Monthly Tax Roundup (Volume 2, Issue 8)
Our Monthly Tax Roundup is back after a summer hiatus and we have a lot to cover. All eyes are on the U.S. Supreme Court as it takes on an individual taxpayer's challenge to the section 965 transition tax. We review developments in several other cases and the U.S. Department of the Treasury (Treasury) and Internal Revenue Service (IRS) guidance, including new fast-track private letter ruling (PLR) procedures.
Tax fact: According to the Government Accountability Office (GAO), the use of IRS alternative dispute resolution (ADR) programs fell by 65 percent over fiscal years 2013-2022. In 2014, IRS ADR programs closed 429 cases. In 2022, just 119 cases were resolved.
"To tax and to please, no more than to love and be wise, is not given to men." –Edmund Burke, Irish economist, statesman, and philosopher
Briefing Underway in Supreme Court Case Addressing Constitutionality of Transition Tax
On August 30, 2023, taxpayers filed their brief on the merits in Moore v. United States, the high-profile case pending in the Supreme Court challenging the constitutionality of the section 965 transition tax. See Moore v. United States, 36 F.4th 930 (9th Cir. 2022), 53 F.4th 507 (denial of rehearing en banc), cert. granted, 143 S.Ct. 2656 (June 26, 2023).
The petitioners in Moore v. United States, a married couple with 11 percent ownership interest in an Indian controlled foreign corporation (CFC), are seeking a refund of $14,729 in transition tax liability related to their ownership of the CFC. The petitioners contend that the transition tax was imposed on "unrealized sums" earned by the CFC over many years but never distributed to shareholders, and therefore the transition tax exceeded the authority of Congress under the Sixteenth Amendment to impose taxes on income without apportionment among the states. The Ninth Circuit held that the "realization of income is not a constitutional requirement" for Congress to impose income taxes exempt from apportionment, and "there is no constitutional prohibition against Congress attributing a corporation's income pro-rata to its shareholders." The petitioners contend that this holding conflicts with the text of the Sixteenth Amendment and with prior precedent.
The potential consequences of a Supreme Court decision in favor of the petitioners in Moore range from a gentle rumble to seismic disruption of the federal income tax system. The level of disturbance will depend on the breadth of the holding and the underlying rationale. The Court may accept the petitioners' position that the Sixteenth Amendment's exemption from apportionment is limited to taxes on realized gains and that the transition tax imposes liability on "ownership of specified property on a specific date in 2017, not realized gains." A broad holding may implicate longstanding anti-deferral or flow-through regimes that tax owners of entities on the current income of such entities, or even other rules that deem gains or amounts to be realized in the absence of a traditional realization event. However, a number of narrower holdings in favor of the petitioners are possible.
For example, the Court may determine that the transition tax only deviates from the definition of an income tax to the extent it applies to shareholders that lack control sufficient to compel a distribution from the relevant foreign corporation. Such a holding would have sweeping consequences for minority shareholders but muted relevance to multinational controlled groups. Similarly, the Court may determine that the transition tax is unconstitutional as applied to individual shareholders, such as the Moore family, without ruling on the constitutionality as applied to domestic corporate shareholders. Before the adoption of the Sixteenth Amendment, the Supreme Court upheld the constitutionality of a tax on "the net income of the corporation" as an excise tax imposed on "the particular privilege of doing business in a corporate capacity." Flint v. Stone Tracy Co., 220 U.S. 107, 151, 165 (1911).
Alternatively, the Court may hold that the transition tax is unconstitutional, but only to the extent it applies to undistributed earnings which were accumulated during periods in which the taxpayer did not own the relevant foreign corporate stock. Such an "as applied" holding may be unlikely, insofar as the specific petitioners appear to have owned the relevant CFC stock since its formation and the petitioners brief appears to present a "facial" challenge to the transition tax as a tax on the "ownership of specified property."
