IRS Power to Reallocate Income, Deductions, and Other Items under IRC Section 482

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Some taxpayers may be tempted, especially in situations involving related parties, to arbitrarily shift the source of income or allocation of deductions, in order to avoid or lessen taxes.  Congress, however, enacted IRC Section 482 to give the IRS wide power to prevent such actions.  This article will give a brief overview of some aspects of this complex area of U.S. tax system.

IRS Authority under IRC Section 482

In general, IRC Section 482 gives the IRS the ability to distribute, apportion, or allocate gross income, deductions, credits or allowances between certain organizations if they are controlled or owned by the same taxpayers, and it is determined that such action is necessary to prevent tax evasion, or to clearly reflect such organizations’ income.  The IRS has broad authority under this section (and the definition of “control” is similarly interpreted broadly); taxpayers, on the other hand, are generally not able to use this section to reallocate income, deductions or other items on their own.

IRS authority under this section to make such determinations is generally granted whenever taxpayers report different income, deductions, or other related items than they would have had if the taxpayers made an arm’s-length transaction with organizations that were not controlled or owned by them.  Various methods are available to the IRS to determine the proper arm’s-length price.

In the context of international taxation, one of the purposes of this section is to prevent taxpayers from improperly shifting income to controlled organizations in countries with lower tax rates (or conversely, transferring deductions to controlled organizations in high tax rate countries).

Penalties under IRC Section 482

Severe penalties may apply under IRC Section 482.  IRC 6662(e)(1)(B) imposes transfer pricing penalties on any underpayment attributable to a “substantial valuation misstatement” pertaining to transfer pricing. There are two types of transfer pricing penalties under this particular provision: (A) the transactional penalty, which applies when the price reported for any property or services is 200% or more (or 50% or less) of the amount determined to be the proper price, and (B) the net adjustment penalty, which applies when the net IRC 482 adjustment (i.e. the reallocation of profit determined by the IRS) exceeds the lesser of $5 million or 10% of a taxpayer’s gross receipts.  An accuracy-related penalty of 20% may be applied in such circumstances.  Further, under IRC Section 6662(h), a 40% penalty for “gross misstatements” (as defined in the provision) may be applied.

Contact Sherayzen Law Office for Legal Advice on Business Transactions and Structure

The powers of the IRS under IRS Section 482 are broad and the penalties can be substantial.  Therefore, it is important to contact a business tax attorney to plan the business transactions and business structure ahead of time, identifying the problem areas and accurately evaluating the risk of potential IRS actions.

This is why you should contact the experienced business tax firm of Sherayzen Law Office for legal help with analyzing your business structure and planning your business transactions.

Voluntary Disclosure of Foreign Accounts and Foreign Assets in 2012

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This article offers an important strategic perspective on the foreign financial accounts disclosure in the year 2012. In particular, it appears that, this year, U.S. taxpayers who have not fully disclosed their foreign financial accounts and foreign assets should make the urgent decision to bring their tax affairs into full compliance.

Three Trends Greatly Enhanced IRS Ability to Identify and Prosecute Non-Compliance

In 2012, waiting with the voluntary disclosure of previously unreported foreign financial accounts is just too dangerous for any U.S. taxpayer to afford. This is the result of three converging trends in U.S. tax enforcement.

First, as a result of the 2009 and 2011 offshore voluntary disclosure programs, the IRS is currently sitting on top of a gigantic mountain of information about the financial institutions, wealth-management advisors, and individual taxpayers involved in the U.S. tax non-compliance. Once processed, this information should allow the IRS to effectively identify and target the main sources of noncompliance, including common countries, financial institutions, and individuals (including U.S. taxpayers). Therefore, the risk of discovery – whether intentional or accidental – has risen tremendously for U.S. taxpayers who either willfully or non-willfully failed to disclosure their reportable foreign assets and foreign income.

Second, the new reporting requirements force U.S. taxpayers to disclose assets that previously may have escaped the IRS disclosure. The first and foremost of these new requirements is Form 8938, which should allow the IRS to collect the information that previously was not required to be collected as well as effectively connect various tax reporting requirements, allowing the IRS to assess the scope of potential non-compliance with relative ease.

Moreover, in addition to Form 8938, a stricter interpretation as well as expansion of other existing forms allows the IRS to upgrade the reach of other reporting requirements. Form 8621 is the best-known example of this trend. Form 8621 is used to report PFIC (Passive Foreign Investment Company) income; soon, the U.S. taxpayers will be required to file a new version of Form 8621 to report their PFIC holdings even if they do not have PFIC income.

