(b) programs for public schools and charitable organizations, section 457 plans for governments and nonprofit organizations, and simplified employee pensions and SIMPLE IRAs for small employers. Individuals who do not have access to an employer-sponsored retirement saving arrangement may be eligible to make smaller tax-favored contributions to individual retirement accounts or individual retirement annuities (IRAs).

IRA contributions are limited to $5,000 a year (plus $1,000 for those age 50 or older). Section 401(k) plans permit contributions (employee plus employer contributions) of up to $49,000 a year (of which $16,500 can be pre-tax employee contributions) plus $5,500 of additional pre-tax employee contributions for those age 50 or older.



Reasons for Change

For many years, until the current recession, the personal saving rate in the United States has been exceedingly low. In addition, tens of millions of U.S. households have not placed themselves on a path to become financially prepared for retirement, and the proportion of U.S. workers participating in employer-sponsored plans has remained stagnant for decades at no more than about half the total work force notwithstanding repeated private-sector and congressional attempts to expand coverage. Participation in employer-sponsored retirement saving plans such as 401(k) plans typically has ranged from two thirds to three quarters of eligible employees, but making saving easier by making it automatic has been shown to be remarkably effective at boosting participation. Automatic enrollment in 401(k) plans (enrolling employees by default unless they opt out) has tended to increase participation to more than 9 out of 10 eligible employees. In contrast, for workers who lack access to a retirement plan at their workplace and are eligible to engage in tax-favored retirement saving by taking the initiative and making the decisions required to establish and contribute to an IRA, the IRA participation rate tends to be less than 1 out of 10.

Numerous employers, especially those with smaller or lower-wage work forces, have been reluctant to adopt a retirement plan for their employees, in part out of concern about their ability to afford the cost of making employer contributions or the per-capita cost of complying with tax-qualification or ERISA (Employee Retirement Income Security Act) requirements. These employers could help their employees save --without employer contributions or plan qualification or ERISA compliance --simply by making their payroll systems available as a conduit for regularly transmitting employee contributions to an employee's IRA. Such "payroll deduction IRAs" could build on the success of workplace-based payroll-deduction saving by using the excess capacity to promote saving that is inherent in employer payroll systems, especially those that use automatic enrollment. However, despite efforts a decade ago by Treasury, the IRS, and the Department of Labor to approve and promote the option of payroll deduction IRAs, few employers have adopted them or even are aware that this option exists.

Accordingly, requiring employers that do not sponsor any retirement plan (and that are above a certain size) to make their payroll system available to employees and automatically enroll them in IRAs could achieve a major breakthrough in retirement saving coverage. Many employers may then be more willing to take the next step and adopt an employer plan (permitting much greater tax-favored employee contributions than an IRA plus the option of employer contributions). In addition, the process of saving and choosing investments could be simplified for employees, and costs minimized, through a standard default investment as well as electronic information and fund transfers. Workplace retirement savings arrangements made accessible to most workers also could be used as a platform to provide and promote retirement distributions annuitized over the worker's lifetime.



Proposal

Employers in business for at least two years that have 10 or more employees would be required to offer an automatic IRA option to employees on a payroll-deduction basis, under which regular payroll-deduction contributions would be made to an IRA. If the employer sponsored a qualified retirement plan or SIMPLE for its employees, it would not be required to provide an automatic IRA option for any employee. Thus, for example, a qualified plan sponsor would not have to offer automatic IRAs to employees it excludes from qualified plan eligibility because they are collectively bargained, under age 18, nonresident aliens, or have not completed the plan's eligibility waiting period. However, if the qualified plan excluded from eligibility a portion of the employer's work force or a class of employees such as all employees of a subsidiary or division, the employer would be required to offer the automatic IRA option to those excluded employees.

The employer offering automatic IRAs would give employees a standard notice and election form informing them of the automatic IRA option and allowing them to elect to participate or opt out. Any employee who did not provide a written participation election would be enrolled at a default rate of three percent of the employee's compensation. Employees could opt for a lower or higher contribution rate up to the IRA dollar limits. For most employees, the payroll deductions would be made by direct deposit similar to the direct deposit of employees' paychecks to their accounts at financial institutions.

Payroll-deduction contributions from all participating employees could be transferred, at the employer's option, to a single private-sector IRA trustee or custodian designated by the employer. Alternatively, the employer, if it preferred, could allow each participating employee to designate the IRA provider for that employee's contributions or could designate that all contributions would be forwarded to a savings vehicle specified by statute or regulation.

Employers making payroll deduction IRAs available would not have to choose or arrange default investments. Instead, a low-cost, standard type of default investment and a handful of standard, low-cost investment alternatives would be prescribed by statute or regulation. In addition, this approach would involve no employer contributions, no employer compliance with qualified plan requirements, and no employer liability or responsibility for determining employee eligibility to make tax-favored IRA contributions or for opening IRAs for employees. A national web site would provide information and basic educational material regarding saving and investing for retirement, including IRA eligibility, but, as under current law, individuals (not employers) would bear ultimate responsibility for determining their IRA eligibility.

Employers could claim a temporary tax credit for making automatic payroll-deposit IRAs available to employees. The amount of the credit would be $25 per enrolled employee up to $250 each year for two years. The credit would be available both to employers required to offer automatic IRAs and employers not required to do so (for example, because they have fewer than ten employees).

Contributions by employees to automatic IRAs would qualify for the saver's credit (to the extent the contributor and the contributions otherwise qualified), and the proposed expanded saver's credit would be deposited to the IRA to which the eligible individual contributed.

The proposal would become effective January 1, 2012.



PROVIDE THE AMERICAN OPPORTUNITY TAX CREDIT



Current Law

Prior to ARRA an individual taxpayer could claim a nonrefundable Hope Scholarship credit for 100 percent of the first $1,200 and 50-percent of the next $1,200 in qualified tuition and related expenses (for a maximum credit of $1,800) per student. The Hope Scholarship credit was limited to the first two years of postsecondary education.

Alternatively, a taxpayer could claim a nonrefundable Lifetime Learning Credit (LLC) for 20 percent of up to $10,000 in qualified tuition and related expenses (for a maximum credit of $2,000) per taxpayer. Both the Hope Scholarship credit and LLC were phased out in 2009 between $50,000 and $60,000 of adjusted gross income ($100,000 and $120,000 if married filing jointly). In addition, through 2009, a taxpayer could claim an above-the-line deduction for qualified tuition and related expenses. The maximum amount of the deduction was $4,000.

ARRA created the American Opportunity Tax Credit (AOTC) to replace the Hope Scholarship Credit for taxable years 2009 and 2010. The new tax credit is partially refundable, has a higher maximum credit amount, is available for the first four years of postsecondary education, and has higher phase-out limits.

The AOTC equals 100 percent of the first $2,000 plus 25 percent of the next $2,000 of qualified tuition and related expenses (for a maximum credit of $2,500). Under ARRA, the definition of related expenses for both the LLC and the AOTC was expanded to include course materials. Forty percent of the otherwise allowable AOTC is refundable (for a maximum refundable credit of $1,000). The credit is available for the first four years of postsecondary education. The credit phases out for taxpayers with adjusted gross income between $80,000 and $90,000 ($160,000 and $180,000 if married filing jointly).

All other aspects of the Hope Scholarship credit are retained under the AOTC. These include the requirement that AOTC recipients be enrolled at least half-time.



Reasons for Change

The AOTC makes college more affordable for millions of middle-income families and for the first time makes college tax incentives partially refundable. If college is not made more affordable, our nation runs the risk of losing a whole generation of potential and productivity.

Making the AOTC partially refundable increases the likelihood that low-income families will send their children to college. Under prior law, low-income families (those without sufficient tax liability) could not benefit from the Hope Scholarship credit because it was not refundable. Under the proposal, low-income families could benefit from both Federal Pell Grants and the refundable portion of the AOTC. In combination, these grants and credits would cover all tuition and fees at an average 2-year public college and about half of tuition and fees at an average 4-year public college.

Moreover, the new credit applies to the first four years of college, instead of only the first two years of college, increasing the likelihood that students will stay in school and attain their degrees. More years of schooling translates into higher future incomes for students and a more educated work force for the country.

Finally, the higher phase-out thresholds under the AOTC give targeted tax relief to an even greater number of middle-income families facing the high costs of college.



Proposal

The proposal would make the AOTC a permanent replacement for the Hope Scholarship credit. To preserve the value of the AOTC, the proposal would index the $2,000 tuition and expense amounts, as well as the phase-out thresholds, for inflation.

This proposal would be effective for taxable years beginning after December 31, 2010.


TAX CUTS FOR BUSINESS




ELIMINATE CAPITAL GAINS TAXATION ON INVESTMENTS IN SMALL BUSINESS STOCK



Current Law

Taxpayers other than corporations may exclude 50-percent (60 percent for certain empowerment zone businesses) of the gain from the sale of certain small business stock acquired at original issue and held for at least five years. Under ARRA the exclusion is increased to 75 percent for stock acquired in 2009 (after February 17, 2009) and in 2010. The taxable portion of the gain is taxed at a maximum rate of 28 percent. Under current law, 7 percent of the excluded gain is a tax preference subject to the alternative minimum tax (AMT). The AMT preference is scheduled to increase to 28 percent of the excluded gain on eligible stock acquired after December 31, 2000 and to 42 percent of the excluded gain on stock acquired on or before that date.

The amount of gain eligible for the exclusion by a taxpayer with respect to any corporation during any year is the greater of (1) ten times the taxpayer's basis in stock issued by the corporation and disposed of during the year, or (2) $10 million reduced by gain excluded in prior years on dispositions of the corporation's stock. To qualify as a small business, the corporation, when the stock is issued, may not have gross assets exceeding $50 million (including the proceeds of the newly issued stock) and may not be an S corporation.

The corporation also must meet certain active trade or business requirements. For example, the corporation must be engaged in a trade or business other than: one involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services or any other trade or business where the principal asset of the trade or business is the reputation or skill of one or more employees; a banking, insurance, financing, leasing, investing or similar business; a farming business; a business involving production or extraction of items subject to depletion; or a hotel, motel, restaurant or similar business. There are limits on the amount of real property that may be held by a qualified small business, and ownership of, dealing in, or renting real property is not treated as an active trade or business.



Reasons for Change

Because the taxable portion of gain from the sale of qualified small business stock is subject to tax at a maximum of 28 percent and a percentage of the excluded gain is a preference under the AMT, the current 50-percent provision provides little benefit. Increasing the exclusion would encourage and reward new investment in qualified small business stock.



Proposal

Under the proposal the percentage exclusion for qualified small business stock sold by an individual or other non-corporate taxpayer would be increased to 100 percent and the AMT preference item for gain excluded under this provision would be eliminated. The stock would have to be held for at least five years and other provisions applying to the section 1202 exclusion would also apply. The proposal would include additional documentation requirements to assure compliance with the statute.

The proposal would be effective for qualified small business stock issued after February 17, 2009.



MAKE THE RESEARCH & EXPERIMENTATION (R&E) TAX CREDIT PERMANENT



Current Law

The research and experimentation (R&E) tax credit is 20 percent of qualified research expenses above a base amount. The base amount is the product of the taxpayer's "fixed base percentage" and the average of the taxpayer's gross receipts for the four preceding years. The taxpayer's fixed base percentage generally is the ratio of its research expenses to gross receipts for the 1984-88 period. The base amount cannot be less than 50-percent of the taxpayer's qualified research expenses for the taxable year. Taxpayers can elect the alternative simplified research credit (ASC), which is equal to 14 percent of qualified research expenses that exceed 50-percent of the average qualified research expenses for the three preceding taxable years. Under the ASC, the rate is reduced to 6 percent if a taxpayer has no qualified research expenses in any one of the three preceding taxable years. An election to use the ASC applies to all succeeding taxable years unless revoked with the consent of the Secretary.

The R&E tax credit also provides a credit for 20 percent of basic research payments in excess of a base amount and payments to an energy research consortium for energy research. The credit for energy research applies to all qualified expenditures, not solely those in excess of a base amount.

The R&E credit is scheduled to expire on December 31, 2009.



Reasons for Change

The R&E tax credit encourages technological developments that are an important component of economic growth. However, uncertainty about the future availability of the R&E tax credit diminishes the incentive effect of the credit because it is difficult for taxpayers to factor the credit into decisions to invest in research projects that will not be initiated and completed prior to the credit's expiration. To improve the credit's effectiveness, the R&E tax credit should be made permanent.



Proposal

The proposal would make the R&E credit permanent.



EXPAND NET OPERATING LOSS CARRYBACK



Current Law

A net operating loss (NOL) generally is the amount by which a taxpayer's business deductions exceed its gross income. For taxpayers other than certain eligible small businesses, an NOL may be carried back two years and carried forward 20 years to offset taxable income in such years. NOLs offset taxable income in the order of the taxable years to which the NOL may be carried. The AMT rules provide that a taxpayer's NOL deduction cannot reduce the taxpayer's alternative minimum taxable income (AMTI) by more than 90 percent of the AMTI.

Different rules apply with respect to NOLs arising in certain circumstances. A three-year carryback applies with respect to: (1) losses arising from casualty or theft losses of individuals, and (2) losses attributable to Presidentially declared disasters for taxpayers engaged in a farming business or a small business. A five-year carryback applies to: (1) farming losses (regardless of whether the loss was incurred in a Presidentially declared disaster area); (2) certain losses related to Hurricane Katrina, Gulf Opportunity Zone, and Midwestern Disaster Area; and (3) qualified disaster losses. Special rules also apply to real estate investment trusts (no carryback), specified liability losses (10-year carryback), and excess interest losses (no carryback to any year preceding a corporate equity reduction transaction). Additionally, a special rule applies to certain electric utility companies. In the case of a life insurance company, present law allows a deduction for the taxable year for operations loss carryovers and carrybacks in lieu of the deduction for NOLs allowed to other corporations. A life insurance company is permitted to treat a loss from operations for any taxable year as an operations loss carryback to each of the three taxable years preceding the loss year and an operations loss carryover to each of the 15 taxable years following the loss year. Special rules apply to new life insurance companies.

Most recently, the ARRA extended the carryback period for applicable 2008 NOLs to up to five years by certain eligible small businesses whose average annual gross receipts do not exceed $15,000,000.



Reasons for Change

The NOL carryback and carryover rules are designed to allow taxpayers to smooth out swings in business income (and Federal income taxes thereon) that result from business cycle fluctuations. The recent economic conditions have resulted in many taxpayers incurring significant financial losses. A temporary extension of the NOL carryback period provides taxpayers in all sectors of the economy that experience such losses with the ability to obtain refunds of income taxes paid in prior years. These refunds can be used to fund capital investment or other operating expenses.



Proposal

The Administration looks forward to working with the Congress to make a lengthened NOL carryback period available to more taxpayers.


MODIFY FEDERAL AVIATION ADMINISTRATION FINANCING




Current Law

The Airport and Airway Trust Fund is supported by taxes on air passenger transportation, domestic air freight transportation, and aviation fuel. The tax on domestic air passenger transportation is 7.5 percent of the amount paid for the transportation plus a segment fee of $3.60 per segment. The tax on international air transportation is $16.10 on each international arrival or departure. Both the segment fee and the international arrival and departure fee are adjusted annually for inflation. The tax on domestic air freight transportation is 6.25 percent of the amount paid for the transportation. The tax on aviation fuel, to the extent dedicated to the Airport and Airway Trust Fund, is 4.3 cents per gallon for kerosene used in commercial aviation, 21.8 cents per gallon for kerosene used in noncommercial (general) aviation, and 19.3 cents per gallon for aviation gasoline. The tax is generally imposed when the fuel is removed from a terminal.

The taxes that support the Airport and Airway Trust Fund expire on September 30, 2009. The taxes on air transportation do not apply to amounts paid after September 30, 2009. The taxes on aviation fuel do not apply to fuel removed from a terminal after September 30, 2009. The authority to make expenditures from the Trust Fund for airport and airway programs also expires on October 30, 2009.



Reasons for Change

The Federal Aviation Administration's (FAA's) financing system should be more cost based. The current excise tax system, to the extent based on taxes on the amount paid for air transportation, does not provide a direct relationship between the taxes paid by users and the air traffic control services provided by the FAA. The Administration believes that the FAA should move toward a model whereby FAA's funding is related to its costs, the financing burden is distributed more equitably, and funds are used to pay directly for services the users need.

To provide for necessary Federal airport and airway expenditures until a cost-based system is developed, the aviation excise taxes and the expenditure authority from the Airport and Airway Trust Fund should be temporarily extended.



Proposal

The taxes on air transportation and aviation fuel would be extended through September 30, 2011, at their current rates. Beginning October 1, 2011, the Budget assumes that the air traffic control system will be funded with direct charges levied on users of the system. The Budget reflects such a reform being in place starting in 2011, with a user charge collecting $9.6 billion in that year and with aviation excise taxes being commensurately reduced. Expenditure authority from the Airport and Airway Trust Fund would be extended through September 30, 2019.



CONTINUE CERTAIN EXPIRING PROVISIONS THROUGH CALENDAR YEAR 2010



Current Law

The existing tax code includes a number of provisions that are scheduled to expire before December 31, 2010. These provisions include the optional deduction for State and local general sales taxes, Subpart F "active financing" and "look-through" exceptions, the exclusion from unrelated business income of certain payments to controlling exempt organizations, the new markets tax credit, the modified recovery period for qualified leasehold improvements and qualified restaurant property, incentives for empowerment and community renewal zones, credits for biodiesel and renewable diesel fuels, and several trade agreements, including the Generalized System of Preferences and the Caribbean Basin Initiative.



Reasons for Change .

In the past, these expiring provisions have been routinely extended. Extending them before they expire helps to provides certainty to taxpayers.



Proposal

This proposal would extend these provisions through December 31, 2010.


OTHER REVENUE CHANGES AND LOOPHOLE CLOSERS




REINSTATE SUPERFUND EXCISE TAXES



Current Law

The following Superfund excise taxes were imposed before January 1, 1996:

(1) An excise tax on domestic crude oil and on imported petroleum products at a rate of 9.7 cents per barrel;

(2) An excise tax on listed hazardous chemicals at a rate that varied from $0.22 to $4.87 per ton; and

(3) An excise tax on imported substances that use as materials in their manufacture or production one or more of the hazardous chemicals subject to the excise tax described in (2) above.

Amounts equivalent to the revenues from these taxes were dedicated to the Hazardous Substance Superfund Trust Fund (the Superfund Trust Fund). Amounts in the Superfund Trust Fund are available for expenditures incurred in connection with releases or threats of releases of hazardous substances into the environment under specified provisions of the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (as amended).



Reasons for Change

The Superfund excise taxes should be reinstated because of the continuing need for funds to remedy damages caused by releases of hazardous substances.



Proposal

The three Superfund excise taxes would be reinstated for periods after December 31, 2010.



REINSTATE SUPERFUND ENVIRONMENTAL INCOME TAX



Current Law

For taxable years beginning before January 1, 1996, a corporate environmental income tax was imposed at a rate of 0.12 percent on the amount by which the modified alternative minimum taxable income of a corporation exceeded $2 million. Modified alternative minimum taxable income was defined as a corporation's alternative minimum taxable income, determined without regard to the alternative minimum tax net operating loss deduction and the deduction for the corporate environmental income tax.

The tax was dedicated to the Hazardous Substance Superfund Trust Fund (the Superfund Trust Fund). Amounts in the Superfund Trust Fund are available for expenditures incurred in connection with releases or threats of releases of hazardous substances into the environment under specified provisions of the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (as amended).



Reasons for Change

The corporate environmental income tax should be reinstated because of the continuing need for funds to remedy damages caused by releases of hazardous substances.



Proposal

The corporate environmental income tax would be reinstated for taxable years beginning after December 31, 2010.



TAX CARRIED (PROFIT) INTERESTS AS ORDINARY INCOME



Current Law

A partnership is not subject to federal income tax. Instead, income and loss of the partnership retains its character and flows through to its partners, who must include such items on their tax returns. Generally, certain partners receive partnership interests in exchange for contributions of cash and/or property, while certain partners (not necessarily other partners) receive partnership interests, typically interests in future profits ("profits interests") in exchange for services. Accordingly, if and to the extent a partnership recognizes long-term capital gain, the partners, including partners who provide services, will reflect their shares of such gain on their tax returns as long-term capital gain. If the partner is an individual, such gain would be taxed at the reduced rates for long-term capital gains. Gain recognized on the sale of a partnership interest, whether it was received in exchange for property, cash or services, is generally treated as capital gain.

Under current law, income attributable to a profits interest of a general partner is generally subject to self-employment tax, except to the extent the partnership generates types of income that are excluded from self employment taxes, e.g., capital gains, certain interest and dividends.



Reason for Change

Although profits interests are structured as partnership interests, the income allocable to such interests is received in connection with the performance of services. A service provider's share of the income of a partnership attributable to a carried interest should be taxed as ordinary income and subject to self-employment tax because such income is derived from the performance of services. By allowing service partners to receive capital gains treatment on labor income without limit, the current system creates an unfair and inefficient tax preference. The recent explosion of activity among large private equity firms has increased the breadth and cost of this tax preference, with some of the highest-income Americans benefiting from the preferential treatment.



Proposal

A partner's share of income on a "services partnership interest" (SPI) would be subject to tax as ordinary income, regardless of the character of the income at the partnership level. Accordingly, such income would not be eligible for the reduced rates that apply to long-term capital gains. In addition, the proposal would require the partner to pay self-employment taxes on such income. Gain recognized on the sale of an SPI would generally be taxed as ordinary income, not as capital gain.

An SPI is a carried interest held by a person who provides services to the partnership. To the extent that the partner who holds an SPI contributes "invested capital" and the partnership reasonably allocates its income and loss between such invested capital and the remaining interest, income attributable to the invested capital would not be recharacterized. Similarly, the portion of any gain recognized on the sale of an SPI that is attributable to the invested capital would be treated as capital gain. "Invested capital" is defined as money or other property contributed to the partnership. However, contributed capital that is attributable to the proceeds of any loan or other advance made or guaranteed by any partner or the partnership is not treated as "invested capital."

Also, any person who performs services for an entity and holds a "disqualified interest" in the entity is subject to ordinary income tax on any income or gain received with respect to the interest. A "disqualified interest" is defined as convertible or contingent debt, an option, or any derivative instrument with respect to the entity (but does not include a partnership interest or stock in certain taxable corporations). This is an anti-abuse rule designed to prevent the avoidance of the proposal through the use of compensatory arrangements other than partnership interests.

The proposal is not intended to adversely impact qualification of a real estate investment trust owning a carried interest in a real estate partnership.

The proposal would be effective for taxable years beginning after December 31, 2010.



CODIFY "ECONOMIC SUBSTANCE" DOCTRINE



Current Law

Economic Substance Doctrine. The common-law "economic substance" doctrine generally denies tax benefits from a transaction that does not meaningfully change a taxpayer's economic position, other than tax consequences, even if the transaction literally satisfies the requirements of the Internal Revenue Code. Although courts have applied the economic substance doctrine with increasing frequency, they have not applied it uniformly. Some courts require both (i) a meaningful change to the taxpayer's economic position (referred to as "objective" economic substance), and (ii) a substantial non-tax business purpose, while other courts require only one of the two factors to satisfy the economic substance doctrine. Still other courts consider objective economic substance and business purpose to be only two factors in a general investigation into whether a transaction has economic effects other than tax benefits.

Accuracy-Related Penalties. Current law contains an accuracy-related penalty that applies to an underpayment of tax attributable to a substantial understatement of income tax. The penalty equals 20 percent of the tax underpayment. Except in the case of tax shelters, the penalty may be reduced if (i) the taxpayer's treatment is supported by substantial authority or (ii) the relevant facts were adequately disclosed, and there is a reasonable basis for the item's tax treatment. A separate 20-percent penalty applies to an understatement of income tax attributable to a "listed transaction" or a "reportable transaction" with a significant purpose of tax avoidance or evasion. The penalty rate is increased to 30 percent if the taxpayer has not disclosed the transaction as required by law. Either penalty may be set aside or reduced if the taxpayer can demonstrate that there was "reasonable cause" for the taxpayer's position and that the taxpayer acted in good faith.

Denial of Interest Deduction. Current law denies any deduction for interest paid with respect to a reportable transaction understatement where the relevant facts were not adequately disclosed.



Reason for Change

Clarifying the economic substance doctrine and increasing the penalty for transactions that lack economic substance will further deter transactions designed solely to obtain tax benefits.



Proposal

Clarification of Economic Substance Doctrine. The proposal would clarify that a transaction satisfies the economic substance doctrine only if (i) it changes in a meaningful way (apart from federal tax effects) the taxpayer's economic position, and (ii) the taxpayer has a substantial purpose (other than a federal tax purpose) for entering into the transaction. The proposal would also clarify that a transaction will not be treated as having economic substance solely by reason of a profit potential unless the present value of the reasonably expected pre-tax profit is substantial in relation to the present value of the net federal tax benefits arising from the transaction. The proposal would allow the Treasury Department to publish regulations to carry out the purposes of the proposal.

New Understatement Penalty. The proposal would impose a 30-percent penalty on an understatement of tax attributable to a transaction that lacks economic substance, reduced to 20 percent if there were adequate disclosure of the relevant facts in the taxpayer's return. The proposed penalty would be imposed with regard to an understatement due to a transaction's lack of economic substance in lieu of other accuracy-related penalties that might be levied with respect to the tax understatement, although any understatement arising from a lack of economic substance would be taken into account in determining whether there is a substantial understatement of income tax under current law.

The IRS could assert and abate the new economic substance penalty. The IRS could assert the penalty even if there has not been a court determination that the economic substance doctrine was relevant. Any abatement of the economic substance penalty would have to be proportionate to the abatement of the underlying tax liability.

Denial of Interest Deduction. The proposal would deny any deduction for interest attributable to an understatement of tax arising from the application of the economic substance doctrine.

The proposal would apply to transactions entered into after the date of enactment. The denial of interest deduction component would be effective for taxable years ending after the date of enactment with respect to transactions entered into after such date.



REPEAL THE LAST-IN, FIRST-OUT (LIFO) METHOD OF ACCOUNTING FOR INVENTORIES



Current Law

The Internal Revenue Code (Code) permits a taxpayer with inventories to determine the value of its inventory and its cost of goods sold using a number of different methods. The most prevalent method is the first-in, first-out (FIFO) method, which matches current sales with the costs of the earliest acquired (or manufactured) inventory items. As an alternative, a taxpayer may elect to use the last-in, first-out (LIFO) method, which treats the most recently acquired (or manufactured) goods as having been sold during the year. The LIFO method can provide a tax benefit for a taxpayer facing rising inventory costs, since the cost of goods sold under this method is based on more recent, higher inventory values, resulting in lower taxable income. If inventory levels fall during the year, however, a LIFO taxpayer must include lower-cost LIFO inventory values (reflecting one or more prior-year inventory accumulations) in the cost of goods sold, and its taxable income will be correspondingly higher. To be eligible to elect LIFO for tax purposes, a taxpayer must use LIFO for financial accounting purposes.



Reasons for Change

The repeal of LIFO would eliminate a tax deferral opportunity that is available to taxpayers that possess inventories whose costs increase over time. In addition, LIFO repeal would simplify the Code by removing a complex and burdensome accounting method that has been the source of controversy between taxpayers and the IRS.

International Financial Reporting Standards do not permit the use of the LIFO method, and their adoption by the Security and Exchange Commission would cause violations of the current LIFO book/tax conformity requirement. Repealing LIFO removes this possible impediment to the implementation of these standards in the United States.



Proposal

The proposal would not allow the use of the LIFO inventory accounting method for Federal income tax purposes. Taxpayers that currently use the LIFO method would be required to write up their beginning LIFO inventory to its FIFO value in the first taxable year beginning after December 31, 2011. However, this one-time increase in gross income would be taken into account ratably over the first taxable year and the following seven taxable years.



Reform U.S. International Tax System



REFORM BUSINESS ENTITY CLASSIFICATION RULES FOR FOREIGN ENTITIES



Current Law

Under current Treasury regulations, an eligible business entity can elect its classification for federal tax purposes. An eligible business entity with a single owner may elect to be treated as a corporation or as an entity disregarded as an entity separate from its owner (a "disregarded entity"). An eligible business entity with at least two owners may elect to be treated as a partnership or as a corporation. Certain foreign entities are always treated as corporations for federal tax purposes (so called "per se corporations").



Reasons for Change

As applied to foreign eligible entities, the entity classification rules may result in the unintended avoidance of current U.S. tax, particularly if a foreign eligible entity elects to be treated as a disregarded entity. In certain cases, locating a foreign disregarded entity under a centralized holding company (or partnership) may permit the migration of earnings to low-taxed jurisdictions without a current income inclusion of the amount of such earnings to a U.S. taxpayer under the subpart F provisions of the Code.



Proposal

Under the proposal, a foreign eligible entity may be treated as a disregarded entity only if the single owner of the foreign eligible entity is created or organized in, or under the law of, the foreign country in, or under the law of, which the foreign eligible entity is created or organized. Therefore, a foreign eligible entity with a single owner that is organized or created in a country other than that of its single owner would be treated as a corporation for federal tax purposes. Except in cases of U.S. tax avoidance, the proposal would generally not apply to a first-tier foreign eligible entity wholly owned by a United States person. The tax treatment of the conversion to a corporation of a foreign eligible entity treated as a disregarded entity would be consistent with current Treasury regulations and relevant tax principles.

The proposal would be effective for taxable years beginning after December 31, 2010.



DEFER DEDUCTION OF EXPENSES, EXCEPT R&E EXPENSES, RELATED TO DEFERRED INCOME



Current Law

Taxpayers generally may deduct ordinary and necessary expenses paid or incurred in carrying on any trade or business. The Internal Revenue Code and the regulations thereunder contain detailed rules regarding allocation and apportionment of expenses for computing taxable income from sources within and without the United States.



Reasons for Change

Under current law, a U.S. person that incurs expenses properly allocable and apportioned to foreign-source income may deduct those expenses even if the expenses exceed the taxpayer's gross foreign-source income or if the taxpayer earns no foreign-source income. For example, a U.S. person that incurs debt to acquire stock of a foreign corporation is generally permitted to deduct currently the interest expense from the acquisition indebtedness even if no income is derived currently from such stock. The U.S. person is also permitted to deduct currently other expenses properly allocated or apportioned to the stock of the foreign corporation. Current law includes provisions that may require a U.S. person to recapture as U.S.-source income the amount by which foreign-source expenses exceed foreign-source income for a taxable year. However, if in a taxable year the U.S. person earns sufficient foreign-source income of the same statutory grouping in which the stock of the foreign corporation is classified, the interest and other expenses properly allocated and apportioned to the stock of the foreign corporation may not be subject to recapture in a subsequent taxable year. This ability to deduct expenses from overseas investments while deferring U.S. tax on the income from the investment may cause U.S. businesses to shift their investments and jobs overseas, harming our domestic economy.



Proposal

The proposal would defer a deduction for expenses (other than research and experimentation expenditures) of a U.S. person that are properly allocated and apportioned to foreign-source income to the extent the foreign-source income associated with the expenses is not currently subject to U.S. tax. The amount of expenses properly allocated and apportioned to foreignsource income generally would be determined under current Treasury regulations. The amount of deferred expenses for a particular year would be carried forward to subsequent years and combined with the foreign-source expenses of the U.S. person for such year before determining the impact of the proposal in such year.

The proposal would be effective for taxable years beginning after December 31, 2010.



REFORM FOREIGN TAX CREDIT: DETERMINE THE FOREIGN TAX CREDIT ON A POOLING BASIS



Current Law

Section 901 provides that, subject to certain limitations, a taxpayer may choose to claim a credit against its U.S. income tax liability for income, war profits, and excess profits taxes paid or accrued during the taxable year to any foreign country or any possession of the United States. Under section 902, a domestic corporation is deemed to have paid the foreign taxes paid by certain foreign subsidiaries from which it receives a dividend (the deemed paid foreign tax credit). The foreign tax credit is limited to an amount equal to the pre-credit U.S. tax on the taxpayer's foreign-source income. This foreign tax credit limitation is applied separately to foreign-source income in each of the separate categories described in section 904(d), i.e., the passive category and general category.



Reasons for Change

The purpose of the foreign tax credit is to mitigate the potential for double taxation when U.S. taxpayers are subject to foreign taxes on their foreign-source income. The reduction to two foreign tax credit limitation categories for passive category income and general category income under the American Jobs Creation Act of 2004 enhanced U.S. taxpayers' ability through "crosscrediting" to reduce the residual U.S. tax on foreign-source income.



Proposal

Under the proposal, a U.S. taxpayer would determine its deemed paid foreign tax credit on a consolidated basis by determining the aggregate foreign taxes and earnings and profits of all of the foreign subsidiaries with respect to which the U.S. taxpayer can claim a deemed paid foreign tax credit (including lower tier subsidiaries described section 902(b)). The deemed paid foreign tax credit for a taxable year would be determined based on the amount of the consolidated earnings and profits of the foreign subsidiaries repatriated to the U.S. taxpayer in that taxable year.

The proposal would be effective for taxable years beginning after December 31, 2010.



REFORM FOREIGN TAX CREDIT: PREVENT SPLITTING OF FOREIGN INCOME AND FOREIGN TAXES



Current Law

Section 901 provides that, subject to certain limitations, a taxpayer may choose to claim a credit against its U.S. income tax liability for income, war profits, and excess profits taxes paid or accrued during the taxable year to any foreign country or any possession of the United States. Under current law, the person considered to have paid the foreign tax is the person on whom foreign law imposes legal liability for such tax.



Reasons for Change

Current law permits inappropriate separation of creditable foreign taxes from the associated foreign income in certain cases such as those involving hybrid arrangements.



Proposal

The proposal would adopt a matching rule to prevent the separation of creditable foreign taxes from the associated foreign income.

The proposal would be effective for taxable years beginning after December 31, 2010.



LIMIT SHIFTING OF INCOME THROUGH INTANGIBLE PROPERTY TRANSFERS



Current Law

Section 482 permits the Commissioner to distribute, apportion, or allocate gross income, deductions, credits, and other allowances between or among two or more organizations, trades, or businesses under common ownership or control whenever "necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses." Section 482 also provides that in the case of any transfer (or license) of intangible property (as defined in section 936(h)(3)(B)), the income with respect to such transfer or license must be commensurate with the income attributable to the intangible property. Further, under section 367(d), if a U.S. person transfers intangible property (as defined in section 936(h)(3)(B)) to a foreign corporation in certain nonrecognition transactions, the U.S. person is treated as selling the intangible property for a series of payments contingent on the productivity, use, or disposition of the property that are commensurate with the transferee's income from the property. The payments generally continue annually over the useful life of the property.



Reasons for Change

Controversy often arises concerning the value of intangible property transferred between related persons. Further, the scope of the intangible property subject to sections 482 and 367(d) is not entirely clear or consistent. This lack of clarity and consistency may result in the inappropriate avoidance of U.S. tax and misuse of the rules applicable to transfers of intangible property to foreign persons.



Proposal

To prevent inappropriate shifting of income outside the United States, the proposal would clarify the definition of intangible property for purposes of sections 367(d) and 482 to include workforce in place, goodwill and going concern value. The proposal would also clarify that in a transfer of multiple intangible properties, the Commissioner may value the intangible properties on an aggregate basis where that achieves a more reliable result. The proposal would also clarify that intangible property must be valued at its highest and best use, as it would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.

The proposal would be effective for taxable years beginning after December 31, 2010.



LIMIT EARNINGS STRIPPING BY EXPATRIATED ENTITIES



Current Law

Section 163(j) applies to limit the deductibility of certain interest paid by a corporation to related persons. The limitation applies to a corporation that fails a debt-to-equity safe harbor (greater than 1.5 to 1) and that has net interest expense in excess of 50 percent of adjusted taxable income (computed by adding back net interest expense, depreciation, amortization and depletion, and any net operating loss deduction). Disallowed interest expense may be carried forward indefinitely for deduction in a subsequent year. In addition, the corporations's excess limitation for a tax year (i.e., the amount by which 50 percent of adjusted taxable income exceeds net interest expense) may be carried forward to the three subsequent tax years.

Section 7874 provides special rules for expatriated entities and the acquiring foreign corporations. The rules apply to certain defined transactions in which a U.S. parent company (the expatriated entity) is essentially replaced with a foreign parent (the surrogate foreign corporation). The tax treatment of an expatriated entity and a surrogate foreign corporation varies depending on the extent of continuity of shareholder ownership following the transaction. The surrogate foreign corporation is treated as a domestic corporation for all purposes of the Code if shareholder ownership continuity is at least 80 percent (by vote or value). If shareholder ownership continuity is at least 60 percent, but less than 80 percent, the surrogate foreign corporation is treated as a foreign corporation but any applicable corporate-level income or gain required to be recognized by the expatriated entity generally cannot be offset by tax attributes. Section 7874 generally applies to transactions occurring on or after March 4, 2003.



Reasons for Change

Under current law, opportunities are available to reduce inappropriately the U.S. tax on income earned from U.S. operations through the use of foreign related-party debt. In its recent study of earnings stripping, the Treasury Department found strong evidence of the use of such techniques by expatriated entities. Consequently, amending the rules of section 163(j) for expatriated entities is necessary to prevent these inappropriate income-reduction opportunities. Because the study did not find conclusive evidence of earnings stripping by foreign-controlled domestic corporations that have not expatriated, additional information is needed to determine whether changes to section 163(j) should be made with respect to those companies. The new Form 8926, Disqualified Corporate Interest Expense Disallowed Under Section 163(j) and Related Information , should assist in obtaining this information.



Proposal

The proposal would revise section 163(j) to tighten the limitation on the deductibility of interest paid by an expatriated entity to related persons. The current law debt-to-equity safe harbor would be eliminated. The 50 percent adjusted taxable income threshold for the limitation would be reduced to 25 percent of adjusted taxable income with respect to disqualified interest other than interest paid to unrelated parties on debt that is subject to a related-party guarantee ("guaranteed debt"). The 50 percent adjusted taxable income threshold would generally contine to apply to interest on guaranteed debt. The carryforward for disallowed interest would be limited to ten years and the carryforward of excess limitation would be eliminated.

An expatriated entity would be defined by applying the rules of section 7874 and the regulations thereunder as if section 7874 were applicable for taxable years beginning after July 10, 1989. This special rule would not apply, however, if the surrogate foreign corporation is treated as a domestic corporation under section 7874.

The proposal would be effective for taxable years beginning after December 31, 2010.



PREVENT REPATRIATION OF EARNINGS IN CERTAIN CROSS-BORDER REORGANIZATIONS



Current Law

Under section 356(a)(1), if as part of a reorganization transaction an exchanging shareholder receives in exchange for its stock of the target corporation both stock and property that cannot be received without the recognition of gain (so-called "boot"), the exchanging shareholder is required to recognize gain equal to the lesser of the gain realized in the exchange or the amount of boot received (commonly referred to as the "boot within gain" limitation). Further, under section 356(a)(2), if the exchange has the effect of the distribution of a dividend, then all or part of the gain recognized by the exchanging shareholder is treated as a dividend to the extent of the shareholder's ratable share of the corporation's earnings and profits. The remainder of the gain (if any) is treated as gain from the exchange of property.



Reasons for Change

In cross-border reorganizations, the boot-within-gain limitation of current law can permit U.S. shareholders to repatriate previously-untaxed earnings and profits of foreign subsidiaries with minimal U.S. tax consequences. For example, if the exchanging shareholder's stock in the target corporation has little or no built-in gain at the time of the exchange, the shareholder will recognize minimal gain even if the exchange has the effect of the distribution of a dividend and/or a significant amount (or all) of the consideration received in the exchange is boot. This result applies even if the corporation has previously untaxed earnings and profits equal to or greater than the boot. This result is inconsistent with the principle that previously untaxed earnings and profits of a foreign subsidiary should be subject to U.S. tax upon repatriation.



Proposal

The proposal would repeal the boot-within-gain limitation of current law in the case of any reorganization in which the acquiring corporation is foreign and the shareholder's exchange has the effect of the distribution of a dividend, as determined under section 356(a)(2).

The proposal would be effective for taxable years beginning after December 31, 2010.



REPEAL 80/20 COMPANY RULES



Current Law

Dividends and interest paid by a domestic corporation are generally U.S.-source income to the recipient and are generally subject to gross basis withholding tax if paid to a foreign person. A limited exception to these general rules applies with respect to a domestic corporation (a socalled "80/20" company) if at least 80 percent of the corporation's gross income during a threeyear testing period is foreign-source and attributable to the active conduct of a foreign trade or business. Look-through rules apply to determine the character of certain income of the 80/20 company for this purpose.



Reasons for Change

The 80/20 company provisions can be manipulated and should be repealed.



Proposal

The proposal would repeal the 80/20 company provisions under current law.

The proposal would be effective for taxable years beginning after December 31, 2010.



