According to a circular released by the Chinese Ministry of Science and Technology on January 11, 2013, Chinese tax authorities have begun a large scale audit of technology companies that claim a special tax status as High and New Technology Enterprises ("HNTEs"). See Circular Guokefahuo No. 1220. Currently, companies that qualify as HNTEs pay a corporate income tax rate of 15%, which is ten percentage points less than the standard Chinese corporate tax rate of 25%.

In terms of qualifying for this special tax status, both Chinese and non-Chinese companies doing high-tech work in areas such as electronics, information technology, biotech and new medical technologies, energy conservation, environmental technology, aerospace, and high-tech transformation of traditional industries are potentially eligible for the HNTE tax break. Companies that fail to qualify as HNTEs under this audit will have their HNTE status revoked and will consequently experience a tax rate increase of 10%. In addition to current year tax increases, these companies may be liable for back taxes, fines, and penalties.

Most likely, this large scale audit is being driven by non-tax fiscal and political factors - namely, the growth rate of China's economy has begun to slow down; as a result, Chinese tax authorities are likely feeling pressured to collect adequate revenues. A crackdown on the HNTE tax break is a potential revenue source because, as of December 31, 2012, more than 60,000 technology companies had claimed this special tax status for Chinese tax purposes, possibly amounting to as much as $USD 32 billion in tax breaks.

Given the large scale of this audit by Chinese tax authorities, companies that claim HNTE status (or have claimed HNTE status in the past) should contact a tax firm to ensure that they satisfy all HNTE eligibility requirements. This self-audit of sorts should be done as soon as possible so that any necessary remedial or protective action can be promptly implemented. Note that even companies that satisfy the criteria for HNTE status often make mistakes that could cause Chinese tax authorities to question their HNTE status during this large-scale audit. Consequently, any company claiming this tax benefit for Chinese tax purposes would be well-advised to engage a tax firm to analyze their eligibility for HNTE status.

The American Taxpayer Relief Act of 2012 was signed into law by President Barack Obama on January 2, 2013. However, many of the resulting tax law changes apply retroactively to the 2012 tax year. As a result, there are going to be delays in this year's filing season as the IRS works to update and modify affected tax forms to account for the new law changes.

Individual Tax Returns

Filing for individual tax returns technically opened on January 30, 2013. However, only the simplest individual returns are currently eligible for electronic filing. The IRS estimates that it will be late February or early March before all forms are available for filing.

Business Tax Returns

The IRS will not be accepting electronic filing for 2012 business tax returns until all forms and systems are updated for the changes. The IRS has not yet indicated when it will begin accepting electronically filed business tax returns, but delays until late February or early March are expected.

Tax-Exempt Entities

The IRS announcement regarding delays in electronic filing of business tax returns also applies to Form 990, "Exempt Business Income Tax Return." In addition, Form 990-T, "Exempt Organization Business Income Tax Return," will be affected. To be clear, Form 990-T is not filed electronically; however, many of the forms needed for completing Form 990-T will not be available until late February or early March.

As a final matter, it should be noted that the IRS has indicated that it will not process paper returns for individual, business, and tax-exempt entities prior to the time that the forms are available for electronic filing.

If someone owes you money that you do not think you will be able to collect, you may have a bad debt for tax purposes. Pursuant to I.R.C. § 162(a), there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. In this respect, I.R.C. § 166(a)(1) allows a deduction for any debt which becomes worthless during the taxable year. As a threshold matter, two things must be established in order for a taxpayer to qualify for a bad debt deduction: (1) that the debt was bona fide at the time it was created; and (2) that the debt became worthless within the tax year.

Bona Fide Debt

A debt is "bona fide" if it arises from a valid and legally enforceable promise to pay a fixed or determinable sum of money. As a threshold matter, it is necessary to confirm that the loan at issue is, in fact, debt (as opposed to disguised equity). In this respect, the basic question is: was there was a genuine intention to create a debt, with a reasonable expectation of repayment, and did that intention comport with normal business practices? The answer to this question turns on the application of judicially developed factors to the facts and circumstances of the particular case.

Worthlessness

In order for a bad debt deduction to be claimed for tax purposes, the debt at issue must be "worthless." In this respect, worthlessness is a question of fact to be determined by the totality of the circumstances. In general, a debt is "worthless" if the facts and circumstances indicate: (1) that the debt is uncollectible; and (2) that legal action to enforce payment would in all probability not result in satisfaction on a judgment. Uncollectibility and unlikely recovery must be established by reference to identifiable events that demonstrate worthlessness and justify abandonment of hope of recovering the debt.

For federal tax purposes, a foreign-based company must have a U.S. "permanent establishment" in order to be subject to federal taxation. In this respect, the concept of a U.S. permanent establishment essentially means a fixed place of business in the United States. Significantly, however, the permanent establishment concept, which drives federal taxation of foreign-based businesses, is generally irrelevant in the state tax context.

For state tax purposes, an in-state presence does not have to be fixed or permanent. To the contrary, the requisite level of presence for state taxing jurisdiction can be created by the transitory presence of an employee, non-employee representatives, or even non-physical presence. In other words, the level of contact required to establish state taxing nexus is substantially less than the level of contact required to establish federal taxing nexus. As a result, the absence of a permanent establishment for federal tax purposes does not necessarily mean that a foreign-based company is not subject to state taxation in the United States.

It is important for foreign-based companies to be aware of this for several reasons. From a compliance perspective, the compliance costs can be substantial even if the state tax liability itself is nominal - i.e. bookkeeping, tax calculation, return preparation. In addition, from a liability perspective, many state laws, including Florida, often allow for collection of unpaid state taxes from individuals associated with a business who should have been aware of the business's state tax obligations and of the business's failure to comply with those obligations - e.g., partners, officers, managers.