Finally, the third trend is the ever expanding IRS statute of limitations. The IRS has been given (or it interpreted the law in such a way) an increasing power to look back farther and deeper into older U.S. tax returns. FATCA (Foreign Account Tax Compliance Act) further enhanced this ability. At this point, failure to file any of the major disclosure forms, such as Forms 5471, 8865, 8938 and so on, is likely to prevent the IRS Statute of Limitations from running, keeping a tax return open potentially forever.

Impact of These Trends on Taxpayer Compliance Strategies

These three trends have a tremendous impact on the tax compliance strategies of U.S. taxpayers. First, as a result of the extended Statute of Limitations, the U.S. taxpayers cannot now just contend themselves with making sure that they are in full compliance in the current year – they need to make sure that they were compliant in all years potentially open to the IRS audit.

This means that the “quiet disclosure” practice (where taxpayers are attempting to amend their tax returns and comply with current reporting requirements without providing any explanation to the IRS) employed by so many accountants in the past can be more damaging than helpful at this point. While I have always been in disagreement with this strategy, it appears that the current enhanced abilities of the IRS to identify and prosecute non-compliance make this strategy downright dangerous for most non-compliant taxpayers.

Second, with the issuance of new Form 8938, the taxpayers’ ability to maneuver around the foreign asset reporting requirements is greatly reduced. Moreover, it appears that Form 8938 forces the previously non-compliant (whether willful or non-willful) taxpayers into a situation where they have to choose between further exacerbating their non-compliance with potentially grave consequences or complete disclosure of all of the assets that they previous did not or could not report.

Third, there is now an added urgency to the voluntary disclosure to non-compliant taxpayers. From one side, the aforementioned obligation to comply with Form 8938 and other forms during this tax season places strict deadlines for conducting voluntary disclosure (even with extensions). From the other side, for the taxpayers who have unreported assets in countries and institutions that were exposed during the 2009 and 2011 offshore voluntary disclosure programs, this is a race against time. As soon as the IRS is able to process the gigantic pile of data that they have accumulated as a result of those programs, these taxpayers are at heightened risk of discovery. It is well-known that, once the IRS launches an investigation against a particular taxpayer, this taxpayer will not be able to take advantage of any existing voluntary disclosure options.

Cumulative Effect: 2012 is the Year of Voluntary Disclosures

The cumulative effect of all of these trends and strategies is likely to be a heavy pressure on the U.S. taxpayers to conduct some form of voluntary disclosure of previously-unreported foreign assets. Therefore, it is very likely that year 2012 will continue to build on the previous years’ pattern of increasing number of disclosures – perhaps, the numbers will climb even higher than in 2011.

Contact Sherayzen Law Office for Help With 2012 Offshore Voluntary Disclosure

If you have any unreported foreign accounts, foreign assets or foreign income, contact Sherayzen Law Office NOW. Our experienced voluntary disclosure firm will assist you during every stage of your disclosure – analysis of your legal situation and your risk exposure, choosing the right disclosure based on your fact pattern, preparation of all necessary documents (including tax returns, FBARs, business ownership disclosure (5471, 8865, 8858), PFIC, foreign trust distribution, foreign inheritance, and other forms), management of proper filing of the disclosure, creative ethical approach to establishing the legal foundation of your case, and rigorous advocacy of your interests during IRS negotiations.

Form 5472 Penalties

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In a previous article, we covered the basics of the IRS Form 5472. In this article we will explain the penalties that may apply for failure to comply with the form’s requirements.

Main Failure to File and Failure to Maintain Records Penalties

If a corporation fails to timely file the required Form 5472, a $10,000 penalty may be assessed. Furthermore, a reporting corporation that files a substantially incomplete Form 5472 will be deemed as having failed to file Form 5472, and penalties may apply.

An interesting twist in Form 5472 penalties is that, in addition to failure to file penalties, the IRS imposes substantial record-keeping penalties. A $10,000 penalty may be assessed for failure to maintain records, as required under IRS regulation Section 1.6038A-3. Under this regulation, “a reporting corporation must keep the permanent books of account or records… that are sufficient to establish the correctness of the federal income tax return of the corporation, including information, documents, or records (“records”) to the extent they may be relevant to determine the correct U.S. tax treatment of transactions with related parties.”

It is also important to note that, for the purposes of Form 5472 penalties, each member of a group of corporations filing a consolidated information return is treated as a separate reporting corporation, and each member is potentially subject to a separate $10,000 penalty, as well as being jointly and severally liable.

Additional Failure to File Penalties

If the IRS issues a failure to file notification, and the failure continues for more than 90 days after such notification, an additional penalty of $10,000 may apply. This penalty applies with respect to each related party for which a failure occurs for each 30-day period (or part of a 30-day period) during which the failure continues after the 90-day period end.