PREVENT THE AVOIDANCE OF DIVIDEND WITHHOLDING TAXES



Current Law

A withholding agent generally must withhold a tax of 30 percent from the gross amount of all U.S.-source fixed or determinable annual or periodical (FDAP) income, profits, or gains of a nonresident alien individual, foreign corporation, or foreign partnership. In general, dividends paid with respect to the stock of a domestic corporation are U.S.-source dividends. Thus, foreign investors holding stock in domestic corporations are generally subject to 30 percent tax on dividends paid with respect to that stock. This rate may be reduced where the dividends are paid to a resident of a jurisdiction with which the United States has entered into a tax treaty.

The source of income from notional principal contracts is generally determined based on the residence of the investor. As a result, substitute dividend payments made to a foreign investor with respect to an equity swap referencing U.S. equities are treated as foreign-source and are therefore not subject to U.S. withholding tax.



Reason for Change

Foreign portfolio investors seeking to benefit from the appreciation in value and dividends paid with respect to the stock of a domestic corporation are not limited to holding stock in the corporation. Instead, such an investor can enter into an equity swap. The U.S. tax consequences of these two alternative investments differ significantly. By entering into equity swaps, foreign portfolio investors receive the economic benefit of dividends paid and appreciation in value with respect to U.S. stock without being subject to gross-basis withholding tax.



Proposal

In order to address the avoidance of U.S. withholding tax through the use of securities lending transactions, the Treasury Department plans to revoke Notice 97-66 and issue guidance that eliminates the benefits of such transactions but minimizes over-withholding.

Further, income earned by foreign persons with respect to equity swaps that reference U.S. equities would be treated as U.S.-source to the extent that the income is attributable to (or calculated by reference to) dividends paid by a domestic corporation. An exception to this source rule would apply to swaps with all of the following characteristics:
 the terms of the equity swap do not require the foreign person to post more than 20 percent of the value of the underlying stock as collateral;

 the terms of the equity swap do not include any provision addressing the hedge position of the counterparty to the transaction;

 the underlying stock is publicly traded and the notional amount of the swap represents less than 5 percent of the total public float of that class of stock and less than 20 percent of the 30-day average daily trading volume;

 the foreign person does not sell the stock to the counterparty at the inception of the contract, or buy the stock from the counterparty at the termination of the contract;

 the prices of the equity that are used to measure the parties' entitlements or obligations are based on an objectively observable price; and

 the swap has a term of at least 90 days.

The Treasury Department would be given regulatory authority to provide additional exceptions to implement the purpose of the rule.

The proposal would be effective for payments made after December 31, 2010.



MODIFY THE TAX RULES FOR DUAL CAPACITY TAXPAYERS



Current Law

Section 901 provides that, subject to certain limitations, a taxpayer may choose to claim a credit against its U.S. income tax liability for income, war profits, and excess profits taxes paid or accrued during the taxable year to any foreign country or any possession of the United States. To be a creditable tax, a foreign levy must be substantially equivalent to an income tax under U.S. tax principles, regardless of the label attached to the levy under foreign law. Under current Treasury regulations, a foreign levy is a tax if it is a compulsory payment under the authority of a foreign government to levy taxes and is not compensation for a specific economic benefit provided by the foreign country. Taxpayers that are subject to a foreign levy and that also receive a specific economic benefit from the levying country (dual-capacity taxpayers) may not credit the portion of the foreign levy paid for the specific economic benefit. The current Treasury regulations provide that, if a foreign country has a generally imposed income tax, the dual-capacity taxpayer may treat as a creditable tax the portion of the levy that application of the generally imposed income tax would yield (provided that the levy otherwise constitutes an income tax or an in lieu of tax). The balance of the levy is treated as compensation for the specific economic benefit. If the foreign country does not generally impose an income tax, the portion of the payment that does not exceed the applicable federal tax rate applied to net income is treated as a creditable tax. A foreign tax is treated as generally imposed even if it applies only to persons who are not residents or nationals of that country.

There is no section 904 foreign tax credit separate category for foreign oil and gas income. However, under section 907, the amount of creditable foreign taxes imposed on foreign oil and gas income is limited in any year to the applicable U.S. tax on that income.



Reasons for Change

The purpose of the foreign tax credit is to mitigate double taxation of income by the United States and a foreign country. When a payment is made to a foreign country in exchange for a specific economic benefit, there is no double taxation. Current law recognizes the distinction between creditable taxes and non-creditable payments for a specific economic benefit but fails to achieve the appropriate split between the two in a case where a foreign country imposes a levy on, for example, oil and gas income only, but has no generally imposed income tax.



Proposal

In the case of a dual-capacity taxpayer, the proposal would treat a foreign levy that would otherwise qualify as an income tax or in lieu of tax as a creditable tax only if the foreign country generally imposes an income tax. An income tax would be considered generally imposed for this purpose only if the income tax applies to trade or business income from sources in that country, and only if the income tax has substantial application to non-dual-capacity taxpayers and to persons who are nationals or residents of that country. The proposal would replace the part of the regulatory safe harbor that applies when a foreign country does not generally impose an income tax. The proposal generally would retain the rule of present law where the foreign country does generally impose an income tax. The proposal also would convert the special foreign tax credit limitation rules of section 907 into a separate category within section 904 for foreign oil and gas income. The proposal would yield to U.S. treaty obligations that allow a credit for taxes paid or accrued on certain oil or gas income.

The proposal would be effective for taxable years beginning after December 31, 2010.



Combat Under-Reporting of Income Through Use of Accounts and Entities in Offshore Jurisdictions

The Administration is concerned about the use of offshore accounts and entities by certain U.S. and foreign persons to evade U.S. tax. To reduce such evasion, the Administration is proposing a series of measures to strengthen the information reporting and withholding systems that support U.S. taxation of income earned or held through offshore accounts or entities.

The qualified intermediary (QI) program is intended to bring foreign financial institutions more directly into the U.S. information reporting and withholding tax system, thereby helping to ensure that foreign persons are subject to the proper U.S. withholding tax. Strengthening the withholding and reporting rules under which QIs operate with respect to U.S. and foreign persons while creating incentives for more foreign financial institutions to become QIs will help to ensure that U.S. persons are properly paying tax in connection with foreign income and accounts and that proper withholding tax applies with respect to foreign persons.



REQUIRE GREATER REPORTING BY QUALIFIED INTERMEDIARIES REGARDING U.S. ACCOUNT HOLDERS



Current Law

A withholding agent generally must withhold tax at a rate of 30 percent from the gross amount of all U.S.-source fixed or determinable annual or periodical gains, profits, or income (FDAP income) of a nonresident alien individual or foreign entity. A payor is generally required to withhold tax at a rate of 28 percent on a reportable payment made to a U.S. non-exempt recipient if the payee fails to provide a taxpayer identification number or fails to certify, when required, that the payee is not subject to backup withholding, or the payor is notified by the IRS or a broker that the payee is subject to backup withholding.

Treasury regulations address certification, documentation, withholding, and reporting of payments to U.S. and foreign persons through foreign financial institutions. Foreign financial institutions may contract with the IRS to operate according to a set of withholding and reporting rules under the so-called "qualified intermediary" (QI) program. QIs agree to collect identifying documentation from their customers, file withholding tax returns and information returns, and submit to periodic audits performed by external auditors supervised by IRS examiners. QIs may furnish a withholding certificate to a withholding agent in lieu of transmitting to the withholding agent documentation for persons for whom the QI receives the payment and, in the case of U.S. non-exempt recipients, assumes primary Form 1099 reporting and backup withholding responsibility.

QIs need not assume primary Form 1099 reporting and backup withholding responsibility. If a QI nevertheless assumes primary Form 1099 reporting and backup withholding responsibility with respect to accounts held by U.S. persons, such reporting may be limited to certain income earned through those accounts. Further, a QI that assumes primary Form 1099 reporting and backup withholding responsibility with respect to U.S. persons is not required to assume that responsibility for all accounts. Moreover, in the case of financial institutions that are part of a controlled group, one member of the controlled group may contract to be a QI while other members of the controlled group do not, and thus accounts and clients may be divided between commonly-controlled QI and non-QI institutions.



Reasons for Change

Strengthening the withholding and reporting rules under which QIs operate with respect to U.S. persons while creating incentives for the use of QIs would help to ensure that U.S. persons are properly paying tax on income earned through foreign accounts and that proper withholding tax applies with respect to foreign persons. In order to facilitate operation of this strengthened QI program, a list of QIs must be made publicly available.



Proposal

Under the proposal, no foreign financial institution would qualify as a QI unless it identifies all of its account holders that are U.S. persons. A QI would be required to report all reportable payments (for this purpose, treating the QI as a U.S. payor) received on behalf of all U.S. account holders. Thus, a QI would file Form 1099s with respect to payments to those U.S. account holders as though the QI were a U.S. financial institution. The Treasury Department would be authorized to issue regulations to implement the purposes of this proposal, including authority to require that for any financial institution to be a QI, commonly-controlled foreign financial institutions must meet certain reporting obligations with respect to account holders or that a financial institution may be a QI only if all commonly-controlled financial institutions are also QIs, and including authority to provide that for any financial institution to be a QI it must collect information indicating the beneficial owners of foreign entity account holders and specifically report if a U.S. person is a beneficial owner. The proposal would also clarify that under section 6103 of the Code the IRS may publish the list of QIs.

The proposal would be effective beginning after December 31 of the year of enactment.



REQUIRE WITHHOLDING ON PAYMENTS OF FDAP INCOME MADE THROUGH NONQUALIFIED INTERMEDIARIES



Current Law

In general, payments of U.S.-source fixed or determinable annual or periodical gains, profits, or income (FDAP income) to nonresident alien individuals and foreign entities are subject to withholding tax at a rate of 30 percent. This 30-percent withholding tax may be reduced or eliminated pursuant to certain statutory provisions or pursuant to the terms of a tax treaty.

To determine whether the recipient of a payment is exempt from withholding tax or eligible for a reduced rate, withholding agents generally must rely on beneficial ownership documentation provided by the payee certifying that the payee is entitled to an exemption from withholding tax or a reduced rate of withholding tax under a Code provision or relevant tax treaty. In general, withholding agents are entitled to rely on the self-certification they receive absent actual knowledge or reason to know that the information provided is incorrect or unreliable. In the case of payments made through an intermediary, the intermediary generally provides to the withholding agent the appropriate documentation on behalf of the payment's beneficial owners.



Reasons for Change

The Administration is concerned that some persons that are not entitled to an exemption from withholding tax or a reduced rate of withholding tax may attempt to avoid U.S. tax by arranging to receive payments through foreign intermediaries that are not qualified intermediaries (nonqualified intermediaries). The proposal would discourage U.S. and foreign persons from attempting to avoid U.S. tax or to obtain a lower rate of withholding tax by providing incorrect self-certification or otherwise relying on the lack of information reporting associated with using nonqualified intermediaries. The proposal would also encourage use of the strengthened qualified intermediary system, by requiring withholding of tax on payments made through nonqualified intermediaries.



Proposal

Any withholding agent making a payment of FDAP income to a nonqualified intermediary would be required to treat the payment as made to an unknown foreign person (and therefore to withhold tax at a rate of 30 percent). The Treasury Department would receive regulatory authority to provide exceptions, including exceptions for payments collected by nonqualified intermediaries for foreign government, central bank, foreign pension fund, and foreign insurance company payees, and other similar investors, and for payments that the Treasury Department concludes present a low risk of tax evasion. The rules will be designed so as not to disrupt ordinary and customary market transactions. Foreign persons that are subject to overwithholding as a result of this proposal would be permitted to apply for a refund of any excess tax withheld.

The proposal would be effective for payments made after December 31 of the year of enactment.



REQUIRE WITHHOLDING ON GROSS PROCEEDS PAID TO CERTAIN NONQUALIFIED INTERMEDIARIES



Current Law

Brokers are generally required to withhold tax at a rate of 28 percent on certain reportable payments made to a U.S. non-exempt recipient if the payee fails to provide a taxpayer identification number or fails to certify that the payee is not subject to backup withholding, or the payor is notified by the IRS or a broker that the payee is subject to backup withholding. Reportable payments include the gross proceeds from certain transactions effected by brokers for their customers. A broker is exempt from reporting a payment (and thus backup withholding) where the broker can, prior to payment, associate the payment with documentation upon which it can rely to either treat the customer as a foreign beneficial owner, or treat the payment as made or presumed to be made to a foreign payee. With respect to payments through foreign intermediaries that are not qualified intermediaries (nonqualified intermediaries), brokers may rely on the beneficial owner's self-certification of non-U.S. status passed on by the nonqualified intermediary to determine whether certain third-party information reporting, and therefore backup withholding, may be required.

A withholding agent generally must withhold tax at a rate of 30 percent from the gross amount of all U.S.-source fixed or determinable annual or periodical gains, profits, or income (FDAP income) of a nonresident alien individual or foreign entity. FDAP income includes interest and dividends, but generally does not include gross proceeds or gains from sales. A foreign payee may claim a refund of any overpayment of tax which is withheld at source.



Reasons for Change

U.S. persons seeking to evade U.S. tax may arrange to receive payments, with respect to which gross proceeds would otherwise be reported, through nonqualified intermediaries and certify that they qualify as foreign persons. A broker making a payment through a nonqualified intermediary is unlikely to be in a position to verify whether self-certification regarding foreign status is accurate. The proposal would discourage U.S. persons from attempting to evade U.S. tax by providing incorrect self-certification or otherwise relying on the lack of information reporting associated with using nonqualified intermediaries. The proposal would also encourage use of the strengthened qualified intermediary system by requiring withholding on gross proceeds on the sale of securities held through nonqualified intermediaries.



Proposal

Under the proposal, a withholding agent would be required to withhold tax at a rate of 20 percent on gross proceeds from the sale of any security of a type that would be reported to a U.S. nonexempt payee, when paid by the withholding agent to a nonqualified intermediary that is located in a jurisdiction with which the United States does not have a comprehensive income tax treaty that includes a satisfactory exchange of information program. The Treasury Department would receive regulatory authority to provide exceptions, including exceptions for payments collected by nonqualified intermediaries for foreign government, central bank, foreign pension fund, and foreign insurance company payees, and other similar investors; payments to nonqualified intermediaries located in jurisdictions with which the United States has a tax information exchange agreement; and payments that the Treasury Department concludes present a low risk of tax evasion. The rules will be designed so as not to disrupt ordinary and customary market transactions. Nonqualified intermediaries would be eligible to claim a refund on behalf of their direct account holders for any taxable year in which they identified all of their direct account holders that are U.S. persons and reported all reportable payments received on behalf of U.S. account holders. Foreign persons that are subject to withholding tax in excess of their income tax liability as a result of this proposal, and on whose behalf a refund claim is not made by a nonqualified intermediary, would be permitted to apply for a refund of any tax withheld.

The proposal would be effective for payments made after December 31 of the year of enactment.



REQUIRE REPORTING OF CERTAIN TRANSFERS OF MONEY OR PROPERTY TO FOREIGN FINANCIAL ACCOUNTS



Current Law

United States persons must disclose whether, at any time during the preceding year, they had an interest in, or signature or other authority over, financial accounts in a foreign country, if the aggregate value of these accounts exceeds $10,000. United States persons must also report certain information with respect to certain foreign business entities that they control. Under Treasury regulations, a U.S. person controls a foreign corporation for this purpose if the person owns, actually or constructively, more than 50 percent of the corporation's stock, by vote or by value. Current law does not contain a provision that generally requires reporting of transfers of money or property to, or receipt of money or property from, a foreign bank, brokerage, or other financial account by U.S. individuals.



Reason for Change

The Administration is concerned about the use of foreign accounts by U.S. citizens and residents to evade U.S. tax. To reduce such evasion, the Administration proposes to increase information reporting requirements with respect to transfers to and from certain foreign accounts.



Proposal

A U.S. individual would be required to report, on the individual's income tax return, any transfer of money or property made to, or receipt of money or property from, any foreign bank, brokerage, or other financial account by the individual, or by any entity of which the individual owns, actually or constructively, more than 50 percent of the ownership interest. Transfers to accounts held at qualified intermediaries and receipts from accounts held by U.S. persons at qualified intermediaries would not be required to be reported. In addition, individuals would be exempt from the reporting requirement if the cumulative amount or value of transfers and the cumulative amount or value of receipts that would otherwise be reportable on the individual's income tax return for a given year were each less than $10,000. Failure to report a covered transfer would result in the imposition of a penalty equal to the lesser of $10,000 per reportable transfer or 10 percent of the cumulative amount or value of the unreported covered transfers. No penalty would be imposed for a failure to report due to reasonable cause. The Treasury Department would receive regulatory authority to issue rules to prevent abuse of the reporting exemptions and to provide exceptions to the reporting requirement, such as an exception for arm's-length payments in the ordinary course of business for services or tangible property.

The proposal would be effective for transfers made after December 31 of the year of enactment.



REQUIRE DISCLOSURE OF FBAR ACCOUNTS TO BE FILED WITH TAX RETURN



Current Law

Individual taxpayers currently must indicate on their income tax returns whether they had an interest in or signature or other authority over a financial account in a foreign country during the year to which the tax return relates. If a taxpayer has a foreign account, the tax return refers the taxpayer to the Report of Foreign Bank and Financial Accounts, Form TD F 90-22.1 (FBAR). The FBAR requires a citizen, resident, or person in and doing business in the United States to disclose whether, at any time during the preceding year, that person had an interest in, or signature authority over, financial accounts, if the aggregate value of these accounts exceeds $10,000. The FBAR further requires the person to disclose certain information regarding the foreign account, including the account number, financial institution, and maximum value during the year. The FBAR is not required to be filed until June 30 of the year following the calendar year to which it relates. The FBAR is filed with the Treasury Department generally and not directly with the IRS.



Reasons for Change

Disclosure of more detailed information regarding foreign accounts on the income tax return itself would assist the IRS in identifying and investigating instances where taxpayers have used foreign accounts to evade U.S. taxes. Further, associating the FBAR disclosure requirements with a taxpayer's obligation to file an income tax return would improve awareness and compliance with the FBAR disclosure obligations and improve the IRS's ability to review FBAR compliance.



Proposal

Individual taxpayers required to file an FBAR would be required to disclose certain information on their income tax returns. The information would be disclosed on a schedule that would be considered part of the individual's income tax return. The schedule would be consistent with the information disclosure obligations of the FBAR itself, and would require the taxpayer to provide information such as the account number, financial institution, and maximum value during the year. The disclosures would be required when the income tax return is due, even if Title 31 does not require the FBAR to be filed until a later date.

The tax return disclosure would not replace or mitigate the individual's obligation to separately file an FBAR with the Treasury Department as required under Title 31. The penalties imposed under Title 31 for failing to file an FBAR would continue to apply to a failure to file an FBAR as required under Title 31. Failure to disclose the foreign accounts with the income tax return would not be subject to the Title 31 penalties, although it could give rise to penalties and other consequences imposed under the Code, including extension of the statute of limitations.

The proposal would be effective for taxable years beginning after December 31 of the year of enactment.



REQUIRE THIRD-PARTY INFORMATION REPORTING REGARDING THE TRANSFER OF ASSETS TO FOREIGN FINANCIAL ACCOUNTS AND THE ESTABLISHMENT OF FOREIGN FINANCIAL ACCOUNTS



Current Law

United States persons must disclose whether, at any time during the preceding year, they had an interest in, or signature or other authority over, financial accounts in a foreign country, if the aggregate value of these accounts exceeds $10,000. Current law does not generally require thirdparty information reporting to the IRS with regard to the transfer of money or property to, or receipt of money or property from, a foreign bank, brokerage, or other financial account on behalf of a U.S. person, or with regard to the establishment of a foreign bank, brokerage, or other financial account on behalf of a U.S. person.



Reasons for Change

The Administration is concerned that U.S. persons are failing to comply with the requirement to report certain foreign financial accounts. Establishing a third-party reporting requirement with respect to transfers to foreign financial accounts, receipts from such accounts, and the establishment of such accounts would lead to greater disclosure of foreign financial accounts, and consequently would discourage the evasion of U.S. taxation. These third-party reporting requirements complement taxpayer reporting requirements.



Proposal

Any U.S. financial intermediary and any qualified intermediary that transfers money or property with a value of more than $10,000 to a foreign bank, brokerage, or other financial account on behalf of a U.S. person (or on behalf of any entity of which a U.S. person owns, actually or constructively, more than 50 percent of the ownership interest) would be required to file an information return regarding such transfer. Any U.S. financial intermediary and any qualified intermediary that receives a transfer of money or property with a value of more than $10,000 from a foreign bank, brokerage, or other financial account on behalf of a U.S. person (or on behalf of any entity of which a U.S. person owns, actually or constructively, more than 50 percent of the ownership interest) would be required to file an information return regarding such transfer. Any U.S. financial intermediary and any qualified intermediary that opens a foreign bank, brokerage, or other financial account on behalf of a U.S. person (or on behalf of any entity of which a U.S. person owns, actually or constructively, more than 50 percent of the ownership interest) would be required to file an information return with the IRS regarding such account, including reporting any amounts of money or property transferred by the financial intermediary to such account. Exceptions to the reporting requirement would be provided for 1) accounts opened and amounts transferred to, from, or on behalf of, publicly traded companies and their subsidiaries, 2) accounts opened at and transfers made to qualified intermediaries on behalf of a U.S. person (or on behalf of any entity of which a U.S. person owns, actually or constructively, more than 50 percent of the ownership interest) or 3) transfers received by or on behalf of a U.S. person (or on behalf of any entity of which a U.S. person owns, actually or constructively, more than 50 percent of the ownership interest) from accounts held by a U.S. person at a qualified intermediary. The Treasury Department would receive regulatory authority to provide additional exceptions to the reporting requirement, to require that certain additional information be reported, and to permit U.S. financial intermediaries and qualified intermediaries to report additional transfers of money or property to a foreign bank, brokerage, or other financial account on behalf of a U.S. person (or on behalf of an entity of which the U.S. person owns, actually or constructively, more than 50 percent of the ownership interest).

The proposal would be effective for amounts transferred and accounts opened beginning after December 31 of the year of enactment.



REQUIRE THIRD-PARTY INFORMATION REPORTING REGARDING THE ESTABLISHMENT OF OFFSHORE ENTITIES



Current Law

United States persons must report certain information with respect to certain foreign business entities that they control. Current law does not generally require third-party information reporting in connection with the acquisition or formation of a foreign business entity on behalf of a U.S. individual. Current law does not require withholding agents to ascertain the ownership of foreign payees that may be entities with respect to which U.S. persons have a U.S. reporting or income tax obligation.



Reasons for Change

Because no information is reported to the IRS by third parties with respect to the formation of foreign business entities, the IRS cannot readily ascertain whether U.S. individuals are complying with their reporting obligations in regard of foreign business entities that they control. Requiring third-party reporting, and providing for additional information collection by withholding agents, would supplement the reporting requirements of current law and help the IRS to enforce U.S. tax law and reduce tax evasion through the use of foreign entities.



Proposal

Any U.S. person, or any qualified intermediary, that forms or acquires a foreign entity on behalf of a U.S. individual (or on behalf of any entity of which the individual owns, actually or constructively, more than 50 percent of the ownership interest) would be required to file an information return with the IRS regarding the foreign entity that is formed or acquired. The Treasury Department would receive regulatory authority to determine the information to be reported and to provide exceptions to the reporting requirement. In addition, the Treasury Department would receive regulatory authority to require, as necessary, withholding agents to collect additional information to determine whether a U.S. person is the beneficial owner of a foreign entity and specifically report if a U.S. person is a beneficial owner.

The proposal would be effective for entities formed or acquired after December 31 of the year of enactment.



NEGATIVE PRESUMPTION FOR FOREIGN ACCOUNTS WITH RESPECT TO WHICH AN FBAR HAS NOT BEEN FILED



Current Law

A citizen or resident of the United States, or a person in and doing business in the United States, who has a financial interest in, or signature or other authority over, financial accounts in a foreign country must file a Report of Foreign Bank and Financial Accounts (FBAR) if the aggregate value of these accounts exceeds $10,000 at any time during the preceding year. The civil penalty for failing to disclose a foreign financial account on an FBAR will not exceed $10,000 absent a willful violation. The penalty may not be imposed if the violation was due to reasonable cause and the balance in the account was properly reported. For willful violations, the maximum civil penalty is the greater of $100,000 or 50 percent of the balance in the account at the time of the violation. The criminal penalties for willfully failing to report a foreign bank account include a maximum fine of $250,000, a maximum term of imprisonment of five years, or both, with higher penalties if the defendant violates any other U.S. law, or if the violation was part of a pattern of any illegal activity involving more than $100,000 in a 12-month period. Civil and criminal penalties may be imposed together.



Reasons for Change

The Administration is concerned that U.S. persons are failing to comply with FBAR filing obligations. Under current law, the civil penalty provisions associated with the requirement to file an FBAR may be difficult to apply in cases where the IRS is aware of the existence of unreported foreign financial accounts but cannot ascertain without documentation from the foreign financial institution whether those accounts contain more than $10,000. Imposing a rebuttable evidentiary presumption would encourage voluntary disclosure of account information and assist the IRS in its enforcement efforts with respect to undisclosed foreign financial accounts.



Proposal

A rebuttable evidentiary presumption would be applicable in a civil administrative or judicial proceeding providing that any foreign bank, brokerage, or other financial account in which a citizen or resident of the United States, or a person in and doing business in the United States, has a financial interest in or signature or other authority over the account contains enough funds to require that an FBAR be filed. An exception would apply for accounts held through a qualified intermediary. The Treasury Department would receive regulatory authority to provide additional exceptions. The rebuttable evidentiary presumption would not apply in criminal proceedings.

The proposal would be effective for FBARs due to be filed beginning after the date of enactment.



NEGATIVE PRESUMPTION REGARDING FAILURE TO FILE AN FBAR FOR ACCOUNTS WITH NONQUALIFIED INTERMEDIARIES



Current Law

A citizen or resident of the United States, or a person in and doing business in the United States, who has a financial interest in, or signature or other authority over, financial accounts in a foreign country must file a Report of Foreign Bank and Financial Accounts (FBAR) if the aggregate value of these accounts exceeds $10,000 at any time during the preceding year. The civil penalty for failing to disclose a foreign financial account on an FBAR will not exceed $10,000 absent a willful violation. The penalty may not be imposed if the violation was due to reasonable cause and the balance in the account was properly reported. For willful violations, the maximum civil penalty is the greater of $100,000 or 50 percent of the balance in the account at the time of the violation. The criminal penalties for willfully failing to report a foreign bank account include a maximum fine of $250,000, a maximum term of imprisonment of five years, or both, with higher penalties if the defendant violates any other U.S. law, or if the violation was part of a pattern of any illegal activity involving more than $100,000 in a 12-month period. Civil and criminal penalties may be imposed together.



Reasons for Change

The Administration is concerned that U.S. persons are failing to comply with FBAR filing obligations. Although qualified intermediaries must perform certain information reporting with respect to U.S. accountholders, foreign intermediaries that are not qualified intermediaries (nonqualified intermediaries) do not perform such information reporting. As a result, the ability of the IRS to discover unreported accounts and enforce compliance with respect to those accounts is limited. Imposing a rebuttable evidentiary presumption with respect to accounts held with nonqualified intermediaries would encourage voluntary disclosure of account information and assist the IRS in its enforcement efforts with respect to undisclosed foreign financial accounts.



Proposal

A rebuttable evidentiary presumption would be applicable in a civil administrative or judicial proceeding providing that failure to file an FBAR with respect to any foreign bank, brokerage, or other financial account held with a nonqualified intermediary is willful if the account has a balance of greater than $200,000 at any point during the calendar year. The evidentiary presumption would not apply to accounts in which the person has signature or other authority by virtue of being an officer or employee of a corporation, but otherwise has no more than a de minimis financial interest in that corporation. The Treasury Department would receive regulatory authority to provide additional exceptions to the evidentiary presumption. The evidentiary presumption would not apply in criminal proceedings.

The proposal would be effective for FBARs due to be filed beginning after the date of enactment.



NEGATIVE PRESUMPTION REGARDING WITHHOLDING ON FDAP PAYMENTS TO CERTAIN FOREIGN ENTITIES



Current Law

In general, payments of U.S.-source fixed or determinable annual or periodical gains, profits, or income (FDAP income) to nonresident alien individuals and foreign entities are subject to withholding tax at a rate of 30 percent. This 30 percent withholding tax may be reduced or eliminated pursuant to certain statutory provisions or pursuant to the terms of a tax treaty.

To determine whether the recipient of a payment is exempt from withholding tax or eligible for a reduced rate, withholding agents generally must rely on beneficial ownership documentation provided by the payee certifying that the payee is entitled to an exemption from withholding tax or a reduced rate of withholding tax under a Code provision or relevant tax treaty. In general, withholding agents are entitled to rely on the self-certification they receive absent actual knowledge or reason to know that the information provided is incorrect or unreliable. In the case of payments made through an intermediary, the intermediary generally provides to the withholding agent the appropriate documentation on behalf of the payment's beneficial owners.



Reasons for Change

Persons that are not entitled to an exemption from withholding tax or a reduced rate of withholding tax may arrange to receive payments through entities that appear to qualify for an exemption or a reduced rate. A withholding agent making a payment to such an entity is unlikely to be in a position to determine whether the entity's self-certification regarding its qualification is accurate.



Proposal

Any withholding agent making a payment of FDAP income to a foreign entity would be required to treat the payment as made to an unknown person (and therefore subject to 30 percent grossbasis withholding tax), unless the foreign entity provides documentation of the entity's beneficial owners. Exceptions would be provided for payments to publicly traded companies and their subsidiaries, foreign governments, and pension funds. In addition, the Treasury Department would receive regulatory authority to provide additional exceptions for payments to entities engaged in the active conduct of a trade or business in their country of residence, charities, widely-held investment vehicles, entities that enter into an agreement with the IRS to collect documentation for all owners and report all U.S. non-exempt owners to the IRS, and for any other payment that the Treasury Department concludes presents a low risk of tax evasion.

The proposal would be effective for payments made after December 31 of the year of enactment.



EXTEND STATUTE OF LIMITATIONS FOR CERTAIN REPORTABLE CROSS-BORDER TRANSACTIONS AND FOREIGN ENTITIES



Current Law

In general, additional Federal tax liabilities in the form of tax, interest, penalties, and additions to tax must be assessed by the IRS within three years after the date a return is filed. If an assessment is not made within the required time period, the additional liabilities generally cannot be assessed or collected at any future time. Section 6501(c)(8) of the Code provides an exception to this general statute of limitations with respect to any tax relating to any event or period for which certain information returns are required with respect to certain foreign transfers, foreign entities, and foreign-owned entities. In these cases, the statute of limitations does not expire until three years after the taxpayer furnishes the information required to be reported.

Section 6038A of the Code requires certain foreign-owned domestic corporations to file information returns containing specified information with respect to related-party transactions, and to maintain such records as may be appropriate to determine the correct treatment of such transactions. Failure to file the required information returns triggers the section 6501(c)(8) extension of the statute of limitations.



Reasons for Change

Compliance with reporting and recordkeeping obligations is essential in order to enable the IRS to enforce the tax laws. The three-year period provided by section 6501(c)(8) does not always allow sufficient time for the IRS to determine a taxpayer's tax liability. Furthermore, the information returns to which section 6501(c)(8) applies do not include some of the information returns the IRS requires in order to enforce the tax law with respect to foreign entities and accounts, including certain newly proposed information returns. The generally applicable threeyear statute of limitations also does not always allow sufficient time for the IRS to determine a taxpayer's tax liability if a violation of record maintenance obligations under section 6038A has occurred.



Proposal

The proposal would extend the period during which the statute of limitations provided by section 6501(c)(8) does not expire to six years after the taxpayer furnishes the information required to be reported. The information returns with respect to which section 6501(c)(8) applies would be broadened to include the information returns filed by qualifying electing funds pursuant to regulations under section 1295(b) of the Code, the proposed tax return disclosure of FBAR information, and the information returns proposed to be required of U.S. individuals with respect to certain transfers of money or property to and receipts from certain foreign bank, brokerage, or other financial accounts. The extended statute of limitations provided by section 6501(c)(8) would also apply in the case of failure to furnish information or maintain records as required by section 6038A(a). The section 6501(c)(8) exception to the general statute of limitations would be made applicable to the entire income tax return. The Treasury Department would receive regulatory authority to provide exceptions to these rules.

The proposal would be effective for returns due to be filed after the date of enactment.



DOUBLE ACCURACY-RELATED PENALTIES ON UNDERSTATEMENTS INVOLVING UNDISCLOSED FOREIGN ACCOUNTS



Current Law

Current law imposes a 20-percent accuracy-related penalty on (i) a substantial understatement of income tax, (ii) an understatement resulting from negligence or disregard of rules or regulations, and (iii) an understatement related to a reportable transaction. The 20-percent accuracy-related penalty increases to 30 percent in the case of an understatement from a reportable transaction that was not properly disclosed. The accuracy-related penalty is not imposed when the taxpayer demonstrates "reasonable cause" for the position and acted in good faith. In the case of a reportable transaction, the reasonable cause exception to the imposition of penalties only applies if the taxpayer disclosed the reportable transaction as required by law and certain other requirements are met.

Individual taxpayers must indicate on their income tax returns whether they had an interest in or signature or other authority over a financial account in a foreign country during the year to which the tax return relates. If the taxpayer had a foreign financial account, the income tax return instructs the taxpayer to refer to the Report of Foreign Bank and Financial Accounts (FBAR), which requires the taxpayer to disclose information regarding certain foreign accounts.



Reason for Change

United States persons may seek to evade U.S. tax liability by transferring assets to foreign accounts. Increasing the penalties on understatements from transactions that involve undisclosed foreign accounts would encourage proper disclosure of such accounts and deter the use of foreign accounts to evade U.S. tax liability.



Proposal

The 20-percent accuracy-related penalty imposed on (i) substantial understatements of income tax, (ii) understatements resulting from negligence or disregard of rules or regulations, or (iii) a reportable transaction understatement, would be doubled to 40 percent when the understatement arises from a transaction involving a foreign account that the taxpayer failed to disclose properly under the proposed requirement that taxpayers disclose FBAR-related information on their income tax returns. In addition, in the case of a reportable transaction understatement, the reasonable cause exception would not be available with respect to this increased penalty.

The proposal would be effective for taxable years beginning after December 31 of the year of enactment.



IMPROVE THE FOREIGN TRUST REPORTING PENALTY



Current Law

Certain information must be reported to the IRS with respect to certain foreign trusts. A civil penalty applies to persons who fail to file a timely return as required or who file an incomplete or incorrect return. Generally, the penalty is equal to 35 percent of the "gross reportable amount," which is defined as the gross value of property involved in a reportable event such as a gratuitous transfer to the trust, the gross value of the portion of the trust's assets at the close of the year that is treated as owned by a United States person, or the gross amount of distributions received from the trust. In the case of a failure to report that continues for more than 90 days after the IRS mails notice of such failure, the penalty (in addition to the 35 percent penalty) is $10,000 for each 30-day period (or fraction thereof) during which the failure continues. The total penalty with respect to any failure may not exceed the gross reportable amount.



Reasons for Change

In many instances, the IRS obtains information relating to the creation of a foreign trust from third parties, or the IRS discovers funding of a foreign trust from public records. Without the cooperation of persons actually involved with the trust, however, it is often difficult for the IRS to determine the gross reportable amount. If the IRS cannot determine the gross reportable amount, the IRS may not be able to assess the penalties, including the $10,000 penalty for continued failure to report. The current penalty regime therefore may create an incentive for persons subject to the reporting requirement not to report or cooperate with the IRS in the hope that the IRS will not be able to determine the gross reportable amount, which is essential to presenting a prima facie case sufficient to meet the Code section 7491(c) burden of production to support the penalty.



Proposal

The penalty provision would be amended to impose an initial penalty of the greater of $10,000 or 35 percent of the gross reportable amount (if the gross reportable amount is known). The additional $10,000 penalty for continued failure to report would remain unchanged. Thus, even if the gross reportable amount is not known, the IRS may impose a $10,000 penalty on a person who fails to report timely or correctly as required, and may impose a $10,000 penalty for each 30-day period (or fraction thereof) that the failure to report continues. If the person subsequently provides enough information for the IRS to determine the gross reportable amount, the total penalties would be capped at that amount and any excess penalty already paid would be refunded. Accordingly, a person can stop the compounding of penalties by cooperating with the IRS so that it can determine the gross reportable amount.

The proposal would be effective for information reports required to be filed after December 31 of the year of enactment.



REQUIRE INFORMATION REPORTING FOR RENTAL PROPERTY EXPENSE PAYMENTS



Current Law

Generally, a taxpayer making payments in the course of a trade or business to a noncorporate recipient aggregating to $600 or more for services or determinable gains in a calendar year is required to send an information return to the IRS setting forth the amount, as well as name and address of the recipient of the payment (generally on Form 1099). If the taxpayer making payments is not engaged in a trade or business, such information reporting is not required.

At present, there is limited third-party information reporting related to rental real estate expenses because only taxpayers whose rental real estate activity is considered a trade or business are required to report payments. Additionally, whether a taxpayer's rental real estate activity should be considered a trade or business requires a case-by-case analysis that depends on the facts and circumstances of each taxpayer.



Reasons for Change

Information reporting requirements generally improve taxpayer compliance. Requiring information reporting by taxpayers receiving rental income and deducting expenses on rental activities would improve the reporting compliance by taxpayers providing services to those rental activities. In addition, increased third-party reporting of major rental expenses is likely to improve reporting compliance on rental real estate income.



Proposal

The proposal would, in general, subject recipients of rental income from real estate would, in general, be subject to the same information reporting requirements as are taxpayers engaging in a trade or business. In particular, rental income recipients making payments of $600 or more to a service provider (such as a plumber, painter, or accountant) in the course of earning rental income would be required to send an information return, generally a Form 1099-MISC, to the IRS and to the service provider. Exceptions to the reporting requirement would be made for particularly burdensome situations, such as for taxpayers (including members of the military) who rent their principal residence on a temporary basis, or for those who receive only small amounts of rental income.

The proposal would be effective for tax years beginning after December 31, 2009.



Eliminate Oil and Gas Company Preferences



LEVY TAX ON CERTAIN OFFSHORE OIL AND GAS PRODUCTION



Current Law

No Federal tax is imposed on the production of oil and gas on the Outer Continental Shelf (OCS).



Reasons for Change

According to the Government Accountability Office, the return to the taxpayer from OCS production is among the lowest in the world, despite other factors that make the United States a comparatively good place to invest in oil and gas development. An excise tax on OCS production would advance important policy objectives, such as providing a more level playing field among producers, raising the return to the taxpayer, and encouraging sustainable domestic oil and gas production.



Proposal

The Administration is developing a proposal to impose an excise tax on certain oil and gas produced offshore in the future. The Administration will work with Congress to develop the details of this proposal.



REPEAL CREDIT FOR ENHANCED OIL RECOVERY (EOR) PROJECTS



Current Law

The general business credit includes a 15-percent credit for eligible costs attributable to EOR projects. If the credit is claimed with respect to eligible costs, the taxpayer's deduction (or basis increase) with respect to those costs is reduced by the amount of the credit. Eligible costs include the cost of constructing a gas treatment plant to prepare Alaska natural gas for pipeline transportation and any of the following costs with respect to a qualified EOR project: (1) the cost of depreciable or amortizable tangible property that is an integral part of the project; (2) intangible drilling and development costs (IDCs) that the taxpayer can elect to deduct; and (3) deductible tertiary injectant costs. A qualified EOR project must be located in the United States and must involve the application of one or more of nine listed tertiary recovery methods that can reasonably be expected to result in more than an insignificant increase in the amount of crude oil which ultimately will be recovered. The allowable credit is phased out over a $6 range for a taxable year if the annual average unregulated wellhead price per barrel of domestic crude oil during the calendar year preceding the calendar year in which the taxable year begins (the reference price) exceeds an inflation adjusted threshold. The credit was completely phased out for taxable years beginning in 2008, because the reference price ($66.52) exceeded the inflation adjusted threshold ($41.06) by more than $6.



Reasons for Change

The credit, like other oil and gas preferences the Administration proposes to repeal, distorts markets by encouraging more investment in the oil and gas industry than would occur under a neutral system. To the extent the credit encourages overproduction of oil, it is detrimental to long-term energy security and is also inconsistent with the Administration's policy of reducing carbon emissions and encouraging the use of renewable energy sources through a cap-and-trade program. Moreover, the credit must ultimately be financed with taxes that result in underinvestment in other, potentially more productive, areas of the economy.



Proposal

The investment tax credit for enhanced oil recovery projects would be repealed for taxable years beginning after December 31, 2010.



