no job namefile/tnsam… · tax policies and the burgeoning number of civil penalties. as in prior...

Volume 122, Number 2 � January 12, 2009

tax notesPutting Stimulus to WorkOn the Subprime Crisis

11 Rules for Defending Tax Shelters

A Look at the Taxpayer Advocate’s Annual Report

Is It Time to Repeal the Antichurning Rules?

Tax Policy During the Recession

Inaugurations and the Rhetoric of Revenue

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ON THE COVER

171 Putting Stimulus to Work on theSubprime Crisisby Martin A. Sullivan

176 11 Rules for Defending Tax Sheltersby Lee A. Sheppard

185 A Look at the Taxpayer Advocate’sAnnual Reportby Michael Joe, Nicole Duarte, Jeremiah Coder, and AmyS. Elliott

227 Is It Time to Repeal the AntichurningRules?by Romina Weiss

269 Tax Policy During the Recessionby Alan D. Viard

275 Inaugurations and the Rhetoric ofRevenueby Joseph J. Thorndike

Cover graphic: AP Photo/David Zalubowski

169 WEEK IN REVIEW

NEWS

182 Obama Lobbies for Recovery Plan WithMassive Tax Cuts

191 New Regulations Likely to Deter Use ofCost-Sharing Agreements

193 Eric Holder Could Face Questions OverTax Firm Prosecution

195 IRS Willing to Work With EconomicallyDistressed Taxpayers

196 House Approves Rules Package EasingPay-Go Requirements

198 Recession to Take Big Bite Out of TaxRevenues, CBO Says

199 Obama’s ‘Performance Officer’ BringsExperience From Treasury

201 Frank Wants Treasury to Invest inLow-Income Housing Credits

202 Exempts Need More Personal ContactWith the IRS, Says Report

WEEKLY UPDATE

205 Guidance

209 Courts

213 Correspondence

TAX PRACTICE

217 Strategies for Defending AgainstDiscovery Requests for Tax Returns

222 Congress: How About a Mulligan for theAccelerated Election?

SPECIAL REPORT

227 Fifteen Years of Antichurning: It’s TimeTo Make Butter

‘‘ Potentially we’ve got trilliondollar deficits for years tocome, even with theeconomic recovery that weare working on at this point.I’m going to be willing tomake some very difficultchoices in how we get ahandle on this deficit.

’’— President-elect Barack Obama, speaking to reportersabout the nation’s long-term fiscal health. (See p. 196.)

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CONTENTS

Volume 122 Number 2January 12, 2009

TAX NOTES, January 12, 2009 167

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VIEWPOINTS

241 Failing to Talk to Yourself — A FIRPTATax Trigger

256 Incorporating the Tax ExpenditureConcept Into the Tax Code

ON THE MARGIN

269 Tax Policy During the Recession: TheRole of Fiscal Stimulus

TAX HISTORY

275 Talking Tax: Inaugurations and theRhetoric of Revenue

OF CORPORATE INTEREST

279 Reorganization of InsolventCorporations

INSIDE TAX REFORM

283 A Pro-Growth and Progressive SocialSecurity Reform Proposal

TAX CALENDAR

285 Government Events

286 Meetings and Seminars

286 Tax Administration

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168 TAX NOTES, January 12, 2009

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Effective Stimulus:Tax Credits for Homeowners

By Jennifer Brown — [email protected]

All of the talk in Washington is about stimulusand the economic crisis. Lawmakers faced with abig job want to make stimulus more effective andreduce foreclosures. What should they do? Theyneed to begin by paying more attention to ourseverely weakened credit markets and financialinstitutions. In that vein, Martin Sullivan has anexcellent suggestion: Convert the mortgage interestdeduction into a credit. This is good tax policy; itchannels the tax benefits of homeownership — nowdisproportionately available to high-income house-holds — to the low-income households that needthe most assistance. There is a lot of bang for thebuck here — the proposal is effective stimulus and itwould reduce foreclosures. For Sullivan’s economicanalysis, turn to p. 171.

And it looks like this is just the time for Congressto look closely at Sullivan’s proposal becausePresident-elect Obama wants a recovery plan withmassive tax cuts (p. 182). Last week he beganlobbying for an economic recovery plan including$300 billion in cuts for individuals and businesses. Ihave to point out that there is something in theObama plan that I don’t like — the proposed‘‘Making Work Pay’’ credit. It was designed to offsetthe regressivity of the payroll tax, providing up to$500 for individuals ($1,000 for joint filers), includ-ing those who don’t make enough to pay incometax. Why don’t I like it? It has been estimated thatthe credit would add approximately $20 to theaverage worker’s paycheck — and that isn’t goingto stimulate anything.

National Taxpayer Advocate Nina Olson usedher annual report to call on both Congress and theIRS to help taxpayers who are in financial trouble.Financial distress, along with simplification of theInternal Revenue Code, topped her annual list ofthe most serious problems facing taxpayers. Shealso voiced concerns about the IRS’s employmenttax policies and the burgeoning number of civilpenalties. As in prior years, the report offers legis-lative proposals, including her perennial plea forreform of the alternative minimum tax (p. 185).

Lee Sheppard has again written on my favoritetopic — tax shelters. Need to defend one and thedeal stinks so much you don’t know what to do?Look no further, Sheppard has some (pretty funny)advice. My favorite is: ‘‘You have to have somelipstick on your pig.’’ She also points out that youcan’t count on privilege to keep out of evidenceembarrassing things like memos with a handwrit-ten ‘‘bs’’ in the margin, and you might not want toput fat cat clients in front of a jury right now. In allseriousness, however, she presents a thorough sur-vey of recent tax shelter cases — from LILO/SILOto son-of-BOSS — analyzing who won and why. ForSheppard’s news analysis, turn to p. 176.

The new cost-sharing regs came out recently, andI printed them out the day they were released. Well,I printed part of them. I hit print, walked over to theprinter, and stood there. And stood there. Afterkilling more than one tree, I hit cancel on the printerand sat down with a huge stack of paper. I tried toread it, sighed, and then put it all in the recycle bin.My decision to read the article by Lisa Nadal on p.191 instead was a good one.

CommentaryAlan Viard believes that fiscal stimulus must be

timed almost perfectly to achieve a beneficial effect.In On the Margin, he argues that stimulus does notcreate output and jobs out of thin air, but ratherborrows them from the future. He writes thatstimulus measures should be temporary and thatour expectations should be limited. Not surpris-ingly, he also says that government spending doesnot necessarily provide a larger stimulative effectthan tax cuts (p. 269).

New presidents don’t like to talk about taxes intheir inaugural address. Joseph Thorndike delvesinto this phenomenon by examining the speeches ofpresidents from William McKinley through GeorgeW. Bush. Thorndike isn’t surprised to find thatwhen presidents do talk about taxes, their tone isnegative. His Tax History piece appears on p. 275.

Tax returns are not subject to an absolute privi-lege against discovery. In a practice article, NancyBowen outlines strategies for defending againstthose discovery requests (p. 217). Bowen says thatthe production of federal income tax returns innontax disputes can be avoided, or at least limited,with proper knowledge of the law. On p. 222,William Raabe, Cherie Hennig, and John Everettexamine the section 168(k)(4) election in the Hous-ing and Economic Recovery Tax Act of 2008 and

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conclude that Congress would probably like a do-over. Their article points out 10 defects in thelegislation.

This week’s special report deals with the anti-churning rule in section 197(f)(9). Romina Weissthinks the rule has outlived its usefulness and thatit should be repealed in the interests of fairness andefficiency (p. 227). Zhicheng Li Swift proposesincorporating the tax expenditure concept directlyinto the code and using adjustment factors to im-prove the estimates of revenues forgone by specifictax provisions. For her analysis of tax expenditures,see p. 256. John Magee and F. Scott Farmer writethat practitioners frequently pay too little attentionto the procedural requirements of the 1980 Foreign

Investment in Real Property Tax Act and that thisresults in unwanted gain recognition. They discusshow the remedial reporting rules provided by theIRS in response to requests for relief are inadequate(p. 241). Inside Tax Reform proposes cutting thepayroll tax immediately by 1 percentage point tohelp workers suffering from rising healthcare costs,high mortgage payments, food prices, and state andlocal taxes. Mark J. Warshawsky thinks this is justthe first step in making Social Security taxes moreequitable (p. 283). In keeping with the general focuson economic distress, Robert Willens addresses thereorganization of insolvent corporations in Of Cor-porate Interest (p. 279).

Jackie Hutchinson, a Tax Analysts employee since 2000, died on January 4.Jackie attended congressional hearings to obtain testimony and collecteddocuments from federal agencies. She knew everyone at Tax Analysts. Herfriendliness was legendary, and she never said an unkind word. To say wewill miss her is an understatement.

In Memoriam

WEEK IN REVIEW

© Tax Analysts 2009. All rights reserved. Users are permitted to reproduce small portions of this work for purposes of criticism, comment, newsreporting, teaching, scholarship, and research only. Any permitted use of these materials shall contain this copyright notice. We provide our publicationsfor informational purposes, and not as legal advice. Although we believe that our information is accurate, each user must exercise professional judgment,or involve a professional to provide such judgment, when using these materials and assumes the responsibility and risk of use. As an objective,nonpartisan publisher of tax information, analysis, and commentary, we use both our own and outside authors, and the views of such writers do notnecessarily reflect our opinion on various topics.


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ECONOMIC ANALYSIS

Putting Stimulus to Work on theSubprime Crisis

By Martin A. Sullivan — [email protected]

The current crisis calls for two main sets of policymeasures. First, measures to repair the financial system.Second, measures to increase demand and restore confi-dence.

— International Monetary Fund report,Dec. 29, 2008

In all recessions, it makes sense for the govern-ment to boost aggregate demand with economicstimulus. This can be done directly with increases ingovernment spending or with tax cuts that induceincreased spending by consumers and businesses.Deciding exactly what to do is causing all thecommotion on Capitol Hill.

To best accomplish their task, our elected repre-sentatives need to recognize that this recession isunlike all the others. Unlike every other downturnsince the Great Depression, this recession was trig-gered by a massive meltdown of the financialsystem. Credit markets ceased to operate. Hugefinancial institutions failed or were massively sub-sidized by the government. For consumers andbusinesses, credit that was plentiful just a year agodried up.

Perhaps it is because our lawmakers fail to seethe difference between this recession and any otherduring their lifetime. Or perhaps it is because theyare too enamored with the Keynesian prescriptionthat insists they increase the deficit any way theywant. Whatever the reason, Congress seems to bedevoting disproportionate attention to stimulus andnot enough to repair of the financial system.

Because Keynesian economics is not specific onwhat form stimulus should take, most of officialWashington wants to channel stimulus into petcauses. One manifestation of this is the repeatedentreaties for ‘‘twofers.’’ We will stimulate theeconomy out of recession . . . and rebuild infrastruc-ture . . . and create a green economy . . . and expandhealthcare . . . and cut taxes on business. At thisshaky stage in our financial history, our economicpolicy should be all crisis management. Until we

are well clear of the financial storm, other policyobjectives — no matter how worthy — are onlydistractions.

The general idea of this article is to urge Con-gress to pay more attention to supporting ourseverely weakened credit markets and institutions.Before we repair the roads, we should repair thefinancial system. Along these lines, this article sug-gests a tax change that will simultaneously stimu-late aggregate demand and strengthen the financialmarkets.

In particular, as proposed by the President’sAdvisory Panel on Federal Tax Reform in 2005,Congress should consider converting the mortgageinterest deduction into a credit. This would be agood tax reform anytime because it channels taxbenefits of homeownership — now disproportion-ately available to high-income households — tolow-income households who need the most assist-ance with meeting the costs of housing.

Before we repair the roads, we shouldrepair the financial system.

In terms of Keynesian economics, it is a goodidea because it gets money into the hands of fami-lies who are most likely to spend it. As a means ofrestoring health to the financial system, it is a goodidea because it targets relief to low-income mort-gage borrowers who pose the greatest risk to mort-gage investors. The credit would reduce mortgagedelinquencies and foreclosures. This in turn wouldreduce losses on mortgage-backed securities andincrease the propensity of financial institutions tolend to businesses and consumers.

To address the needs of the financial crisis, themortgage tax credit proposed by the tax reformpanel should be modified. First, the new ‘‘foreclo-sure mitigation tax credit’’ (as we shall call it)should be refundable so it is available to all tax-payers irrespective of their income tax liability.Second, using what may be thought of as a reversewithholding mechanism, the credit should be pro-vided directly to the mortgage servicers, whowould then reduce monthly mortgage payments bythe amount of the credit. Third, the credit rateshould be boosted from 15 percent to 20 percent.And fourth, at least until after the recession and areasonable transition period, mortgage borrowers

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should be given the choice between using the newcredit or the current mortgage interest deduction.This feature is for the benefit of higher-brackettaxpayers who find a deduction more favorablethan a tax credit. This would prevent any immedi-ate stress at the high end of the housing market.

A foreclosure mitigation tax creditwould reduce monthly mortgagepayments made by low-incomehomeowners.

According to data from the Department of Hous-ing and Urban Development, there were 74.7 mil-lion owner-occupied homes in the United States in2005. Of this total, 66.1 percent — about 49.4 million— had outstanding mortgage debt. (Department ofHousing and Urban Development, American Hous-ing Survey for the United States: 2007, issued Sept.2008.) However, data from the IRS show that only38.6 million taxpayers used the mortgage interestdeduction. (IRS historical statistics, Table 1, ‘‘Indi-vidual Income Tax Returns: Selected Income andTax Items for Tax Years 1999-2006,’’ available athttp://www.irs.gov.) The difference of 10.8 millionis the number of mortgage borrowers who do notget a mortgage interest deduction. These are low-

income individuals who are the most likely todefault on their mortgage loans. These would be theprimary beneficiaries of a foreclosure preventiontax credit.

As an example of how the credit would work,suppose a homeowner has $40,000 of income and a30-year, 6.5 percent, $140,000 mortgage. Monthlymortgage payments would be a little more than$900. In the mortgage’s third year, about 82 percentof each monthly payment is interest. A tax creditequal to 20 percent of interest would reduce themonthly mortgage payment by about $180. Usingmiddle-of-the-road assumptions about taxes andinsurance, this would reduce a common metric ofhousing affordability, the housing cost to incomeratio, from 33 percent to 28 percent. This magnitudeof reduction is comparable to current governmentprograms.

Mortgage MeltdownOur current economic crisis was born in the

housing and mortgage markets. This is a sharpcontrast to the 2001 recession, when rising housingprices saved the economy from a severe downturn.And after that recession, the rise in housing pricesonly accelerated. During the four-year period from2002 through 2006, average U.S. housing prices rose60 percent. Housing prices are shown in Figure 1.

Figure 1. Case-Shiller National Home Price Index, 1997-2008

(Year 2000 = 100.0)

2008:3, 150.0

2006:2, 189.9

50.0

75.0

100.0

125.0

150.0

175.0

200.0

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Over the same period, standards for mortgagelending rapidly deteriorated. An increasingly largeshare of mortgage lending was subprime. Thesehome loans were made to borrowers who put littleor no money down. Borrowers often had low in-come and low credit scores. Lenders often requiredlittle documentation. And an increasing number ofmortgage borrowers were acquiring second homesand homes for investment. The long-term economicviability of these mortgages depended on risinghousing prices.

When a wave of declining house prices sweptover the mortgage market filled with subprimemortgages, disaster struck. The general collapse inhousing prices began in 2006 (and prices havedeclined since then by 20 percent). Because secondmortgages are not an option for zero or negativeequity borrowers, and because mortgage loans aretypically nonrecourse — meaning the only collat-eral at risk was the home itself — unprecedentednumbers of homeowners stopped making theirmortgage payments.

As shown in Figure 2, mortgage foreclosuresbegan to rise in 2006. Foreclosure rates were par-ticularly high for subprime mortgages. From thethird quarter of 2005 through the third quarter of

2008, the foreclosure rate for subprime mortgagesmore than tripled — from 3.31 percent to 12.55percent.

Goldman Sachs economist Jan Hatzius estimatestotal losses in a range from $473 billion, if housingprices stay at their mid-2008 levels, or to $868billion, if housing prices decline by 20 percent fromtheir mid-2008 levels. (‘‘Beyond Leveraged Losses:The Balance Sheet Effects of the Home Price Down-turn,’’ Sept. 10, 2008, Brookings Papers on EconomicActivity, Fall 2008, conference draft. In its latestbudget release, the Congressional Budget Officepredicts a 14 percent decline in home prices fromtheir mid-2008 levels.) Although these are enor-mous numbers, they are not so large in comparisonwith trillion-dollar declines that occasionally occuron the stock market. Why did mortgage losses stirup so much turmoil?

Most of the troubled mortgages had been pack-aged into multitiered securities purchased by finan-cial intermediaries as investments. The purchasersincluded commercial banks, investment banks,hedge funds, and insurance companies. These insti-tutions play a special role in the economy. Theyprovide financing critical to keeping the wheels ofbusiness and consumer activity in motion. When

Figure 2. Quarterly Foreclosure Rate on U.S. Mortgages, 2004-2008

3rd 2008, 2.97

3rd 2005, 0.97

3rd 2008, 12.55

3rd 2005, 3.31

0

2

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t All

Subprime

Source: Mortgage Bankers Association, National Deliquency Survey, Third Quarter 2008.

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financial intermediaries suffer losses, their capital isreduced. When their capital is reduced, they pullback on their lending. With credit availability cur-tailed, consumers spend less and businesses buyless capital equipment and hire fewer workers.

These large losses could not have come at aworse time for financial institutions. As the decadeprogressed, to increase their profits, these compa-nies boosted their borrowing to unprecedentedlevels. This left them with a relatively small capitalcushion given the amount of risk they were assum-ing.

Preventing Foreclosures Is a PriorityDespite resistance on the part of Treasury, econo-

mists and regulators increasingly recognize thatproposals targeted at preventing mortgage foreclo-sures should be a part of any recovery plan for theeconomic crisis. In a December 4 speech in Wash-ington, Federal Reserve Chair Ben Bernankestressed the importance of reducing foreclosuresnot only for families facing the loss of their homes,but for the economy as a whole:

Foreclosures create substantial social costs.Communities suffer when foreclosures areclustered, adding further downward pressureon property values. Lower property values inturn can translate to lower tax revenues forlocal governments, and increases in the num-ber of vacant homes can foster vandalism andcrime.

The president-elect’s transition team announcedon December 7 that Sheila Bair, current chair of theFDIC, will be reappointed by Obama. Even morethan Bernanke, Bair has been sounding the alarmabout the need to reduce foreclosures. In a Decem-ber 17 speech, Bair said she wanted to dispel themyth ‘‘that we can end the housing crisis withoutmodifying troubled mortgages to make them af-fordable for millions of people facing foreclosure.’’Then she added for her Washington audience:

The housing crisis was caused by loose lend-ing practices and unaffordable mortgages.And now unnecessary foreclosures are a veryserious threat to a housing recovery. Millionsof Americans are saddled with mortgages theycannot afford and are in danger of losing theirhomes. The huge surge in foreclosures is hurt-ing everyone by depressing housing valuesand putting more borrowers at risk. Many aresuffering from the recession through lost jobs,lost savings, and lost communities. As regula-tors, we need to use our authority and clout tostop it, and get the country out of the foreclo-sure crisis. This has got to be the top priority.

A particularly gnawing problem in the 21st cen-tury mortgage market is how the economic interestsof borrower and lender have drifted apart. This isdue to securitization. In the past, when banks thatoriginated mortgages held them on their balancesheets, the incentives of borrower and lender toavoid foreclosure were closely aligned. Now it isthird-party mortgage servicers that interface withborrowers, and they have far less incentive thantraditional banks to avoid foreclosure. In fact, be-cause securitized mortgages are divided intotranches, and some tranches may actually benefitfrom foreclosures, servicers risk lawsuits if theyaccommodate borrowers with loan modifications.Also, loan modification to prevent foreclosure is acostly, labor-intensive process that can overwhelmservicers when delinquency rates are high.

Current government programs toprevent foreclosures are not sufficientto restore health to bank balancesheets.

By acknowledging foreclosures to be part of theproblem, the federal government has attempted toprovide some relief. In October 2007 lenders, ser-vicers, and counselors established a voluntary pro-gram called the Hope Now Alliance under theguidance of Treasury and HUD to modify the termsof distressed mortgages. And in 2008 Congressestablished the Hope for Homeowners program.This program, which began operations on October1, allows the Federal Housing Administration toguarantee payments to lenders in exchange for areduction in the loan principal. But there is littledoubt these efforts are insufficient, as Bernankehimself has acknowledged in his December 4speech: ‘‘The foreclosure rate remains too high, withadverse consequences for those both directly in-volved and for the broader economy. More needs tobe done.’’

A proposal floated by Bair to significantly ex-pand these efforts is getting a lot of attention.(‘‘Turmoil in the U.S. Credit Markets: ExaminingRecent Regulatory Responses,’’ statement to theSenate Committee on Banking, Housing and UrbanAffairs, Oct. 23, 2008.) Under the Bair plan, the loanmodification process would be streamlined andloan guarantees (authorized by the Emergency Eco-nomic Stabilization Act of 2008 (P.L. 110-343))would be used as an incentive for servicers toreduce mortgage payments. The proposed reap-pointment of Bair, a Republican, to the FDIC byObama is a signal that the new administration mayadopt this approach.

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Advantages of a Foreclosure Prevention CreditThe main advantage of the proposed foreclosure

prevention tax credit is that it would make adesirable tax reform at precisely a time when itwould provide substantial support to financial mar-kets and the macroeconomy. Under current law,low-income borrowers — who are in low-taxbrackets and who may not itemize — get little or nobenefit from the mortgage interest deduction. Isn’tit ironic that current tax law provides the leastbenefit to borrowers most at risk for foreclosure?

Isn’t it ironic that current tax lawprovides the least benefit toborrowers most at risk forforeclosure?

At a recent House Democratic forum on theeconomy, Mark Zandi of Moody’s Economy.comsuggested that any government stimulus shouldinclude a plan to allow homeowners facing foreclo-sure to reduce their mortgage burdens. ‘‘We need alarge foreclosure mitigation program,’’ he toldDemocratic leaders. Zandi also called for a return tomortgage-backed securities purchases, the originalprimary function of the Troubled Asset Relief Pro-gram (TARP). Both of these programs, by increasingthe value of mortgage securities, would free upbanks’ balance sheets and allow them to resumelending.

Immediately following Zandi, Harvard econo-mist Martin Feldstein agreed on the need for reduc-ing foreclosures to restore banks’ capital andencourage lending. But he did not endorse TARPasset purchases because of the overwhelming com-plexity of pricing mortgage-backed securities.

The foreclosure mitigation tax credit being pro-posed here achieves the common ultimate objectiveof TARP purchases as well as the Bair Plan: Itstrengthens bank balance sheets. By restoring valueto bank assets, which in turn increases bank capital,a foreclosure mitigation tax credit encourages banklending. But the tax credit has a tremendous advan-tage over either of these alternatives: simplicity.Even the FDIC’s streamlined loan modification planknown as ‘‘Loan Mod in a Box’’ requires a determi-nation of qualification, income verification, andextensive paperwork for the servicing company —often on a loan-by-loan basis. Most of all, it requiresno approval from the holders of mortgage securi-ties. The tax credit is a simple refundable credit. It isequal to 20 percent of any mortgage payment —period, unless the borrower opts out. The mortgageservicer receives tax credits from the governmentand then reduces monthly payments by the sameamount.

The Credit as Part of Obama StimulusThe foreclosure mitigation tax credit could stand

alone, but it is more realistic to view it as part of thecoming Obama stimulus plan.

Because the foreclosure mitigation tax credit can-not solve all the problems of the subprime crisis, itwould be most effective in combination with a planlike that proposed by Bair. The tax credit and Bairproposal are complementary tools for the govern-ment’s foreclosure prevention tool kit. Availabilityof a foreclosure prevention tax credit would helplarge swaths of subprime borrowers for whomforeclosure is imminent. This would free up over-worked mortgage servicers and counselors to ad-dress the borrowers with the most difficult issuesand for high-income subprime borrowers who getno additional tax benefit from the credit.

To reduce the revenue cost of this proposedcredit, it could be limited, as in the case of the FDICloan modification plan, to mortgage borrowers indistress as determined by specified financial ratios.But why reduce the credit’s scope, especially at thecost of reducing simplicity when streamlining loanmodification is a policy priority?

At the time of this writing, the general belief isthat the Obama transition team wishes to providemiddle-class tax relief consistent with proposalsmade during the campaign. For example, a $500refundable tax credit is discussed as a likely pos-sibility. It would make a lot of economic sense for aforeclosure mitigation tax credit to replace generictax relief. It would provide superior economicstimulus because it directs proportionately morerelief to low-income households. And it has theadditional — and critically important — benefit ofstrengthening banks so they can lend.

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NEWS ANALYSIS

11 Rules for DefendingTax Shelter Cases

By Lee A. Sheppard — [email protected]

Lee A. Sheppard is a lawyer and contributing editor toTax Notes. This is adapted from a December 2, 2008,speech at the Minnesota Tax Institute.

Never defend your own deal.If you don’t call in outside lawyers when decid-

ing whether to fight, you will be calling them inlater. When it will be much, much more expensive.

Planners tend to overidentify with clients. Out-side litigators bring fresh eyes. They take the worldas they find it. They have no parental interest inyour deal, or in ignoring the bad points.

Long Term Capital Holdings v. United States, 330 F.Supp.2d 122 (D. Conn. 2004), aff’d, 150 Fed. Appx.40 (2d Cir. 2005), Doc 2005-19826, 2005 TNT 187-16,shows what happens when lawyers get too attachedto their own handiwork.

The case involved a lease-stripping deal — basi-cally a tax shelter piled on top of another tax shelter.The partners of the hedge fund Long Term CapitalManagement (LTCM) were accused of having over-valued their preferred equity interest in the deal toproduce huge artificial losses for themselves. Thetaxpayer lost at trial, and there were penalties. Thenthe taxpayer got new law-yers, who appealed only thepenalties, which were up-held.

At trial, the lawyers whoset up the deal put one oftheir own on the stand, withpredictable results. This wasthe lawyer who gave theoral return filing opinion,the later written version ofwhich the taxpayer tried tokeep out of evidence asprivileged. He had repre-sented LTCM on audit andin settlement negotiationsand assisted in the litigation.The judge questioned hiscredibility. (For discussion,see Tax Notes, Sept. 6, 2004,p. 1005, Doc 2004-17569, or2004 TNT 173-5.)

The lawyer was put onthe stand to bolster the busi-ness purpose claim. Now,the taxpayer is supposed to

come to the lawyer with a business purpose whenthe lawyer is being asked to give an opinion, not theother way around. The court would not let thetaxpayer rely on the opinion to get out of penalties,finding that the opinion did not consider the rel-evant facts and circumstances, and that it was basedon false assumptions about profit and businesspurpose.

Bad facts are any facts that contradictyour form. You are trying to sustainyour form.

On appeal, the taxpayer’s new lawyers arguedthat the taxpayers were being punished for themisdeeds of their advisers. The appellate court wasnonplused that the latter could assume profit mo-tive and business purpose. (For coverage, see TaxNotes, Sept. 26, 2005, p. 1497, Doc 2005-19498, or2005 TNT 184-1.)

In its terse per curiam opinion, the court notedthat the trial court had found no evidence that thetaxpayer received the oral opinion that it claimed tohave relied on before filing its return, and that evenif it had, the later documentation of that opinionwas not based on all pertinent facts and circum-stances. The taxpayer, the court said, knew that theassumptions of business purpose and profit motivewere false.

Newscom

You have to have some lipstick on your pig. The judge needs a hook to find in favor of thetaxpayer.

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TIFD III-E Inc. v. United States (the Castle Harbourcase), 459 F.3d 220 (2d Cir. 2006), Doc 2006-14691,2006 TNT 150-8, featured a leveraged lease that wascrossing over, so the taxpayer needed a new shelterin which foreign banks posed as partners for in-come shifting via an elaborate partnership. Thebanks were promised the return of their capitalfrom a segregated stash, plus a guaranteed yield inexchange for being allocated income.

The same lawyers defended their own dealagain, and won at trial showing a business purposethat passed the Second Circuit’s disjunctive eco-nomic substance test. They lost on appeal when theSecond Circuit held that the banks were not part-ners. Neither the trial judge nor the appellate judgeunderstood the technical partnership rules.

Litigation is about penalties. Expect to pay the tax.The son-of-BOSS settlement offer foolishly in-

cluded penalties, because the IRS was on the war-path. The IRS was operating from the view that thetaxpayers owed a 40 percent valuation understate-ment penalty, and so a 20 percent penalty was adiscount. The IRS did not count on well-heeledtaxpayers being willing to wait it out. The settle-ment offer was unusual for its insistence on penal-ties and for its having preceded any litigation.(Announcement 2004-46, 2004-21 IRB 964, Doc 2004-9620, 2004 TNT 88-10.)

Factual disconnect opinions, which can evencome from pricey outside lawyers, do not help.Long Term Capital Holdings, and ACM Partnership v.Commissioner, T.C. Memo. 1997-115 (1997), Doc 97-6453, 97 TNT 44-17, aff’d in part, rev’d in part, andremanded, 157 F.3d 231 (3d Cir. 1998), Doc 98-31128,98 TNT 202-7, cert. denied, 526 U.S. 1017 (1998).

Promoter’s opinions do not help unless the judgeis already inclined toward the taxpayer. Klamath v.United States, Dkt. No. 5:04-cv-00278 (E.D. Tex.2007), Doc 2007-2603, 2007 TNT 22-9; Stobie CreekInvestments LLC v. United States, Dkt. Nos. 05-748T,07-520T (Ct. Fed. Cl. Jul. 31, 2008), Doc 2008-16870,2008 TNT 149-5.

TEFRA partnership-level cases cannot literallyconsider partner-level defenses like reasonablecause because of reg. section 301.6221-1T(d). Theregulation is unreasonable, but it is there and hardto get around. Stobie Creek, and Jade Trading LLC v.United States, Dkt. No. 03-261 (Ct. Fed. Cl. Dec. 21,2007), Doc 2007-28072, 2007 TNT 248-5.

Trials are about facts. Expect to lose on the law.You have to have some lipstick on your pig. We

hope that the president-elect’s impolitic use of thisuseful expression does not remove it from thelexicon. To mix metaphors, you don’t want yourmannequin to be naked in the shop window.

Lipstick requires being able to argue a plausiblebusiness purpose. The judge needs a hook to find infavor of the taxpayer.

ASA Investerings Partnership v. Commissioner, T.C.Memo. 1998-305, Doc 98-26209, 98 TNT 162-7, aff’d,201 F.3d 505 (D.C. Cir.), cert. denied, 121 S. Ct. 171(2000), shows that it is risky to argue that nobusiness purpose is necessary.

A large corporate taxpayer did one of the MerrillLynch installment sale deals. At trial, the taxpayertook the position that it did not have to have abusiness purpose for the deal, that literal compli-ance with the rules it was abusing was enough. Thetaxpayer lost at trial and on appeal.

Don’t go to trial with bad facts. Settle unless youhave been designated for litigation.

Bad facts are any facts that contradict your form.You are trying to sustain your form.

Unless you have a very well-planned deal, some-thing will come along to contradict your form, andthe IRS will pounce. Some retail shelter form isreally sloppy. Retail customers do not get the bestlegal work, even though they pay a lot in fees.Cookie-cutter deals inevitably have mistakes, buteven expensively lawyered deals like LILOs haveinconsistencies. Some bad common facts are:

Backdated documents. In Stobie Creek, the eventsthat created the artificial loss took place over severalweeks in the spring, but lawyers were still changingthe dates on documents in December to get theprogrammed steps in the correct order.

Bank memos. ASA Investerings featured internalbank memos that described the bank’s purportedpartnership equity investment as a loan.

Book treatment. In Castle Harbour, the banksbooked their purported equity investments asloans.

Contrary legal documents. The only decided SILOcase featured municipal documents saying that thefacility had not been sold or moved from the seller’sbalance sheet. AWG Leasing Trust v. United States,No. 1:07-cv-00857-JG (N.D. Ohio May 28, 2008), Doc2008-11830, 2008 TNT 105-10.

Inconsistent acts. In the LILO case BB&T Corp. v.United States, 523 F.3d 461 (4th Cir. 2008), Doc2008-9547, 2008 TNT 84-15, the lessor/sublesseemade substantial improvements to the equipment,which it treated as its own. In AWG, the Germanmunicipal corporation had a contractual guaranteeof quiet enjoyment.

Serial numbers. In a lease-stripping deal, the serialnumbers of the computers on the taxpayer’s leasesdid not match those on the computers that thelessee was using. Andantech LLC v. Commissioner,T.C. Memo. 2002-97, Doc 2002-8572, 2002 TNT 70-10,aff’d in part and remanded in part, No. 02-1213, (D.C.Cir. June 17, 2003), Doc 2003-14649, 2003 TNT 117-8.

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Impossible assumptions about future occurrences.These featured prominently in several cases.Nuclear holocaust would have been required tomake ACM’s interest rate bets pay off. The Germanparty in AWG was theoretically going to commit tooverpay for a service contract and refinance thepurchaser/lessors’ huge debt. The investment part-nership in Stobie Creek would have made moneyonly if the Swiss franc moved inversely to the euro.

No arm’s-length negotiation. In AWG, the SILOcustomers did not negotiate or even question theprice of the valuable asset they were purportedlybuying. Plus there was evidence that value hadbeen jacked up to increase depreciation deductions.

Memos to the file. The family lawyer wrote ‘‘BS’’ inthe margins of memos in the Stobie Creek son-of-BOSS case. Every piece of paper was in court.

Fees. Excessive fees are a bad fact when the courtapplies the opportunity cost analysis the Tax Courtapplied in ACM. Fees disproportionate to the ex-pected pretax profit from the deal are routine inretail deals (Sheldon v. Commissioner, 94 T.C. 46, Dkt.No. 18208-85 (1990), Doc 90-3768, 90 TNT 114-11).

Dressing a shelter up like a businesscosts more, so many retail dealsbasically have naked mannequins inthe shop window.

E-mails. All those sarcastic e-mails about what agarbage deal you have are going into evidence.Nothing is ever erased from a hard drive. Let’s talkabout the Ice Cube, a little portable computer thatgovernment investigators use to copy hard drives.

What do good facts look like?Carlos E. Sala et ux. v. United States, 552 F. Supp.

2d 1167 (D. Colo. 2008), Doc 2008-9012, 2008 TNT80-10, featured both a taxpayer who sincerely be-lieved he had a profit potential and a deal that wasdressed up with other transactions. The case alsofeatured a sympathetic judge and serious govern-ment misbehavior. These circumstances overcamethe bad fact of the taxpayer having zeroed out hisincome.

It is harder for individuals to argue businesspurpose/profit motive. An individual needs noisein the form of other activity in the deal to distractthe judge from the shelter and to dress it up like abusiness. Dressing a shelter up like a business costsmore, so many retail deals basically have nakedmannequins in the shop window.

Don’t count on privilege to keep embarrassingand detrimental things out of evidence.

Attorney-client privilege in tax matters is not asextensive as you think it is. And even if it is, it is

waived at the drop of a pin. Also bear in mind thatthe privilege belongs to the client, not the lawyer.

A tax return is a disclosure document. Informa-tion transmitted for use on a tax return, or backupmaterial for the information presented on the re-turn, is not privileged.

Privilege is waived if the information is used ona tax return. In United States v. Lawless, 709 F.2d 485(7th Cir. 1983), the Seventh Circuit held that there isno expectation of confidentiality in informationtransmitted for use on a tax return, regardless ofwhether the information was actually disclosed onthe return. Implied waiver is the theory of someother circuits in their holding that tax return prepa-ration is not privileged. United States v. Cote, 456F.2d 142 (8th Cir. 1972).

Disclosure to accountants waives attorney-clientprivilege. (Cavallaro v. United States, 284 F.3d 236 (1stCir. Apr. 1, 2002), Doc 2002-7987, 2002 TNT 65-10;Medinol, Ltd. v. Boston Scientific Corp., 214 F.R.D. 113(S.D.N.Y. 2002).) In most situations, transactioncosts would be hugely increased if lawyers had tobaby-sit everything to avoid waiver. (United States v.Kovel, 296 F.2d 918 (2d Cir. 1961).)

Opinions are not privileged. You are not entitledto have penalties waived for reliance on an opinionthat no one is allowed to read. An opinion is onlyworth its persuasive power.

LTCM partners tried to keep a factual disconnectopinion on which the taxpayer had purportedlyrelied out of evidence, but were found to havewaived attorney-client privilege by disclosing thegist of it to the accountant. The taxpayer did suc-ceed in getting work product privilege for someparts of the opinion. Long Term Capital Holdings, etal. v. United States, Dkt. No. 3:01-cv-1290 (JBA) (D.Conn.), Doc 2003-1021, 2003 TNT 7-17.

KPMG tried to keep tax shelter promotionalmaterials out of evidence in United States v. KPMGLLP, 237 F. Supp.2d 35 (D.D.C. 2002). BDO Seidmantried to withhold customer names in United States v.BDO Seidman, Regarding Promoter Examination ofBDO Seidman, Appeals of John Doe and Jane Doe andRichard Roe and Mary Roe, 7th Cir., Nos. 02-3914 and02-3915 (Dec. 18, 2002), Doc 2003-5515, 2003 TNT41-44. Both appear to have been trying to run outthe customers’ statute of limitations. This tactic onlymade it worse down the line. (For discussion, seeTax Notes, June 2, 2003, p. 1303, Doc 2003-13467, or2003 TNT 106-3.)

You can get work product protection if whatyou’re doing is so bad that you planned in advanceto protect some documents. United States v. TextronInc. et al., No. 1:06-cv-00198 (D.R.I. Aug. 29, 2007),Doc 2007-20046, 2007 TNT 169-1. Work productcannot be asserted ex post facto. LTCM got workproduct for some parts of its opinion.

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Regarding tax accrual workpapers, IRS officialskeep saying they will only go after them in listedtransactions. (Announcement 2002-63, Doc 2002-14466, 2002 TNT 117-12.) But United States v. ArthurYoung & Co., 465 U.S. 816 (1984), gives them theright to get them all the time, and there is a lot ofinternal disagreement on this.

Textron and Regions Financial Corp. et al. v. UnitedStates, No. 2:06-cv-00895 (N.D. Ala. May 8, 2008),Doc 2008-10349, 2008 TNT 92-64, are on appeal. Bothare wrongly decided. Tax accrual workpapers arenot prepared for litigation. They are prepared forroutine financial accounting in the ordinary courseof business, which is an exception to the workproduct rule.

Procedure is very important.Somebody won a case on your issue! So what?

Pay very careful attention to how that result cameabout.

The outcome on the merits of a case can behugely affected by procedural posture. Procedurecan prevent litigants from having the argumentthey want to have, or it can be used to force theother party into a disadvantageous argument.

Whether there was trial on the facts is importantwhen assessing the implications of a decision forgoing forward with your case, or deciding whetherand how to fight a similar case.

A summary judgment on the law on your issuemeans your facts ain’t gonna matter. If you have thesame deal, you may not be able to differentiate it tothe next judge. This is what happened in the LILOcases.

In a summary judgment motion, the facts areviewed in the light most favorable to the nonmov-ing party. Summary judgment is proper when thereis no genuine issue of material fact, and the movingparty is entitled to judgment as a matter of law.

Taxpayers lost the LILO cases on motions forsummary judgment. These taxpayers never ex-pected to lose on the law. They wanted to have thearguments within the realm of leasing law andargue about the value of residual. The courts didn’tallow them to have that argument. They were stuckwith their ugly facts.

BB&T, a LILO case, determined the SILO cases,because the taxpayer lost on the law.

The taxpayers lost the AWG SILO case on thefacts, despite the judge accepting their version ofthe law. So the playing field was leasing law, noteconomic substance, but the taxpayer still lost. Thecourt found no tax ownership and no pretax profitpotential. The court believed that the Germanseller/lessee would take back the waste treatmentplant using the contractual out that required nocash outlay.

The leasing bar was collectively shocked thatspreadsheets didn’t carry the day in AWG. Thetaxpayers, a pair of regional banks, insisted that acomputer program in wide use in the leveragedleasing business ensured that they had enoughequity and enough profit built into their SILO deal.

Why was the LILO/SILO settlement so gener-ous? Customers can forgo 80 percent of interest andrent deductions in exchange for having 80 percentof rental income ignored. So taxpayers could deduct20 percent. No penalties. There would be someextra tax if taxpayers did not unwind quickly. Mosttook the deal. (See Doc 2008-17195 or 2008 TNT153-1.)

The government did not ask for 100 percent ofthe tax because of the risk that big taxpayers wouldwin a case. The government believed the deal hadto be attractive. But the government is now de-manding more penalties in son-of-BOSS retail shel-ter cases. Life is not fair.

Countryside Limited Partnership v. Commissioner,T.C. Memo. 2008-3, Doc 2008-61, 2008 TNT 2-15, is acrash course in trial procedure. The taxpayers gotthe result they wanted by controlling the issuesbefore the court. The case was decided on a motionfor summary judgment.

In Countryside, the taxpayers used a convolutedtransaction that straddled tax years to have theirinterests in a real estate partnership redeemed forwhat the IRS said was a cash equivalent. Thephased transaction involved multiple partnerships,the abusive failure to make a section 754 election,and the distribution of liquid privately issued notesso that rules for recognition of gain on cash distri-butions would not be triggered.

The taxpayer’s lawyers succeeded in moving thefight to where they wanted it to be by whacking upthe case into single-issue procedures. They cleverlyseparated the three tax years and multiple partner-ships involved, filing four cases in two differentcourts. The IRS did not move to consolidate, and thejudge rejected IRS importuning to discuss otherquestions.

Basically, the IRS took the bait, and lost on a weakargument that it thought would prevail. The tax-payer won a motion on the narrow question ofwhether a liquid security from AIG was a cashequivalent.

Yes, that AIG — expect the taxpayer to screamabout it in the next phase of the case. The IRSposition on this point was aggressive and legallyquestionable, so it had been backed into a corner.

The taxpayer also got an undeserved economicsubstance holding in its favor. The court found agenuine nontax purpose in the desire of the part-ners to convert their real estate investment to a

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different form. That is either successful tax planningor a tax-sheltered sale, depending on one’s point ofview.

Litigation is expensive.There are no discounts. You are looking at a

decision whether to pay the tax and penalties orincur a potentially open-ended legal bill.

If you take the perspective that penalties are theonly cost that can realistically be avoided, then thepotential legal bill has to be weighed against onlythe cost of the penalties. If you’re heading to TaxCourt, interest charges on the deficiency keep run-ning while the lawyers’ meter is ticking.

Many of the individual taxpayers who are fight-ing son-of-BOSS cases are seriously rich peoplewith boxcar deficiencies. They can afford to absorbhefty litigation costs while looking to get out ofpenalties. Taxpayers with smaller deficiencies basi-cally cannot afford to fight. That fact weighed in thegovernment’s favor when it went after tax shelterssold to salary earners in the 1980s.

Litigation chews up your business people’s time.The only people who have fun are the litigators.Litigation is like transfer pricing compliance in

that it is a huge waste of business people’s time.Substantiating a business purpose takes up time.

Preparing business people to be witnesses takestime. Preparing business witnesses to be deposedby the government takes time.

In Castle Harbour, the taxpayer could not show apotential profit, so it put the business people on thestand with a story about how the transaction would‘‘monetize’’ old commercial aircraft headed straightto Memphis, to the betterment of their personalcareers. Preparing them to do this had to have beena very time-consuming project.

In AWG, the banks had the right to compel aGerman municipal corporation official to be a wit-ness but did not do so, probably for fear he wouldcontradict their story.

Coltec Industries Inc. v. United States, 454 F.3d 1340(Fed. Cir. 2006), cert. denied, 127 S. Ct. 1261 (2007),showed there can be nasty surprises. Putting thebusiness guys on the stand may have impressed thetrial judge, but not the court of appeals.

There is a choice of forum.District court is not necessarily better. Judges

who are unschooled in the technical tax law maynonetheless have a healthy suspicion about gooseeggs on the bottom of a tax return.

Some foreign tax credit generator cases are goingto Tax Court because the banks don’t have themoney to deposit the tax. Tax Court judges aretechnicians, who may not deserve their recent repu-tation as biased against taxpayers. Taxpayers couldvery well win one of these cases. (Compaq Computer

Corp. v. Commissioner, 277 F.3d 778 (5th Cir. 2001),Doc 2002-184, 2002 TNT 1-5.)

Regarding LILO and SILO cases, going to districtcourt did not help them. The judges thought thedeals were phony. This was entirely foreseeable.Even though the government struggled with itslegal arguments for a decade, a judge was going towonder what the hell was going on when a bankwas leasing some French subway cars.

Regarding son-of-BOSS cases, some district courtjudges empathized with rich individuals burdenedby pesky taxation. Just as many thought the dealswere hokey.

Litigation is a crapshoot.You can have the best case in the world and still

have a 20 percent chance of losing.Litigation is not about the merits of the case. Not

when it gets into the hands of litigators and notwhen it gets into the hands of a judge.

You should watch out for the kind ofclient who wants to go to court to beproven right all along.

You should watch out for the kind of client whowants to go to court to be proven right all along.Courts are not engaged in a metaphysical search fortruth. Clients who want their actions blessed by aguy in a black robe should go to church.

The government is fighting everything to thewall. Sometimes, as in son-of-BOSS, they use afighting regulation. Three judges addressed thevalidity of that fighting regulation, with two districtcourts holding it invalid. (Klamath Strategic Invest-ment Fund, LLC v. United States, 440 F. Supp.2d 608(E.D. Tex. 2006), Doc 2006-13753, 2006 TNT 140-14.)

One cannot count on having a regulation invali-dated. The Seventh Circuit upheld the retroactiveson-of-BOSS regulation in Cemco Investors, LLC et al.v. United States, 515 F.3d 749 (7th Cir. 2008), Doc2008-2695, 2008 TNT 27-8.

The IRS usually issues a prospective, curativeregulation or guidance to stop future cases, but itwill still fight the prior deals using general prin-ciples like economic substance. There is no section7805(b) relief for those aggressive taxpayers whogot their deal done before the rules changed.

The economic substance doctrine has been re-written in Coltec. In the Coltec formulation, if ataxpayer had no motive other than tax avoidance,the taxpayer bears a heavy burden of showing thatthe transaction had economic substance. Both profitpotential and meaningful nontax economic effectsmust be shown by objective evidence.

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Coltec requires that the transaction that producedthe tax benefit be analyzed, meaning that extra-neous features added on to dress it up should beignored. In Stobie Creek, there was no windowdressing for the judge to set aside.

‘‘There is a material difference between structur-ing a real transaction in a particular way to providea tax benefit (which is legitimate), and creating atransaction, without a business purpose, in order tocreate a tax benefit (which is illegitimate),’’ FederalCircuit Judge Timothy Dyk commented in Coltec.

In LILO cases, rent and interest deductions weredisallowed on grounds of lack of substance, eventhough the deals might have passed muster underaccepted leasing law. In AWG, the SILO case, thetaxpayers got a favorable economic substance hold-ing, but still lost on the question of tax ownership,which was pertinent to depreciation deductions.

Economic substance, or its kissing cousin, sub-stance over form, has been the only option for thegovernment in fighting old LILO cases, because somuch water has passed under the bridge in theform of widely accepted tax-motivated leveragedleasing, which users of expensive equipment havecome to depend on.

The IRS will assert every penalty that couldconceivably apply. Judges will sometimes imposethem in the alternative because they’re angry at thetaxpayer, as the judge did in Jade Trading.

There are judges who will refuse to apply theeconomic substance doctrine, but part of the crap-shoot is the lack of assurance that the taxpayer willdraw one of these judges. (See Countryside andCompaq, supra.)

Never ask for a jury.We don’t have class warfare in America. There is

no need for you to start a class war by invitingordinary citizens to see how rich your client is.

Any client with enough money to hire lawyers togo to court to argue about taxes is too fat a cat forjuries. In good times, the regular folks don’t mindthat big shots pay no tax. In bad times, they mindvery much.

Don’t forget that court is public. Your client’sfinancial dirty laundry is hanging out there. WillieNelson got the record sealed in his tax shelter casebecause he didn’t want fans to find out how rich hewas.

Even if you think your client is sympathetic,juries are unpredictable. In the LILO case Fifth ThirdBancorp v. United States, No. 1:05-cv-350 (Apr. 17,2008), Doc 2008-9425, 2008 TNT 83-17, jurors gotconfused by instructions that simultaneously askedthem to decide leveraged lease law and economicsubstance. They decided that the LILO compliedwith leveraged lease law but had no economicsubstance, leaving both sides wondering who won.

If you win at trial, you could still lose on appeal.The appellate judge is not likely to retry the case.

The standard of review is clear error. But he canreinterpret facts found by a trial judge. Businesspurpose and economic substance are legal conceptsderived from facts.

The Sala decision has been appealed. The govern-ment refuses to accept a loss.

In Boca Investerings Partnership v. United States, 31F. Supp.2d 9 (D.D.C. 1998), rev’d, 314 F.3d 625 (D.C.Cir. 2003), Doc 2003-1175, 2003 TNT 8-7, the tax-payer won at trial by keeping very damaging stuffout of evidence, benefiting from some dubiousevidentiary holdings by the trial judge.

The appellate judge found no partnership ex-isted, following a decision in the same circuit aboutthe identical deal done by another taxpayer. Practi-tioners like to think they can differentiate their facts,but sometimes they are looking at a distinctionwithout a difference.

In Castle Harbour the taxpayer convinced the trialjudge that it had a business purpose for its deal,and got the judge to ignore some glaring problemswith the deal that were evident from the docu-ments. The next judge was not so willing to ignorethe red flags.

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Obama Lobbies for Recovery PlanWith Massive Tax Cuts

By Sam Goldfarb — [email protected],Chuck O’Toole — [email protected],

Meg Shreve — [email protected],Sam Young — [email protected], andWesley Elmore — [email protected]

Within hours of moving to Washington,President-elect Barack Obama last week began lob-bying Congress for an economic recovery plancontaining some $300 billion in tax cuts for indi-viduals and businesses.

Congressional leaders from both sides of the aislegenerally approved of the direction of Obama’splan, though they were skeptical about some of itsdetails. They pledged to have legislation ready for a

vote soon, but there was also a growing sense thatthe bill would likely proceed through the standardcommittee process.

Obama’s proposal includes initiatives from hispresidential campaign that are supposed to helpworkers and create jobs, as well as other proposalsthat some lawmakers have championed as provid-ing needed assistance to businesses.

One campaign proposal — the ‘‘Making WorkPay’’ credit — would account for roughly half thecost of the entire tax package. Designed to offset theregressivity of the payroll tax, it would provide upto $500 to individuals ($1,000 to joint filers), includ-ing those who don’t earn enough to pay income tax.

During the campaign, the Obama team said thatthe credit would be available to workers who makeunder $200,000. In a speech last week, Obamareinforced that notion, saying that ‘‘95 percent ofworking families’’ would receive a tax break underhis stimulus plan. Based on the total cost of the

PARTIES FINALIZE SEATS ON WAYS AND MEANS

House Republicans last week picked six newtaxwriters to fill their depleted ranks on the Waysand Means Committee and fill all of the remainingempty seats on the committee. House Democratsfilled their remaining slot on the committee earlier inthe week.

Ways and Means ranking minority member DaveCamp, R-Mich., announced in a release that Reps.Charles W. Boustany Jr. of Louisiana, Ginny Brown-Waite of Florida, Geoff Davis of Kentucky, DeanHeller of Nevada, David G. Reichert of Washington,and Peter J. Roskam of Illinois will join his party’scaucus. Camp praised the new members for their‘‘wealth of experience, knowledge and enthusiasm.’’(For the release, see Doc 2009-319 or 2009 TNT 4-33.)

Boustany and Brown-Waite both bring back-grounds in health policy to the committee —Boustany as a former cardiovascular surgeon andBrown-Waite as a former state legislator who focusedmuch of her attention on the health industry. Brown-Waite introduced legislation in 2007 to provide anabove-the-line deduction for long-term care costs.(For H.R. 2482, see Doc 2007-21372 or 2007 TNT183-22.)

Davis serves as a deputy whip in the House GOPleadership and has advocated using tax subsidies tosupport clean coal production. Reichert, who repre-sents the Seattle suburbs, was one of 2008’s leastloyal Republicans in terms of voting habits, votingwith his party only 75 percent of the time and withPresident Bush just 53 percent of the time, accordingto Congressional Quarterly. His record on tax policy issimilarly mixed, supporting both Democratic bills

promoting alternative energy tax subsidies but alsobacking permanent extension of the 2001 and 2003tax cuts.

Roskam and Heller, both in their second congres-sional term, served on the House Financial ServicesCommittee as freshmen and have also advocatedmaking the 2001 and 2003 tax cuts permanent.

Ways and Means Republicans lost eight of theirmembers at the end of 2008 to retirement or electoraldefeat, including then-ranking minority member JimMcCrery of Louisiana. Two of those seats shifted toDemocratic control when the committee reallocatedmembership to reflect Democratic gains in the fullHouse. The committee ratio now stands at 26 Demo-crats to 15 Republicans.

Democrats filled their last open seat earlier in theweek, when Rep. Linda T. Sánchez, D-Calif., wasnamed to the committee. Sister to Rep. LorettaSanchez, D-Calif., Linda Sánchez joined the House in2002 and chaired the Commercial and Administra-tive Law Subcommittee of the House Judiciary Com-mittee in the 110th Congress. She is known for herstrongly liberal voting record, and has a 98 percentlifetime ‘‘right’’ rating from the AFL-CIO.

Linda Sánchez fills the Ways and Means seat leftopen when Rep. Raúl M. Grijalva, D-Ariz., unexpect-edly declined appointment to the committee inDecember. Grijalva opted to maintain his subcom-mittee chairmanship on the House Natural Re-sources Committee. (For prior coverage, see TaxNotes, Dec. 22, 2008, p. 1358, Doc 2008-26444, or 2008TNT 243-1.)

— Chuck O’Toole

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proposal, the nonpartisan Tax Policy Center previ-ously estimated that the credit would begin tophase out for those making over $75,000.

Obama said that ‘95 percent ofworking families’ would receive a taxbreak under his stimulus plan.

The other proposal held over from the campaignis a one-year credit to businesses that make newhires or avoid layoffs. While Obama transition aideshave only said that the overall cost of the proposalcould be $40 billion to $50 billion, the estimateduring the campaign was that the credit couldprovide businesses with as much as $3,000 for eachnew hire. (For prior coverage, see Tax Notes, Oct. 20,2008, p. 239, Doc 2008-21909, or 2008 TNT 200-1.)

Additional business tax cuts under considerationinclude a two-year extension of current 50 percentbonus depreciation and a five-year net operatingloss carryback provision for losses in 2008 and 2009.Under present law, businesses can apply losses toonly two prior years. (For prior coverage, see TaxNotes, Dec. 15, 2008, p. 1233, Doc 2008-26141, or 2008TNT 240-5.)

Obama’s plan would also raise expensing limitsfor small businesses from $175,000 to $250,000 in2009 and 2010.

A spokesperson for the Obama transition teamconfirmed the details of the tax cut proposals,which were first reported by major national news-papers the day before the newly convening 111thCongress was sworn in.

Lawmakers CriticalNear the end of a busy first week, Senate Finance

Committee Chair Max Baucus, D-Mont., predictedthat ‘‘when all is said and done, we will passlegislation that is fairly close’’ to the Obama plan.

Yet many Democrats have strong reservationsabout the plan.

Democrats on the Finance Committee told re-porters that Obama’s centerpiece tax proposals — a$3,000-per-new-hire tax credit for companies thatcreate new jobs and a $500 credit for individualworkers ($1,000 for joint filers) — seem difficult toput into practice and unlikely to succeed.

Finance Committee member John F. Kerry,D-Mass., said the job creation credit would not spurhiring by businesses hampered by a lack of de-mand. ‘‘The creation of a tax credit [to] enable themto hire is not going to make up for the lack of goodsbeing sold or the change of confidence in theeconomy,’’ Kerry said. ‘‘You have to do the thingsthat come first.’’

Senate taxwriter and Budget Committee ChairKent Conrad, D-N.D., echoed Kerry, saying, ‘‘If I aman auto manufacturer, why am I going to hire morepeople when the cars aren’t selling?’’

Conrad also criticized the $500 credit for indi-viduals. According to transition aides, that credit,equal to 6.2 percent of the first $8,100 in incomeearned by workers, could be implemented by re-ducing the amount of payroll or income tax with-held from paychecks for a limited period.

Conrad estimated that that would add $20 to theaverage worker’s paycheck. ‘‘I don’t see how thatwill do much to encourage spending,’’ he said.

Kerry, Conrad, and fellow taxwriter Ron Wyden,D-Ore., said they would prefer to see more of thepackage devoted to infrastructure improvementsthat would enhance the country’s economic com-petitiveness.

The senators made the comments following aclosed-door, bipartisan committee meeting.