Criminal Penalties

Under IRC Sections 7203 (Willful failure to file return, supply information, or pay tax), 7206 (Fraud and False Statements), and 7207 (Fraudulent returns, statements, or other documents), criminal penalties may potentially apply for failure to submit necessary information, or for filing false or fraudulent information.

Contact Sherayzen Law Office for Legal Help With Form 5472 Reporting Requirements

Complying with Form 5472 requirements and dealing with Form 5472 penalties usually requires professional review. Contact Sherayzen Law Office for tax assistance with Form 5472; our experienced international tax firm will determine whether you need to file Form 5472, explain how to comply with the form’s requirement, complete the form for you, and handle any necessary IRS negotiations.

Classification Conversion of A Tax-Exempt Organization: 501(c)(6) and 501(c)(3) Organizations

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In a previous article, I already discussed some of the major differences between 501(c)(3) and 501(c)(6) organizations. However, this discussion was limited to characteristics of these organizations as opposed to dynamic developments that these organizations may experience during their existence. While most of these organizations tend to be stable once a particular type of tax-exempt organization is formed, this is not always the case. Sometimes, after a number of years in existence, an organization may modify its goals or its founders suddenly realize that they are limited in their practical options. For example, one large limitation of a 501(c)(6) organization is the inability of donors to deduct donations as charitable contributions on their tax returns. Conversely, members of a 501(c)(3) organization may desire to convert into another type of tax-exempt organization because of the substantial limitations on lobbying placed on such organizations.

At that point, a Board of Directors of such an organization may start to wonder about whether it is possible to convert the status of an organization, how to do it and whether there are any viable alternatives.  In this article, I will examine the possibility of converting a non-profit organization’s tax-exempt classification, focusing on 501(c)(3) and 501(c)(6) classifications.

General Conversion Process

First, in order to attempt the conversion from one classification to another, a tax-exempt organization will need to change its organizational documents (such as the Articles of Incorporation and the corporation’s Bylaws) to reflect the primary purpose of the new type of tax-exempt organization being sought and to comply with the requirements of such organizations. Usually, the Bylaws or the Articles of Incorporation govern the exact process of approval of the amendment of these important organizational documents. Frequently, these documents will say that a Board of Directors’ resolution is sufficient, but, often, an approval of the majority of members maybe required. If the organizational documents are silent on the amendment process, your state’s statute would need to be consulted on the amendment process.

Amending the documents is usually not enough. Changing the primary purpose of an organization may also entail eliminating, or at least substantially reducing, any prohibited or limited activities under the new desired classification. For instance, if you seek to convert a 501(c)(6) organization into a new 501(c)(3) organization, then, after changing the original organizational documents (and following any necessary rules in doing so) to comply with applicable 501(c)(3) requirements, will also need to limit substantial lobbying activities and any other activities that are prohibited or limited under 501(c)(3) rules. Usually, these activities require a wholesale overview of the organization’s activities by an attorney in order to determine what types of practices need to be modified and how.

Finally, in order to convert, a new form will need to filed with the IRS requesting the grant of the new tax-exempt status, demonstrating compliance with the relevant regulations. For example, in case of conversion to 501(c)(3), Form 1023 will need to filed, demonstrating compliance with IRS 501(c)(3) rules. This, in turn, will require paying an application fee as well as providing any applicable required verification documents. There is no guarantee that the IRS will recognize the new tax-exempt status being sought. This is why it is important for the application to be well drafted, demonstrating adherence to the relevant law and regulations.

Alternatives to Conversion

The motivations for seeking alternatives to full conversion from one classification to another are numerous. Nevertheless, the most popular reason for avoiding such conversion and seeking an alternative is the fact that an outright change in classification of an entity may significantly limit the ability of such organization to achieve their goals.

It is not easy to discuss alternatives to conversion, because the particular circumstances of an organization will determine what alternatives are available and whether they are more desirable than the process of conversion.

Yet, one can identify two general trends (which may or may not apply to a particular organization), which I will state here in their ideal form. First, some organizations attempt to create a hybrid organization which contains completely separate components – one that strictly follows the rules of a 501(c)(3) and another that adheres to the 501(c)(6) rules. This alternative will require separate application forms and fees, but it may give the most flexibility to the Board of Directors (assuming the IRS grants the requested status).

On the other hand, as a second alternative, a lot of organizations opt to create a new organization altogether in order to avoid legal complications. The idea here is that the members of the Board of the old corporation will form the majority of the members of the Board of the new corporation. Beware, while this alternative may solve one type of legal complications, it may actually bring a host of others.

