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San Francisco, CA - Tax Attorney

Tax Information You Need to Know!

The Administrative Procedure Act - Challenging FBAR Penalties

by Liz Prehn, Attorney at Law 8. July 2016 18:29

Over the past 10 years, thousands of U.S. taxpayers with a wide variety of circumstances have been forced to pay extraordinarily high penalties for failure to disclose foreign bank accounts. For years, tax experts said that the penalties imposed by the IRS for non-willful failure to file an FBAR is an issue ripe for a challenge. The first such challenge came in April of 2015 from our firm.

Treading new ground in tax and administrative law

Our case involved a taxpayer who did not report an overseas account for a number of years, then began to remedy his error by  (1) hiring a tax lawyer, (2) participating in the 2009 Offshore Voluntary Disclosure Initiative which included amending tax returns to report his overseas income and filing late FBARs.   As part of the OVDI, the IRS assessed a miscellaneous penalty of $100,218.    Based on our extensive experience with the Offshore Initiative, we advised our client regarding withdrawal from the program; which he then chooses to do.   The IRS then assessed our client $40,000 ($10,000 per year) in FBAR penalties.   However, our client was never given any explanation as to why the penalty was assessed or how the penalties were calculated.

We proceeded with administrative attempts to contest the penalties and to ascertain at a minimum an explanation as to why the penalties were assessed.  Eventually our client's administratively remedies were exhausted without a satisfactory explanation as to the penalties being imposed by the Internal Revenue Service.   The Internal Revenue Service then threatened to collect the Title 31 civil penalties by offsetting his social security benefits.

We believed that the government's conduct violated the US Constitution: the Fifth Amendment's right to Substantive and Procedural Due Process, the Eight Amendment prohibition against excessive fines, and the Delegation Clause.   We further believed that our client was entitled to judicial review of the IRS action under the Administrative Procedures Act.

The Constitutional Arguments

The court held that our client receiving notice and opportunity to contest the penalties was sufficient to provide Due Process.   As to the Eighth Amendment Excessive Fines argument the court held that since the fine involved here was only 10% of our client’s account balance it was therefore not “grossly disproportionate to the gravity of the taxpayer’s offense," however, it further held that such a fine on a smaller balance may well be!   This is a significant development on behalf of taxpayers facing these types of fines and opens the door a little wider for taxpayers to assert an excessive fine violation in these types of matters.

The APA Arguments

Our arguments that the IRS failed to meet the requirements under the Administrative Procedure Act (APA), however, received significant attention by the court. Firstly, it held that as an agency subject to APA requirements, the IRS’ actions are subject to judicial review to determine whether they were “arbitrary or capricious, constituted an abuse of discretion, or were otherwise not made in accordance with law” under 5 U.S. Code § 70. The court also stated that the IRS appeals letter did not satisfy the requirement to inform the taxpayer of its reasons for imposing the maximum penalty. Although the FBAR Summary Memorandum was more detailed in its analysis (this evidence was only discovered by Court Ordered discovery), the court held that it also did not qualify since (1) it was not sent to our client and (2) it still failed to adequately explain the reason for the penalties imposed.

The IRS was ordered to supplement its records with information explaining its decision to impose the maximum penalty. The court threatened that if it failed to do so, it would rule that the IRS had imposed penalties that were “arbitrary and capricious” in violation of the APA.

What everyone learned from this case

The result of this case was clarification of the IRS’ responsibility to comply with APA requirements, and it has received significant attention for that reason. Our case has also created a significant change in the way the IRS determines, calculates, and assesses FBAR penalties. U.S. taxpayers now know that:

  1. The IRS is subject to APA requirements
  2. The APA applies to FBAR penalties imposed by the IRS
  3. Taxpayers are entitled to timely notice of the IRS’ reasons for FBAR penalty assessments
  4. The penalty amount must be reasonable and proportionate
  5. Penalties must be reasonably justified to the taxpayer before they can be enforced

Because of firm’s efforts, the IRS was forced to change the Internal Revenue Manual and issue new guidance on FBAR penalties, significantly changing the way the IRS looks at foreign bank account cases and the imposition of penalties.  See SBSE-4-0515-0025 and applies to all open cases where the FBAR is considered.