Despite all the criticism, participants describedthe meeting as ‘‘positive,’’ and Republicans in themeeting were cautiously optimistic. Finance Com-mittee ranking minority member Chuck Grassley,R-Iowa, said he would like to see more tax benefitsfor businesses to spur private investment, but saidhe was pleased with the bipartisan spirit of discus-sions.

Timing DiscussedBaucus, meanwhile, said he was ‘‘very tenta-

tively’’ planning to mark up a stimulus bill January22.

The potential timing of legislation was also dis-cussed on the other side of the Capitol. HouseMajority Leader Steny H. Hoyer, D-Md., told re-porters last week that he expected a House packageto come together soon — possibly within themonth.

‘‘I think we were somewhat unrealistic, given thecomplexity, that we could pass this in these twoweeks,’’ Hoyer said. ‘‘We need to make sure that wehave the money distributed in a way that will effectthe end we want.’’

House Speaker Nancy Pelosi, D-Calif., empha-sized that legislation should not lag for severalweeks after the initial Inauguration Day goal.

‘‘We must pass an economic recovery and jobspackage no later than mid-February, in my view,’’Pelosi said last week at a House Democratic Steer-ing and Policy Committee hearing on economicstimulus plans.

At the same time, high-ranking Democratic tax-writers were calling for hearings on the legislation.

House Ways and Means Committee membersRichard E. Neal, D-Mass., and Jim McDermott,

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D-Wash., both said they would push for committeehearings when Democratic committee membersmet later in the week.

‘‘I have never come across one piece of legislationyet that wasn’t improved by going through theregular order,’’ said Neal, who chairs the Ways andMeans Select Revenue Measures Subcommittee.‘‘We’re talking about $300 billion in tax cuts. . . . Youneed to have a conversation about things like that,and the best way to do it is through the committeestructure.’’

McDermott, chair of the Ways and Means IncomeSecurity and Family Support Subcommittee, echoedNeal’s sentiments.

‘‘I want people to come in and educate thecommittee,’’ McDermott said.

Both taxwriters said they had not yet spokenwith Ways and Means Chair Charles B. Rangel,D-N.Y., about the possibility of hearings or otherdetails of the proposed package. A Rangel aidedeclined to comment.

Rangel Calls for Corporate Rate CutRangel appeared at the Steering and Policy Com-

mittee hearing, where he talked about longer-termtax issues along with the recovery package.

Rangel called for a reduction in the corporate taxrate, stressing it ‘‘has been long overdue.’’

‘The creation of a tax credit to enablethem to hire is not going to make upfor the lack of goods being sold orthe change of confidence in theeconomy,’ said Kerry.

Rangel said that although lowering the corporatetax rate would not be difficult to accomplish, ‘‘theproblem politically is that we need some help inremoving the loopholes that are there that areenjoyed by certain businesses and certain peoplethat have really gamed the tax system.’’

Rangel suggested that during the current eco-nomic downturn, businesses should acknowledgethat sacrifices need to be made and work withCongress to close those loopholes.

Other witnesses suggested several tax incentivesthat could help spur an economic recovery. Econo-mist and Harvard professor Martin Feldstein, whotestified in favor of the inclusion of a corporate ratecut in stimulus legislation, cautioned that any leg-islation to reform corporate taxation should beshaped in a way that makes it ‘‘more attractive forAmerican firms to locate in the United States ratherthan to put those businesses abroad.’’ Some of the

provisions Rangel referred to as loopholes might infact be ‘‘explicit incentives to invest in the UnitedStates,’’ Feldstein added.

‘‘I think it’s a question of cutting out those thingswhich don’t help to attract businesses to the U.S.while shaping the entire package to make it moreattractive for businesses to invest here and to createjobs here,’’ Feldstein said.

Rangel included a corporate rate reduction of 4.5percentage points in his ‘‘mother of all tax reforms’’bill (H.R. 3970), introduced in 2007. (For the bill, seeDoc 2007-23857 or 2007 TNT 208-20.) Many Repub-lican lawmakers and other critics, however, weredissatisfied with other provisions in the bill andcalled for a steeper cut in the corporate rate.

Tax IncentivesAlthough much of the House hearing focused on

proposals to increase spending and fund infrastruc-ture projects under the stimulus legislation, wit-nesses agreed that tax incentives that spurconsumer spending should also be part of anypackage.

In addition to lowering the corporate rate, Feld-stein in his testimony recommended longer-termtax policies. Were Obama to announce that hewould prolong the Bush tax cuts on higher-incometaxpayers for five years or more while also leavingthe reduced rates on capital gains and dividendsunchanged, Feldstein said, those promises wouldlead to increased aggregate spending and increasedbusiness investment now. Mark Zandi of Moody’sEconomy.com echoed that recommendation in hisown testimony.

Other tax incentives recommended by Feldsteinincluded an increase in the research credit andenactment of Obama’s promised permanent tax cutof $500 per employed person. That act alone‘‘would generate an annual tax cut of about $70billion and would probably raise annual consumerspending by about $50 billion,’’ he said.

Both Zandi and former Clinton administrationofficial Robert Reich, who served as labor secretary,also called for enactment of the Obama tax cut.

Reich’s other recommendations were aimed atlower-income individuals who he said would bemore likely to spend any tax benefits, thus givingthe economy a bigger boost than policies aimed athigher-income individuals. His recommendationsincluded making the child tax credit fully refund-able, expanding the earned income tax credit, andproviding a temporary holiday from sales taxes andfrom payroll taxes on the first $15,000 of wages.

Witnesses also agreed, however, that spendingand tax policy alone would not be enough tocombat the current recession. They noted that un-less action is taken to fix the credit markets andmitigate home foreclosures, unemployment will

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continue to rise and there will be no chance forsustained long-term economic growth.

Feldstein and Zandi both said that the remaining$350 billion made available to the Troubled AssetRelief Program under the financial bailout bill (P.L.110-343) should be used to help homeowners withdistressed mortgages.

Speed and SizeWitnesses were also adamant that the package be

passed sooner rather than later if it is to have itsintended effect.

‘‘The only way out is through aggressive andquick government action,’’ said Zandi.

The danger ‘‘is not that the government will dotoo much. The danger is that the government willbe doing too little,’’ said Reich, adding that the costof the package should be $900 billion or greater overtwo years. If the package is less than that amount, 3million additional jobs will be lost, and the unem-ployment rate will be 10 percent in 2010, he said.

Democratic AgendaThe challenge posed by the stimulus package

didn’t stop Senate Democratic leaders from an-nouncing a to-do list for 2009 that includes educa-tion, healthcare, and tax incentives aimed atmiddle-income earners, along with economic recov-ery.

Finance Committee member Charles E. Schumer,D-N.Y., promised to ‘‘focus like a laser on middle-class families and what they need.’’ He said Demo-crats would double the child tax credit, expand thedependent care credit, increase the tuition deduc-tion to $3,000 per student and $9,000 per family, andestablish a tax credit for families caring for agingparents not living with them.

Taxpayer Advocate RecommendsHelp for Distressed Taxpayers

By Michael Joe — [email protected],Nicole Duarte — [email protected],

Jeremiah Coder — [email protected], andAmy S. Elliott — [email protected]

With a new administration disembarking at atime of economic turmoil, National Taxpayer Advo-cate Nina Olson used her annual report to Congressto call on the IRS and lawmakers to help taxpayerswho are in financial trouble and to simplify the codethrough major reforms.

Those topics topped Olson’s annual list of the 20most serious problems facing taxpayers; they arethe anchor of her report, which was released anddelivered to Congress last week. (For Olson’s ex-ecutive summary and report, see Doc 2009-241 or2009 TNT 4-21. For a related IRS release, see Doc2009-240 or 2009 TNT 4-10.)

Olson also voiced concern that the IRS’s employ-ment tax policies may overreach and turn backimportant taxpayer protections. She said the bur-geoning number of civil penalties in the tax codeincludes many that are obscure or unduly harsh,citing the example of section 6707A’s minimumpenalty for involvement in a tax shelter. And herreport makes recommendations for reaching out tostruggling tax-exempt organizations, as well as forsimplifying and consolidating various higher edu-cation and retirement tax benefits. (For relatedcoverage, see p. 202.)

As in previous reports, Olson offered legislativeproposals — including a perennial plea for reformof the alternative minimum tax, which affects anincreasing proportion of taxpayers — and looked atthe most litigated tax issues. She weighed in on theongoing debate over whether to regulate paid pre-parers, a move she favors.

‘Taxpayers who previously were ableto pay their taxes find themselvesunemployed, behind on housingpayments, and unable to meet theirbasic living expenses,’ Olson wrote.

Olson praised tax administrators for successfullydelivering economic stimulus rebates to about 119million Americans in 2008 and for executing severallate-year tax law changes. But she said that theprospect of a deepening economic recession in 2009requires the IRS to consider the circumstances oftaxpayers facing financial hardship before it ini-tiates enforcement actions.

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‘‘Taxpayers who previously were able to paytheir taxes find themselves unemployed, behind onhousing payments, and unable to meet their basicliving expenses,’’ Olson wrote.

Olson’s recommendations for easing the burdenon taxpayers in financial hardship began with theIRS using more alternative methods to collect de-linquent tax debts, such as offers in compromiseand installment agreements, which she said may bemore effective than increasing the application ofliens and levies.

Culling historical enforcement data, she showedthat the number of levies issued by the IRS in-creased by 1,608 percent from fiscal 2000 to fiscal2007, from 220,000 levies to more than 3.75 million.But the increase in the total collection yield duringthe period was less than 45 percent.

Olson said that the IRS should reserve the moreintrusive tools of liens and levies for situationsinvolving the most uncooperative taxpayers. ‘‘Theline between ‘won’t pay’ and ‘can’t pay’ is a fineone, especially in today’s tough economic timeswhen taxpayers feel desperate,’’ Olson wrote.

Olson also recommended that the IRS develop auniform policy statement defining economic hard-ship, provide guidance in the Internal Revenue

Manual that requires the IRS to consider the eco-nomic situation of a taxpayer before any decisionsare made, and establish a screening system toexclude low-income Social Security recipients withtax debts from continuous, automated tax with-holding under the Federal Payment Levy Program.

Individual and business taxpayersspent 7.6 billion hours and $193billion per year to comply with basicfiling requirements, according to thestudy.

Olson connected the urgent theme of helpingtaxpayers in economic hardship to her call to sim-plify the tax code through reforms.

In a response to Olson’s report, IRS Commis-sioner Douglas Shulman issued a statement lastweek saying that the IRS has announced ‘‘a numberof concrete steps to help taxpayers facing financialhardships in these difficult economic times. In ad-dition, we will be continually reviewing our pro-cedures to make sure that we take appropriateaction for people unable to pay in these tough

PRACTITIONERS DEBATE DEFINITION OF NONRECOURSE AND RECOURSE DEBT

Because section 1001 lacks a definition of recourseor nonrecourse debt, that classification can be basedon state law, practitioners generally agreed at aDistrict of Columbia Bar luncheon last week onpartnership liabilities. But many at the session,which was sponsored by the Passthroughs and RealEstate Committee of the Taxation Section, struggledwith the implications of a 2006 case seemingly incon-sistent with such an analysis.

Under state law, when a partnership takes out aloan and the loan documents limit lender recovery tospecific assets, the debt is generally considered to benonrecourse, meaning that the lender can only pur-sue those specified assets to satisfy the debt, limitingthe partners’ general liability. Practitioners rely onthat definition to determine the characterization ofdebt under section 1001.

‘‘That was the thinking that we had all signedonto until we read this case,’’ said Blake Rubin ofMcDermott Will & Emery, referring to Great PlainsGasification Associates et al. v. Commissioner, T.C.Memo. 2006-276, No. 10578-01 (Dec. 27, 2006), Doc2006-25732, 2006 TNT 249-4.

In Great Plains Gasification, Rubin said, the court‘‘seemed to agree that because it was nonrecoursefrom a [section] 752 perspective, that it was alsononrecourse from a [section] 1001 perspective,’’which would in effect shift the agreed definition ofnonrecourse and recourse debt for purposes of sec-tion 1001 from one that focuses on the loan docu-

ments (under state law) to an analysis of whether apartner bears the economic risk of loss for thatliability (under section 752).

A government panelist declined to take a firmposition on the matter but did speak to the prec-edential weight of the opinion. ‘‘All the parties seemto agree in the litigation that it was nonrecourse debt,and I don’t really think that the court made anindependent determination that it was nonrecourseor recourse. It kind of just glossed over that,’’ saidBeverly Katz, special counsel to the associate chiefcounsel, IRS Office of Associate Chief Counsel(Passthroughs and Special Industries). ‘‘So I’m notsure how much we can rely on this case for anyprinciples on that.’’

‘‘I think you can appropriately conclude, notwith-standing this case, that there’s at least substantialauthority for a contrary position,’’ Rubin said. If youlook at the definition in section 704(b) of partnernonrecourse liability (which is nonrecourse forsection 1001 but recourse for section 752), ‘‘thatclearly compels the conclusion to me that . . . it can’tbe the case that the [section] 1001 determination isthe same as the [section] 752 determination, becauseif so you’d have a null set for partner nonrecoursedebt.’’

— Amy S. Elliott

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times.’’ (For the statement, see Doc 2009-311 or 2009TNT 4-22. For related coverage, see p. 195.)

Untangling the ComplexityThe national taxpayer advocate named code

complexity as the top problem confronting taxpay-ers in 2008, citing specific issues in which complex-ity created unnecessary confusion and burdens ontaxpayers. She recommended ways Congress couldremedy those issues.

To illustrate the problems created by unduecomplexity, a Taxpayer Advocate Service studycalculated that individual and business taxpayersspent 7.6 billion hours and $193 billion per year tocomply with basic filing requirements. To keep upwith the hundreds of tax law changes added eachyear, 80 percent of taxpayers pay for assistance fromeither a tax professional or preparation software.Even then, Olson said in the report, the complexityof the code leads many honest taxpayers to eitheroverpay their taxes or underpay and face enforce-ment action, while more knowledgeable taxpayersmay exploit loopholes to reduce their tax liabilities.

For example, the earned income tax credit is socomplex that nearly 73 percent of low-income tax-payers who claim the credit use a tax professional tofile their return, a move the report says was counterto the expectation that individuals with lower in-comes are more likely to require simpler returns.Also, the code is constantly changed and aug-mented. Since 2001, the report says, more than 3,250tax code changes have been implemented, includ-ing more than 500 in 2008. Also, errors have becomemore costly. More than 130 civil penalties are nowlaid out in the tax code, nearly a tenfold increasefrom 1954.

Legislative RecommendationsStrategies to streamline tax code complexity were

plentiful in the report’s list of legislative recommen-dations. The first recommendation is to repeal theAMT for individual taxpayers. The AMT requirestaxpayers to calculate two sets of tax returns, onegoverned by regular income tax rules and one byAMT rules, and then pay the higher of the two taxtotals. The AMT also disallows some tax deduc-tions, notably those for dependents and for stateand local tax payments. Another major issue is thatthe AMT is not indexed for inflation. (For priorcoverage, see Tax Notes, Oct. 6, 2008, p. 9, Doc2008-21185, or 2008 TNT 194-2.)

‘‘When Congress first enacted a minimum tax in1969, the exemption amount was $30,000 for alltaxpayers,’’ Olson said in the report. ‘‘If thatamount had been indexed, it would be equal toabout $177,000 today.’’ As a result, 33 million indi-vidual taxpayers, or 35 percent of individual filerswho pay income tax, will be subject to the AMT in

2010, according to the report. Olson recommendedthat Congress enact fundamental tax reform thatincludes a repeal of the AMT.

Another recommendation is that Congress sim-plify procedures for cancellation of debt. Althoughcanceled debt is considered taxable income in mostscenarios, taxpayers who lose their homes to fore-closure may apply to have the cancellation of theirmortgage debt excluded from their total taxableincome. To apply, Olson noted, taxpayers mustcomplete Form 982, a complex document not in-cluded in many tax return preparation softwarepackages.

33 million individual taxpayers, or 35percent of individual filers who payincome tax, will be subject to the AMTin 2010, according to the study.

The form takes more than 10 hours to complete,according to the IRS, and the national taxpayeradvocate’s report says that many return preparersmay not be familiar with it. Hence, many taxpayerswho qualify do not take advantage of the exclusion,and those who try to exclude their debt withoutForm 982 may face IRS examination, the reportsays. Congress should set a minimum debt thresh-old and exclude taxpayers with debt below thatminimum from the rules on cancellation of debtincome, the report recommends. Also, Olson saidthe IRS should create a centralized unit to handlecancellation of debt issues and develop an insol-vency worksheet that taxpayers can submit withtheir returns.

Equally in need of reform are the code’s tempo-rary provisions, Olson wrote. To ameliorate budgetshortfalls, Congress often enacts tax measures thatexpire after a specified amount of time, or incen-tives that phase out if a taxpayer earns more than aspecified amount. The code now contains morethan 100 provisions with an expiration date, a morethan fourfold increase from 1992. Provisions withsunset dates and phaseout income thresholds createuncertainty and make it more difficult for taxpayersto estimate liabilities and pay sufficient estimatedtaxes. Also, those incentives complicate return proc-essing for the IRS and ultimately reduce the effec-tiveness of those tax incentives.

What’s more, the report says, phaseouts fosterinequality through the creation of ‘‘marginal ‘ratebubbles’ — income ranges within which an addi-tional dollar of income earned by a relatively lowincome taxpayer is taxed at a higher rate than anadditional dollar of income earned by a relativelyhigh income taxpayer.’’

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The national taxpayer advocate recommendedeliminating, or at least simplifying, phaseout andsunset provisions and removing the legislative in-centives to use temporary provisions in the future.

Revisiting another legislative proposal from aprevious report, Olson emphasized that ‘‘the timehas come to regulate tax return preparers.’’ Thoseinclude unregulated ‘‘unenrolled’’ preparers, aswell as regulated attorneys, CPAs, and enrolledagents.

Congress should enact a registration,examination, certification, andenforcement program for unenrolledpreparers, Olson recommended.

With more than 60 percent of individual tax-payers and most business taxpayers paying practi-tioners to prepare and file their returns, Congressshould enact a registration, examination, certifica-tion, and enforcement program for unenrolled pre-parers, Olson recommended. H.R. 5716, theTaxpayer’s Bill of Rights Act of 2008, was referred tothe House Ways and Means Committee last Apriland is modeled after Olson’s initial recommenda-tion in her 2002 annual report. (For the text of H.R.5716, see Doc 2008-8548 or 2008 TNT 75-37. For priorcoverage, see Tax Notes, Sept. 15, 2008, p. 1020, Doc2008-19425, or 2008 TNT 178-5.)

Penalty ReformAnother highlight of the report is the recommen-

dation that Congress undertake serious penaltyreform. The number of civil tax penalties has bal-looned from 14 in 1954 to more than 130 today, thereport notes. Given that the last time Congressseriously addressed the penalty regime was after acomprehensive study in 1989, Olson called for amultipronged approach to tackle the penalty laby-rinth that has since evolved.

For the longer term, the report asks Congress torequire the IRS to regularly collect detailed penaltydata and study the effect of each penalty on volun-tary compliance. For the immediate future, Olsonadvocated making 11 common-sense reforms basedon work done by the Joint Committee on Taxationand the IRS in preparation for the 1989 reforms. Anideal penalty regime, the report says, should bebased on the principles of fairness, comprehensibil-ity, effectiveness, and ease of administration.

Using tax gap and litigation data, the reportsuggests that Congress focus on penalties forunderreporting, failure to pay, and failure to file,given their frequent application. Olson also saidthat the high level of penalty occurrence in thoseareas might be a sign the penalties are either not

understood by taxpayers or are applied too often bythe IRS without adequate support. And the reportstrongly urges the IRS to clarify the definition of taxshelter for purposes of the substantial understate-ment penalty so as to minimize the risk of taxpayersbeing covered under the current broad definitionmerely by claiming tax benefits Congress intendedthem to have.

Olson singled out the penalty under section6707A for failure to make disclosure of reportabletransactions the poster child for out-of-line taxpenalties in need of modification. That penalty is‘‘unconscionable and possibly unconstitutional,’’the report says. The penalty can be imposed ontaxpayers who fail to make the appropriate disclo-sure, even when the taxpayer had no knowledgethe transaction was reportable, there were no ma-terial tax savings involved, or the transaction waslisted and made retroactive to tax years for whichthe taxpayer had filed a return — all factors evi-dencing the lack of taxpayer culpability, the reportsays.

The section 6707A penalty for failureto disclose a reportable transaction is‘unconscionable and possiblyunconstitutional,’ according to thereport.

Many practitioners agreed. ‘‘Overapplication ofharsh penalties based in a complex, almost incom-prehensible tax code should not serve as the foun-dation for our system of taxation and theadministration of the tax laws within the UnitedStates,’’ Charles Rettig of Hochman, Salkin, Rettig,Toscher & Perez told Tax Analysts. ‘‘Fairness andrestraint should serve as the foundation for penaltyconsiderations by Congress, which has the ability tofix the penalty regime prospectively rather thanforce the federal courts to deal with it on a case-by-case basis with differing results around the coun-try.’’

Because the strict liability of section 6707A im-poses a penalty of $100,000 on any individual, or$200,000 on any entity, for failure to make a re-quired disclosure of a listed transaction — or$10,000 for individuals and $50,000 for entities if thetransaction is not listed but reportable — it ‘‘mayhave the effect of bankrupting middle-class familieswho had no intention of entering into a tax shelter,’’the report says. Other problems mentioned includethe penalty’s requirement that only the IRS commis-sioner may rescind an assessed penalty, and the lackof judicial review of a rescission decision.

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As a result, the penalty provision ‘‘raises signifi-cant constitutional concerns, including possible vio-lation of the Eighth Amendment,’’ the report says.To bolster its case for lessening the potential harshimpact of the penalty, the report quotes an Appealsofficer who said, ‘‘In my 29 years with the IRS Ihave never [before] worked a case or issue that leftme questioning whether in good conscience I coulduphold the government’s position even though it issupported by the language of the law.’’

Some practitioners have argued that practicalrelief can be achieved through the ways in whichthe IRS administers the penalty, such as not makingthe listing notices retroactive. But Olson recom-mended that Congress take on the task of fixing thesection to ensure a proportional relationship be-tween the penalty amount and the taxpayer’s taxsavings realized from the transaction, including theability of the IRS to waive the penalty. The reportnotes that the Taxpayer Advocate Service hadroughly 40 cases in its inventory involving thesection 6707A penalty, and estimates that the IRScould impose the penalty in hundreds of others.

Walter Goldberg, executive director of the na-tional tax office of Grant Thornton LLP, agreed withOlson’s call for modifying the section 6707A pen-alty. ‘‘It is an unusual penalty in that it doesn’tprovide any possibility for relief for the failure todisclose listed transactions, and utilizes a rescissionprocedure rather than looking to see if the taxpayerhad reasonable cause for the failure to disclosenonlisted reportable transactions,’’ he told Tax Ana-lysts. ‘‘It is right for Congress to take another look toensure that section 6707A operates consistentlywith the stated goal behind civil tax penalties ofenhancing voluntary compliance,’’ he said.

Ian Comiskey of Blank Rome LLP told Tax Ana-lysts, ‘‘It’s a terribly unfair penalty in many circum-stances, and Congress could not have anticipatedthe situations in which the penalty applied, entrap-ping innocent taxpayers who had no intention ofengaging in tax shelters.’’

Leniency on Employer Tax ComplianceSmall businesses may find things to their liking

in the 2008 report. That was not the case in 2007,when many small employers complained aboutOlson’s aggressive proposals to reduce underre-ported income from the cash economy — includingvarious recommendations to increase informationreporting and voluntary withholding.

‘‘The rate of compliance among employmenttaxpayers is quite high,’’ Olson wrote in 2008. ‘‘TheIRS needs to take a balanced approach’’ to itscollection of unpaid payroll taxes and reconsiderpolicies that may ‘‘overreach and undermine’’ tax-payer protections.

Olson criticized a Government AccountabilityOffice study released in July that found that em-ployment tax noncompliance had increased overthe last 10 years. The report, which Olson ques-tioned as possibly misleading, prompted Sen. CarlLevin, D-Mich., and other members of Congress ata July Senate hearing to call for the IRS to mobilizeits resources in an aggressive effort to collect out-standing payroll tax debt.

‘The rate of compliance amongemployment taxpayers is quite high,’Olson wrote in the report.

Olson’s report says that the GAO did not adjustits figures for inflation and that, once making thatadjustment, the employment tax gap actuallyshrank over the past decade. (For prior coverage,see Tax Notes, Aug. 4, 2008, p. 413, Doc 2008-16673,or 2008 TNT 147-1. For the report (GAO-08-617), seeDoc 2008-16622 or 2008 TNT 147-26.)

Focusing on the relatively high rate of employ-ment tax compliance, Olson took a more sympa-thetic, softer approach in her recommendations. Sheurged the Service to target its response to thetaxpayer’s individual reason for noncompliance(whether it stems from intention, confusion, or cashflow problems) and act quickly at the first sign of adelinquency to prevent the accumulation of sub-stantial unpaid payroll taxes.

Olson did not let up, however, on her efforts toaddress what she characterizes as ‘‘the growingworker misclassification problem.’’ Whether an em-ployer classifies its workers as employees (subjectto withholding) or independent contractors is basedon a test that looks at the facts surrounding theemployment relationship. Olson pointed out thatthe determination is ‘‘complicated and confusing, inpart because the rules are not the same’’ for federalincome taxes as they are for state employmenttaxes.

One of Olson’s legislative recommendations inthis arena is to repeal the safe harbor in section 530of the Revenue Act of 1978, which effectively allowsemployers to sidestep the ‘‘complicated’’ test andtreat workers as independent contractors if, forinstance, it is considered industry practice. Thatmove has gained momentum in Congress, withPresident-elect Barack Obama calling for the repealof section 530 in S. 2044 as a way to reduceconfusion and ‘‘close its use as a tax loophole.’’

But critics say repeal of section 530 could bringthe fall of whole industries that have been built onthe certainty of this safe harbor. ‘‘While the objec-tive of harmonizing a worker’s status for purposesof both employment taxes and income taxes is

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laudable,’’ Russell A. Hollrah told Tax Analysts, ‘‘itspursuit would be advisable only if there were someassurance that the new safe harbor provision wouldcontinue to cover the relationships that section 530currently covers.’’ Hollrah is the executive directorof the Coalition to Preserve Independent ContractorStatus, an organization that was cited in the reportas encouraging enhanced Form 1099 informationreporting requirements for independent contrac-tors.

While taxpayers generally fare betterwhen represented, pro se taxpayershad a higher success rate in grossincome and civil damage cases thandid represented taxpayers.

Otherwise, ‘‘companies would be less willing totake the risk of contracting with independent con-tractors’’ and Congress would risk the return of an‘‘institutional bias against independent contrac-tors,’’ Hollrah added. ‘‘In today’s economy, manytalented individuals have lost their jobs due toexternal factors and are seeking to work as inde-pendent contractors. Thus, now is an especiallyinappropriate time to eliminate that certainty.’’

The Most Litigated IssuesThe report’s list of the 10 most litigated tax issues

presents the same issues that were listed in 2007.Continuing to receive the most litigation were casesinvolving the following: collection due process ap-peals, gross income, summons enforcement, civildamages for unauthorized collection actions, frivo-lous issue penalties, failure-to-file penalties, tradeor business expenses, accuracy-related penalties,innocent spouse relief, and family status. (For the2007 report, see Doc 2007-671 or 2007 TNT 7-33. Forcoverage of the 2007 report, see Tax Notes, Jan. 14,2008, p. 239, Doc 2008-484, or 2008 TNT 7-1.)

But the ranking of the issues did change for 2008.Gross income moved to first place, largely as aresult of a significant number of cases filed ques-tioning whether income earned in Antarctica wasexcluded from gross income. Trade and businessexpenses jumped to fourth place, with 116 reportedcases in 2008, up from 77 in 2007. Summons enforce-ment cases also saw an increase, from 112 in 2007 to146 in 2008. Olson predicted even more of thosecases in the future as the IRS continues its aggres-sive summons enforcement policy. Taxpayers, how-ever, face an uphill battle in the courts; only threecases were decided in a taxpayer’s favor in 2008.

The case categories involving the highest rate ofpro se litigation were family status issues (97 per-cent), frivolous issues penalties (92 percent), and

civil damages for some unauthorized collections (77percent). The report notes that while taxpayersgenerally fare better when represented, pro se tax-payers had a higher success rate in gross incomeand civil damage cases than did represented tax-payers. The most likely attributable link is commu-nication failure at the administrative level betweentaxpayers and the IRS, the report says.

In making recommendations based on analysis ofthe highlighted litigation categories, the report sug-gests that the IRS incorporate the rationale of courtdecisions that went against the government inaccuracy-related penalty cases into employee train-ing and IRM provisions. After noting several dis-trict court decisions that precluded taxpayers fromasserting innocent spouse relief as an affirmativedefense in district court proceedings, the report alsoadvises Congress to pass a legislative correction toensure that taxpayers could raise section 6015claims in district court.

Curbing Identity TheftThe growing challenges posed by identity theft

made the report’s list of the most serious problemsaffecting taxpayers. Olson praised the measures theIRS has taken to improve internal management ofidentity theft cases, including creating the IdentityProtection Specialized Unit to partially centralizethe management of identity theft cases; creatingmarkers to flag and track the case files of taxpayerswho have reported identity theft; and developingfor 2009 an IRS-specific affidavit to help substanti-ate identity theft claims.

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New Regulations Likely to DeterUse of Cost-Sharing Agreements

By Lisa M. Nadal — [email protected]@tax.org

The revised cost-sharing regulations (T.D. 9441,REG-144615-02) issued by the Treasury Departmentand the IRS will continue to have a chilling effect oncost-sharing agreements (CSAs) despite the addedflexibility introduced in the new rules, David Ca-nale, director of transfer pricing controversy serv-ices at Ernst & Young LLP, told Tax Analysts.

The new rules, issued in December in final andtemporary form, replace proposed cost-sharingrules issued in 2005. The rules entered into forcerecently and are subject to transition rules thatprovide grandfathering for existing CSAs. An addi-tional hearing on the regs is scheduled for April 21,and comments are due by April 6. (For T.D. 9441,see Doc 2008-27341 or 2009 TNT 1-4. For newREG-144615-02, see Doc 2008-27342 or 2009 TNT1-5; for REG-144615-02, as published in 2005, seeDoc 2005-17678 or 2005 TNT 162-1.)

Canale explained that while the new regulationsare more flexible than the 2005 regulations, they arestill restrictive in terms of how taxpayers can valueintangible property transferred in a CSA. He notedthat the new rules retain the ‘‘investor model’’

introduced in the 2005 proposed rules as the mainapproach to evaluate relationships and contribu-tions in a CSA.

In general, the investor model treats each partici-pant in a CSA as having made an investmentcomposed of its share of the intangible develop-ment costs incurred on an ongoing basis and anycontribution of existing resources and capabilities.Many commentators have criticized the model,saying its valuation principles are too restrictive.The IRS, however, says the investor model ‘‘is keyto ensuring consistency of the results of a CSA withthe arm’s-length standard.’’

The investor model ‘is key toensuring consistency of the results ofa CSA with the arm’s-lengthstandard,’ said the IRS.

‘‘It’s all relative,’’ Canale said, noting that whilethe added flexibility in the new regs is ‘‘goodnews,’’ the rules are still very restrictive whencompared with the 1995 regulations.

Jake Feldman, executive director of transfer pric-ing at Grant Thornton, takes a similar view. Heacknowledged that the IRS has made improve-ments and added flexibility with the new regs, buthe told Tax Analysts the improvements are ‘‘at theedges.’’

IRS CLARIFIES NEW DEFERRED COMPENSATION STATUTE

The IRS last week released Notice 2009-8, provid-ing guidance on when employee compensation paidinto a nonqualified deferred compensation plan(NDCP) must be included in a taxpayer’s grossincome under newly enacted section 457A.

Congress enacted section 457A in October 2008 aspart of the Tax Extenders and Alternative MinimumTax Relief Act of 2008 (P.L. 110-343). The statute,which took effect January 1, 2009, generally providesthat compensation deferred under an NDCP is in-cludable in gross income when the NDCP is operatedby a ‘‘nonqualified entity’’ and there is no substantialrisk of forfeiture of the rights to receive the compen-sation. Notwithstanding that general rule, deferredcompensation paid into an NDCP can be excludedfrom gross income if the amount of compensation isindeterminable. (For Notice 2009-8, 2009-4 IRB 1, seeDoc 2009-407 or 2009 TNT 5-5. For prior coverage, seeTax Notes, Dec. 15, 2008, p. 1240, Doc 2008-25718, or2008 TNT 236-1.)

The notice is aimed at identifying which types ofNDCPs are subject to section 457A and whether theplan sponsor will be considered a nonqualifyingentity. The notice provides 27 examples that detail:

• the definition of an NDCP;

• the definition of a nonqualified entity;• which plan sponsors are subject to section 457A;• what is a substantial risk of forfeiture;• what is the exception for short-term deferral;• how to calculate the amount includable in gross

income; and• when the amount of compensation is consid-

ered indeterminable.For purposes of section 457A, the terms nonquali-

fying entity and NDCP have the same meaning asunder section 409A(d), subject to minor modifica-tions.

Nonqualified entities include foreign corporationsunless substantially all of their income is effectivelyconnected to a U.S. trade or business, and thustaxable in the United States, or is subject to acomprehensive income tax in another country. Non-qualified entities also include partnerships, unlesssubstantially all the partnership income is allocatedto persons other than organizations exempt fromU.S. taxation and foreign persons not subject to acomprehensive income tax in another country.

— Robert Goulder

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Added FlexibilityCanale pointed out that the proposed 2005 rules

provided for no grandfathering. Under those rules,any new contribution to a CSA would have broughtthe CSA into the purview of the cost-sharing rules,even if the CSA existed before the rules wereintroduced. The new rules, Canale said, provide afacts and circumstances test to determine whetherthere has been a material change in the scope of theCSA, which would trigger the new rules.

The new rules are also more flexible in terms ofdividing the interests in intangible property devel-oped in a CSA. Under the proposed 2005 regs,controlled participants had to have nonoverlappingterritorial interests that entitled each controlledparticipant to the perpetual and exclusive right tothe profits in its territory.

The new rules will affect taxpayerswith existing CSAs as well as thoseentering into new ones, Canale said.

In response to criticism about the nonoverlap-ping, exclusive, and perpetual conditions, the newrules offer another option — the ‘‘field of usedivision of interests’’ — to qualify divisional inter-ests. Under the field of use option, each controlledparticipant receives the perpetual and exclusiveright to exploit the intangible in an assigned field ofuse.

The rules also allow for other nonoverlappingdivisional interests, provided that the basis used forthe division meets four requirements: (1) the basismust clearly divide all interests in cost-shared in-tangibles among the controlled participants; (2) theconsistent use of the basis must be dependablyverified from the controlled participants’ records;(3) the rights of the controlled participants to exploitcost-shared intangibles must be nonoverlapping,exclusive, and perpetual; and (4) the resulting ben-efits associated with each controlled participant’sinterest in cost-shared intangibles must be predict-able with a reasonable degree of reliability.

The Chilling EffectCanale explained that the new rules were issued

in temporary and final form, so they have the forceof law and are effective for 2009, unlike the 2005regs, which were issued only in proposed form. Asa result, the new rules will affect taxpayers withexisting CSAs as well as those entering into newones, he said.

Overall, the fundamental principles of the 2005regs remain intact, so the chilling effect that startedwith the 2005 regs will likely continue, althoughthat is probably not the IRS’s intention, Canale said.The new regs make CSAs cost prohibitive, he said,

so in many cases, multinational corporations willhave to take on all the risk of developing intan-gibles, rather than sharing the risk with relatedparties through a CSA.

Feldman said that while the investor model maymake CSAs less attractive, viable alternatives arestill a subject of debate. Advance pricing agree-ments are one interesting alternative, he said, ex-plaining that negotiating in advance with the IRSmay be a way to arrive at an acceptable result.

The new rules discuss APAs and announce thegovernment’s intention to issue separate guidanceon the interaction between an APA and a CSA. Thenew regulations state that the forthcoming APAguidance will provide an exception to periodicadjustments for transactions covered by an APA.

Kerwin Chung, a director at Deloitte Tax LLP,told Tax Analysts the regulations also are likely todiscourage ‘‘cashbox’’ CSAs. A tax alert coauthoredby Chung explains that the new rules ‘‘effectivelycontinue the IRS’s attack on cashbox cost-sharingparticipants, while confirming that participantsmay earn risky returns for performing substantialdevelopment functions and bearing developmentrisks.’’ Chung said he doesn’t think the new regswill have the same chilling effect on noncashboxCSAs.

International ImplicationsAddressing the global reach of the new cost-

sharing regs, Canale noted that there will be ‘‘a lotmore controversy around the value of the intellec-tual property that’s being contributed.’’ He ex-plained that several CSAs are between a U.S. parentand a foreign subsidiary, and the new rules willmean that the foreign subsidiaries may have ahigher buy-in, which will increase the number ofcontroversies surrounding valuation.

Given that, Canale said he expects any new CSAsto involve treaty partners so that valuation contro-versies can be referred to the competent authority.

Other ChangesAnother change introduced by the new rules

relates to external contributions and reference trans-actions. In the CSA context, a primary issue is theamount of the buy-in payment or arm’s-lengthamount that must be paid to the U.S. parent forexternal contributions. Under the previous rules,external contributions for which compensation wasdue to the U.S. parent from other controlled partici-pants consisted of the rights in the reference trans-action (RT) to ‘‘any resource of capabilityreasonably anticipated to contribute to developingcost shared intangibles.’’ The RT was a transactiondesignated in CSA documentation that grantedperpetual and exclusive rights in the subject re-source or capability.

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Commentators complained that the external con-tribution definition in the previous rules reacheditems such as goodwill and workforce that shouldnot be classified as compensable, and that the RTconcept was overly broad.

The new rules eliminate the RT concept andreplace the term ‘‘external contributions’’ with‘‘platform contributions’’ and the term ‘‘preliminaryor contemporaneous transaction’’ with ‘‘platformcontribution transaction.’’

There will be ‘a lot more controversyaround the value of the intellectualproperty that’s being contributed,’said Canale.

Under the new rules, platform contributions thatmust be compensated, such as external contribu-tions, are not limited to the transfer of intangiblesdefined in section 936(h)(3)(B). Platform contribu-tions, however, need be compensated only if theyare reasonably expected to contribute to the CSAactivity in the payer’s division, and not to any of thepayee’s resources, capabilities, or rights that arereasonably expected to benefit only the payee’soperations.

On the elimination of the RT concept, the newrules adopt a rebuttable presumption that the payeeprovides any resource, capability, or right to theintangible development activity on an exclusivebasis.

NEWS ANALYSIS

Eric Holder Could Face QuestionsOver Tax Firm Prosecution

By Jeremiah Coder — [email protected]

It’s no secret that Senate Republicans intend togrill President-elect Barack Obama’s nominee forattorney general, Eric Holder Jr., over his participa-tion in President Bill Clinton’s pardon of tax evaderMarc Rich, even though few political observersexpect that involvement to doom the nomination.Republicans are merely out to bloody the incomingadministration where they can.

But there is more in Holder’s public servicefolder that could incite fierce questioning. Backwhen he was deputy attorney general in the Clintonadministration, Holder issued a policy memo oncorporate prosecutions that would later generatesignificant disapproval from some members of Con-gress.

Aspects of the now infamous government pros-ecution of KPMG have roots that spread back to a1999 memo Holder wrote on bringing criminalcharges against corporations. The foundations laidout in that document were repeated in variousiterations prepared by succeeding deputy attorneysgeneral. The legal community now generally refersto them as the Thompson, McNulty, and Filipmemos. Holder’s memo listed factors to be consid-ered when determining the level of cooperationfrom a corporation under threat of prosecution.Factors included the corporation’s willingness towaive attorney-client and work product privilegesand the advancement of legal fees to ‘‘culpableemployees.’’ That approach proved damning to thegovernment.

As deputy attorney general, Holderissued a policy memo on corporateprosecutions that would latergenerate significant disapproval fromsome members of Congress.

What eventually doomed much of the govern-ment’s case against former KPMG employees al-leged to have peddled fraudulent tax shelters wasthe firm’s withholding of legal fees to its indictedpartners and managers. U.S. District Court JudgeLewis A. Kaplan eventually dismissed chargesagainst 13 KPMG defendants after finding thatgovernment coercion of KPMG resulted in consti-tutional violations of the indicted individuals’rights to due process and counsel. The Second

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Circuit affirmed. (For prior coverage of United Statesv. Jeffrey Stein et al., see Tax Notes, Jan. 5, 2009, p. 42,Doc 2008-27137, or 2009 TNT 2-9.)

In response to the brouhaha over the JusticeDepartment’s tactics, several senators expressedoutrage and tried to enact legislation that wouldhave strengthened attorney-client privilege rightsfor corporate employees. Sen. Arlen Specter, R-Pa.,ranking minority member of the Senate JudiciaryCommittee, introduced the Attorney-Client Privi-lege Protection Act of 2007 (S. 186), which wouldhave done away with much of the McNulty memo.

Would having Holder at the helm of the JusticeDepartment bring back the specter of Stein andproduce terror in the tax community? Most sourcescontacted by Tax Analysts think not.

Bryan Skarlatos of Kostelanetz & Fink LLP inNew York said he doubted Holder’s work on the1999 corporate prosecution memo would become alightning rod during his confirmation hearing. ‘‘Mr.Holder could be taken to task for what he meant inthe memo and how far he intended to push,’’Skarlatos said, but there is little likelihood it willbecome a game-changer. ‘‘I like to think that Mr.Holder realizes that the government should usemore finesse and discretion when investigatingcorporations and their employees for allegedabuses,’’ he said.

‘The government learned you can’tunfairly gain leverage over someoneelse; you have to look at the merits ofwhat they did,’ said Skarlatos.

David H. Laufman, a partner in the Washingtonoffice of Kelley Drye & Warren LLP and a formerDOJ official, said that the Holder memorandum isunlikely to be a significant issue. ‘‘Mr. Holder likelywill be asked about the memo, particularly givenSenator Specter’s strong interest in the subject,’’ hesaid, ‘‘but I doubt it will be an impediment to hisconfirmation.’’

Acknowledging the sea change in attitudetoward corporate prosecutions of accounting firmsand tax advisers at Justice, Skarlatos predicted thata reprisal of the KPMG fiasco is highly unlikely.‘‘The Justice Department has probed the extent towhich you can motivate certain behavior in extract-ing concessions,’’ he said. ‘‘In the future, Justice willbe more sensitive, because the spectacular backfirefrom KPMG demonstrated an aggressiveness thatwas inattentive to everybody’s rights. The govern-ment learned you can’t unfairly gain leverage oversomeone else; you have to look at the merits of whatthey did.’’

So, expect the main focus of the hearing to be theRich pardon, although that single instance isn’tlikely to inform how Holder might approach taxwork at the DOJ. One former Justice official said, ‘‘Iwould like to think that Mr. Holder’s advice on thepardon does not reflect disrespect for the importantwork of the Tax Division.’’

Several sources contacted by Tax Analysts saidthat the absence of public discussion about possiblecandidates to head the Tax Division could be anindication that Obama is waiting for the first waveof nominations to make it through the Senate con-firmation process before filling in the Justice De-partment’s remaining empty slots.

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IRS Willing to Work WithEconomically Distressed Taxpayers

By Michael Joe — [email protected]

Expecting more and more Americans to havetrouble paying taxes in tough economic times, theIRS announced last week that taxpayers in financialhardship may be eligible for a temporary suspen-sion of collection actions against them and could beallowed to skip a payment on installment agree-ments and offers in compromise.

‘‘I’ve instructed all personnel at the IRS to besensitive to taxpayers, especially previously compli-ant taxpayers who are for the first time having ahard time paying the IRS,’’ IRS CommissionerDouglas Shulman said in a conference call withreporters.

‘‘But the only way we are going to be able towork with people is if they reach out and talk tous,’’ Shulman added. ‘‘If someone just doesn’t paytheir taxes, doesn’t file, doesn’t make an installmentpayment, they are going to get in trouble with thegovernment.’’

‘If someone just doesn’t pay theirtaxes, doesn’t file, doesn’t make aninstallment payment, they are goingto get in trouble with the government,’said Shulman.

Shulman did not offer detailed criteria for sus-pending collection actions, but he noted that if ataxpayer has recently lost a job or faces largemedical bills, the Service may be able to suspendcollection actions without a requirement that the

taxpayer supply documentation. (For a related IRSrelease, see Doc 2009-146 or 2009 TNT 3-5.)

Taxpayers with existing installment agreementsmay be allowed to miss a periodic payment orreduce their payments without automatically sus-pending the agreement. Similarly, taxpayers en-gaged in OICs, which are agreements taxpayersmake with the IRS to settle their tax debts for lessthan the full amount, may be eligible to miss apayment without defaulting on the OIC.

Asked how many payments a taxpayer might beallowed to miss, Shulman did not commit to anumber. Instead, he suggested that the IRS will beflexible, but added that the limit may be only onepayment.

‘‘We’re going to work with taxpayers who havelegitimate needs,’’ Shulman said. ‘‘We’ve instructedpeople, at this point, that one missed payment is notenough to get rid of an installment agreement or anOIC. The important thing is for people to pick upthe phone.’’

Shulman also said the IRS recognizes that a closerreview may be justified for taxpayers who seek anOIC with the IRS but who have been rejectedbecause they show enough equity in their home topay the tax debt.

Noting that the housing crisis at the center of theeconomic slowdown has left home equity values influx, Shulman said the IRS has established a specialunit of experts to take a second look at OICsrejected because taxpayers had too much homeequity. (For prior coverage, see Tax Notes, Dec. 22,2008, p. 1362, Doc 2008-26679, or 2008 TNT 245-1.)

‘‘Sometimes that piece of paper that says yourhome is worth a certain amount may or may not betrue because of local real estate situations,’’ Shul-man said.

KERIK PLEADS NOT GUILTY TO INTERFERING WITH TAX ADMINISTRATION

Bernard Kerik, former police commissioner forNew York City and former U.S. interim minister ofinterior of Iraq, pleaded not guilty in December tocharges that include obstructing the administrationof the IRS.

Kerik gained national prominence in 2004 asPresident Bush’s nominee to replace Tom Ridge asthe homeland security secretary. He withdrew fromthe nomination process because he had employed anillegal immigrant as his children’s nanny.

The indictment, filed on December 2, 2008, super-sedes a November 8, 2007, indictment that madesimilar claims that Kerik ‘‘corruptly obstructed andimpeded, and attempted to obstruct and impede, thedue administration of the Internal Revenue laws.’’Among the acts cited in the indictment are filing false

tax returns, taking fraudulent deductions, failing toreport income, and providing false information to hisaccountants.

The indictment alleges that Kerik failed to timelyreport more than $587,000 in income from 1999 to2003 and that he took at least $80,000 in fraudulentdeductions.

Kerik is also accused of failing to report the wagesof his children’s nanny and of failing to remit em-ployment taxes on those wages to the IRS.

The case is United States of America v. Bernard B.Kerik, 07-cr-1027 (S.D.N.Y.).

— Sam Young

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Also, IRS officials on the conference call said thattaxpayers in economic hardship who seek an expe-dited release from a levy imposed on a bank ac-count or wages for taxes due may be helped by aneasing of requirements. Levy releases may begranted by IRS officials over the telephone, but, theIRS said, taxpayers should be prepared to providethe Service with the fax number of the bank oremployer processing the levy.

‘Sometimes that piece of paper thatsays your home is worth a certainamount may or may not be truebecause of local real estatesituations,’ Shulman said.

Shulman and the other IRS officials also high-lighted a new option to boost the number of tax-payers who file returns electronically. The Service isoffering free filing to taxpayers who would other-wise not be eligible for the IRS’s established FreeFile program because their adjusted gross incomesare too high.

Only those taxpayers with AGIs of $56,000 or lessare eligible for free electronic return preparationand filing. But this season, the IRS is offering a newoption through the IRS Web site for those withhigher incomes.

Called Free File Fillable Tax Forms, the newoption makes available online common tax formsand schedules and allows taxpayers to fill out andfile them electronically. Unlike Free File offerings,however, the new option does not include an onlineinterview procedure, Shulman said. But it doesallow the taxpayer to do basic math calculations,enter tax data, sign the returns electronically, andprint the returns.

IRS planners think this free e-filing offer might beattractive to taxpayers who are comfortable withthe code, have simpler returns, or prepare thereturn using tax preparation software.

House Approves Rules PackageEasing Pay-Go Requirements

By Chuck O’Toole — [email protected]

House Democrats last week gave themselves abig escape clause from the strictures of ‘‘pay as yougo’’ budget rules.

On the first day of the 111th Congress, the Housevoted largely along party lines, 242 to 181, to adoptH. Res. 5, a set of changes to the rules governingHouse procedures. Included in the resolution isnew language that would automatically waive thepay-go requirement for any spending or revenuebill ‘‘expressly designated as an emergency’’ meas-ure. H. Res. 5 also expands on earmark reformspassed in the 110th Congress, ends term limits forHouse committee chairs, and eliminates the abilityof the minority party to kill bills on the floor bysending them back to committee for indefiniteconsideration. (For a fact sheet on the rules package,see Doc 2009-172 or 2009 TNT 3-29.)

The rules package prompted strong objectionsfrom House Republicans. In an open letter to hisGOP colleagues, House Rules Committee rankingminority member David Dreier, R-Calif., accusedDemocrats of ‘‘avoiding the tough decisions onpay-go.’’

‘‘No longer will the Democratic majority have tostruggle with finding the votes to waive pay-gowhen fixing the alternative minimum tax or bailingout another failing company,’’ Dreier wrote. ‘‘Theysimply declare an emergency, and pay-go doesn’tapply.’’ (For the letter, see Doc 2009-169 or 2009 TNT3-31.)

In floor remarks, House Majority Leader StenyH. Hoyer, D-Md., did not address the new ‘‘emer-gency’’ designation directly, but said the pay-gorules ‘‘confirm our commitment to fiscal respon-sibility.’’

Under the House rules for the 110th Congress,members could raise a point of order against anylegislation that increased the budget deficit or de-creased the budget surplus. A successful point oforder would effectively kill the bill. The point oforder could be waived for specific bills by a specialrule passed by the House Rules Committee andapproved by the full House, a process that wouldhappen only with the support of House majorityleadership. The 110th Congress used that procedureto waive pay-go for several tax bills, including theone-year ‘‘patch’’ of the alternative minimum taxfor the 2007 tax year and the Emergency EconomicStabilization Act of 2008 (P.L. 110-343), which in-cluded a partially offset $150 billion set of taxbreaks.

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The new ‘‘emergency’’ designation lets Houseleaders bypass debate over the pay-go point oforder, streamlining the legislative process but weak-ening a check against deficit spending.

House Democrats are considering waivingpay-go on several major bills in the new Congress,beginning with the economic stimulus package thatPresident-elect Barack Obama has requested. (Forrelated coverage, see p. 182.) Across the Capitol,Senate taxwriter and Budget Committee Chair KentConrad, D-N.D., suggested that the economic crisis‘‘is way beyond tactical approaches’’ such as pay-go, and instead suggested that Congress would

have to alter its method of dealing with the nationaldebt to achieve fiscal health. ‘‘This problem requiresfundamental policy change,’’ he said. Even as histeam is assembling the stimulus bill, which couldadd hundreds of billions of dollars to the deficit,Obama told reporters last week that he is‘‘troubled’’ by the country’s long-term fiscal health.

‘‘Potentially we’ve got trillion dollar deficits foryears to come, even with the economic recoverythat we are working on at this point,’’ Obama said,adding, ‘‘I’m going to be willing to make some verydifficult choices in how we get a handle on thisdeficit.’’

HOUSE TO VOTE ON SCHIP BILL CONTAINING TOBACCO TAX INCREASE

The House will revive a popular children’s healthinsurance bill — and a proposal for higher tobaccotaxes to pay for it — this week, according to a Houseleadership aide.

Congress in 2007 twice passed legislation to reau-thorize and expand the State Children’s Health In-surance Program (SCHIP), with strong bipartisanmajorities. Both times President Bush vetoed thebills. Democrats were unable to win enough Repub-lican votes to override the vetoes, so the programwas extended through a continuing resolution set toexpire in March. (For prior coverage, see Tax Notes,Jan. 28, 2008, p. 453, Doc 2008-1392, or 2008 TNT16-5.)

The most recent bill would have offset the cost ofSCHIP expansion by increasing the tax on a pack of

cigarettes 61 cents and raising the cap on taxes forlarge cigars to $3. The leadership aide said the taxprovisions in the new bill were expected to remainthe same.

House Democratic leaders have said that theyhave not set a date for a vote on the bill, but that itwill take place sometime in the next week. Withstronger control over Congress and a sympatheticnew administration, Democrats expect the bill topass easily through both chambers and be signedinto law shortly after President-elect Barack Obamabecomes president.

— Chuck O’Toole

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Recession to Take Big Bite Out ofTax Revenues, CBO Says


The ongoing recession will hammer federal taxrevenues in fiscal 2009, contributing to a $1.2 trilliondeficit for the year, the Congressional Budget Officesaid in its annual budget and economic outlookreleased last week.

The CBO — the official, nonpartisan budgetwatchdog for Congress — projected that total rev-enues will fall by $166 billion, or 6.6 percent, infiscal 2009, as corporate profits and wages shrink inthe tightening economy. (For the report, see Doc2009-236 or 2009 TNT 4-23.)

The CBO projected that total revenueswill fall by $166 billion, or 6.6 percent,as corporate profits and wages shrinkin the tightening economy.

The report estimates that revenue from indi-vidual income taxes will fall to $1.06 trillion in fiscal2009, a decrease of $86 billion, or 7.5 percent,compared with the previous year. Corporate in-come tax revenue will plunge to $223 billion infiscal 2009, a fall of $81 billion, or nearly 27 percent,compared with fiscal 2008. Payroll tax revenues willrise slightly over the same period, the report says. Itprojected those revenues to rise to $915 billion infiscal 2009, from $900 billion the previous year.Meanwhile, tax revenues from realized capital gainsare projected to drop by $55 billion, or by more than40 percent, while other tax revenues will fall by acombined 7.5 percent to $160 billion.

Overall, revenues are projected to fall to 16.5percent of GDP in 2009, one of the lowest shares ofGDP since 1959. In the last 50 years, revenues haveaveraged slightly more than 18 percent of GDP.

The revenue shortfall is one factor contributing toan estimated $1.2 trillion budget deficit for fiscal2009, equivalent to 8.3 percent of GDP. Real GDPwill shrink by an estimated 2.2 percent in thatperiod, the CBO predicted.

In early September 2008, the CBO estimated thatthe fiscal 2009 deficit would reach only $438 billion,but that was before the credit crunch and the federaltakeover of mortgage giants, Federal NationalMortgage Association and Federal Home LoanMortgage Corporation (Fannie Mae and FreddieMac, respectively), and subsequent emergencyspending and tax cut bills.

Deficit UnderestimatedThe $1.2 trillion figure more than likely underes-

timates the true deficit because it is based oncurrent law and policy. The figure therefore doesnot include ongoing expenses from the wars in Iraqand Afghanistan, which have been funded on anemergency basis outside the budget process sincethe conflicts began.

The CBO figure also omits the cost of an eco-nomic stimulus package that the transition team ofPresident-elect Barack Obama is expected to intro-duce in the coming days. Experts estimate thatpackage could add anywhere from $700 billion tomore than $1 trillion to the deficit over two years.(For related coverage, see p. 182.)

The CBO projects that the deficit picture will startto improve in 2010, shrinking to a mere $188 billionin 2018. But that relatively rosy outlook againassumes that current law will be unchanged, mean-ing that the tax cuts passed in 2001 and 2003 willexpire on schedule at the end of 2010, and that thealternative minimum tax will return to full effectstarting in 2009.

In fact, Obama has proposed extending several ofthe 2001 and 2003 cuts indefinitely, and manyobservers expect that the AMT will either bepatched again or substantially reworked in thecoming years to reduce its impact on middle-income taxpayers.

Lawmaker ReactionOn Capitol Hill, the budget figures prompted

similar expressions of shock from both sides of theaisle, yet very different conclusions about policy.

The CBO projects that the deficitpicture will start to improve in 2010,shrinking to a mere $188 billion in2018.

Democrats laid the blame for the grim report atthe feet of the Bush administration. Senate taxwriterand Budget Committee Chair Kent Conrad, D-N.D.,told reporters the upcoming stimulus bill shouldinclude a framework for long-term reduction of thenational debt. He also called for reform of what hetermed an ‘‘outdated, antiquated revenue system’’by shutting down tax ‘‘scams’’ and offshore taxhavens.

In a briefing with reporters, House taxwriter andBudget Committee ranking minority member PaulRyan, R-Wis., noted that the trillion-dollar deficitcame ‘‘before passing a single bill’’ in the newCongress, and suggested that the business climatewas hampered by the coming expiration of the 2001and 2003 tax cuts.

