Will 2023 Bring Clarity to These Leading IRS Issues?
December 06, 2022
By Miri Forster
Looking for clarity in 2023? We may get some on these top areas of IRS interest involving partnerships and international tax penalties.
Self-Employment Tax (“SECA Tax”) and Limited Partnerships
The IRS first announced its SECA Tax campaign in March of 2018. Since that time, hundreds of limited partnerships have been selected for IRS audit, primarily from the asset management industry. The campaign focuses on limited partnerships which exempt a limited partner’s distributive share of income from self-employment tax under IRC Sec. 1402(a)(13). IRS claims that partnerships organized as state-law limited partnerships have been inappropriately exempting limited partners from SECA tax on the basis that these partners are not “limited partners” as contemplated by the statute. Cases are moving through various stages of the IRS enforcement process, with more cases now proceeding to IRS appeals and litigation.
Might we get clarity on the SECA tax exemption in 2023? There is a decent chance from one pending Tax Court case. In July of 2022, Soroban Capital Partners LP, an investment advisor and limited partnership, filed a petition in Tax Court to challenge the IRS’ posture that its limited partners were subject to SECA tax on their distributive shares of income. According to the petition, Soroban is a Delaware limited partnership with a general partner and three limited partners. Its general partner handled all the partnership’s business affairs and had ultimate authority to act on the partnership’s behalf; the limited partners were not permitted to take part in the partnership’s management, operation or control. For the year at issue, the partnership had 28 employees to whom it paid wages. For services performed by the three limited partners on behalf of the general partner (as managing partner, co-managing partner, and head of trading and risk management, respectively), the partnership provided guaranteed payments reported as self-employment income and subjected to self-employment tax. For their passive investments, the limited partners’ distributive shares of partnership income were exempt from self-employment tax based on the statutory language in IRC Sec. 1402(a)(13).
IRC Sec. 1402(a)(13) was enacted in 1977 and does not define limited partner. IRC Sec. 1402(a)(13) specifically excludes from net earnings from self-employment the distributive share of income or loss of a limited partnership, other than guaranteed payments for services rendered to or on behalf of the partnership to the extent those payments are established to be in the nature of remuneration for those services. Despite numerous Congressional attempts over the past 30 years, the statutory language remains the same as originally enacted. When challenging the treatment, the IRS regularly relies on Renkemeyer, Campbell & Weaver LLP v. Commissioner, 136 T.C. 137 (2011), where the Tax Court held that an attorney and a partner in an LLP was not a limited partner for purposes of IRC Sec. 1402(a)(13) because he was active in his law firm and therefore was subject to SECA tax on his distributive share.
International Information Return Penalties
After years of onerous international information return penalties imposed on taxpayers for failing to timely file Forms 5471, 5472, 3520, 3520-A and the like, Wrzesinski v. United States and Farhy v. Commissioner are two cases with the potential to significantly benefit taxpayers.
Wrzesinski v. United States
In Wrzesinski v. United States, taxpayer challenges a civil penalty imposed for failure to timely file Form 3520 to report a foreign gift. According to the Complaint filed in the Eastern District of Pennsylvania, taxpayer was born in Poland and moved to the United States when he was 19 years old. In 2010, his mother, a citizen and resident of Poland, won the lottery and gifted her son $830,000 over a two-year period. The son asked his U.S. tax preparer and was informed that there was no need to report the gift on his U.S. tax return and that no other U.S. obligations were triggered. During preparation of the 2010 return, taxpayer again asks his tax preparer if any additional paperwork is required for the foreign gift and again is told that there were no additional requirements.
Several years later, taxpayer wants to send back a portion of the winnings to his godson in Poland. He performs online research about foreign gifts and first learns that foreign gifts over $100,000 require the filing of Form 3520. He confirms this new knowledge with a U.S. attorney with international tax expertise, who suggests taxpayer file the outstanding Forms 3520 to report the foreign gifts from his mother under the IRS’ Delinquent International Information Return Submission Procedures, along with a reasonable cause statement to request waiver of penalties for late filing based on reasonable cause.
Taxpayer makes the voluntary filings and subsequently receives IRS notices imposing $207,500 in penalties for the late filed Forms 3520 (calculated at 25% of the foreign gifts received). The Service claims that taxpayer did not act with ordinary business care and prudence and that ignorance of the tax laws did not qualify as reasonable cause.