Quality, aggressive penalty litigation

The tax attorneys at Moskowitz, LLP are ready and prepared to continue to make new ground in contesting unjust FBAR and other tax penalties. We stand ready to litigate the imposition of unfair FBAR penalty case.   Stay tuned.

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Judicial Review

by Liz Prehn, Attorney at Law 8. July 2016 18:19

Judicial review of administrative acts is an important aspect of the U.S. checks and balances system – it prevents administrative overreaching by providing protection from final agency actions for which there is no other adequate remedy. As we discussed above (background), judicial review of agency actions and decisions was an important compromise during negotiations for the Administrative Procedure Act (APA) and was needed to gain the support of conservatives who were otherwise opposed to many of President Roosevelt’s New Deal programs.

The APA states that if a person suffers a legal wrong or is otherwise adversely affected or aggrieved as the result of an agency’s actions, they are entitled to judicial review. In such case a claim may be filed with “The United States” named as defendant.

Scope of judicial review

An agency’s actions may be set aside by a reviewing court if they are found to be improper. 5 U.S. Code § 706 sets forth six situations in which an agency’s actions, findings, or conclusions shall be deemed unlawful and set aside by a court:

  1. Where the agency’s actions or findings were arbitrary or capricious, constituted an abuse of discretion, or were otherwise not made in accordance with the law;
  2. Where the actions or findings were contrary to a constitutional right, power, privilege, or immunity;
  3. Where the agency acted in excess of its statutory jurisdiction, authority, or limitations, or were made short of a statutory right;
  4. Where procedures required under the law were not observed;
  5. Where the agency’s findings or conclusions were unsupported by substantial evidence in accordance with the procedures for formal rulemaking or adjudication set forth in sections 556 and 557 of the statute; or
  6. Where the agency’s findings were unwarranted by the facts to the extent that the facts are subject to new trial.
The standard of review applicable in a given case depends on whether or not the case requires formal rulemaking or adjudication. As noted, with few exceptions, formal proceedings are either (1) required by statute, (2) utilized if an agency’s rule involves facts specific to individual rights, or (3) utilized where a rule includes facts that are controlling on a question of law.
 
The "substantial evidence" standard of review is applied for formal rulemaking and adjudication. In brief, if an agency’s final decision on a rule that is being challenged is deemed reasonable by the Court, or if the Court finds that the record of the agency’s decision contains evidence that a reasonable person would find adequate to support its conclusion, the Court must uphold the rule.

The "arbitrary and capricious" standard of review generally applies to informal rulemakings. Here, the Court will look for a clear error of judgment on the part of the agency and for a rational connection between the facts and the agency’s judgment.

If a court is reviewing an agency’s interpretation of a statute, there is a two-step "statutory interpretation" standard of review that must be applied. First, per the landmark Chevron, U.S.A. Inc. v. NRDC case, the court must determine whether Congress has addressed the precise question at issue. If it hasn’t, then the court determines whether or not the agency’s actions were based on a "permissible construction of the statute." The reviewing court should defer to an agency’s reasonable construction of a statute, even if it is under the impression that there is a different and more appropriate interpretation.
 
Timing and forum

Our tax litigation attorneys always give careful consideration to timing and choice of forum when contesting an IRS decision.

Timing. The APA stipulates that a plaintiff seeking judicial review of an administrative agency action must demonstrate that: (1) the action is final; (2) all administrative remedies required under the law have been exhausted; and (3) that the action is ripe for review.  Note that judicial review may be sought sooner if a delay poses a danger of serious injury to the plaintiff.

Court. The APA specifies that these cases may be brought in any “court of competent jurisdiction,” meaning, federal district court. Note that some challenges to agency actions must be brought to the Court of Appeals, and there are other exceptions as well.

Venue. A lawsuit against an administrative agency, officer, or the United States may be brought in a judicial district where the defendant resides, the cause of action arose, real property in the action is located, or the plaintiff resides (if no real property is involved).

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Adjudication and Licensing

by Liz Prehn, Attorney at Law 8. July 2016 18:00

Tax regulations are subject to the Administrative Procedure Act (APA), and taxpayers are entitled to the protections afforded under the Act.

In addition to the rulemaking requirements discussed above, the APA requires that federal agencies determine procedures for formal and informal adjudication of alleged violations of a particular law or rule and that they conduct agency-level adjudication per a uniform standard. The APA also requires agencies to follow certain procedures in the granting of licenses that are within their purview.