The American Taxpayer Relief Act of 2012 ("2012 Taxpayer Relief Act") was signed into law by President Obama on January 2, 2013. The 2012 Taxpayer Relief Act overrides several tax increases that were scheduled to go into effect in 2013 and preserves several favorable tax provisions that were set to expire at the end of 2012. At the same time, the 2012 Taxpayer Relief Act increases income taxes for certain high income earners and slightly increases transfer tax rates.

Below is a summary of how the provisions of the 2012 Taxpayer Relief Act will impact individual taxpayers.

Preservation of Income Tax Rates for Most Individuals

Income tax rates for most individuals will remain at 10%, 15%, 25%, 28%, 33%, and 35% (as opposed to moving to 15%, 28%, 31%, 36%, and 39.6% as would have otherwise occurred). Note, however, that certain high-income individuals will be subject to an increased tax rate of 39.6% beginning in 2012.

Tax Rate Increases For High Income Individuals

Although the 2012 Taxpayer Relief Act preserved lower income tax brackets for the majority of Americans, tax rates will increase for certain high income individuals. Specifically, a 39.6% rate will apply to income that exceeds an "applicable threshold." The "applicable threshold" is $450,000 for joint filers, $425,000 for heads of household, $400,000 for single filers, and $225,000 for married taxpayers filing separately. These dollar amounts are subject to adjustments for inflation for tax years after 2013.

Capital Gain and Dividend Rate Increases for Higher-Income Taxpayers.

The 2012 Taxpayer Relief Act raised the maximum rate for capital gains and dividends to 20% (up from 15%) for taxpayers with incomes exceeding $400,000 ($450,000 for married filing jointly). In addition, these high-income taxpayers will be subject to the 3.8% surtax on investment income under Section1411 of the Internal Revenue Code, resulting in an aggregate tax rate of 23.8% for higher-income taxpayers.

Capital Gain and Dividend Rates for Other Taxpayers

For taxpayers who are taxed on ordinary income at a rate below 25%, capital gains and dividends will permanently be subject to a 0% rate. Thus, some lower-income taxpayers may actually realize tax savings as compared to the previous rates.

For taxpayers who are taxed on ordinary income at a rate of 25% or more (but whose income levels fall below the $400,000/$450,000"applicable threshold") will continue to be subject to a 15% rate on capital gains and dividends.

In addition, certain taxpayers will be subject to the 3.8% surtax (i.e. married taxpayers with modified adjusted income in excess of $250,000 ($125,000 if married filing separately), all other taxpayers with modified adjusted income in excess of $200,000). For these taxpayers, the maximum tax rate for capital gains and dividends will be 18.8% (15% + 3.8% surtax).

Alternative Minimum Tax ("AMT") Relief

In a nutshell, the AMT is the excess, if any, of the tentative minimum tax for the year over the regular tax for the year. The tentative minimum tax is calculated by adjusting the regularly computed tax liability for certain items. The resulting amount is the alternative minimum taxable income (AMTI), which is subject to an AMT rate of 26% or 28%. The purpose of the AMT is to ensure that higher income taxpayers who would otherwise be able to offset substantial income through the use of favorable deductions and tax credits are liable for a minimum amount of tax. This summary vastly oversimplifies the AMT and is only meant to provide general background information.

Without the 2012 Taxpayer Relief Act, the individual AMT exemption amounts for 2012 would have been $33,750 for single taxpayers, $45,000 for joint filers, and $22,500 for married taxpayers filing separately. Tthe 2012 Taxpayer Relief Act retroactively increased these exemption amounts to $50,600 for single taxpayers, $78,750 for joint filers and $39,375 for married taxpayers filing separately.

Also, without the 2012 Taxpayer Relief Act, many nonrefundable personal tax credits were allowed only to the extent that an individual taxpayer's regular income tax liability exceeded his tentative minimum tax. The 2012 Taxpayer Relief Act retroactively (for tax years beginning after 2011) allows an individual taxpayer to offset his entire regular tax liability and AMT liability by the nonrefundable personal credits.

Retention of Transfer Tax Exemption Amounts (Subject to Rate Increase)

The 2012 Taxpayer Relief Act thwarted a sharp increase in estate, gift and generation-skipping transfer taxes that were scheduled to occur for individuals dying and gifts made after 2012 by permanently preserving the $5 million exemption amount (subject to adjustment for inflation). Note, however, that the 2012 Taxpayer Relief Act also increases the maximum estate, gift and generation-skipping transfer rate from 35% to 40%. As a final note, the 2012 Taxpayer Relief Act maintains the portability feature that allows the estate of the first spouse to die to transfer his or her unused exclusion to the surviving spouse.

Extension of Certain Favorable Tax Provisions for Individuals

The 2012 Taxpayer Relief Act extends the following favorable tax items for individuals that were set to expire at the end of 2012:

American Opportunity Tax Credit extended for 5 years - permits eligible taxpayers to claim a tax credit equal to 100% of the first $2,000 of qualified tuition and related expenses, and 25% of the next $2,000 of qualified tuition and related expenses (for a maximum tax credit of $2,500 for the first four years of post-secondary education)

Deduction for Classroom Expenses of Elementary and Secondary School Teachers - originally expired at the end of 2011; has been revived for 2012 and 2013

Exclusion of Discharge of Qualified Principal Residence Indebtedness from Income - originally applicable to discharges before January 1, 2013; now extended to apply to discharges before January 1, 2014

Treatment of Mortgage Insurance Premiums as Qualified Residence Interest - expired at the end of 2011; has been revived for 2012 and 2013