The Court may determine that shareholder taxation of current foreign corporate earnings constitutes an income tax, but the section 965 transition tax amounts to a tax on the stock of the foreign corporation itself given that the undistributed earnings of a corporation can exceed the gain of any particular shareholder in its stock. Such a holding would invalidate the transition tax, but the reasoning articulated in the opinion may limit any spillover effect on existing anti-deferral regimes addressing current earnings (such as subpart F and global intangible low-taxed income (GILTI)) or systems of flow-through taxation (such as partnerships and subchapter S corporations). Without conceding the constitutionality of subpart F (outside of the transition tax), the petitioners' brief observes that subpart F is based on "constructive realization," limited to circumstances in which Congress determined that domestic shareholders exercise effective control of a foreign corporation, with "narrow categories" of current earnings subject to immediate shareholder taxation, rather than broad attribution of a foreign corporation's retained earnings from prior periods.
Taxpayers should monitor briefing and oral arguments in Moore to evaluate the arguments of the parties and consider the potential implications of a decision. While awaiting a final decision, likely in the first half of 2024, taxpayers should consider modeling the consequences of potential holdings. In particular, taxpayers should evaluate the treatment of current and historic distributions from specified foreign corporations, which taxpayers had expected to be excluded from gross income as previously taxed earnings and profits. If the Court invalidates the transition tax, it is possible that such distributions may qualify for the section 245A dividends received deduction, depending on holding periods, application (and validity) of the extraordinary reduction and extraordinary distribution rules, and whether the shareholder is a corporation or an individual. Such distributions may yield different foreign tax credit outcomes and may result in different consequences with respect to foreign exchange gain or loss. There are many other potential implications, including with respect to the consequences of historic or anticipated sales of specified foreign corporation stock.
Taxpayers may wish to evaluate filing protective refund claims. The viability and timing of refund claims will depend on whether a taxpayer has elected to pay its transition tax liability in installments under section 965(h). Taxpayers that elected installment treatment should expect the government to assert that any refund claim cannot satisfy the full payment requirement of Flora v. United States, 357 U.S. 63 (1958), unless and until all installment payments have been tendered. (See our related coverage, Government Seeks Dismissal in KYOCERA.) Protective claims may also be affected by whether a taxpayer's section 965 inclusion was offset by net operating losses and whether a taxpayer has agreed (e.g., as part of an audit examination) to extend the period of limitations for assessment.
Comments and Hearing on Proposed Regulations Regarding Micro-Captive Insurance Arrangements
As we previously reported, on April 11, 2023, Treasury and the IRS issued proposed regulations under Code section 6011 to designate certain micro-captive insurance arrangements as listed transactions and transactions of interest. The proposed regulations replace Notice 2016-66, which had previously designated some micro-captive insurance arrangements as transactions of interest. Notice 2016-66 was struck down in CIC Servs., LLC v. I.R.S., 592 F. Supp. 3d 677 (E.D. Tenn. 2022), which held that the government failed to satisfy the Administrative Procedure Act (APA) in the issuance of the notice.
Comments on the proposed regulations were due by June 12, 2023, and a hearing was held on July 19, 2023. More than 100 comments were filed and six individuals testified at the hearing. The comments, which were overwhelmingly unfavorable, are available here. Many commenters challenged the proposed 65 percent loss ratio requirement in the proposed regulations and noted that it was entirely inappropriate for the types of low-frequency/high-severity coverages typically provided by small captive insurance companies. Some commenters asserted that the proposed regulations would result in the federal regulation of the business of insurance in violation of the McCarran-Ferguson Act. Commenters also challenged the financing restrictions in the proposed regulations and made various other suggestions for changes.
Treasury and the IRS have their work cut out for them. Due to the recent trend of APA challenges to tax guidance, and particularly here, since the proposed regulations are in direct response to the APA problems with Notice 2016-66, there is likely to be heightened sensitivity to the need to fully respond to the comments, which are extensive. It is unclear how Treasury and the IRS will be able to respond to those comments without making major changes to the proposed regulations. Perhaps the proposed regulations will be withdrawn and the IRS can continue to use its other enforcement tools to attack micro-captives and give up on the listed transaction approach. There is certainly more to come in this space – stay tuned.