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‘‘What we know doesn’t work [to spur theeconomy] is a 33 percent increase in capital gainstaxes,’’ Ryan said, referring to the scheduled in-crease of the long-term capital gains tax rate from 15percent to 20 percent. He and Senate Budget Com-mittee ranking minority member Judd Gregg,R-N.H., said Congress should encourage job growthby making permanent cuts in taxes paid by smallbusinesses.

Obama’s ‘Performance Officer’Brings Experience From Treasury

By Nicole Duarte — [email protected]

Nancy Killefer, newly named as President-electBarack Obama’s White House ‘‘performance of-ficer,’’ brings extensive experience with IRS restruc-turing to her task of coordinating and evaluatingthe efficiency of federal agencies.

Killefer served in the Clinton administration’sTreasury Department during the IRS’s restructuringprocess and later served as a charter member of theIRS Oversight Board.

‘‘This is a really good thing for the IRS,’’ JeffTrinca, a chief of staff of the IRS restructuringcommission who worked with Killefer during hertime at Treasury, told Tax Analysts. (For priorcoverage, see Tax Notes, July 28, 2008, p. 300, Doc2008-15938, or 2008 TNT 140-3.)

Killefer and IRS Commissioner Douglas Shulman‘‘speak each other’s language,’’ added Trinca, cur-rently a vice president of the lobbying firm VanScoyoc Associates in Washington. ‘‘There’s going tobe a great deal of respect and ability for [Shulman]to make his case at the highest level for the re-sources he needs.’’

‘‘She’s familiar, on an up-to-date basis, with theIRS,’’ Robert M. Tobias, director of public sectorexecutive education at American University, toldTax Analysts. Tobias served as the president of theNational Treasury Employees Union duringKillefer’s tenure at Treasury and was another char-ter member of the IRS Oversight Board.

Still serving on the Oversight Board, Tobiasnoted that Killefer’s current employer, consultingfirm McKinsey & Co., was recently under contractwith the IRS to assist the Service in creating itssoon-to-be-released 2007-2012 strategic plan.Killefer was part of the McKinsey team working onthe plan, he said.

Killefer’s Restructuring RoleFrom 1997 to 2000, Killefer served in several

positions in the Treasury Department, notably asassistant secretary for management. While at Treas-ury, she was instrumental in helping the IRS reor-ganize itself under the auspices of the InternalRevenue Service Restructuring and Reform Act of1998. In 2000 Killefer became one of the chartermembers of the newly formed Oversight Board,and became the board’s second chairperson in 2002.

‘‘She understood the IRS,’’ Tobias said. ‘‘Whenyou’re starting a new organization like the Over-sight Board, you have to create a whole new set ofrelationships. Treasury was wary of the OversightBoard, the IRS was wary of the Oversight Board,’’

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Tobias added. ‘‘She was very wise about under-standing and being sensitive to that, while recog-nizing that the board had a real role andresponsibility.’’

Former IRS Commissioner Charles O. Rossottiworked closely with Killefer for about three yearsduring the IRS’s restructuring process. ‘‘She wasinstrumental in making the whole restructuringprocess work,’’ Rossotti, now senior adviser withthe Carlyle Group, told Tax Analysts. ‘‘Almosteverything that was done on restructuring I did inclose consultation with her.’’

Such were Killefer’s collaboration skills, Rossottisaid, that the two were able to make somethingproductive out of the strained relationship thatTreasury and the IRS experienced at the beginningof the restructuring process.

As a result, Rossotti said, he and Killefer wereable to facilitate collaborative efforts to modernizethe IRS’s computer systems, reorganize the internalstructure of the agency, and change the way em-ployee performance was measured.

‘You can’t just shuffle boxes aroundon a flow chart; you have to changethe attitude and the culture in anorganization,’ said Trinca.

Tobias credits Killefer with sponsoring two majorinitiatives during restructuring: the effort to sim-plify the notices that taxpayers receive from theService, and the effort to prioritize improved serviceto taxpayers alongside enforcement.

‘‘Most of the substantive attempts at reform cameout of Killefer’s office,’’ said Trinca, who also creditsher with translating the work of the IRS restructur-ing commission to Clinton Treasury Secretary LarrySummers and other political leaders.

Building BridgesRossotti said Killefer’s role at Treasury was in

some ways comparable to what she might be doingnow, ‘‘just on a bigger scale.’’ Rossotti and Killefermoved Treasury and the IRS ‘‘from an arms-lengthadversarial relationship to where we were workingas a team to decide what the right things were to doand to get them done,’’ Rossotti said, adding, ‘‘Ianticipate she will take the same approach withother agencies.’’

Killefer is familiar with the problem of measure-ment in an agency, Tobias said. One of her first andmost important tasks will be to decide how tomeasure efficiency and effectiveness in outcomes aswell as to provide data to decision-makers on atimely basis.

Trinca added that ‘‘she’s going to understandbetter than anyone how difficult it really is to makefundamental changes in an agency. You can’t justshuffle boxes around on a flow chart; you have tochange the attitude and the culture in an organiza-tion. There’s not an agency out there with a strongerculture than the IRS.’’

Trinca noted that it will be up to the president-elect to decide how important Killefer’s role is andwhether she will speak for Obama. If that’s thesense the agencies get, things will get done, he said.

Trinca was hopeful about Killefer’s prospects. Ifthe position is modeled after former Vice PresidentAl Gore’s efforts to reinvent government initiative,‘‘then I think there could be some real good to comefrom it. If not,’’ he said, ‘‘it could be one of thethings where a few years on, you wonder what theheck ever happened.’’

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Frank Wants Treasury to Invest inLow-Income Housing Credits


The Treasury Department may shore up themarket for low-income housing tax credits, if Con-gress approves a top House Democrat’s plan.

An aide for Financial Services Committee ChairBarney Frank, D-Mass., recently confirmed thatFrank is pushing legislation to let Treasury invest $5billion in housing projects eligible for low-incomehousing tax credits. An additional $5 billion wouldgo to states for the same purpose.

The plan would be part of an economic stimuluspackage that lawmakers are drafting in anticipationof the incoming Obama administration. The Frankaide said that details about the plan were unavail-able as staffers continue negotiations.

Frank’s proposal addresses concerns about theso-called tax-equity investment market, in whichdevelopers form partnerships with banks or otherlarge institutions to construct and manage low-income housing. In a typical arrangement, a bankprovides capital for construction and maintenanceof a low-income housing development in exchangefor a passive majority (usually greater than 99percent) stake in the partnership. That ownershipstake lets the bank claim the tax credits associatedwith the project, while the developer recoups con-struction costs.

Frank is pushing legislation to letTreasury invest $5 billion in housingprojects eligible for low-incomehousing tax credits, said an aide.

But tax-equity specialists and some congressionalaides say that the recent economic downturn andthe credit crisis affecting major financial institutionshave sharply diminished banks’ appetite for taxcredits.

Also, the Federal National Mortgage Associationand the Federal Home Loan Mortgage Corporation(Fannie Mae and Freddie Mac, respectively), bothmajor investors in low-income housing tax credits,entered government conservatorship in September2008 and have announced plans to liquidate theirtax-preferred investment portfolios. (For prior cov-erage, see Tax Notes, Nov. 3, 2008, p. 520, Doc2008-23135, or 2008 TNT 212-2.)

A December report published by the Massachu-setts Housing Partnership and Recap Advisors LLCof Boston estimated that the investment demand forlow-income housing tax credits has fallen by 60

percent since 2006. As a result, the report says,several projects have stalled as funding has driedup. (For the report, see Doc 2008-27361 or 2008 TNT1-24.)

The investment demand forlow-income housing tax credits hasfallen by 60 percent since 2006,according to a report.

The mechanism through which Treasury wouldinvest in the tax credits is unclear. Media outletsreported that Treasury has already overspent thefirst $350 billion in funds released through theTroubled Asset Relief Program that was enactedunder the Emergency Economic Stabilization Act of2008 (P.L. 110-343).

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Exempts Need More PersonalContact With the IRS, Says Report

By Fred Stokeld — [email protected]

The IRS Tax-Exempt and Government EntitiesDivision (TE/GE) is relying heavily on the Internetto provide education and outreach to tax-exemptorganizations at the expense of personal contact,according to the National Taxpayer Advocate’s 2008Annual Report to Congress.

The report, released last week by the TaxpayerAdvocate Service, noted that between October 2007and May 2008 the Exempt Organizations Division,which falls under TE/GE, conducted workshops onthe redesigned Form 990, ‘‘Return of OrganizationExempt From Income Tax,’’ and on other topics, andthat the workshops included face-to-face interactiveforums. But most of the division’s education andoutreach efforts are conducted through the Internetrather than in person, and officials are more likelyto make speeches in response to invitations theyreceive rather than initiate their own speakingengagements, according to the report.

The report adds that EO officials received fewerspeaking requests last year, resulting in a 35 percentdrop in the number of customers reached comparedwith the first quarter of fiscal 2006. (For the execu-tive summary and report, see Doc 2009-241 or 2009TNT 4-21. For a related IRS news release, see Doc2009-240 or 2009 TNT 4-10.)

‘‘Electronic taxpayer service should not supplantface-to-face outreach unless EO has data that sup-ports organizations’ preference for these services,’’the report says.

‘Electronic taxpayer service shouldnot supplant face-to-face outreachunless EO has data that supportsorganizations’ preference for theseservices,’ the report says.

In response, the IRS said the EO Division hasbalanced its Internet outreach with personal ap-pearances by EO Division officials. There are about1,600 articles on EO topics in the Charities andNonprofits portion of the IRS Web site, and therehas been an 81 percent rise in the use of theCharities and Nonprofits section since fiscal 2005,according to the IRS.

The IRS also said EO Division officials receivedalmost 50 percent more speaking invitations duringfiscal 2008, mostly because of interest in the newForm 990 and the Form 990-N, ‘‘Electronic Notice(e-Postcard) for Tax-Exempt Organizations Not Re-

quired to File Form 990 or 990-EZ.’’ The IRS re-sponded to the requests by conducting 19workshops on the new Form 990, and it discussedthe changes to the return at 17 Small and Midsizeorganization workshops across the country. Nearly42,000 people attended the events, which is morethan showed up in fiscal 2006 and fiscal 2007,according to the IRS.

In a section of the report addressing the servicesthe IRS provides taxpayers versus the IRS’s enforce-ment efforts, the national taxpayer advocate criti-cized the IRS for not doing more to educatetaxpayers about the causes of their complianceproblems, and it cited as an example the agency’streatment of charities that fail to include specificforms with their information returns. The IRSabates the penalties when the charity submits theform but does little to educate the filer on how tocomply with the requirement in the future.

The IRS disputed that finding, pointing out thatbefore assessing penalties for filing an incompletereturn, the agency sends a charity two letters re-questing the required information. A toll-free tele-phone number is provided in case a charity hasquestions, and there is information in publications,in the instructions to the return, and on the IRS Website on penalties for not filing complete returns, theIRS said.

Ideas for LegislationThe report offers several legislative proposals,

including one to simplify and streamline highereducation tax incentives. It says Congress shouldconsolidate the HOPE scholarship and lifetimelearning credits and clarify whether families canuse more than one incentive in the same tax year. Italso recommends that standards governing studenteligibility for the tax breaks be made consistent andthat a uniform definition of ‘‘qualifying highereducation expenses’’ and ‘‘eligible education insti-tution’’ be established.

There also should be consistent income-levelthresholds, phaseout calculations, and inflationaryadjustments regarding the education incentives,according to the report, which further recommendsthat Congress eventually make the incentives per-manent.

Steven M. Bloom of the American Council onEducation praised the report for addressing educa-tion incentives, adding that the need for simplifica-tion has been apparent for some time. He said thecouncil has supported recent efforts in Congress toconsolidate and reform some education incentives.

‘‘We look forward to working with the newCongress and the Obama administration on effortsto make higher education tax incentives more effec-tive in enhancing access for students to highereducation,’’ Bloom said.

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Retirement PlansAnother simplification proposal will interest EOs

and other types of entities that offer retirementplans. It asks lawmakers to consider consolidatingsome plans and perhaps establish one type of planfor individuals, another for small businesses, andone for large businesses; plans limited to govern-mental entities would be eliminated.

The report says there should be uniform rulesgoverning hardship withdrawals, plan loans, andportability.

The report says there should beuniform rules governing hardshipwithdrawals, plan loans, andportability.

William F. Sweetnam of the Groom Law Groupsaid proposals to simplify the number and types ofretirement plans are not new, noting that the Bushadministration proposed three types of plans: life-time savings accounts, retirement savings accounts,and employer retirement savings accounts. He saidthere has not been much of an effort on Capitol Hill

to advance any changes, and he noted that there areinfluential people and institutions, some of whichreflect established constituencies such as teachers,that are happy with the current system.

‘‘Whether a strong constituency emerges to try toadvance a major simplification in the number andtypes of retirement plans is unclear at this time,although we could conceivably see a push forpayroll deduction IRAs by the new administra-tion,’’ Sweetnam said.

Another recommendation involves the mileagededuction for charitable activities. The report notesthat the standard mileage deduction for vehicleexpenses related to a charitable activity is 14 cents amile and that the IRS is not empowered to changethe rate when conditions, such as higher gas prices,warrant it. The report urges Congress to change thecode to allow the IRS to determine the mileage rate.

The mileage proposal is likely to be popular withcharities. In November, Diana Aviv, president andCEO of Independent Sector, an umbrella group ofnonprofits, said the 14-cent rate had made it diffi-cult for charities to recruit volunteer drivers duringperiods of fluctuating gas prices. (For Aviv’s com-ments, see Doc 2008-24972 or 2008 TNT 229-34.)

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In-House AdvertisementIntentionally Removed

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Temporary Cost-Sharing RegsUncorked on New Year’s Eve

By Joseph DiSciullo — [email protected] andRobert Goulder — [email protected]

By the time the ball had begun its descent in TimesSquare, some transfer pricing practitioners had spent halfa day cozying up to more than 200 pages of temporaryand proposed cost-sharing regulations issued that after-noon. The preamble to the temporary regs claims that therevised rules offer considerably greater flexibility thanproposed regs published in 2005.

A December 2008 revenue procedure provided tempo-rary guidance on the treatment of stock distributions bypublicly traded corporations that are real estate invest-ment trusts. That guidance has now been extended topublicly traded regulated investment companies.

Recent agricultural policy legislation affects some taxcredits and payments related to the fuel use of alcoholand alcohol fuel mixtures. In response to commentators’concerns about the volume of denaturants that will betreated as alcohol, the Service has released a notice thatincludes a temporary safe harbor and a transitional rule.

An annual series of eight revenue procedures updatesguidance on the issuance of letter rulings, technicaladvice, and determination letters, as well as user fees andlists of areas in which the Service will not rule.

Finally, the IRS wants to inform financially distressedtaxpayers that there are options available for peoplestruggling to meet their tax obligations. A news releasethat provides valuable information on maximizing re-funds also encourages taxpayers to take advantage ofseveral new tax credits and deductions and a majorenhancement to the Free File program.

Cost-Sharing ArrangementsRecently released temporary and proposed regula-

tions for determining taxable income from cost-sharingarrangements are intended to address issues that havearisen in administering the current regs (T.D. 9441, Doc2008-27341, 2009 TNT 1-4; REG-144615-02, Doc 2008-27342, 2009 TNT 1-5). The new regs make significantchanges to proposed regs originally published in 2005(REG-144615-02, Doc 2005-17678, 2005 TNT 162-1) and aregenerally applicable for arrangements that begin on orafter January 5, 2009, with transition rules provided forsome preexisting arrangements. (For additional cover-age, see p. 191.)

Cost-sharing arrangements are contracts between U.S.parent companies and their foreign affiliates under whichthe former transfer self-developed intangible assets to thelatter. As a result, royalty income from the worldwidelicensing and commercial exploitation of the intangiblesaccrues offshore, typically in a low-tax jurisdiction. Ab-sent the reach of the U.S. transfer pricing regime, that

foreign-source income would likely not be taxed in theUnited States until repatriated.

Like the 2005 proposed regs, the new regulations focuson the valuation of the foreign affiliates’ buy-in amount.That is, the controlled participant receiving the intan-gibles must adequately compensate the transferor for itscapital investment and know-how ‘‘in proportion to itsrespective shares of reasonably anticipated benefits.’’Because comparable transactions may be unavailable, theregs generally ask what commercial terms separate,unrelated parties would use if entering into a jointventure for the development of the same property rightsfor the same market. Specific factors to be consideredinclude how the parties choose to allocate material func-tions and risks, the expected duration of contractualcommitments, the degree of uncertainty in profit poten-tial, and the extent to which other resources necessary tocommercial development of the property are contributedor shared.

The new regulations retain the controversial ‘‘investormodel’’ that was harshly criticized by commentatorswhen introduced as part of the 2005 regs. The preambleto the new regs, however, claims that the revised rulesoffer considerably greater flexibility in designing tax-efficient cost-sharing agreements. In response to com-ments, the temporary regs include additional guidanceon the evaluation of the arm’s-length results of cost-sharing transactions and platform contribution transac-tions.

One way the new regulations offer more flexibility isby easing the requirement that controlled participantsmust receive nonoverlapping territorial interests withperpetual and exclusive rights to profits. Commentatorshad suggested that the territorial interest requirementwas an artificial standard that did not comply withcommon business practices. The new regulations permita second option — the ‘‘field of use division of interests’’— which provides an alternative basis for outlining theauthorized rights of controlled participants.

The regs also address the material functional and riskallocations in the context of a cost-sharing arrangement,including the reasonably anticipated duration of thecommitments, the intended scope of the intangible de-velopment, the degree and uncertainty of profit potentialof the intangibles to be developed, and the extent ofplatform and other contributions of resources, capabili-ties, and rights to the development and exploitation ofcost-shared intangibles.

The IRS noted that if available data of uncontrolledtransactions reflect, or may be reliably adjusted to reflect,similar facts and circumstances to a cost-sharing arrange-ment, they may be the basis for application of a compa-rable uncontrolled transaction method to value the cost-sharing transaction and platform contributiontransaction results. Because of the difficulty of findingdata that reliably reflect those facts and circumstances —

tax notes®

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even after adjustments — the temporary regs also pro-vide for other methods. Those include the newly speci-fied income, acquisition price, market capitalization, andresidual profit-split methods.

Regulated Investment CompaniesTemporary guidance affords stock distributions by

publicly traded RICs the same treatment extended lastmonth to stock distributions by REITS (Rev. Proc. 2009-15, 2009-4 IRB 1, Doc 2009-286, 2009 TNT 4-8). The newrevenue procedure, which amplifies and supersedes Rev.Proc. 2008-68, 2008-52 IRB 1373, Doc 2008-25921, 2008TNT 239-14, is effective for distributions declared on orafter January 1, 2008.

Section 305(a) provides that gross income generallydoes not include the amount of any distribution of thestock of a corporation made by the corporation to itsshareholders in connection with its stock. Under section305(b)(1), however, the general rule does not apply to adistribution by a corporation of its stock if the distribu-tion is, at the election of any of the shareholders, payableeither in its stock or in property. In that case, thedistribution will be treated as a distribution of propertyto which section 301 applies. The same treatment isrequired by section 305(b)(2) if the distribution (or aseries of distributions of which the distribution is one)has the result of the receipt of property by some share-holders, and an increase in the proportionate interests ofother shareholders in the assets or earnings and profits ofthe corporation.

In Rev. Proc. 2008-68, the IRS said it will treat a REITstock distribution as a distribution of property to whichsection 301 applies by reason of section 305(b). Also, theamount of the distribution of stock will be considered toequal the amount of the money which could have beenreceived instead. Rev. Proc. 2009-15 extends the sametreatment to RICs.

The temporary guidance applies if the distribution ismade by the corporation to its shareholders, the stock ispublicly traded on an established U.S. securities market,and the distribution is declared for a tax year ending onor before December 31, 2009. Also, the guidance sets aconditional cash limitation on the amount of money to bedistributed in the aggregate to all shareholders. Lastly,provisions in the guidance explain how to calculate thevalue of distributed shares and how the guidance appliesto shareholders participating in a dividend reinvestmentplan.

Alcohol Fuel CreditAn IRS notice introduces a temporary safe harbor and

a transitional rule to implement recent statutory changesmade by the Food, Conservation, and Energy Act of 2008(Food Act) on the volume of denaturants that will be

considered alcohol for purposes of some credits andpayments (Notice 2009-6, 2009-3 IRB 1, Doc 2008-27360,2009 TNT 1-14).

Sections 34, 40(a), 6426(a), and 6427(e) provide taxincentives for alcohol and alcohol fuel mixtures that aresold for use or used as a fuel in specified transactions. Forthose purposes, Notice 2005-4, 2005-1 C.B. 289, Doc2004-23794, 2004 TNT 242-6, defines alcohol to have themeaning given to the term in reg. section 48.4081-6(b)(1)of the Manufacturers and Retailers Excise Tax Regula-tions, except that for purposes of the credit allowed bysection 40, alcohol also includes alcohol with a proof of atleast 150.

Effective for fuel sold or used after December 31, 2008,the Food Act amended section 40(d)(4) to provide thatdenaturants included in the volume of alcohol may notexceed 2 percent of the volume of that alcohol, includingdenaturants. Before January 1, 2009, the limit was 5percent. The Food Act also added section 6426(b)(5) toapply the same 2 percent limit to claims for alcohol fuelmixtures under sections 34, 6426, and 6427. Regulationsissued by Treasury’s Alcohol and Tobacco Tax and TradeBureau (TTB) indicate that alcohol eligible for with-drawal as fuel alcohol must contain two gallons ofdenaturant for each 100 gallons of distilled spirits. Tosatisfy the TTB rule, denaturants included in the volumeof fuel alcohol must exceed 1.96 percent of the volume ofthe fuel alcohol.

Commentators have expressed concern about the abil-ity to meet TTB’s 1.96 percent minimum requirementwhile not exceeding the Food Act’s maximum 2 percentdenaturant allowance. They also noted that there is notest procedure to accurately measure the amount ofdenaturant in alcohol after it has been denatured. As aresult, ethanol producers and blenders have no reliableway of determining when denaturants exceed the 2percent limit. Commentators also wondered how to treatalcohol containing 5 percent denaturant that is in transitor stored by alcohol fuel blenders on January 1, 2009.

In response to the comments about accurately measur-ing denaturants in alcohol, the guidance provides atemporary safe harbor to allow time to study whetherthere are effective ways to test the volume of denaturantin alcohol. Under the safe harbor, the IRS will notchallenge a claim for denaturants included in alcoholunless the denaturants clearly exceed the Food Act limit.The guidance specifies the requirements that must be metfor the safe harbor to apply.

The guidance also includes a transition rule for Janu-ary 2009 to provide relief for alcohol already producedand shipped. Under the transition rule, the volume ofalcohol for which a credit or payment is allowable may bedetermined under the rules in effect before January 1,2009, if the credit or payment is allowable to a personother than the producer of the alcohol and the credit orpayment is allowable on account of an event (such as amixture producer’s sale of an alcohol fuel mixture for useas a fuel) occurring before February 1, 2009.

Annual Procedural UpdatesThe IRS has published revised procedures for issuing

ruling letters, determination letters, and information let-ters on some issues (Rev. Proc. 2009-1, 2009-1 IRB 1, Doc

APPLICABLE FEDERAL RATES

For the full text of the tables setting forth theJanuary 2009 applicable federal rates (AFR) and ad-justed AFR, see Tax Notes, Dec. 22, 2008, p. 1374, Doc2008-26620, or 2008 TNT 245-6.

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2008-27366, 2009 TNT 1-6). Rev. Proc. 2008-1, 2008-1 IRB1, Doc 2008-255, 2008 TNT 4-8, is superseded.

The Service has also published revised procedures forfurnishing technical advice and technical expedited ad-vice to directors and appeals area directors in some areas(Rev. Proc. 2009-2, 2009-1 IRB 87, Doc 2008-27367, 2009TNT 1-7). Rev. Proc. 2008-2, 2008-1 IRB 90, Doc 2008-256,2008 TNT 4-9, is superseded.

The IRS has updated the list of those areas of the codeunder the jurisdiction of the associate chief counsel andthe division counsel/associate chief counsel in which itwill not issue letter rulings or determination letters (Rev.Proc. 2009-3, 2009-1 IRB 107, Doc 2008-27368, 2009 TNT1-8). Rev. Proc. 2008-3, 2008-1 IRB 110, Doc 2008-257, 2008TNT 4-10, and Rev. Proc. 2008-61, 2008-42 IRB 934, Doc2008-20658, 2008 TNT 189-19, are superseded.

The Service has also published revised procedures forfurnishing ruling letters, information letters, and otherguidance on matters concerning sections of the codeunder the jurisdiction of the commissioner (Tax-Exemptand Government Entities (TE/GE) Division) (Rev. Proc.2009-4, 2009-1 IRB 118, Doc 2008-27369, 2009 TNT 1-9).Rev. Proc. 2008-4, 2008-1 IRB 121, Doc 2008-258, 2008 TNT4-11, is superseded.

Revised procedures for furnishing technical advice toarea managers and appeals offices by the commissioner(TE/GE) on employee plans issues and exempt organi-zations have been published (Rev. Proc. 2009-5, 2009-1IRB 161, Doc 2008-27370, 2009 TNT 1-10. Rev. Proc.2008-5, 2008-1 IRB 164, Doc 2008-259, 2008 TNT 4-12, issuperseded.

The procedures for issuing determination letters onthe qualified status of employee plans under sections 401,403(a), 409, and 4975 have been revised (Rev. Proc.2009-6, 2009-1 IRB 189, Doc 2008-27371, 2009 TNT 1-11).Rev. Proc. 2008-6, 2008-1 IRB 192, Doc 2008-260, 2008 TNT4-13, is superseded.

The IRS has provided a revised list of matters underthe jurisdiction of the associate chief counsel (interna-tional) in which it will not issue advance letter rulings ordetermination letters (Rev. Proc. 2009-7, 2009-1 IRB 226,Doc 2008-27372, 2009 TNT 1-12). Rev. Proc. 2008-7, 2008-1IRB 229, Doc 2008-261, 2008 TNT 4-14, is superseded.

Finally, the Service has revised its guidance for com-plying with the IRS user fee program as it pertains torequests for letter rulings and determination letters onmatters under the jurisdiction of the commissioner (TE/GE) (Rev. Proc. 2009-8, 2009-1 IRB 229, Doc 2008-27373,2009 TNT 1-13). Rev. Proc. 2008-8, 2008-1 IRB 233, Doc2008-262, 2008 TNT 4-15, is superseded.

Assistance for Distressed TaxpayersWith the commencement of the 2009 filing season, the

IRS has announced the availability of several options tohelp financially distressed taxpayers maximize their re-funds and expedite payments, while providing addi-tional help to people struggling to meet their taxobligations (IR-2009-2, Doc 2009-146, 2009 TNT 3-5).

To maximize taxpayer refunds, the IRS has alertedindividuals to the first-time homebuyer credit, the recov-ery rebate credit, the standard deduction for real estatetaxes, and the tax consequences of debt forgivenessrelated to mortgage workouts and foreclosures.

To promote speedy refund delivery, the IRS remindsindividuals to file their returns electronically and notesthat its free return preparation program — Free File —will be open to nearly everyone, not just taxpayers withadjusted gross incomes of up to $56,000.

According to the IRS, taxpayers in hardship situationsmay be able to adjust payments for back taxes, avoiddefaulting on payment agreements, or possibly defercollection action. The Service is increasing flexibility formissed payments and will speed the delivery of levyreleases by easing requirements on taxpayers who re-quest expedited levy releases for hardship reasons.

The IRS is also creating an additional level of reviewfor offers in compromise in which home values may notbe accurate. Taxpayers who are unable to meet theperiodic payment terms of an accepted OIC will be ableto contact the IRS office handling the offer for availableoptions to help them avoid default.

***Julie Brienza and Emily Vanderweide contributed to this

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Merrill Lynch Cross-Chain SalesWere Redemptions, Not Dividends

By Jeremy Scott — [email protected]

The Tax Court, on remand from the Second Circuit,has again held that a series of transactions conducted byMerrill Lynch were redemptions and not tax-favoreddividends. In its initial decision, the Tax Court found thatthe transactions undertaken by Merrill Lynch were partof a firm and fixed plan to sell a subsidiary and did notqualify for dividend treatment. The Second Circuitagreed with that decision but remanded the case forconsideration of Merrill Lynch’s alternative argumentregarding constructive ownership, raised for the firsttime on appeal. The Tax Court disagreed with MerrillLynch’s position and concluded that stock must bedirectly held, not indirectly or constructively, to avoidredemption treatment under section 302.

The Eleventh Circuit has affirmed the conviction of anevangelical creationist for failing to pay employmenttaxes, obstructing tax laws, and structuring transactionsto avoid financial reporting laws. The court also affirmedthe conviction of the taxpayer’s wife for structuringtransactions to avoid financial reporting laws. The coupleargued that their indictments were insufficient, thatinsufficient evidence was introduced to support the con-victions, and that the district court erred by adding asentence to the jury instructions. The couple also chal-lenged their sentence, but the appellate court affirmed,upholding a 10-year prison sentence plus restitution forthe husband and a 1-year prison sentence for the wife.

A company operating under the IRS’s private debtcollection program is not a ‘‘government controlled cor-poration’’ for purposes of the Privacy Act, according to arecent holding by the Second Circuit, which affirmed alower court dismissal. A former employee of the debtcollection agency brought suit, alleging that PioneerCredit Recovery Inc. photocopied and impermissiblyhandled his security clearance package. The SecondCircuit rejected the assertion that Pioneer Recovery quali-fied as a government controlled corporation, which is anecessary element of a Privacy Act cause of action.

Redemptions and DividendsIn a remand decision, the Tax Court recently held that

cross-chain sales conducted by Merrill Lynch to sell awholly owned subsidiary but retain a portion of thesubsidiary’s assets do not qualify for dividend treatmentunder section 302. The Tax Court initially disalloweddividend treatment because the transactions wereviewed as part of a firm and fixed plan. For the first timeon appeal, Merrill Lynch alternatively argued that theconstructive ownership test in section 318 allowed it totreat the proceeds of the transactions as dividends andnot as redemptions. The Second Circuit remanded thecase for consideration of that theory. The Tax Court again

denied dividend treatment, holding that under section304, it was not required to test for constructive or indirectownership (Merrill Lynch & Co. et al. v. Commissioner, 131T.C. No. 19 (Dec. 30, 2008), Doc 2008-27312, 2008 TNT251-5).

Merrill Lynch is the parent of an affiliated group ofcorporations that filed consolidated returns for the taxyears at issue. ML Capital Resources was a subsidiary ofMerrill Lynch. The parent wanted to sell a portion ofML’s business but keep nonleasing assets in the group.As a result, Merrill Lynch decided that before it sold ML,the subsidiary would sell to other corporations in thegroup the stock of ML’s subsidiaries that were engagedin lending and financial activities or that owned otherassets and businesses that were not related to its con-sumer leasing operations.

In February 1987, Merrill Lynch opened the biddingon ML and in March, ML sold all the stock of five of itswholly owned subsidiaries to other corporations in theMerrill Lynch group. According to the Tax Court, thosestock sales constituted cross-chain sales. All partiesagreed that those sales were section 304 transactions. InJune, Merrill Lynch agreed to sell ML to GATX LeasingCorp.

On its 1987 tax return, the group claimed a long-termcapital loss of more than $460 million from the sale of MLstock. It also treated the cross-chain sale proceeds asdividend payments to ML, which in turn increased thegroup’s basis in its ML stock. That alleged increase inbasis allowed the group to recognize a loss on the sale ofthe ML stock outside the group.

The IRS issued a notice of deficiency, asserting thatMerrill Lynch overstated the basis of its ML stock bymore than $320 million, the amount of the cross-chainproceeds. The group contested the deficiency before theTax Court.

The Tax Court held for the IRS in Merrill Lynch I. Thecourt decided that the cross-chain stock sales should beintegrated with the later sale of the cross-chain seller, ML,outside the affiliate group. That resulted in a redemptionin complete termination under section 302(a) and (b)(3).Because the sales were part of a firm and fixed plan, theTax Court found redemption treatment most appropriate.Merrill Lynch appealed to the Second Circuit.

The Second Circuit affirmed the Tax Court decision inpart in Merrill Lynch & Co. & Subs v. Commissioner, 386F.3d 464 (2d Cir. 2004), Doc 2004-19204, 2004 TNT 190-14.The appellate court adopted the firm and fixed plan testas the appropriate method for determining whether twotransactions conducted at different times may be inte-grated for the purposes of section 302. It also agreed withthe Tax Court’s reasoning and application of that test.However, the Second Circuit remanded the case to theTax Court because Merrill Lynch raised an alternativeargument based on section 318.

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On appeal, the group argued that the proceeds shouldbe treated as a dividend regardless of whether the actualand constructive ownership interest of ML was com-pletely terminated because the parent, Merrill Lynch,retained a constructive ownership interest in the pur-chased subsidiaries after the sale of ML for the purposesof section 302(b)(3).

On remand, Judge L. Paige Marvel considered MerrillLynch’s new argument for dividend treatment and re-jected it, holding that under section 302, only ML’sownership interest needed to be considered for a trans-action to qualify as a redemption in complete terminationof an ownership interest. Judge Marvel wrote that theissue before the Tax Court was whether Merrill Lynch’scontinuing constructive ownership issue in the subsidiar-ies that participated in the cross-chain sales ‘‘must betaken into account in analyzing the tax consequences’’under sections 304 and 302. Under section 304, ‘‘thepersons in control must actually receive property inexchange for the transfer of their issuing corporationstock to warrant the redemption analysis in section 302.’’(Emphasis in the original.) Because the Merrill Lynchparent did not actually receive property, a section 318construction ownership analysis was unnecessary.

The court did not need to look beyond ML’s owner-ship of the issuing corporations to consider any addi-tional persons who may have an indirect interest in theissuing corporations under the section 318 attributionrules, according to Judge Marvel. Because ML was theonly entity that transferred any stock in the cross-chainsales and it was the only shareholder that receivedproperty in exchange for that stock, the analysis endedwith ML. Therefore, the Tax Court concluded that re-demption treatment was still appropriate under section302. And therefore, the court affirmed the essence of itsearlier decision and sustained the deficiencies againstMerrill Lynch because its basis in ML stock was no longersufficient for it to claim the loss on its original 1987return.

Tax FraudThe Eleventh Circuit affirmed the convictions and

sentences of a husband and wife, the former being apromoter of creationism. The court rejected appealsbased mostly on allegations of insufficient indictmentsand evidence. A district court in Florida convicted thehusband of failing to collect and withhold employmenttaxes, obstructing tax laws, and structuring transactionsto avoid financial reporting losses. It sentenced him to 10years in prison plus restitution. The wife was convictedof structuring transactions to avoid financial reportinglosses and was sentenced to 1 year in prison. (UnitedStates v. Kent E. Hovind et al., No. 07-10090 (11th Cir. Dec.30, 2008), Doc 2008-27364, 2009 TNT 1-19).

The Hovinds owned and operated Creation ScienceEvangelism Enterprises, which sold videos and litera-ture, provided lecture services, and hosted debates aboutcreationism and evolution. Between 1999 and 2003, thecouple withdrew from AmSouth Bank more than $1.5million in increments of less than $10,000 to avoid federalfiling requirements. Mrs. Hovind controlled the financesof the company and Mr. Hovind oversaw payroll and

related federal tax obligations. Mr. Hovind failed towithhold or pay quarterly federal withholding taxesbetween 2001 and 2003.

The Hovinds were charged in a 58-count indictment.Mr. Hovind was charged with willfully failing to deductand pay withholding taxes and obstructing the adminis-tration of internal revenue laws. Both were charged with45 counts of structuring cash withdrawals to avoidfinancial reporting obligations. The indictment includeda provision requiring that the Hovinds forfeit all propertyassociated with the reporting crimes or other property upto the value of the associated property.

During the trial, the Hovinds moved for an acquittalon the basis that the government could not prove thateach withdrawal equaled or exceeded $10,000. The gov-ernment, and the district court, believed that the struc-turing statutes necessarily required a transaction under$10,000. The district judge went so far as to instructdefense counsel that they would not be permitted toargue their interpretation of the structuring statute.

The Hovinds were found guilty of all charges. The juryalso entered a special verdict finding $430,000 in propertytraceable to the reporting crimes and ordered the forfei-ture of real or personal property in that amount. Thepresentencing reports calculated that the tax liabilityattributed to Mr. Hovind’s crimes amounted to morethan $600,000. Initially, the presentencing report recom-mended a sentence of 97 to 121 months for Mr. Hovind,and 0 to 6 months for Mrs. Hovind. However, thegovernment later learned that the Hovinds had trans-ferred the $430,000 in property related to the reportingcrimes to a third party. As a result, the court sentencedMr. Hovind to 120 months of imprisonment and restitu-tion exceeding $600,000 and sentenced Mrs. Hovind toone year and one day of imprisonment.

The Hovinds raised several issues on appeal relatingto the sufficiency of their indictment, the evidenceagainst them, and the jury instructions in the case. TheEleventh Circuit rejected each of these in turn. Mr.Hovind argued that the indictment failed to state whatpart of Title 26 required him to collect and pay federalwithholding taxes and that it failed to define how heacted willfully. The court disagreed that those omissionswere material, stating that Mr. Hovind ‘‘was adequatelynotified of his offenses to prepare a defense and to pleaddouble jeopardy in any future prosecution for the sameoffense.’’ The trial judge also said the indictment clearlylaid out the Hovinds’ reporting crimes. Like the districtcourt, the Eleventh Circuit did not accept the Hovinds’interpretation that each transaction needed to equal orexceed $10,000. Finally, the appeals court rejected Mr.Hovind’s argument that he did not obstruct the admin-istration of the tax laws because he used legal means.‘‘Acts that might otherwise be legal become corrupt andobstructionist when they are used to ‘thwart the efforts ofgovernment officers and employees in executing the lawsenacted by Congress.’’’ The court believed that Mr.Hovind’s legal filings and other activities sufficientlywarranted an indictment for this offense.

The Eleventh Circuit also rejected the Hovinds’ con-tentions that the evidence was insufficient, both in estab-lishing willful intent and knowledge of the tax laws. Thecircuit court believed that the government adequately

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showed Mr. Hovind’s evasion of the withholding taxlaws and that the Hovinds structured the cash with-drawals to avoid federal reporting requirements.

The final argument by the Hovinds related to asentence added to the jury instructions by the court. Thedistrict court’s addition was designed to counter theHovinds’ argument relating to the $10,000 requirementfor the structuring statute. According to the appealscourt, ‘‘the district court was entitled to revise the juryinstructions in this manner.’’ The appeals court alsoupheld the Hovinds’ sentences, finding no errors byeither the jury or the district court. The entirety of theopinion, then, affirmed the district court’s determinationsand the jury verdict.

Private Debt Collectors as Government ActorsA firm working under the IRS’s private debt collection

program is not a government controlled corporation forpurposes of the Privacy Act, according to a SecondCircuit ruling last week that affirmed a district court’sdismissal of the case. A former employee of PioneerRecovery alleged that its handling of his security clear-ance package violated the Privacy Act. However, to statea cause of action under the Privacy Act, the employeemust show that the employer was a government con-trolled corporation. Both the district court and the SecondCircuit did not believe that the employee had made aplausible claim in that regard (Stewart Burch v. PioneerCredit Recovery Inc., No. 07-2963 (2d Cir. Dec. 22, 2008),Doc 2008-27293, 2008 TNT 251-8).

Stewart Burch was an employee of Pioneer Recovery.Pioneer Recovery was a third-party debt collectionagency that provided collection services for the IRS andseveral other government agencies. Employees of Pio-neer Recovery were required to complete security clear-ance packages. In October 2006, after his employment

with Pioneer Recovery had ended, Burch brought a suitclaiming that Pioneer Recovery was photocopying hissecurity clearance packages, keeping a permanent recordof them in his personnel file, and otherwise mishandlinghis private and personal information. The district courtdismissed his case and he appealed to the Second Circuit.

On appeal, Burch argued that Pioneer Recovery was agovernment controlled corporation subject to the PrivacyAct. He also argued he should have been accordedfurther discovery and an opportunity to amend hiscomplaint. Noting that the case was an issue of firstimpression for the Second Circuit, the court consideredeach of his arguments in turn.

The Second Circuit, like many of the other appellatecourts, has held that the private right of civil actioncreated by the Privacy Act is limited to actions againstagencies of the U.S. government. An agency of thegovernment can include government controlled corpora-tions, although there is no definition of that term in theFreedom of Information Act or the Privacy Act. However,the court found Burch’s connections between the federalgovernment and Pioneer Recovery to be ‘‘weak,’’ consist-ing only of the fact that Pioneer Recovery had contractswith the government, that Pioneer Recovery’s employeesmust complete security clearance packages, and thatPioneer Recovery made its records available to the gov-ernment. The court wrote that those factors did notamount to ‘‘a sufficient level of oversight, supervision,and government connection to lead us to believe thatPioneer should be considered an ‘agency.’’’ For thatreason, the Second Circuit upheld the district court’sdismissal on the basis that Burch had failed to state aclaim on which relief could be granted. Accordingly,seeing no reason to allow Burch additional discovery orleave to amend his complaint, the Second Circuit af-firmed the district court’s dismissal in full.

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NYSBA Tax Section ExaminesProposed Deemed Asset Sale Regs

By Joseph DiSciullo — [email protected]

Section 336(e) on deemed asset sales was enacted inlarge part to prevent the triple tax that would arise whenthe stock of a target corporation is sold, exchanged, ordistributed and both the target corporation’s assets andits shares have increased in value. The New York StateBar Association (NYSBA) Section of Taxation says newproposed regs are an excellent first step toward imple-menting the provision, but the 113-page report on theregs submitted by section members seems to indicatethere is considerable room for improvement.

The NYSBA tax section also examines a bill introducedin the House that would address foreign deferred sourceincome and foreign tax credits and reduce corporateincome tax rates. The tax section focuses on ‘‘whether theprovisions as drafted would successfully achieve theirintended purpose, whether they would be likely toproduce unintended consequences, and whether theywould be reasonably easy to administer.’’

Proposed guidance on protected cell companies haspresented the American Bar Association Section of Taxa-tion with an opportunity to make recommendations onthe entity classification of a type of limited liabilitycompany. The guidance asked for comments on whethera cell of a protected cell company should be treated as aninsurance company separate from any other entity, butalso invited submissions on similar arrangements that donot involve insurance.

Two charitable planning groups point out that recentlegislation to assist workers and retirees has an unin-tended adverse effect on donations made from IRAs. Theorganizations have submitted a proposal they say willstimulate the economy and provide ‘‘positive revenue forhousing assistance, feeding the hungry, jobs retraining,education, medical services, and thousands of services’’American citizens need today.

Deemed Asset SalesThe NYSBA tax section has submitted comments on

proposed regulations on deemed asset transfers undersection 336(e) (REG-143544-04, Doc 2008-18199, 2008 TNT165-5), suggesting some improvements to the regs andthat their scope be significantly expanded (Doc 2008-27340, 2009 TNT 1-21).

The proposed regs are intended to provide relief fromthe potential multiple taxation of the same economic gainthat can result when a transfer of appreciated stock istaxed to a corporation without providing a correspond-ing step-up in the basis of the assets of the corporation.The regs would let a domestic corporation elect to treatqualified dispositions of another corporation’s stock astaxable sales of that corporation’s assets.

The tax section recommends that the proposed modelfor deemed transactions involved in a section 355(d) or(e) transaction be eliminated. Section members also sug-gest that the loss disallowance rule either be removedentirely or revised to allow the recognition of built-inasset loss to the extent of built-in asset gain.

Members believe the section 336(e) election shouldgenerally be available in the case of a disposition of targetcorporation stock that is part of a section 351 transactionor in the case of a disposition of target corporation stockgoverned by section 354 or section 356. In the case of anintragroup disposition of stock followed by a sale of atarget corporation in which a section 336(e) election ismade, the tax section requests confirmation that reg.section 1.1502-13(f)(5) elective relief is available.

The tax section also requests that the related-party testof section 338 be modified by eliminating attributionfrom a partner to a partnership and from a partnership toa partner if the partner’s interest in the partnership is lessthan a specified level. Further, members say partnershipattribution should not apply if the partnership itself doesnot bear an economic relationship to the sale transaction.

Members also suggest that the section 336(e) electionshould be made by the seller and the target corporationjointly in a time and manner generally consistent with theprovisions of section 338, at least for cases in which theseller and the target corporation do not file a consoli-dated return. Finally, the tax section urges that theelection be made available for acquisitions of target Scorporations, foreign sellers, and foreign target corpora-tions.

Foreign-Source Income

The NYSBA tax section also sent to Congress lastmonth a report on H.R. 3970, the Tax Reduction andReform Act of 2007, concerning provisions relating toforeign deferred-source income, foreign tax credits, de-nial of treaty benefits, and corporate tax rate reductions(Doc 2008-27152, 2008 TNT 249-24).

The proposed legislation includes a wide variety ofprovisions affecting individuals and businesses, but thetax section’s comments are focused on three aspects ofthe bill. First, the law would add sections 975 and 976 tothe code, requiring deferral of deductions allocable todeferred foreign-source income and changing the rulesfor calculation of the foreign tax credit to prevent themaximization of credits by selectively recognizing orrepatriating high-taxed foreign income. Members say thebill should clarify that the new sections apply on anaffiliated groupwide basis, the definition of deferredforeign income should be clarified and expanded, foreignwithholding taxes imposed on dividends should be cred-itable in the year the dividends are received, and rulesshould be added to determine the effect on a U.S.

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affiliated group’s previously deferred foreign income,deductions, and foreign income taxes when a memberleaves the group.

Also, section members urge reconsideration of thebill’s treatment of interest and royalty payments receivedby a U.S. taxpayer as currently taxed foreign income.Further, members think the section 905(c) regs on theeffect of redeterminations of foreign tax liability shouldbe modified to reflect that the proposed law does notdifferentiate between foreign taxes paid directly by a U.S.taxpayer and foreign taxes paid by controlled foreigncorporations. The tax section also stresses the importanceof issuing additional guidance ‘‘in the form of legislativehistory or administrative pronouncements so that tax-payers fully understand the impact of the bill before itbecomes effective.’’

The second area of discussion is the addition of a newsection 894(d) that would limit treaty benefits for somerelated-party deductible payments received by membersof a foreign-owned controlled group. Section membersnote that the provision is intended to prevent treatyshopping and thus promotes valid policy objectives, butmay be underinclusive by not applying when ‘‘the for-eign common parent corporation is organized in a treatycountry that has a broad participation exemption underits domestic law, even though those situations can pro-duce similar results to structures where the parent isorganized in a tax haven jurisdiction with no treaty.’’Members also question the effectiveness of the proposedprovision because it would apply only if the U.S. payerand the foreign recipient are controlled by a foreigncommon parent corporation.

The third topic examined by the tax section is theeffect of a reduction in corporate income tax rates.Members warn that if the corporate rate falls below thehighest individual tax rate, corporations could onceagain become vehicles for wealthy individuals to sheltertheir income, particularly if the rate differential becomes

sufficiently large. In that case two seldom-used mecha-nisms to prevent tax avoidance — the accumulatedearnings tax and the personal holding company tax —could gain renewed relevance.

Protected Cell Companies

The ABA tax section, responding to proposed guid-ance for determining whether an arrangement between aparticipant and cell of a protected cell company isinsurance for income tax purposes (Notice 2008-19,2008-5 IRB 366, Doc 2008-844, 2008 TNT 11-6), has sub-mitted recommendations for the treatment of some LLCs(Doc 2009-115, 2009 TNT 2-56). In particular, the taxsection is responding to the Service’s request for com-ments on segregated arrangements that are similar toprotected cell companies but that do not involve insur-ance.

Delaware law permits the creation of a single LLCwith separate series, or units, of members, managers,LLC interests, or assets. Thus, a so-called series LLC thatbuys individual pieces of real estate may hold each in aseparate series so that if a lender forecloses on oneproperty, the others are not affected. The tax sectionpoints out that there is no meaningful authority address-ing whether a series of an LLC constitutes an entity forfederal tax purposes that is separate and apart from theLLC and any other series of the limited LLC. Accordingly,members request that Treasury and the IRS issue guid-ance, similar to that provided by Notice 2008-19, on theentity classification of series LLCs.

Section members recommend an approach underwhich each series of an LLC is recognized as a separatebusiness entity for purposes of reg. section 301.7701-2(a),assuming that specified minimum requirements are met.To be treated as a separate business entity, a series mustbe formed under an authorizing statute like the Delawarelaw and satisfy any applicable record-keeping and notice

REG COMMENT CALENDARThe table below lists the dates by which written comments on proposed regulations must be received by the

Service. Comments should be sent to: Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC20044, Attn: CC:DOM:CORP:T:R (IRS file number, as indicated in the table).

The last column contains citations to summaries of the proposed regs in Tax Notes, as well as document (Doc)numbers, and Tax Notes Today (TNT) citations to the full text of the proposals.

Comments CodeDue by Section File Number Prior Coverage

Jan. 30 108 REG-164370-05 Tax Notes, Nov. 3, 2008, p. 544; Doc 2008-23074, 2008 TNT 212-10Jan. 30 897 REG-130342-08 Tax Notes, Nov. 3, 2008, p. 544; Doc 2008-23073, 2008 TNT 212-9Feb. 9 6050P REG-118327-08 Tax Notes, Nov. 17, 2008, p. 813; Doc 2008-23680, 2008 TNT 218-9Mar. 5 3402 REG-158747-06 Tax Notes, Dec. 8, 2008, p. 1124; Doc 2008-25497, 2008 TNT 235-4Mar. 23 881 REG-113462-08 Tax Notes, Jan. 5, p. 59, Doc 2008-26696, 2008 TNT 246-4Mar. 23 6706 REG-160872-04 Tax Notes, Jan. 5, p. 58, Doc 2008-26695, 2008 TNT 246-5Mar. 30 954 REG-150066-08 Tax Notes, Jan. 5, p. 57, Doc 2008-27116, 2008 TNT 249-9Mar. 30 6011, 6302 REG-148568-04 Tax Notes, Jan. 5, p. 60, Doc 2008-27112, 2008 TNT 249-10Apr. 2 409A REG-148326-05 Tax Notes, Dec. 15, 2008, p. 1265; Doc 2008-25614, 2008 TNT 236-9(Unless otherwise noted, all dates are 2009.)

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requirements so that the liabilities of a particular seriesare only enforceable against the assets of that series.

The tax section further recommends that the charac-terization of the LLC itself for federal tax purposesshould depend on whether the LLC satisfies the mini-mum requirements to be a business entity separate fromits series. Members maintain the LLC has no separateexistence and should be treated as transparent or as anominee unless it has assets and liabilities that are notassociated with one or more of its series. Members saythat if it does have separate assets and satisfies applicablerecord-keeping and notice requirements so that the li-abilities of the LLC may only be enforced against its ownassets, the LLC should be characterized as a separatebusiness entity.

The tax section asserts that the treatment of the LLCand each of its series as separate business entities wouldmean their classification for federal tax purposes isdetermined independently. Therefore, if an LLC or anyone of its series has at least two members, that series orthe LLC would be classified as a partnership unless itelects to be classified as an association taxable as acorporation under the regs. Alternatively, if a series or theLLC has a single member, the series or the LLC would bedisregarded as an entity separate from its single memberunless it elects to be classified as an association taxable asa corporation.

Acknowledging that its recommendations may con-flict with the way some taxpayers are treating their seriesLLCs, the tax section proposes that the requested guid-ance generally be applied prospectively. Existing seriesLLCs would be allowed to rely on the guidance if theyare formed under an authorizing state statute such as theone in Delaware, satisfy applicable record-keeping andnotice requirements, and have been consistent in theirtreatment of the arrangement in accordance with theguidance.

Charitable ContributionsThe American Council on Gift Annuities (ACGA) and

the National Committee on Planned Giving (NCPG) in aDecember letter to House and Senate members requestedthat legislation be enacted to expand and make perma-

nent laws that enable individuals to make tax-free chari-table contributions from IRAs (Doc 2008-27305, 2008 TNT251-13).

For 2006 through 2009, individuals who are 70½ orolder can make direct gifts from an IRA, including theirrequired minimum distributions, of up to $100,000 peryear to public charities (other than donor-advised fundsand supporting organizations) and to private operatingfoundations and passthrough foundations without hav-ing to report the IRA distributions as taxable income ontheir federal returns.

ACGA and NCPG contend that the Worker, Retireeand Employer Recovery Act of 2008, which waives therequired minimum distribution rules for 2009, ‘‘has theunintended consequence of adversely affecting thepeople served by our nation’s charities.’’ While support-ing the new law as beneficial during the current eco-nomic crisis, the organizations ask that some charitablecontribution and IRA rollover rules be modified to pre-vent the unintended elimination or reduction of tax-encouraged charitable gifts from IRAs.

First, ACGA and NCPG advocate removing the$100,000 ceiling on direct IRA contributions to charity, orin the alternative, increasing the maximum.

Second, the groups recommend allowing IRAs to berolled over tax free into life-income charitable gifts (suchas charitable remainder annuity trusts, charitable giftannuities with immediate payments, and standard-payout charitable remainder unitrusts), that would pro-vide retirement income for donors. The organizationsclaim that proposal would not cost the Treasury anythingand might even have a positive revenue effect.

ACGA and NCPG say that permitting individuals age59½ or older to make tax-free IRA rollovers to life-incomecharitable gifts would benefit the same qualified doneesas direct rollovers do, while allowing donors to retainretirement income. Further, the groups believe theirproposal will ‘‘generate additional tax revenue for theTreasury, but because income payouts from the life-income plans are higher than the required minimumdistributions it will also stimulate the economy.’’

***Julie Brienza, Eben Halberstam, Andy Sheets, and Emily

Vanderweide contributed to this column.

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Strategies for Defending AgainstDiscovery Requests for Tax Returns

By Nancy T. Bowen

A. Background

As tax practitioners, we are often called on to handletax disputes that are based almost entirely on complexprovisions of the Internal Revenue Code or Treasuryregulations. But we are also often called on to handletax-related issues that arise out of nontax disputes. Onetax-related issue that frequently occurs in nontax dis-putes is a discovery request to produce federal incometax returns. Consider the following scenario:

Your litigation partner calls you late one afternoon. ‘‘Ihave a deadline in a few days for responding to discov-ery requests in a case I am handling in federal court. Theplaintiff has demanded we produce my client’s incometax returns for several years. My client is yelling bloodymurder because he doesn’t want to produce his returns.I looked in Weinstein’s1 and didn’t see any discussion ofany privilege to withhold tax returns, and another trea-tise2 flatly states there is no such privilege. Can you helpme?’’

You can help your partner, but the answer to hisquestion will not be found where a tax lawyer might firstlook for it. Sections 6103 and 7213 prohibit the disclosureof tax returns and return information by governmentemployees, but neither statute applies in litigation be-tween private parties.3 Instead, federal courts have de-veloped a common-law privilege to limit the discovery oftax returns in nontax civil litigation between private

parties.4 Because the privilege is judge-made, it is notuniform and varies from jurisdiction to jurisdiction (andsometimes even within a given jurisdiction). As dis-cussed in more detail below, the keys to defendingagainst the discovery of tax returns are to determineprecisely which versions of the privilege may apply inyour jurisdiction, as well as the policy reasons given forrecognizing the privilege, and then to tailor your argu-ments against the discovery of tax returns accordingly.

This article will first outline the scope of the privilegeagainst the discovery of tax returns as that privilege hasbeen adopted in various jurisdictions, as well as thediffering policy reasons that have been given for adopt-ing the privilege. This article will then suggest specificstrategies and arguments to consider in defendingagainst the discovery of tax returns.

B. The Scope of the PrivilegeThere are three primary permutations of the privilege.

The earliest (and most straightforward) version of theprivilege appears to be grounded in the theory of waiver.That version of the privilege generally prohibits thediscovery of tax returns unless the party resisting discov-ery has effectively waived the privilege by raising anissue to which his tax returns would be relevant. Forexample, under the broadest version of this privilege, taxreturns are not discoverable unless the ‘‘litigant himselftenders an issue as to the amount of his income.’’5 Othercourts have adopted this rule (the Kingsley rule) and havelimited the discovery of tax returns to fact patterns inwhich the party resisting discovery has himself made anissue of his income.6

1Jack B. Weinstein and Margaret A. Berger, 3 Weinstein’sFederal Evidence, section 501.01 through 501.05 (2d ed. 2008)(Joseph M. McLaughlin ed.).

2Charles Alan Wright and Kenneth W. Graham Jr., FederalPractice and Procedure, section 5431 (2008 Supp.). (‘‘Some statesrecognize a privilege for tax returns but there is no suchprivilege under federal law.’’) Another leading treatise onfederal practice seems to suggest that only one magistrate judgehas recognized a privilege to withhold tax returns. See JamesWilliam Moore et al., Moore’s Federal Practice, section 26.52[6][a](3d ed. 2008).

3See Richards v. Stephens, 118 F.R.D. 338, 339 (S.D.N.Y. 1988)(nothing in sections 6103 and 7213 or their legislative history‘‘remotely suggests’’ those sections were designed to apply inprivate litigation).