Option to Deduct State and Local Sales Taxes - expired at the end of 2011; has been revived for 2012 and 2013

Special Rule for Contributions of Capital Gain Real Property made for Conservation Purposes - expired at the end of 2011; has been revived for 2012 and 2013

Above-the-line Deduction for Qualified Tuition Expenses - expired at the end of 2011; has been revived for 2012 and 2013

Tax-Free Distributions from Individual Retirement Plans for Charitable Purposes - expired at the end of 2011; has been revived for 2012 and 2013. (Note: Because 2012 has already passed, a special rule allows distributions taken in 2012 to be transferred to charities for a limited period in 2013. In addition, certain distributions made in 2013 can be treated as deemed made on December 31, 2012)

50% Bonus Depreciation - extended for 1 year so that bonus depreciation continues to be available for qualified property placed in service before 2014

Most states take the position that corporations owned by Native Americans are subject to generally applicable corporate income taxes on the ground that a corporation is a legal entity separate and apart from its Native American shareholders. Indians cannot enjoy the benefits of corporate limited liability while simultaneously rejecting the burden of taxation that comes along with it ... they have their cake and eat it too, right? Actually, maybe they can if all of the corporation's income is earned from activities on the reservation.

Central Machinery Company v. Arizona State Tax Commission involved an isolated sale of tractors to Indians on a reservation by a non-Indian corporation with no permanent establishment on the reservation. There, the Supreme Court invalidated Arizona's gross receipts tax, holding that the transaction was "plainly subject to federal regulation" (emphasis added). To be clear, a gross receipts tax is in the nature of a sales tax, not an income tax. But if the gross receipts tax in Central Machinery was so plainly preempted by federal regulation of Native Americans, it is hard to imagine that income derived from regular sales to Indians on a reservation by an Indian-owned corporation deriving all of its income from activities on the reservation would not be similarly exempt from state taxation.

The Indian Reorganization Act of 1934 encouraged Indians to self-govern and manage their own affairs. One contemplated way of doing this was through the "creation of chartered corporations." See Mescalero Apache Tribe v. New Mexico. Moreover, the Act sought to put control of Indian affairs "in the hands of an Indian council or . . . a corporation organized by the Indians." Id. Given Congress' specific contemplation of Native American owned corporations as mechanisms to facilitate Indian sovereignty and self-governance, this comprehensive federal regulatory scheme arguably preempts a state corporate income tax with respect to a corporation that is wholly owned by Native Americans and that derives all of its income from activities on the reservation.

Under the general provisions of I.R.C. § 332, no gain or loss is recognized by a parent company upon liquidation of an 80% or more owned subsidiary. However, this result may be changed when a foreign subsidiary is the subject of the liquidation.

To the extent that the foreign subsidiary has accumulated earnings and profits ("E&P") from active foreign business operations, that E&P will be subject to U.S. taxation at the domestic parent company level upon liquidation. This is because these earnings and profits were generated by non-subpart F income that was not "effectively connected" with an active U.S. trade or business. Therefore, these earnings and profits have never been subjected to U.S. taxation. If these earnings and profits were allowed to travel up to the domestic parent company tax-free under Section 332, then untaxed E&P would effectively become available for distribution to the domestic parent company's shareholders.

The way the Internal Revenue Code deals with this is to impose a toll charge of sorts upon repatriation of the foreign subsidiary's assets into the United States. More specifically, the U.S. parent company must include a deemed dividend in income based on something called the "all E&P amount." The "all E&P amount" is basically the untaxed E&P that has accumulated in the foreign subsidiary under the parent company's period of ownership. As a final note, it is worth mentioning that there may be foreign tax credit implications as a result of this inclusion. In this respect, the deemed dividend included by the U.S. parent would be a foreign source dividend. This foreign source dividend, in turn, may carry with it a portion of foreign taxes paid with respect to that E&P and the related foreign tax credits.

Under Subpart F of the Internal Revenue Code, U.S. shareholders of a controlled foreign corporation ("CFC") must include the CFC's "subpart F income" on their U.S. income tax returns. I.R.C. § 951. For a foreign corporation to be classified as a CFC for tax purposes, it must be controlled by U.S. shareholders. Significantly, the terms "control" and "U.S. shareholder" are specifically defined legal terms. In this respect, "control" means more than 50% of the vote and value of the corporation and a "U.S. shareholder" means a shareholder who holds 10% or more of the total voting power. Thus, a foreign corporation is considered a CFC if 10% shareholders collectively own more than 50% of the corporation.

But how is "U.S. shareholder" status determined when a U.S. partnership owns a foreign corporation? For instance, consider the scenario where a U.S. general partnership owns 100% of a foreign corporation that generates subpart F income. Assume that none of the individual partners hold a greater than 5% partnership interest. Since none of the individual partners hold a greater than 5% partnership interest, none of them can constructively be considered "U.S. shareholders" by application of upward entity attribution (because 10% ownership is required). Therefore, the foreign corporation cannot be considered a CFC, and none of the individual partners will be required to recognize subpart F income, right? Wrong. A U.S. partnership is considered a "U.S. person" for tax purposes. I.R.C. § 7701(a)(30). Moreover, nothing in Subpart F or the regulations thereunder indicates that a domestic partnership cannot be a "U.S. shareholder" for Subpart F purposes. Consequently, the U.S. partnership would be considered to be a U.S. shareholder because it satisfies the 10% or more ownership test. Moreover, since the U.S. partnership owns more than 50% of the foreign corporation, the foreign corporation would be considered a CFC. As a result, the partnership will have Subpart F income, and because a partnership is a pass-through entity, this Subpart F income will pass-through to the individual partners, notwithstanding the fact that none of them are "U.S. shareholders" within the definition of that term.