In September 2022, taxpayer sued in District Court, a significant development as there is limited case law involving penalties for failure to file Form 3520 and what constitutes reasonable cause. Taxpayer relies on United States v. Boyle, 469 U.S. 241 (1985) which states that reasonable cause is established when a taxpayer shows that he reasonably relied on the advice of an accountant or attorney that it was unnecessary to file a return, even when such advice turned out to be mistaken. United States v. Boyle, 469 U.S. at 250.
To establish reasonable reliance on an advisor, the Service often looks to the three-prong test in Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43 (2000), aff’d 299 F.3d 221 (3d Cir. 2002). First, the advisor must be a competent professional with sufficient experience. Second, the taxpayer must provide the advisor with necessary and accurate information. Third, the taxpayer must rely in good faith on the advisor’s judgment. Neonatology involved taxpayers who participated in an abusive tax shelter and who unsuccessfully claimed reliance on the tax shelter promoter to try to avoid accuracy-related penalties under IRC Sec. 6662. However, the facts in Wrzesinski are unlike those in Neonatology. Wrzesinski does not involve an abusive tax shelter or reliance on a promoter. Rather, based on advice from his tax preparer on two separate occasions, Mr. Wrzesinski simply failed to file an international information return to report a foreign gift. Years later, he voluntarily filed the outstanding Forms 3520 once he learned a filing obligation had been triggered.
International information reporting requirements are complex, and receipt of a foreign gift from your mother is not akin to participating in an abusive tax shelter. The Tax Court recently acknowledged this distinction in Kelly v. Commissioner, T.C. Memo. 2021-76, where Mr. Kelly informed his experienced tax preparer of his ownership in a Cayman entity but did not file Form 5471 based on reasonable reliance on an advisor. The Court determined that taxpayer’s reliance on the tax preparer was reasonable. The Court emphasized that the tax preparer’s failure to advise Mr. Kelly to file Form 5471 (Information Return of U.S. Persons With Respect to Certain Foreign Corporations) was not the result of a conflict of interest or a “too good to be true” scenario. Taxpayers are hopeful for a similar outcome in 2023 from the Wrzesinski case.
Farhy v. Commissioner
In Farhy v. Commissioner, the Tax Court is being asked to consider whether assessment of the IRC Sec. 6038 penalty, imposed for failure to timely file Form 5471, was lawful and the resulting collection efforts unlawful. According to the Petitioner’s Opening Brief:
“there is no law giving the Commissioner of Internal Revenue (“the Commissioner”) the authority to assess a 6038 penalty, such as the one here. The assessment of the 6038 penalties are not authorized under the Code. Without the authority to assess a 6038 penalty, the Commissioner’s purported assessments are ultra vires, null and void. Without a valid assessment, the Commissioner cannot legally use his administrative collection powers to collect the penalty from the Petitioner.”
In the opening brief, Mr. Farhy asserts there is no statutory authority for the IRS to assess penalties for the following international information returns:
Forms 5471 (for certain foreign corporations) under IRC Secs. 6038, 6038A and 6038C
Forms 5472 (for certain foreign-owned U.S. corporations) under IRC Secs. 6038A and 6038C
Forms 8865 (for certain foreign partnerships) under IRC Secs. 6038 and 6038B
Forms 8858 (for certain foreign disregarded entities) under IRC Sec. 6038
Forms 926 (for certain transfers to foreign persons) under IRC Sec. 6038B
Forms 8938 (regarding foreign financial accounts) under IRC Sec. 6038D
The above list is distinguished from the following information returns where the IRS has statutory authority to assess penalties:
Forms 3520 and 3520-A (for foreign gifts and reportable events for foreign trusts) under IRC Sec. 6048
Form 5471, Schedule O (for acquisitions and dispositions of an interest in a foreign corporation) under IRC Sec. 6046
Form 8865 (for acquisitions or dispositions of an interest in a foreign partnership) under IRC Sec. 6046A.
International information reporting is a complicated area of tax law. A taxpayer favorable decision in Farhy in 2023 could be a big win for taxpayers with non-compliance of international information reporting requirements.
Please reach out to your tax advisors to discuss recent IRS audit trends and to proactively prepare for a review by the IRS.
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