FEDERAL TAX UPDATES
West Virginia Tax Institute
67th Annual Meeting
Charleston, West Virginia
October 23-25, 2016
Presented by:
Gary A. Zwick, JD, LL.M., CPA, AEP®
Partner, Walter | Haverfield LLP
Cleveland, Ohio
I.Revised due dates for partnership and C corporation returns, and revised Extended due dates for those and other returns.
Type / Existing Due Date(Effective for Tax Periods Before 2016) / Due Date Under New Law
(Effective for Tax Years Beginning in 2016 Unless Otherwise Noted) / Existing Extension Period
(Effective for Tax Periods Before 2016) / Extended Due Date Under New Law
(Effective for Tax Years Beginning in 2016 Unless Otherwise Noted)
C Corporations
- calendar year / March 15 / April 15 / September 15 / 5 months until 2026,
then 6 months
C Corporations
- June 30 year-end / September 15 / September 15
until 2026,
then October 15 / 6 months
(March 15) / 7 months
(April 15) until 2026, then 6 months (April 15)
C Corporations
- fiscal year other than June 30 / 2 ½ months
after year-end / 3 ½ months
after year-end / 6 months / 6 months
S Corporations / 2 ½ months
after year-end / Unchanged / 6 months / Unchanged
Partnerships / 3 ½ months
after year-end / 2 ½ months
after year-end / 5 months / 6 months
Trust Return
Form 1041 / April 15 / Unchanged / September 15 / September 30
FinCEN
Form 114 / June 30 / April 15 / None / 6 months
(October 15)
II.New IRS § 2704 Regulations Would Curb Small Business/Family Entity Discounts.
The IRS proposed new rules to prevent the undervaluation of transferred interests in corporations and partnerships for estate, gift, and generation-skipping transfer tax purposes. The proposed regulations, affecting the transfer tax liability of individuals who transfer an interest in certain closely-held entities, address a number of things, such as deathbed transfers that result in the lapse of a liquidation right, how transfers creating an assignee interest are treated, and restrictions on the liquidation of an individual interest in an entity.
Effective Date Encourages Transfers Prior to End of 2016. The regulations take effect 30 days after final regulations are published. Since the public hearing is scheduled for December 1, 2016, the earliest the regulations could become final is the end of this year. Anyone considering a gift or sale of an interest in a family-owned entity, or who has an interest in a family-owned entity with the anticipation that the value will be discounted on death, needs to consider transfers prior to year-end to take advantage of existing discounts.
-The amendments to § 25.2701-2 are proposed to be effective on and after the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register.
-The amendments to § 25.2704-1 are proposed to apply to lapses of rights created after October 8, 1990, occurring on or after the date these regulations are published as final regulations in the Federal Register.
-The amendments to § 25.2704-2 are proposed to apply to transfers of property subject to restrictions created after October 8, 1990, occurring on or after the date these regulations are published as final regulations in the Federal Register.
-Section 25-2704-3 is proposed to apply to transfers of property subject to restrictions created after October 8, 1990, occurring 30 days or more after the date these regulations are published as final regulations in the Federal Register.
Three Year Lookback for Death Within 3 Years of Transfer. There is a look-back rule that may result in a phantom asset being subject to estate tax if someone transfers a controlling interest in a family entity within three years of death. This rule could apply to transfers before the effective date if the transferor dies after the effective date.
Lack of Marketability and Minority Discounts Eliminated – Not Limited to Entities with Marketable Securities. It was initially anticipated that these regulations would attack only family entities with marketable securities; however, these proposed regulations are much broader than expected, and will affect valuation discounts on all closely-held family-owned entities. The approach taken is to treat each family owner (even an owner with a minority interest) as having the hypothetical right to sell back his or her interest in the entity within six months for cash for that ownership interest’s percent of total entity value. The interest would be deemed to carry a put right to the minimum value. Thus, typical discounts associated with minority interest or lack of marketability would not be available.
Lifetime and Death Transfers. This rule would apply to gifts or sales during life and transfers on death. A transfer that results in the restriction or elimination of any of the rights associated with the transferred interest is treated as a lapse, and the proposed rules narrow the exception to the definition of a lapse of a liquidation right to transfers occurring at least three years before the transferor’s death.
Disregarded Restrictions. The proposed regulations introduce a new class of “disregarded restrictions” that include limitations on the time and manner of the payment of liquidation proceeds such as the deferral on full payment beyond six months. Exceptions that apply to existing restrictions would also apply to the new class of disregarded restrictions.
Modification of Meaning of Control. Section 2704 only applies to entities that the transferor and members of his or her family control. The proposed regulations would clarify the meaning of control, and there are different rules for determining how control applies for a corporation and for a partnership. In general, holding 50% of the equity in an entity means control. Also, for a limited partnership, having an interest in the general partner is control. Under the proposed regulations, Section 2704 is applicable in the case of a corporation or a partnership or a LLC. They make clear that the Section is applicable in the case of an entity that is disregarded for other tax purposes.