Takeaway: Partners of a U.S. partnership with an interest in a foreign corporation may have Subpart F income to report.

Partnerships and LLCs taxed as partnerships are pass-through entities in the sense that all of the income and expense items pass through the entity to the individual partners and are reported on the partners' individual tax returns. In order to prevent abuse, the tax code places several limits on the deductibility of partnership losses. One such limit is the "at risk" principle found in Section 465 of the Internal Revenue Code. Pursuant to that statute, a partner (or LLC member in an LLC taxed as a partnership) may deduct partnership losses only to the extent that he or she is "at risk." In other words, partnership losses are deductible only to the extent of the partner's financial risk exposure (i.e. how much money the partner stands to lose). Of course, a partner is "at risk" to the extent of cash contributions that have been made to the partnership. I.R.C. § 465(b)(1). However, a partner is not considered at risk for required future capital contributions unless and until the partner actually contributes the funds. Prop. Treas. Reg. § 1.465-22(d).

At the same time, however, a partner's amount at risk includes borrowed amounts to the extent that the partner is personally liable for repayment of a partnership debt. I.R.C. § 465(b)(2); Prop. Treas. Reg. § 1.465-24(a). In this respect, a partner is "personally liable" for at-risk purposes if he has ultimate liability to repay the partnership debt obligation. In other words, we are looking for the person upon whom the liability will eventually fall upon as a practical matter. At a high level then, the determination as to whether a partner is "at risk" with respect to a partnership or LLC debt appears to be a specific application of economic substance principles. Since economic reality controls the at-risk analysis, logic would dictate that a partner should be entitled to an increased at-risk amount to the extent that a deferred or future contribution obligation makes the partner potentially liable for a partnership debt, notwithstanding the rule articulated in Prop. Treas. Reg. § 1.465-22(d). This result is arguably supported by judicial authority.

In Hubert v. Commissioner, the Sixth Circuit effectively held that a partner's contribution obligation can support an increased at-risk amount to the extent that it operates in a way that causes the partner to become liable for a portion of the partnership's debts. Similarly, the Tax Court has held a partner to be at risk with respect to a deferred contribution obligation where the partnership pledged its right to receive that future contribution to an unrelated institutional lender as collateral for a bank loan. See Melvin v. Commissioner. The Tax Court reasoned that the deferred capital contributions would ultimately serve as the source of repayment in the event of the partnership's default on the loan.

In light of the foregoing, a partner may be at risk with respect to future contribution obligations. This increased at-risk amount would allow the partner to deduct a greater portion of his distributive share of a partnership loss. Note, however, that the circumstances under which a future contribution obligation is sufficient to support at-risk basis are very specific.

If you need help calculating your at-risk amount or structuring a partnership loan transaction to support an increased at-risk amount, contact me today.

The Supreme Court is set to review the Defense of Marriage Act ("DOMA") soon. In my opinion, DOMA violates at least three separate provisions of the U.S. Constitution. Most obviously, DOMA clearly violates the explicit guarantee of equality contained in the Equal Protection Clause. In addition, DOMA violates the Due Process Clause insofar as it deprives a significant minority of Americans of the constitutional right of marriage. Finally, DOMA arguably violates the First Amendment's guarantees of religious freedom insofar as primary opposition to same-sex marriage appears to be religiously based. In light of the foregoing, I expect the Supreme Court to invalidate DOMA. From a tax perspective, the invalidation of DOMA will trigger a right to tax refunds for prior year overpayments (because same-sex married couples have been denied the favorable tax treatment associated with being married). From a tax planning perspective, same-sex couples who may be entitled to a tax benefit should not wait for a final decision from the Supreme Court before filing a protective refund claim with the Internal Revenue Service. Rather, same-sex couples who are legally married should file claims now in order to protect their refund rights from expiring under the three-year statute of limitations that applies with respect to tax refund claims.

The U.S. Supreme Court has agreed to consider whether a domestic taxpayer is entitled to a foreign tax credit based on its payment of a windfall tax to the U.K. government. The Court's decision to grant certiorari in PPL Corp is expected to resolve a split among the circuit courts of appeal.

Facts

Beginning in the mid-1980s, the U.K. privatized several utility companies by selling shares in the public market. Following privatization, costs were reduced, and these utility companies became enormously profitable as a result. The shareholders who initially purchased stock of the utility companies were therefore able to sell the shares at enormous profits. Upon seeing this, the U.K. government effectively concluded that the utility companies were privatized at too low of a price (i.e. the government did not get enough money for the shares). Accordingly, the government decided to impose a windfall profits tax. The windfall tax was a one-time 23 percent tax on the difference between each company's profit-making value and the price for which the U.K. government had sold it. Many U.S. taxpayers had acquired shares in these utility companies. Consequently, the question quickly became whether the windfall profits tax was a creditable tax for foreign tax credit purposes.

Procedural History

The taxpayer involved in PPL filed a refund claim seeking a foreign tax credit for windfall profits tax paid to the U.K. The IRS disallowed the refund and the taxpayer petitioned the Tax Court.

The Tax Court initially held that the taxpayer was entitled to a foreign tax credit on the ground that the tax was on profits making it essentially in the nature of an income tax. However, the IRS appealed, and the Third Circuit Court of Appeals concluded that the windfall profits tax was not a creditable foreign tax and reversed the Tax Court. Significantly, however, the Fifth Circuit Court of Appeals agreed with the Tax Court in a companion case (Entergy Corp.).