REPEAL CREDIT FOR PRODUCTION FROM MARGINAL WELLS



Current Law

The general business credit includes a credit for crude oil and natural gas produced from marginal wells. The credit rate is $3.00 per barrel of oil and $0.50 per 1,000 cubic feet of natural gas for taxable years beginning in 2005 and is adjusted for inflation in taxable years beginning after 2005. The credit is available for production from wells that produce oil and gas qualifying as marginal production for purposes of the percentage depletion rules or that have average daily production of not more than 25 barrel-of-oil equivalents and produce at least 95 percent water. The credit per well is limited to 1,095 barrels of oil or barrel-of-oil equivalents per year. The credit rate for crude oil is phased out for a taxable year if the annual average unregulated wellhead price per barrel of domestic crude oil during the calendar year preceding the calendar year in which the taxable year begins (the reference price) exceeds the applicable threshold. The phase-out range and the applicable threshold at which phase-out begins are $3.00 and $15.00 for taxable years beginning in 2005 and are adjusted for inflation in taxable years beginning after 2005. The credit rate for natural gas is similarly phased out for a taxable year if the annual average wellhead price for domestic natural gas exceeds the applicable threshold. The phase-out range and the applicable threshold at which phase-out begins are $0.33 and $1.67 for taxable years beginning in 2005 and are adjusted for inflation in taxable years beginning after 2005. The credit has been completely phased out for all taxable years since its enactment. Unlike other components of the general business credit, the marginal well credit can be carried back up to five years.



Reasons for Change

The credit, like other oil and gas preferences the Administration proposes to repeal, distorts markets by encouraging more investment in the oil and gas industry than would occur under a neutral system. To the extent the credit encourages overproduction of oil, it is detrimental to long-term energy security and is also inconsistent with the Administration's policy of reducing carbon emissions and encouraging the use of renewable energy sources through a cap-and-trade program. Moreover, the credit must ultimately be financed with taxes that result in underinvestment in other, potentially more productive, areas of the economy.



Proposal

The production tax credit for oil and gas from marginal wells would be repealed for production in taxable years beginning after December 31, 2010.



REPEAL EXPENSING OF INTANGIBLE DRILLING COSTS



Current Law

In general, costs that benefit future periods must be capitalized and recovered over such periods for income tax purposes, rather than being expensed in the period the costs are incurred. In addition, the uniform capitalization rules require certain direct and indirect costs allocable to property to be included in inventory or capitalized as part of the basis of such property. In general, the uniform capitalization rules apply to real and tangible personal property produced by the taxpayer or acquired for resale.

Special rules apply to intangible drilling and development costs (IDCs). IDCs include all expenditures made by an operator for wages, fuel, repairs, hauling, supplies, etc., incident to and necessary for the drilling of wells and the preparation of wells for the production of oil and gas. In addition, IDCs include the cost to operators of any drilling or development work (excluding amounts payable only out of production or gross or net proceeds from production, if the amounts are depletable income to the recipient, and amounts properly allocable to the cost of depreciable property) done by contractors under any form of contract (including a turnkey contract). IDCs include amounts paid for labor, fuel, repairs, hauling, and supplies which are used in the drilling, shooting, and cleaning of wells; in such clearing of ground, draining, road making, surveying, and geological works as are necessary in preparation for the drilling of wells; and in the construction of such derricks, tanks, pipelines, and other physical structures as are necessary for the drilling of wells and the preparation of wells for the production of oil and gas. Generally, IDCs do not include expenses for items which have a salvage value (such as pipes and casings) or items which are part of the acquisition price of an interest in the property.

Under the special rules applicable to IDCs, an operator (i.e., a person who holds a working or operating interest in any tract or parcel of land either as a fee owner or under a lease or any other form of contract granting working or operating rights) who pays or incurs IDCs in the development of an oil or gas property located in the United States may elect either to expense or capitalize those costs. The uniform capitalization rules do not apply to otherwise deductible IDCs.

If a taxpayer elects to expense IDCs, the amount of the IDCs is deductible as an expense in the taxable year the cost is paid or incurred. Generally, IDCs that a taxpayer elects to capitalize may be recovered through depletion or depreciation, as appropriate; or in the case of a nonproductive well ("dry hole"), the operator may elect to deduct the costs. In the case of an integrated oil company (i.e., a company that engages, either directly or through a related enterprise, in substantial retailing or refining activities) that has elected to expense IDCs, 30 percent of the IDCs on productive wells must be capitalized and amortized over a 60-month period.

A taxpayer that has elected to deduct IDCs may, nevertheless, elect to capitalize and amortize certain IDCs over a 60-month period beginning with the month the expenditure was paid or incurred. This rule applies on an expenditure-by-expenditure basis; that is, for any particular taxable year, a taxpayer may deduct some portion of its IDCs and capitalize the rest under this provision. This allows the taxpayer to reduce or eliminate IDC adjustments or preferences under the AMT.

The election to deduct IDCs applies only to those IDCs associated with domestic properties. For this purpose, the United States includes certain wells drilled offshore.



Reasons for Change

The expensing of IDCs, like other oil and gas preferences the Administration proposes to repeal, distorts markets by encouraging more investment in the oil and gas industry than would occur under a neutral system. To the extent expensing encourages overproduction of oil and gas, it is detrimental to long-term energy security and is also inconsistent with the Administration's policy of reducing carbon emissions and encouraging the use of renewable energy sources through a cap-and-trade program. Moreover, the tax subsidy for oil and gas must ultimately be financed with taxes that result in underinvestment in other, potentially more productive, areas of the economy. Capitalization of IDCs would place them on a cost recovery system similar to that employed by other industries and reduce economic distortions.



Proposal

Expensing of intangible drilling costs and 60-month amortization of capitalized intangible drilling costs would not be allowed. Intangible drilling costs would be capitalized as depreciable or depletable property, depending on the nature of the cost incurred, in accordance with the generally applicable rules.

The proposal would be effective for costs paid or incurred after December 31, 2010.



REPEAL DEDUCTION FOR TERTIARY INJECTANTS



Current Law

Taxpayers are allowed to deduct the cost of qualified tertiary injectant expenses for the taxable year. Qualified tertiary injectant expenses are amounts paid or incurred for any tertiary injectant (other than recoverable hydrocarbon injectants) that is used as a part of a tertiary recovery method. The deduction is treated as an amortization deduction in determining the amount subject to recapture upon disposition of the property.



Reasons for Change

The deduction for tertiary injectants, like other oil and gas preferences the Administration proposes to repeal, distorts markets by encouraging more investment in the oil and gas industry than would occur under a neutral system. To the extent expensing encourages overproduction of oil and gas, it is detrimental to long-term energy security and is also inconsistent with the Administration's policy of reducing carbon emissions and encouraging the use of renewable energy sources through a cap-and-trade program. Moreover, the tax subsidy for oil and gas must ultimately be financed with taxes that result in underinvestment in other, potentially more productive, areas of the economy. Capitalization of tertiary injectants would place them on a cost recovery system similar to that employed by other industries and reduce economic distortions.



Proposal

The deduction for qualified tertiary injectant expenses would not be allowed for amounts paid or incurred after December 31, 2010.



REPEAL PASSIVE LOSS EXCEPTION FOR WORKING INTERESTS IN OIL AND GAS PROPERTIES



Current Law

The passive loss rules limit deductions and credits from passive trade or business activities. Deductions attributable to passive activities, to the extent they exceed income from passive activities, generally may not be deducted against other income, such as wages, portfolio income, or business income that is not derived from a passive activity. A similar rule applies to credits. Suspended deductions and credits are carried forward and treated as deductions and credits from passive activities in the next year. The suspended losses and credits from a passive activity are allowed in full when the taxpayer completely disposes of the activity.

Passive activities are defined to include trade or business activities in which the taxpayer does not materially participate. An exception is provided, however, for any working interest in an oil or gas property that the taxpayer holds directly or through an entity that does not limit the liability of the taxpayer with respect to the interest.



Reasons for Change

The special tax treatment of working interests in oil and gas properties, like other oil and gas preferences the Administration proposes to repeal, distorts markets by encouraging more investment in the oil and gas industry than would occur under a neutral system. To the extent this special treatment encourages overproduction of oil and gas, it is detrimental to long-term energy security and is also inconsistent with the Administration's policy of reducing carbon emissions and encouraging the use of renewable energy sources through a cap-and-trade program. Moreover, the working interest exception for oil and gas must ultimately be financed with taxes that result in underinvestment in other, potentially more productive, areas of the economy. Eliminating the working interest exception would subject oil and gas properties to the same limitations as other activities and reduce economic distortions.



Proposal

The exception from the passive loss rules for working interests in oil and gas properties would be repealed for taxable years beginning after December 31, 2010.



REPEAL PERCENTAGE DEPLETION



Current Law

The capital costs of oil and gas wells are recovered through the depletion deduction. Under the cost depletion method, the basis recovery for a taxable year is proportional to the exhaustion of the property during the year. This method does not permit cost recovery deductions that exceed basis or that are allowable on an accelerated basis.

A taxpayer may also qualify for percentage depletion with respect to oil and gas properties. The amount of the deduction is a statutory percentage of the gross income from the property. For oil and gas properties, the percentage ranges from 15 to 25 percent and the deduction may not exceed 100 percent of the taxable income from the property. In addition, the percentage depletion deduction for oil and gas properties may not exceed 65 percent of the taxpayer's overall taxable income (determined before the deduction and with certain other adjustments).

Other limitations and special rules apply to the percentage depletion deduction for oil and gas properties. In general, only independent producers and royalty owners (as contrasted to integrated oil companies) qualify for the percentage depletion deduction. In addition, oil and gas producers may claim percentage depletion only with respect to up to 1,000 barrels of average daily production of domestic crude oil or an equivalent amount of domestic natural gas (applied on a combined basis in the case of taxpayers that produce both). This quantity limitation is allocated, at the taxpayer's election, between oil and gas production and then further allocated within each class among the taxpayer's properties. Special rules apply to oil and gas production from marginal wells (generally, wells for which the average daily production is less than 15 barrels of oil or barrel-of-oil equivalents or that produce only heavy oil). Only marginal well production can qualify for percentage depletion at a rate of more than 15 percent. The rate is increased in a taxable year that begins a calendar year following a calendar year during which the annual average unregulated wellhead price per barrel of domestic crude oil is less than $20 by one percentage point for each whole dollar of difference between the two amounts. In addition, marginal wells are exempt from the 100-percent-of-net-income limitation described above in taxable years beginning during the period 1998- 2007 and in taxable years beginning in 2009. Unless the taxpayer elects otherwise, marginal well production is given priority over other production in applying the 1,000-barrel limitation on percentage depletion.

A qualifying taxpayer determines the depletion deduction for each oil and gas property under both the percentage depletion method and the cost depletion method and deducts the larger of the two amounts. Because percentage depletion is computed without regard to the taxpayer's basis in the depletable property, a taxpayer may continue to claim percentage depletion after all the expenditures incurred to acquire and develop the property have been recovered.



Reasons for Change

Percentage depletion effectively provides a lower rate of tax with respect to a favored source of income. The lower rate of tax, like other oil and gas preferences the Administration proposes to repeal, distorts markets by encouraging more investment in the oil and gas industry than would occur under a neutral system. To the extent the lower tax rate encourages overproduction of oil and gas, it is detrimental to long-term energy security and is also inconsistent with the Administration's policy of reducing carbon emissions and encouraging the use of renewable energy sources through a cap-and-trade program. Moreover, the tax subsidy for oil and gas must ultimately be financed with taxes that result in underinvestment in other, potentially more productive, areas of the economy.

Cost depletion computed by reference to the taxpayer's basis in the property is the equivalent of economic depreciation. Limiting oil and gas producers to cost depletion would place them on a cost recovery system similar to that employed by other industries and reduce economic distortions.



Proposal

Percentage depletion would not be allowed with respect to oil and gas wells. Taxpayers would be permitted to claim cost depletion on their adjusted basis, if any, in oil and gas wells.

The proposal would be effective for taxable years beginning after December 31, 2010.



REPEAL DOMESTIC MANUFACTURING DEDUCTION FOR OIL AND GAS PRODUCTION



Current Law

A deduction is allowed with respect to income attributable to domestic production activities (the manufacturing deduction). For taxable years beginning in 2009, the manufacturing deduction is equal to 6 percent of the lesser of qualified production activities income for the taxable year or taxable income for the taxable year, limited to 50-percent of the W-2 wages of the taxpayer for the taxable year. For taxable years beginning after 2009, the deduction is computed at a 9 percent rate, except that the deduction for income oil and gas production activities is computed at a 6 percent rate.

Qualified production activities income is generally calculated as a taxpayer's domestic production gross receipts (i.e., the gross receipts derived from any lease, rental, license, sale, exchange, or other disposition of qualifying production property manufactured, produced, grown, or extracted by the taxpayer in whole or significant part within the U.S.; any qualified film produced by the taxpayer; or electricity, natural gas, or potable water produced by the taxpayer in the U.S.) minus the cost of goods sold and other expenses, losses, or deductions attributable to such receipts.

The manufacturing deduction generally is available to all taxpayers that generate qualified production activities income, which under current law includes income from the sale, exchange or disposition of oil, natural gas or primary products produced in the United States.



Reasons for Change

The manufacturing deduction effectively provides a lower rate of tax with respect to a favored source of income. The lower rate of tax, like other oil and gas preferences the Administration proposes to repeal, distorts markets by encouraging more investment in the oil and gas industry than would occur under a neutral system. To the extent the lower tax rate encourages overproduction of oil and gas, it is detrimental to long-term energy security and is also inconsistent with the Administration's policy of reducing carbon emissions and encouraging the use of renewable energy sources through a cap-and-trade program. Moreover, the tax subsidy for oil and gas must ultimately be financed with taxes that result in underinvestment in other, potentially more productive, areas of the economy.



Proposal

The proposal would exclude from the definition of domestic production gross receipts all gross receipts derived from the sale, exchange or other disposition of oil, natural gas or a primary product thereof for taxable years beginning after December 31, 2010.



INCREASE THE AMORTIZATION PERIOD FOR GEOLOGICAL AND GEOPHYSICAL COSTS TO SEVEN YEARS



Current Law

Geological and geophysical expenditures are costs incurred for the purpose of obtaining and accumulating data that will serve as the basis for the acquisition and retention of mineral properties. The amortization period for geological and geophysical expenditures incurred in connection with oil and gas exploration in the United States is two years for independent producers and seven years for integrated oil and gas producers.



Reasons for Change

The accelerated amortization of geological and geophysical expenditures incurred by independent producers, like other oil and gas preferences the Administration proposes to repeal, distorts markets by encouraging more investment in the oil and gas industry than would occur under a neutral system. To the extent accelerated amortization encourages overproduction of oil and gas, it is actually detrimental to long-term energy security and is also inconsistent with the Administration's policy of reducing carbon emissions and encouraging the use of renewable energy sources through a cap-and-trade program. Moreover, the tax subsidy for oil and gas must ultimately be financed with taxes that result in underinvestment in other, potentially more productive, areas of the economy.

Increasing the amortization period for geological and geophysical expenditures incurred by independent oil and gas producers from two years to seven years would provide a more accurate reflection of their income and more consistent tax treatment for all oil and gas producers.



Proposal

The proposal would increase the amortization period from two years to seven years for geological and geophysical expenditures incurred by independent producers in connection with all oil and gas exploration in the United States. Seven-year amortization would apply even if the property is abandoned and any remaining basis of the abandoned property would be recovered over the remainder of the seven-year period. The proposal would be effective for amounts paid or incurred after December 31, 2010.



ELIMINATE THE ADVANCED EARNED INCOME TAX CREDIT



Current Law

Under current law, low- and moderate-income individuals may be eligible for the refundable EITC. The amount of EITC an eligible individual may claim is a function of income and earnings, the number of children in the household, and filing status. In 2009, families with one child are eligible for a maximum EITC of $3,043. Eligible individuals with more children receive a larger credit.

Since 1978, most eligible individuals have had the option of requesting advance payments of the EITC from their employers throughout the year. Self-employed and childless individuals are not eligible. Under current law, the advance payment is limited to 60 percent of the maximum credit to which a worker with one child would be entitled. In 2009, the maximum advance payment is $1,826.

Employers offset the costs of the advance payments by reducing their payments of withheld income and employment taxes. During the year, employers periodically notify the IRS of the aggregate amount of advance payments withheld from tax payments. After the tax year is over, the employer notifies the IRS of employees' receipts of advance payments. The information is also provided to the employees. Upon filing their tax returns, individuals must reconcile any advance payments received during the year with the amount of EITC for which they actually were eligible. If they received too little, they can obtain the remaining amount; conversely, if they received too much, they must repay the overpayment with their tax return. Individuals who have received an advance payment are required to file a tax return, even if their income is below the filing threshold. In view of the risk of overpayments, the advance payment is limited to 60 percent of the one-child maximum credit.



Reason for Change

The advance payment option provides a mechanism for individuals to receive payments on a timely basis, instead of as a single payment during the filing season. Advance payments could help cash-constrained households meet their daily needs. However, advance payments have been extremely unpopular among eligible taxpayers - at most, 3 percent of eligible individuals participate, and IRS' efforts to increase participation have not had a meaningful impact. Furthermore, recent research shows evidence of significant non-compliance by employers and workers. As a consequence, repealing the advance payment option would affect adversely few individuals who are eligible for this benefit.



Proposal

The proposal would repeal the advance payment option of the EITC. Workers would no longer be able to receive an advance against their expected EITC through their employer. (Individuals with positive tax liability would still be able to receive any non-refundable portion of the EITC during the year through adjustments in their withholding.)

The proposal would be effective for taxable years beginning after December 31, 2009.


UPPER-INCOME TAX PROVISIONS DEDICATED TO DEFICIT REDUCTION




REINSTATE THE 39.6-PERCENT RATE



Current Law

Prior to the enactment of EGTRRA, the highest individual income tax rate was 39.6-percent. EGTRRA reduced the 39.6-percent tax rate temporarily to 35 percent, with the reduction phased in over several years. The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) accelerated the reduction, and since 2003, the highest statutory individual income tax rate has been 35 percent. For 2009, it applies to taxable income over $372,950 ($186,475 if married filing separately). The 35-percent tax rate sunsets after 2010.



Reason for Change

Increasing the income tax liability of wealthy taxpayers would make the income tax system more progressive and would distribute the cost of government more fairly among taxpayers of various income levels.



Proposal

The Administration's tax receipts baseline would permanently extend the EGTRRA tax rates. This proposal would permit the EGTRRA reduction in the highest income tax rate to sunset after 2010. Thus, beginning in 2011, the highest income tax rate would be 39.6 percent. The taxable income levels at which this rate begins to apply would vary by filing status and would be indexed annually for inflation.



REINSTATE THE 36-PERCENT RATE FOR TAXPAYERS WITH INCOME OVER $250,000 (MARRIED FILING A JOINT RETURN) AND $200,000 (SINGLE)



Current Law

Prior to the enactment of EGTRRA, the second highest individual income tax rate was 36 percent. EGTRRA reduced the 36-percent tax rate temporarily to 33 percent, with the reduction phased in over several years. JGTRRA accelerated the reduction, and since 2003, the second highest statutory individual income tax rate has been 33 percent. In 2009, it applies to taxable income over $208,850 if married filing jointly ($171,550 if single). The 33-percent tax rate sunsets after 2010.



Reason for Change

Increasing the income tax liability of wealthy taxpayers would make the income tax system more progressive and would distribute the cost of government more fairly among taxpayers of various income levels.



Proposal

The Administration's tax receipts baseline would permanently extend the EGTRRA tax rates. This proposal would permit the EGTRRA reduction in the second highest income tax rate to sunset after 2010. Thus, beginning in 2011, the second highest tax rate would be 36 percent. The taxable income levels at which that rate begins to apply would vary by filing status and would be indexed annually for inflation. The 36-percent tax rate would apply to taxable income above the following amounts but less than the income levels at which the 39.6-percent rate would apply: $250,000 less the standard deduction and two personal exemptions, indexed from 2009, for married taxpayers filing jointly; $200,000 less the standard deduction and one personal exemption, indexed from 2009, for single filers. The 28-percent tax rate bracket would be expanded so that taxpayers earning less than these amounts would not see their taxes rise as a result of the increased tax rate brackets.



REINSTATE THE LIMITATION ON ITEMIZED DEDUCTIONS FOR TAXPAYERS WITH INCOME OVER $250,000 (MARRIED FILING A JOINT RETURN) AND $200,000 (SINGLE)



Current Law

Individual taxpayers may elect to itemize their deductions instead of claiming a standard deduction. In general, itemized deductions include medical and dental expenses (in excess of 7.5 percent of AGI), state and local property taxes and either income or sales taxes, interest paid, gifts to charities, casualty and theft losses (in excess of 10 percent of AGI), job expenses and certain miscellaneous expenses (some only in excess of 2 percent of AGI).

Prior to the enactment of EGTRRA, otherwise allowable itemized deductions (other than medical expenses, investment interest, theft and casualty losses, and gambling losses) were reduced by 3 percent of the amount by which AGI exceeded a statutory floor that was indexed annually for inflation, but not by more than 80 percent of the otherwise allowable deductions. EGTRRA reduced the itemized deduction limitation in three steps. For 2006 and 2007, itemized deductions were reduced by 2 percent of AGI over the threshold, but not by more than 53-1/3 percent. For 2008 and 2009, itemized deductions were reduced by 1 percent of AGI over the threshold, but not by more than 26-2/3 percent. For 2010, the reduction was to be completely eliminated. However, beginning in 2011, the full itemized deduction reduction of 3 percent of AGI exceeding the floor is scheduled to be reinstated.

For 2009, the AGI floor is $166,800 ($83,400 if married filing separately).



Reason for Change

By limiting the tax benefit of higher-income taxpayers' itemized deductions, the income tax system would be made more progressive and the cost of government would be shared more fairly by taxpayers in all levels of income.



Proposal

The Administration's tax receipts baseline would permanently extend the EGTRRA repeal of the limitation on itemized deductions. This proposal would allow the elimination of the limitation on itemized deduction enacted in EGTRRA to sunset after 2010. Thus, itemized deductions (other than medical expenses, investment interest, theft and casualty losses, and gambling losses) would be reduced by 3 percent of the amount by which AGI exceeds statutory floors which are higher than under current law, but not by more than 80 percent of the otherwise allowable deductions. The floors would be indexed annually for inflation. For 2011, the AGI floors would be adjusted for inflation starting with a value of $250,000 in 2009 for married taxpayers filing jointly and $200,000 in 2009 for single taxpayers.



REINSTATE THE PERSONAL EXEMPTION PHASE-OUT (PEP) FOR TAXPAYERS WITH INCOME OVER $250,000 (MARRIED FILING A JOINT RETURN) AND $200,000 (SINGLE)



Current Law

Individual taxpayers generally are entitled to a personal exemption for the taxpayer and for each dependent. The amount of each personal exemption is $3,650 for 2009 and is indexed annually for inflation.

Prior to the enactment of EGTRRA, all personal exemptions were reduced or completely phased out simultaneously for higher-income taxpayers. For a taxpayer with AGI in excess of the threshold amount for the taxpayer's filing status, the amount of each personal exemption was reduced by 2 percent of the exemption amount for that year for each $2,500 ($1,250 if married filing separately) or fraction thereof by which AGI exceeded that threshold. EGTRRA reduced the otherwise applicable reduction of personal exemptions by one-third for 2006 and 2007, by two-thirds for 2008 and 2009, and eliminated it completely for 2010. However, beginning in 2011, the full personal exemption phase-out is scheduled to be reinstated.

For 2009, personal exemptions are reduced by 0.6667 percentage points for each $2,500 ($1,250 if married filing separately) or fraction thereof by which AGI exceeds the threshold, but not by more than one-third of the unreduced exemption amount. Thus, even the highest-income taxpayers are entitled to claim $2,433.33 for each personal exemption. For 2009, the thresholds at which personal exemptions begin to be reduced if AGI exceeds these amounts are $166,800 for single taxpayers, $208,500 for heads of household, $250,200 for married taxpayers filing jointly, and $125,100 for married taxpayers filing separately.



Reason for Change

By limiting the tax benefit of higher-income taxpayers' personal exemptions, the income tax system would be made more progressive, and the cost of government would be shared more fairly by taxpayers in all levels of income.



Proposal

The Administration's tax receipts baseline would permanently extend the EGTRRA repeal of the personal exemption phase-out. This proposal would allow the elimination of the personal exemption phase-out enacted in EGTRRA to sunset after 2010. The AGI levels at which the phase-out begins would be adjusted. For 2011, the AGI floors would be adjusted for inflation starting with a value of $250,000 in 2009 for married taxpayers filing jointly ($125,000 if filing separately) and $200,000 in 2009 for single taxpayers.



IMPOSE A 20-PERCENT RATE ON DIVIDENDS AND CAPITAL GAINS FOR TAXPAYERS WITH INCOME OVER $250,000 (MARRIED FILING A JOINT RETURN) AND $200,000 (SINGLE)



Current Law

A separate rate structure applies to long-term capital gains and dividends. Under current law, the maximum rate of tax on the adjusted net capital gain of an individual is 15 percent. In addition, any adjusted net capital gain otherwise taxed at a 10- or 15-percent rate is taxed at a zero-percent rate. These rates apply for purposes of both the regular tax and the AMT. Qualified dividends generally are taxed at the same rate as capital gains.

Capital losses generally are deductible in full against capital gains. In addition, individual taxpayers may deduct up to $3,000 of capital losses from ordinary income in each year. Any remaining unused capital losses may be carried forward indefinitely to a future year.

The zero- and 15-percent rates for dividends and capital gains are scheduled to sunset for taxable years beginning after December 31, 2010. In 2011, the maximum rate on capital gains would increase to 20 percent, while the tax rates for dividends would go back to the higher ordinary tax rates of up to 39.6 percent.



Reasons for Change

The Administration supports keeping income tax rates low on corporate dividends and capital gains (including sales and exchanges of corporate stock). Lower- and middle-income taxpayers should be protected from the tax increase that would otherwise occur in 2011. Allowing the 15- percent rate to expire for high-income taxpayers who are most able to absorb it would still keep the top rate at historically low levels. The 20-percent maximum rate on capital gains would be the same as the maximum capital gains rate enacted in 1987, and is the same as the top rate enacted in 1981. Taxing qualified dividends at the same low rate as capital gains reduces the tax bias against equity investment and helps promote more efficient allocation of capital since investors can choose to reallocate their dividends to the most productive investments.



Proposal

The Administration's tax receipts baseline would permanently extend the zero- and 15-percent tax rates for dividends and capital gains. The zero- and 15-percent tax rates for capital gains and qualified dividends would be extended permanently for taxpayers with incomes up to $250,000 for joint returns and $200,000 for single taxpayers. The 20-percent tax rate on long-term capital gains and qualified dividends would apply for married taxpayers filing jointly with income over $250,000 less the standard deduction and two personal exemptions (indexed from 2009) and for single taxpayers with income over $200,000 less the standard deduction and one personal exemption (indexed from 2009). The reduced rates on gains on assets held over 5 years would be repealed.

This proposal is effective on the date of enactment for taxable years beginning after December 31, 2010.


USER FEES




PRESERVE COST-SHARING OF INLAND WATERWAYS CAPITAL COSTS



Current Law

The Inland Waterways Trust Fund is supported by a 20-cents-per-gallon tax on liquids used as fuel in a vessel in commercial waterway transportation. Commercial waterway transportation is defined as any use of a vessel on any inland or intracoastal waterway of the United States (1) in the business of transporting property for compensation or hire or (2) in the business of the owner, lessee, or operator of the vessel (other than fish or other aquatic animal life caught on the voyage). The inland or intracoastal waterways of the United States are the inland and intracoastal waterways of the United States described in section 206 of the Inland Waterways Revenue Act of 1978. Exceptions are provided for deep-draft ocean-going vessels, passenger vessels, State and local governments, and certain ocean-going barges.



Reasons for Change

The fuel excise tax does not raise enough revenue to pay for the users' 50-percent share of the capital costs of the locks and dams that make barge transportation possible on inland and intracoastal waterways. Moreover, the tax is not the most efficient method for financing expenditures on those waterways. Adequate funding for inland and intracoastal waterways can be provided through a more efficient user fee system that is based on lock usage and is tied to the level of spending for inland waterways construction, replacement, expansion, and rehabilitation work.



Proposal

The tax on liquids used as fuel in a vessel in commercial waterway transportation would be phased out and replaced by a fee system based on lock usage. The tax rate would be reduced to 10 cents per gallon beginning January 1, 2012. The tax would be repealed for periods after December 31, 2013. The fee system based on lock usage would be phased in beginning on January 1, 2010. For calendar year 2014 and each subsequent calendar year, the fee schedule would be adjusted as necessary to maintain an appropriate level of net assets in the Inland Waterways Trust Fund.


OTHER INITIATIVES




IMPLEMENT UNEMPLOYMENT INSURANCE INTEGRITY LEGISLATION



Current Law

The Federal Unemployment Tax Act (FUTA) currently imposes a Federal payroll tax on employers of 6.2 percent of the first $7,000 paid annually to each employee. Generally, these funds support the administrative costs of the unemployment insurance system. Employers in States that meet certain Federal requirements are allowed a credit against FUTA taxes of up to 5.4 percent, making the minimum net Federal rate 0.8 percent. States also impose an unemployment tax on employers. A State's unemployment insurance taxes are first placed in the State's own clearing account and then deposited into its Federal unemployment insurance trust fund account from which the State pays unemployment benefits. State recoveries of overpayments of unemployment insurance benefits must be similarly deposited and used exclusively to pay unemployment benefits.

While States may assess penalties for overpayments of benefits, amounts collected as penalties or interest on benefit overpayments may be treated as general receipts by the States.



Reasons for Change

States' abilities to reduce benefit overpayments and increase overpayment recoveries are limited by funding. The mandatory redeposit of the collection of all unemployment benefits overpayments prevents States from redirecting some of these amounts to future recovery activity. Although States might use penalties or interest on overpayments to increase collections, there is no requirement that such amounts be directed for additional enforcement activities.



Proposal

The proposal would increase resources for the recovery of State unemployment benefit overpayments and delinquent employer taxes. The proposal would allow States to redirect up to 5 percent of overpayment recoveries to additional enforcement activity. The proposal would require States to impose a penalty of at least 15 percent on recipients of fraudulent overpayments, and penalty revenue would be used exclusively for additional enforcement activity. The proposal would expand the ability to collect benefit overpayments due to a State from income tax refunds owed to a benefit recipient. The proposal would allow States to deposit up to 5 percent of moneys recovered in the course of an unemployment insurance tax investigation into a special fund dedicated to implementing the State Unemployment Tax Act (SUTA) Dumping Prevention Act of 2004 or enforcing State laws relating to employer fraud or tax evasion. The proposal would require employers to report a "start work date" to the National Directory of New Hires for all new hires.

The proposal would be effective upon the date of enactment.



Restructure Assistance to New York City



PROVIDE TAX INCENTIVES FOR TRANSPORTATION INFRASTRUCTURE



Current Law

The Job Creation and Worker Assistance Act of 2002 (the Act) provided tax incentives for the area of New York City damaged or affected by the terrorist attacks on September 11, 2001. The Act created the "New York Liberty Zone," defined as the area located on or south of Canal Street, East Broadway (east of its intersection with Canal Street), or Grand Street (east of its intersection with East Broadway) in the Borough of Manhattan in the City of New York, New York. New York Liberty Zone tax incentives included: (1) an expansion of the work opportunity tax credit (WOTC) for New York Liberty Zone business employees; (2) a special depreciation allowance for qualified New York Liberty Zone property; (3) a five-year recovery period for depreciation of qualified New York Liberty Zone leasehold improvement property; (4) $8 billion of tax-exempt private activity bond financing for certain nonresidential real property, residential rental property and public utility property; (5) $9 billion of additional tax-exempt, advance refunding bonds; (6) increased section 179 expensing; and (7) an extension of the replacement period for nonrecognition of gain for certain involuntary conversions. 3

The expanded WOTC credit provided a 40 percent subsidy on the first $6,000 of annual wages paid to New York Liberty Zone business employees for work performed during 2002 or 2003.

The special depreciation allowance for qualified New York Liberty Zone property equals 30 percent of the adjusted basis of the property for the taxable year in which the property is placed in service. Qualified nonresidential real property and residential rental property must be purchased by the taxpayer after September 10, 2001, and placed in service before January 1, 2010. Such property is qualified property only to the extent it rehabilitates real property damaged, or replaces real property destroyed or condemned, as a result of the September 11, 2001, terrorist attacks. The provision is no longer applicable for other property.

The five-year recovery period for qualified leasehold improvement property applied, in general, to buildings located in the New York Liberty Zone if the improvement was placed in service after September 10, 2001, and before January 1, 2007, and no written binding contract for the improvement was in effect before September 11, 2001.

The $8 billion of tax-exempt private activity bond financing is authorized to be issued by the State of New York or any political subdivision thereof after March 9, 2002, and before January 1, 2010.

The $9 billion of additional tax-exempt, advance refunding bonds was available after March 9, 2002, and before January 1, 2006, with respect to certain State or local bonds outstanding on September 11, 2001.

Businesses were allowed to expense the cost of certain qualified New York Liberty Zone property placed in service prior to 2007, up to an additional $35,000 above the amounts generally available under section 179. 4 In addition, only 50 percent of the cost of such qualified New York Liberty Zone property counted toward the limitation under which section 179 deductions are reduced to the extent the cost of section 179 property exceeds a specified amount.

A taxpayer may elect not to recognize gain with respect to property that is involuntarily converted if the taxpayer acquires within an applicable period (the replacement period) property similar or related in service or use. In general, the replacement period begins with the date of the disposition of the converted property and ends two years (three years if the converted property is real property held for the productive use in a trade or business or for investment) after the close of the first taxable year in which any part of the gain upon conversion is realized. The Act extended the replacement period to five years for property in the New York Liberty Zone that was involuntarily converted as a result of the terrorist attacks on September 11, 2001, if substantially all of the use of the replacement property is in New York City.



Reasons for Change

Some of the tax benefits that were provided to New York following the attacks of September 11, 2001, likely will not be usable in the form in which they were originally provided. State and local officials in New York have concluded that improvements to transportation infrastructure and connectivity in the Liberty Zone would have a greater impact on recovery and continued development than would some of the existing tax incentive provisions.



Proposal

The proposal would sunset certain existing New York Liberty Zone tax benefits and provide in their place tax credits to New York State and New York City for expenditures relating to the construction or improvement of transportation infrastructure in or connecting to the New York Liberty Zone. New York State and New York City each would be eligible for a tax credit for expenditures relating to the construction or improvement of transportation infrastructure in or connecting to the New York Liberty Zone. The tax credit would be allowed in each year from 2010 to 2019, inclusive, subject to an annual limit of $200 million (for a total of $2 billion in tax credits), and would be divided evenly between the State and the City. Any unused credits below the annual limit would be added to the $200 million annual limit for the following year, including years after 2019. Similarly, expenditures that exceed the annual limit would be carried forward and subtracted from the annual limit in the following year. The credit would be allowed against any payments (other than payments of excise taxes and social security and Medicare payroll taxes) made by the City and State under any provision of the Code, including income tax withholding. The Treasury Department would prescribe such rules as are necessary to ensure that the expenditures are made for the intended purposes. The amount of the credit received would be considered State and local funds for the purpose of any Federal program.



Repeal Certain New York City Liberty Zone Incentives

The special depreciation allowance for qualified New York Liberty Zone property that is either nonresidential real property or residential rental property would be terminated as of the date of enactment. Property placed in service after the date of enactment would be ineligible for this incentive unless a binding written contract is in effect on the date of enactment and the property is placed in service before the original sunset dates set forth in the Act.



Levy Payments to Federal Contractors with Delinquent Tax Debt



IMPROVE DEBT COLLECTION ADMINSTRATIVE PROCEDURES



Current Law

Before the IRS can issue a levy for an unpaid federal tax liability, it must give the taxpayer an opportunity for an administrative collection due process (CDP) hearing. As exceptions to this general rule, a CDP hearing is not required prior to the IRS issuing a levy for liabilities that arise from either a state tax refund or federal employment taxes. When these exceptions apply, the CDP hearing takes place within a reasonable time after the levy.

Prior to making a disbursement to federal contractors, an automated check for federal tax liabilities generally occurs using the Federal Payment Levy Program (FPLP). When a tax liability is identified, the IRS issues a CDP notice to the federal contractor, but cannot levy the payment until the CDP requirements are complete.



Reason for Change

When the FPLP identifies a federal contractor as having federal tax liabilities, the opportunity to levy payments to the contractor may be lost because the CDP requirements cannot be completed before the payment is made.



Proposal

The proposal would allow the IRS to issue levies prior to a CDP hearing for federal tax liabilities of federal contractors identified under the FPLP. When a levy is issued prior to a CDP hearing under this proposal, the taxpayer would have an opportunity for a CDP hearing within a reasonable time after the levy.

The proposal would be effective for levies issued after December 31, 2009.



INCREASE LEVY AUTHORITY TO 100 PERCENT FOR VENDOR PAYMENTS



Current Law

If a federal vendor has an unpaid tax liability, the IRS can levy 100 percent of any payment due to the vendor for goods or services sold or leased to the federal government.



Reason for Change

The statutory language "goods or services sold or leased" has been interpreted as excluding payments for the sale or lease of real estate or other types of property not considered "goods or services."



Proposal

The proposal would clarify that the IRS can levy 100 percent of any payment due to a federal vendor with unpaid tax liabilities, including payments made for the sale or lease of real estate and other types of property not considered "goods or services."

The proposal would be effective for payments made after the proposal's date of enactment.


REVENUES DEDICATED TO THE HEALTH REFORM RESERVE FUND




LIMIT THE TAX RATE AT WHICH ITEMIZED DEDUCTIONS REDUCE TAX LIABILITY TO 28 PERCENT



Current Law

Current law permits the allowable portion of an individual taxpayer's itemized deductions to reduce the amount of taxable income. This, in effect, applies those deductions first to the taxable income in the highest tax bracket, and then to the next lower tax brackets in descending order.

Individual taxpayers may elect to itemize their deductions instead of claiming a standard deduction. In general, itemized deductions include medical and dental expenses (in excess of 7.5 percent of AGI), state and local property taxes and either income or sales taxes, interest paid, gifts to charities, casualty and theft losses (in excess of 10 percent of AGI), and job expenses and certain miscellaneous expenses (some only in excess of 2 percent of AGI).

For higher-income taxpayers, otherwise allowable itemized deductions (other than medical expenses, investment interest, theft and casualty losses, and gambling losses) are reduced if AGI exceeds a statutory floor that is indexed annually for inflation. Prior to the enactment of EGTRRA, itemized deductions were reduced by 3 percent of AGI over the threshold but not by more than 80 percent of the otherwise allowable deductions. EGTRRA reduced the itemized deduction limitation in three steps. For 2006 and 2007, itemized deductions were reduced by 2 percent of AGI over the threshold, but not by more than 53-1/3 percent. For 2008 and 2009, itemized deductions were reduced by 1 percent of AGI over the threshold, but not by more than 26-2/3 percent. For 2010, the reduction was to be completely eliminated. However, beginning in 2011, the full itemized deduction reduction of 3 percent of AGI exceeding the floor, but not by more than 80 percent, is scheduled to be reinstated.

For 2009, the AGI floor is $166,800 ($83,400 if married filing separately).

A separate Budget proposal would adjust the 2011 income thresholds beyond which itemized deductions are reduced to $250,000 (indexed for inflation from 2009) for married taxpayers filing jointly and $200,000 (indexed from 2009) for single taxpayers. Thereafter, the thresholds would be indexed for inflation annually.



Reason for Change

Many itemized deductions reflect social policies of encouraging taxpayers to engage in certain activities by reducing the after-tax cost of those activities. Many worthwhile activities compete for the resources that are available. The Administration believes that limiting the benefits from certain itemized deductions to not more than 28 percent of the taxpayer's outlays would provide some of the resources necessary to fund important reforms to the medical care and medical insurance systems.



Proposal

The proposal would limit the value of all itemized deductions by limiting the tax value of those deductions to 28 percent whenever they would otherwise reduce taxable income in the 36 or 39.6 percent tax brackets. A similar limitation also would apply under the AMT.

This proposal would apply to itemized deductions after they have been reduced under a separate budget proposal that would reinstate the pre-EGTRRA limitation on certain itemized deductions, but with adjusted AGI thresholds in 2011 of $250,000 (indexed from 2009) for married taxpayers filing jointly and $200,000 (indexed from 2009) for other taxpayers. After 2011, these thresholds would be indexed.

The proposal is effective for taxable years beginning after December 31, 2010.



REDUCE THE TAX GAP AND MAKE REFORMS



Expand Information Reporting



REQUIRE INFORMATION REPORTING FOR PRIVATE SEPARATE ACCOUNTS OF LIFE INSURANCE COMPANIES



Current Law

Earnings from direct investment in securities generally result in taxable income to the holder. In contrast, investments in comparable assets through a separate account of a life insurance company generally give rise to tax-free or tax-deferred income. This favorable tax treatment for investing through a life insurance company is not available if the policyholder has so much control over the investments in the separate account that the policyholder, rather than the insurance company, is treated as the owner of those investments.