Adjudication

Adjudication is the process by which agencies issue orders to resolve particular rights and duties. As in rulemakings, they can be formal or informal.
With few exceptions, formal adjudications are subject to the same requirements as formal rulemakings:

  • Notice must be provided (time, location, nature, facts asserted, jurisdiction and legal authority of the hearing)
  • A judge presides over the proceedings
  • Evidence must be introduced
  • Decisions are subject to judicial review
Most adjudications are informal, and their process is not clearly defined in the APA. Prescribed procedures for informal adjudications may vary greatly depending on the relevant statute; they may be explicit or implied, a hearing may or may not be required, and if it does take place it may or may not be oral or adversarial. Decisions made through informal adjudication are usually subject to judicial review.
 
Due process protection is afforded during the adjudicative process whenever a person may be deprived of their property or liberty, and where the outcome may effect a small, particular group.

Licensing

The licensing of individuals and/or entities to engage in certain activities is an effective governmental regulatory device. By creating and maintaining standards, licensing generally provides the general public with a certain level of protection.

Where a federal agency grants permits, certificates, approvals, registrations, charters, memberships, statutory exemptions, or other forms of permission to an individual or entity, it must comply with the same APA procedures that pertain to formal rulemaking and adjudication. The same applies to licensing renewals, denials, suspensions, and revocations. For example:
  • Uniform standards for the granting of licenses must be established and adhered to
  • Notice must be provided where appropriate
  • A licensee must be provided an opportunity to correct a rule violation prior to having their license revoked

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Rulemaking

by Liz Prehn, Attorney at Law 8. July 2016 17:49

On April 4, 2016, the U.S. Treasury Department enacted a package of regulations designed to curb corporate inversions. A corporate inversion is a tax reduction measure whereby a U.S. company reduces its U.S. tax burden by first merging with a company located in a foreign jurisdiction that has lower tax rates and then re-incorporating in that jurisdiction. Since the beginning of his term, President Obama has stated his intent to block what he calls “one of the most insidious tax loopholes out there.” Corporate inversions save companies a significant amount of money and apparently deprive the U.S. Treasury of billions in tax revenue every year.

The new Treasury regulations have already halted the $160 billion merger of Pfizer, a U.S. drugmaker and Allergan plc, a pharmaceutical manufacturing and distribution company based in Ireland. The two companies, the U.S. Chamber of Commerce and other trade groups are apparently contemplating a legal challenge to the new regulations, but this will not be easy.  The Anti-Injunction Act of 1867 bars legal challenges to a tax until one has actually been assessed. This means that Pfizer and Allergan would have to complete their merger, file a tax return, and then wait for the IRS to assess a tax before a lawsuit could be filed.

An interesting and novel alternative has been proposed by a tax attorney in Washington, D.C. – he recently raised the possibility of suing the Treasury Department for having exceeded its legal authority under the Administrative Procedure Act (APA).

Rulemaking requirements under the APA

APA rulemaking requirements include the following:

  • Notice. Notice of a proposed rulemaking must be published in the Federal Register. The notice must include the effective date of the new rule, what the rule encompasses, and the legal authority the agency has for proposing it.
  • Public comments. The agency must then solicit public comments regarding the proposed rule. Comments are usually accepted for 30-60 days, depending on the rule’s complexity, and that time frame may be re-opened or extended if it solicited insufficient feedback from the public. All comments regarding a particular rule must be taken into consideration before the agency finalizes it.
Where applicable, the IRS’ use of Temporary Regulations, which are issued prior to notice and public comments, may be a path to challenging an IRS decision on procedural grounds.
 
Formal rulemaking

If a statute obligates an agency to conduct formal rulemaking, if a rule involves facts specific to individual rights, or if a rule includes adjudicative facts (facts that are controlling on a question of law), formal rulemaking may be required. Formal rulemaking is similar to courtroom proceedings, and includes a hearing on the record and the presentation of evidence.

There are a few exceptions to the above noted rulemaking requirements, particularly for rules involving issues such as military or foreign affairs, intra-agency policy and where the notice and comment procedures are unnecessary, unrealistic, or contrary to the public interest.