Certiorari Granted

As previously mentioned, the Third Circuit and the Fifth Circuit reached opposite conclusions regarding the deductibility of the U.K. windfall profits tax. The Supreme Court opinion will resolve this judicial split between the Third and Fifth Circuits. Hopefully it will also provide some insight for future analysis of foreign tax credit issues. However, the U.K. windfall profits tax is very unique and therefore the opinion will likely be narrow and specific to the nature and characteristics of the U.K. windfall profits tax. With that being said, I would not expect on too much insight beyond what we already have in terms of foreign tax credit analysis as a practical matter.

The Digital Goods and Services Tax Fairness Act (H.R. 1860) was introduced May 12, 2011 and would prohibit state and local governments from imposing taxes on certain sales of digital goods and services that are taxable under current law. The stated intention of H.R. 1860 is to promote neutrality, simplicity, and fairness in the taxation of electronic goods and services. But good intentions are not enough.

As a threshold matter, the proposed legislation arguably exceeds Congress' enumerated powers.

Commerce Clause. The Supreme Court has substantially narrowed its interpretation of the scope of the commerce power in recent years. In this regard, the Court has emphasized the importance of distinguishing between national matters and matters that are truly local. State and local taxation is a local matter insofar as revenue needs and tax issues vary among jurisdictions. The states are in the better position to identify issues with their tax systems and implement remedial measures.

14th Amendment. State action is a necessary prerequisite to the exercise of Congress' Section 5 power. It does not appear that Congress has made any factual findings of actual incidences of discriminatory taxation. To be sure, preventative rules are sometimes necessary, but even then, they must be appropriately tailored to reach the perceived threat in order to pass constitutional muster. The restrictions imposed on states' taxing rights by this legislation are too great in comparison to the threat of discriminatory taxation.

Even if Congress has authority to enact this legislation, the focus on tangible versus intangible is misplaced. A sales tax is best summarized as a tax on consumption. In this respect, there are two basic precepts to the sales tax: (1) all personal consumption should be taxed; and (2) all business inputs should be exempt. Yet, the inquiry as to whether the thing being conveyed is tangible or intangible says nothing about personal consumption or business inputs. Not only does this legislation focus on the wrong issue, but it also explicitly contravenes the established principle that business inputs should not be taxed. See Sec. 5(2)(B) (specifying business location as tax address for sourcing purposes when item is delivered to a business); Sec. 5(2)(F) (indicating that advertising services are sales taxable).

Moreover, although the proposed legislation apparently seeks to "promote neutrality, simplicity, and fairness in the taxation of digital goods and services," it will actually do the opposite. A "digital good" includes a variety of downloadable content - e.g., software, music albums, films, e-books, photography. Significantly, the downloaded content is no different than the content acquired through off-the-shelf software, CDs, DVDs, traditional books, or traditional photos. Yet, these items would be subject to a special federal tax regime under the proposed legislation. Such disparity is not neutral, simple, or fair. The substance of the transaction rather than the form of delivery should govern tax consequences. In this respect, the focus should be on consumption.

To be sure, risks of multiple taxation remain even when the focus is on consumption. However, States are competent to deal with these issues, and the drafters of this bill would agree according to Section 8 (expressing States' competency to deal with multiple taxation in international context). In the e-commerce environment, the issues of multiple taxation are similar domestically and internationally. So if Congress has faith in the States' ability to handle the issue on an international level, then the States are certainly competent to handle the issue domestically.

A taxpayer who underpays their tax liability may be subject to an accuracy-related penalty under Section 6662 of the Internal Revenue Code. That statute provides for a penalty equal to 20% of the underpayment of tax. So this is something that can definitely add up.

There are three types of accuracy-related penalties under Section 6662:

(1) Negligence;
(2) Disregard of Rules and Regulations; or
(3) Substantial Understatement.

Negligence

In the tax context, the term negligence essentially means a failure to make a reasonable attempt to comply with the provisions of the Internal Revenue Code or a failure to exercise ordinary and reasonable care in the preparation of a tax return. I.R.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(1). Thus, the relevant question is essentially whether a reasonable taxpayer would have made similar compliance efforts under similar circumstances. If the answer is yes, than the taxpayer's underpayment cannot be said to be the result of negligence. But if a reasonable taxpayer would have made more of an effort to comply with the tax law, then the taxpayer might be subject to a negligence penalty.

Disregard of Rules and Regulations

When the Internal Revenue Code refers to a disregard of tax rules and regulations, it contemplates taxpayer conduct that is in disregard of the Internal Revenue Code, Treasury regulations, or IRS authority. I.R.C. § 6662(c); Treas. Reg. § 1.6662-3(b)(2). But in order for a taxpayer to be considered to have "disregarded" the rules or regulations, the taxpayer's non-compliance must be careless, reckless, or intentional. In this respect, a taxpayer's disregard of tax rules is "careless" if the taxpayer fails to exercise reasonable diligence to determine the correctness of a tax return position. Treas. Reg. § 1.6662-3(b)(2). A taxpayer's disregard of tax rules is "reckless" if the taxpayer makes little or no effort to determine whether a rule or regulation exists under circumstances which demonstrate a substantial deviation from the standard of conduct that a reasonable person would observe. Id. Finally, a taxpayer's disregard of tax rules is "intentional" if the taxpayer knows that a rule exists, but nevertheless disregards it. Id. Thus, whether a taxpayer has disregarded rules and regulations within the contemplated meaning of this statute is a subjective analysis which will necessarily turn on the facts and circumstances of the particular case.