IRS Announces Permanent "Fast Track" PLR Program
The IRS recently announced that its program for fast-track processing of corporate PLR requests, is now a permanent option for taxpayers. The IRS introduced an 18-month pilot program in January 2022, under which the IRS aimed to issue certain corporate reorganization and spin-off rulings in 12 weeks. As provided in Rev. Proc. 2023-26, the now-permanent option generally retains the same procedures as the pilot program with two clarifications: fast-track processing will not be granted if the PLR includes a closing agreement and while taxpayers must provide a rationale for seeking fast-track processing, they are not required to demonstrate a business need unless requesting a ruling in less than 12 weeks. The pilot program has proven to be a popular option, so this news is welcome for taxpayers seeking to obtain certainty on the tax treatment of their transactions in a timely manner.
Treasury Temporarily Suspends Key Aspects of 2022 Foreign Tax Credit Regulations
On July 21, 2023, Treasury and the IRS released Notice 2023-55, which allows taxpayers to apply prior regulations governing the creditability of foreign taxes, which were in effect before controversial modifications in January 2022 (the 2022 FTC Regulations). The temporary relief is limited to tax years ending on or before December 31, 2023.
The 2022 FTC Regulations had introduced novel requirements for a foreign tax to be creditable, including an attribution rule and stricter standards for satisfying the net gain requirement. In response to vociferous taxpayer complaints, Treasury and the IRS released proposed regulations in November 2022, offering targeted relief on the attribution rules for royalty withholding taxes and clarifying the cost recovery rules. Notice 2023-55 permits taxpayers to set aside the new standards for a limited period. Specifically, the Notice allows taxpayers to rely on the prior definition of a creditable foreign tax and the former net gain requirement by applying Treas. Reg. § 1.901-2(a) and (b) before modification by the 2022 FTC Regulations, with a single change intended to ensure that digital services taxes remain non-creditable. The Notice further provides that taxpayers may apply the regulations governing "in lieu of" taxes (Treas. Reg. § 1.903-1) without regard to § 1.903-1(c)(1)(iv) (jurisdiction to tax excluded income) and § 1.903-1(c)(2)(iii) (source-based attribution requirement). Not all aspects of the 2022 FTC Regulations are suspended under the Notice. For example, the 2022 FTC Regulations remain in effect with respect to the treatment of refundable tax credits and the standards for whether a payment is non-compulsory.
The Notice affords substantial benefits to taxpayers that incurred withholding taxes on services and royalties in jurisdictions that do not conform to U.S. sourcing rules. The Notice also provides relief with respect to foreign taxes that do not satisfy the cost recovery requirements or the arm's length standard (such as Brazil before recent amendments to its transfer pricing rules). For taxes that were not creditable under the 2022 FTC Regulations, but were creditable under a U.S. tax treaty, application of the Notice may nevertheless provide a benefit, by avoiding the relegation such taxes (and any treaty-resourced income) to a separate foreign tax credit category.
A taxpayer electing to apply the Notice must apply its provisions to all foreign taxes in the taxable year, including taxes paid by any member of its consolidated group and any other person for which the taxpayer is eligible to claim a credit. The Notice does not identify any procedural requirements for the election, although applying the Notice may affect the return presentation, including whether the taxpayer attaches Form 8833 (Treaty-Based Return Position Disclosure) for particular taxes.
The Notice advises that Treasury and the IRS "continue to analyze issues related to the 2022 FTC final regulations and are considering proposing amendments to those regulations" and "whether, and under what conditions, to provide additional temporary relief beyond the relief period." Taxpayers, particularly fiscal year taxpayers afforded only a single year of relief, should consider submitting comments.