4The primary focus of this article is on the federal common-law privilege against the discovery of tax returns. If state lawclaims are in issue in federal court, then state (rather thanfederal) privilege law will control. See Fed. R. Evid. 501. (‘‘Incivil actions and proceedings, with respect to an element of aclaim or defense as to which state law supplies the rule ofdecision, the privilege of a witness . . . shall be determined inaccordance with state law.’’) For an example of a case in whicha federal court applied state privilege law regarding the discov-ery of tax returns, see Credit Life Ins. Co. v. Uniworld Ins. Co., 94F.R.D. 113, 118-121 (S.D. Ohio 1982). The distinction betweenfederal and state privilege law may not make a difference inmany cases, as evidenced by the fact that any number ofdiversity cases have resolved discovery disputes involving taxreturns without even mentioning state privilege law. See, e.g.,Mitsui & Co. v. Puerto Rico Water Res. Auth., 79 F.R.D. 72, 80-82(D.P.R. 1978).

5See Kingsley v. Delaware, Lackawanna & W. R.R., 20 F.R.D. 156,158 (S.D.N.Y. 1957).

6See Fed. Sav. & Loan Ins. Corp. v. Krueger, 55 F.R.D. 512, 514(N.D. Ill. 1972) (‘‘Unless a litigant himself makes an issue of hisincome, his income tax returns are not subject to discovery.’’);Wiesenberger v. W.E. Hutton & Co., 35 F.R.D. 556, 557 (S.D.N.Y.

Nancy T. Bowen is a partner with Fulbright &Jaworski LLP, and practices in the area of tax contro-versy.

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Other courts have abandoned the waiver theoryunderlying the Kingsley rule and have allowed discoveryof tax returns even when the party resisting discoverydid not place his income in issue. For example, somecourts routinely allow discovery of a defendant’s taxreturns when punitive damages are in issue, reasoningthat the tax returns are relevant to the calculation ofpunitive damages even though the defendant did notplace his own income in issue. In Payne v. Howard, 75F.R.D. 465, 470 and n.5 (D.D.C. 1977), the court recog-nized the general rule that tax returns are not discover-able unless the party resisting discovery (the defendant)makes an issue of his income, but noted that ‘‘defendant’sincome may be in issue where punitive damages aresought.’’7

Still other cases have recognized that tax returns maybe relevant to issues other than a party’s income, andhave further expanded the scope of permissible discov-ery. For example, in Shaver v. Yacht Outward Bound, 71F.R.D. 561 (N.D. Ill. 1976), the plaintiff sued to recover forher husband’s death while serving as a seaman on ayacht. The plaintiff hoped to make the yacht owner’semployer liable under the theory of respondeat superior,and sought discovery of the owner’s tax returns todetermine the extent to which the owner had deductedhis operating expenses for the yacht as business ex-penses. The court ordered the owner to produce his taxreturns because they were relevant to the owner’s denialthat he was using the yacht for business purposes, ‘‘eventhough his income is not directly in issue.’’ 71 F.R.D. at564.

Each of the permutations of the Kingsley rule outlinedabove focuses solely on whether tax returns may berelevant to an issue in the case. If the returns aresufficiently relevant, the inquiry is over and the returnsare discoverable. Other courts, however, have adopted atest that balances the general interest in broad discoveryunder the Federal Rules of Civil Procedure against thepolicy interest in minimizing the disclosure of tax re-turns. This two-pronged test looks to the relevance (andoften to the degree of relevance) of the tax returns only asthe first step of the inquiry. If the returns are sufficientlyrelevant to an issue in the case, this two-pronged test thenexamines whether there is a compelling need for discov-ery of the returns because the relevant informationcontained in the returns is not readily available else-

where. This test was first expressed in Cooper v. Hallgarten& Co., 34 F.R.D. 482, 484 (S.D.N.Y. 1964)8 as follows: ‘‘Theproduction of tax returns should not be ordered unless itclearly appears they are relevant to the subject matter ofthe action or to the issues raised thereunder, and further,that there is a compelling need therefor because theinformation contained therein is not otherwise readilyobtainable.’’ Many later cases have adopted the Cooperrule, although often with some slight variation.9

Finally, some courts have applied yet a third version ofthe privilege against discovery of tax returns. Thosecourts have concluded that discovery of tax returnsshould not be ‘‘routinely required,’’ but that returnsshould be discoverable in ‘‘appropriate circumstances’’or when ‘‘clearly required in the interests of justice.’’10 Oncareful analysis, however, most of those cases involvesome variant or combination of the Kingsley or Cooperrules outlined above.11 Several cases have considered theCooper and Kingsley rules to be alternatives, and havesuggested that even if the two-pronged and Cooper rule isnot satisfied, discovery will nevertheless be permitted ifa party has placed his own income in issue.12

C. The Policies Behind the PrivilegeCourts also differ widely in their explanations of the

reasons for adopting a privilege against the discovery oftax returns. Some courts have pointed to the broadprivacy concerns that are underscored by sections 6103and 7213. See Kingsley, 20 F.R.D. at 158; and Cooper, 34F.R.D. at 483. Other courts have cited the government’sinterest in encouraging taxpayers to disclose all of theirincome, reasoning that taxpayers might be less willing toreport all of their income if they face the prospect of their

1964) (no tax returns need be produced when the ‘‘plaintiff hasnot tendered any issue here as to his income’’).

7Since the U.S. Supreme Court decided State Farm MutualAutomobile Insurance Co. v. Campbell, 538 U.S. 408 (2003), casesand commentators have questioned whether information con-cerning a defendant’s wealth or financial condition remainsrelevant when punitive damages are sought. See, e.g., LauraClark Fey, Scott D. Kaiser, and William F. Northrip, ‘‘TheSupreme Court Raised Its Voice: Are the Lower Courts Gettingthe Message? Punitive Damages Trends After State Farm v.Campbell,’’ 56 Baylor L. Rev. 807, 848-856 (2004); and Kathleen S.Kizer, ‘‘California’s Punitive Damages Law: Continuing to Pun-ish and Deter Despite State Farm v. Campbell,’’ 57 Hastings L.J.827, 831, and n.23 (2005-2006). That debate is beyond the scopeof this article.

8Note that the Cooper balancing test was adopted in theSouthern District of New York, the same district that adoptedthe Kingsley relevance test. This illustrates the fact that it is oftendifficult to determine which version of the privilege may applyin any given jurisdiction, at least until the appellate courtresolves the issue. See, e.g., United States v. 6469 Polo Pointe Way,444 F. Supp.2d 1258, 1262-1265 (S.D. Fla. 2006) (recognizing thatsome courts within the Southern District of Florida require ashowing of relevance and compelling need for discovery of taxreturns, while others require only relevance).

9See, e.g., Gattegno v. PricewaterhouseCoopers LLP, 205 F.R.D. 70(D. Conn. 2001) (gathering cases and discussing the develop-ment of the Cooper rule).

10See, e.g., Mitsui & Co. v. Puerto Rico Water Res. Auth., 79F.R.D. 72, 80 (D.P.R. 1978) (production of returns not ‘‘routinelyrequired’’); Payne v. Howard, 75 F.R.D. at 469-470 (providing fordiscovery of returns in ‘‘appropriate circumstances’’); Tele-RadioSys. Ltd. v. DeForest Elec. Inc., 92 F.R.D. 371, 375 (D.N.J. 1981)(returns not discoverable unless ‘‘clearly required in the inter-ests of justice’’).

11See, e.g., Mitsui, supra note 10, 79 F.R.D. at 80-81 (consider-ing factors relevant to both the Kingsley rule and the Cooperrule); and Tele-Radio, supra note 10, 92 F.R.D. at 375 (consideringboth the Kingsley factor of whether the party resisting discoveryhad made its income an issue and the Cooper factor of whetherthe information sought was otherwise available).

12See, e.g., United States v. Bonanno Organized Crime Family,119 F.R.D. 625, 627 n.2 (E.D.N.Y. 1988); supra note 10, Securitiesand Exchange Comm’n v. Cymaticolor Corp., 106 F.R.D. 545, 548,and n.2 (S.D.N.Y. 1985).

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tax returns being discoverable in later civil litigation. SeeFed. Sav. & Loan Ins. Corp. v. Krueger, 55 F.R.D. at 514. Stillothers cite the governmental interest in encouragingtaxpayers to file complete and accurate returns in allrespects, including the full disclosure of both income andof available losses or deductions. See Smith v. Bader, 83F.R.D. 437, 438 (S.D.N.Y. 1979) (citing the governmentalinterest in having taxpayers file ‘‘complete and accuratereturns’’); and Payne v. Howard, 75 F.R.D. at 469 (limitingdiscovery of tax returns to encourage full reporting ofincome, as well as full usage of tax saving measures towhich taxpayers are lawfully entitled). Other courtsreason that discovery of returns should be limited be-cause litigants should not be forced to disclose their taxreturns as the price of bringing or defending litigation.See Tele-Radio, 92 F.R.D. at 375 (D.N.J. 1981).

D. Strategies for Defending Against DiscoveryOnce you determine the scope of the privilege against

the discovery of tax returns in your jurisdiction, as wellas the policy reasons given for the privilege, you cantailor your arguments accordingly. Several potential ar-guments are outlined below.

1. Strategies based on relevance.a. Argue that the information contained in the return

is not relevant. The first step in making an effectiverelevance objection is to consider the version of theprivilege adopted in your jurisdiction. If the earliestversion of the Kingsley rule is adopted, tax returns arerelevant (and discoverable) only if the party resistingdiscovery has made an issue of his income. That means,for example, that the plaintiff’s tax return may be rel-evant if the plaintiff seeks lost wages or income. SeeTaylor v. Atchison, Topeka & Santa Fe Ry., 33 F.R.D. 283, 286(W.D. Mo. 1962). On the other hand, the defendant’s taxreturns would not be relevant even if punitive damagesare sought. Many jurisdictions, however, have aban-doned this very narrow reading of the Kingsley rule andhave concluded that tax returns are subject to discovery ifpunitive damages are in issue, or if the returns otherwisemay shed light on an issue in the case. See Payne v.Howard, 75 F.R.D. at 470 and n.5 (punitive damages); andShaver v. Yacht Outward Bound, 71 F.R.D. at 564 (returnsdiscoverable when they ‘‘may cast significant light’’ onan issue, even though income is not directly in issue).

You should also carefully examine the claim of rel-evance that is made by the party seeking discovery of areturn. In some cases, the potential relevance of a returnis apparent — for example, if a party seeks damages forlost wages or lost profits, tax returns that contain infor-mation about the amounts of past and present wages orprofits would be relevant. In other cases, the informationin a party’s tax return simply is not relevant to thematters sought to be proven. Examples are cases in whichonly compensatory damages (not punitive damages) arein issue, or cases in which the tax returns of corporateofficers are sought, but the only defendant is the corpo-ration.

There are other cases in which tax returns at firstglance might appear relevant to an issue in a case, but inreality may not be. One example is a case in whichpunitive damages are sought from an individual, such

that the individual’s net worth is in issue. See VanWestrienen v. Americontinental Collection Corp., 189 F.R.D.440, 441 (D. Ore. 1999) (when punitive damages are inissue, an individual defendant’s financial ability to pay‘‘is best measured in terms of his assets and liabilities asshown by a financial statement’’).13 Unfortunately, courtshave not always carefully considered precisely what taxreturns will and will not reveal and have merely assumedthat tax returns are relevant (for example) to prove aconspiracy, or to establish personal jurisdiction over aparty, or to help prove alter ego allegations.14

b. Argue for a higher standard of, or a more detailedshowing of, relevance. Some courts require that a higherstandard of relevance be met before they allow discoveryof tax returns. See Gattegno v. PricewaterhouseCoopers LLP,205 F.R.D. at 73 (tax returns are discoverable when it‘‘clearly appears’’ they are relevant); and In re Dayco Corp.Derivative Securities Litigation, 99 F.R.D. 616, 625 (S.D.Ohio 1983) (discovery of tax returns is appropriate if theyare ‘‘significantly relevant’’ to an issue).

Other cases require a more detailed showing of rel-evance. For example, some cases have concluded thatbroad allegations of outrageous behavior in support of aclaim for punitive damages are not sufficient to justifydiscovery of tax returns. Instead, these cases concludethat a complaint must allege facts that show a ‘‘realpossibility’’ that punitive damages will be at issue.15

c. Argue that even if a return may eventually berelevant, it is not relevant now, so discovery should bedeferred. There are several fact patterns in which courtshave been willing to defer the production of even admit-tedly relevant tax returns. An obvious case is that ofbifurcation. Some courts are willing to bifurcate the trial

13As tax lawyers are aware, a Form 1040 individual incometax return reveals an individual’s income for a single year, butcontains no balance sheet or financial statement such as thatdiscussed in Van Westrienen. Unfortunately, the court did notmention that fact, but instead went on to suggest that at best,‘‘plaintiffs are only entitled to a redacted personal income taxreturn produced pursuant to a protective order.’’ 189 F.R.D. at441.

14See Pettrey v. Enterprise Title Agency, Inc., 470 F. Supp.2d 790,794 (N.D. Ohio 2006) (assuming, without discussion, that taxreturns are likely to reveal whether a conspiracy exists); Cotra-com Commodity Trading Co. v. Seaboard Corp., 189 F.R.D. 655,664-665 (D. Kan. 1999) (assuming, without discussion, that thedefendant’s returns would be relevant to compare the relativelevel of sophistication of the parties); and Credit Life Ins. Co. v.Uniworld Ins. Co., 94 F.R.D. 113, 120-121 (S.D. Ohio 1982)(holding, without explanation, that returns are relevant todetermining personal jurisdiction over defendants, as well aspossibly supporting plaintiff’s alter ego theory).

15See Chenoweth v. Schaaf, 98 F.R.D. 587, 589 (W.D. Pa. 1983).This is the minority rule, however. See Mid Continent CabinetryInc. v. George Koch Sons Inc., 130 F.R.D. 149, 151-152 (D. Kan.1990) (a majority of federal courts permit discovery of financialinformation without requiring the plaintiff to establish a primafacie case for punitive damages; citing cases); and Aerotech Res.Inc. v. Dodson Aviation Inc., Civil Action No. 00-2099-CM, 2001U.S. Dist. LEXIS 6021 (D. Kan. Apr. 11, 2001) (to obtain discoveryof tax returns, a party must show only that a claim for punitivedamages is ‘‘not spurious’’).

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of the entitlement to punitive damages from the trial ofthe amount of punitive damages, and have deferreddiscovery of financial information (including tax returns)until such time as the plaintiff has established its entitle-ment to punitive damages. See American Maplan Corp. v.Heilmayr, 203 F.R.D. 499, 503 (D. Kan. 2001); and Davis v.Ross, 107 F.R.D. 326, 327-328 (S.D.N.Y. 1985).16 Manycourts will not bifurcate, however, and refuse to defer ordelay discovery of financial information for that reason.See Challenge Aspen v. King World Prods. Corp., No. 00 C6868, 2001 U.S. Dist. LEXIS 18357 (N.D. Ill. Nov. 8, 2001).Other courts refuse to defer or delay discovery of finan-cial information even if the issues of liability and dam-ages have been bifurcated. Zerostat Components Ltd. v.Shure Bros. Inc., 1982 U.S. Dist. LEXIS 17620 (N.D. Ill.1982).

Other courts have suggested other reasons to defer theproduction of tax returns. For example, some courts haveexpressed a willingness to defer production of tax returnsand financial information until a prima facie case isestablished (and relevance becomes more clear) if theparty seeking discovery is a competitor. See Mid Conti-nent Cabinetry, 130 F.R.D. at 152 (dicta).2. Strategies based on policy grounds. Courts havearticulated several different policies as the basis foradopting a privilege against the discovery of tax re-turns.17 When objecting to the discovery of tax returns,consider whether the policy reasons that have beenarticulated in your jurisdiction will support your objec-tion. For example, some courts ground the privilege intheir conclusion that litigants should not be forced todisclose their tax returns as the price for bringing ordefending a lawsuit. See Tele-Radio, 92 F.R.D. at 375. Thatpolicy ground would support an objection to discoveryof tax returns from a party to the litigation, but would notfit particularly well if the person resisting discovery is anonparty witness.

Other courts have grounded the privilege againstdiscovery of tax returns in the government’s interest inmaximizing tax revenues by encouraging taxpayers toreport all their income. See Fed. Sav. & Loan Ins. Corp. v.Krueger, 55 F.R.D. at 514. Some courts have narrowly

interpreted this policy interest, concluding that it wouldnot prevent discovery of tax returns when the discoveryis designed to obtain information about tax losses be-cause it is in a taxpayer’s best interest to disclose thosematters in all events. See Smith v. Bader, 83 F.R.D. at 439(citing Houlihan v. Anderson-Stokes Inc., 78 F.R.D. 232, 234(D.D.C. 1978)). In contrast, other courts have morebroadly interpreted this policy basis for the privilege,concluding that it protects against discovery designed toobtain information about tax saving measures as well astaxable income. See Payne v. Howard, 75 F.R.D. at 469.3. Strategies based on the absence of compelling need.

a. Argue that there is no compelling need for pro-duction of the return because the information sought isavailable elsewhere. The information contained in taxreturns almost always is taken from some other docu-ment or source. That means the information sought to beobtained from the return generally will be availableelsewhere. For example, if lost wages or loss of earningsis in issue, Forms W-2 or even stubs from paychecks canprovide the necessary information.18

Likewise, there are often other sources for financialinformation.19 For example, nearly all of the financialinformation contained in a business’s tax return is takenfrom the business’s financial statements or its books andrecords and is readily available from those othersources.20

Even if the information is not directly available from abusiness’s financial books and records, there are fre-quently other sources for the information. For example, aplaintiff was not allowed discovery of the defendantdentist’s tax returns to show that the dentist had taken ona heavy workload, when the plaintiff could instead

16State law may well influence a federal court’s ultimatedecision concerning the discovery of tax returns when the courtis sitting in diversity. Some federal courts have concluded thaton this fact pattern, they are bound to follow the law of theforum state regarding bifurcation and may defer or delay thediscovery of tax returns when punitive damages are sought. See,e.g., Davis v. Ross, 107 F.R.D. at 327-328. Other federal courtshave ignored state law in this fact pattern, insisting that mattersof procedure in federal court, such as discovery, are governed byfederal law. See Mid-Continent Cabinetry, 130 F.R.D. at 151 andn.1 (criticizing Davis v. Ross, supra). Still other courts at leastconsider state law, but take a middle ground of bifurcating theissues of liability and damages, while allowing discovery of thedefendant’s financial condition to go forward. See Hazeldine v.Beverage Media Ltd., et al., No. 94 Civ. 3466 (CSH), 1997 U.S. Dist.LEXIS 8971 (June 26, 1997).

17For a critique of the policy reasons given for protecting taxreturns against discovery, see William A. Edmundson Note,‘‘Discovery of Federal Income Tax Returns and the New ‘Quali-fied’ Privileges,’’ 1984 Duke L.J. 938.

18See Gattegno, 205 F.R.D. at 73-74 (in an employment dis-crimination case, Forms W-2 provide the necessary informationconcerning lost wages, subject to the court’s in camera review ofplaintiff’s tax returns to confirm that information); and Mal-donado v. St. Croix Discount Inc., 77 F.R.D. 501, 503 (D.V.I. 1978)(defendant in personal injury action not entitled to discovery ofplaintiff’s tax returns when defendant had already been pro-vided with Forms W-2, and the plaintiff would be estoppedfrom claiming any greater income than reflected in the FormsW-2).

19See, e.g., Wiesenberger v. W.E. Hutton & Co., 35 F.R.D. 556, 558(S.D.N.Y. 1964) (plaintiff’s payments for and receipts from oilparticipations may be determined from vouchers, bank state-ments, and canceled checks); and Cooper, 34 F.R.D. at 484(although the plaintiff’s tax rate may be relevant to his motiva-tion in engaging in some transactions and his tax returns wouldnot be discoverable, but he could be questioned at his deposi-tion about his highest tax bracket during relevant years).

20See, e.g., Eastern Auto Distrib. Inc. v. Peugot Motors of AmericaInc., 96 F.R.D. 147, 148-149 and n.1 (E.D. Va. 1982) (informationsought to be obtained from defendant’s tax returns (relation-ships of subsidiaries and personnel, as well as defendant’sfinancial condition) could be obtained from annual, semiannual,and quarterly reports filed with a French regulatory and over-sight agency, as well as other sources); and Feld & Sons Inc. v.Pierre Cardin, Civil Action No. 77-2488, 1979 U.S. Dist. LEXIS12342 (E.D. Pa. May 18, 1979) (plaintiff’s tax returns not discov-erable in antitrust action to recover lost income and profitswhen plaintiff had provided information from other sourcesdetailing its net sales, gross profit, and net income).

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obtain information about the dentist’s workload from hisappointment book. Payne v. Howard, 75 F.R.D. at 470.Likewise, the court refused to order the production of theplaintiff’s tax returns when the defendant had alreadyobtained information through discovery about the plain-tiff’s financial motives to rescind a contract. See Troglionev. McIntyre Aviation Inc., 60 F.R.D. 511 (W.D. Pa. 1973).

There are situations, however, in which the informa-tion sought from a tax return is not otherwise available.One example is that of self-reporting of tips or gratuitiesin addition to wages reported by an employer on FormW-2. See Cooper, 20 F.R.D. at 158. Another example is indetermining whether an individual’s expenditure hadbeen deducted as a business expense for tax purposes,which would indicate that the individual was actingwithin the scope of his employment.21

Courts are also more likely to allow discovery of taxreturns if there is some indication that the books andrecords of a business may not be complete or if there areindications of fraud.22

b. Even if the information sought from a tax return isnot otherwise readily available from a specific docu-ment or source, offer to provide the necessary informa-tion in another form. Courts have been particularlywilling to forgo ordering the production of tax returns ifthe party resisting discovery offers to provide the infor-mation sought in a different form. Some examples areCommodity Futures Trading Comm’n v. Collins, 997 F.2d1230, 1233-1234 (7th Cir. 1993) (refusing to compel thediscovery of tax returns when the plaintiff could simplyask the defendant if he traded off the exchange); Chenow-ith v. Schaaf, 98 F.R.D. at 590 (discovery of tax returns isnot necessary when punitive damages are at issue; gen-eral statement of net worth would be sufficient); andRubenstein v. Kleven, 21 F.R.D. 183, 185 (D. Mass. 1957)(plaintiff sued to enforce an alleged agreement to pay her$1,000 per month for life; if plaintiff will admit thatnothing in her tax returns reflected any of the paymentsshe claimed to have received in the past, then productionof her tax returns will not be ordered). There are obvi-ously limits, however, to the alternative forms of disclo-sure that courts are willing to accept. For example, inShaver v. Yacht Outward Bound, 71 F.R.D. at 564, the court

refused to allow a party resisting discovery to examinehis own returns and then to swear by affidavit aboutwhat those returns contain.

4. Strategies to limit the scope of discovery or thefurther dissemination of tax return information.

a. Attempt to limit the amount of information fromthe return that is produced. Even if a tax return containsrelevant information and even if that relevant informa-tion is not available elsewhere, a return also contains agreat deal of extraneous information that should not bedisclosed. Courts have been receptive to the argumentthat parties should be required to produce only therelevant portions of a return, rather than the entirereturn.23

In addition to limiting discovery only to relevantportions of tax returns, you should also argue thatdiscovery should be limited only to returns for relevanttax years. For example, in Biedler v. Hurst, Civil ActionNo. 20185, 1957 U.S. Dist. LEXIS 4671 (E.D. Pa. May 27,1957), the plaintiff alleged that the defendant had in-duced him to enter into a partnership through falserepresentations. The court allowed discovery of the de-fendant’s tax return for the year in which the partnershipwas formed, reasoning that the return might throw lighton the financial condition of the business at that time. Thecourt also ruled, however, that the defendant’s returnsfor later years were not relevant. Id.24

The opposing party, of course, may be reluctant foryou or your client to make the final determination ofwhether undisclosed portions of the returns are in factrelevant. In that case, a possible compromise is to pro-duce any admittedly relevant portions of the returns, andthen to allow opposing counsel or the court to review theunredacted returns to confirm they contain no additionalrelevant information. For example, in Hilt v. SFC Inc., 170F.R.D. 182 (D. Kan. 1997), the plaintiff produced a re-dacted copy of her tax return and Forms 1099-G and W-2,while defense counsel was allowed to review the unre-dacted returns (subject to a confidentiality order) toconfirm the information reflected in the disclosed forms.For another example, some courts have inspected thedisputed returns in camera to confirm whether they

21See, e.g., Shaver v. Yacht Outward Bound, 71 F.R.D. at 564(recognizing that defendant’s tax returns may be the onlyavailable source of this information).

22See Securities and Exchange Comm’n v. Cymaticolor Corp., 106F.R.D. at 548 (trading records may not reflect all trades in aparticular stock because trades could have been made throughaccounts in foreign countries or in the names of third parties);and Cooper, supra note 8, 34 F.R.D. at 485 (if on examination, itappears that the plaintiff’s financial records are inaccurate thenthe defendants may reapply for the production of tax returns).Other courts, however, will order the production of tax returns,even if the party seeking discovery wants those tax returns onlyto confirm information it already has. See Court DeGraw TheatreInc. v. Loew’s Inc., 20 F.R.D. 85, 86 (E.D.N.Y. 1957) (discovery ofplaintiff’s tax returns ordered so that defendant can determinethe accuracy of the figures it had previously obtained from theplaintiff’s books and records).

23See, e.g., Hilt v. SFC Inc., 170 F.R.D. 182 (D. Kan. 1997) (inwhich plaintiff’s earnings were in issue, and defendant wasentitled to discovery of relevant portions of return); Stark v.Photo Researchers Inc., 77 F.R.D. 18 (S.D.N.Y. 1977) (in action fordamages incurred by defendant photo broker’s failure to returnslides, defendant was entitled to discovery of those portions ofplaintiff’s income tax return relating to income derived fromphotographic endeavors); and Taylor v. Atchison, Topeka & SantaFe Ry., 33 F.R.D. 283 (W.D. Mo. 1962) (in action for loss of wagesand earnings, court ordered the production of portions ofplaintiff’s return relating to wages and earnings).

24See also Taylor v. Atchison Topeka & Santa Fe Ry., 33 F.R.D. at286 (in action for loss of wages and earnings, discovery ofpertinent portions of income tax returns allowed for ‘‘a reason-able period before and after the alleged injury’’).

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contained relevant information.25 Courts have been par-ticularly receptive to this argument in the case of joint taxreturns, when only one spouse’s income is in issue in thelitigation.26

b. Seek to limit further disseminations of the returnor the information in the return. Even if returns orportions of returns are to be produced, alternatives stillexist to limit the public dissemination of return informa-tion. One alternative is to request that the return infor-mation be subject to an ‘‘attorneys’ eyes only’’ order.27

Alternatively, you can argue that the return should besubject to a protective order and/or sealing order.28

E. ConclusionTax returns contain a great deal of sensitive informa-

tion that taxpayers are understandably reluctant to dis-close, including Social Security numbers, names ofdependents, and sources and amounts of income. Recog-nizing this fact, federal courts have developed a privilegeagainst the discovery of tax returns. The scope of theprivilege, as well as the policy reasons for the privilege,vary widely from jurisdiction to jurisdiction, and evenwithin a given jurisdiction. Practitioners should tailortheir arguments accordingly to prevent or limit either thediscovery or the further dissemination of their client’s taxreturns.

Congress: How About a MulliganFor the Accelerated Election?

By William A. Raabe, Cherie J. Hennig,and John O. Everett

Stop! Please close that Word file titled ‘‘Huh, Oh, We NeedMore Tax Stimulus Before We Get Too Far Into 2009 Act,’’back slowly away from the computer and that copy of theInternal Revenue Code, and no one will get hurt.

Admit it. Isn’t this the message you would like to sendto the tax policy proletariat in Washington? Rememberwhen tax legislation was enacted only once every fewyears, rather than every fourth Thursday of the month?In 2008 alone, tax professionals had to deal with thefollowing major pieces of legislation that contained taxprovisions.

• the Economic Stimulus Act of 2008;• the Food, Conservation, and Energy Act of 2008;• the Housing and Economic Recovery Act of 2008;

and• the Emergency Economic Stabilization Act of 2008.

Other 2008 legislation with tax provisions included:• the Consolidated Appropriations Act for FY2008;• the Airport and Airway Extension Act of 2008;• the Genetic Information Nondiscrimination Act of

2008;• the Heroes Earnings Assistance and Relief Tax Act of

2008;• the Federal Aviation Administration Extension Act

of 2008;• the Hubbard Act;• the SSI Extension for Elderly and Disabled Refugees

Act;• the Federal Aviation Administration Extension Act

of 2008, Part II;• the Continuing Appropriations Resolution, 2009,

Division A;• the LU Technical Corrections Act of 2008;• legislation to restore the Highway Trust Fund bal-

ance;• the Court Security Improvement Act of 2007;• the Fostering Connections to Success and Increasing

Adoptions Act of 2008;• Michelle’s Law;• the Inmate Tax Fraud Prevention Act of 2008;• the Unemployment Compensation Extension Act of

2008; and• the Huh, Oh, We Need More Tax Stimulus Before

We Get Too Far Into 2009 Act (awaiting passage).

25See Fed. Sav. & Loan Ins. Corp. v. Krueger, 55 F.R.D. 512 (N.D.Ill. 1972). See also Mitsui & Co. v. Puerto Rico Water Res. Auth., 79F.R.D. 72, 82 (D.P.R. 1978) (plaintiff ordered to produce returnsfor in camera inspection before the magistrate, who will segre-gate all information not pertinent to the case).

26See Gattegno, 205 F.R.D. at 74 and notes 10-11.27See Hilt v. SFC Inc., 170 F.R.D. 182 (D. Kan. 1997) (defense

counsel allowed to review unredacted return subject to aconfidentiality order); and Smith v. Bader, 83 F.R.D. at 439(parties signed confidentiality stipulation that prohibited thedisclosure of tax returns to anyone other than counsel).

28See Bessier v. Precise Tool & Eng’g Co., 778 F. Supp. 1509, 1514(W.D. Mo. 1991) (ordering counsel not to reveal the documentsrequested or the information contained in them to anyone otherthan his client and staff); and Credit Life Ins. Co. v. Uniworld Ins.Co., 94 F.R.D. 113, 121 (S.D. Ohio 1982) (court was willing toorder that tax returns be kept under seal and not be made publicexcept by court order).

William A. Raabe, of the Ohio State University, is anauthor of the texts Federal Taxation and Federal TaxResearch.

Cherie J. Hennig is a professor of accounting atFlorida International University.

John O. Everett is a professor of accounting atVirginia Commonwealth University.

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Granted, there are compelling reasons for much of thislegislation, as a volatile economy continues to dominateeveryone’s lives. But no matter how well-intentioned,this rushed legislation is often vague, confusing, andsometimes contradictory. Even worse, the planning win-dow for many of those provisions is frequently quiteshort because Congress may believe that instant gratifi-cation is the only way taxpayers will respond to a taxstimulus provision in a timely fashion.

One of the stimulus provisions in the Housing Assist-ance Tax Act of 2008 (part of the larger Housing andEconomic Recovery Tax Act of 2008) was the addition ofsection 168(k)(4). That provision allows a rare opportu-nity for corporate taxpayers: the ability to cash in unusedresearch and alternative minimum tax credit carryovers,at the cost of surrendering bonus depreciation1 on speci-fied properties placed in service in 2008. The credits usedunder this election are refundable, an unusual trait incorporate tax law, allowing taxpayers to monetize creditcarryforwards that were thought otherwise to be de-ferred for years or simply lost forever. However, acombination of unanswered questions, unintended con-sequences, and a much-too-short time frame for electionall have made this provision the poster child for thecurrent mad rush to do something — anything — to getthings moving in the economy.

We examine the unanswered questions and unin-tended consequences of the election, suggest changes inthe legislation, and argue that Congress must provide ado-over for the election in 2009 after some fixes are made.We briefly review how the section 168(k)(4) electionworks and raise 10 questions regarding defects in thelegislation. We conclude that the statute should be ex-tended for at least one year so that more corporatetaxpayers will have the time and motivation to evaluatethe election properly and make an informed decisionabout how to best use those tax incentives.

A. The Section 168(k)(4) Election: The BasicsThe section 168(k)(4) election is relatively simple. A

corporate taxpayer may surrender bonus depreciation(and must use straight-line recovery) on all eligiblequalified property placed in service after March 31, 2008,and before January 1, 2009 (some limited exceptions arenoted below). By agreeing to the election, the taxpayerconverts some of its pre-2006 research credit and AMTcredit carryovers into instantly refundable tax dollars.Technically, the converted amount (called the bonusdepreciation amount in the statute) triggers modifica-tions to the business tax credit annual limitation in thecase of research credits, and to the excess of regular taxover tentative minimum tax annual limitation for AMTcredits. The taxpayer chooses how to allocate the bonusdepreciation amount between the two credits.

The bonus depreciation amount2 is 20 percent of thedifference between (1) the aggregate depreciation al-

lowed on the eligible qualified property if bonus depre-ciation is claimed and (2) the aggregate depreciationallowed if no bonus depreciation is claimed. However,the bonus depreciation amount is subject to a maximumincrease amount,3 the lesser of (1) $30 million or (2) 6percent of pre-2006 unused business and AMT credits.This calculation can be illustrated when only one item ofpersonalty qualifying for bonus depreciation was placedin service during the last nine months of 2008.

Example: Stimulus Corp., a calendar-year corporation,has $10 million in unused research credits and $15million in unused AMT credits as of the beginning of2008. During the last nine months of 2008, Stimulusplaced in service $14 million of eligible qualified propertyin the seven-year modified accelerated cost recoverysystem category (a single asset placed in service on July1, 2008). The bonus depreciation amount is computed as$1,199,940.

The bonus depreciation amount of $1,199,940 is lessthan the 6 percent and $30 million limits, so the tax-payer’s unused research and AMT credits now are in-stantly refundable to this extent (allocable between thetwo credits in a manner chosen by the taxpayer).

The cost of making this election is that Stimulus mustforgo bonus depreciation on the $14 million acquisitionof personalty and must use straight-line recovery overthe MACRS life of the asset. Thus, the first-year costrecovery deduction would be $1 million ($14 millioncost/seven-year life * .50 half-year convention), ratherthan $8,000,300.

B. Planning for the Section 168(k)(4) ElectionCredits and deductions are more valuable in earlier

tax years because of the time value of money. The taxbenefit of the deduction or credit is a function of thetaxpayer’s after-tax rate of return.4 Tax planning strate-gies usually involve an acceleration of the taxpayer’sdeduction and credit items that may expire before theycan be used. The section 168(k)(4) election, which allows

1Section 168(k) allows a 50 percent bonus depreciationdeduction for qualifying modified accelerated cost recoverysystem property placed in service during 2008.

2Section 168(k)(4)(C).

3Section 168(k)(4)(C)(ii).4If a tax benefit is realized today, it has a present value factor

of 1.0, but if the item cannot be used for five years and thetaxpayer’s after-tax rate of return is 6 percent, the present valuefactor falls to 0.7473. Thus, the item loses more than 25 percentof its value to the taxpayer due to the deferral.

Depreciation with bonus depreciation[$7,000,000 + ($7,000,000 * .1429)] $8,000,300Depreciation without bonus depreciation[$14,000,000 * .1429] (2,000,600)

Difference $5,999,700x .20

Bonus depreciation amount $1,199,940Maximum increase amount - least of:

(a) Computed bonus depreciationamount; $1,199,940(b) $30,000,000 maximum; or $30,000,000(c) 6 percent of unused research and AMTcredits ($25,000,000 x .06). $1,500,000

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for such an acceleration, is most attractive to a corpora-tion that operates in a generally constant net operatingloss environment. A current-year cash infusion is moreattractive than wishing and hoping that profitability willreturn so that unused credits will shelter future profitsfrom income taxation. Similarly, the election is attractiveto a corporation that is in a generally constant AMTenvironment. While AMT credit carryforwards do notexpire, they are unlikely to be used in the near future,making them worth less in a time value of moneycontext.5

Profitable corporations should also consider the elec-tion. The ability to monetize credit carryforwards at thetaxpayer’s current marginal tax rate may be attractive.Those taxpayers will devise a breakeven point in tradingoff the accelerated credits against the slower cost recov-ery deductions that result from forfeiting the bonusdepreciation amounts.

An evaluation of the section 168(k)(4) acceleratedcredit election must consider the following interrelatedfactors:

• possible loss of bonus depreciation that is not com-pensated for with additional credit accelerationsdue to the 6 percent limitation;

• time value of money concepts to account for differ-ing cost recovery and credit schedules;

• possible alternative use of the credits without theacceleration election;

• orchestrating asset acquisitions late in 2008;• possible additional 2009 acquisitions under the ex-

tended placed-in-service rules for some propertiesthat maximize the acceleration of credits;6 and

• allocations of the credits between the research andAMT carryforward amounts.

C. Ten Reasons for a Mulligan on the ElectionWhile the above example illustrates the tax trade-offs

involved in making a section 168(k)(4) election, otherfactors complicate the decision-making process, andthere is little guidance to help the taxpayer. Our top 10questions highlight those factors and build a case for ado-over of the statute, including an extension of time formaking the election.

1. What’s the underlying policy motivation? The section168(k)(4) election comes on the heels of a provision in theEconomic Stimulus Act of 2008 reinstituting the bonusdepreciation rules that have been dormant since 2005. InFebruary 2008, taxpayers were encouraged to invest inmore personalty to receive this bonus deduction. Com-

panies that responded in the first three months of 2008were chagrined later to learn that those acquisitions didnot qualify for the bonus depreciation amount that couldbe monetized through a refund of unused tax credits thatwas part of the Housing and Economic Recovery Act of2008 passed on July 30. By then, many corporate capitalbudgets for 2008 had been spent and there was littlemaneuverability to take advantage of the election.

In early February 2008, Congress enacted a powerfulincentive to make capital investments immediately andthen in July offered another powerful incentive to give upthe previous incentive of bonus depreciation for somecash, which as a motivating device always is attractive.How can a company plan when to make capital acquisi-tions in this environment? With the one-year window forbonus depreciation, and the nine-month window for theacceleration election, it appears that Congress ended upoffering a cash windfall to corporations that delayed theirequipment purchases to the last half of 2008 rather thantrying to exhibit a steady influence on capital investmentbehavior.2. How can a simple decision become so complicated soquickly? The conventional wisdom of Congress seems tobe that a section 168(k)(4) election will be made bycorporations with either unused losses or unused AMTcredit carryforwards. But the accelerated credits electionmay make sense for profitable corporations as well. Inthis regard, a corporation must consider several factors inthe election decision. These include estimates of amountsand patterns of credit utilization that would otherwiseoccur if the acceleration election were not made, as wellas time value of money considerations for differing costrecoveries. A profitable entity might find that an advan-tage to making the election is an increase in the presentvalue of its after-tax cash flow. An Excel spreadsheetevaluating the election for profitable entities is availablefrom the authors.7

The accelerated credit decision can be complicated byfactors that may easily be overlooked. For example, howdoes the election affect financial accounting reports? (Avaluation allowance related to a deferred tax asset thatmust be reversed if the election is made will affect bookincome.) What about state income tax accruals in thosestates that have not adopted bonus deprecation or other-wise will not recognize the election, even though theymay piggyback the federal law for their starting point oftaxable income? And what about obtaining IRS consentfor a change in a tax accounting method when theaccelerated credit election is changed?

In short, this seemingly simple decision can becomecomplicated very quickly. For cash-strapped businessesthat see the opportunity to resurrect supposedly deadcredits, providing only a few months to alter majorcapital investment decisions and consider all of the taxand nontax ramifications of the election is unrealistic.3. Where’s the guidance? The Housing Assistance TaxAct was not signed by President Bush until July 30, 2008.The first general guidance on the accelerated creditelection (and the only guidance as of December 2008) was

5A minimum tax credit is generated when the taxpayer issubject to the AMT. But the credit then is used only to reduce thetax liability when the regular tax computation, and not the AMTregime, applies.

6Property eligible for the election in 2009 includes an itemthat (1) is subject to the section 263A uniform capitalizationrules; (2) has a production period greater than one year and acost exceeding $1 million; or (3) has a MACRS recovery periodof at least 10 years or is used in the trade or business oftransporting persons or property for hire, such as commercialaircraft. 7Please contact the authors at [email protected].

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not issued until October, when Rev. Proc. 2008-65 wasreleased.8 This document leaves many questions unan-swered and provides general guidance only on allocatingthe credits and clarifying the effect of opting out of bonusdepreciation on some properties.

The language in Rev. Proc. 2008-65 seems to indicatethat the Service is throwing up its hands and saying itcannot respond with adequate guidance in a timelymanner. The document pledges that ‘‘the IRS and Treas-ury intend to publish separate guidance on the time andmanner of making the election.’’ But by then, the periodin which the election must be made will have expired.4. When is ‘eligible property’ eligible? What property iseligible for a section 168(k)(4) election? The statute can beread in several ways so that the ‘‘credit acceleration andstraight-line only’’ provision applies to a calendar-yeartaxpayer for:

• all bonus depreciation property placed in service in2008;

• all bonus depreciation property placed in serviceafter March 31, 2008; and

• only the portion of acquisitions that is necessary tomaximize the credit acceleration (for example, be-cause the 6 percent limit kicks in).

It seems punitive to disallow the accelerated deprecia-tion amounts for assets if the credit acceleration was notavailable due to some other constraint, but the codelanguage does not rule out this interpretation. A moregenerous interpretation would allow the taxpayer toselect, asset-by-asset or class-by-class, eligible propertyfor the purpose of the section 168(k)(4) election, and thenallow other acquisitions to qualify for bonus depreciationwithout constraint. For instance, if asset acquisitions areso large as to overfund the credit acceleration election,why not allow the bonus depreciation for the excessamount? Ideally, the taxpayer would drop assets into oneof several categories.

• assets not eligible for credit acceleration (acquiredbefore April 2008);

• assets eligible for credit acceleration and elected forthis purpose; and

• assets eligible for credit acceleration but the electionis not claimed, so that bonus depreciation still isallowed.

Rev. Proc. 2008-65 seems to imply that the thirdcategory above does not exist; that is, all property placedin service after April 2008 is ‘‘credit acceleration andstraight-line only’’ if the election is made, even if thecredits are not available relative to all of the assets due toone of the computational limitations.5. How does section 179 mesh with the election? Acorporation placing in service personalty with a cost ofless than $1,050,000 during the 2008 tax year will finditself in a quandary. Those acquisitions qualify for thesection 179 immediate expensing option.9 How doessection 179 affect the computation of the bonus deprecia-

tion amount? And would the deduction be allowed evenif the taxpayer makes the acceleration election, with anyamount not expensed subject to straight-line recovery?The statute appears to offer contradictory incentives inthis case. The section 179 election is made first, and theamount of bonus depreciation amount seems to be com-puted after the section 179 amount is claimed. This raisesthe question of whether the bonus depreciation amountis computed only ‘‘after section 179,’’ or must straight-line cost recovery be used on all of the year’s acquisitionsif the election is made?6. What about the mid-quarter rule? Rev. Proc. 2008-65refers to the MACRS mid-quarter convention, so themid-quarter rules continue to apply in computing thebonus depreciation amount, even though section 168(k)is silent about how the election interacts with the mid-quarter test. Thus, it is not clear whether pre-April 2008acquisitions are used in applying the 40 percent test forthe mid-quarter convention.

Look at what happens, however, using the facts of ourearlier example, when the mid-quarter convention is inplay. Assume that all of the acquisitions took place in thefourth quarter of 2008, a result that might not be unex-pected for a taxpayer that has learned about the acceler-ated credit election and is attempting to maximize its taxsavings.

The mid-quarter convention is designed to penalizethe taxpayer for excessive late-year asset acquisitions, byslowing down current-year cost recovery deductions. Butin this context, the mid-quarter convention increasesStimulus Corp.’s bonus depreciation amount by morethan 10 percent. Similar (although slightly smaller) in-creases in the bonus depreciation amount occur when themid-quarter convention kicks in due to second- andthird-quarter acquisitions. So does the new law nowencourage or discourage the bunching of acquisitions atthe end of the tax year?7. What about credits that expired after 2005? Someresearch tax credits of corporations may have expiredafter 2005. Why are they not available to the taxpayer asincreases to the business credit increase amount? If thetax policy objective is to monetize available credits thatthe taxpayer cannot cash in, those amounts should beavailable for the section 168(k)(4) election. Will the tax-payer have available the records by which to reanimatethese credits? How would those credits be treated underIRS audit?8. Why use the copy command for definitions? Thesubset of 2009 asset acquisitions10 that can qualify for the

8Rev. Proc. 2008-65, 2008-44 IRB 1, Doc 2008-21895, 2008 TNT199-16.

9$250,000 maximum, reduced dollar-for-dollar for personaltyexceeding $800,000 placed in service during the year. 10Section 168(k)(4)(d).

Depreciation with bonus depreciation[$7,000,000 + ($7,000,000 x .0357)] $7,249,900Depreciation without bonus depreciation[$14,000,000 x .0357] ($499,800)Difference $6,750,100

x .20Bonus depreciation amount $1,350,020

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credit acceleration (discussed at footnote 6) seems to bethe same as under the pre-2005 bonus depreciation rules.This exception is welcome, in that it allows for someforward acquisition planning by the taxpayer, but a list oftransactions and industries that is more responsive tocurrent economic conditions would be better. For in-stance, the airlines probably still need to be on this list,but how about an incentive for the automotive industryor for aspects of infrastructure projects?9. What is the reduction for prior bonus amounts?Another copy-and-paste problem arises in Rev. Proc.2008-65 concerning a reduction of the bonus depreciationamount by the sum of bonus depreciation amounts thatare computed for prior tax years. This process echoes theearlier reduction of the 2005 50 percent bonus deprecia-tion amounts for those claimed at 30 percent for a priortax year. Given that the 2008 computation relates to thefirst (and only scheduled) tax year for the availability ofthe credit acceleration, and that the statute does notaddress the issue directly, this provision does not appearto be needed. A generous interpretation of the languagewould relate the rule to ‘‘no double counting of acquisi-tions’’ for fiscal year taxpayers. But mainly this restrictionconfuses the issue.10. Why the computational bias by MACRS asset class?There is a computational bias in deriving the taxpayer’soptimal amount of credit acceleration, relative to thetrade-off of the loss of bonus depreciation deductions. Ina time value of money sense, the largest tax savings aregenerated by investing in five-year MACRS property,and the tax benefits from other asset classes for a givendollar of investment are reduced by larger amounts as theasset class of the acquisition asset becomes larger.

For example, consider the following present-valueresults if $5 million were invested separately in each ofsix MACRS classes of property (and that class only),assuming that $10 million of pre-2006 credits are present(that is, the 6 percent limit does not come into play).

Those distortions could be eliminated and the compu-tation of the credits available for acceleration would besimplified, if the bonus depreciation amount were set ata fixed percentage, say 10 percent, of the total cost of the

acquired property. To please tax historians, three-yearproperty might be allowed bonus depreciation of 6percent of the total cost.

D. ConclusionThrough the creative use of tax attributes, Congress

has offered the corporate taxpayer a valuable source ofimmediate cash, not an easy task in today’s politicalenvironment, without threatening the integrity of the taxsystem. The elective nature of the stimulus provisionallows the taxpayer to consider short- and intermediate-term tax planning goals, while limiting the taxpayer’sability to game the system. However, Congress did nottake into account the considerable time and thoughtrequired by the typical corporation’s budgeting and taxdepartments to make a decision concerning a nuancedtax election like this one.

Because asset acquisitions are usually planned at leasta year into the future, the nine-month window doesn’tprovide enough time to use this provision optimally.Moreover, the legislative history makes it seem thatCongress believed the election would be attractive onlyto current-loss corporations. Rather, a trade-off of accel-erated depreciation deductions for current credits alsoshould be considered by profitable entities, a scenariothat Congress apparently did not consider.

The economic difficulties that this provision attemptsto alleviate are global in nature and will not be solved inthe short term. So why the rush to close the window ofavailability for the section 168(k)(4) election by January 5,2009? The accelerated credit election may be a good ideafor the economy, and may have a positive effect onseveral corporate taxpayers in need of a cash infusionthrough the tax incentives offered. However, corpora-tions should be allowed to consider the provision indetail and adjust asset acquisitions appropriately to en-sure that the election is used responsibly. And Treasuryshould be allowed time to issue reasonable and thoroughguidance to explain how to comply with the require-ments for the election.

But more time is needed for this to happen. Good taxpolicy often includes an elective provision with specifictargeted taxpayer behavior and a limited time frame foraction, with a sunset of the provision. The generalplaced-in-service dates should be extended at leastthrough 2009 so that corporate capital budgeting deci-sions can be in synch with the tax incentives that Con-gress has offered. It is encouraging that such an extensionis included in the Obama version of the proposed 2009stimulus bill. Economic recovery in the capital-intensivesector likely will be stabilized and accelerated by expand-ing the time in which this important election can bemade.

SUBMISSIONS TO TAX NOTES

Tax Notes welcomes submissions of commentary andanalysis pieces on federal tax matters that may be ofinterest to the nation’s tax policymakers, academics,and practitioners. To be considered for publication,

articles should be sent to the editor’s attention [email protected]. A complete list of submission guide-lines is available on Tax Analysts’ Web site, http://www.taxanalysts.com/.

$5,000,000 Investment

Asset ClassProjected Tax Cost

(Savings) of Election3-year MACRS ($186,691)5-year MACRS ($333,400)7-year MACRS ($197,786)10-year MACRS ($165,624)15-year MACRS ($143,202)20-year MACRS ($89,756)

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Fifteen Years of Antichurning:It’s Time to Make ButterBy Romina Weiss

Table of Contents

I. Introduction . . . . . . . . . . . . . . . . . . . . . . 227II. Statutory and Regulatory Overview . . . . . 228

A. Section 197 Generally . . . . . . . . . . . . . 228B. The Antichurning Rules of Section

197(f)(9) . . . . . . . . . . . . . . . . . . . . . . . 230III. Practicality and Fairness . . . . . . . . . . . . . 234IV. Same Economics, Different Tax

Consequences . . . . . . . . . . . . . . . . . . . . . 236V. Antichurning Rules Drive the Economic

Deal . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238VI. Conclusion . . . . . . . . . . . . . . . . . . . . . . . 239

I. IntroductionThe intangible assets of a business, such as goodwill,

going concern value, patents, and customer lists, oftenconstitute a significant portion, if not most, of the valueof an enterprise, as compared with its tangible assetssuch as property, plant, and equipment. When a pur-chaser acquires the assets of a business, the purchaser’sability to offset future taxable income generated by the

business with depreciation or amortization deductionsfor U.S. federal income tax purposes can significantlyaffect the economics of the transaction; in other words, itcan affect the price the purchaser is willing to pay for thebusiness.

Before the enactment of the Revenue ReconciliationAct of 1993 (the RRA),1 which added section 197, good-will and going concern value were generally treated asnonamortizable intangible assets.2 As a result, the portionof the purchase price of a business allocated to thoseassets could be used only to offset gain recognized on afuture sale of the assets of the business.

Because of the less-than-optimal tax treatment of thoseintangibles, purchasers of businesses were often temptedto assign a proportionately greater amount of the pur-chase price of a business to depreciable tangible andamortizable intangible assets than to goodwill or goingconcern value. This often gave rise to conflicts betweentaxpayers, who attempted to allocate significant value toshort-lived intangible assets similar to goodwill forwhich a useful life had been assigned and, accordingly,could be amortized, and the IRS, which claimed that agreater portion of the value should have been allocated tononamortizable intangibles, such as going concernvalue.3 The frequent litigation between taxpayers and theIRS, as amplified by the subjective nature of the valuationprocess generally and the significant amount of money atstake, was called one of the oldest controversies betweentaxpayers and the IRS by the General Accounting Officein its 1991 report to Congress on the taxation of intan-gibles.4 Also, because depreciation deductions were al-lowed for the cost or other basis of intangible propertyused in a trade or business or held for the production ofincome only if the intangible property had a limiteduseful life that could be determined with reasonableaccuracy,5 questions about what constituted a limiteduseful life and reasonable accuracy abounded.

1The RRA was enacted as part of the Omnibus BudgetReconciliation Act of 1993.

2Reg. section 1.167(a)-3, before amendment by T.D. 8865, 65Fed. Reg. 3820 (Jan. 25, 2000), Doc 2000-2456, 2000 TNT 14-4.

3It also resulted in protracted negotiations between pur-chasers of businesses, who wanted to allocate as large a portionof the purchase price of a business as reasonably possible to aseller covenant not to compete, which portion could be amor-tized over the term of the covenant, and sellers, who wanted toallocate as small a portion of the purchase price of a business tothe covenant, because the portion of the purchase price allocableto a covenant not to compete was treated as ordinary incomerather than capital gain.

4GGD-91-88, ‘‘Tax Policy: Issues and Policy Proposals Re-garding Tax Treatment of Intangible Assets’’ (Aug. 9, 1991).

5Reg. section 1.167(a)-3, before amendment by T.D. 8865.

Romina Weiss is a tax partner in the New Yorkoffice of Gibson, Dunn & Crutcher LLP.

Section 197 was enacted to reduce controversybetween taxpayers and the IRS in connection with theamortization of certain intangible assets, includinggoodwill and going concern value. Although section197 has largely served its purpose, the antichurningrules contained in section 197(f)(9) remain a source ofmuch consternation for tax practitioners. The authorargues that the antichurning rules have outlived theirusefulness, and that to promote fairness and efficiency,the antichurning rules should be repealed. A previousversion of this report was presented by the author tothe members of the Tax Club in New York.

The author would like to thank Greg S. Walker ofGibson, Dunn & Crutcher LLP, Dallas, for his invalu-able assistance in drafting this article, and Jeffrey M.Trinklein of Gibson, Dunn & Crutcher LLP, New York,for his insightful comments. Any errors are solelythose of the author.

Copyright 2008 Romina Weiss.All rights reserved.

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Legislation similar to that eventually enacted was firstproposed on July 25, 1991, with the GAO report follow-ing shortly thereafter.6 In 1992 the Supreme Courtgranted certiorari in Newark Morning Ledger Co. v. UnitedStates,7 a case involving some of the relevant issues, andit issued its decision on April 20, 1993.8 The taxpayer,Newark Morning Ledger Co. (as successor to the HeraldCo.), was a newspaper publisher that had acquired eightnewspapers and continued to publish them under theirexisting names.9 The taxpayer allocated $67.8 million ofthe purchase price, an amount equal to the publisher’sestimate of future profits to be derived from someidentified subscribers (more than 450,000) to the eightnewspapers as of the date of the merger, to an intangibleasset it called ‘‘paid subscribers.’’ The subscribers’ con-tracts were terminable at will by the subscribers and didnot require advance subscription payments. The taxpayerclaimed depreciation deductions for the paid subscriberson a straight-line basis over the estimated useful lives foraverage at-will subscribers of different types (which hadbeen calculated using actuarial tables and various otherstatistical factors), and the IRS challenged those deduc-tions.

In the litigation that ensued, the government arguedthat the asset ‘‘paid subscribers’’ was indistinguishablefrom goodwill, which was specifically prohibited frombeing depreciated by Treasury regulation section1.167(a)-3, as in effect at the time. However, the govern-ment stipulated to the taxpayer’s estimates of the usefullife of the asset and did not contest the techniques used tocalculate the taxpayer’s estimate of the total value of theasset.10

A divided Supreme Court held 5 to 4 that if a taxpayeris able to prove with reasonable accuracy that an intan-gible asset that the taxpayer uses in a trade or business orholds for the production of income has a value thatwastes over an ascertainable period of time, the taxpayermay depreciate the value of the asset over the asset’suseful life regardless of how much the asset appears toreflect the expectancy of continued patronage. The Su-preme Court cautioned that the taxpayer’s burden ofproof was substantial and would often prove too great tobear.11 In this case, that the government had stipulated tothe taxpayer’s estimates and calculations seemed to playan important role in the decision.

In response, Congress enacted section 197,12 in partbecause the ‘‘severe backlog of cases in audit and litiga-

tion’’ was ‘‘a matter of great concern.’’13 Tax practitionersgenerally greeted the new section 197 with enthusiasm.14

What practitioners may not have realized was that 15years after enactment, they would still be spendingsignificant time and energy grappling with the antiabuseprovisions in section 197(f)(9) (the antichurning rules),which were intended to prevent taxpayers from convert-ing a nonamortizable intangible into an amortizablesection 197 intangible.15 Experience seems to have provensection 197 to have been a success in reducing controver-sies between taxpayers and the IRS in this area. Theauthor believes, however, that because the antichurningrules are complex, appear now to be unfair, result intransactions with almost identical economics having dif-ferent tax consequences, and cause taxpayers to restruc-ture their nontax-motivated business transactions toavoid the rules, the time has come for the repeal of theantichurning rules in section 197(f)(9).