Substantial Understatement

In determining whether there has been a "substantial understatement" within the meaning of the statute, the question is whether the taxpayer understated the gross tax on the return by the greater of $5,000 or 10% of the gross tax required to be shown. Thus, unlike the previous two grounds for assessing an accuracy-related penalty, this ground is clear and objective.

It is important to note that only one 20% accuracy penalty can apply under I.R.C. § 6662. See Treas. Reg. § 1.6662-2(c) (providing that there can be no stacking of accuracy-related penalties). That is, the IRS cannot assess multiple accuracy penalties, even if the taxpayer's understatement satisfies more than one of the three grounds discussed above. Note, however, that the IRS may permissibly assess both an accuracy penalty and a delinquency penalty. For a summary of IRS delinquency penalties, see IRS Delinquency Penalties in a Nutshell.

As a final matter, keep in mind that there are defenses that can be asserted to avoid IRS penalties. For an overview of IRS penalty defense, see IRS Penalty Defense 101.

Is the IRS asserting that you owe an accuracy-related penalty? Contact me today. I may be able to obtain a waiver of the penalties, and consultation is always free.

There are several ways to defend against IRS penalties. Sometimes the asserted defense will depend on the type of penalty at issue, but the most common defense is "reasonable cause." The primary authority for this defense is found in I.R.C. § 6664(c), which provides that, "[n]o penalty shall be imposed . . . if it is shown that there was a reasonable cause . . . and that the taxpayer acted in good faith." See also Treas. Reg. § 1.6664-4(a).

Sounds simple enough, but "reasonable cause" is a legal term of art, and the tax law defines it in abstract terms. The Treasury Regulations tell us that "reasonable cause" entails the exercise of ordinary business care and prudence to comply with the tax law. Treas. Reg. § 301.6651-1. But that begs the question: what constitutes ordinary business care and prudence? That depends.

One thing that I have learned as a lawyer is that people hate it when lawyers answer questions with, "it depends." But before you kill the messenger, let me explain. The standard of reasonable cause "depends" because the determination is made on a case-by-case basis taking into account all pertinent facts and circumstances. See Treas. Reg. § 1.6664-4(b). In this respect, the most important factor is the extent of the taxpayer's effort to properly comply with tax obligations. Id. In other words, what we need to establish to prevail in petitioning the IRS to waive civil tax penalties is that the taxpayer's non-compliance was not only unintentional but that the taxpayer in fact tried to comply with the relevant tax obligation.

Is the IRS trying to assess penalties against you? Contact me today! I may be able to obtain an abatement of the penalties, and consultation is always free!

If you're reading this, your attempted negotiations with the IRS have likely been unsuccessful, and you are considering bringing your case to court. At this stage of the tax controversy, a taxpayer has two options in terms of where to file the lawsuit. One option is to file a petition with the United States Tax Court. The other option is to file a petition with the United States District Court in your jurisdiction. While the decision between tax court and district court may seem inconsequential, this is actually a critical strategic decision that can affect the ultimate outcome of the litigation in some cases.

Pay to Play

In Tax Court, a taxpayer is not required to "pay to play." That is, a taxpayer can dispute the matter in Tax Court without first paying the disputed tax. By contrast, a taxpayer is required to pay the disputed tax, including penalties and interest, prior to filing a lawsuit in district court. This single factor is the determining factor for many taxpayers because paying the tax upfront can be difficult. However, for taxpayers who have the ability to pay, there are several additional considerations that should be taken into account before deciding on where to file the lawsuit.

Scope of Jurisdiction

Once a taxpayer is in Tax Court, the Tax Court acquires exclusive jurisdiction over the entire tax year at issue, regardless of whether the issue was raised in the IRS' pre-trial correspondence. By contrast, the district court's jurisdiction is limited to the specific claim pleaded and filed with the court. As a result, if there are potential additional tax issues that the IRS has not raised, a taxpayer may want to consider filing the lawsuit in district court in order to limit jurisdiction.

Jury

The right to a jury trial and other protections typically associated with litigation are only available in courts which are established under Article 3 of the U.S. Constitution (i.e. "Article 3 courts"). The federal district courts are all Article 3 courts. Consequently, a taxpayer who files in district court is entitled to all of the protections typically afforded to litigants, including the right to a jury of peers. By contrast, the U.S. Tax Court was created under the authority of Article 1 of the U.S Constitution. As a result, there is no right to a jury in Tax Court. Instead, Tax Court cases are decided by the judge in what is commonly referred to as a "bench trial." Thus, if a taxpayer thinks that a jury may be advantageous, he or she should consider filing the lawsuit in district court. For instance, a taxpayer accused of civil tax fraud may want to consider filing the lawsuit in district court given the subjective analysis involved in fraud cases. Similarly, taxpayers with sympathetic cases that a jury would likely be able to relate to may want to consider filing the lawsuit in district court.

Tax Expertise

All of the judges in Tax Court are tax experts. Most of them worked as tax lawyers at prestigious law firms and public accounting firms, and many of them possess accounting degrees, CPAs, and LL.M degrees in taxation. By contrast, district court judges are typically not tax experts, and while some of them may have general business backgrounds, most of them lack prior accounting or tax experience. In cases involving complex tax issues or interpretation and application of technical tax rules, the taxpayer may therefore want to consider filing the lawsuit in Tax Court. However, if the application of technical tax rules is likely to result in an adverse result, the taxpayer may want to consider filing the lawsuit in district court where that technical rule may be given less weight.

Opposing Counsel

The government sends lawyers from the IRS Office of Chief Counsel to prosecute cases in Tax Court. By contrast, the government sends lawyers from the U.S. Department of Justice ("DOJ") to prosecute cases in district court. Many of the lawyers from the DOJ work primarily in the criminal division (rather than civil tax controversies) and consequently have a reputation for being aggressive. As a result, the case may be prosecuted more vigorously in district court. At the same time, Tax Court is like the IRS' home court, so in that respect, the government as a home court advantage of sorts in Tax Court. A taxpayer should consider both of these aspects in determining where to file the lawsuit.

