AGAIN, IT'S BETTER TO LOSE by C. David Anderson

Here is another illustration that taxes are so complicated that it’s hard to understand whether it’s better to win or lose until you do the numbers carefully.

A client had a massive operating loss in the 2008/9 Great Recession and got a large refund by carrying the losses back to profitable 2004/5 years.  This carryback refund got pulled into the IRS special examination program for wealthy taxpayers.

The IRS decided that the client acted more like a passive investor in the business, not like an active manager.  As a result, the losses were “passive losses,” which can only be carried forward, not backward.  Therefore, the refund from the carryback to earlier years had to be repaid.

We thought that the client was in fact quite active in the business, but a lack of email records made this hard to prove to the examiners.  We wound up having to take our argument for a carryback refund to Appeals.   

While in Appeals, we started to think hard about what would happen if we lost the case, besides having to repay the carryback refund.  The natural reaction was to fight the immediate tax from surrendering the carryback refund. 

The main effect of conceding that the losses were passive, however, was that the losses were still allowed but could only be carried forward to later years, and that the losses could only be used against future passive income.  This need for future passive income was a potential problem, because we still thought the client was an active investor. 

By digging deeper and doing the numbers, we realized that the client would actually be far better off if he could use the carried-over passive losses in the future years!  This is because the tax rate in the carryback years, 2004/5, was around 35%, while the tax rate in the future years, after 2010, was more like 43%.  Therefore, the savings from claiming the active loss carryback was quite a bit less than the benefit of carrying the losses forward to the again-profitable years after the Great Recession.  An additional benefit was that California freely allows carryovers of passive losses but restricts carryovers of active losses.

Now the worry was that the IRS might change its position in the later years and argue that the client was actually “active” – so that future income was active and couldn’t be offset by carried-forward passive losses.  The IRS is certainly capable of taking whichever side of the active/passive issue that maximizes the tax at the time.  Hmmm.

We decided this risk was worth taking, since the client actually became less active once the business no longer faced the insolvency risks of the recession years.  Also, we believed that, once the IRS reached a formal finding that the client was a passive investor, it would continue to follow this position as long as the facts didn’t show greater activity in the later years.

Bottom line – we realized that we could concede the audit disallowances in Appeals and be way ahead.

Takeaway – tax calculations are so complicated that sometimes it is hard to tell if you are winning or losing.  Dig deeper to determine all of the consequences of an IRS determination.  Get out your spreadsheets!

TAX COURT "WHACK-A-MOLE" by Steve Mather

         It can be a good move strategically to force an audit to a conclusion to get IRS’s position established in the notice of deficiency (“NOD”). Pursuant to I.R.C. §6212(a), an NOD is only authorized if IRS “determines” a deficiency.

         The vast majority of contested NODs are petitioned to Tax Court.  The reasons for the IRS determination are beyond the scope of Tax Court’s review. Greenberg’s Express v. Commissioner, 62 T.C. 324 (1974). The Court will not “go behind” the NOD to determine the reasons the notice was issued even if IRS issued multiple self-contradictory notices. Bedrosian v. Commissioner, 940 F.3d 467, 473 (9th Cir. 2019). The NOD therefore determines the issues in the Tax Court case before the case is filed.

         The typical “reward” that IRS receives for clearly determining a deficiency is that the burden of proof in the Tax Court proceeding is generally imposed on the taxpayer for those determinations. Tax Court Rule 142. When IRS wants to increase the deficiency or raise a new issue that requires different evidence, however, the new issue is considered to be a “new matter.” Shea v. Commissioner, 112 T.C. 183, 191 (1999). IRS assumes the burden of proof on any new matter IRS raises. Tax Court Rule 142. For new matters on which IRS has the burden of proof, IRS must seek to file an amended answer and affirmatively plead “a clear and concise statement of every ground, together with the facts in support thereof on which [IRS] relies.” Tax Court Rules 36(b), 41(a).

         In several recent cases, IRS tried to change positions shortly before trial. This change of position occurred during trial preparation when IRS Counsel apparently felt there was a “better” position than the position taken in the NOD.  Examples include:  (1) IRS asserting for the first time in the pretrial memo that the real issue in the case was a change of accounting method from accrual to cash rather than the taxpayer’s eligibility to use the cash method in the first place as determined in the NOD; (2) IRS arguing for the first time in the pretrial memo that the challenge to the character of an amount as debt in the NOD should be expanded to include whether the debt was worthless; and (3) IRS seeking leave to amend its answer two months before trial to raise a profit motive issue not stated in the NOD.

These attempted changes must be resisted at the first instance. Otherwise, Tax Court is likely to allow the new position to be tried and briefed. The Court will typically find that the taxpayer consented to try the new issue and will allow IRS to later conform the pleadings to the proof, if need be. Tax Court Rule 41(b). Often the taxpayer may be unaware of this “implied consent.”

         In the three examples above, IRS Counsel felt entitled to raise the new issue whenever IRS wanted. The Court allowed the new position in the accounting method case, but refused to let IRS to raise the new issue in the other two cases.  Even after the Court rejected IRS’s effort to raise the new issue in the latter two cases, however, IRS tried again after trial, ultimately without success.