II. Statutory and Regulatory OverviewAlthough section 197 was enacted in 1993, proposed

regulations were not issued until early 199716 and werenot finalized until January 2000.17 Also, the final regula-tions issued in January 2000 included proposed regula-tions18 that elaborated on specific issues related topartnerships, and those proposed regulations were final-ized in November 2000.19 Since then, there has been nosignificant guidance from the IRS or Treasury on theseissues.20

A. Section 197 GenerallySection 197 permits taxpayers to amortize the adjusted

basis of those intangible assets that constitute amortiz-able section 197 intangibles ratably over 15 years, begin-ning with the month in which they are acquired.21

Section 197 intangibles comprise the following: (1)goodwill; (2) going concern value; (3) workforce in place,including its composition and terms and conditions of its

6H.R. 3035, 137 Cong. Rec. E2706 (July 25, 1991); GGD-91-88,‘‘Tax Policy Proposals Regarding Tax Treatment of IntangibleAssets’’ (Aug. 9, 1991).

7Cert. granted, 503 U.S. 970 (Apr. 6, 1992).8Newark Morning Ledger Co. v. United States, 507 U.S. 546

(1993), Doc 93-4810, 93 TNT 87-1.9Id.10Id.11Id.12Unless otherwise indicated, all section references are to the

Internal Revenue Code of 1986, as amended.

13Omnibus Budget Reconciliation Act of 1993, conferencereport on section 197, H.R. Rep. 213, 103d Cong., 1st Sess.672-696 (1993).

14See, e.g., New York State Bar Association (NYSBA) TaxSection, ‘‘Report on Proposed Legislation on Amortization ofIntangibles,’’ Tax Notes, Nov. 25, 1991, p. 943. Section 197, asfinally enacted, did not differ materially from the 1991 proposal.

15Omnibus Budget Reconciliation Act of 1993, ConferenceReport on section 197, H.R. Rep. 213, 103d Cong., 1st Sess.672-696 (1993).

16Notice of Proposed Rulemaking (REG-209709-94), 62 Fed.Reg. 2336 (Jan. 16, 1997), Doc 97-1565, 97 TNT 14-15.

17T.D. 8865, 65 Fed. Reg. 3820 (Jan. 25, 2000).18Notice of Proposed Rulemaking (REG-100163-00), 65 Fed.

Reg. 3903 (Jan. 25, 2000), Doc 2000-2661, 2000 TNT 20-68.19T.D. 8907, 65 Fed. Reg. 69667 (Nov. 20, 2000), Doc 2000-

29700, 2000 TNT 224-3. Also, T.D. 9257 (Apr. 7, 2006), Doc2006-6817, 2006 TNT 68-7, amended the rules applicable to someinsurance contracts under section 197.

20See, e.g., LTR 200724009 (Feb. 13, 2007), Doc 2007-14269,2007 TNT 117-26; LTR 200551018 (Sep. 15, 2005), Doc 2005-25828,2005 TNT 247-18; and Rev. Rul. 2004-49, 2004-1 C.B. 939, Doc2004-9500, 2004 TNT 87-8.

21Section 197(a).

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employment; (4) business books and records, operatingsystems, or any other information base (including lists orother information regarding current or prospective cus-tomers); (5) any patent, copyright, formula, process,design, pattern, know-how, format, or other similar item;(6) any customer-based intangible, meaning compositionof market, market share, and any other value resultingfrom the future provision of goods or services pursuantto relationships (contractual or otherwise) in the ordinarycourse of business with customers, and, in the case of afinancial institution, deposit base and similar items; (7)any supplier-based intangible, meaning any value result-ing from future acquisitions of goods or services pursu-ant to relationships (contractual or otherwise) in theordinary course of business with suppliers of goods orservices to be used or sold by the taxpayer; (8) any itemsimilar to those listed in (3) through (7) above; (9) anylicense, permit, or other right granted by a governmentalunit or an agency or instrumentality thereof; (10) anycovenant not to compete (or other arrangement to theextent it has substantially the same effect) entered into inconnection with an acquisition (directly or indirectly) ofan interest in a trade or business or substantial portionthereof; and (11) any franchise, trademark, or tradename.22

Intangibles specifically excluded from the definition ofsection 197 intangibles are: (1) any interest in a corpora-tion, partnership, trust, or estate, or under an existingfutures contract, foreign currency contract, notional prin-cipal contract, or other similar financial contract; (2) anyinterest in land; (3) any computer software that is readilyavailable for purchase by the public, is subject to anonexclusive license, and has not been substantiallymodified, and other computer software that is not ac-quired in a transaction (or series of related transactions)involving the acquisition of assets constituting a trade orbusiness or substantial portion thereof; (4) any of thefollowing items if not acquired in a transaction or seriesof related transactions involving the acquisition of assetsconstituting a trade or business or a substantial portionthereof: (a) any interest in a film, sound recording,videotape, book, or similar property; (b) any right toreceive tangible property or services under a contract orgranted by a governmental unit or agency or instrumen-tality thereof; (c) any interest in a patent or copyright; and(d) to the extent provided in reg. section 1.197-2(c)(13),any right under a contract (or granted by a governmentalunit or an agency or instrumentality thereof) if the righthas a fixed duration of less than 15 years or is fixed as toamount and would otherwise be recoverable under amethod similar to the unit-of-production method; (5) anyinterest under an existing lease or tangible property orany existing indebtedness (except as provided regardingfinancial institutions); (6) any right to service indebted-ness that is secured by residential real property unless theright is acquired in a transaction (or series of relatedtransactions) involving the acquisition of assets (otherthan those rights) constituting a trade or business orsubstantial portion thereof; and (7) any fees for profes-

sional services and any other transaction costs incurredby parties to a transaction regarding which any portion ofthe gain or loss is not recognized under sections 351through 368.23

To constitute an amortizable section 197 intangible, asection 197 intangible must have been acquired afterAugust 10, 1993, the date of enactment of section 197, andmust be held in connection with the conduct of a trade orbusiness or an activity engaged in for the production ofincome.24 Intangibles, other than (1) franchises, trade-marks, or trade names; (2) covenants not to competeentered into in connection with an acquisition of aninterest in a trade or business or a substantial portionthereof; and (3) licenses, permits, or other rights grantedby a governmental unit or an agency or instrumentalitythereof that are self-created rather than acquired will notconstitute amortizable section 197 intangibles unless theyare created in connection with a transaction (or series ofrelated transactions) involving the acquisition of assetsconstituting a trade or business or a substantial portionthereof.25

If an asset constitutes an amortizable section 197intangible, no other depreciation or amortization deduc-tion is allowed with respect to it.26 Thus, if a covenant notto compete constitutes an amortizable section 197 intan-gible, a taxpayer must amortize any portion of thepurchase price of a business allocated to the covenantover 15 years, even if, under prior law, that amountwould have been amortizable over the term of thecovenant.27

Section 197(f) contains special rules that affect theapplicability and operation of section 197. Among them isa rule that provides that if a section 197 intangible isacquired in a nonrecognition transaction under section332 (complete liquidations of subsidiaries), section 351(transfers to controlled corporations), section 361 (non-recognition of gain or loss to corporations), section 721(contributions to partnerships), section 731 (distributionsfrom partnerships), section 1031 (like-kind exchanges),section 1033 (involuntary conversions), or in a transac-tion between members of an affiliated group that files aconsolidated income tax return, the transferee steps intothe shoes of the transferor for purposes of applyingsection 197 regarding the amount of the transferee’sadjusted basis that does not exceed the transferor’sadjusted basis in the section 197 intangible.28 The Treas-ury secretary is authorized to issue regulations as may be

22Section 197(d).

23Section 197(e).24Section 197(c)(1). Two transition rules permitted elections

regarding the effective date. A retroactive election was availableto apply the newly enacted section 197 to property acquiredafter July 25, 1991, and on or before August 10, 1993. Temp. reg.section 1.197-1T(c). A separate election was available to applyprior law to property acquired under a written, binding contractin effect on August 10, 1993, and at all times thereafter throughthe date of acquisition of the property. Temp. reg. section1.197-1T(d).

25Section 197(c)(2); reg. section 1.197-2(d)(2)(iii).26Section 197(b).27Id.28Section 197(f)(2); reg. section 1.197-2(g)(2).



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appropriate to carry out the purposes of section 197,including to prevent the avoidance of section 197 throughrelated persons or otherwise.29

B. The Antichurning Rules of Section 197(f)(9)

1. Generally. Section 197(f)(9) contains antichurning rulesthat exclude from the definition of amortizable section197 intangible certain intangibles acquired in certaintransactions. The conference report on section 197 statesthat those rules were enacted to ‘‘prevent taxpayers fromconverting existing goodwill, going concern value, or anyother section 197 intangible for which a depreciation oramortization deduction would not have been allowableunder [prior] law into amortizable property.’’30 Thoserules have been explained and expanded through statu-torily authorized Treasury regulations, are extremelycomplex (with several cross-references), and, in the au-thor’s view, serve as an enduring and unnecessary trapfor the unwary.

The antichurning rules apply to except from thedefinition of amortizable section 197 intangible anyotherwise amortizable section 197 intangible for whichdepreciation and amortization deductions would nothave been allowed under prior law,31 including specifi-cally goodwill and going concern value if (1) the intan-gible was held or used at any time on or after July 25,1991, and on or before August 10, 1993 (the transitionperiod),32 by the taxpayer or a related person; (2) thetaxpayer acquired the intangible from a person who heldit during the transition period, and the user of theintangible does not change as part of the transaction; or(3) the taxpayer grants the right to use the intangible to aperson (or a person related to that person) who held orused the intangible at any time during the transitionperiod, but only if the transaction in which the taxpayer

grants the right and the transaction in which the taxpayeracquired the intangible are part of a series of relatedtransactions.33

2. Related person. The antichurning rules define ‘‘relatedpersons’’ as any persons that are related under sections267(b) or 707(b)(1), in each case applied by substituting20 percent for 50 percent, and any persons that areengaged in trades or businesses under common control,within the meaning of section 41(f)(1)(A) and (B).34

a. Section 267(b). Section 267(b) defines ‘‘related per-sons’’ to include the following:

• members of a family, including only brothers andsisters (by whole or half blood), spouse, ancestors,and lineal descendants;

• an individual and a corporation, more than 20percent of the value of the outstanding stock ofwhich is owned directly or indirectly by or for thatindividual;

• two corporations that are members of the samecontrolled group under section 1563(a), with modi-fications;

• a grantor and a fiduciary of any trust;• fiduciaries of different trusts, if the same person is

the grantor of both trusts;• a fiduciary of a trust and a beneficiary of such trust;• a fiduciary of a trust and a beneficiary of another

trust, if the same person is the grantor of both trusts;• a fiduciary of a trust and a corporation, more than

20 percent of the value of the outstanding stock ofwhich is owned directly or indirectly by or for thattrust or the grantor of that trust;

• a person and an organization to which section 501applies, and that is controlled, directly or indirectly,by that person or, if the person is an individual, bymembers of the person’s family;

• a corporation and a partnership if the same personsown more than 20 percent of the value of theoutstanding stock of the corporation and more than20 percent of the capital or profits interests in thepartnership;

• an S corporation and another S corporation, or an Scorporation and a C corporation, if the same personsown more than 20 percent of the value of theoutstanding stock of each corporation; and

• with some exceptions, an executor of an estate and abeneficiary of the estate.

Also, the following constructive ownership rules ap-ply: (1) stock owned, directly or indirectly, by or for acorporation, partnership, estate, or trust is consideredowned proportionately by or for its shareholders, part-ners, or beneficiaries; (2) an individual is considered asowning the stock owned, directly or indirectly, by or forthe individual’s family (which includes, for this purpose,

29Section 197(g).30Omnibus Budget Reconciliation Act of 1993, conference

report on section 197, H.R. Rep. 213, 103d Cong., 1st Sess.672-696 (1993). Reg. section 1.197-2(h)(1)(ii) describes the pur-pose of the rules as being ‘‘to prevent the amortization of section197(f)(9) intangibles unless they are transferred after the appli-cable effective date in a transaction giving rise to a significantchange in ownership or use.’’

31Section 197(f)(9)(A). Deductions allowable under section1253(d)(2) or under an election under section 1253(d)(3), both asin effect before the enactment of section 197, relating to acqui-sitions of franchises, trademarks, or trade names, and deduc-tions allowable under reg. section 1.162-11, relating to certainimprovements by a lessee on leased property, are treated asdeductions allowable for amortization under prior law. Reg.section 1.197-2(h)(3).

32The transition period has been defined based on the dateslegislation similar to section 197 was first introduced in Con-gress under H.R. 3035, 137 Cong. Rec. E2706 (July 25, 1991), andthe date of enactment of section 197. If a valid retroactiveelection applying section 197 to assets acquired after July 25,1991, was made under temp. reg. section 1.197-1T, the transitionperiod is merely one day, July 25, 1991. Reg. section 1.197-2(h)(4).

33Section 197(f)(9)(A); reg. section 1.197-2(h)(2). If an entityowned or used a section 197 intangible at any time during thetransition period, and the entity no longer exists, the entity isnevertheless deemed to exist for purposes of determiningwhether the taxpayer acquiring the intangible is related to theentity. Reg. section 1.197-2(h)(7).

34Section 197(f)(9)(C)(i).



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only brothers and sisters, spouse, ancestors, and linealdescendants); and (3) an individual owning (otherwisethan by the application of (2)) any stock of a corporationis considered as owning the stock owned, directly orindirectly, by or for the individual’s partner (the partnerstock attribution rule).35 Stock constructively owned byreason of clause (1) of the preceding sentence is treated asactually owned by that person for purposes of applyingthe constructive ownership rules to treat another as theowner of the stock.36

b. Section 707(b)(1). Section 707(b)(1) defines ‘‘relatedpersons’’ to include the following:

• a partnership and a person owning, directly orindirectly, more than 20 percent of the capital orprofits interest in the partnership; or

• two partnerships in which the same persons own,directly or indirectly, more than 20 percent of thecapital or profits interests.

The constructive ownership rules that apply for pur-poses of section 267(b), other than the partner stockattribution rule, also apply for purposes of section707(b)(1).37

c. Common control.38

i. Controlled group of corporations. Section 41(f)(5)provides that the term ‘‘controlled group of corpora-tions’’ has the meaning given to it by section 1563(a), with‘‘more than 50 percent’’ substituted for ‘‘at least 80percent’’ in section 1563(a)(1), without taking into ac-count section 1563(a)(4) and (e)(3)(C). A controlled groupof corporations includes any of three groups: a parent-subsidiary controlled group, a brother-sister controlledgroup, and a combined group.39 A parent-subsidiarycontrolled group consists of one or more chains ofcorporations connected with a common parent corpora-tion through stock ownership of at least 50 percent byvote or value, as long as the common parent owns at least50 percent by vote or value of at least one of the othercorporations, excluding from the calculation stock owneddirectly by any intermediary corporation.40 A brother-sister controlled group consists of two or more corpora-tions in which five or fewer persons who are individuals,

estates, or trusts (1) own 80 percent or more by vote orvalue of each corporation; and (2) own more than 50percent by vote or value of each corporation, taking intoaccount each person’s ownership only to the extent oftheir smallest holding in any of the brother-sister corpo-rations.41 A combined group consists of three or morecorporations, each of which is a member of a parent-subsidiary controlled group or a brother-sister controlledgroup, and one of which is (1) a common parent corpo-ration of a parent-subsidiary controlled group and (2)included in a brother-sister controlled group.42 In makingdeterminations regarding controlled groups of corpora-tions, the excluded stock rules of section 1563(c) apply,which generally exclude nonvoting preferred stock andtreasury stock.43 Finally, constructive ownership rulesmay provide for attribution. For parent-subsidiary con-trolled groups, the following rules apply44:

• stock is treated as owned by a corporation if thecorporation has an option to acquire the stock;

• stock is treated as owned by a partner that owns aninterest of 5 percent or more (by capital or profits) ina partnership that owns the stock, to the extent ofthe partner’s interest in the partnership; and

• stock owned by or for an estate or trust is treated asowned by any beneficiary who has an actuarialinterest of 5 percent or more in the stock, to theextent of that actuarial interest; and stock owned byor for any portion of a grantor or other similar trustis treated as owned by the grantor.

For brother-sister controlled groups, the same rulesapply, with the addition of the following rules45:

• stock owned by or for a corporation is treated asowned by any person who owns 5 percent or morein vote or value of the corporation, to the extent ofthat person’s ownership interest;

• stock is treated as owned by an individual if thestock is owned by or for the individual’s spouse,unless the spouse has unfettered control of disposi-tion of the stock and the individual does not haveany of various connections to the corporation;

• stock is treated as owned by an individual if thestock is owned by or for the individual’s childrenwho are under 21 years of age; and if the individualis under 21, any stock owned by the individual’sparents is treated as owned by the individual; and

• if an individual owns more than 50 percent of thetotal combined vote or value of stock in a corpora-tion, the individual is treated as owning the stock inthat corporation owned by or for his parents, grand-parents, grandchildren, and children who are atleast 21 years of age.46

ii. Trades or businesses under common control. Theterm ‘‘trades or businesses under common control’’

35Although a discussion of the constructive ownership rulesof section 267(b) is beyond the scope of this article, it bearsnoting that given the proliferation of partnerships today, par-ticularly in the context of alternative investing in private equityand hedge funds, many persons could, under the partner stockattribution rule, be treated as owning stock of other persons ofwhich they are unaware.

36Section 267(c).37Section 707(b)(3).38Although section 197 refers to ‘‘common control’’ with a

parenthetical cross-reference to section 41(f)(1)(A) and (B), onlysection 41(f)(1)(B) addresses the term ‘‘common control,’’whereas section 41(f)(1)(A) refers to a ‘‘controlled group ofcorporations.’’ Because of the reference to both subparagraphs(A) and (B), it appears that both subparagraphs apply, but thisis yet another instance of the difficulties inherent in the anti-churning rules.

39Section 1563(a).40Section 1563(a)(1), by operation of section 41(f)(5); temp.

reg. section 1.1563-1T(a)(2); see temp. reg. section 1.1563-1T(a)(2)(ii), Example 4.

41Section 1563(a)(2); temp. reg. section 1.1563-1T(a)(3)(i),(ii).42Section 1563(a)(3); temp. reg. section 1.1563-1T(a)(4).43Section 1563(c)(1).44Section 1563(d)(1).45Section 1563(d)(2).46For purposes of this section, children includes legally

adopted children. Section 1563(e)(6)(C).



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means any group of trades or businesses that is either aparent-subsidiary group under common control, abrother-sister group under common control, or a com-bined group under common control.47 The rules refer tothe term ‘‘organization,’’ which means a sole proprietor-ship, partnership, trust, estate, or corporation, and anorganization may be a member of only one group oftrades or businesses under common control.48

A parent-subsidiary group under common controlconsists of one or more chains of organizations that areconnected through ownership of a controlling interestwith a common parent organization, in which a control-ling interest means more than 50 percent ownership byvote or value of a corporation or more than 50 percent ofthe capital or profits interest in a partnership, if (1) acontrolling interest in each of the organizations, exceptthe common parent organization, is owned by one ormore of the other organizations; and (2) the commonparent organization owns a controlling interest in at leastone of the other organizations, excluding, in computingthe controlling interest, any direct ownership interest bythe other organizations.49 The above calculations aremade with options to acquire outstanding stock of acorporation treated as exercised.50

A brother-sister group under common control consistsof two or more organizations if (1) the same five or fewerpersons who are individuals, estates, or trusts own acontrolling interest of each organization; and (2) thosepersons are in effective control of each organization,taking into account each person’s ownership only to theextent of their smallest holding in any of the organiza-tions.51 ‘‘Controlling interest’’ for those purposes meansmore than 80 percent ownership by vote or value of acorporation or of the capital or profits interests in apartnership, and ‘‘effective control’’ means 50 percentownership by vote or value of a corporation or of thecapital or profits interests in a partnership.52

A combined group under common control consists ofa group of three or more organizations in which (1) eachorganization is a member of either a parent-subsidiarygroup under common control or brother-sister groupunder common control, and (2) at least one organizationis the common parent organization of a parent-subsidiarygroup under common control and also a member of abrother-sister group under common control.53 In makingdeterminations regarding trades or businesses undercommon control, both the excluded stock rules andconstructive ownership rules similar to those detailedabove for controlled groups of corporations apply.54

d. Timing of determination. The determination ofwhether persons are related is made both immediatelybefore and immediately after the acquisition of the sec-

tion 197 intangible.55 In the case of a series of relatedtransactions, or a series of transactions that togethercomprise a qualified stock purchase under section338(d)(3), the determination is made immediately beforethe earliest transaction in the series of transactions andimmediately after the last transaction in the series oftransactions.56

e. De minimis rule. Two corporations are not treatedas related for purposes of the antichurning rules if (1)they would be treated as related persons solely bysubstituting ‘‘more than 20 percent’’ for ‘‘more than 50percent’’ in applying section 267(f)(1)(A), which definesthe term ‘‘controlled group’’; and (2) each corporationpossesses a beneficial ownership interest in the other’sstock of less than 10 percent of the total vote and value ofall shares outstanding.57 For purposes of applying thisrule, the constructive ownership rules of section 318(a)apply, but (1) in applying the attribution ‘‘from corpora-tions’’ rule of section 318(a)(2)(C), the 50 percent limita-tion does not apply; and (2) in applying the attribution‘‘to corporations’’ rule of section 318(a)(3)(C), 20 percentis substituted for 50 percent.58

f. Interaction with nonrecognition transactions. Al-though a transferee in a nonrecognition transactionwould generally step into the shoes of the transferor forpurposes of applying section 197, the antichurning rulesprevent amortization of a section 197 intangible, even if itwas amortizable in the hands of the transferor before thetransaction, if immediately after the transaction (or seriesof transactions) in which the intangible was acquired, thetransferee was related to any person who held or usedthe intangible during the transition period.59

3. Partnership rules. If there is an increase in the basis ofpartnership property under section 732, 734, or 743, forpurposes of applying the ‘‘related person’’ rules, eachpartner is treated as having owned and used its propor-tionate share of the partnership’s assets.60 In those cases,the partnership is treated as an aggregate, rather than asan entity, for purposes of applying the antichurningrules. In all other partnership situations, the antichurningrules are generally applied at the partnership level, ratherthan at the partner level.61

a. Section 743(b). If a partnership interest is sold ortransferred on death and the partnership has in effect anelection under section 754 (a section 754 election) or oneis made for the tax year in which the transfer occurs orthe partnership has a substantial built-in loss immedi-ately after the transfer, the basis of partnership property

47Reg. sections 1.41-6(a)(3)(ii) and 1.52-1(b).48Id.49Reg. section 1.52-1(c).50Reg. sections 1.52-1(c)(1) and 1.414(c)-4(b)(1).51Reg. section 1.52-1(d)(1).52Reg. section 1.52-1(d)(2) and (3).53Reg. section 1.52-1(e).54See section 52(b); reg. sections 1.52-1(g) and 1.414(c)-3.

55Section 197(f)(9)(C)(ii).56Reg. section 1.197-2(h)(6)(ii)(B) and -2(k), examples 24 and

25.57Reg. section 1.197-2(h)(6)(iv)(A).58Reg. section 1.197-2(h)(6)(iv)(B).59Reg. section 1.197-2(h)(10).60Section 197(f)(9)(E).61Reg. section 1.197-2(h)(12)(i) (the commissioner has the

discretion, under the partnership antiabuse rule in reg. section1.701-2(e), to determine whether the partner level is moreappropriate).



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is adjusted with respect to the transferee.62 The anti-churning rules apply to those basis adjustments only ifthe transferee is related to the transferor, and they do notapply based on the transferee’s relationship to the part-nership or other partners.63

Also, in accordance with the exception to the anti-churning rules for transfers on death in which basis isdetermined under section 1014 (discussed further below),the antichurning rules do not apply when a section 743(b)basis adjustment is made by reason of the death of apartner, with the new partner’s basis determined undersection 1014(a). In that situation, the new partner istreated for purposes of the antichurning rules as acquir-ing the interest from an unrelated person.64

b. Section 732(d). Section 732(d) permits a partner thatreceives a distribution of property other than moneywithin two years of the partner’s acquisition of thepartnership interest from a partnership that did not havein effect a section 754 election at the time of the distribu-tion to elect to treat the basis of that property as it wouldhave been treated had the section 754 election been ineffect.65 For purposes of the antichurning rules, adjust-ments under section 732(d) are analyzed as if the section754 election had been in effect at the time of the acquisi-tion of the partnership interest.66

c. Section 732(b). On a partnership’s distribution ofproperty to a partner in liquidation of the partner’sinterest in the partnership, the partner’s basis in theproperty other than money distributed to the partner isequal to the partner’s basis in its partnership interest (lessany money received in the liquidating distribution).67 Inaccordance with the approach of treating each partner asowning and using its share of partnership intangibles, aliquidating distribution that includes an intangible isanalyzed under the antichurning rules as if it were atransfer directly between partners — that is, the distribu-tee partner is treated as receiving both its own share ofthe intangible and the share of each of the other partners.An increase in the basis of the distributed intangible isamortizable to the extent it does not exceed the other

unrelated partners’ shares of unrealized appreciation.68

The share attributable to the distributee partner (or anypartner related to the distributee partner) may nonethe-less be amortizable if that partner’s interest was‘‘cleansed’’ by acquisition in a transaction that was notsubject to the antichurning rules.69

Despite application of the above rules, the antichurn-ing rules may nevertheless continue to apply on asubsequent transfer of the intangible if the total unreal-ized appreciation of the intangible exceeds the section732(b) basis adjustment at the time of the distribution (orif a portion of the intangible was otherwise not amortiz-able in the hands of the distributee).70

d. Section 734(b). If partnership property is distrib-uted to a partner and the partnership has in effect asection 754 election or one is made for the tax year inwhich the transfer occurs, or there is a substantial basisreduction with respect to the distribution, the basis of thepartnership in its assets is adjusted to reflect the recog-nition of gain or loss by the distributee partner.71 Forpurposes of the antichurning rules, when a section 734(b)adjustment applies to an intangible asset held by apartnership, the transaction is analyzed as if each con-tinuing partner acquired an interest in the intangiblefrom the distributee partner.72 Provided the continuingpartner is not the distributee partner or related to thedistributee partner, the antichurning rules will not applyto the continuing partner’s share of any increase in basisin the intangible.73 The continuing partner’s share of theincrease in basis may also be amortizable if that partner’sinterest was ‘‘cleansed’’ by acquisition in a transactionthat was not subject to the antichurning rules.74

e. Antiabuse rule. The special rules applicable topartnership basis adjustments contain their own anti-abuse rule, which is intended to prevent taxpayers fromcircumventing the antichurning rules by transferring titlewithout a corresponding change in the user of theintangible.75 If an ‘‘antichurning partner’’ or a relatedperson (other than the partnership) becomes or remains adirect user of the intangible that is treated as transferred,then the antichurning rules apply to deny amortization tothe extent that the antichurning partner is treated ashaving transferred the intangible.76 An antichurningpartner means (1) regarding all intangibles held by a

62Section 743(b). A partnership has a substantial built-in lossregarding a transfer of property if the excess of (1) the partner-ship’s adjusted basis in partnership property immediately afterthe transfer over (2) the fair market value of the partnershipproperty is greater than $250,000. Section 743(d).

63Reg. section 1.197-2(h)(12)(v).64Reg. section 1.197-2(h)(12)(viii).65Section 732(d). Also, the basis adjustment rules of section

732(d) will apply to a partner (regardless of whether an electionhas been made) if, at the time of the partner’s acquisition of thepartnership interest, (1) the fair market value of all partnershipproperty other than money exceeded 110 percent of its adjustedbasis to the partnership; (2) an allocation of basis under section732(c) on a liquidation of the partner’s interest immediatelyafter the acquisition would have resulted in a shift of basis fromproperty not subject to an allowance for depreciation, depletion,or amortization, to property subject to such an allowance; and(3) a basis adjustment under section 743(b) would change thebasis to the partner of the property actually distributed. Reg.section 1.732-1(d)(4).

66Reg. section 1.197-2(h)(12)(iii).67Section 732(b).

68Reg. section 1.197-2(h)(12)(ii).69Id.70Reg. section 1.197-2(h)(12)(ii)(C).71Section 734(a) and (b). A substantial basis reduction exists

if the sum of (1) the amount of any loss recognized by thedistributee partner regarding the distribution under section731(a)(2); and (2) for any distributed property to which section732(b) applies, the excess of the basis of the distributed propertyto the distributee partner (determined under section 732) overthe adjusted basis of the distributed property to the partnershipimmediately before that distribution (as adjusted by section732(d)) exceeds $250,000. Section 734(d).

72Reg. section 1.197-2(h)(12)(iv).73Id.74Id.75Reg. section 1.197-2(h)(12)(vi).76Reg. section 1.197-2(h)(12)(vi)(A).



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partnership on or before August 10, 1993, any partner tothe extent that (a) the partner acquired its interest in thepartnership on or before August 10, 1993, or (b) thepartner’s interest was acquired from a person related tothe partner on or after August 10, 1993, and that interestwas not held by any person other than persons related tothe partner at any time after August 10, 1993; or (2)regarding any section 197 intangible acquired by thepartnership after August 10, 1993, that is not amortizablewith respect to the partnership, any partner to the extentthat (a) the partner’s interest in the partnership wasacquired on or before the date the partnership acquiredthe section 197 intangible, or (b) the partner’s interest wasacquired from a person related to the partner on or afterthe date the partnership acquired the section 197 intan-gible and that interest was not held by any person otherthan persons related to the partner at any time after thedate the partnership acquired the section 197 intangible.77

f. Section 704(c) allocations. If a partner contributesproperty to a partnership and its tax basis differs from itsbook value, the disparity must be borne by the contrib-uting partner and not shifted to any other partner.78 Theregulations under section 704 provide three methods foraccomplishing this goal (although other methods may beacceptable): the traditional method, the traditionalmethod with curative allocations, and the remedial allo-cation method.79 If a partner contributes an asset (towhich the section 704(c) allocation rules apply) that wasan amortizable section 197 intangible in its hands to apartnership, the partnership may generally use any of theallocation methods provided in section 704(c) with re-spect to the intangible, and the antichurning rules willnot apply.80 If, however, a partner contributes a section197 intangible that was not an amortizable section 197intangible in its hands to a partnership, a noncontribut-ing partner may receive only remedial allocations ofamortization regarding the intangible, and only if (1) thenoncontributing partner is not related to the partner thatcontributed the intangible; and (2) as part of a series ofrelated transactions that includes the contribution of thesection 197 intangible to the partnership, the contributingpartner or a related person (other than the partnership)does not become or remain a direct user of the contrib-uted intangible.81

4. Exceptions. The antichurning rules do not apply toacquisitions of section 197 intangibles by reason of deathwhen basis is increased under section 1014(a).82 Also, theantichurning rules do not apply if the intangible was anamortizable section 197 intangible in the hands of thetransferor before an acquisition, and the acquisition and

the transaction in which the transferor acquired theintangible are not part of a series of related transactions.83

If the antichurning rules would otherwise apply to anacquisition, those rules will not apply if (1) the buyerwould not be related to the seller but for the substitutionof 20 percent for 50 percent in the related person rules; (2)the seller elects to recognize gain on the sale of the section197 intangible; and (3) the seller, regardless of whether itis otherwise subject to tax, pays federal income tax on thegain at the highest rate imposed by section 1 (for non-corporate taxpayers) or section 11 (for corporations andtax-exempt entities).84 The antichurning rules will applyto the extent that the buyer’s basis in the intangibleexceeds the seller’s recognized gain.85

Finally, the antichurning rules will not apply when anelection is made under section 338 to treat a stockpurchase as an asset purchase for U.S. federal income taxpurposes, provided the new corporation deemed to havebeen created as a result of the election is not otherwisetreated as related to the acquired corporation.86

5. The general antiabuse rule. A section 197 intangiblethat would otherwise qualify for amortization undersection 197 will not qualify if one of the principalpurposes of the transaction in which it is acquired is toavoid the requirement that the intangible be acquiredafter August 10, 1993, or to avoid the operation of theantichurning rules.87 A transaction will be presumed tohave such a prohibited purpose if the acquisition doesnot effect a significant change in the ownership or use ofthe intangible.88 For example, if a section 197 intangible isacquired in a transaction (or series of related transac-tions) in which an option to acquire stock is issued to aparty to the transaction, but the option does not triggerrelated person status under the antichurning rules, theantiabuse rule may apply.89

III. Practicality and FairnessRecently, issues regarding the amortization of basis

increases in goodwill have arisen in connection withtransactions in which investment management, privateequity, or hedge fund firms have engaged in initial publicofferings (IPOs). Some of those entities were, before theirIPOs, classified as partnerships for U.S. federal incometax purposes, but used a corporate entity to go public,using an umbrella partnership real estate investmenttrust (UPREIT), or UP-C, structure.90 A new C corpora-tion would be created. That C corporation would sellshares to the public, and the cash raised by the Ccorporation would be used to purchase interests in thepartnership from the existing owners. The partnership

77Reg. section 1.197-2(h)(12)(vi)(B). All references above toAugust 10, 1993, are treated as references to July 25, 1991, if therelevant party made a valid retroactive election under temp. reg.section 1.197-1T. Reg. section 1.197-2(h)(12)(vi)(C).

78Section 704(c).79Reg. section 1.704-3.80Reg. section 1.197-2(h)(12)(vii)(A).81Reg. section 1.197-2(h)(12)(vii)(B).82Section 197(f)(9)(D); reg. section 1.197-2(h)(5)(i). See, e.g.,

LTR 199949037 (Sept. 1, 1999), Doc 1999-38767, 1999 TNT 238-17.

83Reg. section 1.197-2(h)(5)(ii).84Section 197(f)(9)(B); reg. section 1.197-2(h)(9).85Reg. section 1.197-2(h)(9)(ii).86Reg. section 1.197-2(h)(8) and -2(k), Example 23.87Section 197(f)(9)(F).88Reg. section 1.197-2(h)(11).89Id.90See, e.g., Pzena Investment Management Inc., SEC Form

S-1, filed June 11, 2007; Evercore Partners Inc., SEC Form S-1,filed May 12, 2006.



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would make a section 754 election for the year of the sale(if it did not already have one in place), and the Ccorporation would obtain a basis step-up for the portionof the assets of the partnership that it was treated asacquiring. The existing partners would also have theright, over time, to exchange their interests in the part-nership for interests in the C corporation so that theycould obtain liquidity. Those later exchanges of partner-ship interests for stock in the C corporation would betaxable transactions for U.S. federal income tax purposes.

Most of the value attributable to those types of busi-nesses is goodwill, such that the basis step-up to the Ccorporation was primarily reflected in a section 197intangible, and the amortization deductions associatedwith that basis increase would have significant value.Because the investment bankers believed the publicwould not pay for the value of the amortization deduc-tions through a higher price per share on the IPO, the Ccorporation would enter into a tax receivables agreementwith the selling partners under which the C corporationwould be required to pay 85 percent of the tax benefitprovided by the amortization deductions arising fromthe initial sale of partnership interests to the C corpora-tion and from future taxable conversions of partnershipinterests to stock of the C corporation by the sellers of thepartnership interests. Those payments would be treatedas additional purchase price regarding the partnershipinterests, and because they were made after the year inwhich the sale or exchange occurred, a portion of eachpayment would be treated as interest. The portion of eachadditional payment that was treated as additional pur-chase price would further increase the basis in theintangible.91 Because of the significant value attached tothese amortization deductions, it was necessary to ensurethat in the case of a business that existed on or beforeAugust 10, 1993, the antichurning rules did not apply.Those IPOs were done to provide liquidity to the existingpartners, to create a publicly traded security that thebusiness could use to compensate its employees, and, inthe case of IPOs that were primary offerings rather thansecondary sales, to raise capital for the business. None ofthose IPOs were undertaken with a principal purpose ofconverting existing goodwill into an amortizable asset.Those IPOs would have been undertaken even if theamortization deductions associated with the increase inthe basis of the goodwill were not available.92

In those situations, because the basis increase aroseunder section 743, the antichurning analysis was appliedto determine whether the C corporation was related toany of the continuing partners in the partnership.93

Because the ownership structure of the partnership mightitself have been complex with partnership interests heldby upper-tier partnerships and overlapping ownershipamong those partnerships, the application of the relatedperson rules, with their inherent complexity and all oftheir cross-references and modifications, became daunt-ing. Although tax practitioners generally do not shyaway from applying complex rules,94 the time and effortexpended in navigating those rules is not well-spentgiven that the antichurning rules themselves are, from apolicy perspective, no longer necessary. The antichurningrules apply to intangible assets that were held by thetaxpayer on or before August 10, 1993 (and on or afterJuly 25, 1991). Over time, it is likely that the value of anysuch intangible asset has changed significantly, whetherincreasing or decreasing. It would seem unlikely, al-though not impossible, that taxpayers would engage insales of businesses to related persons to achieve anamortizable increase in the basis of their intangible assetsrather than for valid business reasons, as was the case inthe IPOs described above.95

Also, the antichurning rules can apply only to busi-nesses that existed on August 10, 1993. If a business wasstarted on or before August 10, 1993, such that a section197 intangible had already been created by August 10,1993, the antichurning rules could apply at any point inthe future; whereas if the same business was started onAugust 11, 1993, the antichurning rules could neverapply. This potentially disparate treatment of entitiescreated at different times now appears capricious andunfair.

Finally, if the antichurning rules were to apply toprevent a section 197 intangible from being an amortiz-able section 197 intangible, the rules would apply notonly to prevent the amortization of the value of intan-gible assets subject to the antichurning rules as of August10, 1993, but to all of the increase in value of theintangible assets since then. This result is also unfair,

91To reflect the additional basis, the adjusted basis of theintangible is increased as of the beginning of the month of theaddition, and the additional amount, if amortizable, is amor-tized ratably over the remaining months in the original 15-yearperiod. Reg. section 1.197-2(f)(2)(i). Legislation was proposed,but not enacted, in 2007 that would have caused any gainrecognized by the sellers to be treated as ordinary income ratherthan capital gain for transactions in which there existed a taxreceivables agreement. H.R. 3996, 110th Cong. (1st Sess. 2007).

92The UP-C structure described above, in which the existingpartners retained their interests in the original partnershiprather than converting their partnership interests to corporatestock in a nonrecognition transaction under section 351 at thetime of the creation of the C corporation, provided the followingtax benefits to the existing partners: (1) income earned by the

business that was characterized as capital gain rather thanordinary income would flow through to the partners and betaxed at the lower rates applicable to capital gains; (2) thepartners’ bases in their partnership interests would increase asincome of the partnership was allocated to them, therebyreducing gain on a future exchange of interests for stock; and (3)in the case of a dividend-paying stock, a second level of taxcould be avoided if the distributions from the operating part-nership were made directly to the partners in the partnershiprather than having to pass through a C corporation.

93Section 197(f)(9)(E).94This is, of course, how they make their money.95Although the author believes that the antichurning rules of

section 197(f)(9) should be repealed, to the extent that there arestill lingering concerns of abuse, the antichurning rules could beconverted into a purely antiabuse rule, in which the determina-tion of whether a ‘‘churned’’ intangible should be amortizable ismade on a case-by-case basis.


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given that fledgling businesses in 1993 may have grownto multimillion-dollar enterprises over the past 15years.96

IV. Same Economics, Different Tax Consequences

Since the early 1990s, when it started becoming wide-spread for states to adopt limited liability companystatutes,97 the check-the-box regulations were promul-gated,98 and some aspects of the U.S. federal income taxtreatment of single-member and multiple-member LLCsin Rev. Rul. 99-599 and Rev. Rul. 99-6 were clarified,100 theuse of LLCs to operate privately held businesses hasproliferated. An LLC is classified, for U.S. federal incometax purposes, as either (1) an entity disregarded from itsowner (a disregarded entity) if it has a single member or(2) as a partnership if it has more than one member.101

Operating as an LLC is desirable because an LLC pro-vides the limited liability of a corporation, avoids thedouble taxation associated with C corporations, andprovides more flexibility in terms of the ability to dividethe economics among its equity owners than an S corpo-ration, which can have only one class of stock.102 An LLCalso enables its owners to deliver a basis step-up in theassets of the LLC when interests in the LLC are sold.

For an LLC that is treated as a disregarded entity, ataxable acquisition of an interest in the LLC is treated asan asset purchase,103 and for an LLC that is classified asa partnership, a taxable acquisition of an interest in theLLC from another member will provide a basis adjust-ment under section 743(b) if the LLC has in effect, ormakes for the tax year in which the acquisition occurs, asection 754 election. The ability to deliver a step-up in thebasis of its assets to a buyer can have major pricingimplications in the context of a sale of a business. Notonly is the buyer potentially able to amortize the higherbasis in the tangible assets, but under section 197, to theextent that a portion of the purchase price is allocable to

goodwill or going concern value,104 the purchaser wouldgenerally expect to be able to amortize that amount on astraight-line basis over 15 years. In many cases, most ofthe value of a business is allocated to goodwill or goingconcern value.105 The value of those amortization deduc-tions in reducing the U.S. federal income tax liability ofthe new owners of the business can therefore signifi-cantly increase the price a purchaser would be willing topay for the business. Because of this significant value, theability to amortize the goodwill or going concern valuehas become an issue in many acquisitions, in which it isimportant to ensure that the antichurning rules of section197(f)(9) do not apply to an acquisition for the purchaserto get the value for which it has bargained.

As discussed above, the antichurning rules are gener-ally designed to prevent the amortization of goodwillwhen it would not otherwise be amortizable throughsales to related parties, and provide complicated rules fordetermining when this has occurred. The rules, however,with their focus on form, are overbroad and prevent theamortization of goodwill following bona fide third-partypurchases of businesses, rather than just serving thelegitimate purpose of preventing tax avoidance.

This is best illustrated by an example that shows howone can achieve different results in two transactions thatare almost identical from an economic perspective, withthe antichurning rules seeming to constitute a trap for theunwary or unlucky. In the first situation, a womanstarted a business in 1990 that she operated as a soleproprietorship and that she contributed to a single-member LLC in 2000. When her son graduated frommedical school in 2004, she transferred to him as a gift a1 percent interest in the LLC, even though she wasdisappointed that he would not be joining the busi-ness.106 All of the income, gain, loss, and deductions ofthe LLC were shared by the mother and the son in theratio of 99 to 1. In 2006 an unrelated private equity (PE)fund wanted to buy the business, but wanted the motherto retain a 25 percent equity stake in the business becauseshe would continue to operate the business after theacquisition. Accordingly, the PE fund purchased the son’sentire interest in the LLC and an additional 74 percent ofthe equity of the LLC from the mother.

Assuming that the LLC had in effect, or made for theyear of the acquisition, a section 754 election, the PE fundshould be entitled to a basis step-up in the portion of theassets of the LLC attributable to its ownership interest inthe LLC under section 743(b) that it would then seek toamortize or depreciate to offset the future taxable incomegenerated by the LLC.107 Because a portion of the assetsbeing acquired constitutes goodwill, it is necessary to

96The proof of this is that some of the businesses engaging inthose IPOs were small enterprises in 1993, while other busi-nesses engaging in those IPOs did not even exist then. All ofthose entities are today valued in the many millions of dollars.

97Wyoming first enacted an LLC statute in 1977, followed byFlorida in 1982, but no other states enacted the statutes untilafter the IRS issued Rev. Rul. 88-76, 1988-2 C.B. 360, clarifyingthat LLCs would be treated as partnerships for U.S. federalincome tax purposes. 1977 Wyo. Sess. Laws 512; Fla. Stat. Ann.sections 608.401 to -471. In a matter of a few years, all 50 stateshad enacted them, ending with Hawaii in 1996. Haw. Rev. Stat.Ann. sections 428-101 to -1302.

98Reg. section 301.7701-3.99Rev. Rul. 99-5, 1999-1 C.B. 434, Doc 1999-2045, 1999 TNT

10-6.100Rev. Rul. 99-6, 1999-1 C.B. 432, Doc 1999-2092, 1999 TNT

10-7.101Such a classification assumes that no check-the-box elec-

tion has been made to treat the LLC as a corporation for U.S.federal income tax purposes. This assumption applies to thediscussion of LLCs throughout this article.

102Section 1361(b)(1)(D).103Supra note 99.

104Reg. sections 1.1060-1(a)(1) and 1.338-6. Goodwill andgoing concern value are Class VII assets.

105References to goodwill in the remainder of this reportinclude ‘‘going concern value.’’

106The woman paid all applicable gift taxes on the transfer.107A more common structure would be for the PE fund to use

debt to acquire a portion of the interests, that is, the LLC wouldborrow money that would be distributed to the mother and theson in connection with the acquisition, instead of using 100percent equity. This, however, creates additional complications




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ensure that the antichurning rules do not prevent theamortization of the goodwill. The general rule in section197(f)(9) provides that the goodwill will not be treated asan amortizable section 197 intangible if ‘‘the intangiblewas held or used at any time on or after July 25, 1991, andon or before such date of enactment by the taxpayer or arelated person.’’ Under this general rule, the PE fundwould be the taxpayer, and under the related person ruleof section 707(b)(1), the LLC would be treated as a relatedperson regarding the PE fund because the PE fund ownsmore than 20 percent of the capital and profits interests inthe LLC, so that the antichurning rules would normallyapply to the acquisition. However, the special rule appli-cable to increases in the basis of partnership propertyunder section 743 contained in section 197(f)(9)(E), whichprovides that determinations are made at the partnerlevel and each partner is treated as having owned andused that partner’s proportionate share of the partner-ship assets, applies. As a result, it is the relationshipbetween the ‘‘taxpayer,’’ that is, the PE fund, and themother that must be tested. Because the mother is notrelated to the PE fund, the antichurning rules do notapply.

The facts of the second situation are the same as in thefirst except that in 2003, the PE fund approached thewoman regarding a potential acquisition of the business.The woman owned all of the interests in the LLC becausealthough she intended to gift to her son a 1 percentinterest in the LLC on his graduation from medicalschool, he had not yet graduated. In this case, the PE fundpurchased from the mother 75 percent of the interests inthe LLC. Under Rev. Rul. 99-5, the purchase is treated asan acquisition by the PE fund of a 75 percent undividedinterest in each of the assets of the LLC, followed by acontribution to a newly formed partnership of a 25percent interest in each of the assets of the LLC by themother (with no stepped-up basis) and a contribution ofa 75 percent interest in each of the assets of the LLC bythe PE fund (with a stepped-up basis) under section 721.In this situation, because the PE fund’s basis step-up didnot arise under section 732, 734, or 743, the PE fundcannot rely on section 197(f)(9)(E) to avoid the antichurn-ing rules. Under section 197(f)(2) and reg. section 1.197-2(g)(2), because the partnership acquired the section 197intangible from a person in whose hands it was anamortizable asset in a transaction governed by section721, the section 197 intangible contributed by the PE fundto the LLC should be amortizable by the LLC.

Reg. section 1.197-2(h)(10) and -2(k), Example 18,however, conclude that the antichurning rules apply notonly to the portion of the intangible deemed contributedto the partnership by the mother, but also to the portionof the intangible deemed contributed to the partnershipby the PE fund. Although the original deemed purchaseof the assets was by a party (the PE fund) unrelated to theseller (the mother) such that the antichurning rulesshould not literally apply, at the end of the series oftransactions that are deemed to occur under Rev. Rul.

99-5, the result reached is identical to that in section197(f)(9)(A)(i), because the mother held the assets duringthe transition period and the mother and the partnershipare related persons.108

This rule and the example in the regulations followalmost exactly the suggestion in the New York State BarAssociation (NYSBA) Tax Section’s ‘‘Report on Issues toBe Addressed in Regulations Under Section 197.’’109 TheNYSBA report offered this fact pattern and concludedthat the result under the statute — whether section197(f)(9)(A)(i) should trump section 197(f)(2) — wasunclear. Nevertheless, the NYSBA report suggested thatfor purposes of simplicity, the antichurning rules shouldapply, even though up to 80 percent of the deductionsmay be allocable to the new partner, because it wouldotherwise complicate the capital account maintenancerules if amortization were permitted for the new part-ner’s share of the intangible but not for the continuingpartner’s share of the intangible. Despite the ‘‘simplicity’’of the approach, the result, given the almost identical factpatterns and economics in the two situations describedabove — which are different only because of the timing ofthe PE fund’s purchase relative to the son’s graduationfrom medical school — seems patently unfair.110

One potential solution would be for a taxpayer to usea self-help mechanism in which the taxpayer would sellor transfer a portion of the LLC interest to form a newpartnership before a sale to a third party. Given theform-driven nature of the antichurning rules, one wouldthink this should be permissible. The NYSBA reportdiscussed this type of situation as well — the creation ofa partnership before a sale to a third party of an interestin the partnership for cash. The NYSBA report said the

regarding basis adjustments under section 734(b), which are notnecessary to discuss for purposes of the argument here.

108Although the application of the rules is form-driven, theconclusion reached in the regulations is based on a substance-over-form step transaction approach. In contrast, if one acquiresa section 197 intangible that was an amortizable section 197intangible in the hands of the seller, and the transaction in whichthe intangible is acquired and the transaction in which the selleracquired the intangible are not part of a series of relatedtransactions, the antichurning rules do not apply to the acqui-sition of the intangible, even if the acquirer is related to the partythat sold the intangible to the seller. Reg. section 1.197-2(h)(5)(ii).

109The difference between the fact pattern in the NYSBAreport and the example in the regulations is that the NYSBAreport says that the parties ‘‘previously contemplated’’ thedrop-down at the time of the asset sale, and the regulation saysthat the drop-down occurred ‘‘immediately after’’ the assetpurchase. One can assume that if the drop-down occurredimmediately after the asset purchase, then it was contemplatedat the time of the asset purchase. NYSBA, ‘‘Report on Issues toBe Addressed in Regulations Under Section 197’’ (Jan. 19, 1995),Doc 95-724, 95 TNT 12-20; reg. section 1.197-2(k), Example 18.

110A question to ponder is whether the NYSBA report wouldhave reached a different conclusion on this issue had thecheck-the-box regulations and Rev. Rul. 99-5, 1999-1 C.B. 434,already been issued, and the fact pattern described abovebecome commonplace, when the NYSBA report was drafted.One with a revenue-raising mindset could, of course, argue thatthis disparate treatment could also be eliminated through therepeal of the generally taxpayer-favorable rule in section197(f)(9)(E).



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choice of form should not implicate the antichurningrules, even though the result was the same as under thefacts referenced in section 197(f)(9)(A)(i) and the situationin which there is a disguised sale to a partnership. TheNYSBA report recommended, and Example 17 of reg.section 1.197-2(k) ultimately confirmed, that the anti-churning rules apply. The regulations under section 197adopted the proposal of the NYSBA report in modifiedform. Reg. section 1.197-2(k), Example 19, provides that ifa taxpayer forms a partnership with an affiliate and ‘‘in asubsequent year, in a transaction that is properly charac-terized as a sale of a partnership for Federal income taxpurposes,’’ sells an interest in the partnership to a thirdparty (and the partnership has in effect a section 754election or one is made for the tax year in which thepurchase of the partnership interest occurs), the third-party purchaser may amortize the basis increase in asection 197 intangible held by the partnership. It is left forthe taxpayer to determine whether the step transactiondoctrine might apply to conclude that the sale is notproperly characterized as a sale of a partnership interestfor U.S. federal income tax purposes in a situation inwhich the partnership was formed in contemplation ofthe sale. Also, the example in the regulations states thatthe sale of the partnership interest to a third partyoccurred in a year after the year in which the partnershipwas formed, suggesting that some time may need to passbetween the formation of the partnership and the sale ofthe partnership interest to rely on the favorable conclu-sion reached in the example. The description of the factpattern in the example makes it less than useful in manyof the situations encountered by tax practitioners.111

V. Antichurning Rules Drive the Economic DealEven more troubling are situations, such as the one

described below, in which parties to a legitimate businesstransaction are forced to alter the economic deal to whichthey agreed to avoid the application of the antichurningrules.

A PE fund wanted to acquire an interest in an existingLLC (Opco LLC) that had been formed before August 10,

1993, and was owned equally by a father and son. Thefather was planning to retire, but the son would continueto operate the business after the acquisition by the PEfund. To align the interests of the son with those of the PEfund, the PE fund wanted the son to retain a 25 percentinterest in Opco LLC. A portion of the purchase price wasto be financed using debt, and the remainder with equitysupplied by the PE fund.112 In connection with the loan,the lenders wanted to obtain a lien on all of the assets ofOpco LLC and a pledge of all of the interests in OpcoLLC. Also, the PE fund wanted to ensure it had theunilateral ability to force a sale of the business to a thirdparty without having to rely on a ‘‘drag along’’ right inthe operating agreement of Opco LLC. To accomplishboth of these goals, it was determined that Opco LLCshould become a wholly owned subsidiary of a holdingcompany LLC (Holdco LLC) and that Holdco LLCshould be owned 75 percent by the PE fund and 25percent by the son. That way, Holdco LLC could pledgeto the bank all of the equity of Opco LLC rather thanreceiving a separate pledge of interests in Opco LLC fromthe PE fund and the son. Also, the PE fund, which was incontrol of Holdco LLC, could itself cause Holdco LLC tosell all of the interests in Opco LLC to a purchaser.

From a U.S. federal income tax perspective, this couldeasily be accomplished by having Opco LLC transfer allof its assets and liabilities to a newly formed LLC inexchange for interests in the newly formed LLC. Thattransaction would be disregarded for U.S. federal incometax purposes because the newly formed LLC would be adisregarded entity for U.S. federal income tax purposes.The newly formed LLC would then become the operatingcompany, and Opco LLC would become Holdco LLC.The PE fund could then purchase 75 percent of theinterests in Holdco LLC and would be entitled to a basisstep-up under section 743(a), assuming a section 754election were in place or were made by Opco LLC for theyear in which the purchase occurred, and the portion ofthe goodwill of the business indirectly purchased by thePE fund would be amortizable by the PE fund. Such astructure would have been impractical, if not impossible,from a corporate law perspective because it would haverequired an asset transfer and obtaining all of the attend-ant consents.

Instead it was determined that the PE fund wouldcreate a new LLC, Holdco LLC. The PE fund wouldcontribute the cash that would be used to purchase theinterests in Opco LLC to Holdco LLC. The formation ofHoldco LLC and the contribution of cash to Holdco LLCwould be disregarded for U.S. federal income tax pur-poses because Holdco LLC would be wholly owned bythe PE fund. It was then contemplated that the son wouldcontribute a 25 percent interest in Opco LLC to HoldcoLLC in exchange for a 25 percent interest in Holdco LLC,which would enable the son to retain his continuinginterest in the business. The son’s contribution of thisinterest in Opco LLC to Holdco LLC in exchange for an

111This example changed from the proposed regulationsunder section 197 issued in 1997 to the final regulations thatwere issued in 2000. Notice of Proposed Rulemaking (REG-209709-94), 62 Fed. Reg. 2336 (Jan. 16, 1997), prop. reg. section1.197-2(k), Example 17; T.D. 8865, 65 Fed. Reg. 3820 (Jan. 25,2000), reg. section 1.197-2(k), Example 19. In the proposedregulations, this example said that the taxpayer formed thepartnership with an affiliate and that the partnership interestwas sold in an unrelated transaction. That language impliedthat if the partnership were formed in connection with the saleto the third party, no amortization would be permitted. Thepreamble to the final Treasury regulations stated that, in re-sponse to comments that the concept of an unrelated transactioncreates a new standard for making determinations, the languageof the example was changed and that existing step transactionprinciples would apply to making the determination of whetheramortization would be permitted. This change would not seemto alter the result in a material way, but effectively admits asubstance-over-form standard into these formalistic rules toreach a result that is less favorable to the taxpayer.

112The use of debt and the implications of a basis step-upunder section 734(b), while interesting to consider, are notnecessary for purposes of this example.



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interest in Holdco LLC would cause Holdco LLC tobecome a partnership for U.S. federal income tax pur-poses, with the PE fund treated as having contributed tothe partnership the cash that was in Holdco LLC.113

Holdco LLC would then acquire all of the interests of thefather and the remaining interests of the son in OpcoLLC, such that Holdco LLC would own all of the interestsin Opco LLC. When Holdco LLC acquired the 75 percentof Opco LLC that it did not already own, that transactionwould be treated as an asset purchase for U.S. federalincome tax purposes.114 Holdco LLC would have astepped-up basis in 75 percent of each of the assets ofOpco LLC as a result of the deemed asset purchase.115

Because Holdco LLC would be treated as related to theson, who maintained a 25 percent continuing interest inHoldco LLC, Holdco LLC would not be entitled toamortize the basis step-up attributable to the goodwillthat was acquired.116 In this case, a transaction form thatwould have been undertaken for a valid business pur-pose, and when the same end result could have beenachieved with amortization of the acquired goodwill ifthe corporate law issues associated with asset transfersdid not exist, could not be used to achieve the desiredresult because of the application of the antichurningrules.117 Ultimately, the parties determined that to avoidthe antichurning rules, the son would retain less than a 20percent interest in Holdco LLC. The parties were re-quired to change the business deal to achieve the amor-tization of the goodwill.