Procedure

Litigation in Tax Court is governed by special procedures that are different from those that govern other federal courts. In this respect, there are different discovery rules, different requirements for parties' briefs, etc. As compared to the Federal Rules of Civil Procedure which govern in other federal courts, the Tax Court rules are less formal. For instance, the parties are required to stipulate as many facts as possible. In practice, this often means that the parties have agreed to the relevant facts prior to trial so that the court is only evaluating the legal merits of the case and not considering any factual disputes. For taxpayers who elect to represent themselves against the IRS (which I would not recommend), the informal practice and procedure of the U.S. Tax Court may be less intimidating and more conducive to pro se representation.

A taxpayer must go to IRS Appeals prior to going to Tax Court. In this respect, a taxpayer has two options:

(1) the taxpayer can pursue what is referred to as a "non-docketed appeal" following receipt of the 30-day letter*; or

(2) the taxpayer can pursue a "docketed appeal" following receipt of the statutory notice of deficiency.**

So which route should you take? In matters of tax law, the answer is usually a resounding "it depends," and the answer is no different here. There are potential advantages to both courses of appeal, so a taxpayer should consider the advantages of each and make his or her decision accordingly.

Docketed Appeal. Waiting to go to IRS Appeals is mostly a strategic trial decision and probably the more aggressive course of action. Most significantly, by waiting until after receipt of the 90-day letter, the taxpayer is able to learn more about the government's case against him or her. Additionally, some practitioners believe that waiting for appeal sends a signal to the IRS that you're tough and not willing to immediately settle. Similarly, waiting creates a little bit of time pressure since the case is docketed on the Tax Court's calendar at this point. Thus, the IRS may be more willing to settle as the trial date approaches.

Non-Docketed Appeal. Notwithstanding the foregoing, there are two very good reasons to consider a non-docketed appeal earlier on. First, all information relating to the tax controversy is protected by privacy laws at this stage of the controversy. See I.R.C. § 6103 (providing that all tax returns and return information shall be confidential). However, once the petition is filed with the Tax Court, it becomes a matter of public record. Second, in cases where it is determined that the IRS was not justified in taking the taxpayer to court, then the court can compel the IRS to pay the taxpayer's legal costs. See I.R.C. § 7430. Significantly, however, a taxpayer must "exhaust all administrative remedies," including pursuit of a non-docketed appeal, in order to be eligible to receive legal costs under this statute. See .R.C. § 7430(b). Thus, if the taxpayer's case is sufficiently strong so that the IRS could potentially be viewed as unjustified in going to court, then the taxpayer would be well-advised to pursue a non-docketed appeal in order to preserve the right to relief under Section 7403.

* The 30-day letter is a form letter which states the determination proposed by the IRS. It is accompanied by a copy of the IRS report explaining the basis for the proposed IRS determination. If the taxpayer agrees with the IRS, he or she can indicate agreement by executing and returning a waiver or acceptance. Alternatively, if the taxpayer disagrees with the IRS, he or she can appeal within 30 days.Treas. Reg. §601.105(d).

**If the taxpayer does not respond to the 30-day letter within the 30-day period, then a statutory notice of deficiency will be issued. The taxpayer has 90 days from the mailing of this letter to petition he Tax Court. I.R.C. § 6213(a).

There are two types of IRS delinquency penalties, one for failure to timely file a return and another for failure to timely pay tax owed. The failure to file penalty applies if a taxpayer files a tax return after the due date (including extensions). I.R.C. § 6651(a)(1). The failure to pay penalty applies if a taxpayer pays the tax owed after the due date (excluding extensions). I.R.C. § 6651(a)(2).

Amount of Penalty

The amount of the penalty depends on which delinquency penalty we are talking about. With respect to the failure to file penalty, the penalty is equal to 5% of the net tax required to be shown for each month, or fraction thereof, that the return is late. With respect to the failure to pay penalty, the penalty is equal to 0.5% of the net tax shown for each month, or fraction thereof, that the return is late.

In order to understand the practical application of these penalties, three things must be noted:

(1) The method for calculating the failure to file penalty is different than the method for calculating the failure to pay penalty.

If you look at the statutory language of I.R.C. § 6651(a), the failure to timely file penalty is calculated by reference to the tax required to be shown whereas the failure to timely pay penalty is calculated by reference to the tax shown. In other words, the failure to timely file penalty is applied to the tax that should have been reported on the return whereas the failure to timely pay penalty is applied to the tax that was actually reported on the return.

This is best illustrated by an example. Assume that an individual taxpayer's total federal income tax owed is $100,000. [This is the amount of tax required to be shown]. The return is due on April 15. The taxpayer files his return on July 16 at which time he reports and pays $75,000 of federal income tax. [This is the amount of tax actually shown]. Both a failure to timely file penalty and a failure to timely pay penalty would apply here.

The failure to timely file penalty would be equal to 20% of the $100,000 of tax required to be shown, or $20,000. Right now, you're probably wondering why I just applied a 20% penalty when the statute provides for a 5% penalty. The answer is because the penalty is not 5% in the aggregate but rather 5% for every month (or fraction of a month) that the return is late. Here, the return was due on April 15, but filed on July 16. Thus, the return was 3 months and 1 day late, or 4 units. 5% for each of these 4 units is equal to 20%. So you can see here that just 1 day can make a big difference when you're talking about tax penalties.