Tenth Circuit Affirms IRS Tax Court Win on Section 199 Online Software Claim
In June 2022, we discussed the recent Tax Court decision in BATS Global Markets Holding, Inc. v. Commissioner, 158 T.C. No. 5 (Mar. 31, 2022), the first court decision concerning online software under section 199. BATS addressed whether fees the taxpayer charged for access to its online software qualified for the section 199 deduction under the online software regulations set forth in Treas. Reg. § 1.199-3(i)(6). The Tax Court ruled in favor of the IRS, holding that: 1) Treas. Reg. § 1.199-3(i)(6)(ii) precluded these fees from qualifying for the section 199 deduction because the fees were charged for access to the taxpayer's communications network, not to provide direct access to software, and 2) the third-party software on which BATS relied was not "substantially identical" to the taxpayer's software and therefore did not satisfy the third-party comparable exception in Treas. Reg. § 1.199-3(i)(6)(iii)(B). The taxpayer appealed the BATS decision to the U.S. Court of Appeals for the Tenth Circuit.
On July 12, 2023, the Tenth Circuit affirmed the Tax Court's decision in a non-precedential summary affirmance with only abbreviated analysis of the facts and law. BATS Global Markets Holding, Inc v. Commissioner, Case No. 22-9002 (10th Cir. 2023). The appellate court's decision addressed only the "substantially identical" argument, holding that the taxpayer "failed to demonstrate that a third party derived revenue from licenses or other dispositions of software that was substantially identical to [taxpayer's] software, as required by the so-called third-party comparable exception." The court agreed with the taxpayer's argument that the Tax Court improperly excluded evidence but found the error to be "harmless" because that evidence was cumulative. In a footnote, the court explained that because the Tax Court's holding on the third-party comparable exception was affirmed, there was no need for it to rule on the Tax Court's determination that the fees were charged for access to the network and not for direct access to software.
Because the Tenth Circuit's decision is a summary affirmance without detailed analysis, it is unclear that the decision will have any meaningful impact on other section 199 online software cases. The fact-intensive nature of section 199 disputes means the specific facts and circumstances of each taxpayer are crucial and taxpayers should analyze whether their facts are distinguishable from those in BATS.
Third Circuit Finds Equitable Tolling Available for Late-Filed Tax Court Petition
Reversing the Tax Court, the U.S. Court of Appeals for the Third Circuit held in Culp v. Commissioner, 75 F.4th 197 (3d Cir. 2023), that failure to file a Tax Court petition within the 90-day statutory period did not necessarily deprive the Tax Court of jurisdiction to redetermine a deficiency. Section 6213(a) provides that within 90 days of receiving a notice of deficiency a taxpayer may file a petition with the Tax Court for a redetermination of the deficiency. It had been widely understood that the Tax Court does not have jurisdiction to consider a petition filed outside this statutory filing period. Consistent with this view, the Tax Court granted an IRS motion to dismiss because the petition was filed almost three years after the statutory deadline. The Third Circuit's reversal was likely foreshadowed by the Supreme Court's 2022 ruling in Boechler v. Commissioner, 142 S. Ct. 1493 (2022), that a similar statutory filing period was not jurisdictional.
In Boechler, the IRS assessed an addition to tax and then issued a notice of intent to levy to satisfy the liability. The taxpayer first challenged the levy in a collection due process (CDP) hearing before IRS Appeals and, when the levy was upheld there, filed a petition for review with the Tax Court. Its petition was filed one day after the 30-day statutory period for filing a CDP petition under section 6330(d)(1). In considering whether this filing deadline was a jurisdictional requirement or merely a procedural rule, the Supreme Court explained that although Congress need not use magic words to show that a filing deadline is jurisdictional, the statute must "plainly show that Congress imbued a procedural bar with jurisdictional consequences." Boechler, 142 S. Ct. at 1497 (cleaned up). Construing section 6330(d)(1), the Court found that the text "does not clearly mandate the jurisdictional reading." Id. at 1498. In contrast, the Court previously held in United States v. Brockamp, 519 U.S. 347, 350 (1997), that the statutory time limit for filing a claim for refund under section 6511 was written in "unusually emphatic form" and thus the failure to timely file a claim for refund precluded a suit for refund.
