IRS

 Last month, the Finance Committee released a bipartisan report on syndicated conservation easement transactions.

The new IRS data shows that despite IRS designating them as potentially-abusive tax shelter transactions, promoters of syndicated conservation easements have continued to push the schemes. Between 2017 and 2018 the number of individual participants increased from 14,000 to 16,900, with many participating in multiple deals.  And the total amount of deductions claimed through these tax shelters increased from $6.8 billion in 2017 to $9.2 billion in 2018.

Notably, it is a small number of unscrupulous actors who make these deals possible. In its latest figures, IRS identified only 34 appraisers who provided valuations on some 296 syndicated conservation easement transactions.

The numbers provided by IRS show that dubious syndicated conservation easement tax shelters are a growing problem. Using sham partnerships to essentially buy tax breaks like this undermines the fairness of the American tax system, deprives the Treasury of revenue and leaves all other taxpayers out to dry. Our bipartisan report detailed this exact problem and concluded that every part of the federal government needs to take further action to crack down on these schemes.

Our bipartisan report detailed serious and persistent abuse of the syndicated conservation easement program. This new IRS data, which shows a significant increase in these transactions in recent years, reinforces our findings.  Of particular concern, transactions continued to increase even after the IRS flagged them as potential tax shelters. Cracking down on abusive syndicated conservation easements requires ensuring IRS has the resources and legal tools to do its job, and I’m eager to work in a bipartisan way to get that done.

Conservation Easement

The IRS has prevailed in more than three dozen conservation easement disputes in the Tax Court over the past year alone. On 9 July 2020, the Tax Court handed the IRS victories in four conservation easement disputes on the same day, on the basis that none of the easements were protected ‘in perpetuity’ under Code Section 170(h)(5)(A). The cases are: Englewood Place v. Commissioner, T.C. Memo. 2020-105, Maple Landing v. Commissioner, T.C. Memo. 2020-104, Riverside Place v. Commissioner, T.C. Memo. 2020-103, and Village At Effingham v. Commissioner, T.C. Memo. 2020-102.

Syndicated Conservation Easements Named on IRS 2019 “Dirty Dozen” Tax Scams

The Internal Revenue Service announced a significant increase in enforcement actions for syndicated conservation easement transactions, a priority compliance area for the agency. Syndicated conservation easements are private placements that promise tax deductions worth four to four-and-a-half times a person’s investment. Some syndicated conservation easement deals are offering investors charitable contribution deductions on taxes for large amounts. According to the IRS, coordinated examinations are being conducted across the IRS in the Small Business and Self-Employed Division, Large Business and International Division and Tax Exempt and Government Entities Division. Separately, investigations have been initiated by the IRS' Criminal Investigation division. These audits and investigations cover billions of dollars of potentially inflated deductions as well as hundreds of partnerships and thousands of investors. According to an IRS Notice: The Treasury Department and the IRS have become aware that some promoters are syndicating conservation easement transactions that purport to give investors the opportunity to claim charitable contribution deductions in amounts that significantly exceed the amount invested. In such a syndicated conservation easement transaction, a promoter offers prospective investors in a partnership or other pass-through entity (“pass-through entity”) the possibility of a charitable contribution deduction for donation of a conservation easement.

Conservation Easement

A conservation easement is a securitized corporate structure that owns real estate. The landowner(s) sells the right to develop that land in exchange for favorable tax deductions. In many instances, investors are enticed with tax deductions worth multiples of the principal amount of the investment. These investment opportunities are pooled together so that they can be marketed and sold to a broad audience of investors across the country. In theory, there is less development and impact to the ecosystem, which makes the investments also appear socially conscious. Through a network of brokerage firms and Financial Advisors, retail investors are sold these opportunities and, in exchange, receive high commissions. However, the issuers of the conservation easements and the brokerage firms that are marketing and selling them to retail investors do not have opinion letters from the IRS confirming the advantageous tax treatment. The IRS and Department of Justice (DOJ) are believed to be narrowing in on selling groups who were involved in the marketing and sale of these fraudulent products. In November 2019, the IRS issued a notice indicating that it was “increasing its enforcement actions for syndicated conservation easement transactions, a priority compliance area for the agency.” https://www.irs.gov/newsroom/irs-increases-enforcement-action-on-syndicated-conservation-easements. The IRS went on to state that “we will not stop in our pursuit of everyone involved in the creation, marketing, promotion and wrongful acquisition of highly inflated deductions based on these aggressive transactions.” The conservation easement investments were among the “dirty dozen” investments. In a recently filed case against a large conservation easement issuer, Ecovest Capital, Inc., the Department of Justice alleges that the Ecovest conservation eastment was nothing more than “the sale of grossly overvalued federal tax deductions under the guise of investing in a partnership.” https://www.justice.gov/opa/press-release/file/1121451/download. The essence of the scheme involved the overvalued appraisal of the underlying property which, in turn, causes investors to improperly claim artificially inflated deductions on their personal tax returns. If and when the IRS determines that Ecovest and other conservation easement issues overstated the value of their properties in order to maximize the attractiveness of the investment, and nullifies the tax deductions, investors will potentially be on the hook for unpaid taxes in arrears, plus applicable penalties. In June 2020, the IRS announced a “time-limited settlement offer” to taxpayers with pending docketed Tax Court cases involving conservation easements. The IRS went on to say that it “will continue to actively identify, audit and litigate these syndicated conservation easement deals as part of its vigorous and relentless effort to combat abusive transactions,” said IRS Commissioner Chuck Rettig. “These abusive transactions undermine the public’s trust in private land conservation and defraud the government of revenue. Ending these abusive schemes remains a top priority for the IRS.” If your Financial Advisor recommended that you invest in conservation easements or other tax shelters, you may be able to recover your investment losses, including adverse tax consequences and penalties, through a FINRA arbitration claim.