Conclusion

Conversion from one tax-exempt classification to another can be very complex and usually requires an in-depth knowledge of the Internal Revenue Code, IRS regulations and case law. Therefore, you will need to consult an experienced attorney familiar with both business and tax aspects of these issue.

If you have any questions concerning tax-exempt classifications of non-profit corporations, contact Sherayzen Law Office for legal help. Our experienced tax firm can assist you in resolving any problems in this area of law.

Offshore Voluntary Disclosure Program 2012: Impact of Form 8938

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The announcement by the IRS of the opening of the new Offshore Voluntary Disclosure Program (OVDP) on January 9, 2012 (now closed) came as a surprise to most tax practitioners, especially since the 2011 OVDI just ended on September 9, 2011. Yet, if one analyzes the number of new developments in international tax compliance over the past several years, then the surprise of the announcement of a new offshore voluntary disclosure program is greatly reduced.

One of these latest developments is the new Form 8938, which was born out of the passage of FATCA (Foreign Account Tax Compliance Act). In this article, I will analyze some of the key aspects of the interaction between Form 8938 and OVDP 2012.

Link between OVDP 2012 and Form 8938

In an earlier article, I already described the main features of the OVDP 2012. In announcing the OVDP 2012, IRS cited several reasons for announcing the new voluntary disclosure program for U.S. taxpayers with offshore assets, particularly the success of the previous programs and the mountain of information gathered by the IRS which would allow it to investigate (and ultimately penalize and/or prosecute) additional non-compliant U.S. taxpayers as well as Swiss bankers. Some international tax attorneys elaborated on the IRS motivation as well as added some of their own reasoning.

Yet, among all of these reasons, most international tax attorneys completely omitted even mentioning the new Form 8938. Yet, in my opinion, Form 8938 is likely to play a very important role in driving additional U.S. taxpayers toward OVDP 2012.

Form 8938’s Impact on Foreign Asset Disclosure Structure

The main reason for Form 8938‘s potentially profound impact on OVDP 2012 participation lies in the nature of Form 8938.

As I explained in an earlier article, Form 8938 is a fundamental tool for the IRS to identify the scope of international tax non-compliance of a given U.S. taxpayer. It is very important to understand the reason why Form 8938 is so useful for the IRS. It is not only because Form 8938 now requires a taxpayer to disclose more information, but, rather, because Form 8938 connects various parts of a taxpayer’s international tax compliance including the information that escaped disclosure on other forms earlier. This summary, in turn, allows the IRS to identify the overall scope of a taxpayer’s noncompliance in an efficient manner. Moreover, compliance with Form 8938 may lay the foundation for an IRS investigation of whether the taxpayer has been in compliance previously.

Compliance With Form 8938 May Force Taxpayers to Enter a Voluntary Disclosure Program

This ability by the IRS to discern whether the areas of actual or potential non-compliance in current as well as prior years puts previously non-compliant taxpayers in a highly uncomfortable position.

For example, suppose that taxpayer T was previously non-compliant with respect to reporting his foreign bank accounts because he did not know anything about the FBAR. Since Form 8938 is filed together with the tax return, T will have to go through a voluntary disclosure of some type because failure to file Form 8938 at this point is likely to turn his previous non-willful non-compliance into a willful one.

Similarly, suppose T was did not report his ownership of a business entity because he classified the entity as a partnership (assuming at this point that it is not a “controlled partnership”) instead of as a corporation. Prior to Form 8938, it was unlikely that the IRS would challenge this classification because the partnership ownership was never disclosed. However, with Form 8938, T will have to disclose his partnership ownership drawing IRS attention to the classification issue. T will have to consult Sherayzen Law Office in order to figure out what is the best course of action to deal with this dilemma.

Thus, as the examples above demonstrate, Form 8938 is likely to have a profound impact on the number and depth of voluntary disclosures as taxpayers are forced to re-evaluate their tax compliance strategies.

It is important to emphasize that the impact of Form 8938 on your particular situation should be analyzed separately by an international tax attorney. This article can only provide a very general background, because the exact strategies, including the optional enrollment into OVDP 2012, will differ from situation to situation.

Contact Sherayzen Law Office for Legal Help With U.S. Tax Compliance Issues

If you have any questions with respect to Form 8938, OVDP 2012, and any other international tax compliance issues, contact Sherayzen Law Office. Our experienced international tax firm will guide you through the complex web of international tax requirements, identify potential problem areas, create a plan of action to deal with these problems, and implement the plan while providing zealous ethical IRS representation.