Turning back to the decision in Culp, the Third Circuit found insufficient textual evidence to conclude that the 90-day filing deadline under section 6213(a) was jurisdictional, noting that "[i]f the § 6330(d)(1) deadline in Boechler fell short of being jurisdictional, § 6213(a)'s limit must as well." Culp, 75 F.4th at 201. Since the failure to file a Tax Court petition within the statutory deadline is not jurisdictional, the taxpayer could argue that the time limit to file a petition should be tolled under equitable principles. As the court explained, non-jurisdictional limitations periods are presumptively subject to equitable tolling. The Third Circuit found insufficient evidence that this presumption would not apply to the 90-day deadline and remanded the case to the Tax Court to determine if the taxpayers were eligible for relief. Equitable tolling allows taxpayer to show that a failure to meet a procedural deadline should be excused because of extraordinary circumstances.
Although missing a statutory deadline is never advisable, Boechler and now Culp reveal that equitable relief is at least theoretically available. But as these decisions show, distinguishing between jurisdictional and procedural deadlines turns on a careful reading of the relevant statutory text.
Seventh Circuit Affirms IRS Win in Memphis Grizzlies Economic Performance Case
The U.S. Court of Appeals for the Seventh Circuit has affirmed a Tax Court decision (previously covered here) denying a seller a current deduction for a deferred compensation liability that a buyer assumed in acquiring a trade or business. Hoops, LP v. Commissioner, No. 11308-18 (7th Cir. Aug. 9, 2023), involved the sale of the Memphis Grizzlies National Basketball Association (NBA) team and the interaction of the economic performance rule and deferred compensation rules. The buyer assumed certain player contracts with deferred compensation obligations. The seller included the liability assumption in amount realized and claimed an offsetting deduction based on Treas. Reg. § 1.461-4(d)(5), which provides that economic performance occurs with respect to a liability assumed in connection with the sale or exchange of a trade or business as the seller includes the assumed liability in amount realized.
In the Tax Court, the IRS conceded that economic performance had occurred and that the deferred compensation liability had been incurred for section 461 purposes. However, the IRS asserted that another Code provision — section 404(a)(5) — controls the way this incurred liability is taken into account for federal income tax purposes and defers a deduction until the taxable year in which the deferred compensation is included in the recipient's gross income. The Tax Court held for the IRS, stating that "it is the section 404(a)(5) limitation as to the amount deductible for any year that precludes deduction for the year of the 2012 sale, not any purported failure to satisfy the economic performance requirement."
In affirming the Tax Court decision, the Seventh Circuit observed that the liabilities at issue related to services that certain players had already performed for the seller at the time of the sale. Economic performance for liabilities relating to services occurs as the services are provided, and so economic performance for the liabilities at issue occurred before the sale. Consequently, the Seventh Circuit concluded that Treas. Reg. § 1.461-4(d)(5), which applies only to liabilities that would be deductible at the time of the sale but for the economic performance requirement, did not apply here. The seller argued that section 404(a)(5) was an economic performance rule that deferred the timing of the compensation deduction until payment. But the Seventh Circuit disagreed: "We cannot agree with [the seller] that the definition of economic performance sweeps broadly enough to include the specific, deferred-compensation provision in § 404(a)(5)."
The Seventh Circuit acknowledged that the seller could claim a deduction in the tax year when the players are paid the deferred compensation but was unmoved by the possibility that the seller could lose the deduction altogether if, for example, the buyer never pays the players, or the buyer otherwise fails to tell the seller that payment has occurred. According to the court, these risks were "foreseeable" and could have been avoided in many ways — by adjusting the sales price, contributing to qualified plans to trigger earlier deductions, or renegotiating the players' contracts and accelerating their compensation to the date of the sale.
Hoops provides a cautionary tale to taxpayers who sell a trade or business with deferred compensation obligations. These taxpayers should consider taking steps before a sale to obtain a current deduction or otherwise include terms in the purchase and sale agreement to have access to information necessary to obtain a future deduction.
Third Circuit Affirms Current Deduction for Patent Litigation Fees
In its July 27, 2023, opinion in Mylan Inc. v. Commissioner, the Third Circuit affirmed the Tax Court's allowance of a current deduction for patent litigation fees incurred in the context of an expedited Food and Drug Administration (FDA) approval process for generic drugs. As the Third Circuit noted, the decision came down to "what the word 'facilitate' means," as the regulations require capitalization of amounts paid to "facilitate" the acquisition or creation of intangible assets.