VI. Conclusion

The repeal of section 197(f)(9), the antichurning rules,would serve several important policy goals. Althoughmany obstacles would remain, the repeal of section197(f)(9) would be one small step toward tax simplifica-tion. It would promote fairness by eliminating the dis-parate treatment of taxpayers acquiring section 197intangibles that were created on or before August 10,1993, and taxpayers acquiring intangibles that were cre-ated after that date, as well as the inability to amortizesection 197 intangibles that are subject to the antichurn-ing rules, even though their value today may be 100

times greater than it was on August 10, 1993.118 Finally, itwould promote economic efficiency by enabling tax-payers to structure their transactions as they deem ap-propriate — for example, by encouraging managementrollovers of more than 20 percent of the equity of thebusiness in private equity transactions that may beconsidered important to the success of the transaction —rather than with a view to avoiding the application of theantichurning rules.

113Supra note 99.114Supra note 100.115Holdco LLC would not obtain a basis step-up regarding

the portion of the assets of Opco LLC that were deemed to havebeen contributed to Holdco LLC in connection with the forma-tion of the Holdco LLC partnership.

116Reg. section 1.197-2(k), Example 17.117The transaction could also have been structured by having

Holdco LLC purchase the LLC interests from the father and theson before the son’s contribution of the Opco LLC interests toHoldco LLC. In that case, Holdco LLC would have acquired aninterest in a partnership and a basis step-up under section 743,assuming a section 754 election was in effect or was made forthe year of the acquisition. However, given that the twotransactions would be occurring under a plan, the concern wasthat the IRS would view both the purchase of the partnershipinterests and the contribution of the Opco LLC interests by theson to Holdco LLC as a single asset acquisition, resulting in thesame U.S. federal income tax consequences as discussed above.

118If the repeal of section 197(f)(9) were deemed too drastic,another approach would be to limit the nonamortizable portionof the section 197 intangible to its value on August 10, 1993. Butbecause that approach would result in valuation issues, it wouldlikely result in controversy and prove less efficient than repeal.Given the time that has passed since those rules were firstenacted and the potential increase in value of any section 197intangibles in the intervening period, one would expect therelative loss of revenue to the government resulting from arepeal of section 197(f)(9), as compared to the compromiseposition, to be insignificant.



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Failing to Talk to Yourself —A FIRPTA Tax Trigger

By John B. Magee and F. Scott Farmer

‘‘Facts do not cease to exist because they are ignored.’’

— Aldous Huxley, Proper Studies (1927)

A. Introduction

The Foreign Investment in Real Property Tax Act of1980 (FIRPTA) added to the Internal Revenue Code asubstantive liability for dispositions of U.S. real propertyinterest under section 897 of the code.1 In 1984 a comple-mentary withholding tax regime was added in section1445.2 Both the statutes and their underlying regulationsare extremely complex and cover a wide range of circum-stances. This article is concerned only with the limitedcircumstances in which foreign-owned U.S. corporategroups may run afoul of these rules for failure to providetimely information between members of the group whencertain events occur and to notify the Internal RevenueService. In particular, it is our view that the remedialreporting rules adopted in Rev. Proc. 2008-273 as apreliminary substitute for the increased number of tax-payer requests for relief under reg. section 301.9100-1 and

reg. section 301.9100-34 regarding the FIRPTA regime areinadequate as applied to the circumstances discussed inthis article. The limited foreign controlled U.S. corporategroup circumstances we consider would be more effec-tively dealt with by regulations that created a presump-tion of FIRPTA liability in these circumstances that couldbe rebutted on audit of the domestic corporate group.

The simplest paradigm for our foreign controlled U.S.corporate group is the circumstance in which a foreigncorporation (FP or FS) owns 100 percent5 of a domesticcorporation (US), and US either owns no real propertyinterests in the United States, or plainly falls below the 50percent fair market value threshold for a U.S. real prop-erty holding corporation (USRPHC) set forth in section897(c)(2).6 Our simplified potential tax triggers includeFP (or FS) reorganizing the US holdings outside theUnited States, receiving a distribution from US in excessof its earnings and profits, or making a distributionregarding its interest in US. The statutes and regulationscreate a binding presumption of tax liability in thesecircumstances unless US provides a timely written state-ment to the foreign transferee that it is not a USRPHCunder section 897(c)(2) and notifies the IRS within aspecified period of time (the statement/notification pro-cedural requirements).7

Failure to timely comply with these procedural re-quirements could trigger U.S. tax on the entire gainrealized on the transfer, as well as interest and penalties.

1FIRPTA was part of the Omnibus Reconciliation Act of 1980.Section 1122(a) of that public law added section 897 to theInternal Revenue Code. Unless otherwise indicated, all refer-ences to ‘‘section’’ or ‘‘sections’’ herein are to the InternalRevenue Code of 1986, as amended as of the relevant date; allreferences to ‘‘reg.,’’ ‘‘temp. reg.,’’ or ‘‘regulations’’ are toregulations of the U.S. Department of Treasury, as most recentlyadopted, proposed, or amended as of the relevant date.

2Tax Reform Act of 1984, section 129(a)(1) (adding section1445 effective for any disposition on or after January 1, 1985). In1980 the Senate version of the bill contained a withholdingprovision, but it was dropped in conference to carefully struc-ture the withholding provision. Enactment of a withholdingprovision was further delayed in part by a delay in reportingregulations under sections 897 and 6039C.

32008-21 IRB 1014, Doc 2008-10592, 2008 TNT 94-6.

4Reg. section 301.9100 provides a mechanism under whichthe commissioner may grant extensions for some filing failuresupon demonstration of reasonable action and good faith.

5Our analysis should apply equally to an 80 percent con-trolled group as defined in section 1504(a), but without regardto section 1504(b)(3). As discussed herein, this is the definitionadopted in the section 7874 regulations, and we believe it wouldadequately address most circumstances that we are aware ofwhen these issues arise.

6Section 897(c)(2) defines USRPHC as any corporation if (A)the FMV of its U.S. real property interest equals or exceeds 50percent of (B) the FMV of (1) its U.S. real property interests, (2)its interests in real property located outside the United States,plus (3) any other of its assets that are used or held for use in atrade or business. For purposes of FIRPTA, real propertyinterests include not only ownership of traditional real estateinterests such as land, improvements, and structures, but alsomovable walls, furnishings, and other personal property asso-ciated with the use of real property. Section 897(c)(6); reg.section 1.897-1(b); see also Announcement 2008-115, 2008-48 IRB1228, Doc 2008-25185, 2008 TNT 231-6 (announcing the publica-tion of a notice of proposed rulemaking (REG-130342-08) on thedefinition of an interest in real property under section 897(c),addressing the rights granted by a government unit that arerelated to the lease, ownership, or use of real property).

7The tax liability and procedural requirements are discussedin more detail below.

John B. Magee and F. Scott Farmer are partners withMcKee Nelson LLP in Washington. They gratefullyacknowledge the assistance of Cornelia J. Schnyder,counsel to the firm, for her assistance in the prepara-tion of this article. This article was originally pre-sented as a paper to the Washington International TaxStudy Group.

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The amounts at issue can be large, and even though theprospects are high for correcting the failure under Rev.Proc. 2008-27 or through the reg. section 301.9100 reliefprocess, there is some risk that a request for more timecould be denied, resulting in the imposition of tax.8 Andbecause the taxpayer subject to U.S. tax on the gain undersection 897 is a foreign corporation that typically has notfiled U.S. returns because it is not otherwise subject toU.S. tax, the statute of limitations remains open. Simi-larly, assuming that no withholding return has been filedreflecting the transaction, the statute of limitations onwithholding tax liability also remains open.9

Although taxpayers and practitioners are generallyaware of the FIRPTA provisions, in our experience therehas been frequent inattention to the procedural require-ments, creating exposure to gain recognition when thedisposition transactions relate to stock ownership of U.S.corporations that clearly fell below the 50 percent FMVthreshold in section 897(c)(2) (the substantive rules).Although practitioners frequently check the FMV of realestate,10 they often overlook the procedural requirementsnecessary to avoid a FIRPTA tax on gains. These omis-sions created a flood of reg. section 301.9100 reliefrequests, starting in 2005 with a request for which theauthors were responsible,11 and reaching a peak in 2007and 2008.

Rev. Proc. 2008-27 is a response to these increasingrequests and deflects them to Ogden, Utah, under asimplified procedure. Under the revenue procedure, thetaxpayer’s submission is deemed to have establishedreasonable cause for late compliance if the taxpayer hasnot been notified within 120 days that the IRS hasdetermined that its noncompliance was not supported byreasonable cause or that additional time is needed for thedetermination.12 Only if denied relief under the revenueprocedure is the taxpayer required to file a private letterruling application under reg. section 301.9100. It is tooearly to gauge how this process will be administered inpractice, but, as discussed below, we believe morechanges should be made to the regulations to addressforeign controlled group situations more appropriately.13

B. Illustrative Transactions

The following are four relatively common situationsthat will trigger FIRPTA substantive and withholding taxliabilities if the statement/notice reporting provisionsdescribed here are not followed. They are presented herefor purposes of illustration. Under section 897(c)(1)(A),dispositions of any interest in a domestic corporationother than as a creditor will trigger these rules. Simpleadditional examples would include changes in owner-ship of preferred stock or options held by foreign parties.

Situation 1. US makes a distribution to FP in excess of itsE&P.

Situation 2. FS distributes its US stock to FP.

Situation 3. FP checks the box to treat FS as a disregardedentity.14

8See recommendations below.9Although in situations 2, 3, and 4 (illustrated below) it may

be difficult for the IRS as a practical matter to collect any suchtax (both the taxpayer and the withholding agent are foreigncorporations, and their only U.S. asset is stock of US), fewforeign-owned U.S. groups are willing to rely on uncollectibilityto resolve the issue.

10Reg. section 1.897-2(b)(2) contains a presumption that thereal property interests are less than 50 percent of the FMV if thebook value of those interests is 25 percent or less of book value.

11The authors were reviewing the FIRPTA implications of aproposed distribution in excess of E&P by a U.S. corporation toits foreign shareholder. Our FIRPTA inquiry revealed a series ofprevious restructurings involving the U.S. stock, which requiredrelief under reg. section 301.9100.

12Rev. Proc. 2008-27, 2008-21 IRB 1014.13See also Kenneth J. Krupsky, ‘‘New Relief for Failure to File

No-Withholding FIRPTA Certificates: Secret Law?’’ 37 TaxMgm’t Int’l J. 685 (Nov. 14, 2008), raising the issue of private lawdeveloping at the service center level.

14A similar issue arises when FP sells the stock of FS and thebuyer makes a section 338 election, which treats a stock pur-chase as an asset acquisition. That scenario presents additionalissues regarding the proper application of the procedural re-quirements, given that the election likely postdates the date ofdisposition of the stock. See section 338(g)(1), providing that theelection must be made no later than the 15th day of the 9thmonth beginning after the month in which the acquisition

FP

US

$100Basis = $20

E&P = $80

Figure 1. Situation 1

FP

US

FS

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Situation 4. FP contributes stock of US to FS.

C. A Brief Review of FIRPTA Rules

1. Substantive FIRPTA liability. Under section 897(a)(1),a foreign corporation is taxed on gain from the disposi-tion of a United States real property interest undersection 882(a)(1)15 as if it were engaged in a trade orbusiness within the United States and the gain wereeffectively connected with that trade or business.16 Mostof the problems we focus on are attributable to section897(c)(1)(A)(ii), which defines a U.S. real property inter-est to include any interest in any domestic corporation(other than solely as a creditor), unless the taxpayerestablishes in the time and manner directed by theTreasury regulations that at no time during the five-yearperiod ending on the date of the disposition was it aUSRPHC. As discussed in more detail below, the generalrule for withholding under section 1445(a) is 10 percentof the amount realized on the disposition of a UnitedStates real property interest. A 10 percent rate appliesspecifically to section 301 distributions from a domesticcorporation that is a USRPHC to a foreign person to the

extent that the distribution exceeds E&P and to section302 distributions of property to a foreign person.17

The term ‘‘disposition’’ is broadly defined in reg.section 1.897-1(g) as ‘‘any transfer that would constitute adisposition by the transferor for any purpose of theInternal Revenue Code and regulations thereunder.’’ Reg.section 1.897-1(h) provides that gain or loss from adisposition of the United States real property interest is‘‘the amount determined as provided in section 1001(a)and (b).’’ Also, that gain or loss is subject to section897(a), unless a nonrecognition provision in section897(d)(2) or (e) applies.18

Section 897(d)(1) states that except as otherwise pro-vided in regulations, a foreign corporation recognizesgain for section 897(a) purposes on its distribution (in-cluding a distribution in liquidation or redemption) of aU.S. real property interest in an amount equal to theexcess of FMV of that interest over its adjusted basis.19 A35 percent withholding rate applies to gain on thesedispositions.20

2. Binding presumption of USRPHC status. Pursuant tothe regulatory authority in section 897(c)(1)(A)(ii), reg.section 1.897-2 sets forth the required proof of a domesticcorporation’s exclusion from classification as a USRPHC.Reg. section 1.897-2(g)(1)(i) provides that the foreigncorporation must establish that the domestic corporationis not a U.S. real property holding corporation as of thedate of disposition, either by obtaining a statement fromthe domestic corporation in accordance with reg. section1.897-2(g)(1)(ii), or by obtaining a determination by thecommissioner under reg. section 1.897-2(g)(1)(iii). If theforeign person fails to implement either proof mecha-nism, the interest in the domestic corporation is pre-sumed to have been a U.S. real property interest and thestatutory liability is triggered.

Although presumptions in tax law are frequentlyrebuttable, this presumption appears to be binding,based on the structure and operation of the regulation.The private letter rulings regarding relief under reg.section 301.9100 confirm that this is the IRS’s interpreta-tion of the rules. Reg. section 1.897-2(a) describes thestructure of the regulation and states:

Paragraph (g) explains the manner in which aninterest-holder can establish that a corporation isnot a U.S. real property holding corporation, andparagraph (h) provides rules regarding certain no-tification requirements applicable to corporations.The statement/notification mechanics for avoiding tax

by establishing non-FIRPTA status are as follows. Theforeign corporation requests and obtains from the domes-tic corporation a statement under penalties of perjurythat an interest in the corporation was not a U.S. realproperty interest.21 To rely on a statement from thedomestic corporation, the foreign person ‘‘must obtainthe [domestic] corporation’s statement no later than the

occurred. For instance, does old FS need to request a statementfrom US to give to itself (as new FS) when the deemed sale of thestock of US occurs?

15Net based taxation.16FIRPTA has equal application to nonresident alien indi-

viduals. See section 897(a)(1)(A); section 897(a)(2).

17Section 1445(e)(3).18Reg. section 1.897-1(h).19Temp. reg. section 1.897-5T(c) has similar provisions.20Section 1445(e)(2).21Reg. section 1.897-2(g)(1)(ii)(A).

FP

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FS

FP

US

FS

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due date, including any extensions, on which a tax returnwould otherwise be due regarding the disposition.’’22

However, this statement is valid only if the domesticcorporation complies with the notice requirements of reg.section 1.897-2(h)(2) (or -2(h)(4)). Reg. section 1.897-2(h)(2) requires that notice with certain information mustbe provided to the IRS at the FIRPTA unit in Philadelphiaon or before the 30th day after the statement was mailedto the interest holder that requested it. Failure to providethe notice to the IRS within that time period will invali-date the statement provided to the interest holder underreg. section 1.897-2(h)(1).23 Under reg. section 1.897-2(h)(4), if the domestic corporation has provided a vol-untary notice to the IRS with its last tax return and hasnot had an event described in reg. section 1.897-2(c)(1)(ii)- (iv) (acquisitions of realty or dispositions of trade orbusiness assets), the notice does not need to be sent to theIRS. This rule does not eliminate the need for (1) theforeign corporation to request a statement of non-FIRPTAstatus from the domestic corporation, or (2) the domesticcorporation’s statement of non-FIRPTA status to be givento the foreign corporation.

Reg. section 1.897-2(g)(1)(ii)(B) provides a coordina-tion rule with section 1445 eliminating withholding li-ability for the transferee if it receives the corporation’sstatement. As discussed below, the section 1445 rulesgenerally require that the statement be received by thetransferee before the transfer at issue, so that the state-ment requirements for section 1445 purposes typicallymust be satisfied earlier than may be required undersection 897.

The taxpayer may also satisfy the proof requirementsby obtaining a commissioner’s determination under reg.section 1.897-2(g)(1)(iii)(B), (C), or (D), but these rules arenot typically applicable to the foreign controlled U.S.corporate group transactions we are focusing on here.The mechanics in (B) and (C) also require that thetaxpayer make timely filings. For example, both (B) and(C) appear to contemplate situations in which the tax-payer has sought a statement from the U.S. corporationand has received no response from the U.S. corporationor has adequate information in its possession that wouldallow the commissioner to make the determination. Cu-riously, (D) appears to allow the commissioner upon hisown motion to determine, at any time, that a U.S.corporation is not a USRPHC. Given that the commis-sioner previously has allowed taxpayers relief onlythrough a reasonable cause showing under reg. section301.9100-3 or Rev. Proc. 2008-27, it seems unlikely that thecommissioner would unilaterally make that determina-tion on a basis different from reasonable cause. We areunaware of any situation in which the commissioner hasindependently exercised this authority.

Accordingly, even where the controlled group knowsthat US is not a USRPHC because its real estate is toosmall a fraction of its business assets to be anywhere nearthe 50 percent threshold or the 25 percent or less bookvalue test, FP (or FS) must timely request from its

controlled US subsidiary a statement of a known fact, andthe subsidiary must file an additional notice with the IRSto avoid the binding presumption of taxable gain.3. The USRPHC determination. Determining whether adomestic corporation is a USRPHC at any time within thefive years preceding the disposition is not as simple asjust asserting that the domestic corporation cannot be aUSRPHC because it holds insignificant real property inthe United States or the U.S. Virgin Islands. The state-ment must be signed under penalties of perjury, whichrequires care in the determination process.

Under section 897(c)(2) and reg. section 1.897-2(b)(1),establishing non-USRPHC status by satisfying the lessthan 50 percent test requires the domestic corporation todetermine the FMV of its United States real propertyinterests, its interests in real property located outside theUnited States (that is, foreign real property), and anyother of its assets that are used or held for use in a tradeor business.24

For purposes of the FIRPTA rules, real property in-cludes the following three categories of property: landand unsevered natural products of the land, improve-ments, and personal property associated with the use ofreal property.25

The term ‘‘interest in real property’’ includes feeownership and co-ownership of land or improvementsthereon, leaseholds of land or improvements thereon,options to acquire land or improvements thereon, andoptions to acquire leaseholds of land or improvementsthereon.26 An interest in real property other than aninterest solely as a creditor includes a fee ownership,co-ownership, or leasehold interest in real property, atime-sharing interest in real property, and a life estate,remainder, or reversionary interest in such property.27

The term also includes any direct or indirect right toshare in the appreciation in the value of, or in the gross ornet proceeds or profits generated by, the real property.28

The term ‘‘asset used or held in a trade or business’’includes:

• Property, other than a U.S. real property interest,that is: ‘‘[s]tock in trade of an entity or otherproperty of a kind which would properly be in-cluded in the inventory of the entity if on hand at

22Id.23Reg. section 1.897-2(h)(2)(v).

24The alternative book value test referred to above is foundin reg. section 1.897-2(b)(2). Although this simple alternative istypically the preferred method, it is still difficult to comply withand often may not be available. It requires that the books becomputed according to U.S. generally accepted accountingprinciples, rather than the international accounting standardsmore generally used by foreign-owned U.S. corporate groups.Also, the presumption as to the FMV of a corporation’s U.S. realproperty interests provided by the alternative test may bedenied in some circumstances, under reg. section 1.897-2(b)(2)(iii).

25Reg. section 1.897-1(b)(1). Local law definitions will not becontrolling for purposes of determining the meaning of the term‘‘real property’’ as it is used in sections 897, 1445, and 6039C andthe regulations thereunder. Id.

26Section 897(c)(6)(A).27Reg. section 1.897-1(d)(2)(i).28Id; see also supra note 6.



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the close of the taxable year, or property held by theentity primarily for sale to customers in the ordinarycourse of its trade or business,’’29 or ‘‘depreciableproperty used or held for use in the trade orbusiness, as described in section 1231(b)(1) butwithout regard to the holding period limitations ofsection 1231(b).’’30

• ‘‘Goodwill and going concern value, patents, inven-tions, formulas, copyrights, . . . trademarks, tradenames, franchises, licenses, customer lists, and simi-lar intangible property, but only to the extent thatsuch property is used or held for use in the entity’strade or business and subject to the valuation rulesof section 1.897-1(o)(4).’’31

• ‘‘Cash, stock, securities, receivables of all kinds,options or contracts to acquire any of the foregoing,and options or contracts to acquire commodities,but only to the extent that such assets are used orheld for use in the corporation’s trade or businessand do not constitute U.S. real property interests.’’32

• A proportionate share of the property, other than aUnited States real property interest, described in theabove three categories that is owned by a partner-ship, trust, estate in which a person holds an inter-est, or that is owned by a corporation in which aperson holds a controlling interest.33

The domestic corporation also must consider when tomake its determination of status as a USRPHC. Onceagain, the determination date rules are far from simple. Itcan be as simple as at the end of each tax year.34 Or theremay be multiple determination dates, such as the date ofacquisition of any U.S. real property interest, the date on

which the corporation disposes of foreign real property,or the date of disposition of certain trade or businessassets.35

4. Withholding under section 1445. Section 1445(a) pro-vides as a general rule that in the case of any dispositionof a U.S. real property interest, as defined in section897(c), by a foreign person (which includes foreigncorporations and foreign partnerships),36 the transfereemust deduct and withhold a tax equal to 10 percent of theamount realized37 on the disposition.38

Section 1445(b) provides several exemptions to thegeneral withholding rule of section 1445(a) that generallyparallel the rules in section 897. Section 1445(b)(6) ex-empts the disposition of a U.S. real property interest if‘‘the disposition is of a share of a class of stock that isregularly traded on an established securities market.’’39

The regulations explain the scope of other exemptions byproviding that in general, a transferee has a duty towithhold under section 1445(a) only if both of the follow-ing are true:

• the transferor is a foreign person; and• the transferee is acquiring a U.S. real property

interest.40

However, the transferee must comply with the pro-cedures in the regulations to ascertain whether liability isrelieved because one or the other of these two elements ismissing.41 The procedures depend on the transaction atissue.42

29Reg. section 1.897-1(f)(1)(i)(A).30Reg. section 1.897-1(f)(1)(i)(B).31Reg. section 1.897-1(f)(1)(ii).32Reg. section 1.897-1(f)(1)(iii). ‘‘Assets described in para-

graph (f)(1)(iii) of this section shall be presumed to be used orheld for use in a trade or business, in an amount up to 5 percentof the fair market value of other assets used or held for use inthe trade or business. However, the rule of this paragraph(f)(3)(i) shall not apply with respect to any assets described inparagraph (f)(1)(iii) of this section that are held or acquired forthe principal purpose of avoiding the provisions of section 897or 1445.’’ Reg. section 1.897-1(f)(3)(i).

33Reg. section 1.897-1(e)(1). This applies only to a corporationin which a person holds a controlling interest. In such a case, theactual interest in the controlled corporation is not itself takeninto account. Reg. section 1.897-2(e)(3)(iii). However, if a personholds less than a controlling interest in the stock of a domesticor foreign corporation, that interest in the corporation is itselfconsidered a U.S. real property interest unless it can be shownthat the corporation in which the person owns stock is not a U.S.real property holding corporation. There is no look-through tothe assets of the corporation in which the person does not owna controlling interest. Section 897(c)(1)(A)(ii); reg. section 1.897-2(e)(1).

34Reg. section 1.897-2(c)(1)(i).

35Reg. section 1.897-2(c)(1)(ii) and (iii). These are additionaldetermination dates because it is more likely that after suchtransactions the domestic corporation has become a USRPHC.

36For purposes of section 1445, the term ‘‘foreign person’’means any person other than a United States person. Section1445(f)(3). The term ‘‘United States person’’ is not defined insection 1445 or the regulations thereto. Section 7701(a)(3) definesa United States person as a citizen or resident of the United States,a domestic partnership, a domestic corporation, and some trustsand estates. Section 7701(a)(1) defines person as an individual,trust, estate, partnership, association, company, or corporation.

37The amount realized by the transferor of a U.S. realproperty interest is equal to the sum of (1) cash paid, or to bepaid; (2) the FMV of other property transferred; and (3) theoutstanding amount of liability assumed by the transferee or towhich the transferred U.S. real property interest was subject toboth before and after the transfer. Reg. section 1.1445-1(g)(5).

38Section 1445(e)(3) also imposes a withholding obligationunder section 1445(a) in the case of certain distributions (that is,redemptions under section 302(a), taxable liquidating distribu-tions under section 331, and a return of capital distributionunder section 301(c)) from a U.S. real property holding corpo-ration, as defined in section 897(c)(2).

39See reg. sections 1.1445-2(c)(2) and 1.1445-5(b)(4)(ii).40Reg. section 1.1445-2(a).41Id.42For example, section 1445 has a parallel exception from

withholding for some nonrecognition transactions. Under reg.section 1.1445-2(d)(2), a transferee is not required to withhold ifthe transferor provides notice to the transferee that, by reason ofthe operation of a nonrecognition provision of the code or theprovisions of any U.S. treaty, the transferor is not required torecognize any gain or loss regarding the transfer. The noticemust include the information described in reg. section 1.1445-2(d)(2)(iii). The transferee must provide a copy of the notice to




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For purposes of this article, the procedure that paral-lels the section 897 statement process in the context of aforeign controlled group is section 1445(b)(3), whichrelieves the transferee’s withholding duty if the nonpub-licly traded domestic corporation provides an affidavitstating, under penalty of perjury, that:

• the domestic corporation is not and has not been aU.S. real property holding corporation during theapplicable period; or

• as of the date of the disposition, interests in suchcorporation are not U.S. real property interests byreason of section 897(c)(1)(B) (the so-called cleansingrule in which the corporation disposed of all of itsU.S. real property interests in transactions in whichall gain was recognized).

Under reg. section 1.1445-2(c)(3), section 1445(b)(3)(A)is satisfied if the transferor provides the transferee withthe statement issued by the domestic corporation underpenalties of perjury in accordance with reg. section1.897-2(h).43 At the request of the transferor, the domesticcorporation can provide the statement directly to thetransferee.44 The transferor must request the statementbefore the transfer, and at the time of the transfer, thetransferor or the transferee must have the statement inhand.45

Section 1445(e) provides special rules for certain dis-positions and distributions, including distributions byforeign corporations.46 Section 1445(e)(2) and reg. section1.1445-5(d) provide that in the case of any distribution bya foreign corporation on which gain is recognized by theforeign corporation under section 897(d) or (e), the for-eign corporation is required under section 1445(e) towithhold a tax equal to 35 percent of the amount of gain

recognized. Withholding is not required if no gain isrequired to be recognized by reason of the operation of anonrecognition provision or provision of any treaty of theUnited States, but only if notice requirements are com-plied with.47

Withholding is also not required in two other circum-stances. First, it is not required if the foreign corporationdetermines that the property distributed is not a U.S. realproperty interest.48 The foreign corporation must makethat determination in compliance with the procedures inthe regulations.49 Reg. section 1.1445-5(b)(4)(iii) providesone method involving the transferor’s receipt of thestatement from the domestic corporation issued underreg. section 1.897-2(h),50 and reg. section 1.1445-5(b)(4)(ii)provides another method for interests in publicly tradedentities. Second, withholding is not required regarding aforeign corporation’s distribution of a U.S. real propertyinterest if the distributing corporation obtains a with-holding certificate from the IRS under reg. section 1.1445-6.51

5. Does absence of gain avoid the rules? Unfortunately,the absence of gain does not clearly remove the transac-tion from the scope of the rules. Although there would beno substantive tax liability and no related withholdingtax liability in the absence of gain from the disposition,there is still potential exposure for interest under reg.section 1.1445-1(e)(3)(ii) from the date the withholdingwas required to the date the IRS issues a withholdingcertificate establishing that the transferor’s maximum taxliability is zero. The relief originally announced in Notice2006-9952 for potential exposure for interest and penal-ties, under reg. section 1.1441-1(b)(7) before amend-ment,53 for failure to withhold under section 1441 or 1442when there was no substantive tax liability, was notextended to withholding under section 1445, and theregulations under section 1445 have not been amended.

The policy rationale for the changes to section 1441appears to be based on the notion that withholding issimply a means of collecting what is otherwise thesubstantive tax and thus should not result in greaterliability to the withholding agent than the substantive taxliability. Even though section 1445 withholding normallyis applied at a 10 percent rate on the amount realized

the IRS within 20 days of the transfer. Reg. section 1.1445-2(d)(2)(i)(B). Similarly, in transfers described in section 1445(e),an entity or fiduciary otherwise required to withhold is notrequired to withhold if, by reason of the operation of a nonrec-ognition provision of the code or the provisions of any U.S.treaty, no gain or loss is required to be recognized by the foreignperson with respect to which withholding would otherwise berequired. Reg. section 1.1445-5(b)(2)(i)(A). Withholding is notrequired if, within 20 days of the transfer, the entity or fiduciarydelivers a notice to the IRS that includes the informationdescribed in reg. section 1.1445-5(b)(2)(ii). See reg. section1.1445-5(b)(2)(i)(B).

43Reg. section 1.897-2(g)(1)(ii)(B) provides a coordinationrule with section 1445, such that the statement for section 897satisfies the affidavit requirement of section 1445. Also, thedomestic corporation could get such a determination from theIRS. Reg. section 1.897-2(g)(1)(iii).

44Reg. section 1.1445-2(c)(3)(i).45Id.46Other special rules include: withholding on some disposi-

tions of U.S. real property interests by a domestic partnership,domestic trust, or domestic estate (section 1445(e)(1)); withhold-ing on distributions by some domestic corporations to foreignshareholders (section 1445(e)(3)); taxable distributions by do-mestic or foreign partnerships, trusts, or estates (section1445(e)(4)); rules relating to dispositions of interests in suchentities (section 1445(e)(5)); and some distributions by a regu-lated investment company or real estate investment trust (sec-tion 1445(e)(6)). These other special rules are not the subject ofthis article.

47Reg. section 1.1445-5(d)(1); reg. section 1.1445-5(b)(2).48Reg. section 1.1445-5(d)(2)(i).49Id. The regulation’s cross-reference to (b)(3) should be to

(b)(4).50Reg. section 1.1445-5(b)(4)(iii)(A) refers only to the domes-

tic corporation’s statement that the interest is not a U.S. realproperty interest. The regulation does not address a determina-tion by the commissioner.

51Reg. section 1.1445-5(d)(2)(ii).522006-2 C.B. 907, Doc 2006-22022, 2006 TNT 209-11.53See T.D. 9323, 72 Fed. Reg. 18,386 (Apr. 12, 2007), Doc

2007-9302, 2007 TNT 71-11, retroactively incorporating Notice2006-99 into the regulations under section 1441 (and thus section1442). Before T.D. 9323, reg. section 1.1441-1(b)(7)(iii) providedthat a withholding agent that failed to withhold tax for reasonsother than reliance on the appropriate presumptions is notrelieved from liability for interest under section 6601. It furtherprovided that such liability exists even when there is nounderlying tax that is ultimately shown to be due.



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without regard to the ultimate tax liability of the tax-payer, it is difficult to discern why the policy rationalewould not apply to section 1445 obligations. As notedabove, however, nothing explicitly exempts section 1445liability for interest or potential penalties in these circum-stances.54

When a domestic corporation makes a distribution inexcess of earnings and profits to a foreign shareholder,section 1445(e)(3) and reg. section 1.1445-5(e) require awithholding tax equal to 10 percent of the value of theamount distributed, without regard to any determinationof whether the excess distribution exceeds the recipient’sbasis in the stock of the domestic corporation. Althoughas illustrated in Situation 1, FP would not have a sub-stantive tax liability under section 897, US’s failure towithhold potentially raises, again, the section 1445 inter-est and penalty exposures discussed above.6. Surely there are some exceptions. Despite the sharedknowledge of non-USRPHC status that is apparent in ourforeign controlled U.S. corporate group paradigm, underthe current regulation structure there are no applicableexceptions or exclusion that would avoid the need fortimely compliance with the procedural requirement toavoid application of both sections 897 and 1445.7. Zero current real property holdings. Section897(c)(1)(B) excludes from the term ‘‘United States realproperty interest’’ any interest in a corporation if, at thedate of disposition, the corporation has zero U.S. realproperty interests and all of the U.S. real propertyinterests held by it during the five-year period ending onthe disposition date were disposed of in taxable transac-tions. This appears to be a complete override, withoutrequired regulations, of the USRPHC status conferred bysection 897(c)(1)(A)(ii) on interests in domestic corpora-tions generally. Nevertheless, the regulations implement-ing (A) seem to override the statutory structure. Reg.section 1.897-2(a) makes paragraph (g) of that section theexclusive means of establishing an exemption. While reg.section 1.897-2(f) reiterates the statutory rule exemptingdomestic corporations with zero real property from thestatus conferred by (A), it seems reasonable to interpretthe regulations as requiring compliance with the proce-dural rules of reg. section 1.897-2(g). Finally, the rule in(B) is referred to explicitly in the context of the statementrequirement in reg. section 1.897-2(h)(1)(ii).8. Publicly traded domestic stock. Section 897(c)(3) ex-cludes from the definition of U.S. real property interestany class of stock of a domestic corporation that isregularly traded on an established securities market, ifheld by a person holding less than 5 percent of that classof stock.55 Section 1445 eliminates any withholding re-

quirement even if the transfer is of stock held by a 5percent shareholder.56 Because US’s stock is not publiclytraded, this exception does not apply in the foreigncontrolled U.S. group contexts in any of the situations setforth above.9. Foreign distributors. The gain rule for distributions bya foreign corporation under section 897(d)(1) is subject toan exception in section 897(d)(2) if the distributee wouldbe subject to U.S. tax on the subsequent distribution ordisposition of the property and has a carryover basis.57

Although one could argue in Situation 3 that this provi-sion is satisfied because of the presumed status of US asa USRPHC, that argument could require that the tax-payer treat US as a USRPHC for the next five years. Andeven if the U.S. real property interest was subject to U.S.tax immediately after the exchange, there are timely filingrequirements in temp. reg. section 1.897-5T(d)(1)(iii) thatmust be satisfied58 that makes this exception inapplicablein our assumed facts.10. Nonrecognition transactions. The exception in sec-tion 897(e)(1) for nonrecognition transactions59 also doesnot apply to our foreign controlled U.S. corporate grouptransactions. Section 897(e)(1) and temp. reg. section1.897-6T60 require that the interest being exchanged is aU.S. real property interest and the exchange is for aninterest the sale of which is subject to U.S. tax.61 Thisrequirement raises the same issues as the foreign dis-tributor situation described above.62 If a nonrecognitionprovision does not apply to a transaction because it failsto meet the requirements of section 897(e) and temp. reg.section 1.897-6T, the gain realized from the transfer of theU.S. real property interest will be subject to U.S. taxunder section 897.63

Finally, it is interesting to note that Situation 4 is thefact pattern that led to the issuance of recent regulationsunder section 7874 that exempt from the inversion rulesrestructurings within a foreign controlled group. Nosimilar exception has been provided under FIRPTA. Ingeneral, under section 7874, if a foreign corporationacquires directly or indirectly substantially all of the

54See letter from American Institute of Certified Public Ac-countants to Treasury and the IRS (June 2, 2008), followingNotice 2006-99 and the retroactive withdrawal of reg. section1.1441-1(b)(7)(iii), recommending to add to the priority listguidance on liability of a withholding agent for interest regard-ing withholding under section 1445 or section 1446, if thewithholding agent does not withhold for a foreign person thathas no U.S. tax liability, or that has satisfied its U.S. tax liability.

55See reg. section 1.897-1(c)(2)(iii); see also reg. section 1.897-2(g)(3).

56Reg. section 1.1445-2(c)(2).57Section 897(d)(2).58Temp. reg. section 1.897-5T(c)(2)(i)(C), adding to the statu-

tory exception under section 897(d)(2)(A) that the distributingcorporation must comply with the filing requirements.

59For purposes of section 897(e) and temp. reg. section1.897-6T, the term ‘‘nonrecognition provision’’ includes thefollowing: (1) section 332; (2) section 351; (3) section 354; (4)section 355; (5) section 361; (6) section 721; (7) section 731; (8)section 1031; (9) section 1033; and (10) section 1036. Temp. reg.section 1.897-6T(a)(2).

60See temp. reg. section 1.897-6T(b)(1), providing exception tothe general rule for some foreign-to-foreign exchanges.

61See also temp. reg. section 1.897-5T(d)(1), providing rulesfor interests subject to taxation upon later disposition.

62There are timely filing requirements for this exception setforth in temp. reg. section 1.897-5T(d)(1). Also, section 897(j)provides that gain inherent in contributions to capital is taxableunless exempted by regulations as well. Presumably this refersto contributions not otherwise covered by nonrecognition treat-ment.

63Temp. reg. section 1.897-6T(a)(3).



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assets of a domestic corporation and after the acquisitionformer shareholders of the domestic corporation own 80percent or more (by vote or value) of the stock of theforeign corporation by reason of their ownership in thedomestic corporation, then section 7874 treats the foreigncorporation as a domestic corporation unless the foreigncorporation has substantial business activities in thecountry in which it is incorporated compared with thesubstantial business activities of the expanded affiliatedgroup (EAG), as defined in section 7874(c)(1), as a whole.

A special rule in section 7874(c)(2) provides that anystock owned by the EAG is excluded from both thenumerator and denominator in determining the 80 per-cent ownership threshold. In our Situation 4, FP, US, andFS would all be part of the EAG. Accordingly, in deter-mining the ownership threshold after the transfer by FP,the stock that FP owns in FS would be excluded fromboth the numerator and denominator, so that if therewere any minority ownership in US that received stock inFS — no matter how small — the 80 percent ownershipthreshold would be triggered; moreover, even if therewere no minority ownership as illustrated in Situation 4,the result would produce a fraction of 0/0, a result that ismathematically described as indeterminate or infinity,leading some to question even in a wholly owned factpattern whether it was clear that the 80 percent owner-ship threshold had not been satisfied. Reg. section1.7874-1, finalized in May 2008, provides relief from theserules in such intercompany restructurings by providingthat FP’s stock ownership in FS is excluded from thenumerator but not the denominator of the ownershipfraction, thereby resulting in a fraction of 0/100.64

D. Requests for ReliefGiven the FIRPTA status presumption regarding do-

mestic corporations, a transferor or transferee may realizeafter a distribution/disposition date that they failed tocomply with section 897 and/or section 1445. Because thestatement/notice procedure described in reg. sections1.897-2(g)(1)(ii)(A), 1.897-2(h), 1.1445-2(c)(3)(i), 1.1445-2(d)(2), 1.1445-5(b)(2), and 1.1445-5(b)(4) all fall withinthe definition of a regulatory election,65 the taxpayer(which may be the transferor or the transferee) mayrequest under reg. section 301.9100-1 and -3 an extensionof time to file the statements and notices. This relief maybe granted by the IRS if the taxpayer provides evidencethat it acted reasonably and in good faith and the grant ofrelief will not prejudice the interests of the government.66

Since the enactment of the FIRPTA rules, there havebeen over 30 ruling requests granted for relief under reg.section 301.9100. While there were a few submissions inthe 1990s, there were 21 submissions beginning in 2005.Although a few related to real USRPHCs, most dealt withcases in which the failure to follow the proceduralrequirements exposed the transaction to tax and thetransferee to withholding tax liability, even though thedomestic corporation was not a USRPHC under the

substantive test of section 897(c)(2). Some of these rulingsare illustrated below in the appendix to illustrate howeasy it is run afoul of the FIRPTA rules and the varioussituations in which the issue arises.

Finally, there is the practical problem of the scope ofrelief to request when the belated preparation of infor-mation regarding USRPHC status reveals there havebeen similar oversights in prior years, each of whichcould involve a preceding five-year period. The answerappears to lie in the general policy of the IRS not toenforce filing requirements for more than six years absenta history of noncompliance or other negative factors.67

E. Rev. Proc. 2008-27After several ruling requests for relief under reg.

section 301.9100, the IRS responded on May 13, 2008, byissuing Rev. Proc. 2008-27, which provides a simplifiedmethod for taxpayers to request relief for late filingsunder reg. sections 1.897-2(g)(1)(ii)(A), 1.897-2(h), 1.1445-2(c)(3)(i), 1.1445-2(d)(2), 1.1445-5(b)(2), and 1.1445-5(b)(4).This procedure is in lieu of the letter ruling procedurethat otherwise would be used under reg. section301.9100, and it is applicable to all requests for reliefreceived after June 26, 2008.68

Unlike a ruling request under reg. section 301.9100,user fees do not apply to corrective action under Rev.Proc. 2008-27. A taxpayer can request relief under reg.section 301.9100 only if the taxpayer is denied relief bythe IRS under Rev. Proc. 2008-27.

A taxpayer is eligible for relief from late filing of thestatement/notice procedural requirements under Rev.Proc. 2008-27 on the same reasonable cause basis thatapplied for purposes of reg. section 301.9100. Once thetaxpayer becomes aware of the failure to file the state-ments or notices, the taxpayer must file the completedstatement and/or notice with the appropriate person andinclude a statement at the top of the documents that theyare ‘‘Filed pursuant to Rev. Proc. 2008-27.’’ With a com-pleted statement or notice required to be filed with theIRS, the taxpayer must attach an explanation describingwhy the failure to timely file the statement or notice wasdue to reasonable cause. And in the explanation thetaxpayer must state that it filed with, or obtained from,an appropriate person the appropriate statement or no-tice. The completed statement or notice attached to theexplanation must be sent to the Ogden Service Center,P.O. Box 409101, Ogden, UT 84409.

Upon receipt of a completed application requestingrelief, the IRS will determine whether the requirementsfor granting more time have been satisfied. The IRS willnotify the taxpayer in writing within 120 days of thefiling of the completed application only if it determines

64See reg. section 1.7874-1(f), Example 3.65Reg. section 301.9100-1(b).66Reg. section 301.9100-3(a).

67See P-5-133 Delinquent Returns, I.R.M. 1.2.1.5.19 (approvedNov. 24, 1980); Enforcement Determination, I.R.M. 5.1.11.6.1(May 7, 2002).

68Taxpayers that have ruling requests pending as of May 27,2008, were not required to use the procedures of Rev. Proc.2008-27. However, if taxpayers have not received a determina-tion of their request as of May 27, 2008, they may withdraw theirrelief request under reg. section 301.9100, and the IRS willrefund the taxpayer’s user fee.



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that the failure to comply was not due to reasonablecause, or if more time will be needed to make a determi-nation. If, once that period commences, the taxpayer isnot again notified within 120 days, the taxpayer will bedeemed to have established reasonable cause.

The implication of Rev. Proc. 2008-27 is that theNational Office no longer wants to deal with rulingrequests for relief under reg. section 301.9100 (whichdepicts the foolishness of the FIRPTA rules). The sameinformation that would have been included in the rulingrequest regarding the failure and the reasonable cause isnow merely shipped off to Ogden. The only change isthat there will no longer be any transparency through theruling publication process.

F. RecommendationsThe foreign controlled circumstances that we have

focused on here, in which the domestic corporation isclearly not a USRPHC, deserve a simplified process thateliminates the current regulation statement/notificationprocedures and the frequent need for Rev. Proc. 2008-27(or reg. section 301.9100) relief. We recommend the IRSchange the regulations to eliminate these requirements inthe case of foreign controlled U.S. corporate groups. Theregulations should replace the current mechanism with apresumption of FIRPTA tax liability in the case of covereddispositions, subject to rebuttal on audit. If the issue isnot raised in an audit, the presumption should expirewith the statute of limitations of the domestic corporationfor the year of the covered distribution/disposition.

This recommendation has several advantages over thecurrent process, without any additional compliance ex-posure for the IRS. It may even enhance compliance. Itseems clear that foreign controlled groups that havedispositions involving U.S. subsidiaries that are in factUSRPHCs either recognize and report their tax liabilitiesor are eligible for a nonrecognition exception. The currentstatement/notification process is of no benefit to them. Itmerely presents an easily overlooked administrativehurdle in circumstances when the U.S. entity is not aUSRPHC. On the other hand, reliance on a regular auditmechanism could increase the likelihood of identifyingtaxable transactions while providing the means for acareful review of exempt status.

Thus, permitting the presumption of liability to expirewith the statute of limitations is unlikely to reduce taxcollections. Audit practices should incorporate an auto-matic, pattern information document request to aforeign-owned U.S. corporate group regarding the exist-ence of any potential FIRPTA distributions/dispositions,followed by requests for information necessary to deter-mine the USRPHC status of the U.S. company if dispo-sitions exist. The regulations should provide thatdisposition transactions create a rebuttable presumptionof tax liability and require the U.S. subsidiary of theforeign group to rebut the presumption by providinginformation similar to the current statement within areasonable, fixed period following a request during anaudit.

These recommended changes for foreign controlledU.S. corporate groups would avoid many of the problems

with the current compliance regime. The currentstatement/notice procedures are artificial in requiringcontrolled parties to report to one another, and theserequirements are easily and understandably overlookedby foreign owners conducting internal group restructur-ings. They deserve relief similar to that granted to foreigncontrolled groups in the context of the inversion rulesunder section 7874. Our recommended procedureswould acknowledge that the statement/notice process isartificial in this context and would leave the determina-tions to the audit. The existence of the rebuttable pre-sumption would provide the IRS with all of theenforcement leverage it requires in these circumstances.

The recommendations also have the advantage ofeliminating prospects for the body of private law thatmay arise under the silence-is-approval policy of therevenue procedure, while eliminating the administrativedrain that is necessarily involved in these requests.Moreover, it is not clear under what circumstances ataxpayer would not have reasonable cause for failing tofollow the statement/notification procedures. We assumethat if there have been unsuccessful requests for reliefunder reg. section 301.9100 in this area, they were with-drawn before the public benefited from the publication ofa negative private letter ruling. Nevertheless, the IRS’sdiscretion to find that reasonable cause for the compli-ance failure existed presents the potential for abuse. Theauthors are aware of at least one circumstance in whichrelief under reg. section 301.9100 was withheld until thetaxpayer made additional concessions on issues relatedto the transaction that triggered the potential FIRPTAliability. This seems an improper exercise of discretionunder reg. section 301.9100.

Reporting requirements do not appear to be a suitablealternative. Congress has already attempted two report-ing regimes regarding the FIRPTA rules. The OmnibusReconciliation Act of 1980 added section 6039C to thecode in conjunction with section 897. That provisionrequired domestic corporations to file a return if it was aUSRPHC under section 897(c)(2) listing all of its foreignshareholders and any transfers of its stock. Congressintroduced the section 1445 withholding regime in 1984in part because the IRS had delayed the regulationsunder section 6039C, but at the same time Congressrevised section 6039C.

As revised, to the extent provided in regulations, thereporting requirement now falls on any foreign personthat owns ‘‘direct investments in United States realproperty interests.’’ While the use of the word ‘‘direct’’might appear at first blush to exclude stock interests indomestic corporations, the definition in section 6039C(c)incorporates section 897(c) and thus the rule that anyinterest in domestic corporation stock is a U.S. realproperty interest. Fortunately, no regulations have beenissued under this provision, so there is currently noreporting requirement.

Appendix

A. Illustrations of ReliefFor presentation purposes, any shaded square repre-

sents a domestic corporation. Indirect ownership is notedby a slash mark on the connecting lines between the



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corporations. For simplicity, the defined terms for theparties used in our illustrations may not correspond withthe terminology used in the private letter rulings.

Unless otherwise noted, the domestic corporations inthe private letter rulings were not USRPHCs under thesubstantive test of section 897(c)(2), but the statement/notice procedural requirements discussed in this articlewere not followed.

1. Redemption of stock. In LTR 200840014 (June 20,2008), Doc 2008-21269, 2008 TNT 194-47, domestic parent(US), a nonpublicly traded corporation, owned all thestock of a foreign corporation (FS). FS owned shares inUS, and US redeemed the shares held by FS for a note.The redemption of shares of a domestic corporationunder section 302 is a disposition for purposes of section897(a), as shown in Figure 5.69

2. Section 351 transactions. In LTR 200838007 (June 13,2008), Doc 2008-20069, 2008 TNT 184-18, a foreign corpo-ration (FP) wholly owned two domestic corporations (US1 and US 2). In a section 351 transaction, FP contributedits shares of US 2 to US 1 in exchange for one share of US1 and a note.

Even though section 351 is a nonrecognition provision,the contribution is subject to section 897(a), a variation ofSituation 4, because section 897(e) was inapplicablewhere FP received in the exchange stock in anotherdomestic corporation (US 1), which was not a U.S. realproperty interest under the substantive test of section897(c)(2).

Afterwards, at a time when US 1 had no current oraccumulated E&P, US 1 distributed cash to FP in a section301 transaction. Section 301 distributions in excess ofE&P are subject to section 897(a) and section 1445(e)(3),similar to Situation 1. (See Figure 6.)

In LTR 200831007 (Apr. 20, 2008), Doc 2008-16884, 2008TNT 150-32, a foreign corporation (FP), through a disre-garded entity (DE), owned all of a domestic corporation(US 1) and two foreign corporations (FS 1 and FS 2). US

1 in turn owned all of a domestic corporation (US 2). (SeeFigure 7.)

DEtransferredall its interests inUS1andFS2toFS1.Thecontribution was intended to qualify under section 351, avariation of Situation 4.70 Section 897(a) was applicable tothe contribution because a U.S. real property interest wasnot received in the exchange (that is, section 897(e) wasinapplicable where DE received stock of a foreign corpo-ration).Afterwards, FS 1 transferred its entire interest in US1 to FS 2, similar to Situation 4.Although it was a section 351transaction, section 897(a) was applicable to the contribu-tionbecausestock inFS2,a foreigncorporation, isnotaU.S.real property interest (that is, section 897(e) was inappli-cable).Figure8depicts thestructureafter thecontributions.

To effectuate an internal restructuring, LTR 200726028(Mar. 23, 2007), Doc 2007-15570, 2007 TNT 127-21, repre-sents a case in which the FIRPTA rules were violated in69The ruling request dealt only with the section 897 liability.

The transaction would also have been subject to section1445(e)(3) (distributions by domestic corporations to foreignshareholders) and the requirements under reg. section 1.1445-5(e)(3). 70The ruling request dealt only with the section 897 liability.

US

FS

100%

Redemption ofshares of US

Figure 5

US 1

FP

US 2

Contribution ofstock of US 2

US 1

FP

US 2

Structure after contribution

Distribution inexcess of E&P

Figure 6

FP

US 2

US 1 FS 1 FS 2

DE

Figure 7



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consecutive section 351 transfers of the same domesticcorporation stock (similar to Situation 4). Section 897(e)was inapplicable to the section 351 transactions because aU.S. real property interest was not received in the ex-changes (either stock in another foreign corporation or adomestic corporation that was not a U.S. real propertyinterest under the substantive test of section 897(c)(2) wasreceived). (See Figure 9.)

LTR 200631020 (May 4, 2006), Doc 2006-15210, 2006TNT 156-26, involved three types of transactions. First, aforeign subsidiary (FS 1) transferred all of the stock of adomestic corporation (US 1) to its parent (FP) in exchangefor cancellation of debt by FP. Such a disposition issubject to section 897(a) and section 1445. Second, FPtransferred all of the stock of US 1 to its foreign subsid-iary (FS 2), and then FS 2 transferred that US 1 stock toanother foreign corporation (FS 3) (similar to Situation 4).Although they were section 351 transactions, both trans-fers were subject to section 897(a) and section 1445.Lastly, FS 1 sold stock of a domestic corporation (US 2) toFS 3 in a taxable transaction, clearly subject to section897(a) and section 1445. Figure 10 shows the structurebefore the transacton.

The final structure is shown in Figure 11.

FP

US 2

US 1

FS 1

FS 2

DE

Figure 8

FP

US 2

US 1

FS 1

FS 2

FS 3

FS 4

FS 5

FS 6

FS 7

FP acquired Target, a domestic corporationfollowed by transfer of Target to FS 2.

Then:

FS 2 transferred Target to FS 3FS 3 transferred Target to FS 4FS 4 transferred Target to FS 5FS 5 transferred Target to FS 6FS 6 transferred Target to FS 7FS 7 transferred Target to US 1

US 2 merged into Target, with Target surviving.

Figure 9

FS 2

US 1

FS 1

FP

US 2FS 3

Figure 10

FS 2

US 1

FS 1

FP

US 2

FS 3

Figure 11



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B. Liquidations and Entity ClassificationIn LTR 200735004 (June 4, 2007), Doc 2007-20133, 2007

TNT 171-40, a foreign corporation (FP) owned all of thestock of a foreign corporation (FS), which in turn ownedall of the stock of a domestic corporation (US). FSliquidated into FP, a variation of Situation 3, in a liqui-dation under section 332. Section 897(d) is applicable toliquidating distributions and provides that gain will berecognized for section 897(a) purposes. The exception insection 897(d)(2) was inapplicable where FP would not besubject to tax on the subsequent distribution of US(which under the substantive test is not a U.S. realproperty interest). (See Figure 12.)

LTR 200634014 (May 17, 2006), Doc 2006-16254, 2006TNT 167-78, had the same fact pattern — the liquidationof a foreign subsidiary (FS), which owned all of the stockof a domestic corporation (US), into its foreign parent(FP). Again, section 897(d) was applicable and the excep-tion in section 897(d)(2) was inapplicable.

In LTR 200609017 (Nov. 28, 2005), Doc 2006-4157, 2006TNT 43-37, a foreign corporation (FP) owned all of adomestic corporation (US). Corp C, which was unrelatedto FP or US before the transactions at issue, owned all ofthe stock of a foreign corporation (FS). (See Figure 13.)

Corp C transferred all of its stock in FS to US inexchange for US stock. FS then converted from an ItalianS.p.A. (Società per azioni) to an S.r.l. (Società a responsabilitàlimitata), an eligible entity, and checked the box to bedisregarded for federal income tax purposes, which istreated as a deemed liquidation of FS (similar to Situation3). This was in the event that relief under reg. section301.9100 was granted. While not specifically addressed inthe ruling, it appears that the check-the-box election by

FS (which was followed by the liquidation of Corp C)was treated as a reorganization under section368(a)(1)(D). As a result, FS received stock of US in thereorganization and thus was a disposition subject tosection 897.

Both LTR 200409013 (Nov. 17, 2003), Doc 2004-3943,2004 TNT 40-56, and LTR 200304022 (Oct. 23, 2002), Doc2003-2222, 2003 TNT 17-27, involved the same fact pat-tern: A foreign corporation (FP) owned all of a foreignsubsidiary (FS), and FS owned all the stock of a domesticcorporation (US). FS checked the box to be disregardedfor federal income tax purposes, which is treated as adeemed liquidation of FS (similar to Situation 3). Section897(d)(1) was applicable to the deemed liquidation. (SeeFigure 14.)

C. Intended ReorganizationsIn LTR 200714014 (Apr. 6, 2007), Doc 2007-8964, 2007

TNT 68-35, to simplify the U.S. ownership structure, adomestic corporation (US 1) merged into another domes-tic corporation (US 2). As a result, foreign corporation(FP), though a disregarded entity (DE), exchanged its US1 stock for US 2 stock. This is a disposition for purposesof section 897, and section 897(e)(1) was inapplicable. US2 was not a U.S. real property interest under the substan-tive test of section 897(c)(2). (See Figure 15.)

LTR 199942024 (July 27, 1999), Doc 1999-34304, 1999TNT 205-37, involved a reorganization under section368(a)(1)(F) of a domestic corporation (US) that waswholly owned by a foreign corporation (FP). In thereorganization, stock of US was exchanged for stock ofNew US. Even though section 354(a)(1) provides nonrec-ognition to the shareholder FP, section 897 was applicablebecause a subsequent disposition of New US would notbe subject to taxation. (See Figure 16.)

D. Nine Restructuring TransactionsLTR 200742008 (July 5, 2007), Doc 2007-23410, 2007

TNT 204-34, involved nine separate transactions thatcrossed several tax years. All transactions were solelywithin the group of corporations owned by foreignparent (FP) and involved internal restructuring.1. Transaction 1. A foreign corporation (FS Entity 1),which was a subsidiary of FP, sold its entire interest in adomestic corporation (US Entity 2) to an entity (DE Entity

US

FS liquidated

FP

FS

Figure 12

FS

Corp CFP

US

Figure 13

FS

US

FP

Check-the-box electionby FS

Figure 14



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3). For federal tax purposes, DE Entity 3 was classified asa disregarded entity of a foreign partnership (F Partner-ship Entity 4). The partners of F Partnership Entity 4 weretwo foreign corporations within FP’s then existing group.FS Entity 1’s sale of its interest in US Entity 2 was adisposition for purposes of section 897(a), and gain wasrealized under section 1001. (See Figure 17.)

