The Large Business and International (LB&I) of the Internal Revenue Service (IRS) has announced five additional compliance campaigns. The campaigns target AMT credits carryforwards, S corporation distributions, virtual currency, reorganizations, and transition tax.
A compliance campaign is pretty much what it sounds like: an attempt to get taxpayers to comply with existing laws. Typically, it works like this. First, the IRS identifies a behavior that’s considered a concern – like, say, failing to report offshore income. Then, the IRS tries to figure out how best to educate taxpayers about the problem while also curbing the behavior.
Curbing the behavior can many different forms. One of the most obvious is increased or targeted audits. The IRS may send out “soft letters” – think of those as a stern warning. Those letters advise the taxpayer that the IRS is aware of behavior that could be problematic, and as a first step, they are advising taxpayers of their filing requirements and may ask for additional information. A soft letter can look like this (example downloads as a pdf) and include language like this:
We’re sending you this as an inquiry. This inquiry is not an audit of your tax return, or of your failure to file one.
Campaigns are generally developed after significant research to maximize results. Clearly, if there is a problem that IRS sees on repeat, that’s worth consideration. True to form, the IRS says the most recent campaigns “were identified through LB&I data analysis and suggestions from IRS employees.”
But before you stop reading because maybe, say, you’re a small business (and not a large one), consider this: Targets are targets. Don’t be fooled by the “large business” label. While it’s true that campaigns are developed with certain taxpayers in mind, these are universal tax issues that could affect numerous taxpayers, including small businesses.
Here’s what you need to know about the campaigns:
1. Restoration of Sequestered AMT Credit Carryforward.
This is a highly technical issue, yet ranks first on the most recent list of campaigns. Here’s the problem. Corporations are sometimes entitled to refundable Alternative Minimum Tax (AMT) credits which they can carry forward. But remember sequestration? That results in automatic cuts: The idea is that if spending exceeds revenues in the budget, spending should automatically be cut. As a result, under the Balanced Budget and Emergency Deficit Control Act of 1985 (sometimes called Gramm-Rudman-Hollings Deficit Reduction Act), corporations entitled to refundable AMT credits during sequestration must reduce their claims by a sequestration rate. Refunds which are issued or applied to a subsequent year’s tax (a carryforward) remain subject to sequestration and are a permanent loss of refundable credits. Taxpayers may not simply put them back. According to the IRS, soft letters will be mailed to taxpayers making improper restorations of sequestered amounts, and the IRS will monitor taxpayers for subsequent compliance.
2. S Corporation Distributions
It shouldn’t surprise anyone to see S corporation distributions on the list. There is wiggle room on distributions, and the IRS and taxpayers often disagree on the sweet spot, making S corporations an audit target. The IRS has now identified three specific issues to be part of a compliance campaign:
- When an S Corporation fails to report gain upon the distribution of appreciated property to a shareholder.
- When an S Corporation fails to determine that a distribution, whether in cash or property, is properly taxable as a dividend.
- When a shareholder fails to report non-dividend distributions in excess of their stock basis that are subject to taxation.
If that sounds complicated, here’s the gist. S corporation shareholders generally contribute property – which can be cash but doesn’t have to be – to the corporation. When the corporation makes distributions, those distributions are not considered income to the shareholder so long as the distribution does not exceed the shareholder’s basis in the stock. If the distribution does exceed the shareholder’s basis, the excess is taxed as capital gain. That means that the corporation should be tracking the basis for each shareholder, but that doesn’t always happen as it should.
The IRS will attempt to tackle this issue with issue-based examinations (that means audits), tax form change suggestions, and stakeholder outreach.
3. Virtual Currency
We expect to see IRS targeting taxpayers on virtual currency quite a bit in the near future. As IRS argued for a subpoena in the Coinbase case (more on that here), one statistic, in particular, stood out: In 2016, only 802 individual tax returns out of the 132 million filed electronically with the IRS reported income related to cryptocurrencies.
The IRS intends to tackle the problem in many ways, including outreach and examinations. Accordingly, taxpayers with unreported virtual currency transactions are urged to correct their returns as soon as practical. The IRS stated very clearly that it “is not contemplating a voluntary disclosure program specifically to address tax non-compliance involving virtual currency.” It’s worth noting that many tax practitioners expect that to change.
(For more on what you need to know about cryptocurrency and taxes, click here.)
4. Repatriation via Foreign Triangular Reorganizations
You probably know more about foreign triangular reorganization transactions than you think. They’ve been in the news over the past few years as part of discussions surrounding corporate inversions. At the end of 2016, the IRS issued Notice 2016-73 (downloads as a pdf), which targeted transactions which were allegedly “tax-free” because of the use of these certain foreign triangular reorganization transactions. The IRS was specifically targeting the so-called “Killer B” re-organizations – for example, where a subsidiary buys shares of a parent company so that the parent can make a tax-free acquisition of a target corporation. Among other things, the Notice makes clear that if the target corporation is a foreign corporation, the Killer B regulations will be triggered. The IRS intends to “identify and challenge these transactions” that are arranged in an effort to avoid tax.
5. Transition Tax
In April of this year, the IRS provided more guidance in the form of Notice 2018-26 (downloads as a pdf) for computing the transition tax on the untaxed foreign earnings of foreign subsidiaries of U.S. companies under the Tax Cuts and Jobs Act (TCJA). It’s a complicated concept (the Notice alone is 43 pages) but generally, under section 965 of the Tax Code, a U.S. shareholder is liable for a transition tax on the untaxed foreign earnings of certain specified foreign corporations as if those earnings had been repatriated to the United States (even if they are not). Hadn’t heard of it? You’re not alone. The IRS is engaging in an outreach campaign to raise awareness about this provision.
That’s all – for now. Last year, LB&I announced the rollout of its first 13 campaigns; additional campaigns followed. Currently, IRS is conducting a review to see whether the TCJA might impact any of the existing campaigns. Any related information will be communicated once the review is complete.
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