Mylan was involved efforts to obtain FDA approval for generic drugs through an expedited process under the Hatch-Waxman Act. In this process, the generic drug manufacturer can submit an Abbreviated New Drug Application (ANDA), rather than the costly and time-consuming New Drug Application (NDA), if it can show that its proposed drug has the same active ingredients as, and is biologically equivalent to, an already approved brand-name drug. The ANDA must also certify that it will not infringe on any relevant patents. One means of so certifying is to assert that such relevant patents are invalid. Such a certification often (but not always) provokes litigation.
The IRS asserted that the patent litigation fees facilitated the acquisition of the FDA approval of the ANDA. The Tax Court rejected the IRS's argument, finding that the FDA approval was not dependent on the outcome of the patent litigation. The Third Circuit agreed. The Third Circuit noted that "even if the generic manufacturer loses the patent suit after receiving effective [FDA] approval, the FDA does not revoke or suspend approval, but merely converts the approval to a tentative approval effective after the expiration of the relevant patents."
This case is important because the IRS will often try to argue for broad interpretations of the term "facilitative." Just because two events or processes are related, or even intertwined, does not mean that one facilitates the other. The Third Circuit also had some interesting language to suggest that burdensome obstacles that need to be overcome are not "facilitative" – a term that is used in the regulations for the acquisition or creation of intangibles but also for other types of transactions. The Third Circuit said: "If anything, an ANDA suit makes acquisition of FDA approval more difficult because it slows it down." Many regulatory approvals and many transactions run into hurdles and obstacles. The key will be the ability to show overcoming that hurdle or obstacle is a "distinct and ultimately separate" process.
Third Circuit Affirms IRS Win Regarding Effect of Written but Unpaid Check
In a non-precedential opinion, the U.S. Court of Appeals for the Third Circuit has affirmed a Tax Court decision (previously covered here) holding that a decedent's gross estate includes the value of checks that were validly written before the decedent's death but paid by the drawee bank after the decedent's death. Estate of William E. DeMuth v. Commissioner, No. 22-3032 (3d Cir., July 12, 2023). Both the Tax Court and the Third Circuit focused on the Code and regulations in the gift tax context that determine when a gift has been completed. Both courts cited Treas. Reg. § 25.2511-2(b), which provides that a gift is not complete until a donor has "parted with dominion and control as to leave him no power to change its disposition." The courts then looked to state law to determine if the decedent had indeed parted with "dominion and control," and found that the potential for a stop payment order on the day of the decedent's death could prevent payment, making the gift revocable and thus incomplete.
Estate of DeMuth stands in stark contrast to longstanding case law holding that for income tax purposes a check constitutes payment upon delivery. In Estate of Spiegel, 12 T.C. 524 (1949), the Board of Tax Appeals held that a check written and delivered to a charity at the end of one year but paid by the drawee bank in the following year supported an income tax deduction in the first year. Citing existing authorities, the court reasoned that "upon the issuance and delivery of the checks in question, [the taxpayer] made a conditional payment of charitable contributions which, upon the presentation and payment of the checks, became absolute and related back to the time when the checks were delivered." Treasury regulations have since adopted this rule. See Treas. Reg. § 1.170A-1(b) ("The unconditional delivery or mailing of a check which subsequently clears in due course will constitute an effective contribution on the date of delivery or mailing").
As Estate of DeMuth focused only on whether there had been a completed gift for estate tax purposes, the case should have little bearing on the longstanding principle that a check constitutes payment upon delivery for income tax purposes.