Reasons for Change

In some cases, private separate accounts are being used to avoid tax that would be due if the assets were held directly. Better reporting of investments in private separate accounts will help the IRS to ensure that income is properly reported. Moreover, such reporting will enable the IRS to identify more easily which variable insurance contracts qualify as insurance contracts under current law and which contracts should be disregarded under the investor control doctrine.



Proposal

The proposal would require life insurance companies to report to the IRS, for each contract whose cash value is partially or wholly invested in a private separate account for any portion of the taxable year, the policyholder's taxpayer identification number, the policy number, the amount of accumulated untaxed income, the total contract account value, and the portion of that value that was invested in one or more private separate accounts. For this purpose, a private separate account would be defined as any account with respect to which a related group of persons owned policies whose cash values, in the aggregate, represented at least 10 percent of the value of the separate account.

The proposal would be effective for taxable years beginning after December 31, 2010.



REQUIRE INFORMATION REPORTING ON PAYMENTS TO CORPORATIONS



Current Law

Generally, a taxpayer making payments to a recipient aggregating to $600 or more for services or determinable gains in the course of a trade or business in a calendar year is required to send an information return to the IRS setting forth the amount, as well as name and address of the recipient of the payment (generally on Form 1099). Under a longstanding regulatory regime, there are certain exceptions for payments to corporations, as well as tax-exempt and government entities.



Reasons for Change

Generally, compliance increases significantly for payments that a third party reports to the IRS. In the case of tax-exempt or government entities that are generally not subject to income tax, information returns may not be necessary. On the other hand, during the decades in which the regulatory exception for payments to corporations has become established, the number and complexity of corporate taxpayers have increased. Moreover, the longstanding regulatory exception from information reporting for payments to corporations has created compliance issues. Although the exception for information reporting to corporations is set forth in existing regulations, because it has been in place for many years and because Congress, during that time period, has made numerous changes to the information reporting rules, elimination of the exception should be made by legislative change.



Proposal

A business would be required to file an information return for payments aggregating to $600 or more in a calendar year to a corporation (except a tax-exempt corporation).

The proposal would be effective for payments made to corporations after December 31, 2009.



REQUIRE A CERTIFIED TAXPAYER IDENTIFICATION NUMBER FROM CONTRACTORS AND ALLOW CERTAIN WITHHOLDING



Current Law

In the course of a trade or business, service recipients ("businesses") making payments aggregating to $600 or more in a calendar year to any non-employee service provider ("contractor") that is not a corporation are required to send an information return to the IRS setting forth the amount, as well as name, address, and taxpayer identification number (TIN) of the contractor. The information returns, required annually after the end of the year, are made on Form 1099-MISC based on identifying information furnished by the contractor but not verified by the IRS. Copies are provided both to the contractor and to the IRS. Withholding is not required or permitted for payments to contractors. Since contractors are not subject to withholding, they may be required to make quarterly payments of estimated income taxes and self-employment (SECA) taxes near the end of each calendar quarter. The contractor is required to pay any balance due when the annual income tax return is subsequently filed.



Reasons for Change

Without accurate taxpayer identifying information, information reporting requirements impose avoidable burdens on businesses and the IRS, and cannot reach their potential to improve compliance.

Estimated tax filing is relatively burdensome, especially for less sophisticated and lower-income taxpayers. Moreover, by the time estimated tax payments (or final tax payments) are due, some contractors will not have put aside the necessary funds. Given that the SECA tax rate is 15.3 percent (up to certain income limits), the required tax payments can be more than 25 percent of a contractor's gross receipts, even for a contractor with modest income.

An optional withholding method for contractors would reduce the burdens of having to make quarterly payments, would help contractors automatically set aside funds for tax payments, and would help increase compliance.



Proposal

A contractor receiving payments of $600 or more in a calendar year from a particular business would be required to furnish to the business (on Form W-9) the contractor's certified TIN. A business would be required to verify the contractor's TIN with the IRS, which would be authorized to disclose, solely for this purpose, whether the certified TIN-name combination matches IRS records. If a contractor failed to furnish an accurate certified TIN, the business would be required to withhold a flat-rate percentage of gross payments. Contractors receiving payments of $600 or more in a calendar year from a particular business could require the business to withhold a flat-rate percentage of their gross payments, with the flat-rate percentage of 15, 25, 30, or 35 percent being selected by the contractor.

The proposal would be effective for payments made to contractors after December 31, 2009.



REQUIRE INCREASED INFORMATION REPORTING FOR CERTAIN GOVERNMENT PAYMENTS FOR PROPERTY AND SERVICES



Current Law

Businesses, governments, and other taxpayers are subject to a number of information reporting and withholding requirements. Generally, a taxpayer making payments aggregating to $600 or more for services or determinable gains in the course of a trade or business in a calendar year is required to send an information return to the IRS (except if the recipient is a corporation) setting forth the amount, as well as the name and address of the recipient of the payment (generally on Form 1099). In addition, any service recipient engaged in a trade or business is required to file an information return if the aggregate of payments for services is $600 or more in a calendar year. This requirement specifically applies to government agencies, even if the service provider is a corporation. Moreover, Federal agencies must file information returns with respect to contractors, generally on Form 8596 (Information Return for Federal Contracts) and Form 8596A (Quarterly Transmittal of Information Returns for Federal Contracts). Under recently enacted legislation that will take effect in 2012, Federal, State and local government agencies generally must withhold 3 percent of payments for goods or services. Exceptions apply to certain payments such as those actually subjected to backup withholding, wages and public assistance.



Reasons for Change

Generally, compliance increases significantly for payments that a third party reports to the IRS. Some government vendors fail to meet their tax filing and payment obligations.



Proposal

The IRS and Treasury Department would be authorized to promulgate regulations requiring information reporting on all non-wage payments by Federal, State and local governments to procure property or services. It is expected that certain categories of payments would be excluded from the new information reporting requirements, including payments of interest, payments for real property, payments to tax-exempt entities or foreign governments, intergovernmental payments, and payments made pursuant to a classified or confidential contract.

The proposal would be effective for payments made after December 31, 2009.



INCREASE INFORMATION RETURN PENALTIES



Current Law

There are a number of information reporting requirements under the Code. When these requirements are not followed, penalties may apply based on whether and when a correct information return is filed. If a person subject to the information reporting requirements files a correct information return after the prescribed filing date, but on or before the date that is thirty days after the prescribed filing date, the amount of the penalty is $15 per return (the "first-tier penalty"), not to exceed $75,000 per calendar year. If such a person files a correct information return more than thirty days after the prescribed filing date but on or before August 1, the amount of the penalty is $30 per return (the "second-tier penalty"), not to exceed $150,000 per calendar year. If such a person does not file a correct information return on or before August 1, the amount of the penalty is $50 per return (the "third-tier penalty"), not to exceed $250,000 in a calendar year. For certain small filers whose average annual gross receipts do not exceed $5,000,000, the maximum calendar year limit is $25,000 (instead of $75,000) for the first-tier penalty, $50,000 (instead of $150,000) for the second-tier penalty, and $100,000 (instead of $250,000) for the third-tier penalty. If a failure is due to intentional disregard of a filing requirement, the minimum penalty for each failure is $100, with no calendar year limit.



Reasons for Change

Generally, compliance increases significantly with respect to amounts reported on information returns. In some cases, filers may have failed to comply with existing information reporting requirements because the amount of the potentially applicable penalties is too small to discourage non-compliance. Increasing the penalty amounts, which were established in 1989 and have not been increased, will help to ensure the timely filing of accurate information returns.



Proposal

The first-tier penalty would be increased from $15 to $30, and the calendar year maximum would be increased from $75,000 to $250,000. The second-tier penalty would be increased from $30 to $60, and the calendar year maximum would be increased from $150,000 to $500,000. The third-tier penalty would be increased from $50 to $100, and the calendar year maximum would be increased from $250,000 to $1,500,000. For small filers, the calendar year maximum would be increased from $25,000 to $75,000 for the first-tier penalty, from $50,000 to $200,000 for the second-tier penalty, and from $100,000 to $500,000 for the third-tier penalty. The minimum penalty for each failure due to intentional disregard would be increased from $100 to $250. The proposal would also provide that every five years the penalty amounts would be adjusted to account for inflation.

The proposal would be effective for information returns required to be filed after December 31, 2010.



Improve Compliance by Business



REQUIRE E-FILING BY CERTAIN LARGE ORGANIZATIONS



Current Law

Effective for tax years ending on or after December 31, 2005, corporations with assets of $10 million or more filing Form 1120 are required to file Schedule M-3 (Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More). Effective for tax years ending on or after December 31, 2006, this Schedule M-3 filing requirement also applies to S corporations, life insurance corporations, property and casualty insurance corporations, and cooperative associations filing various versions of Form 1120 and having $10 million or more in assets. Schedule M-3 is also required for partnerships with assets of $10 million or more and certain other partnerships.

Corporations and tax-exempt organizations that have assets of $10 million or more and file at least 250 returns during a calendar year, including income tax, information, excise tax, and employment tax returns, are required to file electronically their Form 1120/1120S income tax returns and Form 990 information returns for tax years ending on or after December 31, 2006. In addition, private foundations and charitable trusts that file at least 250 returns during a calendar year are required to file electronically their Form 990-PF information returns for tax years ending on or after December 31, 2006, regardless of their asset size. Taxpayers can request waivers of the electronic filing requirement if they cannot meet that requirement due to technological constraints, or if compliance with the requirement would result in undue financial burden on the taxpayer. Although electronic filing is required of certain corporations and other taxpayers, others may convert voluntarily to electronic filing.

Generally, regulations may require electronic filing by taxpayers (other than individuals, estates and trusts) that file at least 250 returns annually. Before requiring electronic filing, the IRS and Treasury Department must take into account the ability of taxpayers to comply at a reasonable cost.



Reasons for Change

Generally, compliance increases when taxpayers are required to provide better information to the IRS in usable form. Large organizations with assets of $10 million or more generally maintain financial records in electronic form, and generally either hire tax professionals who use tax preparation software or use tax preparation software themselves although they may not currently file electronically.

Electronic filing supports the broader goals of improving IRS service to taxpayers, enhancing compliance, and modernizing tax administration. Overall, increased electronic filing of returns may improve customer satisfaction and confidence in the filing process, and it may be more cost effective for affected entities. Expanding electronic filing to certain additional large entities will help provide tax return information in a more uniform electronic form. This will enhance the ability of the IRS to more productively focus its audit activities. This can reduce burdens on businesses where the need for an audit can be avoided.

In the case of a large business, adopting the same standard for electronic filing as for filing Schedule M-3 provides simplification benefits.



Proposal

All corporations and partnerships required to file Schedule M-3 would be required to file their tax returns electronically. In the case of certain other large taxpayers not required to file Schedule M-3 (such as exempt organizations), the regulatory authority to require electronic filing would be expanded to allow reduction of the current threshold of filing 250 or more returns during a calendar year. Nevertheless, any new regulations would balance the benefits of electronic filing against any burden that might be imposed on taxpayers, and implementation would take place incrementally to afford adequate time for transition to electronic filing. Taxpayers would be able to request waivers of this requirement if they cannot meet the requirement due to technological constraints, if compliance with the requirement would result in undue financial burden, or if other criteria specified in regulations are met.

The proposal would be effective for tax years ending after December 31, 2009.



IMPLEMENT STANDARDS CLARIFYING WHEN EMPLOYEE LEASING COMPANIES CAN BE HELD LIABLE FOR THEIR CLIENTS' FEDERAL EMPLOYMENT TAXES



Current Law

Employers are required to withhold and pay Federal Insurance Contribution Act (FICA) and income taxes, and are required to pay Federal Unemployment Tax Act (FUTA) taxes (collectively "Federal employment taxes") with respect to wages paid to their employees. Liability for Federal employment taxes generally lies with the taxpayer that is determined to be the employer under a multi-factor common law test or under specific statutory provisions. For example, a third party that is not the common law employer can be a statutory employer if the third party has control over the payment of wages. In addition, certain designated agents are jointly and severally liable with their principals for employment taxes with respect to wages paid to the principals' employees. These designated agents prepare and file employment tax returns using their own name and employer identification number. In contrast, reporting agents (often referred to as payroll service providers) are generally not liable for the employment taxes reported on their clients' returns. Reporting agents prepare and file employment tax returns for their clients using the client's name and employer identification number.

Employee leasing is the practice of contracting with an outside business to handle certain administrative, personnel, and payroll matters for a taxpayer's employees. Employee leasing companies (often referred to as professional employer organizations) typically prepare and file employment tax returns for their clients using the leasing company's name and employer identification number, often taking the position that the leasing company is the statutory or common law employer of their clients' workers.



Reasons for Change

Under present law, there is often uncertainty as to whether the employee leasing company or its client is liable for unpaid Federal employment taxes arising with respect to wages paid to the client's workers. Thus, when an employee leasing company files employment tax returns using its own name and employer identification number, but fails to pay some or all of the taxes due, or when no returns are filed with respect to wages paid by a taxpayer that uses an employee leasing company, there can be uncertainty as to how the Federal employment taxes are assessed and collected.

Providing standards for when an employee leasing company and its clients will be held liable for Federal employment taxes will facilitate the assessment, payment and collection of those taxes and will preclude taxpayers who have control over withholding and payment of those taxes from denying liability when the taxes are not paid.



Proposal

The proposal would set forth standards for holding employee leasing companies jointly and severally liable with their clients for Federal employment taxes. The proposal would also provide standards for holding employee leasing companies solely liable for such taxes if they meet specified requirements.

The provision would be effective for employment tax returns required to be filed with respect to wages paid after December 31, 2009.



Strengthen Tax Administration



ALLOW ASSESSMENT OF CRIMINAL RESTITUTION AS TAX



Current Law

In criminal tax cases, a District Court may issue an order requiring the defendant to pay restitution of existing tax liabilities. The District Court has authority to order restitution under the criminal provisions of Title 18, not the Internal Revenue Code (Code). Because the assessment procedures under the Code apply only to taxes imposed by the Code, those procedures do not apply to restitution orders issued under Title 18, even if the restitution order relates to an existing tax liability.



Reasons for Change

Because court-ordered restitution in criminal tax cases cannot be assessed as a tax, the IRS cannot use its existing assessment systems to collect and enforce the restitution obligation. This leads to unnecessary duplication of efforts, delays, and confusion in the administration of courtordered restitution.



Proposal

The proposal would allow the IRS and the Treasury Department to immediately assess, without issuing a statutory notice of deficiency, and collect as a tax debt court-ordered restitution. The taxpayer would not be able to collaterally attack the amount of restitution ordered by the court, but would retain the ability to challenge the method of collection.

The proposal would be effective after December 31, 2010.



REVISE OFFER-IN-COMPROMISE APPLICATION RULES



Current Law

Current law provides that the IRS may compromise any civil or criminal case arising under the internal revenue laws prior to a reference to the Department of Justice for prosecution or defense. In 2006, a new provision was enacted to require taxpayers to make certain nonrefundable payments with any initial offer-in-compromise of a tax case. The new provision requires taxpayers making a lump-sum offer-in-compromise to include a nonrefundable payment of 20 percent of the lump-sum with the initial offer. In the case of an offer-in-compromise involving periodic payments, the initial offer must be accompanied by a nonrefundable payment of the first installment that would be due if the offer were accepted.



Reasons for Change

Requiring nonrefundable payments with an offer-in-compromise may substantially reduce access to the offer-in-compromise program. The offer-in-compromise program is designed to settle cases in which taxpayers have demonstrated an inability to pay the full amount of a tax liability. The program allows the IRS to collect the portion of a tax liability that the taxpayer has the ability to pay. Reducing access to the offer-in-compromise program makes it more difficult and costly to obtain the collectable portion of existing tax liabilities.



Proposal

The proposal would eliminate the requirements that an initial offer-in-compromise include a nonrefundable payment of any portion of the taxpayer's offer.

The proposal would be for offers-in-compromise submitted after the date of enactment.



EXPAND IRS ACCESS TO INFORMATION IN THE NATIONAL DIRECTORY OF NEW HIRES FOR TAX ADMINISTRATION PURPOSES



Current Law

The Office of Child Support Enforcement of the Department of Health and Human Services (HHS) maintains the National Directory of New Hires (NDNH), which is a database that contains newly-hired employee data from Form W-4, quarterly wage data from State and Federal employment security agencies, and unemployment benefit data from State unemployment insurance agencies. The NDNH was created to help State child support enforcement agencies enforce obligations of parents across State lines.

Under current provisions of the Social Security Act, the IRS may obtain data from the NDNH, but only for the purpose of administering the EITC and verifying employment reported on a tax return.

Generally, the IRS obtains employment and unemployment data less frequently than quarterly, and there are significant internal costs of preparing these data for use. Under various State laws, the IRS may negotiate for access to employment and unemployment data directly from State agencies that maintain these data.



Reasons for Change

Employment data are useful to the IRS in administering a wide range of tax provisions beyond the EITC, including verifying taxpayer claims and identifying levy sources. Currently, the IRS may obtain employment and unemployment data on a State-by-State basis, which is a costly and time-consuming process. NDNH data are timely, uniformly compiled, and electronically accessible. Access to the NDNH would increase the productivity of the IRS by reducing the amount of IRS resources dedicated to obtaining and processing data without reducing the current levels of taxpayer privacy.



Proposal

The Social Security Act would be amended to expand IRS access to NDNH data for general tax administration purposes, including data matching, verification of taxpayer claims during return processing, preparation of substitute returns for non-compliant taxpayers, and identification of levy sources. Data obtained by the IRS from the NDNH would be protected by existing taxpayer privacy law, including civil and criminal sanctions.

The proposal would be effective upon enactment.



MAKE REPEATED WILLFUL FAILURE TO FILE A TAX RETURN A FELONY



Current Law

Current law provides that willful failure to file a tax return is a misdemeanor punishable by a term of imprisonment for not more than one year, a fine of not more than $25,000 ($100,000 in the case of a corporation), or both. A taxpayer who fails to file returns for multiple years commits a separate misdemeanor offense for each year.



Reasons for Change

Increased criminal penalties would help to deter multiple willful failures to file tax returns.



Proposal

Any person who willfully fails to file tax returns in any three years within any five consecutive year period, if the aggregated tax liability for such period is at least $50,000, would be subject to a new aggravated failure to file criminal penalty. The proposal would classify such failure as a felony and, upon conviction, impose a fine of not more than $250,000 ($500,000 in the case of a corporation) or imprisonment for not more than five years, or both.

The proposal would be effective for returns required to be filed after December 31, 2009.



FACILITATE TAX COMPLIANCE WITH LOCAL JURISDICTIONS



Current Law

Although Federal tax returns and return information (FTI) generally are confidential, the IRS and Treasury Department may share FTI with States as well as certain local government entities that are treated as States for this purpose. Generally, the purpose of information sharing is to facilitate tax administration. Where sharing of FTI is authorized, reciprocal provisions generally authorize disclosure of information to the IRS by State and local governments. State and local governments that receive FTI must safeguard it according to prescribed protocols that require secure storage, restricted access, reports to IRS, and shredding or other proper disposal. See, e.g., IRS Publication 1075. Criminal and civil sanctions apply to unauthorized disclosure or inspection of FTI. Indian Tribal Governments (ITGs) are treated as States by the tax law for several purposes, such as certain charitable contributions, excise tax credits, and local tax deductions, but not for purposes of information sharing.



Reasons for Change

IRS and Treasury compliance activity, especially with respect to alcohol, tobacco and fuel excise taxes, may necessitate information sharing with ITGs. For example, the IRS may wish to confirm if a fuel supplier's claim to have delivered particular amounts to adjacent jurisdictions is consistent with that reported to the IRS. If not, the IRS in conjunction with the ITG, which would have responsibility for administering taxes imposed by the ITG, can take steps to ensure compliance with both Federal and ITG tax laws. Where the local government is treated as a State for information sharing purposes, IRS, Treasury, and local officials can support each other's efforts. Where the local government is not so treated, there is an impediment to compliance activity.



Proposal

ITGs that impose alcohol, tobacco, or fuel excise or income or wage taxes would be treated as States for purposes of information sharing to the extent necessary for ITG tax administration. An ITG that receives FTI would be required to safeguard it according to prescribed protocols. The criminal and civil sanctions would apply.

The proposal would be effective for disclosures made after enactment.



EXTENSION OF STATUTE OF LIMITATIONS WHERE STATE TAX ADJUSTMENT AFFECTS FEDERAL TAX LIABILITY



Current Law

In general, additional Federal tax liabilities in the form of tax, interest, penalties and additions to tax must be assessed by the IRS within three years after the date a return is filed. If an assessment is not made within the required time period, the additional liabilities generally cannot be assessed or collected at any future time. The Code contains exceptions to the general statute of limitations. In general, the statute of limitations with respect to claims for refund expires three years from the time the return was filed or two years from the time the tax was paid, whichever is later.

State and local authorities employ a variety of statutes of limitations for State and local tax assessments. Pursuant to agreement, the IRS and State and local revenue agencies exchange reports of adjustments made through examination so that corresponding adjustments can be made by each taxing authority. In addition, States provide the IRS with reports of potential discrepancies between State returns and Federal returns.



Reasons for Change

The general statute of limitations serves as a barrier to the effective use by the IRS of State and local tax adjustment reports when the reports are provided by the State or local revenue agency to the IRS with little time remaining for assessments to be made at the Federal level. Under the current statute of limitations framework, taxpayers may seek to extend the State statute of limitations or postpone agreement to State proposed adjustments until such time as the Federal statute of limitations expires in order to preclude assessment at the Federal level. In addition, it is not always the case that a taxpayer that files an amended State or local return reporting additional liabilities at the State or local level that also affect Federal tax liability will file an amended return at the Federal level.



Proposal

The proposal would create an additional exception to the general three-year statute of limitations for assessment of Federal tax liability resulting from adjustments to State or local tax liability. The statute of limitations would be extended the greater of: (1) one year from the date the taxpayer first files an amended tax return with the IRS reflecting adjustments to the State or local tax return; or (2) two years from the date the IRS first receives information from the State or local revenue agency under an information sharing agreement in place between the IRS and a State or local revenue agency. The statute of limitations would be extended only with respect to the increase in Federal tax attributable to the State or local tax adjustment. The statute of limitations would not be further extended if the taxpayer files additional amended returns for the same tax periods as the initial amended return or if the IRS receives additional information from the State or local revenue agency under an information sharing agreement. The statute of limitations on claims for refund would be extended correspondingly so that any overall increase in tax assessed by the IRS as a result of the State or local examination report would take into account agreed-upon tax decreases or reductions attributable to a refund or credit.

The proposal would be effective for returns required to be filed after December 31, 2009.



IMPROVE INVESTIGATIVE DISCLOSURE STATUTE



Current Law

Generally, tax return information is confidential, unless a specific exception in the Code applies. In the case of tax administration, the Code permits Treasury and IRS officers and employees to disclose return information to the extent necessary to obtain information not otherwise reasonably available, in the course of an audit or investigation, as prescribed by regulation. Thus, for example, a revenue agent may identify himself or herself as affiliated with the IRS, and may disclose the nature and subject of an investigation, as necessary to elicit information from a witness in connection with that investigation. Criminal and civil sanctions apply to unauthorized disclosures of return information.



Reasons for Change

Treasury Regulations effective since 2003 state that the term "necessary" in this context does not mean essential or indispensable, but rather appropriate and helpful in obtaining the information sought. In other contexts, a "necessary" disclosure is one without which performance cannot be accomplished reasonably without the disclosure. Determining if an investigative disclosure is "necessary" is inherently factual, leading to inconsistent opinions by the courts. Eliminating this uncertainty from the statute would facilitate investigations by IRS officers and employees, while setting forth clear guidance for taxpayers, thus enhancing compliance with the tax Code.



Proposal

The taxpayer privacy law would be clarified by stating that it does not prohibit Treasury and IRS officers and employees from identifying themselves, their organizational affiliation, and the nature and subject of an investigation, when contacting third parties in connection with a civil or criminal tax investigation.

The proposal would be effective for disclosure made after enactment.



EXPAND REQUIRED ELECTRONIC FILING BY TAX RETURN PREPARERS



Current Law

The Department of the Treasury currently may issue regulations regarding when tax returns must be filed electronically on magnetic media or in other machine-readable form. But the regulations may not require individuals, estates, or trusts to file their tax returns electronically. In addition, the regulations may not require any person to file electronically unless the person files at least 250 tax returns during the calendar year.



Reasons for Change

Electronic filing benefits taxpayers and the IRS because it decreases processing errors, expedites processing and payment of tax refunds, and allows the IRS to efficiently maintain up-to-date taxpayer records.



Proposal

The proposal generally would maintain the current rule that regulations may not require any person to file electronically unless the person files at least 250 tax returns during the calendar year. But the proposal also would provide an exception to this rule under which regulations may require electronic filing by tax return preparers (as currently defined in the Internal Revenue Code) who file more than 100 tax returns in a calendar year. The proposal also would allow regulations requiring tax return preparers who file more than 100 returns (or any other person who files more than 250 returns) to file electronically tax returns for individuals, estates, or trusts.

The proposal would be effective for tax returns required to be filed after December 31, 2010.



Expand Penalties



CLARIFY THAT THE BAD CHECK PENALTY APPLIES TO ELECTRONIC CHECKS AND OTHER PAYMENT FORMS



Current Law

The Code imposes a penalty on any taxpayer who attempts to satisfy a tax liability with a check or money that is not duly paid. The penalty is 2 percent of the amount of the bad check or money order. If the bad check or money order is for less than $1,250, the penalty is the lesser of $25 or the amount of the check or money order.



Reasons for Change

Taxpayers use a variety of commercially acceptable instruments to pay tax liabilities, but only two types of instruments are covered by the Code's bad check penalty: checks and money orders.



Proposal

The proposal would expand the bad check penalty to cover all commercially acceptable instruments of payment that are not duly paid.

The proposal would be effective for returns required to be filed after December 31, 2009.



IMPOSE PENALTY ON FAILURE TO COMPLY WITH ELECTRONIC FILING REQUIREMENTS



Current Law

Certain corporations and tax-exempt organizations (including certain charitable trusts and private foundations) are required to file their returns electronically. Generally, filing on paper instead of electronically is treated as a failure to file if electronic filing is required. Additions to tax are imposed for the failure to file tax returns reporting a liability. For failure to file a corporate return, the addition to tax is 5 percent on the amount required to be shown as tax due on the return, for the first month of failure, and an additional 5 percent for each month or part of a month thereafter, up to a maximum of 25 percent.

For failure to file a tax-exempt organization return, the addition to tax is $20 a day for each day the failure continues. The maximum amount per return is $10,000 or 5 percent of the organization's gross receipts for the year, whichever is less. Organizations with annual gross receipts exceeding $1 million, however, are subject to an addition to tax of $100 per day, with a maximum of $50,000.



Reasons for Change

Although there are additions to tax for the failure to file returns, there is no specific penalty in the tax Code for a failure to comply with a requirement to file electronically. Because the addition to tax for failure to file a corporate return is based on an underpayment of tax, no addition is imposed if the corporation is in a refund, credit, or loss status. Thus, the existing addition to tax may not provide an adequate incentive for certain corporations to file electronically. Generally, electronic filing increases efficiency of tax administration because the provision of tax return information in an electronic form enables the IRS to focus audit activities where they can have the greatest impact. This also assists taxpayers where the need for audit is reduced.



Proposal

The proposal would establish an assessable penalty would be established for a failure to comply with a requirement of electronic (or other machine-readable) format for a return that is filed. The amount of the penalty would be $25,000 for a corporation or $5,000 for a tax-exempt organization. For failure to file in any format, the existing penalty would remain, and the proposed penalty would not apply.

The proposal would be effective for returns required to be electronically filed after December 31, 2010.



MAKE REFORMS TO CLOSE TAX LOOPHOLES



Financial Institutions and Products



REQUIRE ACCRUAL OF INCOME ON FORWARD SALE OF CORPORATE STOCK



Current Law

A corporation generally does not recognize gain or loss on the issuance or repurchase of its own stock. Thus, a corporation does not recognize gain or loss on the forward sale of its own stock. A corporation sells its stock forward by agreeing to issue its stock in the future in exchange for consideration to be paid in the future.

Although a corporation does not recognize gain or loss on the issuance of its own stock, a corporation does recognize interest income upon the current sale of stock for deferred payment.



Reasons for Change

There is little substantive difference between a corporate issuer's current sale of its stock for deferred payment and an issuer's forward sale of the same stock. The only difference between the two transactions is the timing of the stock issuance. In a current sale, the stock is issued at the inception of the transaction, while, in a forward sale, the stock is issued at the time the deferred payment is received. In both cases, a portion of the deferred payment economically compensates the corporation for the time-value of the deferred payment. It is inappropriate to treat these two transactions differently.



Proposal

The proposal would require a corporation that enters into a forward contract to issue its stock to treat a portion of the payment on the forward issuance as a payment of interest.

The proposal would be effective for forward contracts entered into after December 31, 2010.



REQUIRE ORDINARY TREATMENT FOR CERTAIN DEALERS OF EQUITY OPTIONS AND COMMODITIES



Current Law

Under current law, commodities dealers (within the meaning of section 1402(i)(2)(B)), commodities derivatives dealers (within the meaning of section 1221(b)(1)(A)), dealers in securities (within the meaning of section 475(c)(1)) and options dealers (within the meaning of section 1256(g)(8)), treat the income from certain of their day-to-day dealer activities as giving rise to capital gain. Under section 1256, these dealers treat 60 percent of their income (or loss) from their dealer activities as long-term capital gain (or loss) and 40 percent of their income (or loss) from their dealer activities as short-term capital gain (or loss). Dealers in other types of property generally treat the income from their day-to-day dealer activities as giving rise to ordinary income.



Reasons for Change

There is no reason to treat dealers in commodities, commodities derivatives dealers, dealers in securities and dealers in equity options differently than dealers in other types of property. Dealers earn their income from their day-to-day dealing activities and should be taxed at ordinary rates.



Proposal

The proposal would require commodities derivatives dealers, dealers in securities and dealers in equity options and commodities and to treat the income from their day-to-day dealer activities as ordinary in character, not capital.

The proposal would be effective for taxable years beginning after the date of enactment.



MODIFY DEFINITION OF CONTROL FOR PURPOSES OF THE SECTION 249 DEDUCTION LIMIT



Current Law

In general, if a corporation repurchases a debt instrument that is convertible into its stock, or into stock of a corporation in control of or controlled by the corporation, section 249 may disallow or limit the issuer's deduction for a premium paid to repurchase the debt instrument. For this purpose, "control" is determined by reference to section 368(c), which encompasses only direct relationships ( e.g. , a parent corporation and its wholly-owned, first tier subsidiary).



Reasons for Change

The definition of "control" in section 249 is unnecessarily restrictive, and has resulted in situations in which the limitation in section 249 is too easily avoided. Indirect control relationships ( e.g. , a parent corporation and a second-tier subsidiary) present the same economic identity of interests as direct control relationships, and should be treated in a similar manner.



Proposal

Under the proposal, the definition of "control" in section 249(b)(2) would be amended to incorporate indirect control relationships, of the nature described in section 1563(a)(1).

The proposal would be effective on the date of enactment.



Insurance Companies and Products



MODIFY RULES THAT APPLY TO SALES OF LIFE INSURANCE CONTRACTS



Current Law

The seller of a life insurance contract generally must report as taxable income the difference between the amount received from the buyer and the adjusted basis in the contract, unless the buyer is a viatical settlement provider and the insured person is terminally or chronically ill.

Under a transfer-for-value rule, the buyer of a previously-issued life insurance contract who subsequently receives a death benefit generally is subject to tax on the difference between the death benefit received and the sum of the amount paid for the contract and premiums subsequently paid by the buyer. This rule does not apply if the buyer's basis is determined in whole or in part by reference to the seller's basis, nor does the rule apply if the buyer is the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer.

Persons engaged in a trade or business that make payments of premiums, compensations, remunerations, other fixed or determinable gains, profits and income, or certain other types of payments in the course of that trade or business to another person generally are required to report such payments of $600 or more to the IRS. However, reporting may not be required in some circumstances involving the purchase of a life insurance contract.



Reasons for Change

Recent years have seen a significant increase in the number and size of life settlement transactions, wherein individuals sell previously-issued life insurance contracts to investors. Compliance is sometimes hampered by a lack of information reporting. In addition, the current law exceptions to the transfer-for-value rule may give investors the ability to structure a transaction to avoid paying tax on the profit when the insured person dies.



Proposal

The proposal would require a person or entity who purchases an interest in an existing life insurance contract with a death benefit equal to or exceeding $1 million to report the purchase price, the buyer's and seller's taxpayer identification numbers (TINs), and the issuer and policy number to the IRS, to the insurance company that issued the policy, and to the seller.

The proposal also would modify the transfer-for-value rule to ensure that exceptions to that rule would not apply to buyers of policies. Upon the payment of any policy benefits to the buyer, the insurance company would be required to report the gross benefit payment, the buyer's TIN, and the insurance company's estimate of the buyer's basis to the IRS and to the payee.

The proposal would apply to sales or assignment of interests in life insurance policies and payments of death benefits for taxable years beginning after December 31, 2010.



MODIFY DIVIDENDS-RECEIVED DEDUCTION FOR LIFE INSURANCE COMPANY SEPARATE ACCOUNTS



Current Law

Corporate taxpayers may generally qualify for a dividends-received deduction (DRD) with regard to dividends received from other domestic corporations, in order to prevent or limit taxable inclusion of the same income by more than one corporation. In the case of a life insurance company, the DRD is permitted only with regard to the "company's share" of dividends received, reflecting the fact that some portion of the company's dividend income is used to fund tax-deductible reserves for its obligations to policyholders. Likewise, the net increase or net decrease in reserves is computed by reducing the ending balance of the reserve items by the policyholders' share of tax-exempt interest. The regime for computing the company's share and policyholders' share of net investment income is sometimes referred to as proration.

A life insurance company's separate account assets, liabilities, and income are segregated from those of the company's general account in order to support variable life insurance and variable annuity contracts. A company's share and policyholders' share are computed for the company's general account and separately for each separate account.

The policyholders' share equals 100 percent less the company's share, whereas the latter is equal to the company's share of net investment income divided by net investment income. The company's share of net investment income is the excess, if any, of net investment income over certain amounts, including "required interest," that are set aside to satisfy obligations to policyholders. Required interest with regard to an account is calculated by multiplying a specified account earnings rate by the mean of the reserves with regard to the account for the taxable year.



Reasons for Change

The proration methodology currently used by some taxpayers may produce a company's share that greatly exceeds the company's economic interest in the net investment income earned by its separate account assets, generating controversy between life insurance companies and the IRS. The purposes of the proration regime would be better served if the company's share bore a more direct relationship to the company's actual economic interest in the account.



Proposal

As under current law, required interest under the proposal would equal an earnings rate times the mean of reserves. For a separate account, the earnings rate would equal a gross earnings rate (net investment income of the account, divided by the mean of the account's assets), minus a company-retained percentage (amounts retained by the company from the account's net investment income, if any, divided by the mean of reserves). For this purpose, amounts retained by the company would be treated as funded proportionately by items included in net investment income and items not so included. It is intended that this formula would generally produce a company's share with regard to a separate account that approximates the ratio of the mean of the surplus attributable to the account to the mean of the account's assets.

The proposal would be effective for taxable years beginning after December 31, 2010.



EXPAND PRO RATA INTEREST EXPENSE DISALLOWANCE FOR CORPORATEOWNED LIFE INSURANCE (COLI)



Current Law

In general, no Federal income tax is imposed on a policyholder with respect to the earnings credited under a life insurance or endowment contract, and Federal income tax generally is deferred with respect to earnings under an annuity contract (unless the annuity contract is owned by a person other than a natural person). In addition, amounts received under a life insurance contract by reason of the death of the insured generally are excluded from gross income of the recipient.

Interest on policy loans or other indebtedness with respect to life insurance, endowment or annuity contracts generally is not deductible, unless the insurance contract insures the life of a key person of the business. A key person includes a 20-percent owner of the business, as well as a limited number of the business' officers or employees. However, this interest disallowance rule applies to businesses only to the extent that the indebtedness can be traced to a life insurance, endowment or annuity contract.

In addition, the interest deductions of a business other than an insurance company are reduced to the extent the interest is allocable to unborrowed policy cash values based on a statutory formula. An exception to the pro rata interest disallowance applies with respect to contracts that cover individuals who are officers, directors, employees, or 20-percent owners of the taxpayer. In the case of both life and non-life insurance companies, special proration rules similarly require adjustments to prevent or limit the funding of tax-deductible reserve increases with tax preferred income, including earnings credited under life insurance, endowment and annuity contracts that would be subject to the pro rata interest disallowance rule if owned by a non-insurance company.



Reasons for Change

Leveraged business can fund deductible interest expenses with tax-exempt or tax-deferred income credited under life insurance, endowment or annuity contracts insuring certain types of individuals. For example, these businesses frequently invest in investment-oriented insurance policies covering the lives of their employees, officers, directors or owners. These entities generally do not take out policy loans or other indebtedness that is secured or otherwise traceable to the insurance contracts. Instead, they borrow from depositors or other lenders, or issue bonds. Similar tax arbitrage benefits result when insurance companies invest in certain insurance contracts that cover the lives of their employees, officers, directors or 20-percent shareholders and fund deductible reserves with tax-exempt or tax-deferred income.



Proposal

The proposal would repeal the exception from the pro rata interest expense disallowance rule for contracts covering employees, officers or directors, other than 20-percent owners of a business that is the owner or beneficiary of the contracts.

The proposal would apply to contracts entered into after the date of enactment.



Tax Accounting Methods



DENY DEDUCTION FOR PUNITIVE DAMAGES



Current Law

No deduction is allowed for a fine or similar penalty paid to a government for the violation of any law. If a taxpayer is convicted of a violation of the antitrust laws, or the taxpayer's plea of guilty or nolo contendere to such a violation is entered or accepted in a criminal proceeding, no deduction is allowed for two-thirds of any amount paid or incurred on a judgment or in settlement of a civil suit brought under section 4 of the Clayton Antitrust Act on account of such or any related antitrust violation. Where neither of these two provisions is applicable, a deduction is allowed for damages paid or incurred as ordinary and necessary expenses in carrying on any trade or business, regardless of whether such damages are compensatory or punitive.



Reasons for Change

The deductibility of punitive damage payments undermines the role of such damages in discouraging and penalizing certain undesirable actions or activities.



Proposal

No deduction would be allowed for punitive damages paid or incurred by the taxpayer, whether upon a judgment or in settlement of a claim. Where the liability for punitive damages is covered by insurance, such damages paid or incurred by the insurer would be included in the gross income of the insured person. The insurer would be required to report such payments to the insured person and to the Internal Revenue Service.

The proposal would apply to damages paid or incurred after December 31, 2010.



REPEAL LOWER-OF-COST-OR-MARKET INVENTORY ACCOUNTING METHOD



Current Law

Taxpayers required to maintain inventories are permitted to use a variety of methods to determine the cost of their ending inventories, including methods such as the last-in, first-out ("LIFO") method, the first-in, first-out ("FIFO") method, and the retail method. Taxpayers not using a LIFO method may write down the carrying values of their inventories by applying the lower-of-cost-or-market ("LCM") method and may write down the cost of "subnormal" goods (i.e., those that are unsalable at normal prices or unusable in the normal way because of damage, imperfection or other similar causes). Taxpayers using the retail method for tax currently are not required to use that method for financial statement reporting purposes.



Reasons for Change

The allowance of inventory write-downs under the LCM and subnormal goods provisions is an exception from the realization principle, and is essentially a one-way mark-to-market regime that understates taxable income. Thus, a taxpayer is able to obtain a larger cost-of-goods-sold deduction by writing down an item of inventory if its replacement cost falls, but need not increase an item's inventory value if its replacement cost increases. This asymmetric treatment is unwarranted. Also, the market value used under LCM for tax purposes generally is the replacement or reproduction cost of an item of inventory, not the item's net realizable value, as is required under generally accepted financial accounting rules. While the operation of the retail method is technically symmetric, it also allows retailers to obtain deductions for write-downs below inventory cost because of normal and anticipated declines in retail prices.



Proposal

The proposal would statutorily prohibit the use of the LCM and subnormal goods methods. Appropriate wash-sale rules also would be included to prevent taxpayers from circumventing the prohibition. The retail method would be allowed only if the taxpayer employs the method for purposes of financial accounting. The proposal would be treated as a change in the method of accounting for inventories, and any resulting section 481(a) adjustment generally would be included in income ratably over a four-year period beginning with the year of change.

The proposal would be effective for taxable years beginning after 12 months from the date of enactment.



Modify Estate and Gift Tax Valuation Discounts and Make Other Reforms



REQUIRE CONSISTENCY IN VALUE FOR TRANSFER AND INCOME TAX PURPOSES



Current Law

Section 1014 provides that the basis of property acquired from a decedent generally is the fair market value of the property on decedent's date of death. Similarly, property included in the decedent's gross estate for estate tax purposes generally must be valued at its fair market value on date of death. Although the same valuation standard applies to both provisions, current law does not explicitly require that the recipient's basis in that property be the same value at which that property was reported for estate tax purposes.