When the ruling request was submitted, US Entity 2was no longer in existence and through reorganizations isnow part of US Entity 6, a domestic corporation. (SeeTransaction 5 discussed below.)

2. Transaction 2. A foreign corporation (FS Entity 7) con-verted under foreign law from an entity classified as a perse corporation for federal tax purposes to an entity clas-sified as an eligible entity for federal tax purposes. FSEntity 7 also changed its name and elected under reg.section 301.7701-3 to be treated for federal tax purposes asan entity disregarded from its owner, a foreign corpora-tion (FS Entity 8). At the time of the election, FS Entity 7owned all the stock of a domestic corporation (US Entity6). The election to be a disregarded entity for U.S. taxpurposes is treated as a deemed liquidation of FS Entity7. The constructive section 332 liquidation was subject to

gain recognition under section 897(d) and, similarly, sec-tion 1445(e)(2) and reg. section 1.1445-5(d) (similar to Situ-ation 3). (See Figure 18.)

3. Transaction 3. FS Entity 8 converted under foreign lawto an entity classified as a per se corporation for purposesof reg. section 301.7701-2(b)(8) in a transaction intendedto qualify under section 368(a)(1)(F). At that time, FSEntity 8, through its disregarded entity (FS Entity 7),owned the stock of a domestic corporation (US Entity 6).For U.S. tax purposes, FS Entity 8 is treated as exchangingits assets, including its stock in US Entity 6, for stock ofNew FS Entity 8. This deemed asset transfer was adisposition for purposes of section 897, and in thedisposition, FS Entity 8 realized gain under section 1001.(See Figure 19.)

US 3

US 1 US 2

FP

Merger

DE

Figure 15

US

FP

New US

FP

Before After

Figure 16

USEntity 2

FP

FSEntity 1 Sale of

US Entity 2

FP’ship

Entity 4

DEEntity 3

Figure 17

USEntity 6

FP

FSEntity 7

Check-the-boxelection

FSEntity 8

Figure 18



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4. Transaction 4. DE Entity 3, which was a disregardedentity of a foreign partnership (F Partnership Entity 4),contributed assets that included stock of a domesticcorporation (US Entity 271) to a foreign corporation (FSEntity 8) in exchange for voting and nonvoting stock ofFS Entity 8, which is not a U.S. real property interest, andcash. The partners of F Partnership Entity 4 were twoforeign corporations within FP’s then existing group. Inthe contribution, gain was realized under section 1001and is therefore subject to section 897(a). (See Figure 20.)

5. Transaction 5. US Entity 2, a domestic corporation,statutorily merged into a domestic corporation (US Entity11), which was the predecessor to US Entity 6. US Entity11 later changed its name to US Entity 6. Before the

merger, a foreign corporation (FS Entity 8) was the soleshareholder of US Entity 2 and US Entity 11. At that time,FS Entity 8 owned stock of other domestic corporations.For simplicity, only the domestic corporations at issue areshown in the diagrams. FS Entity 8 received US Entity 11stock and the right to deferred cash payments in ex-change for its US Entity 2 stock. This exchange was arealization event under section 1001.72 (See Figure 21.)

6. Transaction 6. A foreign corporation (FS Entity 8) madea distribution of the stock of two domestic corporations(US Entity 6 and US Entity 12) to its sole shareholder, aforeign corporation (FS Entity 13, a variation of Situation2). FS Entity 13 is now known as FS Entity 14. (SeeTransaction 7 below.) The distribution of stock in adomestic corporation by a foreign corporation to anotherforeign corporation was subject to gain recognition undersection 897(d). (See Figure 22.)7. Transaction 7. A foreign corporation (FS Entity 13)changed its place of incorporation from one foreigncountry to another foreign country and changed its nameto FS Entity 14. At the time of reincorporation and namechange, FS Entity 13 owned all the stock of US Entity 6and US Entity 12,73 both domestic corporations. Thistransaction was likely a reorganization under section368(a)(1)(F), in which FS Entity 13 is treated as distribut-ing all of its assets to New FS Entity 13 (FS Entity 14). Thisdeemed asset transfer was a disposition, and in thedisposition, FS Entity 13 realized gain under section 1001.(See Figure 23.)8. Transaction 8. A foreign corporation (FS Entity 14)distributed all the stock of US Entity 6 and US Entity 12,both domestic corporations, to its sole shareholder, a

71US Entity 2 no longer exists and through reorganizations isnow part of US Entity 6. (See Transaction 5 discussed below.)

72The taxpayer did not request section 1445 relief for thistransaction given that the transferee did not ‘‘acquire’’ a U.S.real property interest; section 1445 does not appear to beapplicable to this transaction. See reg. section 1.1445-2(a); reg.section 1.1445-5(e).

73US Entity 12 was liquidated into FS Entity 15 after thetransaction.

USEntity 6

FP

Conversion FSEntity 8

FSEntity 7

Figure 19

US Entity 2

FP

FSEntity 8Contribution

FP’ship

Entity 4

DEEntity 3

Figure 20

FSEntity 8

USEntity 2

USEntity 11Merger

FP

Figure 21



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foreign corporation (FS Entity 16, a variation of Situation2). The distribution of stock in a domestic corporation bya foreign corporation to another foreign corporation wassubject to gain recognition under section 897(d). (SeeFigure 24.)9. Transaction 9. A foreign corporation (FS Entity 16) soldall the stock of US Entity 12,74 a domestic corporation, toa foreign corporation (FS Entity 15). At the time of thesale, FS Entity 16 was an indirect subsidiary of FS Entity15. The sale was a disposition under section 897(a) andgain was realized under section 1001. (See Figure 25.)

74US Entity 12 was liquidated into FS Entity 15 after thetransaction.

FSEntity 8

USEntity 6

USEntity 12

FP

FSEntity 13

Distribution of stockof US Entity 6 andUS Entity 12

Figure 22

USEntity 6

FSEntity 13

USEntity 12

FP

Reincorporationand name change toFS Entity 14

Figure 23

FSEntity 14

FP

FSEntity 16

Distributionof stock

USEntity 6Other Subs

USEntity 12

Figure 24

FSEntity 16

USEntity 6

FP

FSEntity 15

Sale of stockof US Entity 12

USEntity 12

Figure 25



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Incorporating the Tax ExpenditureConcept Into the Tax Code

By Zhicheng Li Swift

A. Introduction

Under section 3(a)(3) of the Congressional Budget Actof 1974,1 tax expenditures are defined as ‘‘those revenuelosses attributable to provisions of the Federal tax lawswhich allow a special exclusion, exemption, or deductionfrom gross income or which provide a special credit, apreferential rate of tax or a deferral of tax liability.’’ Inthat same act, a tax expenditure budget is defined as ‘‘anenumeration of such tax expenditures.’’

The concept of tax expenditures was first introducedby Stanley Surrey in 1967 for the purpose of distinguish-ing between two totally different roles of tax provisionsin the Internal Revenue Code, namely, tax structureprovisions and tax expenditure provisions. As Surreydescribed it:

The federal income tax system consists really of twoparts: one part comprises the structural provisionsnecessary to implement the income tax on indi-vidual and corporate net income; the second partcomprises a system of tax expenditures underwhich Governmental financial assistance programsare carried out through special tax provisionsrather than through direct Government expendi-tures. This second system is grafted on to thestructure of the income tax proper; it has no basicrelation to that structure and is not necessary to itsoperation. Instead, the system of tax expendituresprovides a vast subsidy apparatus that uses themechanics of the income tax as the method ofpaying the subsidies.2

Since it was introduced by the Budget Act of 1974, taxexpenditure budgeting has never reached its full poten-tial as an analytical tool designed to achieve the two maingoals that inspired its proponents: clarifying the aggre-gate size and application of government expenditures,and improving the code.3 Several essential factors con-tribute to the ineffectiveness of tax expenditure analysis— for example, the disagreements about the definition ofa normal tax benchmark based on which tax expendi-

tures are identified as deviations from that system, andthe interactive effects, which cause the sum of individualtax expenditures estimated separately to often be mean-ingless.

As a result, the use of tax expenditures in Congress hasaccelerated (measured both by the number of items andin dollar terms) rather than being controlled. The numberof tax expenditure items has increased from 70 items in1974 to 170 in 2007.4 The size of tax expenditures in dollarterms has tripled over that same period.

The Joint Committee on Taxation recently proposed anew approach under which tax expenditures would bereclassified, based on the general rule of a tax system, andunder which the analysis of the effects of tax expendi-tures on the tax system would be improved.

This article, based on the JCT’s new approach, pro-poses incorporating the tax expenditure concept into thecode and using adjustment factors to improve the esti-mates of revenues forgone. Doing both would improvethe analysis of the effects of tax expenditures on thefederal budget.

This article has five sections. Section B briefly de-scribes the JCT’s new approach. Section C discusses theconcept of tax expenditures and the code. Section D offersa proposal, and Section E concludes.

B. JCT’s New Approach5

In response to the controversy regarding the choice ofan appropriate baseline for determining whether a par-ticular provision in the tax law is a tax expenditure, theJCT recently proposed a new approach to reclassifyingtax provisions as tax expenditures.

The JCT’s new approach — which takes a neutral andprincipled position and builds on the criteria proposedby Seymour Fiekowsky6 — uses the general rules in thecode to classify tax provisions as tax expenditures. Therevised classification divides tax expenditures into twomain categories: ‘‘Tax Subsidies’’ (a narrow concept of taxexpenditures) and ‘‘Tax-Induced Structural Distortions’’(a new category, and an expanded concept of tax ex-penditures). For continuity purposes, the JCT proposes tocontinue to carry those tax expenditure items that maynot be neatly defined as tax subsidies or tax-inducedstructural distortions.

The JCT’s new approach does not use the ‘‘normal’’baseline that has dominated the field of tax expendituressince 1974 because the normal tax system has encoun-tered significant criticism for being an insufficientlyrigorous foundation on which to base tax expenditureanalysis.

1P.L. 93-344.2Stanley S. Surrey, Pathways to Tax Reform (Cambridge, MA:

Harvard University Press, 1973).3Joint Committee on Taxation, ‘‘A Reconsideration of Tax

Expenditure Analysis’’ (JCX-37-08), May 12, 2008, p. 1.

4Id. at 4.5See supra note 3.6In 1980 Seymour Fiekowsky proposed a narrow concept of

tax expenditures — tax subsidies that depart from general taxrules with the following two criteria: (1) in the absence of theparticular provision, existing tax law provides a general rule fordetermining tax liability; and (2) it is possible to formulate anexpenditure program administrable by a cognizant governmentagency that would achieve the same objective at equal, higher,or lower budgetary cost (JCT report, supra note 3).

Zhicheng Li Swift is a former senior economist atthe World Bank.

Emil M. Sunley reviewed and provided importantcomments and advice to this article. The author alsothanks Weizhen Li for her research assistance. Anyerrors are the responsibility of the author.



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According to the JCT’s new approach, a tax subsidy isdefined as a specific tax provision that is deliberatelyinconsistent with an identifiable general rule of thepresent tax law.7 This definition of tax subsidies confirmsthat they are not tax structure provisions (which are theelements of tax law whose purpose is to produce taxrevenue). Tax subsidies perform a function of govern-ment financial assistance.

The tax subsidies category covers three forms ofgovernment financial assistance channeled through thetax system: tax transfers (for example, refundable por-tions of the earned income tax credit, the child tax credit,and the 2008 tax rebate); social spending, which is relatedto supply of labor, but unrelated to the production ofbusiness income (for example, charitable giving, IRAdeductions, and the nonrefundable portion of the childtax credit); and business synthetic spending, which isrelated to the production of business or investmentincome but unrelated to supply of labor (for example,various energy subsidies, the section 199 deduction forincome attributable to domestic production activities,and the research and experimentation credit).

Tax-induced structural distortions are defined as anexpanded concept of tax expenditures that is broaderthan the narrow concept of tax subsidies. Tax-inducedstructural distortions are those tax provisions that are

structural elements of the code and that materially affecteconomic decisions in a manner that imposes substantialeconomic efficiency costs.

Examples of tax-induced structural distortions includedeferral treatment of foreign earnings and the differentialtaxation of debt and equity.

The JCT’s classification of tax expenditures aims tofacilitate tax policy analysis regarding equity, efficiency,and ease of administration.

The JCT’s new approach is generally consistent withinternational practice, using general taxation rules toclassify tax provisions as tax expenditures. This system isused in many countries around the world, includingAustralia, Belgium, the Netherlands, and Turkey.8 Thesecountries use general rules of taxation to establish taxbenchmarks and to identify the deviations from thosebenchmarks as tax expenditures.

The JCT’s new approach has solved the foundationalcontroversy regarding the ‘‘normal tax system’’ concept.The JCT’s approach now provides the opportunity toincorporate the concept of tax expenditures into the code,and to improve estimates of revenues forgone and theanalysis of the effects of tax expenditures on federalbudget.

C. The Concept of Tax Expenditures and the Code

The Budget Act of 1974 recognizes that tax expendi-ture provisions are special provisions that result in rev-enue losses, thus characterizing their particular role intaxation as the opposite of the roles of tax structuralprovisions, which are necessary to implement individualand corporate income taxes.

This tax expenditure concept recognizes that a taxsystem contains two components that are conceptuallyand functionally distinct in, although interwoven into,the tax law. One component contains those provisionsnecessary to implement the structural function of taxa-tion. The other contains tax expenditure provisions toimplement government spending programs.9

However, this recognition of the concept of tax ex-penditures and the role of tax expenditure provisions inthe tax system has not been incorporated into the code.Even today, the code does not distinguish between struc-tural provisions and tax expenditure provisions.

Historically, this can be traced back to at least the 1939version of code, which had only one type of tax provi-sion. Although the concept of tax expenditure provisionswas written into the Budget Act of 1974, and the twotypes of tax provisions play distinctive roles in taxation,the code has not been updated in this respect since 1974.

7See id. at p. 9 and p. 20. P.L. 93-344, section 3(3)(3) currentlycodified to 2 U.S.C. 622.3.

8Hana Polackova Brixi, Christian M.A. Valenduc, and Zhi-cheng Li Swift, ‘‘Tax Expenditures — Shedding Light on Gov-ernment Spending Through the Tax System,’’ World Bank, 2004,and ‘‘Turkey — Public Expenditure Review,’’ World Bank, 2006.

9Paul R. McDaniel and Stanley Surrey, ‘‘International As-pects of Tax Expenditures,’’ Kluwer Law and Taxation Pub-lisher, Deventer, the Netherlands, 1984.

General Principal Criterion for EstablishingA Tax Benchmark

1. Represents a consistent tax treatment of similaractivities or classes of taxpayers and neither favors nordisadvantages similarly placed activities or classes oftaxpayers.

2. Includes certain tax provisions (such as exemp-tions, deductions, tax credits, and other tax prefer-ences) to adjust taxable income in order to:

• comply with the ability-to-pay principle; and

• enhance the economic and collection efficiency oftaxation.

3. Ensures that tax expenditure reporting providessufficient information for policy formulation.

In addition, each country will have its own pur-poses or demands for a tax expenditure report so thatthe benchmark should reflect such purposes or de-mands.

Source: Graham Glenday and Zhicheng Li Swift, ‘‘Es-tablishing Tax Expenditure Accounts — Towards Bet-ter Fiscal Accountability and Transparency’’ in TurkeyPublic Expenditure Review, The World Bank, December2006.



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As a result, taxpayers often understand tax provisionsonly in the broad sense and do not recognize the differ-ence between tax structural provisions and tax expendi-ture provisions. Also, it is difficult to analyze the differenteffects of the two types of provisions on taxation and onthe federal budget.

D. A ProposalTo improve the analysis of tax structure and the effects

of tax expenditures on federal budgets, as well as toimprove tax code transparency, the code should incorpo-rate the concept of tax expenditures. This proposal dis-cusses incorporating the concept of tax expenditures intothe code and estimates the amount of revenue forgonewhen the code is updated.

1. Incorporating the concept of tax expenditure provi-sions into the code. This article proposes incorporatingthe concept of the tax expenditure provision into the codeby defining tax structural provisions and tax expenditureprovisions.

The clarity of the code might be improved by group-ing chapters dealing with tax expenditures together.Also, the computation of taxable income has to beadjusted accordingly to distinguish between tax structureprovisions and tax expenditure provisions. This willinvolve five necessary changes to the code, includingadjusting the definition of gross income, creating twonew concepts (structural taxable income and structuralinterim tax liability), and adjusting the definition oftaxable income. The five changes are presented in thefollowing formulas:

(1) Gross income = income - tax structural exclu-sions;

(2) Structural taxable income = gross income - taxstructural provisions (for example, deductions andexemptions); and

(3) Structural tax interim liability can then be cal-culated based on the tax rate schedules (structuralrates) using structural taxable income.

Taxable income, then, is defined as structural taxableincome minus tax expenditure provisions:

(4) Taxable income = structural taxable income - taxexpenditure provisions.

Here, tax expenditure provisions include all specialexclusions, exemptions, or deductions identified by theJCT’s approach.

The amount of taxable income, after whatever adjust-ments have been made above, should be the sameamount as that computed under the current provisions ofthe code.

(5) Tax liability can be calculated based on thetaxable income and applicable tax rate schedules,allowed tax credits, and deferral of tax liabilities, asdetermined by the code.

The amount of tax liabilities should also be the same asthose under current provisions of the code.2. Estimates of forgone tax revenue and adjustmentfactors. If the concepts of structural taxable income andstructural tax interim liability were introduced in the

code, forgone tax revenue would be estimated as taxliability minus structural tax interim liability.

As usual, forgone revenue is estimated by applyingindividual tax expenditure provisions separately, assum-ing all other factors remain unchanged. The differencebetween tax liability and the structural tax interim liabil-ity is the revenue forgone because of the application ofthis tax expenditure provision.

In a progressive income tax rate structure, the com-bined effect of claiming several tax expenditure provi-sions may move a taxpayer to a lower tax bracket thanwould have been applicable had none of the tax ex-penditure provisions existed.

For example, consider a taxpayer that has structuraltaxable income of $79,500 and is in the 28 percent taxbracket, and assume that the structural tax interim liabil-ity is $16,370.75.

Imagine the taxpayer took two tax deductions, $12,000for mortgage interest and $2,500 for a regular IRA.Applying the mortgage interest deduction would reduceher taxable income and later her federal tax liability by$3,072. Applying her IRA deduction would reduce hertaxable income and later her tax liability by $697. Apply-ing both measures simultaneously, however, would re-duce her taxable income and later her tax liability by$3,697. This is less than the sum ($3,769) of the reductionsin tax liability that result from each of these deductionscomputed separately (see Table 1).

This difference is caused by interactive effects afterapplying the two tax expenditure provisions, either sepa-rately or simultaneously, that drop the taxpayer’s taxableincome into a tax rate bracket that is different from theone applicable to her structural taxable income.

Because of the interactive effects, the total revenueforgone by a group of tax expenditures (calculated indi-vidually) often differ from the dollar value of the revenueforgone calculated by applying the same group of taxexpenditures at the same time.

To solve the interactive effects problem, this articleproposes to use factors to adjust the estimates of forgonerevenue, which are calculated by applying tax expendi-ture provisions separately.

The process of deriving the formulas of adjustmentfactors and estimates of adjusted forgone individual taxrevenue (by applying each individual tax expenditureprovision separately) are presented in the appendix. Theproposed adjustment factors and estimates of adjustedforgone individual tax revenue apply to three types ofcases.

Case One. When each individual tax expenditureprovision is applied separately, the reduced taxable in-come stays in the same marginal tax rate bracket asstructural taxable income. However, when all tax expen-diture provisions are applied simultaneously, the re-duced taxable income drops into the next lower bracket.

Case Two. When each tax expenditure provision isapplied separately, the reduced taxable income dropsinto the next lower marginal tax rate bracket. Also, whenall tax expenditure provisions are applied simulta-neously, the reduced taxable income drops into the nextlower bracket.

Case Three. When some individual tax expenditureprovisions are applied separately, the reduced taxable



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income stays in the same marginal tax rate bracket asstructural taxable income. However, when other indi-vidual tax expenditure provisions are applied separately,the reduced taxable income drops into the next lowermarginal tax rate bracket. Also, when all tax expenditureprovisions are applied simultaneously, the reduced tax-able income drops into the next lower bracket.

Here, the assumption will be that structural taxableincome is Y0, which has an applicable marginal ratebracket T0 and is more than the amount of α0, and thestructural tax interim liability, y0.

When applying the individual tax expenditure provi-sion, xi (i = 1...n), separately, the reduced taxable incomeis Yi (i = 1...n), whose applicable marginal rate bracket isTi (i = 1...n), which is over the amount of α i (i = 1...n); thecorresponding tax liability is yi (i = 1...n).

When applying all tax expenditure provisions to-gether, Σ

n

1xi, the reduced taxable income is Ye, whose

applicable marginal tax rate bracket is Te, which is morethan the amount of αe; the corresponding tax liability isye.

The relationship of Yi, Ti, yi, andα i (i = 1...n) is shownin the 2007 tax rate schedules below.

The adjustment factor is presented as λ , and theadjusted individual tax revenue forgone is presented asΔy i. The formulas for these are listed below, and arederived in the Appendix. The tax rate schedule table isbelow.

In Case One, because of Ti=T0, the formulas can bederived as follows:

λ = 1n (Y0 - α0)*(Te-T0) - 1

n Σn

1xi*(Te-T0) (A1)

Δy i = - xi*T0 + [ 1n

(Y0 -α0) - x ] *(Te-T0); i =1,..., n. (B1)

In Case Two, because of Ti=Te, the formulas can bederived as follows:

λ =n-1n

(Y0 -α0)*(T0-Te) (A2)

Δy i= -xi*Te - 1n

(Y0 -α0)*(T0-Te), i = 1,..., n, (B2)

In Case Three, the formulas for the adjustment factor canbe derived as follows:

λ = n j-n

*(Y0 -α0)*(T0-Te) + 1n

Σj-1

1xi (T0-Te) (A3)

So that when i = 1, . . . , j-1,

Δy i= n j-n

*(Y0 -α0)*(T0-Te) + j-1n

* x a *(T0-Te)-xi*T0 (B3)

And when i = j, . . . ,n

Δy i= -jn

(Y0 -α0)*(T0-Te) + j-1n

x a *(T0-Te) - xi*Te (B4)

In the appendix, it is demonstrated that by usingadjustment factors to adjust forgone individual tax rev-enue estimated by applying tax expenditure provisionsseparately, interactive effects can be corrected.

Table 1. Interactive EffectsTaxableIncome

MarginalTax Rate

TaxLiabilitiesa

RevenueForegone

Taxpayer (single) $79,500 0.28 $16,370.75A. Applying individual deduction separately(1) Mortgage interest($12,000) 67,500 0.25 13,298.75 -$3072(2) Contribution to IRA($2,500) 77,000 0.25 15,673.75 -697Total -3,769B. Applying both deductions (1) and (2) together($12,000 + $2,500) 65,000 0.25 12,673.75 -3,697Interactive effects (Difference between (B) and thetotal in (A)) -72aCalculated based on the 2007 tax rate schedules published by the Internal Revenue Service.

2007 Tax Rate SchedulesSchedule X — if your filing status is Single

If your taxableincome is over . . . But not over . . . Marginal tax rate The tax is . . .

Of the amountover . . .

Yi Ti yi αi

$0 $7,825 10% 10% $07,825 31,850 15% $782.50 + 15% 7,825.00

31,850 77,100 25% 4,386.25 + 25% 31,850.0077,100 160,850 28% 15,698.75 + 28% 77,100.00

160,850 349,700 33% 39,148.75 + 33% 160,850.00349,700 . . . 35% 101,469.25 + 35% 349,700.00

Source: Form 1040 Instructions, Internal Revenue Service, 2008.



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As a result, the sum of the adjusted individual revenueforgone (estimated by applying individual tax expendi-ture provisions separately) would be equal to the forgonerevenue that is estimated by applying all tax expenditureprovisions simultaneously.

Therefore, the adjusted forgone revenue can besummed up. A group of tax expenditure provisions, or alltax expenditure provisions, can be aggregated. The totalof forgone revenue can now be estimated and used muchmore effectively in the overall budget analysis.

E. ConclusionTax expenditures are an important fiscal policy mea-

sure. In the United States, total tax expenditures aregrowing, and almost approach the amount of discretion-ary and non-interest mandatory spending. In particular,in the FY2008 budget, Treasury listed a total of $987billion in tax expenditures for FY2008. This total ap-proaches the total amount of discretionary spending($1,114 billion in FY2008) and noninterest mandatoryspending ($1,527 billion in FY2008).10

Both the Government Accountability Office and theCongressional Budget Office have urged a restoration ofthe statutory budget controls — including meaningfulcaps on discretionary spending and ‘‘pay as you go’’budget rules on both the tax and spending sides of theledger.11 To make ‘‘pay as you go’’ effective on the taxside, it is critical to manage tax expenditures in the sameway as managing outlays in the budget, in order toachieve fiscal accountability and transparency.

Hence, it is critically important to effectively imple-ment the legislative decision of the Congressional BudgetAct of 1974 regarding the definition of tax expenditures,to incorporate the new approach proposed by JCT toclassify tax provisions as tax expenditures, and to incor-porate the concept of tax expenditures into the code,paving a pathway to build a budget system which is ableto effectively manage spending and ensure fiscal ac-countability on both the tax and outlays sides of theledger. In addition, it is also important to implementmeaningful methods for estimating tax expenditures. Theadjustment factors described in this article would beuseful for this purpose.

Adjustment factors are commonly used in economicstatistics for making necessary and meaningful correc-tions in statistical measurements when facing economicuncertainty. The adjustment factors in this article exhibitonly one type of adjustment: the simple average adjust-ment factor.

If necessary, other kinds of adjustment factors can alsobe formulated — for example, weighted average adjust-ment factors. The principles for formulating adjustmentfactors for tax expenditure estimates are basically thesame. It should be decided in advance what kind ofadjustment factor is most suitable when adjusting taxexpenditure estimates.

For example, suppose we present a tax expenditurebudget (with all of the adjustment factors), but Congresswants to repeal only the deduction for mortgage interest.The simple average adjustment factor could underesti-mate the revenue gain. With this in mind, we may decidein advance to use the weighted average adjustment factorby adding proper weights in the formulas in calculatingadjustment factors. However, this article does not expandthe discussion on weighted average adjustment factors,but instead leaves it to the readers to explore.

More importantly, by incorporating the concept of taxexpenditures into the code, introducing the new defini-tion of gross income and concepts of structural taxableincome and structural tax interim liability, and usingadjustment factors in estimating forgone revenue, itbecomes possible to link together three factors: the struc-tural tax interim liabilities, forgone tax revenues, and taxrevenue actually received. This can be shown as follows:

Structural Tax Interim Liability - Forgone TaxRevenue = Tax Revenue Received

This relationship among structural tax interim liabili-ties, forgone tax revenue, and tax revenue receivedwould further confirm the concept of tax expenditures —namely, that tax expenditures are ‘‘those revenue lossesattributable to provisions of the Federal tax laws whichallow a special exclusion, exemption, or deduction fromgross income or which provide a special credit, a prefer-ential rate of tax or a deferral of tax liability.’’

This relationship also confirms that tax expenditureprovisions are government spending channeled throughthe tax system, and that the true size of governmentshould be the sum of direct expenditures and tax revenueforgone.

By using these techniques, the effectiveness of budgetmanagement and control, as well as fiscal accountabilityand transparency of both the tax and the outlays sides ofthe budget, can be greatly improved.

Appendix1. Adjustment factors for correcting interactive effectsin estimates of forgone revenue. Interactive effects areone of the major problems in estimating forgone taxrevenue. Because of interactive effects, the sum of theamount of forgone tax revenue (as estimated by applyingindividual tax expenditure provisions separately) oftendoes not equal the amount of forgone tax revenue, asestimated by applying all tax expenditure provisionssimultaneously. As a result, the estimates of forgone taxrevenue cannot be summed up; therefore, the total im-pact of tax expenditure provisions cannot be meaning-fully assessed.

This analysis introduces adjustment factors that willbe used to adjust the amount of individual revenueforgone (as estimated by applying tax expenditure pro-visions separately) and to correct the interactive effects,

10Jason Furman, ‘‘The Concept of Neutrality in Tax Policy’’testimony before the U.S. Senate Committee on Finance Hearingon ‘‘Tax: Fundamentals in Advance of Reform’’ (Apr. 15, 2008).Please also refer to footnote 3 in this article, which states thatthese totals are indicative of the extent of tax expenditures butare not an estimate of the revenue that would be raised byrepealing these tax expenditures because they ignore behavioraleffects and the interaction of tax expenditures with otherprovisions in the tax code and other tax expenditures.

11GAO, ‘‘Long-Term Fiscal Challenge, Addition Transpar-ency and Controls are Needed,’’ GAO-07-1144T (July 2007), Doc2007-17335, 2007 TNT 144-146.



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thus making the sum of those estimates equal to therevenue forgone. Using the estimates of adjusted forgonerevenue, we are able to calculate the sum of a group of taxexpenditures, or of all tax expenditure provisions, forpolicymaking purposes.

The adjustment factors introduced in this analysiswould be used for three circumstances common in esti-mating forgone revenue. The core situations are those inwhich, as a result of separate application of individualtax expenditure provisions, the reduced taxable incomewill either stay at the same marginal tax rate bracket asthe structural taxable income, or drop into the next lowerbracket. In either event, the reduced taxable income,when all tax expenditure provisions are applied simulta-neously, will be in the next lower bracket as the structuraltaxable income.

Many other adjustment factors can be generated byfollowing the method used in this article to deal withother special situations not commonly found in thetaxation process. For example, one situation is that thereduced taxable income (as calculated by applying indi-vidual tax expenditure provisions separately) drops intothe next lower bracket. However, this bracket is not thesame bracket applicable to the reduced taxable income,as calculated by applying all tax expenditure provisionssimultaneously.

In this analysis, we used Case One, Case Two, andCase Three, referred to in Section D.2.

For purposes of this analysis, the IRS’s 2007 tax rateschedules will be used.

a. Case One. In Case One, the assumption is that thestructural taxable income is Ys in the 28 percent marginaltax rate bracket (ts), and structural tax interim liability isy0. When applying the individual tax expenditure provi-sions, xi (i = 1, . . . , n), the reduced taxable income is Yi (i= 1, . . . , n), which stays in the 28 percent marginal ratebracket, and the reduced tax liability is Yi (i = 1, . . . , n).When applying all tax expenditure provisions simulta-neously, Σ

n

jxi, the reduced taxable income is (Ye), which

drops into the 25 percent marginal rate bracket (te).

Here, Yi = Ys-xi, i = 1, . . . , n; and Ye=Ys-Σn

1

xi, i =1, . . . ,n.

The forgone revenue (as estimated by applying indi-vidual tax expenditure provisions separately) is pre-sented asΔyi. The forgone revenue as estimated using alltax expenditure provisions simultaneously is presentedas Δye.

Here, Δyi = yi - y0 and Δye = ye - y0

Using the above information, the formula for estimat-ing forgone individual revenue by applying each taxexpenditure provision separately can be derived as:

Δyi = 15,698.75 + (Yi-77,100)*28% - [15,698.75 + (Ys-77100)*28%]

= 15,698.75 + [Ys-77100 - xi)*28%] - [15,698.75 + (Ys-77,100)*28%]

= (Ys-77,100)*28% - xi*28% - (Ys-77,100)*28%

= -xi*28%; i = 1, . . . , n

Then, the sum of above is:

Σn

1Δyi = - Σ

n

1

xi*28 (1)

The formula for forgone revenue, as estimated byapplying all tax expenditure provisions simultaneously,can be derived as:

Δye = 4,386.28 + (Ye - 31,850)*25% - [15,698.75 + (Ys-77,100)*28%]

= 4,386.25 + (Ys - Σn

1

xi - 31,850 + 77,100 - 77100)*25% -[4,386.25+(77,100-31,850)*25% +(Ys-77,100)*28%]

= (Ys-77,100)*(25%-28%) - Σn

1

xi*25% (2)

Thus, the formula for the sum of interactive effect canbe derived as the difference betweenΔye andΣ

n

1Δy i, using

formulas (1) and (2):

Δye - Σn

1Δy i

= (Ys- 77,100)*(25%-28%) - Σn

1

xi*25% - (- Σn

1

xi*28%)

= (Ys-77,100)*(25%-28%) - Σn

1

xi*(25%-28%) (3)

To resolve the interactive effect,Δyi (i = 1,...,n) has to beadjusted. The adjustment factor (λ ) can be derived, withn tax expenditure provisions, from formula (3), as fol-lows:

λ = 1n [(Ys-77,100)*(25%-28%) - Σ

n

1

xi*(25%-28%)]

= 1n (Ys-77,100)*(25%-28%) - 1

n Σn

1

xi*(25%-28%)

Box 2. 2007 Tax Rate SchedulesSchedule X — if your filing status is Single

If your taxableincome is over . . . But not over . . . The tax is . . . Of the amount over . . .

$0 $7,825 10% $07,825 31,850 $782.50 + 15% 7,825

31,850 77,100 4,386.25 + 25% 31,85077,100 160,850 15,698.75 + 28% 77,100

160,850 349,700 39,148.75 + 33% 160,850349,700 101,469.25 + 35% 349,700

Source: Form 1040 Instructions, Internal Revenue Service, 2008.



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After rearranging

λ = [1n (Ys-77,100) - x ]*(25%-28%) (4)

Here, x = 1n Σ

n

1

xi.

To adjust Δyi by adding λ to Δyi, the formula foradjusted forgone revenue Δy i is as follows:

Δy i= -xi*28% + [1n (Ys-77,100) - x ]*(25%-28%); i = 1,...,n(5)

Now, to examine the interactive effects, we can calcu-late the difference between Δye and the sum of theestimates of adjusted forgone revenue, Δyi.

Δye - Σn

1Δy i

= [(Ys-77,100)*(25%-28%) - Σn

1

xi*25%] - {(-Σn

1

xi*28%) +

Σn

1

[1n (Ys-77,100) - x ]*(25%-28%)}

= 0As a result, the interactive effects do not exist when

using adjusted Δy i by adding the adjustment factor λ toΔyi i = 1,..., n.

Therefore, using adjusted forgone revenue, the sum offorgone individual revenue estimated separately equalsthe forgone revenue estimated by applying all tax ex-penditure provisions simultaneously.

Table 2 above gives an example.x and λ can be calculated as:

x = ½(1,200+1,600) = 1,400

Using formula (4),

λ = [½*(79,500-77,100)-1,400] *(25%-28%) = 6

Using formula (5), adjusted forgone revenue, Δy i iscalculated by adding 6 (λ = 6) to Δ yi. The results areshown in Table 2.

Finally, the sum of adjusted revenue foregone of Δy 1andΔy 2 is -772. This equalsΔye (-772), which is estimated

by applying (x1) and (x2) simultaneously. Therefore, theinteractive effects have been corrected.

As a result, the sum of the adjusted revenue forgone ofindividual tax expenditure, as estimated separately, be-comes meaningful and usable.

b. Case Two. In Case Two, the assumption is that thestructural taxable income is Ys in the 28 percent marginaltax rate bracket (ts) and that structural tax interim liabil-ity is y0. When applying the individual tax expenditureprovisions, xi(i = 1...n), the reduced taxable income is Yi (i= 1...n), which drops into the 25 percent bracket, and thereduced tax liability is yi(i = 1...n). Also, when applyingall tax expenditure provisions simultaneously, Σ

n

1

xi, thereduced taxable income is (Ye), which drops into the 25percent bracket (te).

Here Yi=Ys-xi, i = 1, . . . , n; and Ye=Ys-Σn

1

xi, i = 1, . . . , n

The forgone revenue estimated separately by applyingindividual tax expenditures provisions is presented asΔyi. The forgone revenue estimated using all tax ex-penditure provisions simultaneously is presented asΔye.

Here, Δyi=yi-y0, and Δye= ye-y0

Therefore, the formula for estimating forgone indi-vidual revenue by applying each tax expenditure provi-sion separately can be derived as:

Δyi = 4,386.25 + (Yi-31,850)*25% - [15,698.75+(Ys-77,100)*28%]

= 4,386.25 + (Yi-31,850)*25% - [4,386.28 +(77,100-31,850)*25%] - (Ys-77,100)*28%]

= [(Ys-xi+77,100-77,100-31,850)*25%] -(77,100-31,850)*25% - (Ys-77,100)*28%

= (Ys-77,100)*25% + (77,100-31,850)*25% - xi*25% - (77,100-31,850)*25% - (Ys-77,100)*28%

= (Ys-77,100)*(25%-28%) -xi*25%; i = 1 . . . n, and theformula for the sum of all forgone individual revenue isderived as:

Table 2. Adjusted Estimates of Revenue Foregone for Individual Tax Expendituresa

Taxexpenditure

provisionTaxable

income (Y)

Applicablemarginaltax rate

Taxliabilities

(y)

Revenueforegone

(∆y)

Revenueforegone

(adjusted)(∆y’)

Taxpayer (single)Structural $79,500 28% $16,370.75A. Applying individual deductions independently1. Deduction X1 $1,200 78,300 28% 16,034.75 -$336.00 -$330.002. Deduction X2 1,600 77,900 28% 15,922.75 -448.00 -442.00Total -784.00 -772.00B. Applying all deductions (X1 + X2)

2,800 76,700 25% 15,598.75 -772.00 -772.00Interactive Effects 12.00 0.00aBased on 2007 Tax Rate Schedules Internal Revenue Service.



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Σn

1Δyi = Σ

n

1

(Ys-77,100)*(25%-28%) - Σn

1

xi*25%; (6)

Using formula (2),Δye for revenue forgone, estimatedby applying all tax expenditure provisions simulta-neously, can be calculated as follows:

Δye= (Ys-77,100)*(25%-28%) -Σn

1

xi*25%

Therefore, the sum of the interactive effects betweenΔye and Δyi is as follows:

Δye- Σn

1Δyi

= (Ys-77,100)*(25%-28%) - Σn

1

xi*25% - [(Ys- 77,100)*

(25%-28%) - Σn

1

xi*25%]

= (n-1)*(Ys-77,100)*(28%-25%) (7)

To resolve the interactive effects, Δyi has to be ad-justed. The adjustment factor (λ ) can be derived, with ntax expenditure provisions, from formula (7) as follows:

λ =n-1n (Ys-77,100)*(28%-25%) (8)

Therefore, to add λ to adjust Δyi, the formula foradjusted revenue forgone Δy i is as follows:

Δy i= (Ys-77,100)*(25%-28%) -xi*25% +n-1n (Ys-77,100)*(28%-25%)

= -xi*25% - 1n (Ys-77,100)*(28%-25%), i = 1,..., n, (9)

Now, to examine the interactive effects, we can calcu-late the difference between Δye and the sum of theadjusted revenue forgone estimates, Δy i.

Δye- Σn

1Δy i

= Σn

1

[-xi*25% - 1n (Ys-77,100)*(28%-25%)] -

[(Ys-77,100)*(25%-28%) - Σn

1

xi*25%]

= 0

As a result, the interactive effects do not exist whenadjusting Δyi (i = 1, . . . , n) by adding the adjustmentfactor λ to it.

Therefore, using adjusted forgone revenue, the sum offorgone individual revenue estimated separately equalsthe forgone revenue estimated by applying all tax expen-diture provisions simultaneously.

Table 3 above gives an example.Based on formula (8), λ = ½ [(79,500-77,100)] *(28%-

25%) = ½ (2,400) * 0.03 = 36Using formula (9), adjusted forgone revenue,Δy i (i = 1

and 2), is calculated by adding 36 (λ = 36) toΔyi (i = 1 and2). The results are shown in Table 3.

Finally, the sum of adjusted forgone revenue of Δy 1andΔy 2 is -3,697, which equalsΔye (-3,697), when apply-ing (x1) and (x2) simultaneously. As a result of using theadjustment factor, the interactive effects have been cor-rected.

As a result, the sum of the adjusted forgone revenue ofindividual tax expenditure, as estimated separately, be-comes meaningful and usable.

c. Case Three. In Case Three, the assumption is thatthe structural taxable income is Ys in the 28 percentmarginal tax rate bracket (ts) and that structural taxinterim liability is y0. There are tax expenditure provi-sions xi(i = 1 . . . j-1, j, . . . , n). When applying certainindividual tax expenditure provisions separately, xi(i =1 . . . j-1), the reduced taxable income is Yi(i = 1 . . . j-1),which stays in the 28 percent bracket, and the tax liabilityis yi(i = 1, . . . , j-1). However, when applying certain otherindividual tax expenditure provisions, xi(i = j, . . . , n),separately, the reduced taxable income Yi (i = j, . . . , n)drops into the 25 percent bracket, and the reduced taxliability is yi (i = j, . . . , n). Also, when simultaneouslyapplying all tax expenditure provisions,Σ

n

1

xi, the reducedtaxable income is (Ye), which drops into the 25 percentbracket (te).

Yi = Ys-xi, i = 1, . . . , j - 1, j, . . . , n; and

Ye=Ys - Σn

1

xi, i = 1, . . . , j-1, j, . . . , n;

The forgone revenue estimated by applying indi-vidual tax expenditure provisions separately is presentedas Δyi(i = 1, . . . , j-1, j, . . . , n), and the forgone revenue


Taxexpenditure

provisionTaxable

income (Y)


Taxliabilities

(y)

Revenueforegone

(∆y)

Revenueforegone

(adjusted)(∆y’)

Taxpayer (single)Structural $79,500 28% $16,370.75A. Applying individual deductions independently1. Deduction X3 $12,000 67,500 25% 13,298.75 -$3,072.00 -$3,036.002. Deduction X4 2,500 77,000 25% 15,673.75 -697.00 -661.00Total -3769.00 -3697.00B. Applying all deductions(X3+X4) 14,500 65,000 25% 12,673.75 -3697.00 -3,697.00Interactive Effects 72.00 0.00aBased on 2007 Tax Rate Schedules, Internal Revenue Service.



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estimated by applying all tax expenditure provisionssimultaneously is presented as Δye.

Δyi=yi-y0 (i = 1 . . . j - 1, j . . . n), and Δye= ye-y0

Therefore, Σn

1Δyi = Σ

j-1

1

Δyi + Σn

jΔyi

Based on formula (1), when applying individual taxexpenditure provisions, xi i = 1,..., j-1 separately, thereduced taxable income stays in the 28 percent tax ratebracket, and the sum of forgone revenue, Σ

j-1

1

Δyi, is calcu-lated as follows:

Σj-1

1

Δy i = - Σj-1

1

xi *28%

Based on formula (6), when applying individual taxexpenditure provisions, xi i = j, . . . , n separately, thereduced taxable income stays in the 28 percent tax ratebracket, and the sum of forgone revenue, Σ

n

jΔyi, is calcu-

lated as follows:

Σn

jΔyi = Σ

n

j(Ys-77,100)*(25%-28%) -Σ

n

jxi*25%;

Thus, Σn

1Δyi = Σ

j-1

1

Δyi+Σn

jΔyi

= - Σj-1

1

xi*28% + Σn

j(Ys-77,100)*(25%-28%) - Σ

n

jxi*25% (10)

Based on formula (2), the estimated forgone revenue,by applying all tax expenditure provisions simulta-neously, is calculated as follows:

Δye = (Ys-77,100)*(25%-28%) - Σn

1

xi*25%

Therefore, the sum of interactive effects is, usingformulas (10) and (2),

Δye - Σn

1Δyi

= (n-j)*(Ys-77,100)*(28%-25%) + Σj-1

1

xi*28% - Σj-1

1

xi*25%

= (n-j)*(Ys-77,100)*(28%-25%) + Σj-1

1

xi (28%-25%) (11)

Based on formula (11), the adjustment factor (λ) can bederived with n tax expenditure provisions as follows:

λ = n j-n

*(Ys-77,100)*(28%-25%) + 1n Σ

j-1

1

xi (28%-25%)

= n j-n

*(Ys-77,100)*(28%-25%) + j-1n

* x a, *(28%-25%) (12)

Where Σj-1

1

xi= (j-1) * x a, x a is the mean of xi, i = 1...j-1

Therefore, to add λ to adjust Δyi, the formula foradjusted forgone revenue Δy i is as follows:

Δy i = Δy i +λ

As a result, there are two situations that have to betreated separately in adjusting the forgone revenue (thesetwo situations are labeled (a) and (b) below).

(a) When i = 1, . . . , j-1,

Δy i= + n j-n

*(Ys-77,100)*(28%-25%) + j-1n

* x a*(28%-25%) -

xi*28% (13)

Therefore,

Σj-1

1

Δy i = {( -1)( -1)n jn

(Ys-77,100)*(28%-25%) +

+ ( -1)( -1)j jn

* x a*(28%-25%) - Σj-1

1

xi*28% (14)

(b) When i = j, . . . , n

Δy i= Δyi +λ

= (Ys-77,100)*(25%-28%) - xi*25%+ n j-n

*(Ys-77,100) *(28%-25%) +

+ j-1n

* x a*(28%-25%)

= -jn

(Ys-77,100) * (28%-25%) + j-1n

x a*

(28%-25%) - xi*25%

(15)

Therefore,

Σn

jΔy i = Σ

n

j[ -j

n(Ys-77,100)*(28%-25%) + j-1

nx a *(28%-25%) -

xi*25%]

=(- )( - 1)j n j+n

(Ys-77,100)*(28%-25%) +( -1)( - 1)j n j+

n* x a*(28%-25%) + (-Σ

n

jxi *25%) (16)

To examine the interactive effects, we can calculate thedifference between Δye and the sum of the estimates ofadjusted forgone revenue, Δy i.

Δye - Σn

1Δy i= Δye- ( Σ

j-1

1

Δy i + Σn

jΔy i)

= (Ys-77,100)*(25%-28%) - Σn

1

xi*25% - {[( -1)( -1)n jn

(Ys-77,100)*(28%-25%) + ( -1)( -1)j jn

* x a*(28%-25%) -Σj-1

1

xi*28%]

+ [(- )( - 1)j n j+n

(Ys-77,100)*(28%-25%) + ( -1)( - 1)j n j+n

x a

*(28%-25%) - Σn

1

xi*25%]}

= (Ys-77,100)*(25%-28%) - (Ys-77,100)*(25%-28%) -

Σn

1

xi*25% -{(j-1)* x a*(28%-25%) - Σj-1

1

xi*28%+ Σn

jxi*25%}

= Σn

1

xi*25% - Σn

1

xi*25%

= 0

As a result, the interactive effects do not exist whenusing adjusted Δy i, by adding the adjustment factor λ toΔy i, i = 1, . . . , j-1, j, . . . , n.

Therefore, using adjusted forgone revenue, the sum offorgone individual revenue estimated separately equalsthe forgone revenue estimated by applying all tax ex-penditure provisions simultaneously.

Table 4 above gives an example.



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In this example, there are four tax expenditure provi-sions, i = 1, 2, 3, and 4. Here, n = 4, j = 3, j-1 = 2. Based onformula (12), can be calculated as

λ = n j-n

*(Ys-77,100)*(28%-25%) + 1n Σ

j-1

1

xi (28%-25%)

= (4-3)/4*(79,500-77,100)*(28%-25%) + 1⁄4*(1,200+1,600) *(28%-25%)

= 39Using formulas (13) and (15), adjusted forgone rev-

enue, Δy i (i = 1, 2, 3, and 4), is calculated by adding 39(λ = 39) toΔyi (i = 1, 2, 3, and 4). The results are shown inTable 4.

After using the adjustment factor λ , the sum of ad-justed revenue forgone, Δy i(i = 1, 2, 3, and 4), is (-4,397).This equals Δye which is (-4,397), calculated by applyingxi i = 1, 2, 3, and 4, simultaneously. The sum of theinteractive effects is zero. Therefore, the interactive effectshave been corrected.

As a result, by using the adjusted forgone revenue, thesum of the revenue forgone of individual tax expenditureas estimated separately becomes meaningful and usable.2. Generalized formulas for adjustment factors andestimates of adjusted forgone revenue. The assumptionwill be that structural taxable income, before applying fortax expenditure provisions, is Y0, which falls into mar-ginal rate bracket T0, is over the amount of α0, andassumes a tax liability, y0.

When applying individual tax expenditure provisionxi(i = 1, . . . , n) separately, the reduced taxable income isYi(i = 1, . . . , n), which falls into marginal rate bracket Ti(i= 1, . . . , n), is over the amount of α i(i = 1, . . . , n) andassumes a tax liability, yi(i = 1...n).

When applying all tax expenditure provisions to-gether,Σ

n

1

xi, the reduced taxable income is Ye, which fallsinto marginal rate bracket Te, is over the amount ofαe andassumes a tax liability, ye.

The relationship of Yi, Ti, yi, and α i(i = 1, . . . , n), isshown in the 2007 tax rate schedules below.

In generalizing the formulas for the adjustment factors(λ ) and for the adjusted individual revenue forgone (Δy ii = 1, . . . , n) as estimates by applying individual taxexpenditure provisions separately, we will use the for-mulas that were created in the three cases previouslydiscussed.

a. Case One. When each individual tax expenditureprovision is applied separately, the reduced taxable in-come stays in the same marginal tax rate bracket. How-ever, when all tax expenditure provisions are appliedsimultaneously, the reduced taxable income drops intothe next lower bracket.

Previously generated formulas (4) and (5) are asfollows:


Taxexpenditure

provisionTaxable

income (Y)


Taxliabilities

(y)

Revenueforegone

(∆y)

Revenueforegone

(adjusted)(∆y’)

Taxpayer (single)Structural $79,500 28% $16,370.75A. Applying individual deductions independently1. Deduction X1 $1,200 78,300 28% 16,034.75 -$336.00 -$297.002. Deduction X2 1,600 77,900 28% 15,922.75 -448.00 -409.003. Deduction X3 12,000 67,500 25% 13,298.75 -3,072.00 -3,033.004. Deduction X4 2,500 77,000 25% 15,673.75 -697.00 -658.00Total -4,553.00 -4,397.00B. Applying all deductions(X1 + X2 + X3 + X4) 17,300 62,200 25% 11,973.75 -4,397.00 -4,397.00Interactive Effects 156.00 0.00aBased on 2007 Tax Rate Schedules, Internal Revenue Service.

2007 Tax Rate SchedulesSchedule X — if your filing status is Single

If your taxableincome is over . . . But not over . . . Marginal tax rate The tax is . . .

Of the amountover . . .

Yi Ti yi αi

$0 $7,825 10% 10% $0$7,825 $31,850 15% $782.50 + 15% $7,825

$31,850 $77,100 25% $4,386.25 + 25% $31,850$77,100 $160,850 28% $15,698.75 + 28% $77,100

$160,850 $349,700 33% $39,148.75 + 33% $160,850$349,700 . . . 35% $101,469.25 + 35% $349,700

Source: 1040 Instructions, Internal Revenue Service, 2008



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λ = 1n (Ys-77,100)*(25%-28%) - 1

n Σn

1

xi *(25%-28%) (4)

Δy i= -xi*28% + [ 1n (Ys-77,100) - x ] * (25%-28%);

i = 1, . . . , n. (5)

In this case Ti=T0, thus, the formulas can be general-ized as follows:

λ = 1n (Y0 - α0)*(Te-T0) - 1

n Σn

1

xi *(Te-T0) (A1)

Δy i= -xi*T0 + [ 1n (Y0 - α0) - x ] * (Te-T0); i = 1, . . . , n (B1)

b. Case Two. When each individual tax expenditureprovision is applied separately, the reduced taxable in-come drops into the next lower marginal tax rate bracket.Also, when all tax expenditure provisions are appliedsimultaneously, the reduced taxable income drops intothe next lower bracket.

Previously generated formulas (8) and (9) are asfollows:

λ =n-1n (Ys-77,100)*(28%-25%) (8)

Δy i= -xi*25% - 1n (Ys-77,100)*(28%-25%), i = 1, . . . , n (9)

In this case Ti=Te, thus, the formulas can be general-ized as follows:

λ =n-1n (Y0 - α0)*(T0-Te) (A2)

Δy i= -xi*Te - 1n (Y0 - α0)*(T0-Te), i = 1, . . . , n (B2)

c. Case Three. When some individual tax expenditureprovisions are applied separately, the reduced taxableincome stays in the same marginal tax rate bracket.However, when other individual tax expenditure provi-sions are applied separately, the reduced taxable incomedrops into the next lower marginal tax rate bracket. Also,when all tax expenditure provisions are applied simulta-neously, the reduced taxable income drops into the nextlower bracket.

Previously generated formulas (12), (13), and (15) areas follows:

λ = n j-n

*(Ys-77,100)*(28%-25%) + 1n Σ

j-1

1

xi (28%-25%) (12)

(a) When i = 1, . . . , j-1

Δy i= n j-n

*(Ys-77,100)*(28%-25%)

+ j-1n

* x a*(28%-25%)-xi*28%

(13)

(b) When i = j, . . . , n

Δy i = -jn

(Ys-77,100)*(28%-25%) + j-1n

x a*(28%-25%) -

xi*25%

(15)

Where x =j-11

Σj-1

1

xi

In situation (a), Ti=T0, and in situation (b), Ti=Te; thus,the formulas can be generalized as follows:

λ = n j-n

*(Y0 - α0)*(T0-Te) + 1n Σ

j-1

1

xi (T0-Te) (A3)

Therefore, when i = 1, . . . , j-1

Δy i= n j-n

*(Y0 - α0)*(T0-Te) + j-1n

* x a*(T0-Te)-xi*T0 (B3)

And, when i = j, . . . , n

Δy i= -jn

(Y0 - α0)*(T0-Te) + j-1n

x a*(T0-Te) - xi*Te (B4)

Where x =j-11

Σj-1

1

xi

ReferencesBrixi, Hana Polackova, Christian M.A. Valenduc, and

Zhicheng Li Swift, eds. Tax Expenditures — SheddingLight on Government Spending Through the Tax System,The World Bank, 2004.

Cordes, Joseph J., Robert D. Ebel, and Jane G. Gravelle,eds., The Encyclopedia of Taxation and Tax Policy, UrbanInstitute Press, Washington, D.C., 2005.

Department of Treasury, Internal Revenue Service, ‘‘1040Instructions 2007,’’ Washington, D.C.

Furman, Jason, ‘‘Increasing Transparency and Account-ability for Tax Expenditures,’’ Testimony Before theSenate Homeland Security and Governmental AffairsSubcommittee on Federal Financial Management,Government Information, and International Security,Sept. 26, 2006.

Furman, Jason, ‘‘the Concept of Neutrality in Tax Policy,’’Testimony before the U.S. Senate Committee on Fi-nance Hearing on ‘‘Tax: Fundamentals in Advance ofReform,’’ Apr. 15, 2008.

GAO, ‘‘Long-Term Fiscal Challenge, Additional Trans-parency and Controls Are Needed’’ (GAO-07-1144T),July 2007, Doc 2007-17335, 2007 TNT 144-46.

Glenday, Graham and Zhicheng Li Swift, ‘‘EstablishingTax Expenditure Accounts—Towards Better Fiscal Ac-countability and Transparency’’ in ‘‘Turkey PublicExpenditure Review,’’ The World Bank, December2006.

Government Accountability Office (GAO), ‘‘Long-termFiscal Outlook, Action Is Needed to Avoid the Possi-bility of a Serious Economic Disruption in the Future’’(GAO-08-411T), Jan. 2008, Doc 2008-1848, 2008 TNT20-57.

Joint Committee on Taxation, ‘‘A Reconsideration of TaxExpenditure Analysis’’ (JCX-37-08), May 2008, Doc2008-10450, 2008 TNT 93-21.

P.L. 93-344, section 201(g), codified at 2 U.S.C. 601(f).Smith, James E., West’s Internal Revenue Code of 1986 and

Treasury Regulations: Annotated and Selected, 2006 edi-tion, Thomson, South-Western, USA.

Surrey, Stanley S., Pathways to Tax Reform, Cambridge,Mass., Harvard University Press, 1973.



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Surrey, Stanley S., and Paul R. McDaniel, Tax Expendi-tures, Cambridge, Mass., Harvard, University Press,1985.

Swift, Zhicheng Li, ‘‘Managing the Effects of Tax Expen-ditures on National Budgets,’’ Tax Notes Int’l, Mar. 13,2006, p. 917, Doc 2006-779, WTD 50-13.

Swift, Zhicheng Li, ‘‘Strengthening the Governance ofTax Expenditures’’ Tax Notes International, Aug. 20,2007, p. 765, Doc 2007-16533, 2007 TNT 163-9.



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Tax Policy During the Recession:The Role of Fiscal Stimulus

By Alan D. Viard

A. Introduction

The U.S. economy is mired in a severe recession thatofficially began in December 2007.1 The unemploymentrate rose from 4.4 percent in March 2007 to 6.7 percent inNovember 2008, and nonfarm payrolls shed 1.9 millionjobs from December 2007 to November 2008. Real GDPdeclined at a 0.5 percent annual rate in the third quarterof 2008 and undoubtedly fell much more rapidly in thefourth quarter. The Conference Board’s index of leadingeconomic indicators fell 2.8 percent in the six monthsending in November 2008, signaling the economy islikely to remain weak for at least several more months.