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Background of Administrative Procedure Act

by Liz Prehn, Attorney at Law 8. July 2016 17:29

The Administrative Procedure Act (APA) governs the practice and procedural formalities of administrative agencies of the federal government, including the U.S. Department of the Treasury.  The APA basically delineates the manner in which U.S. administrative agencies may establish regulations and the process of judicial review of agency decisions.

History of the APA

The APA was essentially a compromise between supporters and opponents of the New Deal programs that were initiated mainly during President Franklin D. Roosevelt’s first term in office (1933-1937). For a decade after the passage of the controversial Second New Deal, which included the establishment of the Social Security Act, the U.S. Housing Authority and the Fair Labor Standards Act, Republicans and Southern Democrats attempted to terminate New Deal programs (particularly the Securities and Exchange Commission and the National Labor Relations Board) through administrative and judicial restrictions on various governmental agencies. In turn, President Roosevelt vetoed bills that sought to strictly control those agencies.

In the early 1940s, a lengthy and detailed negotiation process was initiated that eventually led to enactment of the APA. Carl McFarland, Chairman of the American Bar Association’s Special Committee on Administrative Law, was respected by both supporters and opponents of the New Deal and was able to facilitate a compromise between the two sides. The APA effectively ended the battle between those who sought more bureaucratic power and supporters of individual rights. Although neither side was particularly enthusiastic about the APA, it gave broad freedom to governmental agencies yet imposed procedural requirements and standards for public participation in and judicial review of agency actions. In short, both sides gained a great deal and agreed that it was better than nothing.

Purposes of the APA

The APA has four main purposes:

  1. Establish uniform standards for rulemaking and adjudication
  2. Ensure that administrative agencies keep the public informed of rules and procedures
  3. Provide opportunities for the public to participate in the rulemaking process
  4. Define the scope of judicial review
The APA sets forth guidelines for administrative agencies on how to develop and issue rule and regulations. It includes guidelines the publishing of notices, policy statements, licenses, and permits, and provides an opportunity for the public to comment on proposed rules before they become effective.

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FBAR

IRS Agrees to Increased Enforcement of IRS's Offshore Voluntary Disclosure Program

by Liz Prehn, Attorney at Law 25. June 2016 00:53

Both Prior Submissions and Future Submissions Effected

(Announced by Government June 21, 2016)

Treasury Inspector General's Report Issued to Internal Revenue Service Criminal Division and International Division

In a report issued to the Internal Revenue Service  International Division and Criminal Division, the Treasury Inspector General for Tax Administration (TIGTA) found that taxpayers trying to avoid criminal charges and monetary fines by participating in the Offshore Voluntary Disclosure Program (OVDP)  had been incorrectly analyzed.

The OVDP is designed to allow taxpayers to report previously unreported offshore bank accounts and  allows taxpayers to report offshore accounts in exchange for a set lower penalty and no criminal investigation or prosecution.  TIGTA' s findings were that the IRS should have assessed millions more in penalties, and thus, made the following recommendations to the IRS civil and criminal divisions (note for brevity, only three of the six recommendations are discussed below).    IRS management agreed to take TIGTA's recommendations and has taken plans to implement them.

 

TIGTA RECOMMENDATIONS:  

  1. Review all denied or withdrawn offshore voluntary disclosure requests identified in this report for potential FBAR penalty assessments and criminal investigation:

    TIGTA recommended that the IRS International Division review all denied or withdrawn requests for FBAR penalty assessments and possible referral to IRS Criminal Investigation Division.  In the Management's Response the IRS agreed with this recommendation and has had technical specialists review all withdrawn and denied requests.

    From a tax defense perspective, a re-review subjects the taxpayers to potential civil and criminal exposure - not to mention, attorney fees, stress, fear, and monetary and liberty considerations.   Another potential ramification is that the re-review will open the door to potential false statement allegations if the original submission is found to be not fully accurate or complete.

  2. Develop procedures for reviewing denied and withdrawn cases for further compliance actions:

    The TIGTA did not define "further compliance actions" and the IRS management stated that it agreed to come up with procedures for reviewing denied and withdrawn cases.   From a tax defense perspective the procedures developed will likely include a re-review of denied and withdrawn cases for criminal and civil action.