Section 1015 provides that the donee's basis in property received by gift during the life of the donor generally is the donor's adjusted basis in the property, increased by gift tax paid on the transfer. If, however, the donor's basis exceeds the fair market value of the property on the date of the gift, the donee's basis is limited to that fair market value for purposes of determining any subsequent loss.

Section 6034A imposes a consistency requirement - specifically, that the recipient of a distribution of income from a trust or estate must report on the recipient's own income tax return the exact information included on the Schedule K-1 of the trust's or estate's income tax return - but this provision applies only for income tax purposes, and the Schedule K-1 does not include basis information.



Reasons for Change

Taxpayers should be required to take consistent positions in dealing with the Internal Revenue Service, whether or not principles of privity apply. If the logic underlying the new basis in property acquired on the death of the owner is that the new basis is the amount used to determine the decedent's estate tax liability, then the law should require that the same value be used by the recipient, unless that value is in excess of the accurate value. In the case of property transferred on death or by gift during life, often the executor of the estate or the donor, respectively, will be in the best position to ensure that the recipient receives the necessary information that will determine that recipient's basis in the transferred property.



Proposal

This proposal would require both consistency and a reporting requirement. The basis of property received by reason of death under section 1014 would have to equal the value of that property for estate tax purposes. The basis of property received by gift during the life of the donor would have to equal the donor's basis determined under section 1015. This proposal would require that the basis of the property in the hands of the recipient be no greater than the value of that property as determined for estate or gift tax purposes (subject to subsequent adjustments). A reporting requirement would be imposed on the executor of the decedent's estate and on the donor of a lifetime gift to provide the necessary information to both the recipient and the IRS. A grant of regulatory authority would be included to provide details about the implementation and administration of these requirements, including rules for situations in which no estate tax return is required to be filed or gifts are excluded from gift tax under section 2503, for situations in which the surviving joint tenant or other recipient may have better information than the executor, and for the timing of the required reporting in the event of adjustments to the reported value subsequent to the filing of an estate or gift tax return.

The proposal would be effective as of the date of enactment.



MODIFY RULES ON VALUATION DISCOUNTS



Current Law

The fair market value of property transferred, whether on the death or during the life of the transferor, generally is subject to estate or gift tax at the time of the transfer. Sections 2701 through 2704 of the Internal Revenue Code were enacted to prevent the reduction of taxes through the use of "estate freezes" and other techniques designed to reduce the value of the transferor's taxable estate and discount the value of the taxable transfer to the beneficiaries of the transferor when the economic benefit to the beneficiaries is not reduced by these techniques. Generally, section 2704(b) provides that certain "applicable restrictions" (that would normally justify discounts in the value of the interests transferred) are to be ignored in valuing interests in family-controlled entities if those interests are transferred (either by gift or on death) to or for the benefit of other family members. The application of these special rules results in an increase in the transfer tax value of those interests above the price that a hypothetical willing buyer would pay a willing seller, because section 2704(b) generally directs an appraiser to ignore the rights and restrictions that would otherwise support significant discounts for lack of marketability and control.



Reasons for Change

Judicial decisions and the enactment of new statutes in most states have, in effect, made section 2704(b) inapplicable in many situations, specifically, by recharacterizing restrictions such that they no longer fall within the definition of an "applicable restriction". In addition, the Internal Revenue Service has identified additional arrangements designed to circumvent the application of section 2704.



Proposal

This proposal would create an additional category of restrictions ("disregarded restrictions") that would be ignored in valuing an interest in a family-controlled entity transferred to a member of the family if, after the transfer, the restriction will lapse or may be removed by the transferor and/or the transfer's family. Specifically, the transferred interest would be valued by substituting for the disregarded restrictions certain assumptions to be specified in regulations. Disregarded restrictions would include limitations on a holder's right to liquidate that holder's interest that are more restrictive than a standard identified in regulations. A disregarded restriction also would include any limitation on a transferee's ability to be admitted as a full partner or holder of an equity interest in the entity. For purposes of determining whether a restriction may be removed by member(s) of the family after the transfer, certain interests (to be identified in regulations) held by charities or others who are not family members of the transferor would be deemed to be held by the family. Regulatory authority would be granted, including the ability to create safe harbors to permit taxpayers to draft the governing documents of a family-controlled entity so as to avoid the application of section 2704 if certain standards are met. This proposal would make conforming clarifications with regard to the interaction of this proposal with the transfer tax marital and charitable deductions.

This proposal would apply to transfers after the date of enactment of property subject to restrictions created after October 8, 1990 (the effective date of section 2704).



REQUIRE MINIMUM TERM FOR GRANTOR RETAINED ANNUITY TRUSTS (GRATS)



Current Law

Section 2702 provides that, if an interest in a trust is transferred to a family member, the value of any interest retained by the grantor is valued at zero for purposes of determining the transfer tax value of the gift to the family member(s). This rule does not apply if the retained interest is a "qualified interest". A fixed annuity, such as the annuity interest retained by the grantor of a GRAT, is one form of qualified interest, so the gift of the remainder interest in the GRAT is determined by deducting the present value of the retained annuity during the GRAT term from the fair market value of the property contributed to the trust.

Generally, a GRAT is an irrevocable trust funded with assets expected to appreciate in value, in which the grantor retains an annuity interest for a term of years that the grantor expects to survive. At the end of that term, the assets then remaining in the trust are transferred to (or held in further trust for) the beneficiaries, who generally are descendants of the grantor. If the grantor dies during the GRAT term, however, the trust assets (at least the portion needed to produce the retained annuity) are included in the grantor's gross estate for estate tax purposes. In this event, although the beneficiaries will own the remaining trust assets, the estate tax benefit of creating the GRAT (specifically, the tax-free transfer of the appreciation during the GRAT term in excess of the annuity payments) is not realized.



Reasons for Change

GRATs have proven to be a popular and efficient technique for transferring wealth while minimizing the gift tax cost of transfers, providing that the grantor survives the GRAT term and the trust assets do not depreciate in value. The greater the appreciation, the greater the transfer tax benefit achieved. Taxpayers have become more adept at maximizing the benefit of this technique, often by minimizing the term of the GRAT (thus reducing the risk of the grantor's death during the term), in many cases to 2 years, and by retaining annuity interests significant enough to reduce the gift tax value of the remainder interest to zero or to a number small enough to generate only a minimal gift tax liability.



Proposal

This proposal would require, in effect, some downside risk in the use of this technique by imposing the requirement that a GRAT have a minimum term of 10 years. 5 Although a minimum term would not prevent "zeroing-out" the gift tax value of the remainder interest, it would increase the risk of the grantor's death during the GRAT term and the resulting loss of any anticipated transfer tax benefit.

This proposal would apply to trusts created after the date of enactment.



MODIFY ALTERNATIVE FUEL MIXTURE CREDIT



Current Law

The Code provides excise tax credits for alternative fuel and alternative fuel mixtures. Alternative fuel means liquefied petroleum gas, P Series fuels (as defined by the Secretary of Energy under 42 U.S.C. sec. 13211(2)), compressed or liquefied natural gas, liquefied hydrogen, certain liquid fuel derived from coal through the Fischer-Tropsch process, compressed or liquefied gas derived from biomass, and liquid fuel derived from biomass, but does not include ethanol, methanol, or biodiesel. The alternative fuel credit is 50 cents per gallon for liquid fuel and 50 cents per gasoline gallon equivalent for nonliquid fuel. The alternative fuel credit is available only for fuel sold by the taxpayer for use as a fuel in a motor vehicle or motorboat or so used by the taxpayer. The alternative fuel mixture credit is computed at the same rate on each gallon of alternative fuel used in producing a mixture of alternative fuel and taxable fuel for sale or use in the taxpayer's trade or business. The mixture must be sold by its producer for use as a fuel or used as a fuel by the producer. Both credits are allowed against fuel excise tax liability. In addition, a person may file a claim for payment equal to the amount of the alternative fuel and alternative fuel mixture credits. Except in the case of liquefied hydrogen, the credits expire on December 31, 2009.



Reasons for Change

Alternative fuels include liquid byproducts derived from the processing of paper or pulp (known as "black liquor" when derived from the kraft process), which paper companies burn to produce energy in their mills. Certain paper companies, to take advantage of the alternative fuels mixture credit, have recently begun mixing diesel fuel with black liquor, burning the mixture, and claiming the alternative fuel mixture credit. This is resulting in substantial revenue losses and provides a windfall to the paper industry.



Proposal

The Administration proposes to limit the credit for mixtures containing alternative fuel derived from the processing of paper or pulp to mixtures that are sold for use or used as fuel in a motor vehicle or motorboat. Accordingly, black liquor mixtures used as a fuel in paper processing would no longer be eligible for the credit.

The change would be effective after the date of enactment.



APPENDIX: EXTENDING CURRENT POLICIES

The first step in addressing the nation's fiscal problems is to be upfront about them - and to establish an honest baseline that measures where we are before new policies are enacted. The Administration's Budget does so by adjusting the Budget Enforcement Act (BEA) baseline to reflect the true cost of the current policy path. The BEA baseline, which is commonly used in budgeting and is defined in a now expired statute, with some exceptions reflects the projected receipts level under current law. But, under current law, relief from the AMT would expire at the end of this year, causing millions of Americans to begin paying this additional tax, and, furthermore, the 2001 and 2003 tax cuts would expire entirely at the end of 2010. These expirations were not written into law for policy reasons; instead, they reflect decisions made to artificially reduce the cost estimates of AMT relief and the 2001 and 2003 tax cuts to fit these policies within certain budget process rules. Because of this, the BEA's "current law" baseline is not an accurate reflection of what it would mean to continue forward with current policies. The Administration's Budget uses an adjusted tax baseline that continues AMT relief and the 2001 and 2003 tax cuts, so as to project future receipts under current policy and to better measure the effects of the Administration's proposed policy changes.

Index to inflation the 2009 parameters of the AMT as enacted in the American Recovery and Reinvestment Act of 2009. The Administration's baseline projection of current policy reflects annual indexation of the AMT exemption amounts in effect for taxable year 2009 ($46,700 for single taxpayers, $70,950 for married taxpayers filing a joint return and surviving spouses, and $35,475 for married taxpayers filing a separate return and for estates and trusts); the income thresholds for the 28-percent rate ($87,500 for married taxpayers filing a separate return and $175,000 for all other taxpayers); and the income thresholds for the phaseout of the exemption amounts ($150,000 for married taxpayers filing a joint return and surviving spouses, $112,500 for single taxpayers, and $75,000 for married taxpayers filing a separate return). The baseline projection of current policy also extends AMT relief for nonrefundable personal credits.

Continue the 2001 and 2003 tax cuts. Most of the tax reductions enacted in 2001 and 2003 expire on December 31, 2010. The Administration's baseline projection of current policy continues all of these expiring provisions except for repeal of estate and generation-skipping transfer taxes. Estate and gift taxes are assumed to be extended at parameters in effect for calendar year 2009 (a top rate of 45 percent and an exemption amount of $3.5 million).


TABLES OF REVENUE ESTIMATES


Revenue estimates begin on next page.

View Document


1 The Administration's primary policy proposals reflect changes from a tax baseline that modifies current law by "patching" the alternative minimum tax, freezing the estate tax, and making permanent a number of the tax cuts enacted in 2001 and 2003. The baseline changes to current law are described in the Appendix. In some cases, the policy descriptions in the body of this report make note of the baseline (e.g., descriptions of upper-income tax provisions), but elsewhere the baseline is implicit.

1 Specifically, the otherwise allowable child tax credit is reduced by $50 for each $1,000 (or fraction thereof) of modified adjusted gross income over $75,000 for single individuals or heads of households, $110,000 for married individuals filing joint returns, and $55,000 for married individuals filing separate returns.

2 Earned income for purposes of the refundable amount is defined as the sum of wages, salaries, tips, and other taxable employee compensation plus net self-employment earnings to the extent that these amounts are included when computing taxable income.

3 The Working Families Tax Relief Act of 2004 amended certain of the New York Liberty Zone provisions relating to tax-exempt bonds.

4 Section 179 provides that, in place of depreciation, certain taxpayers, typically small businesses, may elect to deduct up to $125,000 of the cost of section 179 property placed in service each year. In general, section 179 property is defined as depreciable tangible personal property that is purchased for use in the active conduct of a trade or business.

5 Cf. section 673 as applicable to a so-called Clifford trust created before or on March 1, 1986, with a 10-year minimum term.

Economis substance test - son of Boss

It is important to have an awareness of the substantive judicial doctrine of economic substance. If you want to avoid the 6694 penalty, report complex financial situations to the IRS because that would at least get you to the "reasonable basis" standard.


Klamath Strategic Investment Fund, by and through St Croix Ventures (Managing member), Plaintiff-Appellee-Cross-Appellant v. United States of America Defendant-Appellant-Cross-Appellee; Kinabalu Strategic Investment Fund, by and through Rogue Ventures LLC (Managing member), Plaintiff-Appellee-Cross-Appellant v. United States of America, Defendant-Appellant-Cross-Appellee.

U.S. Court of Appeals, 5th Circuit; 07-4086, May 15, 2009.

Affirming in part, vacating and remanding in part, a DC Tex. decision, 2007-1 USTC ¶50,223.





Before: Garwood, Garza and Owen, Circuit Judges.

GARZA, Circuit Judge: In this tax case, Plaintiffs Klamath Strategic Investment Fund ("Klamath") and Kinabalu Strategic Investment Fund ("Kinabalu") (collectively, the "Partnerships") filed suit against defendant the United States of America for readjustment of partnership items. Both parties appeal various aspects of the district court's readjustment determination. For the following reasons, we affirm in part, vacate in part, and remand.

This case involves a highly complex series of financial transactions, which the district court categorized as a tax shelter known as Bond Linked Issue Premium Structure ("BLIPS"). The transactions were undertaken by two law partners, Cary Patterson and Harold Nix. Patterson and Nix's law firm represented the State of Texas in litigation against the tobacco industry and each partner earned around $30 million between 1998 and 2000. Interested in managing this wealth, Patterson and Nix requested their long-time accounting firm, Pollans & Cohen, to investigate investment opportunities.

The accountants identified Presidio Advisory Services ("Presidio"), an investment advisory firm purporting to specialize in foreign currency trading. Presidio advocated a complex plan involving strategic investments in foreign currencies pegged to the U.S. dollar. Patterson and Nix agreed to invest in Presidio's plan. Generally, the Presidio strategy was structured as a three-stage, seven-year investment program. Stage I lasted 60 days and entailed relatively low risk investments. Stage II lasted from day 60 through day 180, and the risk was somewhat higher. Stage III extended from day 180 through the end of the seventh year and involved the highest risk as well as potentially the highest return. At each stage of the plan, Presidio required the investors to contribute significantly more capital. The investors retained the right to exit the plan at the end of Stage I and at each 60-day period thereafter.

To implement the strategy Presidio formed Klamath and Kinabalu as limited liability companies, taxed as partnerships. Next, Presidio formed two single-member LLCs, which are disregarded for tax purposes: St. Croix for Patterson and Rogue for Nix. Patterson owned 100% of St. Croix, and St. Croix became a 90% partner of Klamath. The other 10% partners of Klamath were Presidio Resources LLC and Presidio Growth LLC. Presidio Growth was the managing partner. Kinabalu had a similar structure. Nix owned 100% of Rogue, and Rogue was a 90% partner of Kinabalu. The other 10% partners of Kinabalu were Presidio Growth and Presidio Resources, with Presidio Growth acting as the managing partner.

To fund Klamath and Kinabalu, Patterson and Nix (acting through St. Croix and Rogue) made two distinct contributions. First, they each contributed $1.5 million to their respective partnership. Second, they entered into loan transactions with National Westminster Bank ("NatWest"), where the bank loaned each company $66.7 million. This included $41.7 million denominated as the "Stated Principal Amount" and $25 million as a "loan premium." The classification of the $25 million as something different than the principal loan amount is central to this case. The loan premium was given in exchange for Patterson and Nix paying NatWest a higher than market interest rate on the principal: 17.97%. To protect NatWest from the possibility that the loans would be repaid early and the benefit of the higher interest rate would not be realized, the credit agreements required that a prepayment amount be paid if the loans were paid off early. The prepayment amount would vary depending on when the loan was repaid, starting at about $25 million and decreasing over seven years. After year seven, no prepayment amount would apply.

Patterson and Nix each contributed the $66.7 million to Klamath and Kinabalu and assigned the corresponding loan obligations to the Partnerships. The Partnerships deposited the funds into accounts controlled by NatWest. Presidio directed Klamath and Kinabalu to use these funds to purchase very low risk contracts on U.S. dollars and Euros. They also made small, short 60- to 90-day term forward contract trades in foreign currencies. These were the only investments the Partnerships ever made, and Patterson and Nix elected to withdraw from Klamath and Kinabalu before the end of Stage I. They received cash and Euros on liquidation, and they sold the Euros in 2000, 2001, and 2002.

On their income tax returns for 2000, 2001, and 2002, Patterson claimed total losses of $25,277,202 arising from Klamath's activities and Nix claimed total losses of $25,272,344 arising from Kinabalu's. These massive losses occurred because each partner claimed a significant tax basis in their respective partnership. Generally, a partner's basis in a partnership is determined by the amount of capital he contributes to the partnership, and when a partnership loses money the partners can only deduct the losses from their taxable income to the extent of their basis in the partnership. When a partnership assumes a partner's individual liabilities, the liability amount is subtracted from the partner's basis. 1 Patterson and Nix were able to report such high losses because when they each calculated their basis in the partnership, they did not reduce it by the $25 million loan premium amount. When Patterson and Nix contributed the $66.7 million plus the $1.5 million to Klamath and Kinabalu, they would have each had a $68.2 million basis in their partnership. However, the Partnerships also assumed the loan obligations, so Patterson and Nix's bases had to be reduced by the amount of the liabilities. Patterson and Nix did not consider the loan premiums to be liabilities, so they only subtracted the $41.7 million principal amount. Therefore, each claimed a taxable basis in the partnership in excess of $25 million. This meant that when Patterson and Nix sold the Euros, they were able to deduct over $25 million from their taxable income. 2

The IRS disagreed with this basis calculation, and in 2004 issued Final Partnership Administrative Adjustments ("FPAAs") to Klamath and Kinabalu stating that under 26 U.S.C. § 752 of the Internal Revenue Code (the "Code"), the partners should have treated the entire $66.7 million as a liability. Alternatively, the IRS argued that the transactions were shams or lacked economic substance and should be disregarded for tax purposes. The FPAAs also made adjustments to operational expenses reported by the Partnerships and asserted accuracy-related penalties. Patterson and Nix paid the taxes owed based on the FPAAs, and then re-formed the partnerships in order to seek readjustment in the district court.

The Partnerships filed suit against the Government under 26 U.S.C. § 6226 for readjustment of partnership items. The Partnerships moved for partial summary judgment, and the Government cross-moved for summary judgment on the issue of whether the partners' tax bases were properly calculated; specifically, whether the loan premiums constituted liabilities under § 752 of the Code. The district court granted the Partnerships' motion and denied the Government's, holding that the loan premiums were not liabilities under § 752 and therefore the partners' bases were properly calculated under the Code. However, following a bench trial the district court held that the loan transactions must nonetheless be disregarded for federal tax purposes because they lacked economic substance. The district court also concluded that the penalties asserted by the IRS did not apply and the Partnerships' operational expenses were deductible. The Government moved the court to reconsider and vacate its summary judgment decision, arguing that the decision was mooted by the bench trial judgment. The court denied this motion. Finally, the court issued an order holding that it had jurisdiction to order a refund to the Partnerships, and that Patterson and Nix could deduct the $250,000 management fee paid to their accountants.

The Government appeals the district court's partial summary judgment in favor of the Partnerships, arguing that the "loan premiums" constitute liabilities under § 752. The Government also argues that the Partnerships are liable for penalties, that operating expenses and fees may not be deducted, and that the district court lacked jurisdiction to order a refund to the Partnerships. The Partnerships cross-appeal the district court's bench trial judgment, arguing that the loan transactions had economic substance.


II


We review the district court's grant of summary judgment de novo, applying the same standard as the district court. Kornman & Assocs. v. United States, 527 F.3d 443, 450 (5th Cir. 2008). On appeal from a bench trial, we review findings of fact for clear error and legal issues de novo. Houston Exploration Co. v. Halliburton Energy Servs., Inc., 359 F.3d 777, 779 (5th Cir. 2004). Specifically, we have held that a district court's characterization of a transaction for tax purposes is a question of law subject to de novo review, but the particular facts from which that characterization is made are reviewed for clear error. See Compaq Computer Corp. and Subsidiaries v. Comm'r, 277 F.3d 778, 780 (5th Cir. 2001) (citing Frank Lyon Co. v. United States, 435 U.S. 561, 581 n.16 (1978)).


III


We first consider the Partnerships' cross-appeal, namely whether the district court erred in determining that the loan transactions lacked economic substance and must be disregarded for tax purposes.

The economic substance doctrine allows courts to enforce the legislative purpose of the Code by preventing taxpayers from reaping tax benefits from transactions lacking in economic reality. See Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1353-54 (Fed. Cir. 2006). As the Supreme Court has recognized, taxpayers have the right to decrease or avoid taxes by legally permissible means. See Gregory v. Helvering, 293 U.S. 465, 469 (1935). However,"transactions[ ] which do not vary control or change the flow of economic benefits[ ] are to be dismissed from consideration." See Higgins v. Smith, 308 U.S. 473, 476 (1940). In a more recent pronouncement, the Supreme Court held that "[w]here ... there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached, the Government should honor the allocation of rights and duties effectuated by the parties." Frank Lyon, 435 U.S. at 583-84.

The law regarding whether a transaction should be disregarded as lacking economic reality is somewhat unsettled in the Fifth Circuit, and a split exists among other Circuits. The Fourth Circuit applies a rigid two-prong test, where a transaction will only be invalidated if it lacks economic substance and the taxpayer's sole motive is tax avoidance. See Rice's Toyota World, Inc. v. Comm'r, 752 F.2d 89, 91-92 (4th Cir. 1985). The majority view, however, is that a lack of economic substance is sufficient to invalidate the transaction regardless of whether the taxpayer has motives other than tax avoidance. See, e.g., Coltec, 454 F.3d at 1355; United Parcel Serv. of Am., Inc. v. Comm'r, 254 F.3d 1014, 1018 (11th Cir. 2001); ACM Partnership v. Comm'r, 157 F.3d 231, 247 (3d Cir. 1998); James v. Comm'r, 899 F.2d 905, 908-09 (10th Cir. 1990). We have previously declined to explicitly adopt either approach. See Compaq, 277 F.3d at 781-82 (finding that the transaction in question had both economic substance and a legitimate business purpose, so it would be recognized for tax purposes under either the minority or majority approach).

We conclude that the majority view more accurately interprets the Supreme Court's prescript in Frank Lyon. The Court essentially set up a multifactor test for when a transaction must be honored as legitimate for tax purposes, with factors including whether the transaction (1) has economic substance compelled by business or regulatory realities, (2) is imbued with taxindependent considerations, and (3) is not shaped totally by tax-avoidance features. See Frank Lyon, 435 U.S. at 583-84. Importantly, these factors are phrased in the conjunctive, meaning that the absence of any one of them will render the transaction void for tax purposes. Thus, if a transaction lacks economic substance compelled by business or regulatory realities, the transaction must be disregarded even if the taxpayers profess a genuine business purpose without tax-avoidance motivations.

The following facts found by the district court are critical to this issue: Presidio and NatWest understood that the transactions would not last beyond Stage I, despite the purported seven-year term --meaning that the high risk foreign currency transactions were never intended to occur. If the investors failed to withdraw voluntarily, NatWest could use economic pressure to force them out because the credit agreements required the borrowers to maintain collateral on deposit at NatWest that exceeded the value of the maximum obligations owed to the bank by some varying amount. At the time the loans were issued, this amount was at least 101.25% of the total $66.7 million. NatWest had the discretion to determine whether the ratio was satisfied and could accelerate the ratio to declare a default if the bank wished to force an investor to withdraw. This requirement also meant that none of the $66.7 million loan could ever be used for investments --it had to stay in the accounts at NatWest. NatWest and Presidio understood that the bank would hold the money in relatively risk-free time deposits. Presidio's management fee was calculated as a percentage of the tax losses generated by the investment plan. The district court determined, however, that Patterson and Nix pursued the transactions with a genuine profit motive and were not solely driven by the desire to avoid taxes.

Here, the evidence supports the district court's conclusion that the loan transactions lacked economic substance. Numerous bank documents stated that despite the purported seven-year term, the loans would only be outstanding for about 70 days. NatWest's profit in the loan transactions was calculated based on a 72-day period. In the event that the investors wanted to remain with the plan beyond 72 days, NatWest would force them out. The bank noted in an internal memo that it "had no legal or moral obligation to deal [with the investors] after Day 60." During that 60- to 70-day window the loan funds could not be used to facilitate the investment strategy that Presidio designed. The requirement of keeping at least 101.25% of the $66.7 million in the NatWest account meant, as the Government's expert testified, that the Partnerships could not make any investments without supplying their own funds in excess of the loan amount.

The Partnerships contend that the loan funds were critical to the high-risk foreign currency transactions even if the funding amount could not be spent because the money provided the necessary security for the high-risk transactions. However, the structure of the plan shows that these high-risk transactions could not occur until Stage III, which was never intended to be reached. As the district court found, NatWest would force the investors out long before Stage III, so the loan transactions served no real purpose beyond creating a massive tax benefit for Nix and Patterson.

The Partnerships further argue that the loan transactions had a reasonable possibility of profit, as evidenced by the fact that two small, low-risk investments were actually made in foreign currencies. However, these investments were made using the $1.5 million that Patterson and Nix contributed to the Partnerships, not the funding amounts of the loans. Various courts have held that when applying the economic substance doctrine, the proper focus is on the particular transaction that gives rise to the tax benefit, not collateral transactions that do not produce tax benefits. See Coltec, 454 F.3d at 1356-57; Nicole Rose Corp. v. Comm'r, 320 F.3d 282, 284 (2d Cir. 2002). Here, the transactions that provided the tax benefits at issue were the loans from NatWest. Therefore, the proper focus is on whether the loan transactions presented a reasonable possibility of profit, not whether the capital contributions from Patterson and Nix could have produced a profit. The loan transactions could never have been profitable because the funding amount could not actually be used for investments, and the high-risk investments for which the funding amount might have provided security were never intended to occur.

The evidence clearly shows that Presidio and NatWest designed the loan transactions and the investment strategy so that no reasonable possibility of profit existed and so that the funding amount would create massive tax benefits but would never actually be at risk. Regardless of Patterson and Nix's desire to make money, they entered into transactions controlled by Presidio and NatWest that were not structured or implemented to make a profit. This particular situation highlights the logic of following the majority approach to the economic substance doctrine, because the minority approach would allow tax benefits to flow from transactions totally lacking in economic substance as long as the taxpayers offered some conceivable profit motive. In cases such as the instant one, this approach would essentially reward a "head in the sand" defense where taxpayers can profess a profit motive but agree to a scheme structured and controlled by parties with the sole purpose of achieving tax benefits for them. We therefore agree with the district court that since the loan transactions lacked economic substance, they must be disregarded for tax purposes.


IV


Next we consider the Government's appeal, namely whether the district court properly granted the Partnerships' motion for partial summary judgment, declined to impose various penalties on the Partnerships, allowed the Partnerships to deduct operational expenses and fees, and ordered a refund.


A


The Government argues that the district court erred in granting the Partnership's motion for partial summary judgment, determining that the loan premiums were not liabilities for purposes of § 752. The Government states in its brief that they are appealing this issue "as a protective matter, due to possible collateral estoppel implications" in several lawsuits pending against Presidio in California.

Despite this adverse summary judgment ruling, the Government ultimately prevailed at trial on economic substance grounds and received the relief it requested when the loan transactions were disregarded for tax purposes. As a general matter, a party who is not aggrieved by a judgment does not have standing to appeal it. See Ward v. Santa Fe Indep. Sch. Dist., 393 F.3d 599, 603 (5th Cir. 2004). In some situations, adverse collateral estoppel implications may show that a party is aggrieved by a particular ruling. See In re DES Litig., 7 F.3d 20, 23 (5th Cir. 1993). However, an interlocutory ruling will only have collateral estoppel effect in subsequent litigation if the ultimate judgment in the case was dependent upon the interlocutory ruling. Id. (finding that a prevailing party had no standing to appeal adverse interlocutory rulings, regarding jurisdiction and choice of law, because the ultimate judgment in the case was not dependent on those rulings). Accordingly, where a party who ultimately prevails in a case attempts to show they have standing to appeal an earlier adverse ruling by arguing that the earlier ruling could have collateral estoppel effect in other pending cases, standing will only exist where the ultimate judgment in the case was "dependent" on the earlier adverse ruling. Id.

Here, the district court's summary judgment ruling has no collateral estoppel effect. The judgment following the bench trial was entirely based on the district court's conclusion that the loan transactions lacked economic substance and must be disregarded for tax purposes. This determination was totally independent of the partial summary judgment ruling that the loan premiums were not liabilities under § 752. Though the Government further argues that "[i]t could be concluded that [it] is aggrieved by the [summary] judgment [ruling] to the extent it played a part in the District Court's rejection of the IRS's imposition of penalties," we conclude that the district court's penalty decision was likewise not dependent on the partial summary judgment determination. Therefore, we hold that the Government lacks standing to appeal the district court's partial summary judgment ruling that neither § 752 nor Treas. Reg. § 1.752-6 operates to eliminate the claimed tax benefits arising from the Partnerships' participation in the loan transactions.


B


The Government also appeals the district court's ruling that no penalties may be imposed on the Partnerships. 3 The district court found that the Partnerships' actions did not meet the statutory requirements for imposition of the penalties, and that even if they were met, none of these penalties apply because the Partnerships acted in good faith and with reasonable cause. Specifically, the Government argues that the district court erred in finding that the Partnerships' actions did not meet the statutory requirements for the imposition of penalties, and that the district court lacked jurisdiction to consider the reasonable cause and good faith defenses. Since the issue of whether the Partnerships' conduct met the requirements for the penalties is moot if the district court had jurisdiction to consider the reasonable cause and good faith defenses, we first consider the jurisdictional issue.

This issue is governed by the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA"), 26 U.S.C. § § 6221-6233. Under TEFRA, "the tax treatment of any partnership item (and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item) shall be determined at the partnership level." 26 U.S.C. § 6221. TEFRA specifically sets forth the scope of judicial review:
A court with which a petition is filed in accordance with this section shall have jurisdiction to determine all partnership items of the partnership for the partnership taxable year to which the notice of final partnership administrative adjustment relates; the proper allocation of such items among the partners, and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item.

26 U.S.C. § 6226(f) (emphasis added). This provision clearly grants the district court jurisdiction to determine the applicability of any penalty relating to an adjustment of a partnership item. The Code also makes clear that if a taxpayer acts in good faith and with reasonable cause in the calculation of his or her taxes, penalties may not be applied: "[n]o penalty shall be imposed under section 6662 or 6663 with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion." 26 U.S.C. § 6664(c)(1).

The Government argues that the district court lacked jurisdiction to consider the reasonable cause and good faith defense because the court's jurisdiction in a TEFRA proceeding is limited to assessment of partnership-level items. Here, the Government claims, reasonable cause and good faith is a partner-level defense that can only be asserted in separate refund proceedings. To support this argument, the Government cites Temporary Treasury Regulation § 301.6221-1T, which states that assessment of penalties or any addition to tax related to partnership items is determined at the partnership level, and "[p]artner-level defenses to any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item may not be asserted in the partnership-level proceeding, but may be asserted through separate refund actions following assessment and payment." Temp. Treas. Reg. § 301.6221-1T(c)-(d) (1999). 4 The regulation defines partner-level defenses as "those that are personal to the partner or are dependent upon the partner's separate return and cannot be determined at the partnership level ... [including] ... whether the partner has met the criteria of ... section 6664(c)(1) (reasonable cause exception)." Temp. Treas. Reg. § 301.6221-1T(d).

The TEFRA structure enacted by Congress does not permit a partner to raise an individual defense during a partnership-level proceeding, but when considering the determination of penalties at the partnership level the court may consider the defenses of the partnership. See New Millennium Trading, LLC v. Comm'r, 131 T.C. No. 18, 2008 WL 5330940 at * 7 (2008). Though Temp. Treas. Reg. § 301.6221-1T(d) lists the reasonable cause exception as an example of a partner-level defense, it does not indicate that reasonable cause and good faith may never be considered at the partnership level. Several courts have found that a reasonable cause and good faith defense may be considered during partnership-level proceedings if the defense is presented on behalf of the partnership. See Santa Monica Pictures v. Comm'r, 89 T.C.M. 1157, 1229-30 (2005) (considering the reasonable cause and good faith defense asserted by the partnership to determine whether accuracy-related penalties should apply); See also Stobie Creek Investments, LLC v. United States, 82 Fed. Cl. 636, 703-04, 717-21 (2008) (considering the reasonable cause defense at the partnership level). Here, reasonable cause and good faith were asserted on behalf of Klamath and Kinabalu, by the current managing partners. Accordingly, we hold that the district court did not err in considering the defenses.

The plaintiff bears the burden of proof on a reasonable cause defense. See Montgomery v. Comm'r, 127 T.C. 43, 66 (2006). The most important factor is the extent of the taxpayer's effort to assess his proper liability in light of all the circumstances. Treas. Reg. § 1.6664-4(b). Reliance on the advice of a professional tax adviser does not necessarily demonstrate reasonable cause and good faith; rather, the validity of this reliance turns on "the quality and objectivity of the professional advice which they obtained." Swayze v. United States, 785 F.2d 715, 719 (9th Cir. 1986). The district court found that Patterson and Nix sought legal advice from qualified accountants and tax attorneys concerning the legal implications of their investments and the resulting tax deductions. They hired attorneys to write a detailed tax opinion, providing the attorneys with access to all relevant transactional documents. This tax opinion concluded that the tax treatment at issue complied with reasonable interpretations of the tax laws. At trial, the Partnerships' tax expert concluded that the opinion complied with standards established by Treasury Circular 230, which addresses conduct of practitioners who provide tax opinions. Overall, the district court found that the Partnerships proved by a preponderance of the evidence that they relied in good faith on the advice of qualified accountants and tax lawyers.

The Government argues only that the district court lacked jurisdiction to consider the reasonable cause and good faith defense; it has not alleged error in the substance of the district court's finding that Patterson and Nix acted with reasonable cause and in good faith. Therefore, having concluded that the district court had jurisdiction to consider this defense, we affirm the district court's conclusion that no penalties should apply.


C


The Government also appeals the district court's order that the Partnerships may deduct "operational expenses" associated with the loan and foreign currency transactions. These operational expenses include interest on the loans, a breakage fee, a management fee paid to Presidio, and a $250,000 fee paid to Pollans & Cohen. 5 The Government argues that the district court erred because no deduction may be taken for expenses related to a sham transaction.

The Code governs the deductibility of actual economic expenditures. Although the district court did not specify the provision under which the operating expenses are deductible, the Partnerships argue that they are entitled to the deductions under 26 U.S.C. §§ 163, 165(c)(2), and 212. Section 163 governs the deductibility of interest expenses, stating generally that "[t]here shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness." 26 U.S.C. § 163(a). Under § 165, deductions are permitted for "any loss sustained during the taxable year and not compensated for by insurance or otherwise." 26 U.S.C. § 165(a). Particularly, deductions for losses of individuals are limited to "losses incurred in any transaction entered into for profit ...." 26 U.S.C. § 165(c)(2). Section 212 allows deductions for "all the ordinary and necessary expenses paid or incurred during the taxable year [ ] for the production or collection of income." 26 U.S.C. § 212.

Generally, when a transaction is disregarded for lack of economic substance, deductions for costs expended in furtherance of the transaction are prohibited. See Winn-Dixie Stores, Inc. v. Comm'r, 113 T.C. 254, 294 (1999) (observing that "a transaction that lacks economic substance is not recognized for Federal tax purposes" and that "denial of recognition means that such a transaction cannot be the basis for a deductible expense") ; see also Salley v. Comm'r, 464 F.2d 479, 483 (5th Cir. 1972); Lerman v. Comm'r, 939 F.2d 44, 45 (3d Cir. 1991); Kirchman v. Comm'r, 862 F.2d 1486, 1490 (11th Cir. 1989). This makes sense in light of the fact that the effect of disregarding a transaction for lack of economic substance is that, for taxation purposes, the transaction is viewed to have never occurred at all. 6 Courts have determined that they may not disregard a transaction for some purposes but not for others. See ACM P'ship, 157 F.3d at 261 (observing that "we are not aware of any cases applying the economic substance doctrine selectively to recognize the consequences of a taxpayer's actions for some tax purposes but not others"). This also supports the idea that a transaction may not be disregarded under the economic substance doctrine for purposes of determining a partner's tax basis in a partnership, yet still support the deduction of operational expenses and fees. However, courts have upheld deductions based on genuine debts, where the debts are elements of a transaction that overall is lacking in economic substance. See Rice's Toyota World, Inc. v. Comm'r, 752 F.2d 89, 95-96 (4th Cir. 1985) (allowing deductions based on recourse note debt that was an element of a sham purchase transaction, because the notes represented actual indebtedness).

Here, the district court concluded that the interest payments were deductible because they were real economic losses. However, § 163 does not base the deductibility of interest on whether or not the interest paid was a real economic loss. Rather, the test is simply whether the interest was paid or accrued on indebtedness. See Salley, 464 F.2d at 485 (disallowing interest deductions under § 163 because the taxpayers did not take on actual indebtedness: "[i]n no sense can it be said that taxpayers paid any interest ... as compensation for the use or forbearance of money ... which is the standard business test of indebtedness") (internal quotations and citation omitted). Further, "the fact that an enforceable debt exists between the borrower and lender is not dispositive of whether interest arising from that debt is deductible under section 163." Winn-Dixie Stores, 113 T.C. at 279. The overall transaction must have economic substance in order to show genuine indebtedness, otherwise "every tax shelter ... could qualify for an interest expense deduction as long as there was a real creditor in the transaction that demanded repayment." Id.

In concluding that the loan transactions in this case lacked economic substance, the district court found that "[i]n truth, NatWest did not make any loans" and "[t]he loans ... were not loans at all." These findings preclude the conclusion that the Partnerships took on actual indebtedness. As we found above, the loan transactions in this case lacked economic substance partly because they were structured such that the Partnerships could never actually spend the loaned funds --101.25% of the funding amount had to stay in the accounts at NatWest to prevent a default. Therefore, despite the appearance of a loan, functionally the Partnerships never took on any actual debt. Since the loans did not constitute indebtedness, the Partnerships may not deduct the interest paid under § 163. 7

Presumably, though not specified, the district court found the remainder of the operating expenses and fees deductible under § 212 as necessary expenses incurred. This provision requires a profit motive. See Agro Science, 934 F.2d at 576 (noting that an expenditure is deductible under § 212 "only ... if the facts and circumstances indicate that the taxpayer made them primarily in furtherance of a bona fide profit objective independent of tax consequences"). The Government argues that the profit motive must be determined based on Presidio's subjective intentions because Presidio acted as managing partner when the transactions occurred. The district court, however, determined that the proper focus is on the motives of Patterson and Nix. Having concluded that Patterson and Nix entered into the transactions genuinely seeking to make a profit, the district court allowed the deductions.

The profit motive of a partnership is determined at the partnership level. Id.; Simon v. Comm'r, 830 F.2d 499, 507 (3d Cir. 1987). We have previously observed that the "testimony of general partners and promoters taken as a whole is relevant in determining a partnership's profit motive, because these individuals control a partnership's activities." Agro Science, 934 F.2d at 576 (internal citations omitted). Here, the district court concluded that the partners had different motivations: Nix and Patterson at all times pursued the investment strategy with a genuine profit motive, while Presidio's primary intent was to achieve a tax benefit. The crucial inquiry, then is which partner's intentions should be attributed to the Partnership. Under Agro Science, this answer depends on which partner effectively controlled the partnership's activities. Id.; Simon, 830 F.2d at 507 (observing that "a determination of [a partnership's] profit objective can only be made with reference to the actions of those ... who manage the partnership affairs").

During the time of the transactions in question, Presidio acted as the managing partner but had less than 10% ownership of Klamath and Kinabalu. Patterson and Nix each had 90% ownership. After reforming the Partnerships to bring this lawsuit they became managing partners. Though Patterson and Nix were never limited partners, the LLC agreements state that "the overall management and control of the business and affairs of the Company shall be vested solely in the Managing Member." The district court, however, did not analyze which partner retained control over the partnership. The district court appears to have concluded, with little explanation, that Patterson and Nix's motives must be attributed to the Partnerships because they paid the expenses at issue here and reported them on their individual tax returns. 8 However, for purposes of determining the deductibility of expenses it is the motive of the Partnership that matters, regardless of whether certain operating expenses were borne by one partner or another. None of the arguments articulated by the Partnerships or the district court persuade us that the motives of Patterson and Nix, to whom the overall control and management of the Partnerships was expressly denied under the LLC agreements, should be attributed to the Partnerships. We therefore hold that the district court erred as a matter of law by failing to consider which partners effectively controlled the management of the Partnerships' affairs, at the time the transactions occurred, in determining whether the operating expenses and fees are deductible.