During recessions, the government invariably pursuespolicies to stimulate aggregate demand, that is, to in-crease spending by households, firms, and government.(In this context, spending refers to consumer purchases,business and housing investment, government purchasesof goods and services, and exports net of imports.)Monetary policy can stimulate aggregate demand byexpanding the money supply and thereby lowering in-terest rates, which increases households’ and firms’ de-sired spending.

Fiscal policy is another available tool. A variety of taxand spending measures can stimulate aggregate demandby increasing the amount of spending that householdsand firms wish to do at any given interest rate. Anincrease in government purchases of goods and servicesdirectly increases spending. Under some circumstances,simply giving households or firms more money throughtax cuts or government transfer payments may increaseconsumer or investment spending to some extent. More-over, tax measures can provide incentives, or reduce

disincentives, for firms and households to engage ininvestment and consumer spending.

Both monetary policy and fiscal policy have been usedto stimulate aggregate demand before and during thecurrent recession. The Federal Reserve has lowered thetarget value of the federal funds rate 10 times, reducing itto a range of zero to 0.25 percent on December 16, 2008,down from 5.25 percent in September 2007. Congress andPresident Bush enacted a stimulus package in early 2008that included tax rebates intended to bolster consumerspending and temporary incentives for some businessinvestment.2

Because interest rates cannot fall below zero, theFederal Reserve cannot further reduce short-term rates,although it may be able to reduce long-term interest ratesto some extent. As the severity of the recession and thelimits of monetary policy have become clear, support foradditional fiscal stimulus has grown. After unsuccessfulattempts to pass a modest stimulus package in the fall of2008,3 Congress and President-elect Barack Obama areplanning to consider a far larger plan this month. Obamaadviser David Axelrod said December 28 that the pro-posed stimulus package will cost $675 billion to $775billion and that it will include tax reductions as well asspending increases.4

In this article, I consider the general principles of fiscalstimulus and the role of tax measures. Because fiscalstimulus does not create output and jobs from thin air,but ‘‘borrows’’ them from the future, stimulus must beproperly timed to be beneficial. Although it is reasonableto pursue fiscal stimulus under today’s harrowing con-ditions, expectations should remain limited. Stimulusmeasures should be temporary or business-cycle-contingent. Government purchases do not necessarilyprovide a larger (correctly measured) stimulative effectthan tax cuts. On a more specific note, allowing greateruse of net operating loss carryforwards during recessions

1National Bureau of Economic Research, Determination of theDecember 2007 Peak in Economic Activity, Dec. 2008 (available athttp://www.nber.org/cycles/dec2008.pdf).

2The Economic Stimulus Act of 2008, P.L. 110-185, 122 Stat.613 (enacted Feb. 13, 2008).

3On September 26, 2008, the House of Representativespassed H.R. 7110, the proposed Job Creation and Unemploy-ment Relief Act of 2008, but the bill did not become law. The billcalled for $59 billion of spending on infrastructure, food stamps,Medicaid, and unemployment compensation. ‘‘Estimated Costof H.R. 7110, the Job Creation and Unemployment Relief Act of2008, as Introduced on September 26, 2008,’’ CongressionalBudget Office (http://www.cbo.gov/ftpdocs/98xx/doc9816/hr7110.pdf).

4Phillip Rucker, ‘‘Obama Tax Cuts Likely Very Soon,’’ TheWashington Post, Dec. 29, 2008, p. A4.

Alan D. Viard is a resident scholar at the AmericanEnterprise Institute. He thanks Amy Roden for re-search assistance and Alex Brill for helpful discus-sions. The views expressed in this article are his ownand do not necessarily reflect the views of any otherperson or any organization.

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than during expansions can provide a modest fiscalstimulus while also reducing tax penalties on riskyinvestment.

B. Role of Aggregate Demand StimulusTo understand the role of tax and spending measures

in stimulating aggregate demand, it is necessary to clarifythe potential and the limits of stimulus.

Because of various frictions in the economy, monetary andfiscal policies that affect aggregate demand can alter the level ofoutput relative to its natural level (the level that would prevailin the absence of frictions) while also affecting inflation.

Those frictions may include sluggish adjustment ofprices and nominal wages or various types of incompleteinformation. Economists do not agree on the exact typesof frictions, but most have rejected the notion that theeconomy operates in a frictionless manner.5 Nevertheless,the effect of stimulus measures is limited, as set forthbelow.

Tax and spending measures that stimulate aggregate de-mand change the timing of output. Those measures temporarilyincrease output relative to its natural level, with a subsequent‘‘payback’’ in which output is temporarily reduced relative toits natural level.

For present purposes, the following provides the bestsimple representation of the tradeoff between inflationand output. A rise in the inflation rate is associated witha period in which output is high relative to its naturallevel. A fall in the inflation rate is associated with aperiod in which output is low relative to its natural level.Output is unaffected if the inflation rate remains stable,whether at a higher or lower level.6

In such an economy, tax and spending measurescannot permanently increase output by stimulating ag-gregate demand. To achieve a permanent increase inoutput, the inflation rate would have to continue risingforever and eventually reach hyperinflation levels, whichis unsustainable.

In contrast, a sustainable policy could permanentlyboost the inflation rate from one level to another, perhapsfrom 2 percent to 3 percent. In such a case, a period oftemporarily high output would be associated with therise in inflation from 2 percent to 3 percent, but the effectson output disappear as inflation stabilizes at its new

level. To obtain this one-time boost to the economy, it isnecessary to live with higher inflation forever.

The case described in the preceding paragraph doesnot apply to the current fiscal stimulus debate. To beginwith, tax and spending measures that stimulate aggre-gate demand do not permanently boost the inflation rate,even if the measures are permanent. Also, as far as theauthor is aware, no one has proposed that the inflationrate be increased forever to combat the current recession.

The case applicable to the current debate is one inwhich inflation is temporarily increased to combat therecession. Consider an initial increase in the inflation ratefrom 2 percent to 3 percent, with a subsequent reductionback to 2 percent. A period of higher output is associatedwith the rise from 2 percent to 3 percent, and a period oflower output is associated with the decline back to 2percent. An unaffected level of output is associated withthe period during which inflation remains at 3 percentand the period after it returns to 2 percent.

In other words, tax and spending measures thatstimulate aggregate demand not only fail to providepermanent employment gains, but also fail to produce aone-time gain that the economy can keep. Instead theyproduce a one-time gain that must be ‘‘paid back’’through a one-time loss later. A fiscal stimulus packagecan add output and jobs in the next year or two, butunless the inflation rate is permanently increased, it willalso cause a loss of output and jobs sometime later.

‘‘Jobs’’ arguments for tax and spending measures are un-founded in the long run.

An argument made for many tax and spending meas-ures is that they create jobs by increasing the productionof particular goods and services. Middle-income tax cutsand other tax policies that promote consumption are saidto create jobs in industries that produce and sell con-sumer goods. Tax incentives for business investment aresaid to create jobs in the industries constructing plant andequipment. Government spending on infrastructure ordefense is said to create jobs in the construction ordefense industries. Tax incentives and governmentspending that promote renewable energy are said tocreate green jobs.

While those arguments are made from virtually allpoints of the political spectrum, the above discussionindicates that they are invalid in the long run. In the longrun, tax and spending measures that increase productionof an item do not increase overall employment; instead,they increase employment in a particular industry whilereducing employment elsewhere in the economy. Accord-ingly, none of those policies should be justified in thelong run on the basis of job creation. The appropriatelong-run levels of consumption, business investment,infrastructure and defense, and renewable-energy spend-ing depend on the economic gains provided by using theoutput, not the jobs involved in producing it.

As noted above, the jobs argument has some relevancein the short run. Tax and spending measures that pro-mote the production of certain items have stimuluseffects that initially create output and jobs, albeit with asubsequent payback.

5For a prominent macroeconomist’s recent survey of thistopic, see Olivier Blanchard, ‘‘The State of Macro,’’ NationalBureau of Economic Research Working Paper 14259, Aug. 2008.

6The term ‘‘associated with’’ reflects uncertainty about therelative timing of the change in the inflation rate and the changein output. In technical terms, the description in the text is mostconsistent with a backward-looking Phillips curve in which theinflation rate responds positively to output or employment andto lagged inflation rates, with the coefficients on lagged inflationsumming to 1. Many statistical estimates, such as those by MarkA. Hooker, ‘‘Are Oil Shocks Inflationary? Asymmetric andNonlinear Specifications Versus Changes in Regime,’’ Journal ofMoney, Credit, and Banking, 34(2), May 2002, pp. 540-561, at p.542, find the sum of the lagged coefficients to be close to 1 in abackward-looking specification. The analysis in the text alsolargely applies to Phillips curves that also include expectationsof future inflation, provided that the coefficients on laggedinflation and expected future inflation sum to 1.

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C. Guidelines for Stimulus MeasuresTax and spending measures that stimulate aggregate de-

mand are beneficial on those grounds only if society’s need forthe jobs and output initially gained is greater than its need forthe jobs and output lost in the payback period. Proper timing ofstimulus is therefore essential but may be difficult to achieve.

Because the initial output boost from stimulus must bepaid back in the future, proper timing is essential. Ifstimulus provides output and jobs when they are lessneeded and the payback occurs when they are moreneeded, the net effects are harmful. As many economistshave noted, however, proper timing is difficult to achievebecause the desired increase in consumer spending,business or housing investment, government purchases,or net exports may take some time to occur.7

Because of the severity of the current recession, theeconomy desperately needs additional output and jobs.Stimulus that boosts the economy in the next severalmonths would be beneficial, despite the subsequentpayback. Of course, matters become more problematic ifmeasures enacted today take a long time to affect spend-ing.

Tax and spending measures adopted solely to stimulateaggregate demand should not and will not apply permanentlywithout regard to the state of the economy. They should andwill be either temporary, or contingent on the state of theeconomy.

It is senseless to support a permanent tax or spendingmeasure that applies in both good times and bad solelyon the grounds that it will stimulate aggregate demand.Because the output and inflation effects of the policy aretemporary, there is no reason to permanently maintainthe policy if its only purpose is aggregate demandstimulus.

A permanent change can provide short-run stimulus,but that can be, at most, only part of the reason foradopting the policy. Consider, for example, a decisionduring the current recession to adopt a permanent taxincentive for business investment or to permanentlyincrease infrastructure spending. The policy would pro-duce a one-time output gain because of its demandstimulus, followed by a subsequent payback. Giventoday’s economic conditions, that effect could be benefi-cial, assuming that the extra business investment orinfrastructure spending occurred quickly enough. Butthat benefit could not be the sole reason for changinginvestment incentives or infrastructure spending untilthe end of time. The stimulus could be only a favorableside effect of a policy adopted for other reasons, such as

a conviction that our nation needs more business invest-ment or infrastructure. If stimulus were the sole motiva-tion, the policy would be temporary or would be put inplace on a permanent, but business-cycle-sensitive, basis.

Similarly, it is sometimes argued that a permanentincrease in households’ disposable income is a desirableway to increase consumer spending and thereby providefiscal stimulus, because consumer spending is based onlong-run, rather than current, income for many house-holds. Again, however, a permanent change in dispos-able income (which would presumably require apermanent reduction in government purchases) wouldnot be maintained solely for stimulus reasons.

In contrast, stimulus considerations could, and some-times should, be the sole motivation for a decision toaccelerate or delay a permanent change being made forother reasons. Someone who supports (on the groundsmentioned above) a permanent increase in businessinvestment incentives or in infrastructure spending coulddecide on stimulus grounds to accelerate such a changeto take effect during the current recession. Similarly,someone who favors (on distributional and revenuegrounds) a permanent rise in the top two individualincome tax brackets could decide on stimulus grounds todelay the rate increases until after the current recession, adecision that Obama may well make. Note that in eachcase, the change made for stimulus reasons is itselftemporary, although it alters an underlying permanentmeasure.

Government purchases do not necessarily provide a larger(correctly measured) stimulative effect than tax cuts.

Tax changes are often regarded as inferior stimulustools on the ground that the GDP stimulus from increasesin government purchases of goods and services is largerthan that from tax cuts. In general, however, it is impos-sible to say which policy provides a larger (correctlymeasured) stimulus.

The claim that government purchases have a largerstimulative effect than tax cuts arises from a simpletextbook analysis. Consider, for example, a choice be-tween a $100 tax rebate and a $100 road constructionproject. Suppose that 20 percent of the tax rebate is spenton domestic consumer goods, with the remainder eithersaved or spent on imported goods, and that the same 20percent spending ratio applies to the wages and supplierpayments generated by the road project.

Then the rebate boosts measured GDP by only $25,while the road project boosts it by $125. The rebateinitially generates $20 of consumer spending plus $4 ofspending in the second round (as 20 percent of the $20received by producers of the consumer goods is spent)plus 80 cents in the third round and so on, for a total of$25. The road project produces the same $25 consumerspending but also provides a road that is included inmeasured GDP at a $100 value. Unlike the $100 road, the$100 rebate is not part of GDP because it is merely atransfer from some members of society to others ratherthan production.

The impact on measured GDP is not, however, theright criterion. The road is treated as if it is worth $100 inthe GDP accounts solely because it costs $100 to build (inaccordance with the accounts’ general treatment of gov-ernment transactions). The actual value of the road to its

7Several studies have discussed the possible timing lagsassociated with different stimulus measures. Leading studiesinclude Congressional Budget Office, ‘‘Options for Respondingto Short-Term Economic Weakness,’’ Jan. 2008, pp. 8, 19, 22(http://www.cbo.gov/ftpdocs/89xx/doc8916/01-15-Econ_Stimulus.pdf); Douglas W. Elmendorf and Jason Furman, ‘‘If,When, How: A Primer on Fiscal Stimulus,’’ Tax Notes, Jan. 28,2008, p. 545, Doc 2008-890, 2008 TNT 19-42; Alan S. Blinder, ‘‘TheCase Against the Case Against Discretionary Fiscal Policy,’’Princeton University, Department of Economics, Center forEconomic Policy Studies Working Paper 100, June 2004, (http://www.princeton.edu/~ceps/workingpapers/100blinder.pdf).



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users may be either smaller or larger than that amount. Inthe extreme case of a worthless road, the actual improve-ment in (valued) output is $25 for each of the twopolicies. Also, the road construction, unlike the rebates,requires workers to give up their time and provide effort.In general, the road is the better option only if its value toits users exceeds the value of the workers’ time.8

The road is inferior to the rebate if it has little value toits users. However, the road is better than the rebate if ithas a large value to its users; indeed, it may then besuperior by a wider margin than the textbook analysisindicates. It is necessary to scrutinize the value of eachproject; we cannot rely on generalizations about govern-ment purchases being better or worse than tax rebates.

This analysis highlights the importance of properproject selection. If infrastructure investment is to be alarge component of the stimulus package, it is imperativethat wasteful projects be avoided.

D. Loss CarrybacksA large literature has discussed the relative merits of

different stimulus measures, such as tax rebates, transferpayments, government purchases, and temporary invest-ment incentives.9 I will not review that discussion here,except to note that the literature has yet to identify apowerful stimulus measure that can be applied broadly.Instead, I discuss a specific policy option that has re-ceived less attention than it deserves. Allowing greatercarrybacks of NOLs during recessions would serve auseful, although small, stimulus function while reducingthe tax penalty on risky investments.

NOL carrybacks should be more generous during recessionsthan during economic expansions.

Section 172(b)(1)(A) generally allows NOLs to becarried back 2 years or to be carried forward (withoutinterest) for 20 years. As set forth in section 172(b)(1)(H),a five-year carryback applied to losses arising in 2001 and2002, a change that was adopted as part of the 2002 fiscalstimulus package.10 Another temporary five-year carry-back provision is being considered.11

As the Congressional Budget Office has noted, allow-ing greater use of NOLs can strengthen investmentincentives to a modest extent. A firm that has unused lossdeductions obtains no current benefit from deductionsfor new investment, which blunts its incentive to invest.In particular, such a firm is less likely to respond to anytemporary investment incentive provisions included in astimulus package. If a more generous NOL carrybackallows a firm to move out of an excess-loss position, itfaces greater marginal incentives to make new invest-

ments, particularly those that qualify for expensing orother large upfront deductions. More generous carry-backs also provide firms with cash flow, which maypromote investment if they are constrained from borrow-ing, a common situation today.12

Still, as the CBO comments, NOL changes are ‘‘un-likely to generate substantial changes in investment inthe short run.’’ The best case for allowing more generousNOL carryback during recessions is the need to reducetax penalties on risky investment.

If all losses reported on tax returns were real lossesarising from risky investments that were intended, exante, to generate profits, then losses should be fullydeducted at the same tax rate that applies to profits, withany resulting negative tax liability refunded in cash. Onlythat policy provides neutral treatment for risky invest-ments relative to safe investments; any more restrictivepolicy offers firms a ‘‘heads I win, tails you lose’’ dealthat penalizes them for taking risks.

Unfortunately, some restrictions on loss deductionsare likely to be necessary because some losses may bespurious, arising from code provisions that mismeasureincome — and some losses may be claimed in connectionwith outright tax evasion. Although the restrictions dis-allow some genuine losses and thereby penalize riskyinvestments, they safeguard the Treasury from unlimiteddeduction of spurious losses.

The extent to which loss deductions should be allowedreflects a balancing between the desire to allow truelosses and to disallow spurious losses. That implies,however, that more generous loss deductions should beallowed during recessions. During a recession, a higherfraction of reported losses are likely to be true lossescaused by the bad economy, while a lower fraction arelikely to be spurious.

In short, allowing firms to deduct losses if a futurerecession causes their risky investments to go sour helpslevel the playing field. The loss deductions provide theappropriate counterbalance to the taxes that firms willpay on their gains if a future economic upturn boosts thepayoffs from their risky investments.13

Strictly speaking, this level-playing-field argumentprimarily implies that firms should be assured of lossdeductions during future recessions for risky invest-ments they will undertake in coming years. It does notdirectly imply that firms should receive more generousloss deductions during the current recession for riskyinvestments that they have already undertaken. Allow-ing a longer carryback during the current recession,however, is probably the most direct way to provide anassurance about policy during future recessions (and, asnoted above, is also modestly useful as stimulus). Con-sideration should be given to amending section 172 togive the Treasury secretary regulatory authority tolengthen the carryback period during future recessions.

8This point was recently developed by N. Gregory Mankiw,‘‘How Not to Stimulate the Economy,’’ Greg Mankiw’s blog,Dec. 22, 2008 (http://gregmankiw.blogspot.com/2008/12/how-not-to-stimulate-economy.html).

9See the sources listed in supra note 7, and the references thatthey cite.

10The Job Creation and Worker Assistance Act of 2002, P.L.107-147, section 102(a), 116 Stat. 25 (enacted Mar. 9, 2002).

11Chuck O’Toole, ‘‘Stimulus Bill Might Include Five-YearNOL Carryback, Aide Says,’’ Tax Notes, Dec. 15, 2008, p. 1233,Doc 2008-26141, 2008 TNT 240-5.

12CBO, supra note 7, p. 16.13A similar argument suggests that the $3,000 limit on

deductions of net capital losses, as set forth in section 1211(b),should be loosened during recessions or bear markets. Thatchange would probably have no appreciable stimulus effects.



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E. Conclusion

The above analysis suggests several conclusions. Thepotential role of tax and spending measures as stimulusshould not be overstated; fiscal stimulus borrows outputfrom the future rather than creating it from nothing.Proper timing is essential and may be difficult to achieve.Stimulus measures should be temporary or business-cycle-contingent. Government purchases do not neces-sarily provide a larger (correctly measured) stimulativeeffect than tax cuts. Allowing greater use of NOL carry-

forwards during recessions would provide a modestfiscal stimulus while also reducing tax penalties on riskyinvestment.

As a final note, the stimulus debate should supple-ment, rather than replace, the quest for long-run growth.To that end, tax policy should be oriented to tax con-sumption rather than saving. It should also keep mar-ginal tax rates as low as reasonably possible. As weaddress the current economic calamity, let’s also adoptpolicies that will continue to enable each generation toattain a higher standard of living.



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Talking Tax: Inaugurations andThe Rhetoric of Revenue

By Joseph J. Thorndike

When Barack Obama delivers his inaugural addressnext week, how much are we likely to hear about taxes?If history is any guide, not much. Tax professionals mayfind it hard to believe, but when new presidents reach forstirring rhetoric, they don’t start talking tax.

Democratic presidents have been particularly averseto inaugural tax talk. For a party reputed to love taxes,they clearly don’t like to talk about them. Even thegreatest tax-and-spender of all time, Franklin D.Roosevelt, proved unwilling to discuss the subject —only once did he even mention the ‘‘T’’ word in threetrips to the Capitol steps. (FDR’s fourth inauguration, in1945, took place at the White House, with festivitiescanceled because of the war; and no, he didn’t talk abouttaxes then, either.)

Still, the history of inaugural tax talk is worth a quickreview, if only to confirm the popularity of a well-trodrhetorical trope: Taxation as an intolerable, anti-American burden.

McKinleyFor the sake of brevity and relevance, let’s confine this

survey to the modern tax era, starting in 1897 whenfederal taxes — and income levies in particular — were ahot topic of national debate. In his first inaugural ad-dress, President William McKinley managed to bury thenotion of a permanent federal income tax and confirm hispreference for a protective tariff.

‘‘It is the settled policy of the Government, pursuedfrom the beginning and practiced by all parties andAdministrations, to raise the bulk of our revenue fromtaxes upon foreign productions entering the UnitedStates for sale and consumption, and avoiding, for themost part, every form of direct taxation, except in time ofwar,’’ McKinley declared. ‘‘The country is clearly op-posed to any needless additions to the subject of internaltaxation, and is committed by its latest popular utteranceto the system of tariff taxation.’’

McKinley was simply confirming the RepublicanParty’s long-standing support for steep protective tariffs,ostensibly designed to protect the interests of both capitaland labor. And while he never mentioned the income taxby name, he was clearly serving notice that no such levywould win his approval, despite its growing popularity

among workers, farmers, and Democrats (not to mentiona few progressive Republicans).

The next year, McKinley would be forced to accept avariety of new internal taxes to help finance the Spanish-American War. But even under the pressure of war, heand his fellow Republican leaders remained staunchlyopposed to the income tax.

When McKinley delivered his second inaugural ad-dress in 1901, he mentioned taxes only once, taking creditfor their reduction the previous year.

TaftIn his 1905 inaugural address, Theodore Roosevelt

never mentioned taxes at all. The omission was striking,given Roosevelt’s support for progressive tax reform,including a permanent federal estate tax. Instead, it fell toRoosevelt’s handpicked successor, William Howard Taft,to make the Republican case for progressive reform.

Taking office in 1909, Taft faced the prospect of a $100million deficit. Like every major political figure of his era,he considered such a shortfall intolerable. ‘‘It is impera-tive that such a deficit shall not continue,’’ he said.Lawmakers must revise the tariff to produce additionalrevenue. And if that proved impossible, then they shoulddevise new taxes to cover the shortfall. ‘‘Among these Irecommend a graduated inheritance tax as correct inprinciple and as certain and easy of collection,’’ he added.

It would take the better part of a decade, but Congresswould eventually take his advice.

HardingWoodrow Wilson presided over the introduction of

the modern income tax in 1913, but his inaugural rhetoricmade scant mention of tax issues. In 1913 he noted inpassing the unfairness of a heavy protective tariff, whichDemocrats resented for the burden it placed on con-sumers. But he offered no alternatives. In 1917, havingorchestrated a monumental increase in federal taxesduring World War I, Wilson avoided the topic entirely.

Once again it fell to a Republican to talk about tax. Inhis 1921 inaugural address, Warren G. Harding almostrose to the level of eloquence while outlining his plans toreduce high wartime taxes and scale back federal spend-ing:

We can reduce the abnormal expenditures, and wewill. We can strike at war taxation, and we must.We must face the grim necessity, with full knowl-edge that the task is to be solved, and we mustproceed with a full realization that no statuteenacted by man can repeal the inexorable laws ofnature. Our most dangerous tendency is to expecttoo much of government, and at the same time dofor it too little. We contemplate the immediate taskof putting our public household in order. We needa rigid and yet sane economy, combined with fiscaljustice, and it must be attended by individual

Joseph J. Thorndike is a contributing editor for TaxNotes.

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prudence and thrift, which are so essential to thistrying hour and reassuring for the future.Harding began the postwar rollback in federal tax

burdens — a project that many Democrats also supported(although more than a few hoped to retain heavy taxes onbusiness profits).

CoolidgeBut when it came to Republican tax rhetoric, Harding

was quickly eclipsed by his successor, Calvin Coolidge.Taking office after Harding died from a heart attack in1923, Coolidge quickly established himself as an ardenttax cutter. Indeed, he spoke more — and more passion-ately — about taxes than any president before or since.‘‘The collection of any taxes which are not absolutelyrequired, which do not beyond reasonable doubt contrib-ute to the public welfare, is only a species of legalizedlarceny,’’ he famously declared in 1925. ‘‘Under thisrepublic the rewards of industry belong to those whoearn them. The only constitutional tax is the tax whichministers to public necessity. The property of the countrybelongs to the people of the country. Their title isabsolute. ‘‘

Coolidge insisted that cuts be aimed at the rich, as wellas the poor and middle class. He rejected the morallegitimacy of a steeply progressive rate structure, like theone established during World War I:

I am opposed to extremely high rates, because theyproduce little or no revenue, because they are badfor the country, and, finally, because they arewrong. We cannot finance the country, we cannotimprove social conditions, through any system ofinjustice, even if we attempt to inflict it upon therich. Those who suffer the most harm will be thepoor. This country believes in prosperity. It isabsurd to suppose that it is envious of those whoare already prosperous. The wise and correct courseto follow in taxation and all other economic legis-lation is not to destroy those who have alreadysecured success, but to create conditions underwhich everyone will have a better chance to besuccessful. The verdict of the country has beengiven on this question. That verdict stands. Weshall do well to heed it.As president, Coolidge made good on his rhetoric. Tax

rates declined dramatically during his term and a half inoffice.

The Great SilenceHerbert Hoover didn’t mention taxes in his sole

inaugural address, delivered in 1929. Franklin Rooseveltmade a passing reference to them in 1933, taking a swipeat Hoover for the 1932 tax increase. But in his next threeinaugural addresses, FDR never again let the word passhis lips — a striking silence for a chief executive whomade progressive tax reform a centerpiece of his eco-nomic program in the 1930s and who presided over thecreation of the modern tax regime during World War II.

Later presidents followed FDR’s lead: Taxes disap-peared entirely from inaugural addresses for more thanhalf a century. Practitioners of the modern rhetoricalpresidency, Democrat and Republican alike, apparentlydecided that taxes were not the stuff of stirring speeches.

Even presidents who would go on to champion impor-tant tax reforms, like Kennedy in 1961, chose to avoid thesubject.

The Great CommunicatorSo who would revive the tradition of inaugural tax

talk? Ronald Reagan, of course, the most ardent tax cutterto occupy the Oval Office since Coolidge. (Not surpris-ingly, Reagan famously chose Coolidge’s portrait for aprominent place in the Cabinet Room.)

Taking office in the midst of economic turmoil, Reaganpointed to taxes as a key culprit in the nation’s decline.‘‘Idle industries have cast workers into unemployment,human misery, and personal indignity,’’ he declared in1981. ‘‘Those who do work are denied a fair return fortheir labor by a tax system which penalizes successfulachievement and keeps us from maintaining full produc-tivity.’’

Like Coolidge, Reagan could wax eloquent on taxa-tion, imbuing this, the driest of political topics, with atleast a modicum of excitement — or indignation:

In the days ahead I will propose removing theroadblocks that have slowed our economy andreduced productivity. Steps will be taken aimed atrestoring the balance between the various levels ofgovernment. Progress may be slow, measured ininches and feet, not miles, but we will progress. It istime to reawaken this industrial giant, to get gov-ernment back within its means, and to lighten ourpunitive tax burden. And these will be our firstpriorities, and on these principles there will be nocompromise.

In his second inaugural address, Reagan had evenmore to say about taxes. He took more than a fewmoments to glory in the tax cuts of his first term. ‘‘By1980 we knew it was time to renew our faith, to strivewith all our strength toward the ultimate in individualfreedom, consistent with an orderly society,’’ he recalled.‘‘We believed then and now: There are no limits togrowth and human progress when men and women arefree to follow their dreams. And we were right to believethat. Tax rates have been reduced, inflation cut dramati-cally, and more people are employed than ever before inour history.’’

But more important, Reagan went on to call for furthertax reform, invoking the need for simplification. He alsocalled for a balanced budget amendment to halt thegrowth of government. ‘‘We must take further steps topermanently control government’s power to tax andspend,’’ he said. ‘‘We must act now to protect futuregenerations from government’s desire to spend its citi-zens’ money and tax them into servitude when the billscome due.’’

Servitude! Silent Cal would have been proud.After Reagan, presidents resumed their rhetorical tax

avoidance. George H. W. Bush and Bill Clinton studi-ously sidestepped the topic, while George W. Bushmentioned it only in passing during his 2001 address.Clearly, taxes have remained unwelcome terrain forpresidents intent on inspirational speechifying.

So what can we take home from all of this? Two things,I think.

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First, the disappearance of inaugural tax talk afterWorld War II reflects the bipartisan fiscal consensus thatmarked this era. Until 1940 or so, taxes were a centerpieceof political contest, giving Democrats and Republicanssomething important to argue about. But after the war,tax policy ceased to provide an organizing principle forinterparty rivalry. To be sure, partisan sniping continued.But both parties embraced the broad outlines of thewartime tax regime and accepted its permanence.

Second, when it comes to tax, indignation is the onlyacceptable rhetorical mode. Even Democrats — osten-sible champions of shared sacrifice, the common good,and communal enterprise — have been reluctant to makean affirmative case for taxation, at least from the inaugu-ral stand. That’s why even Roosevelt chose to avoid taxrhetoric during his inaugurations.

When it comes to taxes, if you don’t have anythingmean to say, then don’t say anything at all.

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Reorganization ofInsolvent Corporations

By Robert Willens

With the intention of affording ‘‘troubled’’ corpora-tions a meaningful chance for rehabilitation, Congressauthorized a type of reorganization specifically for them.The section 368(a)(1)(G) reorganization (G reorganiza-tion) is available exclusively to corporations, the assets ofwhich are transferred to another corporation in a ‘‘Title 11or similar case’’ (as defined in section 368(a)(3)(A)) butonly if stock or securities of the corporation to which theassets are transferred are distributed in a transaction thatqualifies under section 354, 355, or 356. In the case of anacquisitive G reorganization, the corporation to whichthe target’s assets are transferred must acquire substan-tially all of the target’s assets, and at least one share-holder of the target must receive stock of the acquiringcorporation (or its parent), or at least one security holderof the target must receive stock and/or securities in theacquiring corporation. Accordingly, if the target’s share-holders receive no consideration for their stock and notarget creditor holds securities, there can be no G reorga-nization. If the transaction qualifies as a G reorganization,the acquiring corporation inherits under section 381(a)the target’s tax attributes enumerated in section 381(c),most notably its net operating loss carryovers. The ac-quiring corporation will also inherit under section 362(b)the target’s basis in any assets transferred.

To qualify for the exception from taxation forspecified reorganizations, reg. section 1.368-1(b) statesthat a taxpayer must satisfy ‘‘both the terms of thespecifications and their underlying assumptions andpurposes.’’ This means that the transaction must becarried out for one or more corporate business purposesand the transaction must exhibit continuity of businessenterprise. The continuity of business enterprise require-ment of reg. section 1.368-1(d)(1) is met if the acquiringcorporation or any member of its qualified group eithercontinues the target’s historic business or uses in abusiness a significant portion of the target’s historicbusiness assets. Under the continuity of interest (COI)requirement, those persons who, directly or indirectly,were the owners of the enterprise before its conveyanceto the acquiring corporation must maintain a continuinginterest therein. Moreover, the continuing interest mustbe definite and material and represent a substantial part

of the value of the thing transferred. See Helvering v.Minnesota Tea Co., 296 U.S. 378 (1935).

The modern incarnation of the COI requirement will bemet if, and only if, a substantial part of the value of theproprietary interests in the target corporation is preservedin the potential reorganization.1 See reg. section 1.368-1(e)(1)(i). For this purpose, a proprietary interest is pre-served if it is exchanged for a proprietary interest in theissuing corporation. By contrast, a proprietary interest isnot so preserved when, in connection with the potentialreorganization, (i) it is acquired by the issuing corporationfor consideration other than stock of the issuing corpo-ration; (ii) stock of the issuing corporation furnished inexchange for a proprietary interest in the target is re-deemed by the issuing corporation; or (iii) considerationreceived before the potential reorganization, in a redemp-tion of, or distribution in connection with, the target’sstock, is treated as other property or money received in theexchange for purposes of section 356 (or would be sotreated if the target shareholder had also received stock ofthe issuing corporation in exchange for stock owned bythe shareholder in the target corporation).2

1Regarding the notion of a ‘‘substantial part,’’ the Service hasannounced, in recent regulations, that it considers 40 percent tobe sufficient. See reg. section 1.368-1T(e)(2)(v), Example 1. Thispercentage represents the proportion of equity consideration toaggregate consideration received for the transferred net assetsand not the relationship between the transferors’ equity in thetransferee to the total equity therein. See Bittker and Eustice,Federal Income Taxation of Corporations and Shareholders, para.12.21. Moreover, the consideration to be exchanged shall bevalued (for purposes of determining whether the equity com-ponent of the consideration represents a substantial partthereof) not at the effective time but, instead, as of the close ofthe last business day before the first date on which the contract(under which the transaction will be effected) is a bindingcontract, but only if the contract provides for fixed considera-tion. See reg. section 1.368-1T(e)(2)(i).

2However, a mere disposition of stock of the target, beforethe potential reorganization, to persons not related to the targetor to the issuing corporation, is disregarded as is a meredisposition of the stock of the acquiring corporation, received inthe potential reorganization, to persons not related to theacquiring corporation. Those concessions eliminate the notionof historical shareholder continuity (under which only stockreceived by historical shareholders of the target counted for COIpurposes) and postmerger continuity (under which a precon-ceived plan or arrangement to dispose of the stock received inthe potential reorganization could cause that stock to be ex-cluded in the computation of continuing equity. See Bittker andEustice, supra note 1. Thus, COI now focuses solely on thequality of the consideration furnished in the exchange withoutregard to whom it is furnished (historical shareholder or other-wise) or what those persons do with the consideration once it isreceived.

Robert Willens is the president of Robert WillensLLC, New York, and an adjunct professor of finance atColumbia University Graduate School of Business,New York.

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How are those principles applied to a case in which atroubled corporation is seeking the benefits of reorgani-zation treatment? In many instances, the nominal share-holders of the target are shut out of the process andreceive no consideration for their stock. Thus, the ques-tion arises whether COI can ever be satisfied when theshareholders of the target do not maintain a continuinginterest in the business enterprise but, instead, the tar-get’s creditors, in whole or in part, maintain a continuinginterest. This question is answered affirmatively in re-cently published final regulations3 and, as an addedbenefit, the IRS has extended the G reorganization pro-visions to cases in which the target is merely insolventand is not enmeshed, formally, in a Title 11 or similarcase. According to the regs, the applicability of the Greorganization rules to reorganizations of insolvent cor-porations outside of bankruptcy is entirely consistentwith congressional intent to facilitate the rehabilitation oftroubled corporations.

Creditor Claims as Proprietary InterestsThus, new reg. section 1.368-1(e)(6)(i) provides that a

creditor’s claim against a target corporation may be aproprietary interest in the target if the target is in a Title11 or similar case, or the amount of the target’s liabilitiesexceeds the fair market value of its assets (that is, thetarget is ‘‘insolvent’’ as that term is defined in section108(d)(3)) immediately before the potential reorganiza-tion.

In those cases, if any creditor receives a proprietaryinterest in the issuing corporation in exchange for itsclaim, every claim of that class of creditors, and everyclaim of all and equal and junior classes (in addition tothe claims of shareholders), is a proprietary interest in thetarget immediately before the potential reorganization tothe extent provided in reg. section 1.368-1(e)(6)(ii).4

For a claim of the most senior class of creditorsreceiving a proprietary interest in the issuing corporationand a claim of any equal class, the value of the propri-etary interest in the target represented by the claim isdetermined by multiplying the fair value of the claim bya fraction, the numerator of which is:

• the fair value of the proprietary interests in theissuing corporation that are received, in the aggre-gate, in exchange for the claims of those classes ofcreditors; and

• the denominator of which is the sum of the amountof money and the fair value of all other consider-ation (including the proprietary interests in theissuing corporation) received, in the aggregate, inexchange for those claims.

The regulations provide that if only one class (or oneset of equal classes) of creditors receives stock, that class(or set of equal classes) is treated as the most senior classof creditors receiving stock. Moreover, when only oneclass (or one set of equal classes) of creditors receivesstock in exchange for a creditor’s proprietary interest inthe target, that stock will be counted for measuring COI,provided that the stock is not de minimis in relation tothe total consideration received by the insolvent target,its shareholders, and creditors. Finally, the regulationsindicate that the value of a proprietary interest in thetarget held by a creditor with a claim that is junior to theclaims of other classes of target creditors receiving pro-prietary interests in the issuing corporation shall be thefair value of the junior creditor’s claim.5

Continuity of InterestThe final regs include illustrative examples. In the first

example, the target, an insolvent entity, possesses assetswith a fair value of $150x and is burdened by liabilities inthe amount of $200x. The target has two senior creditors,A and B, with claims of $25x each, and a single juniorcreditor with a claim amounting to $150x. The targettransfers its assets to unrelated P Corp. (P) in exchangefor cash in the amount of $95x and P stock with a valueof $55x. In exchange for their claims, both A and B receive$20x in cash and $5x worth of P stock. The junior creditorreceives the balance of the amounts conveyed by P —$55x of the cash and P stock with a value of $45x.

The transaction in the example exhibits the requisiteCOI. Therefore, because the amount of the target’s liabili-ties exceeds the fair value of its assets, the claims of itscreditors may be proprietary interests in the target. Thetransaction, moreover, can qualify as a G reorganizationeven though the target is merely insolvent and is notenmeshed in a Title 11 or similar case. Because the seniorcreditors of the target, A and B, receive proprietaryinterests in exchange for their claims, those claims andthe claim of the junior creditor and the target stock aretreated as proprietary interests in the target. The value ofthe proprietary interest of each of the senior creditors’claims is $5x ($25x multiplied by the ratio that $10x (thefair value of the proprietary interests in the issuingcorporation that are received, in the aggregate, in ex-change for the claims) bears to $50x, the sum of themoney and the fair value of all other considerationreceived, in the aggregate, in exchange for such claims).Accordingly, in the example, $5x of the stock that each ofthe senior creditors receives is counted in measuring COI.Further, the value of the junior creditor’s proprietaryinterest in the target is $100x, an amount equal to the fairvalue of her claim. The value of the creditors’ proprietaryinterests in the target, in total, is $110x and the creditorsreceive $55x in P stock in exchange for their proprietaryinterests. Consequently, a substantial part of the value of3T.D. 9434, Doc 2008-26044, 2008 TNT 240-39.

4A proprietary interest in the target is not preserved to theextent that creditors (or former creditors) of the target that owna proprietary interest in the corporation (or would be so treatedif they had received the consideration in the potential reorgani-zation) receive payment for their claim before the potentialreorganization and the payment would be treated as otherproperty or money received in the exchange for purposes ofsection 356 had it been a distribution with respect to stock. Seereg. section 1.368-1(e)(1)(ii).

5If a creditor’s claim is bifurcated into a secured claim and anunsecured claim under an order in a Title 11 or similar case orunder an agreement between the creditor and the debtor, thebifurcation of the claim and the allocation of consideration toeach of the resulting claims will be respected for purposes ofapplying the rules of reg. section 1.368-1(e)(6).

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the proprietary interests in the target corporation ispreserved in the potential reorganization, with the resultthat the transaction displays the requisite COI. Whetherthe transaction qualifies as a G reorganization dependson whether the terms of the specifications have been met.Has P acquired substantially all of the properties of thetarget and will stock or securities of P be distributed in atransaction in a transaction that qualifies under section354?

The second example — which applies to transactionsoccurring after December 12, 2008 — illustrates how COIcan be satisfied even though one creditor within thetarget’s single class of creditors receives solely cash inexchange for his claim and the other creditor, within thatsingle class, receives a combination of cash and stock in

the issuing corporation. In this case, the creditors in theaggregate received $10x worth of P stock in exchange fortheir proprietary interests in the target, the value ofwhich in total was $20x. Here, as in the first example,there was 50 percent continuity, and the requisite sub-stantial part of the value of the proprietary interests in thetarget is preserved in the potential reorganization. More-over, this second example is instructive because it con-firms that when the stock component of the considerationtransferred by the acquirer is at least 25 percent of thetotal consideration conveyed, the stock issued will not beregarded as de minimis in relation to the total consid-eration received by the insolvent target and its share-holders and creditors.

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A Pro-Growth and ProgressiveSocial Security Reform Proposal

By Mark J. Warshawsky

Given current economic weakness, policymakers andanalysts are now discussing the need for another stimu-lus package and what temporary measures it shouldinclude. I would like to propose that the essential elementof a package should instead be an immediate and per-manent cut in the Social Security payroll tax rate. At thesame time, I put forward a proposal to deal with thelong-term financial challenge facing the Social Securityprogram. While we have been saying for several yearsnow, appropriately so, that it is better to take actionsooner rather than later for Social Security, I believe thecurrent economic situation represents a particularly goodopportunity. A lack of investor and consumer confidenceis essentially what is ailing our markets and economy.What better way to boost confidence than to finally tacklea stubborn fundamental economic and fiscal problem ina way that is comprehensive, responsible, and fair, andthat draws on a spirit of serious reform and bipartisan-ship?

A spirit of cooperation is the key to any reform ofSocial Security for the simple reason it affects almostevery American worker through the payroll tax used tofinance the system. In fact, right now, more payroll taxesare being paid by workers than are needed to pay currentbenefits. Those excess taxes have been used to cover thegovernment’s profligate spending ways over many yearsand are an added burden on our struggling economy. Tomake the budget of the federal government more honestand transparent, we should cut the payroll tax immedi-ately by 1 whole percentage point. This cut would benefitthose workers most hurt by rising healthcare costs, highmortgage payments, increasing state and local taxes, andstill high food prices. And this tax cut should be perma-nent, to be fair to future generations of workers and toencourage hiring and employment by businesses.

This is just the first step in making the Social Securitytax equitable. The next step is to increase, gradually overthe next three years, the amount of wages for which theSocial Security tax rate applies, so that 95 percent of allworkers, the historical norm, have their earnings totallyincluded in the Social Security system. This means that in2008 dollars, the earnings cap would be $110,000 insteadof the current (in 2008) $102,000 — a seemingly modestchange that will have a noticeable impact on the long-runfinances of the program.

To be fair to those individuals who have spent alifetime in the workforce, and to encourage other workersto follow a similar path, we need to create a category of‘‘paid-up’’ status. After 45 years of credited earnings, allSocial Security payroll taxes would be lifted.

Addressing the tax side of the equation only gets us sofar on the path to strengthening Social Security. We mustalso address benefits by temporarily slowing the sched-uled growth in future benefits, but maintaining, or evenimproving, their value against the steady erosion ofinflation. Any change must not affect those alreadyreceiving benefits, or workers who were age 55 or olderin 2005, the year President Bush cast a spotlight on thesystem’s financial problems. We should also recognizethe rising labor-force participation rate of men andwomen over the age of 55, that ‘‘70 is the old 60,’’ andmake gradual adjustments to the retirement ages accord-ingly.

All of the above changes, along with others affectingnewly hired state and local government workers, thetaxation of Social Security benefits, and discouragingunwarranted disability benefit applications by olderworkers, have been estimated by the Social SecurityAdministration’s Office of the Chief Actuary to bring thesystem into sustainable and permanent solvency. More-over, unlike others, this proposal would not necessitategeneral revenue transfers from the Treasury to achievesolvency and maintain prudent Trust Fund balances.

Most middle- and upper-income workers can expectto make up for those benefit changes through theirpension or their personal 401(k) accounts. Most lower-income and disabled workers, however, do not haveaccess to those private plans. To help those individualsovercome this challenge, we should establish a systemwhereby all workers who earn less than $40,000 a yearwould voluntarily deposit 3 percent of their pay in apersonal account. The contribution for disabled workerswould be paid by the government.

The federal government would provide a dollar-for-dollar match, funded by general revenues, for contribu-tions on the first $20,000 of a person’s earnings and on asliding scale for contributions by those earning up to$40,000. The personal accounts would be managedthrough an independent administrative organizationproviding a few simple investment options intended

Mark J. Warshawsky is a member of the SocialSecurity Advisory Board (SSAB), and was Treasuryassistant secretary for economic policy from 2004through 2006. Details of this proposal and estimates ofimplications for the Trust Fund, the federal budget,and retirement benefits may be found in a memoran-dum dated September 17, 2008, prepared by the Officeof the Chief Actuary of the Social Security Admin-istration (SSA), available at http://www.ssa.gov/OACT/solvency. The proposal is the sole opinion ofthe author and does not represent the views of theSSAB or the SSA.

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exclusively for retirement purposes. According to SocialSecurity’s actuaries, employee contributions and govern-ment matches at those levels will be sufficient to meetneeds now, and mostly exceed in the future, traditionalincome replacement goals, even if those workers investconservatively in Treasury bonds.

This new system of personal accounts, plus a morerobust flow of funds into employer-sponsored pensionplans and personal retirement accounts, would have thesalutary effect of prospectively helping markets andsteadily increasing our national savings rate — just the

right thing to do to help finance the growing retirementof the baby-boom generation and to reduce our nation’sdependence on foreign sources of capital like China andthe Middle East.

This proposal draws on ideas that have been advo-cated by both Democrats and Republicans and embodiesthe calls for bold thinking and bipartisan solutions weheard praised on the campaign trail. More importantly, itwould boost the confidence of the American people thattheir leaders can solve long-term problems before theyturn into a crisis.

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GOVERNMENTEVENTS

Tuesday, January 13

Filing Season. The IRS will sponsor a100-minute Tax Talk Today webcast on the2009 filing season for individuals andbusinesses. The program is set for 2 p.m.ET. Telephone: (202) 622-4000. Web site:http://www.TaxTalkToday.tv.

Extension of Time for Filing Re-turns. The IRS has scheduled a hearingon proposed regulations (REG-115457-08)relating to the simplification of pro-cedures for automatic extensions of timeto file certain returns. The hearing is setfor 10 a.m. in the IRS Auditorium.

Thursday, January 15

Employee Stock Purchase Plans.The IRS has scheduled a hearing on pro-posed regulations (REG-106251-08) thatclarify some rules regarding optionsgranted under an employee stock pur-chase plan and provide guidance on com-plying with section 423. The hearing is setfor 10 a.m. in the IRS Auditorium.

Thursday, January 22

New Markets Tax Credit. The IRS hasscheduled a hearing on proposed regula-tions (REG-142339-05) on how an entitymeets the requirements to be a qualifiedactive low-income community businesswhen its activities involve targeted popu-lations under section 45D(e)(2). The hear-ing is set for 10 a.m. in the IRSAuditorium.

Friday, January 23

Reporting Requirements/Cash andNoncash Charitable Contributions. TheIRS has scheduled a hearing on proposedregulations (REG-140029-07) relating tothe substantiation and reporting require-ments for cash and noncash charitable

contributions under section 170. The hear-ing is set for 10 a.m. in the IRS Audito-rium.

Monday, January 26

Tax-Exempt Bonds. The IRS hasscheduled a hearing on proposed regula-tions (REG-128841-07) on the public ap-proval requirements under section 147(f)applicable to tax-exempt private activitybonds issued by state and local govern-ments. The hearing is set for 10 a.m. in theIRS Auditorium.

Monday, February 9

Fuel Credits and Payments. The IRShas scheduled a hearing on proposedregulations (REG-155087-05) on creditsand payments for renewable and alterna-tive fuels and on the definition of gasolineand diesel fuel. The hearing is set for 10a.m. in the IRS Auditorium.

Thursday, February 19

Discharge of Partnership Indebted-ness Income. The IRS has scheduled ahearing on proposed regulations (REG-164370-05) on the application of section108(e)(8) to partnerships and their part-ners, providing guidance on the determi-nation of discharge of indebtednessincome of a partnership that transfers apartnership interest to a creditor in satis-faction of the partnership’s indebtedness.The hearing is set for 10 a.m. in the IRSAuditorium.

Friday, February 20

Notice Requirements/RetirementPlan Participants. The IRS has scheduleda hearing on proposed regulations (REG-107318-08) providing that a notice of aretirement plan participant’s right to de-fer the receipt of immediately distribut-able benefits must also describe theconsequences of failing to defer receipt,and that the election period for waivingthe qualified joint and survivor annuity

form of benefit has been expanded. Thehearing is set for 10 a.m. in the IRSAuditorium.

Tuesday, March 3

Tax Shelter Case Arbitration. TheU.S. Supreme Court will hear oral argu-ments in Arthur Andersen LLP et al. v.Wayne Carlisle et al., Dkt. No. 08-146. Atissue is whether nonsignatories to an ar-bitration agreement may seek a stay ofproceedings pending arbitration in a caseagainst them by investors whom theyadvised to engage in tax shelter transac-tions. Arguments are scheduled to beginat 10 a.m.

Friday, March 13

Reporting for Discharges of Indebt-edness. The IRS has scheduled a hearingon proposed regulations (REG-118327-08)on the section 6050P information report-ing requirements for debt cancellation.The hearing is set for 10 a.m. in the IRSAuditorium.

Thursday, April 2

Calculating Inclusion of IncomeFrom Deferred Compensation. The IRShas scheduled a hearing on proposedregulations (REG-148326-05) on the calcu-lation of amounts includable in incomeunder section 409A(a) and the additionaltaxes for service providers participatingin some nonqualified deferred compensa-tion plans. The hearing is set for 10 a.m. inthe IRS Auditorium.

Monday, April 20

Foreign Base Company Sales In-come. The IRS has scheduled a hearingon proposed regulations (REG-150066-08)providing guidance on section 954(d) for-eign base company sales income in casesin which personal property sold by acontrolled foreign corporation is manu-factured, produced, or constructed undera contract manufacturing arrangement orby one or more branches of the CFC. Thehearing is set for 10 a.m. in the IRSAuditorium.

Tuesday, April 21

Cost-Sharing Arrangements. TheIRS has scheduled a hearing on proposedregulations (REG-144615-02) on deter-mining taxable income from cost-sharingarrangements. The hearing is set for 10a.m. in the IRS Auditorium.

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TAX CALENDAR

CONTACT INFORMATION

For further information regarding the hearings listed, contact:Internal Revenue Service: Regulations Unit, CC:CORP:T:R, Assistant Chief Counsel

(Corporate), Internal Revenue Service, Room 5288, Washington, DC 20224. Telephone:(202) 622-7180, ask for Hearing Clerk Kelley Banks or Richard Hurst.

Senate Finance Committee: Press Officer, Senate Finance Committee, Room SD-219,Dirksen Senate Office Building, Washington, DC 20510. Telephone: (202) 224-4515.

House Ways and Means Committee: A telephone request to Cooper Smith, staffassistant, House Ways and Means Committee, is required. Call (202) 225-3625. Thetelephone request should be followed by a formal written request to Janice Mays, Chiefof Staff, House Ways and Means Committee, Room 1102, Longworth House OfficeBuilding, Washington, DC 20515.


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MEETINGS ANDSEMINARS

Monday, January 12Stimulus Package — Washington.

The American Enterprise Institute willsponsor a 90-minute program on eco-nomic stimulus options. Web site: http://www.aei.org/events. E-mail: Amy Rodenat [email protected].

Disclosure Documents — Chicagoand Webcast. The Practising Law Insti-tute will sponsor a two-day program ontopics including recent SEC develop-ments, executive compensation, fair valuedisclosure, shareholder proposals andcorporate governance, and audit commit-tee obligations. Priority Code: TVF9. Tele-phone: (800) 260-4754. Web site: http://www.pli.edu.

Estate Planning — Orlando, Fla. TheUniversity of Miami School of Law willsponsor a five-day annual Heckerling In-stitute on topics including planning forretirement benefits, grantor trusts, busi-ness succession, Circular 230, estate plan-ning for unmarried couples, transfer taxvaluation, and variable life insurance.Telephone: (305) 284-4762. E-mail:[email protected].

Tuesday, January 13Tax Reform — Washington. The D.C.

Bar Taxation Section will sponsor a one-day program, ‘‘Current Perspectives onTax Reform.’’ Speakers will include Ed-ward Kleinbard, chief of staff, Joint Com-mittee on Taxation; and staff membersfrom the House Ways and Means andSenate Finance committees. Telephone(202) 626-3463 for reservations.

State of the Union — Washington.The American Enterprise Institute willsponsor an afternoon program on theforeign, defense, and economic policy is-sues that will probably be covered inPresident-elect Barack Obama’s addressto the nation. E-mail: Veronique Rodmanat [email protected]. Web site: http://www.aei.org/events.

International Tax — New York. TheFoundation for Accounting Educationwill sponsor a one-day conference ontopics including the application of taxtreaties, investing abroad, estate and gifttax planning for nonresident aliens, andtax compliance and forms. Treasury Asso-ciate International Tax Counsel David Er-nick will be the luncheon speaker.Telephone: (212) 719-8383 or (800) 537-3635. Web site: http://www.nysscpa.org.Course code: 25610911.

Wednesday, January 14

Section 382 Issues — Washington.The Corporate Tax Committee of the D.C.

Bar Taxation Section will sponsor a lunch-eon program on section 382 issues that arerelevant to the current economic situa-tion. This program was scheduled origi-nally for December 16. Telephone:Leonnetta McMillon at (202) 737-4700,ext. 257. Web site: http://www.dcbar.org.

Nonprofits — New York. The Foun-dation for Accounting Education willsponsor a one-day conference on topicsincluding the new Form 990, endowmentfunds, FIN 48, and uncertainties in UBIT.Telephone: (212) 719-8383 or (800) 537-3635. Web site: http://www.nysscpa.org.Course code: 25550911.

Monday, January 19Financial Planning — San Diego.

The American Institute of Certified PublicAccountants will sponsor a three-dayconference on topics including hedgefunds, succession planning for small busi-ness owners, IRAs payable to trusts, So-cial Security, and property and casualtyinsurance. The location was originally an-nounced in this calendar as Washington.Telephone: (888) 777-7077. Web site:http://www.cpa2biz.com/conferences.

Thursday, January 22State and Local Taxation — Wash-

ington. The State and Local Taxes Com-mittee of the D.C. Bar Taxation Sectionwill sponsor a luncheon program on fun-damental rules and policies of state andlocal taxation. Telephone: Leonnetta Mc-Millon at (202) 737-4700, ext. 257. Website: http://www.dcbar.org.

Friday, January 23Taxation — Chapel Hill, N.C. The

University of North Carolina Kenan-Flagler Business School will host a day-and-a-half tax symposium on topicsincluding corporate tax research, the un-intended consequences of the HomelandInvestment Act, the influence of capitalmarket incentives on U.S. multinationalintra-firm dividend policy, executive com-pensation, and wealth funds. Contact:Kelly Hammond at (919) 962-3168 [email protected].

Taxation of Internet — Teleconfer-ence. Lorman Education Services willsponsor a 90-minute program on salesand use tax issues of Internet transactions.Telephone: (866) 352-9539; priority code389787; seminar ID 383808. E-mail:[email protected].

TAXADMINISTRATION

During JanuaryAll employers. Give your employees

their copies of Form W-2 for 2008 by

February 2, 2009. If an employee agreedto receive Form W-2 electronically, post iton a Web site accessible to the employeeand notify the employee of the posting byFebruary 2.

January 12

Employees who work for tips. If youreceived $20 or more in tips during De-cember, report them to your employer.You can use Form 4070, ‘‘Employee’s Re-port of Tips to Employer.’’

Communications and air transpor-tation taxes under the alternativemethod. Deposit the tax included inamounts billed or tickets sold during thefirst 15 days of December 2008.

January 14

Regular method taxes. Deposit thetax for the last 16 days of December 2008.

Social Security, Medicare, and with-held income tax. Deposit the tax forpayments on January 7-9.

January 15

Individuals. Make a payment of yourestimated tax for 2008 if you did not payyour income tax for the year throughwithholding (or did not pay in enough taxthat way). Use Form 1040-ES. This is thefinal installment date for 2008 estimatedtax. However, you do not have to makethis payment if you file your 2008 return(Form 1040) and pay any tax due byFebruary 2, 2009.

Farmers and fishermen. Pay yourestimated tax for 2008 using Form 1040-ES. You have until April 15 to file your2008 income tax return (Form 1040). Ifyou do not pay your estimated tax byJanuary 15, you must file your 2008 returnand pay any tax due by March 2, 2009, toavoid an estimated tax penalty.

Social Security, Medicare, and with-held income tax. If the monthly depositrule applies, deposit the tax for paymentsin December 2008.

Nonpayroll withholding. If themonthly deposit rule applies, deposit thetax for payments in December 2008.

January 16


January 23



TAX CALENDAR


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ax Analysts 2009. A