Tax Court Denies Claimed R&E Credits and Sustains Penalties Against S Corp Shareholders
On July 6, 2023, the Tax Court issued a memorandum decision in Betz v. Commissioner, T.C. Memo. 2023-84. The taxpayers in Betz are shareholders in an S corporation called Catalytic Products International, Inc. (CPI) that designs and supplies air pollution control systems. CPI claimed I.R.C. § 41 research and experimentation (R&E) credits on its 2014 return, based on a research credit study performed by a consultant. CPI did not maintain time-tracking records for its employees' activities, instead relying on estimates. Several of CPI's projects were performed under contract with customers, with the customers retaining rights to the resulting research in the relevant agreements.
The Tax Court determined that CPI did not adequately substantiate its research credit claims. The court agreed with CPI that a taxpayer "need not necessarily maintain and produce contemporaneous time-tracking records for its employees." The court further held that a taxpayer must, at a minimum, "make a threshold showing that a particular employee performed activities that constituted qualified services with respect to a business component." Relying on the Seventh Circuit's recent decision in Little Sandy Coal Co. v. Commissioner, 62 F.4th 289, 308 (7th Cir. 2023), the court determined that CPI failed to introduce sufficient evidence to substantiate that its employees performed qualified research. In an alternative holding, the Tax Court held that several of the projects fell under the "funded research" exclusion in I.R.C. § 41(d)(4)(H), on the ground that CPI did not retain substantial rights in the research. Finally, the court sustained accuracy-related penalties for negligence and substantial understatement under I.R.C. § 6662, rejecting CPI's assertion that its reliance on the consultant constituted reasonable cause under I.R.C. § 6664.
Betz serves a reminder that reliance on a consultant's study is not a substitute for adequate substantiation and compliance with the requirements of section 41. It also highlights the IRS's increased practice of asserting penalties in research credit cases.
No Vacation for Crypto This Summer
Nobody gave the Treasury, the IRS, or the courts the memo that August was supposed to be for vacation. Instead, the past month has been one of significant developments for the tax treatment of cryptocurrency.
Revenue Ruling 2023-14 Stakes Expected Position
The IRS kicked things off with its release of Rev. Rul. 2023-14, 2023-33 I.R.B. 484. Technically this was on July 31, but we didn't read it until August.
Rev. Rul. 2023-14 takes up the question that is addressed on the first day of Introduction to Federal Income Tax: is it income? Specifically, when a cash-method taxpayer receives a staking reward in the form of additional crypto tokens for validating crypto transactions and putting up ("staking") already-owned tokens that may be forfeited if the validation is not successful, is there income? In the real world, the staking reward typically comes in the form of additional tokens, and so, too, in the ruling.
The IRS notes that the Supreme Court has said (in Commissioner v. Glenshaw Glass, 348 U.S. 426, 431 (1955)) that gross income means all accessions to wealth clearly realized over which the taxpayer has complete dominion and that it doesn't matter what form the "accession" takes. Cryptocurrency is property anyway under Notice 2014-21, and gains from property are income, even when the result is additional property. So there is your answer, says the IRS.
While the Revenue Ruling focused on a cash-method taxpayer specifically, one would expect the same analysis to apply to an accrual method taxpayer as well. See generally, Treas. Reg. § 1.451-1(a) ("Under an accrual method of accounting, income is includible in gross income when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy (all events test).").
The Jarretts Don't Get Their Day in Court
The crypto tax bar has been tracking this issue for a while. The Jarretts made a modest profit in Tezos tokens through staking, which the IRS said was income, and assessed additional tax on that basis. The Jarretts paid a tax of $3,793 and claimed a refund. After the requisite six months required by section 6532(a), they filed a refund suit in the Middle District of Tennessee. See No. 21-cv-04419 (filed 2021). But while the case was pending the IRS simply wrote them a check for the full amount due plus interest. The Jarretts fought on, seeking to "vindicate[e] their rights in court," and amended their complaint to seek injunctive and declaratory relief. They didn't cash the check, either.
Substantively, the Jarretts would have had some arguments not addressed by Rev. Rul. 2023-14. One can see the argument that tokens obtained through staking are self-created property and therefore not income. The argument goes that like a farmer growing crops, there would be no true accession to wealth until the crops are sold. Or, perhaps, the staked tokens could simply be said to be a dilution in the value of all Tezos tokens outstanding and therefore not an accession to wealth under the logic of Eisner v. Macomber, 252 U.S. 189 (1920) (proportional stock dividend is nontaxable).