D


We turn now to the Government's argument that the district court lacked jurisdiction to order a refund.

The district court based its authority to order the refund on its jurisdiction to order readjustment of partnership items, see 26 U.S.C. § 6226(f), and the Code provision stating that a partner should not have to file a claim for a refund following this readjustment. See 26 U.S.C. § 6230(d)(5) ("any overpayment by a partner which is attributable to a partnership item (or an affected item) and which may be refunded under this subchapter [26 U.S.C. §§ 6221 et seq.], to the extent practicable credit or refund of such overpayment shall be allowed or made without any requirement that the partner file a claim therefor"). The district court interpreted this provision to mean that it may order a refund following a readjustment of partnership items under § 6226, since the refund is permitted without the taxpayers filing a claim.

The Government argues, however, that the Code imposes a strict "exhaustion of administrative remedies" jurisdictional prerequisite with respect to tax refund actions, and that nothing in the Code grants the district court the authority to eliminate this prerequisite by ordering a refund as part of readjustment proceedings under § 6226. As the Government contends, § 6230(d)(5) only grants the IRS the authority to provide a refund attributable to partnership items without requiring the party to file a claim first --it does not expand the district court's specifically defined jurisdiction to include the authority to order a refund.

We have not previously confronted this question, and the few cases available reach mixed conclusions. The Government cites an unpublished opinion from the Ninth Circuit holding that "a district court does not have jurisdiction to order a refund in an action brought pursuant to 26 U.S.C. § 6226." See Gold Coast Hotel and Casino v. United States, 139 F.3d 904, 1998 WL 74991, at *2 (9th Cir. 1998) (unpublished). Another court has ordered refunds in a § 6226 action, though it did not explain its jurisdictional basis for doing so, and the Second Circuit reversed on appeal such that no refund was ultimately awarded. See TIFD III-E Inc. v. United States, 342 F. Supp. 2d 94, 121-22 (D. Conn. 2004), rev'd on other grounds, 459 F.3d 220 (2d Cir. 2006).

We conclude that the Code does not grant the district jurisdiction to order a refund in a readjustment action brought pursuant to § 6226. This provision specifically sets forth the scope of the district court's jurisdiction in readjustment proceedings. See § 6226(f). Though the provision specifies the district court's jurisdiction to determine partnership items, allocate those items to individual partners, and apply penalties, taxes, or additional amounts, it does not grant jurisdiction to order a refund.

Generally, no suit or proceeding may be maintained for the recovery of a refund "until a claim for refund or credit has been duly filed with the Secretary ...." See § 7422(a). Section 7422(h) provides a special rule for refund actions with respect to partnership items: "No action may be brought for a refund attributable to partnership items ... except as provided in section 6228(b) or section 6230(c)." The applicable provision here, § 6230(c), does not grant refund authority to the district court; rather, it sets forth the grounds on which a partner of a TEFRA partnership may file an administrative refund claim following a final partnership administrative adjustment. Specifically, a partner may file a claim for refund on the grounds that (1) the Secretary failed to allow a credit or to make a refund to the partner in the amount of the overpayment attributable to the application to the partner of a settlement, a final partnership administrative adjustment, or the decision of a court in an action brought under § 6226, or (2) the Secretary erroneously imposed any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item. See § 6230(c)(1)(B)-(C).

We agree with the Government that the provision upon which the district court based its jurisdiction, § 6230(d)(5), merely contemplates that "to the extent practicable" the IRS may grant a refund for an overpayment attributable to partnership items without any requirement that the partner file an administrative claim. Nothing in § 6230(d)(5) authorizes the district court to grant a refund pursuant to readjustment proceedings under § 6226, and it would be unreasonable to conclude that this provision --which is not referenced in § 6226(f) and is placed under the heading "Additional administrative proceedings" --alters the clearly defined limits of a district court's jurisdiction in readjustment proceedings.

We accordingly hold that the district court was without jurisdiction to order a refund. The Partnerships may seek a refund through administrative proceedings, as governed by § 7422.


V


For the foregoing reasons, we AFFIRM the district court's judgment that the loan transactions lacked economic substance and must be disregarded for tax purposes. We also AFFIRM the district court's judgment that no penalties apply. We VACATE the district court's order allowing the deduction of interest and operating expenses and REMAND for reconsideration in accordance with this opinion. We also VACATE the district court's order directing the IRS to grant the Partnerships a refund.

1 These rules are defined in 26 U.S.C. § 752 et seq. of the Internal Revenue Code, described more fully below.

2 Specifically, the losses occurred from the following. Patterson received 67,341.88 Euros when Klamath liquidated. He treated these Euros as having a tax basis of $25,316,393, calculated as:
Premium amount 25,000,000
Cash contributions 1,500,000
Interest income 91,307
Advisory fee to Pollans & Cohen 250,000
Cash distributions from Klamath (359,635)
Klamath partnership loss (1,165,279)
_________________________
Basis 25,316,393


This meant that since Patterson was able to treat the loan premium as money he had put into the partnership (i.e. not a liability that the partnership had to repay), he could claim a tax basis of $365.94 in each Euro he received from Klamath. When he sold the Euros for much less than this amount, large losses were created. Nix's basis calculation was nearly identical.

3 In the FPAAs, the IRS asserted four penalties against the Partnerships, all based on § 6662 of the Code: (1) a 40% penalty for gross valuation misstatement; (2) a 20% penalty for substantial valuation misstatement; (3) a 20% penalty for substantial understatement of income tax; and (4) a 20% penalty for negligence or disregard of rules and regulations. See 26 U.S.C. § 6662(a), (b)(1), (2), (3).

4 This regulation was temporary for the taxable years at issue. See Temporary Proced. & Admin. Regs., 64 Fed. Reg. 3838 (Jan. 26, 1999). However, it was made final and applicable to partnership taxable years beginning on or after Oct. 4, 2001. See § 301.6221-1(f), Proced. & Admin. Regs.

5 The Government concedes the deductibility of the trading losses suffered by the Partnerships in the foreign currency transactions.

6 The Partnerships rely extensively on Fabreeka Prods. Co. v. Comm'r, 34 T.C. 290, 299-300 (1960), vacated on other grounds by 294 F.2d 876 (1st Cir. 1961), for the proposition that operational expenses incurred in connection with a sham transaction may be deducted as long as they are "separable" from the underlying transaction. To the extent that this proposition can be supported by the since-vacated opinion in Fabreeka, we conclude that the Tax Court has subsequently failed to follow Fabreeka's approach to the deduction of operational expenses, and has instead maintained that expenses incurred in connection with a sham transaction are generally not deductible. See Winn-Dixie, 113 T.C. at 294 (finding that administrative fees "were incurred in connection with, and were an integral part of, a sham transaction and, as a result, were not deductible").

7 The Partnerships may likewise not deduct interest under other provisions of the Code as a business expense or an expense paid for the production of income. See Salley, 464 F.2d at 483 (noting that if lack of economic substance prevents the deduction of interest under § 163, the interest is likewise not deductible under §§ 162(a) or 212).

8 In its brief, the Government contends that it was the Partnerships that paid the expenses, citing to Plaintiff's Exhibits 49, 50, 142, and 143. Since these exhibits have apparently not made it into the record on appeal, and have not been able to be obtained from the district court, we cannot verify the Government's contention. Nonetheless, whether it was an individual partner or the Partnership that paid the expenses is not dispositive of the issue of who effectively controlled the Partnerships' activities, and we conclude that the district court erred in relying on this fact to allow the deductions.

6694 Final Regulations -

T.D. 9436 , filed with the Federal Register on December 15, 2008 – the 6694 Final Regulations reflect amendments made by the Small Business and Work Opportunity Act of 2007 (P.L. 110-28) to the return preparer penalties under Code Secs. 6694 and 6695 and related Code Secs. 6060, 6107, 6109, 6696 and 7701 have been amended and finalized by the IRS. The tax return preparer regulations were amended to extend the application of the income tax return preparer penalties to all tax return preparers, including those who prepare estate, gift, and generation-skipping transfer (GST) tax returns; heighten the standards for both disclosed and undisclosed positions that must be met by preparers to avoid the Code Sec. 6694(a) penalty; and increase the Code Sec. 6694 penalty. The final regulations provided that only one person within a firm would be considered primarily responsible for each position giving rise to an understatement. The final regulations also clarify that a tax return preparer may rely on advice furnished by another advisor, return preparer, or other party, even if the advisor or tax return preparer is within the tax return preparer's same firm. However, the tax return preparer must meet the diligence standards in order to rely on the provided information. Furthermore, while the amendments made to Code Sec. 6694 by the Tax Extenders and Alternative Minimum Tax Relief Act of 2008 (P.L. 110-343) (the 2008 Act) changed the language from the previously used "reasonable belief that the position would more likely than not be sustained on its merits" standard to the "reasonable to believe" standard, the IRS interpreted the two standards to have the same meaning. However, the terminology was changed in the final regulations. The final version of Reg. §1.6694-2 does not contain substantive guidance regarding the amendments made by the 2008 Act. Accordingly, the IRS reserved Reg. §1.6694-2(c), and simultaneously issued Notice 2009-5, which provides interim guidance on the amendments. The final regulations modified the definition of adequate disclosure and removed provisions addressing the burden of proof regarding whether a tax return preparer has willfully attempted to understate the liability for tax. The final regulations are effective for advice given and returns and claims for refund filed after December 31, 2008.

.

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations implementing amendments to the tax return preparer penalties under sections 6694 and 6695 of the Internal Revenue Code (Code) and related provisions under sections 6060, 6107, 6109, 6696, and 7701(a)(36) reflecting amendments to the Code made by section 8246 of the Small Business and Work Opportunity Tax Act of 2007 and section 506 of the Tax Extenders and Alternative Minimum Tax Relief Act of 2008. The final regulations affect tax return preparers and provide guidance regarding the amended provisions.

DATES: Effective Date: These regulations are effective on December 22, 2008.

Applicability Date: For dates of applicability, see §§1.6060-1(d), 1.6107-1(e), 1.6109-2(d), 1.6694-1(g), 1.6694-2(f), 1.6694-3(g), 1.6694-4(d), 1.6695-1(g), 1.6695-2(d), 1.6696-1(k), 20.6060-1(b), 20.6107-1(b), 20.6109-1(b), 20.6694-1(b), 20.6694-2(b), 20.6694-3(b), 20.6694-4(b), 20.6695-1(b), 20.6696-1(b), 20.7701-1(b), 25.6060-1(b), 25.6107-1(b), 25.6109-1(b), 25.6694-1(b), 25.6694-2(b), 25.6694-3(b), 25.6694-4(b), 25.6695-1(b), 25.6696-1(b), 25.7701-1(b), 26.6060-1(b), 26.6107-1(b), 26.6109-1(b), 26.6694-1(b), 26.6694-2(b), 26.6694-3(b), 26.6694-4(b), 26.6695-1(b), 26.6696-1(b), 26.7701-1(b), 31.6060-1(b), 31.6107-1(b), 31.6109-2(b), 31.6694-1(b), 31.6694-2(b), 31.6694-3(b), 31.6694-4(b), 31.6695-1(b), 31.6696-1(b), 31.7701-1(b), 40.6060-1(b), 40.6107-1(b), 40.6109-1(b), 40.6694-1(b), 40.6694-2(b), 40.6694-3(b), 40.6694-4(b), 40.6695-1(b), 40.6696-1(b), 40.7701-1(b), 41.6060-1(b), 41.6107-1(b), 41.6109-2(b), 41.6694-1(b), 41.6694-2(b), 41.6694-3(b), 41.6694-4(b), 41.6695-1(b), 41.6696-1(b), 41.7701-1(b), 44.6060-1(b), 44.6107-1(b), 44.6109-1(b), 44.6694-1(b), 44.6694-2(b), 44.6694-3(b), 44.6694-4(b), 44.6695-1(b), 44.6696-1(b), 44.7701-1(b), 53.6060-1(b), 53.6107-1(b), 53.6109-1(b), 53.6694-1(b), 53.6694-2(b), 53.6694-3(b), 53.6694-4(b), 53.6695-1(b), 53.6696-1(b), 53.7701-1(b), 54.6060-1(b), 54.6107-1(b), 54.6109-1(b), 54.6694-1(b), 54.6694-2(b), 54.6694-3(b), 54.6694-4(b), 54.6695-1(b), 54.6696-1(b), 54.7701-1(b), 55.6060-1(b), 55.6107-1(b), 55.6109-1(b), 55.6694-1(b), 55.6694-2(b), 55.6694-3(b), 55.6694-4(b), 55.6695-1(b), 55.6696-1(b), 55.7701-1(b), 56.6060-1(b), 56.6107-1(b), 56.6109-1(b), 56.6694-1(b), 56.6694-2(b), 56.6694-3(b), 56.6694-4(b), 56.6695-1(b), 56.6696-1(b), 56.7701-1(b), 156.6060-1(b), 156.6107-1(b), 156.6109-1(b), 156.6694-1(b), 156.6694-2(b), 156.6694-3(b), 156.6694-4(b), 156.6695-1(b), 156.6696-1(b), 156.7701-1(b), 157.6060-1(b), 157.6107-1(b), 157.6109-1(b), 157.6694-1(b), 157.6694-2(b), 157.6694-3(b), 157.6694-4(b), 157.6695-1(b), 157.6696-1(b), 157.7701-1(b), and 301.7701-15(g).

FOR FURTHER INFORMATION CONTACT: Michael E. Hara, (202) 622-4910, and Matthew S. Cooper, (202) 622-4940 (not tollfree numbers).

SUPPLEMENTARY INFORMATION:



Paperwork Reduction Act

The collections of information contained in these final regulations were previously reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)) under control number 1545-1231. The collections of information in this final regulation are in §§1.6060-1(a)(1), 1.6107-1, 1.6694-2(d)(3), 20.6060-1(a)(1), 20.6107-1, 25.6060-1(a)(1), 25.6107-1, 26.6060-1(a)(1), 26.6107-1, 31.6060-1(a)(1), 31.6107-1, 40.6060-1(a)(1), 40.6107-1, 41.6060-1(a)(1), 41.6107-1, 44.6060-1(a)(1), 44.6107-1, 53.6060-1(a)(1), 53.6107-1, 54.6060-1(a)(1), 54.6107-1, 55.6060-1(a)(1), 55.6107-1, 56.6060-1(a)(1), 56.6107-1, 156.6060-1(a)(1), 156.6107-1, 157.6060-1(a)(1), and 157.6107-1.

This information is necessary to make the record of the name, taxpayer identification number, and principal place of work of each tax return preparer, make each return or claim for refund prepared available for inspection by the Commissioner of Internal Revenue, and to document that the tax return preparer advised the taxpayer of the penalty standards applicable to the taxpayer in order for the tax return preparer to avoid penalties under section 6694. The collection of information is required to comply with the provisions of section 8246 of the Small Business and Work Opportunity Tax Act of 2007 and section 506 of the Tax Extenders and Alternative Minimum Tax Relief Act of 2008. The likely respondents are tax return preparers and their employers.

Estimated total annual reporting burden: 10,679,320 hours.

Estimated average annual burden per respondent: 15.6 hours.

Estimated number of respondents: 684,268.

Estimated frequency of responses: 127,801,426.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Office of Management and Budget.



Background

This document contains final amendments to the Income Tax Regulations (26 CFR part 1), the Estate Tax Regulations (26 CFR part 20), the Gift Tax Regulations (26 CFR part 25), the Generation-Skipping Transfer Tax Regulations (26 CFR part 26), the Employment Tax and Collection of Income Tax at Source Regulations (26 CFR part 31), the Excise Tax Procedural Regulations (26 CFR part 40), the Highway Use Tax Regulations, (26 CFR part 41), the Wagering Tax Regulations (26 CFR part 44), the Foundation and Similar Excise Tax Regulations (26 CFR part 53), the Pension Excise Tax Regulations (26 CFR part 54), the Excise Tax on Real Estate Investment Trusts and Regulated Investment Companies Regulations (26 CFR part 55), the Public Charity Excise Tax Regulations (26 CFR part 56), the Excise Tax on Greenmail Regulations (26 CFR part 156), the Excise Tax on Structured Settlement Factoring Transactions Regulations (26 CFR part 157), and the Regulations on Procedure and Administration (26 CFR part 301) implementing the amendments to tax return preparer penalties under sections 6694 and 6695 (and the related provisions under sections 6060, 6107, 6109, 6696, and 7701(a)(36)) made by section 8246 of the Small Business and Work Opportunity Tax Act of 2007, Title VIII-B of Public Law 110-28 (121 Stat. 190) (May 25, 2007) (the 2007 Act) and section 506 of the Tax Extenders and Alternative Minimum Tax Relief Act of 2008, Div. C of Public Law 110- 343 (122 Stat. 3765) (October 3, 2008) (the 2008 Act).

Section 8246 of the 2007 Act amended sections 6694 and 7701(a)(36) and made conforming changes to other Code provisions to make tax return preparer penalties applicable to a broader range of tax returns and claims for refund. The 2007 Act's amendments to section 6694 also changed the standards of conduct that tax return preparers must meet in order to avoid imposition of penalties in the event that a return prepared results in an understatement of tax. For undisclosed positions, the 2007 Act replaced the "realistic possibility" standard with a standard requiring the tax return preparer to have a "reasonable belief that the position would more likely than not be sustained on its merits." For disclosed positions, the 2007 Act replaced the "not-frivolous" standard with a standard requiring the tax return preparer to have a "reasonable basis" for the tax treatment of the position.

The 2007 Act also increased the first-tier penalty under section 6694(a) from $250 to the greater of $1,000 or 50 percent of the income derived (or to be derived) by the tax return preparer from the preparation of a return or claim for refund with respect to which the penalty was imposed. In addition, the 2007 Act increased the secondtier penalty under section 6694(b) from $1,000 to the greater of $5,000 or 50 percent of the income derived (or to be derived) by the tax return preparer. The amendments made by the 2007 Act were effective for tax returns prepared after the date of enactment, May 25, 2007.

The Treasury Department and the IRS released Notice 2008-13 (2008-3 IRB 282) on December 31, 2007, to provide interim guidance under the 2007 Act. Additional guidance was simultaneously provided in Notice 2008-12 (2008-3 IRB 280) with respect to the implementation of the tax return preparer signature requirement of section 6695(b), and in Notice 2008-11 (2008-3 IRB 279), which clarified the earlier transition relief provided in Notice 2007-54 (2007- 27 IRB 12 (July 2, 2007)). Notice 2008-46 (2008-18 IRB 868) was released on April 16, 2008, to add certain returns and documents to Exhibits 1, 2, and 3 of Notice 2008-13.

On June 17, 2008, the Treasury Department and the IRS published in the Federal Register (73 FR 34560) proposed amendments to the regulations (REG-129243-07) reflecting amendments made by the 2007 Act and comments received on the notices. A public hearing was held on these proposals on August 18, 2008. Written public comments responding to the proposed regulations were received.

On October 3, 2008, section 506 of the 2008 Act modified the standards of conduct that tax return preparers must meet in order to avoid imposition of the section 6694(a) penalty. Specifically, the 2008 Act changed the standard for undisclosed positions from "reasonable belief that the position more likely than not will be sustained on the merits" to "substantial authority for the position." The 2008 Act maintained the "reasonable basis" standard for disclosed positions. If a position is with respect to a tax shelter (as defined in section 6662(d)(2)(C)(ii)) or a reportable transaction to which section 6662A applies, it must be "reasonable to believe that the position more likely than not will be sustained on the merits." The amendments made by the 2008 Act are retroactively effective for tax returns prepared after May 25, 2007, except that the special rules applicable to positions with respect to tax shelters and reportable transactions to which section 6662A applies are effective for tax returns or claims for refund prepared for tax years ending after October 3, 2008, the date of enactment of the 2008 Act.

After consideration of the public comments and the amendments made by the 2008 Act, the proposed regulations are adopted as revised by this Treasury decision. Section 1.6694-2 of these final regulations does not provide substantive guidance reflecting amendments to the Code made by the 2008 Act. Rather, the Treasury Department and the IRS are reserving §1.6694-2(c) in these final regulations and are simultaneously issuing a notice in the Internal Revenue Bulletin providing interim guidance on the amendments to the Code made by the 2008 Act. With these final regulations, the Treasury Department and the IRS are also simultaneously issuing a revenue procedure in the Internal Revenue Bulletin that specifically identifies the returns and claims for refund subject to penalty under sections 6694 and 6695.



Summary of Comments and Explanation of Revisions

Over 30 written comments were received in response to the notice of proposed rulemaking. All comments were considered and are available for public inspection upon request. A number of these comments are summarized in this preamble. The changes included in these final regulations are discussed in order of the Code sections to which they relate.

In accordance with the 2007 Act, these final regulations amend existing regulations defining tax return preparers, which were previously limited to income tax return preparers, to broaden the scope of that definition to include preparers of estate, gift, and generationskipping transfer tax returns, employment tax returns, excise tax returns, and returns of exempt organizations. These final regulations also revise current regulations to amend the standards of conduct that must be met to avoid imposition of the tax return preparer penalty under section 6694. In addition, these final regulations reflect changes to the computation of the section 6694 tax return preparer penalty made by the 2007 Act. These final regulations also amend current regulations under the penalty provisions of section 6695 to conform them with changes made by the 2007 Act expanding the scope of that statute beyond income tax returns. These final regulations are applicable to returns and claims for refund filed (and advice given) after December 31, 2008.



Furnishing of Copy of the Tax Return and Retaining Copy

The final regulations adopt the proposed amendments to §1.6107-1 regarding the requirement of a signing tax return preparer to furnish a copy of the completed tax return to the taxpayer and also to retain a copy, with modification.

One commentator requested that the final regulations make clear that a tax return preparer may provide copies of tax returns to taxpayers in either hard copy or electronic formats. The Treasury Department and the IRS recognize that because many returns are prepared and filed electronically and consist of electronic data, it may be unclear what is an acceptable copy of a return that must be furnished to the taxpayer. Upon further consideration, the Treasury Department and the IRS agree that clarification is necessary. Under §1.6107-1(a) of the final regulations, the tax return preparer must provide a complete copy of the return filed with the IRS to the taxpayer in any medium, including electronic, that is acceptable to both the taxpayer and the return preparer. In the case of an electronically-filed return, a complete copy of a taxpayer's return consists of the electronic portion of the return, including all schedules, forms, pdf attachments, and jurats, that was filed with the IRS. The copy provided to the taxpayer must include all information submitted to the IRS to enable the taxpayer to determine which schedules, forms, electronic files, and other supporting materials have been filed with the return. The copy, however, need not contain the identification number of the tax return preparer. The electronic portion of the return can be contained on a replica of an official form or on an unofficial form. On an unofficial form, however, data entries must reference the line numbers or descriptions on an official form.

The same commentator requested that the final regulations specifically provide that the copy of the tax return retained by tax return preparers may be retained electronically. The Treasury Department and the IRS, however, have concluded that revising the existing regulations to include this rule is not necessary. Existing revenue procedures address the maintenance of business records through use of electronic storage systems. See, for example, Rev. Proc. 97-22, 1997-1 CB 652. Tax return preparers may retain copies of tax returns in accordance with existing revenue procedures to comply with the final regulations.

Another commentator agreed with the general approach taken in §1.6107-1(c) but suggested clarification of the language regarding who is a signing tax return preparer for purposes of the section 6107 requirements. Upon consideration, the Treasury Department and the IRS agree that there is a potential for the proposed language to be misconstrued. Section 1.6107-1(c) of the final regulations clarifies that for purposes of complying with the requirements of section 6107, a corporation, partnership or other organization that employs a signing tax return preparer to prepare for compensation (or in which a signing tax return preparer is compensated as a partner or member to prepare) a return of tax or claim for refund shall be treated as the sole signing tax return preparer.



Furnishing Identification Number

A commentator requested that the final regulations clarify whether the tax return preparer's identifying number must be included on the taxpayer's copy of the tax return as well as on the copy filed with the I RS. Section 6109(a)(4) provides that any return or claim for refund prepared by a tax return preparer shall bear an identification number for securing proper identification of the tax return preparer, his employer, or both as may be prescribed. Upon further consideration, the Treasury Department and the IRS agree that for identification purposes, it is only important for the tax return preparer identification number to be included on the return that is filed with the IRS. Section 1.6109-2(a) of the final regulations, therefore, is amended to provide that each filed return or claim for refund containing the identification number of the tax return preparer required to sign the return (and the identification number of the person who has an employment arrangement or association with the individual tax return preparer, if applicable) will meet the needs of the IRS. This modification will assist in maintaining the privacy of the tax return preparer's information. Additional guidance may be provided in the future regarding tax return preparer identification numbers under section 6109.



Defining the Preparer Within a Firm

The final regulations adopt the proposed amendments to §1.6694-1(b)(1), with modification. Accordingly, the final regulations maintain a framework defining a "preparer per position within a firm", with the focus of any penalty on the position(s) giving rise to the understatement on the return or claim for refund and any responsible parties with respect to such position(s).

Under this framework, an individual is a tax return preparer subject to section 6694 if the individual is primarily responsible for the position on the return or claim for refund giving rise to the understatement. Under §1.6694-1(b)(1), only one person within a firm will be considered primarily responsible for each position giving rise to an understatement and, accordingly, be subject to the penalty.

Three commentators questioned whether this framework will lead to significant problems in return preparer firms, in particular whether the framework may discourage any particular person within the firm from looking at the return in whole. These commentators also questioned whether the IRS will be able to identify the responsible party if individuals at the firm attempt to identify others at the firm who may be more responsible for the position. Two other commentators, however, agreed with this framework in light of the high level of specialization that exists in modern tax practice. The Treasury Department and the IRS continue to conclude that the expansion from a "one preparer per firm" to a "one preparer per position within a firm" will further compliance and will result in more equitable administration of the tax return preparer penalty regime. This framework, therefore, is adopted in the final regulations.

Section 1.6694-1(b)(2) of the proposed regulations provided that the individual who signs the return or claim for refund as the tax return preparer generally will be considered the person within a firm who is primarily responsible for all of the positions on the return or claim for refund giving rise to an understatement. This language is finalized as proposed except for some minor conforming changes.

Proposed §1.6694-1(b)(3) established a similar rule for situations when there are one or more nonsigning tax return preparers at the same firm and either no signing tax return preparer within the firm, it is concluded that the signer is not primarily responsible for the position, or the IRS cannot conclude which individual is primarily responsible for the position for purposes of section 6694. In these situations, the proposed regulations stated that the individual within the firm with overall supervisory responsibility for the position(s) giving rise to the understatement is the tax return preparer who is primarily responsible for the position for purposes of section 6694.

Several commentators requested that this rule for nonsigning tax return preparers not be adopted as proposed because it will lead to more harm than good. Specifically, one commentator requested the deletion of the clause "or the IRS cannot conclude which individual (as between the signing tax return preparer and other persons within the firm) is primarily responsible for the position" from proposed §1.6694-1(b)(3) because a tax return preparer penalty is not appropriate when the IRS is not able to reach a conclusion as to who is primarily responsible for the conduct giving rise to the position. The other commentator recommended qualifying the rule in proposed §1.6694-1(b)(3) with the requirement that the individual with overall supervisory responsibility for the position either possess actual knowledge of the position or fail to exercise appropriate diligence in the review of the position subject to penalty through willfulness, recklessness, or gross indifference.

Upon consideration of these comments, the Treasury Department and the IRS have revised §1.6694-1(b)(3) to provide that if there is no signing tax return preparer for the return or claim for refund within that firm or if, after the application of §1.6694-1(b)(2), it is concluded that the signing tax return preparer is not primarily responsible for the position, the nonsigning tax return preparer within the firm with overall supervisory responsibility for the position(s) giving rise to the understatement generally will be considered the tax return preparer who is primarily responsible for the position for purposes of section 6694. Based upon credible information from any source, however, it may be concluded that another nonsigning tax return preparer within the firm is primarily responsible for the position(s) on the return or claim for refund giving rise to an understatement.

In response to the commentators' concerns that the default rule in proposed §1.6694-1(b)(3) assigning liability for the penalty to the nonsigning tax return preparer may lead to more harm than good, §1.6694-1(b)(4) of the final regulations is added. The final regulations in §1.6694-1(b)(4) provide that, if the information presented would support a finding that either the signing tax return preparer or a nonsigning tax return preparer within a firm is primarily responsible for the position(s) giving rise to the understatement, the IRS may assess the penalty against either one of the individuals within the firm, but not both, as the primarily responsible tax return preparer. This determination will be based upon all the evidence presented and will allow for certainty regarding the identification of the primarily responsible tax return preparer within the expiration of the period of limitations on making an assessment under section 6694(a). It is expected that the IRS will assess the penalty under section 6694 under these rules against the tax return preparer with the greatest amount of responsibility for the position based upon the best information available to the IRS. The rule adopted in §1.6694-1(b)(4) is not a rule reflecting joint and several liability for the penalty among the signing tax return preparer and nonsigning tax return preparer as the penalty may be assessed against one of these individuals, but not both.



Reliance on Information Provided

The final regulations adopt the proposed amendments to §1.6694-1(e), with modification. Most commentators supported expanding the regulations in §1.6694-1(e) to provide that a tax return preparer may rely in good faith and without verification on information furnished by another advisor, another tax return preparer, or other party (even if the advisor or tax return preparer is within the tax return preparer's same firm) as long as the tax return preparer does not ignore the implications of information furnished to the tax return preparer or actually known by the tax return preparer, and makes reasonable inquiries if the information as furnished appears to be incorrect or incomplete.

Commentators, however, requested that the final regulations clarify that a tax return preparer may rely on "advice" furnished by another advisor, another tax return preparer, or other party (even if the advisor or tax return preparer is within the tax return preparer's same firm.) This recommendation is adopted in §1.6694-1(e)(1) of the final regulations. The same changes are made for conformity to the definitions of "reasonable to believe that the position would more likely than not be sustained on its merits" in §1.6694-2(b)(1), "reasonable basis" in §1.6694-2(d)(2) and "reasonable cause" in §1.6694-2(e)(5). These modifications are consistent with the intent of the rules in the proposed regulations regarding reliance given the heightened standards imposed on tax return preparers by the 2007 and 2008 Acts and the increased complexity of the law.

Section 1.6694-1(e) of the proposed regulations also proposed a new rule providing that a tax return preparer may not rely on legal conclusions regarding Federal tax issues furnished by taxpayers. The purpose behind this proposal was the belief that in general, although it was reasonable to allow a tax return preparer to rely on facts furnished by the taxpayer in good faith without verification, the tax return preparer should not be able to rely on legal conclusions on issues when the taxpayer may not be an expert and looked to the tax return preparer to determine the legal issue for purposes of preparing the return or claim for refund.

Most commentators expressed concern, however, that tax return preparers have long relied on information that involve mixed questions of fact and law furnished by taxpayers, in addition to legal conclusions. Moreover, the commentators point out that many large entity taxpayers have in-house tax departments staffed by tax professionals who are qualified to perform research and analysis necessary to address many legal issues.

The Treasury Department and the IRS acknowledge that the proposed regulations may be unclear on how the "no reliance on legal conclusions by taxpayers" language in proposed §1.6694-1(e) interacts with the language in proposed §1.6694-2(b)(2) regarding unreasonable assumptions. Accordingly, the "no reliance on legal conclusions by taxpayers" is removed from §1.6694-1(e) of the final regulations. While this phrase is removed from the text of the final regulations, the tax return preparer nevertheless must meet the diligence standards otherwise imposed by this regulation in order to rely properly on information and advice provided by taxpayers or other individuals. Tax return preparers must have no reason to believe that the taxpayer is incompetent to make these conclusions, have no knowledge that the conclusions are incorrect or incomplete, and make reasonable inquiries if the information as furnished appears to be incorrect or incomplete.



Use of Estimates

One commentator noted that the nature of accounting, upon which calculations of taxable income are based, requires the use of estimates, and urged the Treasury Department and the IRS to include a specific reference to allow the use of estimates in the final regulations. The Treasury Department and the IRS recognize that there are some circumstances when the use of reasonable estimates may be appropriate in the preparation of tax returns (see, for example, §§1.448-2(d), 1.451-1(a), and 1.451-5(c)(1)(ii)), and there are some circumstances in which there may be no practical alternative to the use of reasonable estimates, for example, when the taxpayer's records are destroyed accidentally or through computer failure. The Treasury Department and the IRS, however, conclude that including a general rule regarding the use of estimates in the preparer penalty regulations that could impact other substantive tax provisions is not appropriate.



Income Derived Determination in Computing Penalty Amount

The final regulations adopt the proposed amendments to §1.6694-1(f), with minor modification. Section 1.6694-1(f) defines "income derived (or to be derived)" with respect to a return or claim for refund as all compensation the tax return preparer receives or expects to receive with respect to the engagement of preparing the return or claim for refund or providing tax advice (including research and consultation) with respect to the position(s) taken on the return or claim for refund that gave rise to the understatement.

Several commentators requested clarification on this definition of "income derived (or to be derived)" for purposes of computing the section 6694 penalty because it is not necessarily clear what compensation is captured by this definition, which could be interpreted broadly. The final regulations maintain the same definition of "income derived (or to be derived)" as proposed because the Treasury Department and the IRS conclude that the other rules described in §1.6694-1(f) provide appropriate limitations to this definition.

In response to a commentator's request, the final regulations in §1.6694-1(f)(4) also add an example illustrating how the penalty will be computed in cases involving employees and partners who spend a portion of their time on a particular position subject to the section 6694 penalty for which the firm earns a specific amount.



Firm Liability

The final regulations adopt the proposed amendments to §§1.6694-2(a)(2) and 1.6694-3(a)(2), without modification. One commentator requested examples of a firm disregarding its review procedures through willfulness, recklessness, or gross indifference in the formulation of the advice, or the preparation of the return or claim for refund, that included the position for which the penalty is imposed. The determination as to whether a firm disregards its review procedures will be made based upon all facts and circumstances. Because any example necessarily would be limited to the facts of a particular firm's review procedures, additional examples on this issue would not meaningfully add to the guidance provided in the proposed regulations.



Reasonable to Believe That More Likely Than Not

Section 1.6694-2(b) of the final regulations defines the "reasonable to believe that the position would more likely than not be sustained on its merits" standard that now applies to positions that are tax shelters and reportable transactions to which section 6662A applies. While the 2008 Act amendment to section 6694 includes a "reasonable to believe" standard rather than the "reasonable belief" standard used in the 2007 Act, the Treasury Department and the IRS are of the view that the two standards have the same meaning. Conforming changes are made throughout the final regulations to reflect the 2008 Act terminology.

Proposed §1.6694-2(b)(1) provided that the "reasonable belief that the position would more likely than not be sustained on its merits" standard will be satisfied if the tax return preparer analyzes the pertinent facts and authorities and, in reliance upon that analysis, reasonably concludes in good faith that the position has a greater than 50 percent likelihood of being sustained on its merits. The proposed regulations stated that whether a tax return preparer meets this standard will be determined based upon all facts and circumstances, including the tax return preparer's due diligence. Moreover, in determining the level of diligence in a particular case, the proposed regulations provided that the IRS would take into account the tax return preparer's experience with the area of tax law and familiarity with the taxpayer's affairs, as well as the complexity of the issues and facts in the case.

Several commentators requested that the final regulations specify that the amount of due diligence required on the part of the tax return preparer should not be disproportionate to the amount of the tax liability that would be affected by the position at issue. There was also some confusion on whether the due diligence rules in the proposed regulations allowed a less educated, sophisticated, or experienced tax return preparer to escape penalty liability more easily than educated, sophisticated, or experienced tax return preparers. This was not the intent of this rule in the proposed regulations. Due diligence is only one of many factors to consider in determining whether a tax return preparer meets the "reasonable to believe that the position would more likely than not be sustained on its merits" standard and all of the facts and circumstances of each specific case will need to be evaluated in making this determination.

Several commentators suggested that the provisions in §1.6694-2(d)(5) of the proposed regulations permitting tax return preparers to rely upon generally accepted administrative or industry practice in establishing reasonable cause relief from penalties under section 6694 should be extended to allow consideration of generally accepted administrative or industry practice in determining whether the "reasonable to believe that the position would more likely than not be sustained on its merits" standard is satisfied. These comments are not adopted in the final regulations because the Treasury Department and the IRS continue to conclude that the authorities contained in §1.6662-4(d)(3)(iii) (or any successor provision) are the appropriate authorities to be considered in determining whether it is reasonable to believe that the position would more likely than not be sustained on its merits. The "reasonable to believe that the position would more likely than not be sustained on its merits" standard relates to the tax return preparer's evaluation of the merits of a return position, and the merits of a tax return position must be considered in light of established relevant legal authorities. Generally accepted administrative or industry practice are less relevant in considering the merits of a tax return position under applicable law and guidance, although they may be appropriate factors to consider in the context of a tax return preparer's reasonable cause and good faith.

Based upon a comment received, the final regulations in §1.6694-2(b)(4) adopt the same rule as in §1.6662-4(d)(3)(iv)(B) regarding the effect of the taxpayer's jurisdiction on meeting the appropriate standard. The Treasury Department and the IRS are of the view that it is appropriate that the same rule apply for purposes of satisfying the "reasonable to believe that the position more likely than not be sustained on its merits" standard. This approach supports uniform disclosure by taxpayers and tax return preparers and prevents conflicts between taxpayers and tax return preparers in complying with the federal tax laws.



Adequate Disclosure

The final regulations adopt the proposed amendments to §1.6694-2(d)(3), with modification based upon comments received and revisions made in the 2008 Act. For a signing tax return preparer within the meaning of §301.7701-15(b)(1), the final regulations provide that disclosure of a position for which there is a reasonable basis but for which there is not substantial authority is adequate in one of three ways. First, the position may be disclosed on a properly completed and filed Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement, as appropriate, or on the tax return in accordance with the applicable annual revenue procedure. See Revenue Procedure 2008-14 (2008-7 IRB 435 (February 19, 2008)). Second, disclosure of the position is adequate if the tax return preparer provides the taxpayer with a prepared tax return that includes the appropriate disclosure in accordance with §1.6662-4(f). Third, for tax returns or claims for refund that are subject to penalties other than the accuracy-related penalty for substantial understatements under sections 6662(b)(2) and (d), the tax return preparer advises the taxpayer of the penalty standards applicable to the taxpayer under section 6662. This third rule is intended to address the situation when the penalty standard applicable to the taxpayer is based on compliance with requirements other than disclosure on the return (for example, section 6662(e)). In the case of a nonsigning tax return preparer within the meaning of §301.7701-15(b)(2), the final regulations in §1.6694-2(d)(3)(ii) maintain the same three disclosure rules that were in the proposed regulations.

Two commentators requested clarification of the prohibition against a boilerplate disclaimer and recommended clarifying that a firm does not violate the prohibition simply by adopting a standard approach to disclosure issues. Section 1.6694-2(d)(3)(iii) of the final regulations is revised to provide that no general disclaimer is allowed with respect to the specific facts and circumstances of the taxpayer and the position for which there is no substantial authority. Tax return preparers, and their firms, may use standard language to describe applicable law and may adopt a standard approach to disclosure issues.

One commentator stated that it is unclear what specifically must be documented by the nonsigning tax return preparer in order to avoid imposition of penalties. The final regulations are revised by clarifying that the documented advice that would constitute adequate disclosure in §1.6694-2(d)(3)(ii)(A) with respect to a nonsigning tax return preparer's advice to a taxpayer, if the firm is advising the taxpayer, should confirm that the affected taxpayer has been advised by a tax return preparer in the firm of the potential penalties and the opportunity, if any, to avoid penalty through disclosure.

Similarly, in §1.6694-2(d)(3)(ii)(B) with respect to a nonsigning preparer's advice to another tax return preparer, if providing nonsigning preparer advice to another preparer in the same firm, contemporaneous documentation should be satisfied if there is a single instance of contemporaneous documentation within the firm. If the firm is advising another preparer outside of the firm, the final regulations provide that this documentation should confirm that the preparer outside the firm has been advised that disclosure under section 6694(a) may be required.

Finally, the disclosure rules in §1.6694-3(c)(2) of the final regulations are revised to clarify that a tax return preparer is not considered to have recklessly or intentionally disregarded a rule or regulation if the position contrary to the rule or regulation has a reasonable basis as defined in §1.6694-2(d)(2) and is adequately disclosed in accordance with §§1.6694-2(d)(3)(i)(A) or (C) or 1.6694-2(d)(3)(ii). In the case of a position contrary to a revenue ruling or notice, a tax return preparer also is not considered to have recklessly or intentionally disregarded the ruling or notice if the position meets the substantial authority standard described in §1.6662-4(d) and is not with respect to a reportable transaction to which section 6662A applies. This modification ensures that tax return preparers may advise their clients to challenge an IRS ruling or notice under the appropriate circumstances.