The failure to pay penalty would be equal to 2% (0.5% penalty * 4 units late) of the $75,000 tax actually reported (not the $100,000 tax that should have been reported) on the return, or $1,500.

(2) Total Delinquency Penalties Capped at Failure to File Penalty

In cases where both the failure to file penalty and the failure to pay penalty apply, the failure to file penalty is reduced by the failure to pay penalty with the practical effect being that the aggregate delinquency penalty is limited to the amount of the failure to file penalty.

Once again, this is best illustrated by an example. In the above example, it was determined that a failure to file penalty of $20,000 and a failure to pay penalty of $1,500 would apply. However, the $20,000 failure to file penalty would be reduced by the $1,500 failure to pay penalty resulting in failure to file penalty of $18,500 and a failure to pay penalty of $1,500 for an aggregate delinquency penalty of $20,000. See I.R.C. § 6651(c).

(3) Maximum Penalty of 25% of Tax Required to be Shown

Both the failure to file penalty and the failure to pay penalty are subject to a cap of 25% of the tax required to be shown. That is, the maximum penalty that can be imposed for late filing or late payment is 25% of the tax that should have been reported on the return. In our example above, the maximum penalty allowed would be $25,000 (25% * $100,000 tax required to be shown). In our example, however, the $20,000 penalty calculated is less than the $25,000 maximum penalty allowed, so the 25% cap is not triggered.

Behind on your taxes? Contact me. I may be able to help you obtain some relief from IRS penalties and interest, and consultation is always free.

A federal court has held the denial of federal tax benefits to same-sex couples to be unconstitutional. More specifically, the Second Circuit held that the federal government unconstitutionally denied an estate tax marital deduction to a same-sex couple. See Windsor v. U.S., 2d. Cir., No. 12-2335-cv(L) (October 18, 2012).

But the implications of this case are far broader than the tax implications. Significantly, the Windsor Court treated sexual orientation as a quasi-suspect class, applying a heightened level of constitutional scrutiny. From an analytical perspective, this is a perceptible and welcomed improvement from many prior cases which have identified sexual orientation as a non-suspect class subject to an extremely low threshold of constitutional review. Moreover, the Court held that the denial of the federal tax benefit in this case was unconstitutional based on the broader holding that Section 3 of the Defense of Marriage Act ("DOMA")* was unconstitutional. This is another big step toward marriage equality.

*Section 3 of the Defense of Marriage Act ("DOMA") defines "marriage" as a relationship between a man and a woman and thereby legally codifies the non-recognition of same-sex marriages for all federal purposes, including federal tax benefits.

If you're reading this article, your corporation has probably experienced some sort of significant change recently and you're wondering whether you need to obtain a new employer identification number ("EIN") from the IRS.

As a general rule, a corporation must obtain a new EIN following an ownership or structure change. Most commonly, this includes:

• Receipt of a new charter from the state;
• A change from a partnership or sole proprietorship to a corporation; and
• Creation of a new corporation as a result of a statutory merger.

On the other hand, a corporation is not required to obtain a new EIN for minor changes such as a corporate name change, a change of the corporation's location, or an election by a c-corporation to be taxed as an s-corporation. In addition, a corporation may be able to retain its EIN following some significant events such as declaration of bankruptcy or a corporate reorganization.

At the end of the day, each case will turn on the particular facts and circumstances of that case. With that being said, anyone who is unsure of whether a new EIN is required should consider consulting with a tax professional who will be able to make a determination and initiate the EIN request process if necessary.

According to statistics released by the IRS, approximately 10 out of every 1,000 individual tax returns will be selected for audit. So what should you do if your return is selected for audit?

#1 - Relax!

Just because your return has been selected for audit, doesn't mean you've done anything wrong. A return may be selected for audit for any of the following reasons:

Certain Types of Transactions: the IRS has identified certain types of transactions as deserving of special scrutiny due to the potential for abuse;

DIF Score: DIF score stands for "discriminate index function" score. This is a special algorithm that has been developed by the IRS used to select returns for audit. Basically, the IRS has collected information over the years relating to typical income and deduction amounts for similarly situated taxpayers. If your amounts fall outside this range, your return may be selected for audit;

Information Gathering: Sometimes the IRS may audit people simply to collect information for the purpose of being able to audit in the future - i.e. for the purpose of the DIF score.

#2 - Understand the Audit Process

There are three types of IRS audits:

(1) Correspondence Audit
(2) Office Audit
(3) Field Audit

A correspondence audit is usually settled with the IRS via mail without any in-person contact between the taxpayer and the IRS. For instance, the IRS will challenge a specific item, and the taxpayer will provide substantiation for that item via mail. Once the IRS receives this information from the taxpayer substantiating the tax position, the audit will be closed.

In an office audit, the taxpayer will be asked to come to the IRS office with documentation to substantiate the challenged tax position. If the taxpayer is able to produce sufficient documentation to substantiate the tax position, the audit will be closed following this meeting.

In a field audit, the IRS will actually go to the taxpayer's residence and/or place of business in an effort to collect information. This is the type of audit that most people think of when they think of an IRS audit, but the truth is that most audits will be either of the correspondence of office type.

If the IRS finds no problem following the audit, it will issue a no change letter stating that no change is required with respect to the challenged tax return. If, on the other hand, the IRS finds a problem, it will propose that an adjustment be made to the challenged tax return. The taxpayer can agree to the proposed adjustment and pay the additional tax or the taxpayer can challenge the proposed adjustment. If the taxpayer challenges the adjustment, the road to Tax Court begins.

Is the IRS auditing your return? I can help defend your IRS audit. Contact me for a free consultation.