  3. Centrally track and control OVDP requests to ensure better communication between Criminal Investigation and OVDP:

    Currently, in order to complete the OVDP, several IRS groups are involved - Criminal Investigation Division, the OVDP Unit, and examination units.  Each is responsible for its role in the OVDP and TIGTA has determined that information garnered by each group is not being adequately shared (and thus leveraged) between the units.  By centralizing control, it is believed that the IRS will be far more efficient in analyzing information for maximum government benefit, both as to the criminal prosecutions and as to the imposition of more and larger monetary penalties.

 

What is TIGTA?

The Treasury Inspector General for Tax administration (TIGTA) is an office in the United States Federal Government.  It is independent of the Internal Revenue Service and reports directly to the Secretary of the Treasury and to Congress promoting the administration of the federal tax system.

 

Moskowitz LLP's Recommendations to Taxpayers

If you have or have had offshore bank accounts or foreign asset or foreign income, we recommend that you immediately consult with an experienced international tax attorney.   The U.S. government has imposed unprecedented criminal and monetary penalties related to offshore accounts, assets, and income, and is clearly looking to make sure that no one is slipping through its system without receiving 'punishment'.    Basically, there is blood in the water, and the sharks are now here. 

Moskowitz LLP is a tax law firm representing individuals and businesses both internationally and domestically.   It is our mission to successfully defend our clients, while preserving their personal freedom and financial lives, through the experienced pursuit of all legal strategies available to achieve the desired favorable outcome. 

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Government Investigations: Use of the Financial Crimes Enforcement Network and Virtual Currency

by Liz Prehn, Attorney at Law 1. June 2016 17:14

Since 2009, the US Department of Justice has implemented an aggressive anti-tax evasion strategy that has changed by targeting tax havens that host financial intermediaries (i.e., banks) to the financial intermediaries themselves as well as individuals holding funds offshore.   The criminal prosecutions of foreign banks and individuals with un-reported accounts overseas has led to the imposition billions of dollars of monetary penalties and prison time for individuals,  as well as the implementation of Foreign Accounts Tax Compliance Act (FATCA).

In 2016, the Internal Revenue Service announced that it will dedicate agents of its Criminal Investigation Division (who tout themselves as the best financial crimes investigators in the world) to Virtual Currency and Cyber Crime investigations.  As part of this strategy, the Internal Revenue Service is working in conjunction with the Financial Crimes Enforcement Network (FinCEN).     


What is FinCEN

The Financial Crimes Enforcement Network, FinCEN, is a bureau in the U.S. Department of the Treasury, established in 1990 to analyze and disseminate information to law enforcement at the federal state, local and international levels  for the purpose of detecting and deterring money laundering and other financial crimes.   Today, FinCEN has numerous areas of responsibility, including but not limited to,

  • Bank Secrecy Act - development of regulations and enforcement of regulations, 
  • Financial Reports - Receiving and maintaining a database of required information reports,
  • Information sharing with domestic and foreign partners in government and private industry.  


Goals of FinCEN 

The United States Department of the Treasury, FinCEN Strategic Plan reports that, FinCEN's broad goals are to:

  1. Safeguard the financial system from evolving money laundering and national security threats; and,
  2. Maximize sharing of financial intelligence between FinCEN and its domestic and foreign partners in government and private industry.  

 

What this Means for Virtual Currency

Basically, what these goals mean, is that the virtual currency community can expect more required information reporting to FinCEN, which can then be used by other government agencies, such as the Internal Revenue Service, investigating crimes and other alleged wrongdoing.   What this also means: it is likely that financial penalties for failing to file reports will be imposed and enforced.

For example, currently, account holders of overseas bank accounts are required to file an information report (Form 114) with FinCEN each year, reporting financial accounts in excess the U.S. dollar equivalent of $10,000.  The Secretary of the Treasury has delegated to the Director of FinCEN the authority to implement, administer, and enforce compliance with the Bank Secrecy Act and associated regulations.  The BSA provides criminal and civil punishments for failing to file Form 114 (as well as other forms, such as Form 8300).   The monetary (civil) penalties can be $10,000 or more per violation!

As you can see, the fines can be draconian, and the reality is, the reporting requirements regarding virtual currency, whether it be individual users or money services banks are still being defined.

In our next post, we will cover some of the virtual currency reporting requirements for individuals and money services banks.