Reasonable Cause

The final regulations in §1.6694-2(e) adopt the proposed amendments to §1.6694-2(e) regarding reasonable cause, with minor conforming changes.

Section 1.6694-2(e)(5) permits tax return preparers to rely upon generally accepted administrative or industry practice in establishing reasonable cause relief from penalties under section 6694. Several commentators indicated that guidance is necessary to explain how a tax return preparer should determine whether a practice is "generally accepted" and "industry practice." The final regulations do not provide further guidance regarding these terms. An accepted administrative or industry practice will be determined based upon all facts and circumstances.



Burden of Proof

One commentator urged that the rules regarding "burden of proof" in tax return preparer penalty litigation cases should be either eliminated or be substantially revised to comport with section 7491. Section 7427 imposes upon the Secretary the burden of proof on the issue of whether a tax return preparer has willfully attempted in any manner to understate the liability for tax. Section 7491(c) imposes upon the Secretary the burden of production in any court proceeding with respect to the liability of any individual for a penalty. After consideration of the comment, proposed §§1.6694-2(f) and 1.6694-3(g) are removed from the final regulations because these other Code sections as well as case law provide the substantive rules regarding burden of proof and burden of production for penalties.



Negotiation of Check

Section 6695(f) and §1.6695-1(f)(1) prohibit a tax return preparer from endorsing or negotiating a refund check relating to a return for which he or she is a preparer. One commentator recommended that the regulations be clarified to state specifically that a tax return preparer is not prohibited from affixing the taxpayer's name on a refund check (typically accomplished via a mechanical stamp) for the purpose of depositing the check into an account in the name of the taxpayer. This comment is adopted in §1.6695-1(f)(1) of the final regulations.



Due Diligence for Earned Income Credit

Section 1.6695-2(b)(3) of these final regulations adopt the rules regarding a signing tax return preparer's due diligence requirements with respect to determining eligibility for the earned income credit, with minor modification. Based upon the concerns of a commentator about one of the examples in this section addressing the representation of married but separated individuals, Example 3 in the proposed regulations is removed. The Treasury Department and the IRS agree that this example may raise conflict of interest issues and, therefore, replace the example with another example focusing on the need of the tax return preparer to ask relevant questions if a taxpayer attempts to claim a niece or nephew as a qualifying child.



Definition of Tax Return Preparer

The final regulations adopt the proposed amendments to §301.7701-15(b)(1) and (2), with modification. Section 301.7701-15(b)(1) and (2) of the final regulations adds to the section 7701 regulations the definitions of "signing tax return preparer" and "nonsigning tax return preparer."

Several commentators requested that the final regulations expressly state who is required to sign a tax return. Section 301.7701-15(b)(1) of the final regulations is revised to provide that a signing tax return preparer is the individual tax return preparer who has the primary responsibility for the overall substantive accuracy of the preparation of such return or claim for refund. Conforming changes are additionally made to §1.6695-1(b). The definitions of nonsigning tax return preparer in §301.7701-15(b)(2) and substantial portion in §301.7701-15(b)(3) are generally adopted as proposed. An anti-abuse rule, however, is added in §301.7701-15(b)(2)(i) based upon several commentators' suggestions. The anti-abuse rule provides that time spent on advice given after events have occurred, even if such time is less than 5 percent of the aggregate time incurred by such individual with respect to the position(s) giving rise to the understatement, will be taken into account if all facts and circumstances show that an individual is primarily responsible for a position taken on a return, gave advice on that position before events occurred primarily to avoid treatment as a tax return preparer subject to section 6694, and for purposes of preparing a tax return the individual confirmed the advice after events had occurred.



List of Returns Subject to Penalty

Several commentators contended that proposed §301.7701-15(b)(4) and the accompanying revenue procedure listing the returns and claims for refund subject to the section 6694 penalty should not include information returns and should limit the definition of return to exclude documents that do not report a tax liability. Similarly, commentators requested excluding Form 8038, Information Return for Tax-Exempt Private Activity Bond Issues, Form 8038-G, Information Return for Government Purpose Tax-Exempt Bond Issues, Form 8038-GC, Consolidated Information Return for Small Tax-Exempt Government Bond Issues, and Form 5500, Annual Return/Report of Employee Benefit Plan. After consideration of the comments, the Forms 8038, 8038-G, and 8038-GC are classified in the contemporaneously issued revenue procedure with forms that will not subject the preparer to a penalty under section 6694(a), but may subject the preparer to a willful or reckless conduct penalty under section 6694(b) if the information reported on the form constitutes a substantial portion of the tax return or claim for refund and is prepared willfully in any manner to understate the liability of tax on a tax return or claim for refund, or in reckless or intentional disregard of rules or regulations. Also, Form 8038-T, Arbitrage Rebate and Penalty in Lieu of Arbitrage Rebate, and Form 8038-R, Request for Recovery of Overpayment Under Arbitrage Rebate Provisions, are added to the list of forms of returns in the revenue procedure subject to the section 6694 penalties. Form 5500 remains in the same category as in Notice 2008-13.

The same commentators also raised the issue of whether the Treasury Department and the IRS should publish the list of returns and claims for refund subject to penalty under sections 6694 and 6695 in these final regulations, rather than in separate guidance in the Internal Revenue Bulletin. The Treasury Department and the IRS continue to conclude that it is appropriate to publish a revenue procedure in the Internal Revenue Bulletin. Notices 2008-12, -13, and - 46, along with the previously issued proposed regulations, provided the public with notice of, and an opportunity to comment on, the forms subject to penalty.

Another commentator requested that the final regulations in both §301.7701-15(f) and Circular 230 specifically define the terms "in-house tax professional" and "employer" and provide other guidance on the applicability of these return preparer rules to in-house counsel in Circular 230. Section 7701(a)(36) and §301.7701-15(f)(ix) already except from the definition of tax return preparer any person who prepares a return or claim for refund of the employer (or of an officer or employee of the employer) by whom he or she is regularly and continuously employed. Additionally, §301.7701- 15(f)(4) of the final regulations deems an employee of a corporation owning more than 50 percent of the voting power of another corporation, or the employee of a corporation more than 50 percent of the voting power of which is owned by another corporation, to be the employee of the other corporation as well. The Treasury Department and the IRS will consider if any other changes are necessary on this issue in future revisions to §10.34 of Circular 230.



Appraisers

Under Treasury Regulations in place since 1977 and the proposed regulations, an appraiser might be subject to penalties under section 6694 as a nonsigning tax return preparer if the appraisal is a substantial portion of the return or claim for refund and the applicable standards of care under section 6694 are not met. Several commentators have stated that appraisers should not be subject to penalties under section 6694 because they are subject to new, higher standards of conduct under section 6695A as set out in the Pension Protection Act of 2006, Pub. L. No. 109-280. The commentators have also urged that assessment of penalties under section 6694 against appraisers would result in imposition of a gratuitous and unnecessary layer of requirements and sanctions without any additional public policy benefit.

After consideration of the comment, the Treasury Department and the IRS continue to include appraisers in the definition of both signing and non-signing preparers, thereby providing the IRS with discretion to impose the section 6694 and 6695A penalties in the alternative against an appraiser depending on the facts and circumstances of the appraiser's conduct. The IRS, however, will not stack the penalties under sections 6694 and 6695A with respect to the same conduct. A separate regulation will provide guidance under section 6695A.



Disclosure Under Section 6103

One commentator recommended that the Treasury Department and the IRS issue regulations under section 6103 authorizing the disclosure of tax returns and return information to a tax return preparer at the tax return preparer's request upon initiation of an examination of the tax return preparer for tax return preparer penalties to the extent the returns and return information are relevant and material to the tax return preparer examination. The Treasury Department and the IRS conclude that no further guidance on this issue in these regulations is necessary because section 6103(h)(4) already authorizes the disclosure of returns and return information by the Government in federal or state, judicial or administrative tax proceedings if the disclosure meets an item or transaction test and the third-party return or return information is directly related to the resolution of an issue in the case.



Appeal Rights

A number of individual commentators questioned whether the proposed regulations would remove the administrative appeal rights available to tax return preparers who are subject to penalty under section 6694. Under Treasury Regulations in place since 1991, the IRS will send a 30-day letter to the tax return preparer notifying the tax return preparer of the proposed penalty or penalties and offering an opportunity to the tax return preparer to request further administrative consideration and a final administrative determination by the IRS concerning the proposed assessment prior to assessment of a penalty under section 6694 (unless the period of limitations (if any) under section 6696(d) may expire without adequate opportunity for assessment). If the tax return preparer then makes a timely request, assessment may not be made until the IRS makes a final administrative determination adverse to the tax return preparer. These appeal rights are maintained in §1.6694-4(a) of the final regulations.



Applicability Dates

To eliminate any adverse impact that the adoption of these final regulations could have on pending or recently filed returns, these final regulations will apply to returns and claims for refund filed, and advice provided, after December 31, 2008.



Availability of IRS Documents

The IRS notices referred to in this preamble are published in the Internal Revenue Bulletin and are available at http://www.irs.gov.



Effect on Other Documents

The following publications are obsolete as of January 1, 2009:
Notice 2007-54 (2007-27 IRB 12).

Notice 2008-11 (2008-3 IRB 279).

Notice 2008-12 (2008-3 IRB 280).

Notice 2008-13 (2008-3 IRB 282).

Notice 2008-46 (2008-18 IRB 868).



Special Analyses

It has been determined that this final rule is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations.

When an agency issues a rulemaking, the Regulatory Flexibility Act (5 U.S.C. chapter 6) (RFA), requires the agency to "prepare and make available for public comment an initial regulatory flexibility analysis" that will "describe the impact of the proposed rule on small entities." (5 U.S.C. 603(a)). Section 605 of the RFA provides an exception to this requirement if the agency certifies that the final rulemaking will not have a significant economic impact on a substantial number of small entities.

The final rules affect tax return preparers. The IRS estimates there are 38,566 tax return preparation firms and 260,338 self-employed tax return preparers that qualify as small entities. Therefore, the IRS has determined that these final rules will have an impact on a substantial number of small entities.

The IRS has determined, however, that the impact on entities affected by the final rule will not be significant. The statute and final regulations would require entities that employ tax return preparers to retain a record of the name, taxpayer identification number and principal place of work of each tax return preparer employed. The IRS estimates that this would not require purchase of additional software and would take five minutes per tax return preparer employed. The statute and final regulations would also require tax return preparers to retain a complete copy of a return (or claim for refund) or a list of the name, taxpayer identification number and taxable year for each return (or claim for refund) and the name of the tax return preparer required to sign the return or claim for refund. Many tax return preparers have copying machines or scanners and already make copies of the returns prepared, and the IRS estimates this would not require the purchase of additional equipment. The IRS estimates that it would take an average of five minutes to make copies or prepare a record of the returns or claims for refund prepared. Accordingly, the burden on employers of tax return preparers to make a record of the name, taxpayer identification number, and principal place of work of each employed tax return preparer, and a copy of each return or claim for refund prepared, or a record, is insignificant.

The final regulations also conform the standards of conduct for the tax return preparer penalties under section 6694(a) to the provisions of the 2007 and 2008 Acts. Tax return preparers already enroll in educational seminars or training programs to keep up to date with the latest changes to the Code, and the provisions of the 2007 and 2008 Acts and the regulations generally will be part of that training.

Based on these facts, it is certified that the collection of information contained in these final regulations will not have a significant economic impact on a substantial number of small entities. Accordingly, a Regulatory Flexibility Analysis is not required.

Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking preceding these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.



Drafting Information

The principal authors of these final regulations are Matthew S. Cooper and Michael E. Hara, Office of the Associate Chief Counsel (Procedure and Administration).

"reasonable cause" - reliance on a professional

As indicated in thn Kierstead case, the negligence penalty can be abated for "reasonable cause" if there is reliance on a "professional." This 9th Circuit case and the annnotations below indicate who is NOT a "professional." This case states that a "tax attorney" is a professional and they did not recognize, as a professional, an attorney who is not a tax attorney. The court also appears to classify a CPA as a "professional" for purposes of the reaconable cause exception. This issue is and will continue to be important for the reasonable cause exception for the 6694 penalty, although the threshold for "reasonable cause" under 6677 is much higher. Notwithstanding, everyone would be advised to use a tax professional if opinions are needed to support the "substantial authority" standard under section th4 6694(a)statute.


Glenn E. Kierstead; Carol L. Kierstead, Petitioners v. Commissioner of Internal Revenue, Respondent.

U.S. Court of Appeals, 9th Circuit; 07-74870, May 11, 2009.

Unpublished opinion affirming the Tax Court, 93 TCM 1392, Dec. 56,975(M), TC Memo. 2007-158.



Accuracy-related penalties were properly imposed on a couple because they did not show that they received advice from competent professionals with sufficient experience to justify reliance and that they actually relied on their attorney's advice regarding their use of two business trusts to avoid personal tax. The couple sought the advice of an attorney who did not claim to be a tax specialist and specifically advised them to seek the assistance of a tax attorney or an accountant. Moreover, the attorney advised them of the general legal requirements for creating and operating business trusts, not as to the permissibility of the deductions actually taken. Although the couple allegedly sought the additional advice of a tax attorney, they failed to call the attorney as a witness and did not present any evidence regarding his expertise or the nature of any specific tax advice he gave.



Before: Hug, Hawkins and Tallman, Circuit Judges.

UNITED STATES COURT OF APPEALS FOR THE NINTH CIRCUIT. NOT FOR PUBLICATION. No. 07-74870. Tax Ct. No. 24184-05. Appeal from a Decision of the United States Tax Court. Submitted May 6, 2009 ** . San Francisco, California.


MEMORANDUM *


Glenn and Carol Kierstead appeal the decision of the United States Tax Court finding them liable for accuracy-related penalties under I.R.C. § 6662. They claim they should not be subject to penalties because they believed in good faith, based on advice of counsel, that their use of the G. Kierstead Holdings Trust and the G. Kierstead Family Trust (the "Trusts") was proper. We have jurisdiction under I.R.C. § 7482(a)(1), and we affirm.

The Commissioner's decision to impose negligence penalties is presumptively correct. Hansen v. Comm'r, 820 F.2d 1464, 1469 (9th Cir. 1987). The taxpayer bears the burden of proving that he is eligible for an exception to the penalty. I.R.C. § 7491(a), (c); Higbee v. Comm'r, 116 T.C. 438, 446-47 (2001). We review for clear error the Tax Court's findings of fact and its finding that a taxpayer is liable for accuracy-related penalties. See Keane v. Comm'r, 865 F.2d 1088, 1090 (9th Cir. 1989); Custom Chrome, Inc. v. Comm'r, 217 F.3d 1117, 1121 (9th Cir. 2000).

Reliance on the advice of a tax professional may demonstrate reasonable cause for an understatement of tax, if the reliance was reasonable and in good faith. See United States v. Boyle, 469 U.S. 241, 251 (1985) (noting that a taxpayer may reasonably rely on an accountant's or attorney's advice regarding a matter of tax law); Collins v. Comm'r, 857 F.2d 1383, 1386 (9th Cir. 1988); 26 C.F.R. § 1.6664-4(b)(1) (reliance on practitioner may be reasonable cause for understatement if "under all the circumstances such reliance was reasonable and the taxpayer acted in good faith"). We "examine the circumstances surrounding the advice to determine whether the taxpayer's actions were reasonable." Hansen v. Comm'r, 471 F.3d 1021, 1032 (9th Cir. 2006).

Here, the Tax Court determined the Kiersteads had not proven that they received advice from competent professionals with sufficient expertise to justify reliance, and had not actually relied in good faith on the attorneys' advice. G. Kierstead Family Holdings Trust v. Comm'r, T.C. Memo. 2007-158, at 5 (2007). The record supports these findings. The Kiersteads first sought advice from attorney David Kallman. Mr. Kallman appears to be an experienced attorney, but does not hold himself out as a tax specialist. He advised the Kiersteads to seek specific advice from a tax attorney or Certified Public Accountant ("CPA"). He advised the Kiersteads of the general legal requirements for creating and operating business trusts. However, he did not advise them that all of the deductions actually taken were permissible uses of the Trusts. When questioned about the notion that a person might use a business trust to avoid all personal income tax, he testified the idea was "crazy stuff" and contrary to the advice he gives to his clients.

The Kiersteads apparently sought additional advice from David Carter, a tax attorney and CPA, but he did not testify at trial. Nor did the Kiersteads call as a witness William Yee, a tax preparer on whose advice they also purportedly relied. The Kiersteads introduced no evidence, other than Mr. Kierstead's own hearsay testimony, of Mr. Carter's or Mr. Yee's qualifications or the specific tax advice received from them.

The Tax Court considered and weighed all of the relevant evidence. It reasonably concluded that the Kiersteads failed to prove that they had received advice from a competent professional, the nature of that advice, or that reliance on such advice was justifiable. While the Kiersteads did put forth some evidence of their good faith, the Tax Court's determination that the Kiersteads were liable for penalties under I.R.C. § 6662 was not clearly erroneous.

AFFIRMED.

** The panel unanimously finds this case suitable for decision without oral argument. See Fed. R. App. P. 34(a)(2).

* This disposition is not appropriate for publication and is not precedent except as provided by 9th Circuit Rule 36-3.



G. Kierstead Family Holdings Trust, et al. v. Commissioner.

Dkt. Nos. 24183-05 , 24184-05 , 24185-05 , TC Memo. 2007-158, June 20, 2007.


A couple failed to prove they reasonably relied on the advice of a competent tax professional regarding two trusts they created and were, therefore, subject to the accuracy-related penalty under Code Sec. 6662(a). The husband assigned all rights to his lifetime services and future earnings to two trusts from which the couple deducted all personal and other living expenses. The couple sought the advice of an attorney regarding income tax issues related to the trusts. At trial, however, the couple failed call the attorney as a witness, failed to present any evidence of his expertise, and failed to present evidence of any specific tax advice he gave.


Anthony V. Diosdi, for petitioner; Jeremy L. McPherson, for respondent.

G. KIERSTEAD FAMILY HOLDINGS TRUST, ET AL.,1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent.


MEMORANDUM FINDINGS OF FACT AND OPINION

HAINES, Judge: Petitioners in these consolidated cases are G. Kierstead Family Holdings Trust, G. Kierstead Family Trust, and Glenn E. and Carol L. Kierstead as individuals. Before trial, the parties stipulated that there are no deficiencies in Federal income tax or penalties due from petitioners G. Kierstead Family Holdings Trust or G. Kierstead Family Trust. Respondent determined Federal income tax deficiencies and penalties for petitioners2 Glenn and Carol Kierstead as follows3 :



Year at
Issue Deficiency Sec. 6662(a)




2001 $40,410 $8,080

2002 38,165 7,633

2003 66,179 13,235


The parties filed a stipulation of settled issues necessary for a determination of the amount of the liability for the years in question, other than applicable penalties. Accordingly, the only issue to be determined is whether petitioners Glenn and Carol Kierstead are liable for accuracy-related penalties under section 6662(a) for 2001, 2002, and 2003 (years at issue).4


FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulation of facts and the attached exhibits are incorporated herein by reference. Petitioners resided in Vacaville, California, when they filed this petition. Petitioner trusts both used addresses in Lansing, Michigan, on their Tax Court petitions.

In 1998, with the assistance of National Trust Services (NTS), petitioners established the G. Kierstead Family Holdings Trust and the G. Kierstead Family Trust. Petitioner Glenn Kierstead assigned all rights to his lifetime services and future earnings to the trusts. Petitioners deducted inter alia their personal living expenses and depreciation of their residence on Form 1041, U.S. Income Tax Return for Estates and Trusts, filed for the years at issue.

In early 2001, upon learning that one of the promoters of NTS stole money from an investment promoted by NTS, petitioners sought advice about the legality of the trusts from attorney David Kallman. Mr. Kallman provided petitioners with information about the classification of business trusts for Federal income tax purposes. He advised petitioners to consult David Carter, an attorney who is also a certified public accountant (C.P.A.) regarding the income tax issues of the trusts. At petitioners' request, Mr. Kallman amended the terms of the trusts in July 2001.

Petitioners timely filed Federal individual as well as trust income tax returns for the years at issue. On September 28, 2005, separate notices of deficiency were sent to each party. In the notice of deficiency sent to petitioners Glenn and Carol Kierstead, respondent determined that the trusts must be disregarded for Federal income tax purposes. Petitioners Glenn and Carol Kierstead, as well as the two trusts, timely filed petitions with the Court on December 22, 2005.


OPINION

Section 6662(a) imposes a 20-percent penalty on the portion of an underpayment attributable to a substantial understatement of income tax. While the Commissioner bears the initial burden of production and must come forward with sufficient evidence showing it is appropriate to impose an accuracy-related penalty, the taxpayer bears the burden of proof as to any exception to the penalty. See sec. 7491(c); Rule 142(a); Higbee v. Commissioner [Dec. 54,356], 116 T.C. 438, 446-447 (2001). In order to meet the burden of proof, a taxpayer must present evidence sufficient to persuade the Court that the Commissioner's determination is incorrect. Higbee v. Commissioner, supra at 447. Petitioners concede that respondent has met his burden of production. However, they argue that they are not liable for a portion of the section 6662(a) penalties because they, in good faith, relied on the advice of two competent tax professionals.

An accuracy-related penalty is not imposed on any portion of the understatement as to which the taxpayer acted with reasonable cause and in good faith. Sec 6664(c)(1). Reliance on the advice of a tax professional may constitute reasonable cause and good faith, if under all the facts and circumstances the reliance is reasonable and in good faith. Neonatology Associates, P.A. v. Commissioner [Dec. 53,970], 115 T.C. 43, 98 (2000), affd. [2002-2 USTC ¶50,550] 299 F.3d 221 (3d Cir. 2002); sec. 1.6664-4(c)(1), Income Tax Regs. To qualify for this exception, a taxpayer must prove by a preponderance of the evidence that: (1) The adviser was a competent professional who had sufficient expertise to justify reliance; (2) the taxpayer provided necessary and accurate information to the adviser; and (3) the taxpayer actually relied in good faith on the adviser's judgment. Neonatology Associates, P.A. v. Commissioner, supra at 98-99.

Petitioners contend that their reliance on attorneys Kallman and Carter relieves them from the accuracy-related penalties. We disagree. Respondent has not disputed that petitioners satisfied part (2) of the 3-prong test. Accordingly, the issue to be determined is whether petitioners actually relied in good faith on the advice of competent tax professionals possessing sufficient expertise to justify their reliance.

In 2001, petitioners consulted Mr. Kallman, an attorney with 24 years' experience regarding the trusts. Mr. Kallman does not hold himself out as a tax attorney, nor does he prepare tax returns. Mr. Kallman provided petitioners with limited tax advice about the tax treatment of business trusts. He also provided general tax information that business expenses, but not personal expenses, were allowed as deductions. Mr. Kallman was careful to qualify any tax advice by telling petitioners to consult their tax attorney and accountant. Therefore, petitioners did not rely on Mr. Kallman's advice in the preparation and filing of their Federal individual and trust income tax returns.

On the advice of Mr. Kallman, petitioners consulted David Carter, an attorney and C.P.A., regarding tax issues of the trusts. Petitioner Glenn Kierstead testified that Mr. Carter "said he was very comfortable with [the trusts]." Though petitioners listed Mr. Carter as a potential witness, he did not testify at trial. Petitioners introduced no evidence as to Mr. Carter's qualifications as a tax expert other than Mr. Kallman's testimony that he was an attorney with a C.P.A. background. No evidence has been submitted of any specific tax advice provided by Mr. Carter relating to petitioner's assignment of lifetime earnings to the trusts or the allowance of deductions for personal expenses. For these reasons, petitioners failed to prove that Mr. Carter was a competent tax professional and that petitioners were justified in relying on his opinion.

Because petitioners failed to prove they reasonably relied on a competent tax professional, and because they failed to assert any other basis for relief, we hold that petitioners failed to prove that they had reasonable cause within the meaning of section 6664(c). Therefore, we find petitioners are liable for accuracy-related penalties under section 6662(a) for the years at issue.

In reaching our holdings, we have considered all arguments made, and, to the extent not mentioned, we conclude that they are moot, irrelevant, or without merit.

To reflect the foregoing,

Decision will be entered under Rule 155 in docket No. 24184-05.

Decisions will be entered for petitioners in docket Nos. 24183-05 and 24185-05.

1 Cases of the following petitioners are consolidated herewith: Glenn E. and Carol L. Kierstead, docket No. 24184-05; and G. Kierstead Family Trust, docket No. 24185-05.

2 Unless otherwise indicated, reference to "petitioners" shall mean petitioners Glenn E. and Carol L. Kierstead as individuals.

3 Unless otherwise indicated, all section references are to the Internal Revenue Code, as amended. All Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated.

4 The parties stipulated that petitioners are liable for accuracy-related penalties under sec. 6662(a) for 2001, 2002, and 2003 for the portion of their deficiencies allocable to their failure to include interest income in the amounts of $8,633, $8,465, and $8,174, respectively.

Reliance on professionals was not reasonable cause. --Substantial Understatement: Reliance on professionals was not reasonable cause

Absent substantial authority, a domestic holding corporation was liable for the substantial understatement component of the accuracy-related penalty for one tax year. The understatement was attributable to foreign tax credits that the corporation claimed with respect to a sizable dividend that it reported it received from one of its foreign operating subsidiaries. The relevant facts affecting the tax treatment of the transaction were not adequately disclosed in the taxpayer's return or in a later disclosure letter; and the entity did not have reasonable cause for, or act in good faith with respect to, its treatment of the transaction in its return. Finally, no evidence supported the taxpayer's contention that it reasonably relied on its accounting firm.

InterTan, Inc., CA-5, 2005-1 USTC ¶50,111, 353 F3d 1357.

A corporation's officers and attorney were liable for the substantial understatement penalty because their tax treatment of options was not supported by substantial authority and they did not adequately disclose the facts relevant to the tax treatment. They could not avoid the penalty because they did not reasonably rely in good faith on their tax advisors.

R.A. Cramer, CA-9, 95-2 USTC ¶50,491. Cert. denied, 6/10/96.

T.D. Davenport, DC Ky., 2006-2 USTC ¶50,394.

Understatement penalties were imposed in the following cases because relying on a professional is not reasonable when the taxpayer does not provide the professional with correct, sufficient and/or complete and accurate information.

S.R. Loftus, 63 TCM 2944, Dec. 48,203(M), TC Memo. 1992-266.

E. Taylor, 69 TCM 2932, Dec. 50,701(M), TC Memo. 1995-269. Aff'd, CA-10 (unpublished opinion), 97-1 USTC ¶50,310.

United Circuits, Inc., 70 TCM 1619, Dec. 51,069(M), TC Memo. 1995-605.

S.D. Podd, 75 TCM 2575, Dec. 52,765(M), TC Memo. 1998-231.

D.W. Stark, 77 TCM 1181, Dec. 53,202(M), TC Memo. 1999-1.

J.C. Archer, 79 TCM 2057, Dec. 53,891(M), TC Memo. 2000-166.

Delaware Corp., 88 TCM 589, Dec. 55,825(M), TC Memo. 2004-280.

H.J. Kaplan, 91 TCM 695, Dec. 56,422(M), TC Memo. 2006-16.

The substantial understatement penalty was properly imposed because the taxpayers failed to prove that they acted in good faith in the preparation of their returns and that there was reasonable cause for the understatement in their tax or that there was an abuse of discretion by the IRS in refusing to waive the addition to penalty.

J.M. Estes, Jr., 64 TCM 705, Dec. 48,494(M), TC Memo. 1992-531.

A "termination allowance" received by a telephone technician from his employer was not excludable from his income because the payment was in the nature of severance pay rather than damages received for personal injuries. The taxpayer's reliance on his tax return preparer did not insulate him from liability for the tax deficiency or substantial understatement penalty.

J.E. Huff, 64 TCM 1547, Dec. 48,698(M), TC Memo. 1992-718.

Individual joint filers who claimed that their attorney failed to notify them of the Tax Court's decision on their petition were not entitled to have the decision vacated after the appeal period had expired. The deficiency and additions to tax were upheld.

V.C. Gazdak, 66 TCM 479, Dec. 49,233(M), TC Memo. 1993-381.

A damage award received by an individual as compensation for a breach of contract suit was taxable income. The taxpayer's reliance on an attorney's opinion that the award was excludable did not relieve him from failure to file and substantial understatement penalties.

J.A. Climenhage, 65 TCM 2736, Dec. 49,051(M), TC Memo. 1993-223.

Reliance on its accounting service did not excuse a publishing company from liability for penalties for failure to timely file returns and for substantial understatement of income. The substantial understatement penalty was imposed because the expenditure for a land purchase was large in relation to the expense account to which it was attributed and the accountant's mistake should have been detected on a reasonable inspection of the return by the taxpayer.

Olde Towne Typesetters, Inc., 66 TCM 51, Dec. 49,138(M), 1993-296.

Additions to tax for substantial understatement of taxes were owed by investors in a limited partnership who unreasonably relied upon their accountant's advice and did not make an independent factual analysis that would enable them to formulate a reasonable belief as to the tax treatment of the investment.

A. Kaplan, 67 TCM 2258, Dec. 49,691(M), TC Memo. 1994-81.

A taxpayer who relied on a tax professional was subject to the substantial understatement penalty. Reliance on a professional did not constitute substantial authority for their tax treatment of the affected items that enabled him to avoid the penalty.

J. Epstein, 67 TCM 2046, Dec. 49,636(M), TC Memo. 1994-34.

The substantial understatement penalty was imposed because the taxpayers did not act reasonably in relying on an accountant's preparation of their return. They unreasonably relied on their accountant and invested in tax shelter partnerships without a profit motive when they knew that he lacked expertise regarding various investment recommendations. The taxpayers, who made numerous poor business decisions based on the accountant's advise, did not act in good faith when they relied on his investment recommendations.

R. Lax, CA-3 (unpublished opinion), 95-2 USTC ¶50,639.

A circuit board manufacturer that improperly claimed deductions for equipment lease payments that should have been capitalized was liable for the substantial understatement penalty. The manufacturer did not reasonably rely in good faith on the advice of its accountant. The manufacturer did not provide its accountant with full details or complete and accurate information concerning the transactions. It relied on the accountant for accounting advice rather than for tax advice. Moreover, the manufacturer did not follow the accountant's advice as to the characteristics of a legitimate lease. Finally, the negligence penalty was also imposed.

United Circuits, Inc., 70 TCM 1619, Dec. 51,069(M), TC Memo. 1995-605.

An individual who operated his business through a number of trusts that were determined to be part of a scheme to avoid taxation on his business income was not liable for the fraud penalty because the IRS did not prove fraud by clear and convincing evidence. However, the individual was liable for substantial understatement penalties because he was unable to show substantial authority for his position. Opinion letters from the promoter's attorney did not constitute substantial authority for the individual's actions.

Para Technologies Trust, 68 TCM 294, Dec. 50,013(M), TC Memo. 1994-366. Aff'd sub nom. T. Anderson, CA-9 (unpublished opinion), 97-1 USTC ¶50,294.

Penalties for negligence and substantial understatement were imposed against a realtor who improperly attempted to use the installment method to report income from his transfer of depreciable property to a related buyer. He failed to show that there was reasonable cause for his understatement of tax or that he had acted in good faith. He did not carefully review his return or correct obvious errors on the document, and he failed to show the types of information or documentation that he had provided to his return preparer.

R.J. Guenther, 69 TCM 2980, Dec. 50,713(M), TC Memo. 1995-280.

An owner and his giftware corporation were liable for negligence and substantial understatement penalties. They could not avoid liability for the penalties based on their purported reliance on the advice of their accountants in light of the fact they had conspired to prepare and present to the IRS backdated documents and accounting entries. Even if the owner and the corporation relied on the accountants, they disregarded that advice.

G. Georgiou, 70 TCM 1341, Dec. 51,005(M), TC Memo. 1995-546.

In the following cases, the substantial understatement penalty was imposed because the taxpayers' claimed reliance on the advice of an unidentified IRS employee was insufficient to avoid the penalty.

D.W. Harker, 68 TCM 1272, Dec. 50,259(M), TC Memo. 1994-583. Aff'd on another issue, CA-8, 96-1 USTC ¶50,244.

M. Dogali, 69 TCM 1759, Dec. 50,445(M), TC Memo. 1995-39.

An individual was subject to the penalty for substantial understatement of income tax because he showed no reasonable cause for the understatement. Self-serving testimony that the taxpayer relied on his accountant to correctly prepare his returns was not credible, and the accountant did not testify.

M.D. Morgan, 73 TCM 2313, Dec. 51,940(M), TC Memo. 1997-132.

In the following cases, the substantial understatement penalty was imposed because the taxpayers' claimed reliance on the advice of a tax professional was not reasonable cause for the understatement.

B.R. House, 69 TCM 2005, Dec. 50,502(M), TC Memo. 1995-92.

INI, Inc., 69 TCM 2113, Dec. 50,526(M), TC Memo. 1995-112.

N. Nahikian, 69 TCM 2370, Dec. 50,582(M), TC Memo. 1995-161.

T.M. Fries, 73 TCM 2085, Dec. 51,898(M), TC Memo. 1997-93.

K.S. Rao, 72 TCM 1198, Dec. 51,642(M), TC Memo. 1996-500.

Cordes Finance Corp., 73 TCM 2493, Dec. 51,975(M), TC Memo. 1997-162. Aff'd, CA-10 (unpublished opinion), 98-2 USTC ¶50,824.

J. Montoro, 73 TCM 3113, Dec. 52,107(M), TC Memo. 1997-281.

Reaves Livestock, Inc., 73 TCM 3137, Dec. 52,108(M), TC Memo. 1997-283.

A.M. Moye, 74 TCM 1397, Dec. 52,400(M), TC Memo. 1997-554.

M. Roy, M.D., Inc., 74 TCM 1428, Dec. 52,409(M), TC Memo. 1997-562. Aff'd, CA-9 (unpublished opinion), 99-1 USTC ¶50,588.

Cleo Perfume, Inc., 75 TCM 2200, Dec. 52,677(M), TC Memo. 1998-155.

S.D. Emmons, 75 TCM 2275, Dec. 52,696(M), TC Memo. 1998-173.

Florida Industries Investment Corp., 78 TCM 605, Dec. 53,590(M), TC Memo. 1999-346. Aff'd, per curiam, CA-11 (unpublished opinion), 2001-1 USTC ¶50,334.

E.R. Stolz, II, 78 TCM 941, Dec. 53,654(M), TC Memo. 1999-404.

J. Pinson, 80 TCM 13, Dec. 53,945(M), TC Memo. 2000-208.

R. Haeder, 81 TCM 987, Dec. 54,211(M), TC Memo. 2001-7.

W.O. Bowen, 81 TCM 1216, Dec. 54,257(M), TC Memo. 2001-47.

V.M. Bello, 81 TCM 1271, Dec. 54,268(M), TC Memo. 2001-56.

Burien Nissan, Inc., 81 TCM 1624, Dec. 54,339(M), TC Memo. 2001-116. Aff'd , CA-9 (unpublished opinion), 2004-1 USTC ¶50,102, 75 Fed Appx 652.

J.J. LeBouef, 82 TCM 685, Dec. 54,504(M), TC Memo. 2001-261.

L.T. Baldwin, III, 83 TCM 1915, Dec. 54,798(M), TC Memo. 2002-162.

W. Pratt, 84 TCM 523, Dec. 54,929(M), TC Memo. 2002-279.

C.R. Bitker, 86 TCM 72, Dec. 55,229(M), TC Memo. 2003-209.

W.A. Egan, 90 TCM 365, Dec. 56,162(M), T.C. Memo. 2005-234.

L.J. Wadsworth, 96 TCM 20, Dec. 57,490(M), TC Memo. 2008-171.

A married couple, whose tax shelter trust's charitable contributions deduction were disallowed, was liable for accuracy-related penalties. The couple conceded that their understatement was substantial; however, they argued that they reasonably relied on their tax preparer to prepare their return correctly. Although reliance on a tax professional may be a defense to the accuracy-related penalty in certain circumstances, the couple failed to prove that (1) they relied on a competent professional whose expertise was sufficient to justify reliance, (2) they provided necessary and accurate information to that professional, and (3) they actually relied on the professional's advice in good faith.

J.L. Hill, 87 TCM 1451, Dec. 55,680(M), TC Memo. 2004-156.

A privately organized pooled investment vehicle, or "hedge fund", created by two Nobel Prize winning economists participated in transactions that lacked economic substance and, therefore, the IRS properly denied its capital loss deductions and imposed penalties for gross valuation misstatements and substantial understatements. The district court found that the accuracy-related penalties imposed by the IRS were not erroneous because the taxpayer did not satisfy the reasonable cause exception. Although the taxpayer argued that (1) there was no valuation misstatement on its tax return, (2) it did not act negligently, and (3) that it had substantial authority for its return position, the court concluded that the penalties imposed were justified. The court found that there was a substantial valuation misstatement on the taxpayer's return; the taxpayer substantially overstated its basis in the stock it sold. Additionally, the taxpayer acted negligently because LTCH lacked a reasonable belief that the basis it claimed for the stock was valid. Finally, the taxpayer did not have substantial authority for its return position; a tax professional's opinion did not constitute "substantial authority" for the taxpayer's return position.

Long Term Capital Holdings, DC Conn., 2004-2 USTC ¶50,351.

A tax shelter partnership was subject to the gross valuation misstatement, negligence and substantial understatement penalties. The TMP, a highly educated, sophisticated tax attorney, engineered the plan to transfer built-in losses to the partnership, which transaction had no economic substance for federal tax purposes. Under the circumstances, a reasonably prudent person with the TMP's tax experience would not have reported the partnership's basis in the receivables as he did. Thus, the partnership failed to meet the reasonable cause exception to the negligence penalty.

Santa Monica Pictures, LLC, 89 TCM 1157, Dec. 56,016(M), TC Memo. 2005-104.

An individual was liable for the substantial understatement penalty for failing to report income and claiming unsupported deductions. He failed to maintain adequate books and records. His claim that he relied on the advice of an attorney with respect to his failure to include forgiveness of debt in his income was rejected. The attorney merely advised the taxpayer as to the characterization of the settlement, not the tax consequences of the forgiveness of debt.

R.E. Corrigan, 89 TCM 1313, Dec. 56,034(M), TC Memo. 2005-119.

Taxpayers failed to satisfy the threshold requirements of a reasonable cause exception to the penalty for gross valuation misstatement. The taxpayers' argument that they relied on tax advice failed because they did not present evidence that the advice was relevant to the valuation misstatement. Furthermore, even if the advice were relevant, there was no evidence that the tax advice was based on all of the pertinent facts and circumstances.

Long-Term Capital Holdings LP, CA-2, 2005-2 USTC ¶50,575.

An accuracy-related penalty under Code Sec. 6662(a) for substantial understatement of income tax was imposed. The taxpayer's claim that the understatement was due to reasonable cause and made in good faith because he relied on his accountant, was not persuasive. The only alleged erroneous advice related to the carryforward of a claimed NOL, which the court disallowed because the taxpayer failed to substantiate it.

M.D. Lee, 91 TCM 999, Dec. 56,476(M), TC Memo. 2006-70.

A taxpayer was liable for the accuracy-related penalty for substantial understatement of income tax attributable to the portion of the jury award she received and incorrectly excluded from income. While the taxpayer alleged that she and her husband met with a nationally renowned expert on the taxation of legal awards, the reasonable cause exception did not apply because she provided no evidence of what tax advice was actually rendered.

M.S. Green, 93 TCM 917, Dec. 56,841(M), TC Memo. 2007-39.

A taxpayer was liable for the accuracy-related penalty on substantial understatements of tax. Although he claimed that he reasonably relied on his accountant's advice, he failed to show that the accountant was a competent professional who had sufficient expertise to justify the taxpayer's purported reliance.

J. Calvao, 93 TCM 988, Dec. 56,862(M), TC Memo. 2007-57.

Similarly.

G. Kierstead Family Holdings Trust, 93 TCM 1392, Dec. 56,975(M), TC Memo. 2007-158.

A married couple's reliance on their accountant to calculate their taxes did not excuse them from liability for the penalty for substantial understatement of tax. The taxpayers' actions were not reasonable, given the substantial amounts of gross receipts involved, the taxpayer's business experience, and the large discrepancy between the tax reported and the actual tax owed.

J. Ramirez, 94 TCM 496, Dec. 57,181(M), TC Memo. 2007-347.

The accuracy-related penalty for substantial underpayment of income tax was imposed on a car dealership that improperly deducted legal fees relating to its landlord's defense of title and its acquisition of another dealership. The exception for reliance on a tax professional did not apply in the absence of evidence that its accountant was supplied with all of the correct and necessary information needed to establish its position, that the error was the result of a preparer's mistake, or that there was any discussion of the treatment of the legal fees with the accountant before the return was filed.