Benefit – Step-up in Basis at Death. Some families will enjoy higher income tax bases in connection with the inheritance of an interest subject to Section 2704 than without the Section.
Validity? Will these regulations be valid under Chevron? Under Chevron, agency inconsistency is not a basis for invalidating a new approach. See Mayo Foundation v. U.S., 562 U.S. 44 at 55 (2011): “We have repeatedly held that ‘[a]gency inconsistency is not a basis for declining to analyze the agency’s interpretation under the Chevron framework.’”). Chevron also permits agencies to overrule court decisions. See, e.g., National Cable & Telecommunications Assn. v. Brand X Internet Services, 545 U.S. 967 (2005). Regulations only need to be a reasonable interpretation, not the best interpretation, of the statute. IRC Section 2704(3)(B) says: “any restriction imposed, or required to be imposed, by any Federal or State law.” “Required to be imposed” means mandatory restrictions under state law. Thus “imposed” should mean something different, i.e., restrictions imposed by the entity’s agreements. Prop. Reg. § 25.2704(b)(4)(ii) interprets the meaning of “imposed or required to be imposed by federal or state law.” The new proposed regulations apparently mean that state law default rules are not “imposed or required to be imposed” because they can be changed by the parties.
III.House Bill Introduced to Prevent Implementation of Section 2704 Proposed Regs.
The bill, H.R. 6042, was introduced by Rep. Jim Sensenbrenner (R-Wis.) on September 15, 2016. It calls for the revocation of regulations the Internal Revenue Service proposed in August, discussed above.
The proposed regulation limits the use of valuation discounts that reduce the value of ownership interests in family-owned businesses, thus lowering estate and gift tax liability. They are typically applied to compensate for the lack of marketability and control that can make those entities harder to sell.
In a news release, Sensenbrenner said his bill would nullify the IRS regulations, which would make it “difficult for family-owned businesses to keep their doors open.” The bill proposes that the rules and “any substantially similar regulations hereafter promulgated, shall have no force or effect.”
When asked why the legislation was introduced before waiting to see what the IRS includes in the final regulations, Nicole Tieman, the congressman's communications director, said: “Because more than half of the economy is supported by small and family-owned businesses. That’s millions of people this bill can potentially help.”
A spokeswoman for the House Ways and Means Committee said: “Chairman Brady also has strong concerns about these regulations and appreciates Congressman Sensenbrenner's leadership on this issue.” The chairman is reviewing the bill and “continues to focus on fully repealing the death tax through our tax reform blueprint,” she said in an e-mail to Bloomberg BNA.
However, many practitioners believe the bill will not be passed, but should elevate the level of scrutiny over the regulations and their likely deleterious effect on small businesses.
IV.New Partnership Audit Rules.
The Bipartisan Budget Act of 2015 replaced the TEFRA partnership audit rules with new procedures generally effective for partnership years beginning after 2017, but with an option for partnerships to adopt them for years beginning after their enactment in November 2015. Generally, the new rules require adjustment of all items of income, gain, loss, deduction, or credit at the partnership level, with the partnership liable for any resulting underpayment of tax.
Partnerships may generally elect out of the new rules if:
A.Their only partners are individuals, estates of a deceased partner, or S or C corporations (or foreign entities treated a C corporation);
B.They are required to issue no more than 100 Schedules K-1; and
C.They follow certain requirements as to the time and manner of making the election.
As under TEFRA, if partners do not treat all items of income, etc., consistent with the treatment on the partnership return, the IRS may collect a resulting underpayment under its math or clerical error authority without resorting to traditional audit procedures, including issuance of a deficiency notice.
Under the rules, a partnership’s net adjustments for the reviewed year (the imputed underpayment) will be taxed at the highest individual or corporate tax rate. The IRS is authorized to promulgate rules adjusting or allocating imputed underpayments to take into account several factors including the character of the income being adjusted.
Additional taxes, as well as penalties and interest, arising from an audit are payable by the partnership. However, the partnership may elect to pass through to its partners their respective shares of the adjustment, with the partners paying tax, penalties and interest on their adjusted distributive shares.
Similar to the TEFRA rules, the new rules allow a partnership to file an administrative adjustment request to adjust its taxable income for any open partnership year.
V.Partnerships Opting Into New Audit Rules Cannot Later Opt Out.
The IRS, in implementing new audit rules for partnerships, has determined those partnerships that opt in early will be bound by that decision and prohibited from later opting out under the regime’s small partnership exception, according to regulations published August 5, 2016 in the Federal Register.