 

Contact an Attorney

However, in the meantime, if you have a specific question, please do not hesitate to contact us. Phone: 415-394-7200 or email.   Moreover, should you have the need for a civil or criminal tax attorney or are the subject of government investigation, you should obtain legal advice immediately from an attorney.    The government has massive resources but never forget you have rights and are entitled to a vigorous  defense.

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Why a Tax Attorney's Advice is Important: Estate Planning, Gift Tax, Business Succession, and the Ability to Rely on Advice by Counsel

by Stephen M. Moskowitz, Esq. and Elizabeth E. Prehn, Law Clerk 6. February 2015 07:42

Case of the Week: Cavallaro

A recently published tax court opinion provides us with a fascinating case involving a rags to riches story of a tightly-knit hardworking family and the creation, merger and eventual sale of two related family companies. It hit our radar because of the impermissible tax position taken that resulted in the US Tax Court upholding an enormous gift tax assessment and the resulting tax problems for the founders (the parents).  

A Rags to Riches Story

In the 1950s, William Cavallaro transferred from the 9th grade to a trade school machine shop program and then worked his way from janitor to production manager at a local tool company. His wife, Patricia, earned a high school degree, took a few college-level secretarial courses and had one year of experience doing clerical work before getting married in 1960 and raising their three sons. In 1979, the Cavallaros established Knight Tool Co. ("Knight"). William made and sold custom manufacturing tools and parts for other companies, and Patricia handled the secretarial work and the bookkeeping. Their three sons finished school and eventually they all worked for the company. 

In 1982, William and his eldest son Kevin began work on the first liquid-dispensing machine prototypes to neatly and repetitively attach various parts to computer circuit boards (they called it CAM/ALOT). Knight initially lost money on CAM/ALOT and in order to acquire additional capital through third-party investors to correct flaws in the machine, the Cavallaro sons incorporated a second company in 1987.  The sole purpose of the new company, Camelot Systems, Inc. ("Camelot") was to develop a successful liquid-dispensing machine and market it. This was done with their parents’ full consent—at the new company’s first meeting William handed the minute book over to Ken, saying, "Take it; it’s yours"; however, no documentation was ever prepared transferring rights in the machine to Camelot. 

Ken continued to develop the market for the machine, while his father and the Knight engineers made and improved on them.  Knight in effect was acting as the manufacturer and Camelot as the contractor. On the administrative, bookkeeping, tax and legal documentation side, however, Camelot was characterized as a sales agent thus leaving only Knight at risk for nonpayment, the intellectual property registered to Knight, all Camelot wages were paid by Knight, Knight received the R&D credits for all work on the machines, and Knight paid all of Camelot’s bills.  However, Camelot received a disproportionate share of the profits.

Estate Planning problem

In 1994 and 1995, the Cavallaros revised their estate plans. Recognizing the potential problem of Knight’s increasing value, their estate planning attorney decided that the 1987 handing of the minute book to Ken constituted a "symbolic transfer" of the CAM/ALOT technology to Camelot.  As noted above, the respective companies’ administrative records and tax returns did not reflect any transfer.  

While the court characterized as either "the deliberate benevolence of Mr. and Mrs. Cavallaro toward their sons" or "a non-arm’s-length carelessness born of the family relationships of the parties," and as such, the sons’ company ("Camelot") received a disproportionate share of profits that technically belonged to the father’s company ("Knight").  In essence, the estate attorney's planning conflicted with the administrative and tax records previously maintained and filed.     

In order to effectuate the estate plan, the Cavallaro's (through their accountants) prepared sets of amended tax returns for both Camelot and Knight, disclaiming research and development credits previously taken by Knight and claiming them for Camelot.   

Merger and Sale 

By 1995, the value of the CAM/ALOT machine had increased significantly and the Cavallaros decided to merge the two companies to assure that Camalot could more easily comply with certification in the European market. The combined entity was valued between $70 and $75 million, with Knight’s portion between $13 and $15 million. The tax-free merger took place on December 31, 1995, with Camelot as the surviving corporation. The majority of the shares were allocated to the Cavallaro sons. The company was sold in 1996 for $57 million in cash and up to $43 million in potential deferred payments based on future profits. William and Patricia received a total of $10.8 million and each of their sons received $15.29 million.