West Covina Motors, Inc., Dec. 57,564(M), TC Memo. 2008-237.

The accuracy-related penalty for substantial underpayment of income tax was imposed on a car dealership that improperly deducted legal fees relating to its landlord's defense of title and its acquisition of another dealership. The exception for reliance on a tax professional did not apply in the absence of evidence that its accountant was supplied with all of the correct and necessary information needed to establish its position, that the error was the result of a preparer's mistake, or that there was any discussion of the treatment of the legal fees with the accountant before the return was filed.

West Covina Motors, Inc., Dec. 57,564(M), TC Memo. 2008-237.

The accuracy-related penalty for a substantial underpayment of tax attributable to a net operating loss that an individual taxpayer conceded was improper was imposed. Reliance on the taxpayer's accountant was not reasonable since no steps were taken to verify that the accountant had sufficient expertise or was sufficiently independent of the entity that sponsored the offshore investment programs that generated the net operating loss.

W.C. Wyatt, Dec. 57,581(M), TC Memo. 2008-253.

The Tax Court's decision finding that an individual was liable for the accuracy-related penalty for substantial understatement of income tax was reversed and remanded. Since the individual and her husband sought tax advice from two attorneys, the Tax Court should have considered the aggregate advice received from both attorneys to determine the reasonableness of the individual's reliance on their tax advice.

M. Green, CA-9, 2009-1 USTC ¶50,245.

Accuracy-related penalties were imposed because the authority cited by the taxpayer was easily distinguished.

P. Ackerman, Dec. 57,790(M), TC Memo. 2009-80.



No evidence of reliance on professional advice. --Negligence: No evidence of reliance on professional advice

The taxpayer was liable for an addition to tax for negligence where there was no showing of what information the taxpayer gave his accountant. Furthermore, the issues were neither complex nor did they require any sophisticated tax knowledge which might have excused the taxpayer's errors.

F. Samp, 43 TCM 89, Dec. 38,488(M), TC Memo. 1981-706. Taxpayer's appeal to CA-10 dismissed 7/30/82.

A taxpayer who improperly deducted interest paid to brokerage firms as a trade or business expense was liable for additions to tax for negligence. The taxpayer failed to prove that he relied on his accountant's advice.

S.A. Paoli, 62 TCM 275, Dec. 47,506(M), TC Memo. 1991-351.

The taxpayers failed to prove that they had relied on the advice of either an accountant or an attorney in setting up the family trust which resulted in their income tax deficiency.

R.N. Brown, 43 TCM 1322, Dec. 39,006(M), TC Memo. 1982-253.

J.W. Preston, 47 TCM 417, Dec. 40,625(M), TC Memo. 1983-705.

There was no evidence that the accountant had given any advice resulting in the understatements of taxpayer's income.

A.C. Engineering Corp., 17 TCM 737, Dec. 23,114(M), TC Memo. 1958-147.

The Commissioner's imposition of a negligence penalty against the taxpayers for underpayment of tax was sustained. The taxpayer failed to prove that his underpayment of tax was not due to negligence. There was no evidence to show that the taxpayer relied in good faith upon the advice of competent counsel or an experienced accountant to assure himself of the validity of a grantor trust.

H.M. Ward, 47 TCM 588, Dec. 40,661(M), TC Memo. 1983-736.

Where taxpayers presented no evidence that their professional return preparer was aware of the facts and circumstances of their various disallowed claimed deductions, or that he ever advised their sales corporation that it was proper to claim such deductions, or that he advised the taxpayer/president that he recognized no income from having personal expenses paid by his corporation, the taxpayers were held liable for additions to tax for negligence.

H.L. Snyder, 47 TCM 355, Dec. 40,611(M), TC Memo. 1983-692.

An individual was held liable for the negligent underpayment of tax. He persisted in structuring a transaction as a sale despite his attorney's warnings that the transaction would be characterized as a sham.

N.W. Portemain, 58 TCM 293, Dec. 46,065(M), TC Memo. 1989-359.

Taxpayer was liable for additions to tax where he alleged, but introduced no evidence to support the allegation, that his accountant was informed of the income but failed to include it in the taxpayer's income tax return.

E. Ross, 37 TCM 1560, Dec. 35,427(M), TC Memo. 1978-380.

Additions to tax for negligence were imposed against a nurse who failed to establish that she had not acted negligently in claiming her mother as a dependent and in taking an excessive deduction for work clothes. Her purported reliance on the advice of her certified public accountant did not relieve her of liability for the penalties absent proof that she had provided him with accurate information.

C. Chacon, 64 TCM 1169, Dec. 48,606(M), TC Memo. 1992-632. Aff'd, CA-11 (unpublished opinion 10/21/94).

A married couple who assembled clothing in their home for clothing manufacturers was liable for the negligence penalty because they offered no substantiation of their contention that they relied on the advice of a tax professional.

T.V. Pham, 70 TCM 814, Dec. 50,912(M), TC Memo. 1995-459.

In the following cases, the negligence penalty was imposed because the taxpayers failed to show that they reasonably relied on the advice of a tax professional.

M. Veglia, DC Ill., 97-2 USTC ¶50,700.

W.T. Wright, 66 TCM 214, Dec. 49,174(M), TC Memo. 1993-328. Aff'd, CA-9 (unpublished opinion), 96-1 USTC ¶50,086.

D. Page, 66 TCM 571, Dec. 49,251(M), TC Memo. 1993-398. Aff'd on other issues, CA-8, 95-2 USTC ¶50,369, 58 F3d 1342.

M. Lieber, 66 TCM 722, Dec. 49,280(M), TC Memo. 1993-424.

M.L. Stiebling, 67 TCM 3006, Dec. 49,865(M), TC Memo. 1994-233. Aff'd, CA-9 (unpublished opinion), 97-1 USTC ¶50,467.

W.L. Marcy, 68 TCM 1028, Dec. 50,201(M), TC Memo. 1994-534.

J.R. Williams, Jr., 68 TCM 1172, Dec. 50,229(M), TC Memo. 1994-560.

INI, Inc., 69 TCM 2113, Dec. 50,526(M), TC Memo. 1995-112.

J.A. Ruf, CA-9 (unpublished opinion), 95-2 USTC ¶50,331.

L.F. Paullus, 72 TCM 636, Dec. 51,554(M), TC Memo. 1996-419.

P.M. Welch, 73 TCM 2256, Dec. 51,927(M), TC Memo. 1997-120.

M.L. Stephens, 73 TCM 2700, Dec. 52,023(M), TC Memo. 1997-204.

M.J. Laney, 74 TCM 507, Dec. 52,236(M), TC Memo. 1997-403. Aff'd, per curiam, CA-4 (unpublished opinion), 99-1 USTC ¶50,187.

R.D. Ciaravella, 75 TCM 1635, Dec. 52,535(M), TC Memo. 1998-31.

C.C. Wang, 75 TCM 2087, Dec. 52,645(M), TC Memo. 1998-127.

Prindle Intl. Marketing, 75 TCM 2239, Dec. 52,686(M), TC Memo. 1998-164. Aff'd sub nom. R.R. Fox, CA-9 (unpublished opinion), 2000-2 USTC ¶50,554.

R.A. Garcia, 75 TCM 2405, Dec. 52,728(M), TC Memo. 1998-203. Aff'd, per curiam, CA-5 (unpublished opinion), 99-2 USTC ¶50,762.

D.S. Bundridge, 75 TCM 2452, Dec. 52,734(M), TC Memo. 1998-206.

C.A. Willits, 78 TCM 74, Dec. 53,455(M), TC Memo. 1999-230.

K.W. Frische, 80 TCM 143, Dec. 53,979(M), TC Memo. 2000-237.

M.L. Barmes, 80 TCM 209, Dec. 53,999(M), TC Memo. 2000-254. Aff'd, CA-7 (unpublished opinion), 2001-2 USTC ¶50,487.

R.A. Lund, 80 TCM 599, Dec. 54,101(M), TC Memo. 2000-334. Aff'd, CA-9 (unpublished opinion), 2002-2 USTC ¶50,507.

U. Tarakci, 80 TCM 727, Dec. 54,129(M), TC Memo. 2000-358.

R. Haeder, 81 TCM 987, Dec. 54,211(M), TC Memo. 2001-7.

A.A. Tokh, 81 TCM 1207, Dec. 54,255(M), TC Memo. 2001-45. Aff'd, CA-7 (unpublished opinion), 2002-1 USTC ¶50,128.

R. O'Connor, 81 TCM 1509, Dec. 54,306(M), TC Memo. 2001-90.

K.D. Castro, 81 TCM 1615, Dec. 54,338(M), TC Memo. 2001-115.

E.C. Tietig, 82 TCM 304, Dec. 54,423(M), TC Memo. 2001-190. Aff'd, per curiam, CA-11 (unpublished opinion), 2003-1 USTC ¶50,205.

Z. Brodsky, 82 TCM 505, Dec. 54,480(M), TC Memo. 2001-240.

J.L. Thomas, 83 TCM 1576, Dec. 54,729(M), TC Memo. 2002-108. Aff'd, CA-11 (unpublished opinion), 2003-1 USTC ¶50,460.

H.C. Boler, 83 TCM 1879, Dec. 54,791(M), TC Memo. 2002-155.

B.M. Cohen, 85 TCM 861, Dec. 55,048(M), TC Memo. 2003-42.

F. Assaad, 85 TCM 1478, Dec. 55,186(M), TC Memo. 2003-171.

G.W. Gouveia, 88 TCM 424, Dec. 55,799(M), TC Memo. 2004-256.

O. Kooyers, 88 TCM 605, Dec. 55,826(M), TC Memo. 2004-281.

L. G. Bangs, Dec. 56,492(M), TC Memo. 2006-83.

T. Gleason, 92 TCM 250, Dec. 56,616(M), TC Memo. 2006-191.

G. Kierstead Family Holdings Trust, 93 TCM 1392, Dec. 56,975(M), TC Memo. 2007-158.

N.J. McConnell, 96 TCM 10, Dec. 57,486(M), TC Memo. 2008-167.

The issue of married taxpayers' liability for negligence penalties was remanded for further proceedings. No evidence in the record indicated that the taxpayers had consulted with tax professionals in an effort to obtain advice during the tax years at issue. However, the couple's returns, at least facially, supported their position.

J.Z. Schrum, CA-4, 94-2 USTC ¶50,451.

A taxpayer was liable for the negligence component of the accuracy-related penalty. Even though she claimed to have reasonably relied on the advice of the tax preparer who signed her return when she claimed a mortgage interest deduction with respect to property owned by her brother, she did not call the preparer as a witness and failed to provide other supporting evidence regarding the disallowed deduction.

J. Song, 70 TCM 745, Dec. 50,897(M), TC Memo. 1995-446.

An individual who greatly overvalued a flight helmet that he donated to a museum was liable for the accuracy-related penalty. Although he claimed to have relied on the advice of his accountant and of the individual who purportedly appraised the helmet, they were not called as witnesses and the record was devoid of evidence relating to what information he provided to them.

M.H. Droz, 71 TCM 2204, Dec. 51,184(M), TC Memo. 1996-81.

A married couple was liable for the negligence penalty for an underpayment attributable to the rent-free use of a new apartment. They did not reasonably rely on the advice of their attorney since his testimony established that he did not provide tax advice.

G. Stotis, 72 TCM 704, Dec. 51,567(M), TC Memo. 1996-431.

The negligence penalty applied to an attorney's underpayment of tax attributable to a disallowed real estate rental loss deduction. His defense of "good-faith" reliance was rejected because he did not produce evidence, apart from his own testimony, establishing that he had received tax advice concerning the losses.

S.G. Opperwall, CA-9 (unpublished opinion), 97-1 USTC ¶50,160, aff'g an unreported Tax Court decision.

Taxpayers who failed to adequately substantiate various deductions were liable for accuracy-related penalties for negligence. The husband's testimony, without more, did not establish reasonable reliance on an accountant.

T.E. Tilley, 73 TCM 2763, Dec. 52,041(M), TC Memo. 1997-222.

Married taxpayers were liable for the negligence component of the accuracy-related penalty for their failure to include Code Sec. 1231 gain in income. The taxpayers failed to establish that they reasonably relied on their accountant in failing to report such income. Documentation indicated that the couple's accountant advised them to report the gain.

R.K. Lowry, 86 TCM 198, Dec. 55,247(M), TC Memo. 2003-225. Motion to reconsider denied, 87 TCM 811, Dec. 55,511(M), TC Memo. 2004-10. Aff'd, CA-9 (unpublished opinion), 2006-1 USTC ¶50,187, 171 FedAppx 6.

In consolidated cases involving an automobile dealership, a former shareholder, and his deceased wife, the dealership was properly required to amortize payments made to the shareholder pursuant to a noncompetition agreement over a 15-year period because the agreement constituted an amortizable intangible that was entered into by the parties after the effective date of Code Sec. 197. In light of the taxpayers' failure to take due care in reporting their income, the assessed deficiencies and accuracy-related penalties were sustained.

Burien Nissan, Inc., 81 TCM 1624, Dec. 54,339(M), TC Memo. 2001-116. Aff'd, CA-9 (unpublished opinion), 2004-1 USTC ¶50,102, 75 FedAppx 652.

A C corporation's transfers to various related parties were not loans, but were distributions of property to shareholders or contributions to capital of related entities. The IRS's imposition of the accuracy-related penalty on the shareholder was sustained if the recalculation of the taxpayer's liabilities indicates substantial understatements for the years at issue. The shareholder was well-versed in corporate finance and made the decisions regarding the terms and conditions of the transfers between the C corporation and its subsidiaries. Thus, the shareholder's argument that he relied on professional advice for the treatment of the transfers as debt rather than equity was unpersuasive.

P.K. Ventures, Inc., 89 TCM 880, Dec. 55,965(M), TC Memo. 2005-56.

Similarly.

PK Ventures, Inc., 91 TCM 806, Dec. 56,442(M), TC Memo. 2006-36, aff'd in part and rev'd in part on another issue, CA-11 (unpublished opinion), per curiam, 2008-1 USTC ¶50,318.

The accuracy-related penalty was imposed. A couples' failure to maintain and produce the required documentation to support their deductions was negligence that was not attributable to their tax return preparer.

K. Jackson, 89 TCM 1516, Dec. 56,079(M), T.C. Memo. 2005-159.

An individual was held liable for an accuracy-related penalty under Code Sec. 6662(a) because he claimed a Schedule C trade or business expense deduction for legal fees incurred in what was an employment-related controversy. His reliance upon certain nonapplicable decisions did not provide substantial authority for his argument. He also did not introduce evidence indicating he reasonably relied upon the advice of a tax professional. Finally, his argument that his liability for the alternative minimum tax (AMT) was penalty enough for his underreporting was not acceptable. The effect of the AMT does not have any bearing upon the accuracy-related penalty.

P.T. Chaplin, 93 TCM 991, Dec. 56,863(M), TC Memo. 2007-58.

The negligence penalty was imposed on an individual who claimed that a taxable bonus from her employer was a gift. The taxpayer failed to establish that she had reasonable cause for her position and that she acted in good faith Although the taxpayer claimed that she relied upon professional advice she did not meet the three-prong test for reliance. The taxpayer did not present credible evidence that the owner of the company and the company accountant characterized the payment as a gift or were qualified to do so. The company attorney who prepared her return provided no advice to the taxpayer and merely relied on her characterization of the payment, without independent inquiry.

F.J. Larsen, 95 TCM 1273, Dec. 57,378(M), TC Memo. 2008-73.

Married taxpayers who ran a motel business did not fall under the reasonable cause exception to the accuracy-related penalty on the ground that they relied on their return preparer because they provided the preparer with false information.

B.I. Patel, 96 TCM 202, Dec. 57,546(M), TC Memo. 2008-223.

An individual who invested in a jojoba partnership was liable for additions to tax for negligence. The underlying activity was determined to lack legitimacy by the Tax Court and deductions for research and development expenditures were disallowed. Although the taxpayer sought some advice before investing in the partnership, there was no written opinion regarding the investment. Neither the taxpayer's CPA, who was deceased, nor his broker with whom the taxpayer discussed the investment, testified at trial. The taxpayer himself offered only vague testimony as to the advice he received, but testified that neither he nor his advisors reviewed the pertinent documents. The promotional private placement letter, touting substantial tax benefits, should have provided a warning, given the deduction, which was 225 percent of the taxpayer's investment. The taxpayer's actions were unreasonable under the circumstances. Additions to tax for the substantial understatement of tax were also imposed. The taxpayer did not argue that he had substantial authority for claiming the loss. Nor did he demonstrate that the facts of the investment were adequately disclosed on his return or an attached statement.

C.D. Helbig, 96 TCM 287, Dec. 57,570(M), TC Memo. 2008-243.

Married taxpayers, who invested with her husband in a jojoba partnership from which claimed losses were ultimately disallowed, were subject to additions to tax for underpayments due to negligence. The partnership was not a reasonable investment from an income tax perspective. In addition, the couple's use of professional tax return preparers to prepare their joint federal income tax returns did not shield them from being liable for the negligence additions to tax at issue, as there was no evidence that the preparer did not merely transfer the losses from the Schedules K-1 provided by the partnership onto the couple's returns.

D.L. Watson, 96 TCM 418, Dec. 57,607(M), TC Memo. 2008-276.

A married couple who had deducted losses arising from an investment in a jojoba partnership was liable for additions to tax for understatement of tax due to negligence. They improperly relied for advice on two people who were involved with the partnership, failed to notice obvious indicators of problems with the investment, and did not act with due care with respect to their investment. Moreover, there was insufficient evidence that the petitioners had relied on the advice of their tax return preparer.

D. Altman, 96 TCM 479, Dec. 57,626(M), TC Memo. 2008-290.


Reliance on professionals was not reasonable cause. --Substantial Understatement: Reliance on professionals was not reasonable cause

Absent substantial authority, a domestic holding corporation was liable for the substantial understatement component of the accuracy-related penalty for one tax year. The understatement was attributable to foreign tax credits that the corporation claimed with respect to a sizable dividend that it reported it received from one of its foreign operating subsidiaries. The relevant facts affecting the tax treatment of the transaction were not adequately disclosed in the taxpayer's return or in a later disclosure letter; and the entity did not have reasonable cause for, or act in good faith with respect to, its treatment of the transaction in its return. Finally, no evidence supported the taxpayer's contention that it reasonably relied on its accounting firm.

InterTan, Inc., CA-5, 2005-1 USTC ¶50,111, 353 F3d 1357.

A corporation's officers and attorney were liable for the substantial understatement penalty because their tax treatment of options was not supported by substantial authority and they did not adequately disclose the facts relevant to the tax treatment. They could not avoid the penalty because they did not reasonably rely in good faith on their tax advisors.

R.A. Cramer, CA-9, 95-2 USTC ¶50,491. Cert. denied, 6/10/96.

T.D. Davenport, DC Ky., 2006-2 USTC ¶50,394.

Understatement penalties were imposed in the following cases because relying on a professional is not reasonable when the taxpayer does not provide the professional with correct, sufficient and/or complete and accurate information.

S.R. Loftus, 63 TCM 2944, Dec. 48,203(M), TC Memo. 1992-266.

E. Taylor, 69 TCM 2932, Dec. 50,701(M), TC Memo. 1995-269. Aff'd, CA-10 (unpublished opinion), 97-1 USTC ¶50,310.

United Circuits, Inc., 70 TCM 1619, Dec. 51,069(M), TC Memo. 1995-605.

S.D. Podd, 75 TCM 2575, Dec. 52,765(M), TC Memo. 1998-231.

D.W. Stark, 77 TCM 1181, Dec. 53,202(M), TC Memo. 1999-1.

J.C. Archer, 79 TCM 2057, Dec. 53,891(M), TC Memo. 2000-166.

Delaware Corp., 88 TCM 589, Dec. 55,825(M), TC Memo. 2004-280.

H.J. Kaplan, 91 TCM 695, Dec. 56,422(M), TC Memo. 2006-16.

The substantial understatement penalty was properly imposed because the taxpayers failed to prove that they acted in good faith in the preparation of their returns and that there was reasonable cause for the understatement in their tax or that there was an abuse of discretion by the IRS in refusing to waive the addition to penalty.

J.M. Estes, Jr., 64 TCM 705, Dec. 48,494(M), TC Memo. 1992-531.

A "termination allowance" received by a telephone technician from his employer was not excludable from his income because the payment was in the nature of severance pay rather than damages received for personal injuries. The taxpayer's reliance on his tax return preparer did not insulate him from liability for the tax deficiency or substantial understatement penalty.

J.E. Huff, 64 TCM 1547, Dec. 48,698(M), TC Memo. 1992-718.

Individual joint filers who claimed that their attorney failed to notify them of the Tax Court's decision on their petition were not entitled to have the decision vacated after the appeal period had expired. The deficiency and additions to tax were upheld.

V.C. Gazdak, 66 TCM 479, Dec. 49,233(M), TC Memo. 1993-381.

A damage award received by an individual as compensation for a breach of contract suit was taxable income. The taxpayer's reliance on an attorney's opinion that the award was excludable did not relieve him from failure to file and substantial understatement penalties.

J.A. Climenhage, 65 TCM 2736, Dec. 49,051(M), TC Memo. 1993-223.

Reliance on its accounting service did not excuse a publishing company from liability for penalties for failure to timely file returns and for substantial understatement of income. The substantial understatement penalty was imposed because the expenditure for a land purchase was large in relation to the expense account to which it was attributed and the accountant's mistake should have been detected on a reasonable inspection of the return by the taxpayer.

Olde Towne Typesetters, Inc., 66 TCM 51, Dec. 49,138(M), 1993-296.

Additions to tax for substantial understatement of taxes were owed by investors in a limited partnership who unreasonably relied upon their accountant's advice and did not make an independent factual analysis that would enable them to formulate a reasonable belief as to the tax treatment of the investment.

A. Kaplan, 67 TCM 2258, Dec. 49,691(M), TC Memo. 1994-81.

A taxpayer who relied on a tax professional was subject to the substantial understatement penalty. Reliance on a professional did not constitute substantial authority for their tax treatment of the affected items that enabled him to avoid the penalty.

J. Epstein, 67 TCM 2046, Dec. 49,636(M), TC Memo. 1994-34.

The substantial understatement penalty was imposed because the taxpayers did not act reasonably in relying on an accountant's preparation of their return. They unreasonably relied on their accountant and invested in tax shelter partnerships without a profit motive when they knew that he lacked expertise regarding various investment recommendations. The taxpayers, who made numerous poor business decisions based on the accountant's advise, did not act in good faith when they relied on his investment recommendations.

R. Lax, CA-3 (unpublished opinion), 95-2 USTC ¶50,639.

A circuit board manufacturer that improperly claimed deductions for equipment lease payments that should have been capitalized was liable for the substantial understatement penalty. The manufacturer did not reasonably rely in good faith on the advice of its accountant. The manufacturer did not provide its accountant with full details or complete and accurate information concerning the transactions. It relied on the accountant for accounting advice rather than for tax advice. Moreover, the manufacturer did not follow the accountant's advice as to the characteristics of a legitimate lease. Finally, the negligence penalty was also imposed.

United Circuits, Inc., 70 TCM 1619, Dec. 51,069(M), TC Memo. 1995-605.

An individual who operated his business through a number of trusts that were determined to be part of a scheme to avoid taxation on his business income was not liable for the fraud penalty because the IRS did not prove fraud by clear and convincing evidence. However, the individual was liable for substantial understatement penalties because he was unable to show substantial authority for his position. Opinion letters from the promoter's attorney did not constitute substantial authority for the individual's actions.

Para Technologies Trust, 68 TCM 294, Dec. 50,013(M), TC Memo. 1994-366. Aff'd sub nom. T. Anderson, CA-9 (unpublished opinion), 97-1 USTC ¶50,294.

Penalties for negligence and substantial understatement were imposed against a realtor who improperly attempted to use the installment method to report income from his transfer of depreciable property to a related buyer. He failed to show that there was reasonable cause for his understatement of tax or that he had acted in good faith. He did not carefully review his return or correct obvious errors on the document, and he failed to show the types of information or documentation that he had provided to his return preparer.

R.J. Guenther, 69 TCM 2980, Dec. 50,713(M), TC Memo. 1995-280.

An owner and his giftware corporation were liable for negligence and substantial understatement penalties. They could not avoid liability for the penalties based on their purported reliance on the advice of their accountants in light of the fact they had conspired to prepare and present to the IRS backdated documents and accounting entries. Even if the owner and the corporation relied on the accountants, they disregarded that advice.

G. Georgiou, 70 TCM 1341, Dec. 51,005(M), TC Memo. 1995-546.

In the following cases, the substantial understatement penalty was imposed because the taxpayers' claimed reliance on the advice of an unidentified IRS employee was insufficient to avoid the penalty.

D.W. Harker, 68 TCM 1272, Dec. 50,259(M), TC Memo. 1994-583. Aff'd on another issue, CA-8, 96-1 USTC ¶50,244.

M. Dogali, 69 TCM 1759, Dec. 50,445(M), TC Memo. 1995-39.

An individual was subject to the penalty for substantial understatement of income tax because he showed no reasonable cause for the understatement. Self-serving testimony that the taxpayer relied on his accountant to correctly prepare his returns was not credible, and the accountant did not testify.

M.D. Morgan, 73 TCM 2313, Dec. 51,940(M), TC Memo. 1997-132.

In the following cases, the substantial understatement penalty was imposed because the taxpayers' claimed reliance on the advice of a tax professional was not reasonable cause for the understatement.

B.R. House, 69 TCM 2005, Dec. 50,502(M), TC Memo. 1995-92.

INI, Inc., 69 TCM 2113, Dec. 50,526(M), TC Memo. 1995-112.

N. Nahikian, 69 TCM 2370, Dec. 50,582(M), TC Memo. 1995-161.

T.M. Fries, 73 TCM 2085, Dec. 51,898(M), TC Memo. 1997-93.

K.S. Rao, 72 TCM 1198, Dec. 51,642(M), TC Memo. 1996-500.

Cordes Finance Corp., 73 TCM 2493, Dec. 51,975(M), TC Memo. 1997-162. Aff'd, CA-10 (unpublished opinion), 98-2 USTC ¶50,824.

J. Montoro, 73 TCM 3113, Dec. 52,107(M), TC Memo. 1997-281.

Reaves Livestock, Inc., 73 TCM 3137, Dec. 52,108(M), TC Memo. 1997-283.

A.M. Moye, 74 TCM 1397, Dec. 52,400(M), TC Memo. 1997-554.

M. Roy, M.D., Inc., 74 TCM 1428, Dec. 52,409(M), TC Memo. 1997-562. Aff'd, CA-9 (unpublished opinion), 99-1 USTC ¶50,588.

Cleo Perfume, Inc., 75 TCM 2200, Dec. 52,677(M), TC Memo. 1998-155.

S.D. Emmons, 75 TCM 2275, Dec. 52,696(M), TC Memo. 1998-173.

Florida Industries Investment Corp., 78 TCM 605, Dec. 53,590(M), TC Memo. 1999-346. Aff'd, per curiam, CA-11 (unpublished opinion), 2001-1 USTC ¶50,334.

E.R. Stolz, II, 78 TCM 941, Dec. 53,654(M), TC Memo. 1999-404.

J. Pinson, 80 TCM 13, Dec. 53,945(M), TC Memo. 2000-208.

R. Haeder, 81 TCM 987, Dec. 54,211(M), TC Memo. 2001-7.

W.O. Bowen, 81 TCM 1216, Dec. 54,257(M), TC Memo. 2001-47.

V.M. Bello, 81 TCM 1271, Dec. 54,268(M), TC Memo. 2001-56.

Burien Nissan, Inc., 81 TCM 1624, Dec. 54,339(M), TC Memo. 2001-116. Aff'd , CA-9 (unpublished opinion), 2004-1 USTC ¶50,102, 75 Fed Appx 652.

J.J. LeBouef, 82 TCM 685, Dec. 54,504(M), TC Memo. 2001-261.

L.T. Baldwin, III, 83 TCM 1915, Dec. 54,798(M), TC Memo. 2002-162.

W. Pratt, 84 TCM 523, Dec. 54,929(M), TC Memo. 2002-279.

C.R. Bitker, 86 TCM 72, Dec. 55,229(M), TC Memo. 2003-209.

W.A. Egan, 90 TCM 365, Dec. 56,162(M), T.C. Memo. 2005-234.

L.J. Wadsworth, 96 TCM 20, Dec. 57,490(M), TC Memo. 2008-171.

A married couple, whose tax shelter trust's charitable contributions deduction were disallowed, was liable for accuracy-related penalties. The couple conceded that their understatement was substantial; however, they argued that they reasonably relied on their tax preparer to prepare their return correctly. Although reliance on a tax professional may be a defense to the accuracy-related penalty in certain circumstances, the couple failed to prove that (1) they relied on a competent professional whose expertise was sufficient to justify reliance, (2) they provided necessary and accurate information to that professional, and (3) they actually relied on the professional's advice in good faith.

J.L. Hill, 87 TCM 1451, Dec. 55,680(M), TC Memo. 2004-156.

A privately organized pooled investment vehicle, or "hedge fund", created by two Nobel Prize winning economists participated in transactions that lacked economic substance and, therefore, the IRS properly denied its capital loss deductions and imposed penalties for gross valuation misstatements and substantial understatements. The district court found that the accuracy-related penalties imposed by the IRS were not erroneous because the taxpayer did not satisfy the reasonable cause exception. Although the taxpayer argued that (1) there was no valuation misstatement on its tax return, (2) it did not act negligently, and (3) that it had substantial authority for its return position, the court concluded that the penalties imposed were justified. The court found that there was a substantial valuation misstatement on the taxpayer's return; the taxpayer substantially overstated its basis in the stock it sold. Additionally, the taxpayer acted negligently because LTCH lacked a reasonable belief that the basis it claimed for the stock was valid. Finally, the taxpayer did not have substantial authority for its return position; a tax professional's opinion did not constitute "substantial authority" for the taxpayer's return position.

Long Term Capital Holdings, DC Conn., 2004-2 USTC ¶50,351.

A tax shelter partnership was subject to the gross valuation misstatement, negligence and substantial understatement penalties. The TMP, a highly educated, sophisticated tax attorney, engineered the plan to transfer built-in losses to the partnership, which transaction had no economic substance for federal tax purposes. Under the circumstances, a reasonably prudent person with the TMP's tax experience would not have reported the partnership's basis in the receivables as he did. Thus, the partnership failed to meet the reasonable cause exception to the negligence penalty.

Santa Monica Pictures, LLC, 89 TCM 1157, Dec. 56,016(M), TC Memo. 2005-104.

An individual was liable for the substantial understatement penalty for failing to report income and claiming unsupported deductions. He failed to maintain adequate books and records. His claim that he relied on the advice of an attorney with respect to his failure to include forgiveness of debt in his income was rejected. The attorney merely advised the taxpayer as to the characterization of the settlement, not the tax consequences of the forgiveness of debt.

R.E. Corrigan, 89 TCM 1313, Dec. 56,034(M), TC Memo. 2005-119.

Taxpayers failed to satisfy the threshold requirements of a reasonable cause exception to the penalty for gross valuation misstatement. The taxpayers' argument that they relied on tax advice failed because they did not present evidence that the advice was relevant to the valuation misstatement. Furthermore, even if the advice were relevant, there was no evidence that the tax advice was based on all of the pertinent facts and circumstances.

Long-Term Capital Holdings LP, CA-2, 2005-2 USTC ¶50,575.

An accuracy-related penalty under Code Sec. 6662(a) for substantial understatement of income tax was imposed. The taxpayer's claim that the understatement was due to reasonable cause and made in good faith because he relied on his accountant, was not persuasive. The only alleged erroneous advice related to the carryforward of a claimed NOL, which the court disallowed because the taxpayer failed to substantiate it.

M.D. Lee, 91 TCM 999, Dec. 56,476(M), TC Memo. 2006-70.

A taxpayer was liable for the accuracy-related penalty for substantial understatement of income tax attributable to the portion of the jury award she received and incorrectly excluded from income. While the taxpayer alleged that she and her husband met with a nationally renowned expert on the taxation of legal awards, the reasonable cause exception did not apply because she provided no evidence of what tax advice was actually rendered.

M.S. Green, 93 TCM 917, Dec. 56,841(M), TC Memo. 2007-39.

A taxpayer was liable for the accuracy-related penalty on substantial understatements of tax. Although he claimed that he reasonably relied on his accountant's advice, he failed to show that the accountant was a competent professional who had sufficient expertise to justify the taxpayer's purported reliance.

J. Calvao, 93 TCM 988, Dec. 56,862(M), TC Memo. 2007-57.

Similarly.

G. Kierstead Family Holdings Trust, 93 TCM 1392, Dec. 56,975(M), TC Memo. 2007-158.

A married couple's reliance on their accountant to calculate their taxes did not excuse them from liability for the penalty for substantial understatement of tax. The taxpayers' actions were not reasonable, given the substantial amounts of gross receipts involved, the taxpayer's business experience, and the large discrepancy between the tax reported and the actual tax owed.

J. Ramirez, 94 TCM 496, Dec. 57,181(M), TC Memo. 2007-347.

The accuracy-related penalty for substantial underpayment of income tax was imposed on a car dealership that improperly deducted legal fees relating to its landlord's defense of title and its acquisition of another dealership. The exception for reliance on a tax professional did not apply in the absence of evidence that its accountant was supplied with all of the correct and necessary information needed to establish its position, that the error was the result of a preparer's mistake, or that there was any discussion of the treatment of the legal fees with the accountant before the return was filed.

West Covina Motors, Inc., Dec. 57,564(M), TC Memo. 2008-237.

The accuracy-related penalty for substantial underpayment of income tax was imposed on a car dealership that improperly deducted legal fees relating to its landlord's defense of title and its acquisition of another dealership. The exception for reliance on a tax professional did not apply in the absence of evidence that its accountant was supplied with all of the correct and necessary information needed to establish its position, that the error was the result of a preparer's mistake, or that there was any discussion of the treatment of the legal fees with the accountant before the return was filed.

West Covina Motors, Inc., Dec. 57,564(M), TC Memo. 2008-237.

The accuracy-related penalty for a substantial underpayment of tax attributable to a net operating loss that an individual taxpayer conceded was improper was imposed. Reliance on the taxpayer's accountant was not reasonable since no steps were taken to verify that the accountant had sufficient expertise or was sufficiently independent of the entity that sponsored the offshore investment programs that generated the net operating loss.

W.C. Wyatt, Dec. 57,581(M), TC Memo. 2008-253.

The Tax Court's decision finding that an individual was liable for the accuracy-related penalty for substantial understatement of income tax was reversed and remanded. Since the individual and her husband sought tax advice from two attorneys, the Tax Court should have considered the aggregate advice received from both attorneys to determine the reasonableness of the individual's reliance on their tax advice.

M. Green, CA-9, 2009-1 USTC ¶50,245.

Accuracy-related penalties were imposed because the authority cited by the taxpayer was easily distinguished.

P. Ackerman, Dec. 57,790(M), TC Memo. 2009-80.

Call Alvin Brown is you have any questions about the reasonable cause issue
703 425-1400 ex 111

IRS method of proving income

The Seo case illustrated the importance of documenting the source of all deposits. This support documentation and notations on the check are necessary whehter or not the taxpayer filed tax returns


Blake Hyun Seo v. Commissioner

Dkt. No. 21622-05 , TC Memo. 2009-106, May 19, 2009.


A nonfiler whose income was reconstructed using the bank deposits method was liable for deficiencies, failure to file and pay penalties and the underpayment of estimated tax penalty. The individual provided no evidence that he had reasonable cause for his failure to file or pay; furthermore, he did not qualify under any exceptions to the underpayment penalty. The individual's bank account documents, obtained through IRS summonses, were properly used to reconstruct income for the three tax years using the bank deposits method. The revenue agent excluded transfers between bank accounts and did not include portions of checks not deposited in bank accounts. The individual's arguments that certain bank deposits belonged to his brother-in-law, certain deposits were loans or gifts, and certain deposits were proceeds from insurance claims, real estate refinancing or a home equity line of credit were not credible since he offered only his uncorroborated testimony that was deemed vague and self-serving. He was denied gambling loss deductions in two tax years where no gambling winnings were included in his income and denied the loss in the third year because, although gambling winnings were reported, he failed to provide evidence of his losses.





Blake Hyun Seo, pro se; Richard J. Hassebrock, for respondent.





MEMORANDUM FINDINGS OF FACT AND OPINION



CHIECHI, Judge: Respondent determined the following deficiencies in, and additions to, petitioner's Federal income tax (tax):





Additions to Tax

Sec. 6651(a)(1)
Year Deficiency 1 Sec. 6651(a)(2) Sec. 6654(a)

2000 $251,430 $56,571.75 * $583.14

2001 132,318 29,771.55 * 5,287.91

2002 51,412 11,567.70 * 1,718.05

1All section references are to the Internal Revenue Code in
effect for the years at issue. All Rule references are to the Tax
Court Rules of Practice and Procedure.

*Amount to be determined at a later date pursuant to
sec. 6651(a)(2) and (c).





The issues remaining for decision are: 2



(1) Does petitioner have for each of his taxable years 2000, 2001, and 2002 unreported income as determined by respondent under the bank deposits method? We hold that he does to the extent stated herein.



(2) Is petitioner entitled for each of his taxable years 2000, 2001, and 2002 to deduct certain gambling losses? We hold that he is not.



(3) Does petitioner have unreported interest income for each of his taxable years 2000 and 2001? We hold that he does.



(4) Is petitioner liable for each of his taxable years 2000, 2001, and 2002 for the addition to tax under section 6651(a)(1)? We hold that he is.



(5) Is petitioner liable for each of his taxable years 2000, 2001, and 2002 for the addition to tax under section 6651(a)(2)? We hold that he is.



(6) Is petitioner liable for each of his taxable years 2000, 2001, and 2002 for the addition to tax under section 6654(a)? We hold that he is.





FINDINGS OF FACT



Some of the facts have been stipulated and are so found except as stated below. 3



Petitioner's address shown in the petition in this case was in Ohio.




Bank Accounts


During the years at issue, petitioner maintained in his name or in the name of an entity (discussed below) certain bank accounts over which he had control and/or signature authority.



During 2000, petitioner maintained at Huntington National Bank two checking accounts in his name (petitioner's checking account No. 5210 and petitioner's checking account No. 4730) and a savings account (petitioner's savings account) in his name. During 2001 and 2002, petitioner maintained petitioner's checking account No. 4730 and petitioner's savings account.



During 2000, petitioner maintained at Fifth Third Bank a checking account (Seo & Leonard account) in the name of Seo & Leonard Co. (Seo & Leonard).



During 2001, petitioner maintained at Fifth Third Bank a bank account (petitioner's Fifth Third Bank account) in his name. 4



During 2002, petitioner maintained at Huntington National Bank a money management account (Amnesia Lounge account) in the name of Amnesia Lounge, LLC (Amnesia Lounge), an Ohio limited liability company that petitioner formed on December 1, 2001. 5




Certain Deposits Into Petitioner's Bank Accounts


During 2000, petitioner deposited a total of $338,472.32 6 into petitioner's checking account No. 5210. Included in that total amount were the following deposits that petitioner claims are not includible in his income:





Date of Description and
Deposit Payor of Item Deposited

Check for $25 issued by First USA
1/7/00 and payable to petitioner

Check for $450 issued by Eric
Chang (Mr. Chang) and payable to
1/14/00 petitioner

Check for $1,713.83 issued by
Countrywide Home Loans, Inc.
(Countrywide), and payable to
1/14/00 petitioner

Check for $83.62 issued by
Farmers Insurance Group of Cos.
(Farmers Insurance) and payable to
1/18/00 petitioner

Check for $72,084.96 issued by
Midland Title Security, Inc.
(Midland Title), and payable to
1/18/00 Stephen T. Hutchinson

Check for $30,000 issued by
Beneficial and payable to
petitioner and Harry Wood (Mr.
1/25/00 Wood)

Check for $1,000 issued by CMACO
Investments, Inc. (CMACO
Investments), and payable to Seo &
1/31/00 Leonard

Check for $25 issued by First USA
2/14/00 and payable to petitioner

Check for $269.86 issued by
Farmers Insurance and payable to
Innova Funding, Inc. (Innova
2/15/00 Funding)

Check for $19.21 issued by The
Dispatch Printing Co. (Dispatch
2/15/00 Printing) and payable to petitioner

Check for $25,000 issued by
Firelands Federal Credit Union
(Firelands) and payable to
2/16/00 petitioner

Check for $152.66 issued by
Farmers Insurance and payable to
2/18/00 petitioner

Check for $151.76 issued by
Farmers Insurance and payable to
3/9/00 petitioner

Check for $70,000 issued by
Clyde-Findlay Area Credit Union
(Clyde-Findlay) and payable to
4/5/00 petitioner 1

Check for $168.95 issued by
ABN-AMRO Mortgage Group, Inc.
(ABN-AMRO), and payable to
4/19/00 petitioner 2