While those rules go into effect January 1, 2018, some partnerships can elect to have them apply to their tax returns dating to the law’s enactment November 2, 2015, and these new regulations are aimed at guiding when and how partnerships can make the early adoption.
Once a partnership has signed up for the audit regime, they will not be able to exit out without IRS permission. Nor will an early adoption be considered valid if it “frustrates the purposes” of the Bipartisan Budget Act of 2015, which created the regime. Those purposes include “the collection of any imputed underpayment that may be due by the partnership.”
The essence of the new audit system is that partnerships could be subject to a federal income tax that has historically been imposed on individual partners when there has been an understatement of income. Opt-out elections are available to partners who are individuals, C corporations, foreign entities that would be treated as C corporations if they were domestic, S corporations or estates of deceased partners.
In addition, adjustments to a partnership’s tax liabilities as a result of an audit will apply to the year the adjustment is made, rather than to the year of the tax return in question, which means that partners that join a partnership could be liable for tax positions taken by the partnership before the partners joined.
There are several exceptions to the early adoption procedures, which are effective immediately, barring partnerships from early use on those taxable years where they have already chosen to apply the partnership procedures under the Tax Equity and Fiscal Responsibility Act (“TEFRA”). This occurs when the tax matters partner has filed a request for an administrative adjustment for the partnership taxable year under Section 6227(c) of the TEFRA partnership procedures with respect to a partnership taxable year. Similarly, an election under these temporary regulations also does not apply if a partnership that is not subject to the TEFRA partnership procedures has filed an amended return of partnership income for the partnership taxable year.
Upon being notified that one of the eligible tax year has been selected for audit, partnerships will have 30 days to ask in writing for the application of the new procedures.
The IRS does envision an exception to the timing of the opt-in, allowing adoption of the new audit regime for eligible years without an examination notice if the partnership wants to file an administrative adjustment request (“AAR”) on its taxes. AARs for a given return can be sought within three years of its filing, according to the IRS. However, the exception will apply only to AARs filed after January 1, 2018.
Those signing the new procedures request must be the tax matters partner or someone authorized to sign for the return under review. The statement requesting the new procedures needs to include detailed information, such as the identification number of both the signer and the partnership itself, as well as that of a designated representative of the partnership.
“The statement must include representations that the partnership is not insolvent and does not reasonably anticipate becoming insolvent, the partnership is not currently and does not reasonably anticipate becoming subject to a bankruptcy petition under Title 11 of the United States Code, and the partnership has sufficient assets, and reasonably anticipates having sufficient assets, to pay the potential imputed underpayment that may be determined during the partnership examination.”
VI.IRS Clarifies: Partners Cannot be Employees, T.D. 9766.
Regulations quash taxpayers’ position that partners can be employees of a disregarded entity owned by the partnership.
The IRS issued temporary regulations intended to halt the practice some partnerships have adopted of treating partners as employees of a disregarded entity owned by the partnership so they can be included in employee benefit plans and receive other benefits. However, the IRS is also asking for comments on when it might be appropriate to allow partners to also be employees of a partnership.
To give taxpayers time to implement the new rules, the IRS is allowing any plan sponsored by an entity that is disregarded as an entity separate from its owner to apply them on August 1, 2016, or the first day of the latest-starting plan year following May 4, 2016, whichever is later.
Under Regs. Sec. 301.7701-2(c)(2)(iv)(B), a disregarded entity is treated as a corporation for employment tax purposes, meaning that the entity, rather than its owner, is treated as the employer of the entity’s employees. However, this rule does not apply for self-employment tax purposes, so the owner of an entity that is treated as a sole proprietorship is subject to self-employment tax.
The regulations include an example in which the owner of the disregarded entity is an individual who is subject to self-employment tax on the net earnings from the disregarded entity’s activities. The Regulations do not provide an example in which the disregarded entity is owned by a partnership.
Some taxpayers have taken the position that where a partnership is the sole owner of a disregarded entity, partners in the partnership can be treated as employees of the disregarded entity because the regulations did not include a specific example applying the general rule in the context of a partnership.
In the preamble to the temporary regulations, the IRS explains that the holding of Rev. Rul. 69-184 is still in effect. That ruling stated that (1) bona fide members of a partnership are not employees of the partnership for purposes of the FICA and FUTA rules, and income tax withholding, and (2) a partner who devotes time and energy in conducting the partnership’s trade or business, or who provides services to the partnership as an independent contractor, is considered self-employed and is not an employee.
The preamble notes that the IRS did not intend to “create a distinction between a disregarded entity owned by an individual (that is, a sole proprietorship) and a disregarded entity owned by a partnership in the application of the self-employment tax rule.” Rather, the general rule making the owner of an entity that is treated as a sole proprietorship subject to self-employment tax applies for any owner of a disregarded entity – there is no exception for partnerships.