Tax Audit as Trigger for the Disallowance

In January of 1998, the IRS conducted an audit of Knight’s and Camelot’s 1994 and 1995 income tax returns.  During the income tax examination, the IRS learned that there might be a possible gift tax issue, and a gift tax examination was opened the following month.   In 2005, the Cavallaros filed gift tax returns for the 1995 gifts, showing no amount due.   In November 2010, the IRS issued notices of deficiency to William and Patricia, deeming the merger a constructive gift to the Cavallaro’s sons in the amount of $46.1 million, with a gift tax liability of approximately $25 million.  Although the gift amounts were later reduced by IRS to $29.6 million, the Cavallaros appealed the enormous sum to Tax Court.    The Tax Court concluded that as a result of the distorted allocation of the stock, William and Patricia Cavallaro, did in fact, convey gifts to their sons totaling nearly $30 million.

Additions to tax were also asserted under IRC section 6651(a)(1) for failure to file timely gift tax returns and penalties under section 6663(a) for fraud. The IRS Commissioner later substituted the fraud penalties with alternative section 6662 accuracy-related penalties. 

Section 6662 Accuracy-Related Penalties and Defenses

Under IRC section 6662, an "accuracy-related penalty" may be imposed for a number of reasons, among them "a substantial estate or gift tax valuation understatement" and a "gross valuation misstatement." 

A "substantial estate or gift tax valuation understatement" is defined under section 6662(g)(1) as a valuation reported at 50% or less of the actual value and where the underpayment is more than $5,000.  The tax imposed is 20% of the underpayment. 

A "gross valuation misstatement" under section 6662(h) occurs when the valuation reported is less than 25% of its actual value. Where there is a gross valuation misstatement, the penalty is increased from 20% to 40%.

Reasonable Cause as a Defense to Accuracy Related Tax Penalties

The court determined that since the parents’ gift tax returns were filed 9 years late, section 6651(a)(1) applied to the case. It also held that the threshold for accuracy-related penalties under section 6662 had been met.  However, the judge agreed with the Cavallaros’ assertion of "reasonable cause" as a defense to liability and did not impose the penalties—the Court was clearly impressed by the work ethic and honesty of the parents, and found that they acted in good faith, relying on the mistaken advice of their otherwise competent tax advisers. The court found that the Cavallaros met all three requirements for avoidance of liability due to reliance on a tax adviser’s guidance:

  1. Their estate planning attorney and accountants were competent professionals, well known in their areas of practice and all had sufficient expertise to justify reliance,
  2. They provided their advisors with all the necessary and accurate information required to structure their businesses and estate, and
  3. The taxpayers were not highly educated and relied in good faith on their advisers’ judgment.

The court pointed out that the Cavallaros should not be held responsible for a legal fiction concocted by their estate planning attorney.  Unfortunately, the gift tax assessment was still applicable and the Cavallaros have for all intents and purposes been punished for their benevolence.

 

A Full Service Tax Preparation and Law Firm 

The Cavallaro case demonstrates how important it is to have top-notch legal and tax planning advice, and for your attorneys and accountants to be consistently on the same page. The tax firm of Moskowitz, LLP is staffed by tax attorneys, certified public accountants, enrolled agents and a phenomenal support staff.  We are known for our pursuit of excellent tax law representation.    

The hard lesson learned here is that it is crucial to obtain tax law advise from a knowledgeable tax attorney before (and when) making estate and business decisions.   

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Case of the Week

Taxation of Convertible Virtual Currency, Part III: Reporting and Penalties for Noncompliance

by Liz Prehn, Attorney at Law 11. November 2014 14:48

When it comes to Bitcoins and other convertible virtual assets, anonymity may not be all it’s cracked up to be.  For one thing, an underlying assumption is that individuals who keep their financial transactions hidden have something illegal to hide.

Earlier this month in Brisbane, Australia, a Bitcoin ATM owned by a local cafe was seized by the authorities as part of a drug investigation--apparently the "Bandidos Bikie Gang" was using the cafe in a multimillion dollar methamphetamine trafficking network.

IRS Notice 2014-21 now makes it a requirement to report all convertible virtual currency payments.

Reporting Virtual Currency

Payment received in the form of convertible virtual currency is now subject to federal income tax withholding, payroll taxes, and information reporting to the same extent as payment earned in any other manner.