Rev. Rul. 2023-14 doesn't grapple with these arguments and neither did the Middle District of Tennessee. That court dismissed the case on September 30, 2022, holding that the IRS's payment of the refund mooted the claim, as Article III of the Constitution limited subject matter jurisdiction to "cases" and "controversies," which no longer existed after the IRS's payments.
The Jarretts appealed to the Sixth Circuit, arguing that the case was analogous to the issue in Campbell-Ewald v. United States, 577 U.S. 153 (2016), which held that a defendant's offer of relief does not deprive a court of jurisdiction. In that case, the plaintiff filed a class action after he received unwanted text messages from the defendant. The defendant offered the plaintiff the maximum amount he could receive by statute for each offending text message, which the plaintiff refused. The Supreme Court held that the unaccepted settlement offer did not moot the plaintiff's claim for Article III purposes.
The Sixth Circuit rendered its decision on August 18, 2023. Judge Jeffrey S. Sutton, who may be best known for the taxpayer-favorable decision on substance-over-form issues in Summa Holdings v. Commissioner, 849 F.3d 779 (2017), delivered the unanimous opinion of the three judge panel. The court didn't accept the analogy to Campbell-Ewald, stating that "[t]he IRS paid Jarrett. Offers differ from tenders, just as words differ from deeds." If the IRS paid the refund claim over which the taxpayer was suing, there was simply nothing left to litigate, unlike a normal defendant's offer to settle (even on the most favorable terms possible), which had to be accepted. It didn't matter that the Jarretts didn't cash the check the IRS gave them; the issuance of it was enough.
The Sixth Circuit acknowledged the Jarretts' argument that, if the dismissal stood, then "the government could mail refund checks strategically, mooting refund suits whenever it wishes for all kinds of reason," but didn't see how such conduct would rise to the level of abuse, as it would mean the government would have paid the full refund amount sought, plus interest. The case was therefore moot and any prospective relief, i.e., the requested injunction, could not be supported if the refund claim fell out.
The Sixth Circuit also acknowledged a "recent IRS revenue ruling [that] formalizes the Service's long-tentative view that new tokens arising from staking constitute income when the taxpayer receives them." But the court said that the ruling had no bearing on the Jarretts' taxes for 2019 or the outcome of their court case.
Still, there is nothing stopping another taxpayer from taking a position contrary to Rev. Rul. 2023-14 and litigating it, either in Tax Court or through a refund suit as the Jarretts did.
The Proposed Regulations
A large (282 pages) package of crypto proposed regulations dropped on August 25. These proposed regulations in part reflect changes made by section 80603 of the Infrastructure Investment and Jobs Act, Pub. L. 117-58 (Nov. 15, 2021) to the broker reporting provisions of section 6045 relating to how crypto and other digital asset transactions must be reported.
The issue is that some people aren't paying taxes on their crypto gain. As the preamble notes, "Digital assets may also be popular, however, because the distributed ledger record of transactions does not include the identity of the parties involved in the transactions. This pseudonymity creates a significant risk to tax administration."
The proposed regulations generally focus on changes to Treas. Reg. § 1.6045-1 and would require brokers, including crypto trading platforms, crypto payment processes, and certain crypto wallets to file information returns on sales or exchanges of crypto and other digital assets. They would also have to provide taxpayers statements on new Form 1099-DA. Other aspects of the proposed regulations provide guidance on the computation of gain and loss and the basis of digital assets under sections 1001 and 1012.
As far as effective dates go, the proposed regulations that change reporting under Treas. Reg. § 1.6045-1 would go into effect with respect to sales and exchanges on or after January 1, 2025. Brokers will be required to report the adjusted basis and character of any gain or loss for sales and exchanges that occur after January 1, 2026.
Comments are due on October 30 and, given the significant changes to the reporting regime that will result in the reporting of millions of new transactions, we expect there to be a lot of them.
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