         Committing IRS to a position in the NOD is a useful strategy. Immediate and emphatic objection is required to avoid letting IRS push up a new “mole” once the original position has been “whacked,” however.

IT'S BETTER TO LOSE by C. David Anderson

Shortly after Reagan’s 1981 ERTA tax cuts, a major client asked if I could help with a troubled tax project. 

The client was working with a real estate tax specialist firm to see if a three-cornered like-kind exchange could be arranged for him.  The problem was that this was then a technically unsettled issue, and the legal bill had ballooned to well over $100k in today’s dollars – still with no certain answer.

I had recently joined the planning committee for the USC Tax Institute, which gave me an opportunity to ask the committee – all distinguished senior practitioners – a question which bothered me:  Just how good were the tax planning moves which were our bread and butter?  Were tax free reorganizations and like-kind exchanges really that good financially for taxpayers?

Surprisingly, everyone, including the accountants, said they hadn’t really done the analysis.  They just relied on the taxpayer-attractive idea that paying tax later is better.  The committee talked me into writing an article for the Institute on the “quantitative dimension” of tax planning.

Writing the presentation caused me to realize that ERTA’s combination of faster depreciation and lower capital gain rates had stood real estate tax deferral on its head.  The new faster depreciation meant that the tax benefit of the depreciation after a taxable sale was greater than the new lower capital gain paid up front to get the additional depreciable basis.  So, after ERTA, real estate tax deferral was bad!

Armed with this insight, I gave the client a simple spreadsheet present value calculation which showed that the client would be better off if the three-cornered exchange failed.  If it did fail, he would pay a capital gain tax up front which was smaller than the value of the resulting increased depreciation deductions against future ordinary income.

The client agreed to shut down the expensive tax analysis and just finish the exchange, which was well along.  My strategy, if the transaction was audited, was to ask IRS to please disqualify the exchange, let us pay tax on the gain, but then to give us a refund for the increased depreciation deductions in the later years under audit.  

The specialty tax firm’s partner was incredulous – this turned-on-its-head result was a shock – but the client was delighted.

ARE THE MATERIAL PARTICIPATION REGS INVALID? by Steve Mather

Steve’s recent case of Rogerson v. Commissioner, T.C. Memo. 2002-49, raises an interesting question. Activities are classified as passive or nonpassive based on whether the taxpayer meets the “material participation” standard in I.R.C. §469(h). IRS for decades has relied on “temporary” regulations to apply this material participation standard. The opinion in Rogerson suggests these regulations are no longer valid.

         As added to the Code in 1986, the definition of material participation is: 

         (h) MATERIAL PARTICIPATION DEFINED, -- For purposes of

              this section –

                  (1) IN GENERAL – A taxpayer shall be treated as

                       materially participating in an activity only if the

                       taxpayer is involved in the operations of the activity on

                       a basis which is –

                       (A)         regular,

                       (B)         continuous, and

                       (C)         substantial

100 Stat. 2237, reprinted at 1986-3 C.B. (Vol. I) 154. 

         Treasury Regulations are generally acknowledged as the appropriate exercise of respondent’s authority to administer the Internal Revenue Code. Bittiker & Lokken, Federal Taxation of Income, Estates and Gifts, ¶110.5; I.R.C. §7805(a). In fact, I.R.C. §469(k) as originally enacted in 1986 specifically delegated the authority to IRS to “. . .prescribe such regulations as may be necessary or appropriate to carryout the provisions of this [passive activity] section. . .” 100 Stat. 2240, reprinted at 1986-3 C.B. (Vol. I) 157.  

         The material participation regulations were enacted as temporary regulations in February 1988. T.D. 8175. The assumed benefit of a temporary tax regulation was it could be issued without complying with the notice and comment process required for regulations generally under the Administrative Procedure Act (APA). 

         This belief in the “tax exceptionalism” of temporary tax regulations was rejected by the Supreme Court in Mayo Foundation for Medical Research v. United States, 562 U.S. 44 (2011).  Mayo ultimately upheld the Treasury Regulation at issue because it had been promulgated following notice and comment procedures. See, Hickman, “Unpacking the Force of Law,” 66 Vand. L. Rev. 465, 502 (2013).

         More recent authorities go even further. Recent case law and commentary asserts that temporary regulations are entirely invalid without a notice and comment process. Chamber of Commerce of the U.S. v. IRS, 120 AFTR 2d 2017-5967 (W.D. Tex. 2017). See also, Salzman & Book, IRS Practice and Procedure, at ¶3.02(3)(d).

          Congress also limited the life of temporary regulations issued after November 20, 1988 by causing them to expire within three years of enactment. I.R.C. §7805(e); Pub. L. 100-647 §6232(b).

         The material participation temporary regulations pre-date the Congressional sunset provision but are nevertheless of questionable effect after Mayo because they were issued without notice and comment. The Tax Court showed this concern in Rogerson. The Court acknowledged the doubtful status of the material participation regulations and (sort of) refused to apply them. The Court nevertheless ruled against Rogerson, holding the concepts underlying the regulations were consistent with the statutory material participation definition so it did not matter if the regulations were valid.

         We have appealed Rogerson to the Ninth Circuit and will challenge the Tax Court’s tacit use of these otherwise invalid regulations. More to come.