  • Payments made to an independent contractor in convertible virtual currency worth $600 or more must be reported on Form 1099-MISC.
  • If a taxpayer identification number has not been obtained from the taxpayer, the payor must withhold 'backup withholding.'
  • Third party settlement organizations (TPSOs) are required to report payments to a merchant on Form 1099-K if the payments to that merchant exceed 200 in a calendar year and the gross amount of payments exceeds $20,000.

The amount reported should be the fair market value of the virtual currency (in U.S. dollars) on the date of payment.

Penalties for Noncompliance

Taxpayers who have failed to pay tax or file an information return regarding their convertible virtual currency transactions prior to the date of the IRS guidelines (March 25, 2014) may be subject to penalties under Internal Revenue Code section 6662.  Relief, however, is available to taxpayers who can show “reasonable cause” for their underpayment or failure to properly file their returns.
The intent appears to be a warning to traders and virtual currency businesses to heed their income tax responsibilities

Things to watch out for

There is no such thing as the anonymity of convertible virtual currency transactions since your virtual currency holdings are not FDIC-insured, you should at least know and trust the people you work with.  As with any business, those that deal in virtual currency need a certain level of professional recognition to build their reputation, something that client anonymity cannot provide.

Further, online exchanges may be forced at some point to report their clients’ accounts, as do banks and brokerage firms, and may even classify these exchanges as financial institutions for purposes of FATCA reporting. In addition, by classifying convertible virtual currency as property, IRS Notice 2014-21 may lead to a situation where cities and states demand that sales tax be applied to virtual currency transactions. All we know at this point is that the IRS has finally taken notice of virtual currencies and you should as well.

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Taxation of Convertible Virtual Currency, Part II: Taxation of Virtual Currency Income

by Liz Prehn, Attorney at Law 10. November 2014 14:32

In Part I of this series, we discussed the IRS guidelines on the taxation of gains and losses associated with convertible virtual currency.  In this post, we will focus on the taxation of income--wages, self-employment income and income from the “mining” of virtual currency.

Virtual currency income

James Howells of the UK began “mining” Bitcoins in 2009, when the pastime of creating virtual currency by having your computer solve mathematic problems was done exclusively by tech geeks and the value was minimal.  A few years later, Howells cleaned house and threw away an old computer with a digital store of 7,500 Bitcoins. In November of 2013, he realized that those Bitcoins were worth $7.5 million.  With no backup, the only way of retrieving the Bitcoins was to go through 25,000 cubic meters of waste and earth at the nearby landfill-an obviously hopeless task.

A growing number of taxpayers are now earning in Bitcoins and other convertible virtual currency, and IRS Notice 2014-21 provides guidelines on how this income is treated for income tax purposes.  In sum, income in the form of convertible virtual currency is treated no differently than income received in more traditional ways:

  • Wages.  Employees paid in virtual currency must pay taxes on their earnings, at the fair market value on the date of payment. This income is subject to federal income tax withholding and payroll taxes. The wages must be reported by the taxpayer’s employer on Form W-2.
  • Self-Employment Income. Virtual currency received for services performed as an independent contractor are subject to the self-employment tax.  This self-employment tax is imposed on the fair market value of the income as of the date of receipt (measured in U.S. dollars). Payers must issue a Form 1099 to the taxpayer for the annual payment of more than six hundred dollars when the payment is incurred as an ordinary and necessary expense of the payor's business.
  • "Mining" Virtual Currency. If a taxpayer generates new Bitcoins or other convertible virtual currency, the fair market value of that virtual currency on the date of receipt is includible in the taxpayer’s gross income. If the taxpayer mines virtual currency as their trade or business, and the taxpayer is not mining as an employee, the taxpayer’s gross income from mining (less allowable deductions) is considered self-employment income and is subject to self-employment tax.

Look to the not so distant future:

San Francisco’s first Bitcoin Teller Machine (BTM) was just installed this past September at the Workshop Cafe on Montgomery Street.  Right in our office building!   The BTM allows users to convert their Bitcoins to cash (and get a great cup of coffee in the process).  We will be keeping a close eye on how the new tax guidance affects the Bitcoin and other convertible virtual currency markets, and whether Bitcoin will proceed to develop as a form of “currency” for ordinary transactions. In the meantime, keep track of your virtual currency--and please don’t throw it out.

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Part III of this series will address reporting requirements for employees, employers, independent contractors, and third party settlement organizations, as well as penalties for noncompliance.

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Virtual Currency

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