Conservation Easements

 

July 13, 2020 WASHINGTON — On July 9, the U.S. Tax Court struck down four more abusive syndicated conservation easement transactions. The Internal Revenue Service calls on any taxpayer involved in syndicated conservation easement transactions who receives a settlement offer from the agency to accept it soon. These time-limited settlement offers, announced June 25, are only being made to certain taxpayers with pending docketed Tax Court cases involving this type of abusive transaction. These and other recent Tax Court decisions support the abusive nature of the underlying syndicated conservation easement deduction. The four most recent U.S. Tax Court decisions disallowed conservation easement deductions totaling nearly $21 million. "The IRS will continue to actively identify, audit and litigate these syndicated conservation easement deals as part of its vigorous and relentless effort to combat abusive transactions," said IRS Commissioner Chuck Rettig. "These abusive transactions undermine the public's trust in private land conservation and defraud the government of revenue. We strongly recommend that participants seek the advice of competent, independent advisors. Ending these abusive schemes remains a top priority for the IRS." The IRS recognizes the important role of legitimate conservation easement deductions in incentivizing land preservation for future generations. However, abusive syndicated conservation easement transactions have been of concern to the IRS for several years. The IRS is aware that some promoters of these abusive transactions have downplayed the significance of the string of recent court decisions holding in the government's favor, arguing that their cases are somehow different or that those decisions might be reversed on appeal. These promoters ignore common sense and argue that the real dispute is about value, neglecting to explain how the reporting of short-term appreciation, often exceeding many multiples of reality, could possibly withstand judicial scrutiny. "Taxpayers should ignore this nonsense, take an objective look at their cases, and cut their losses," said IRS Chief Counsel Mike Desmond. "Abusive transactions, like settlement offers, do not get better with time, and this is a good opportunity to get out."  In listed syndicated conservation easement structures, promoters syndicate ownership interests in real property through partnerships, using promotional materials to suggest that prospective investors may be entitled to a share of a conservation easement contribution deduction that equals or exceeds two and one-half times the investment amount. The promoters obtain an appraisal that greatly inflates the value of the conservation easement based on a fictional and unrealistic highest and best use of the property before it was encumbered with the easement. After the investors invest in the partnership, the partnership donates a conservation easement to a land trust. Investors in the partnership then claim a deduction based on an inflated value. The investors typically claim charitable contribution deductions that grossly multiply their actual investment in the transaction and defy common sense. ReplyForward

IRS Tax Court

 

The Tax Court recently issued two opinions denying conservation easement deductions. The cases illustrate Internal Revenue Service (IRS) challenges to these deductions based on terms and conditions reserved by taxpayers when conveying conservation easements. In Carter v. Commissioner, T.C. Memo. 2020-21 (Carter), the easement deed restricted use of the property but retained a right to build single-family dwellings in certain areas. In Railroad Holdings, LLC v. Commissioner, T.C. Memo. 2020-22 (Railroad Holdings), the easement deed provided that if the easement were extinguished, sale proceeds would be allocated to the charitable organization based on the fair market value of the conservation easement as of the date granted, rather than a future proportionate share of the proceeds. Background – Carter The petitioners in Carter were joint owners of Dover Hall Plantation, LLC (DHP), which owned a large tract of land in Georgia. In 2011, DHP conveyed a 500-acre easement to the North American Land Trust (NALT). The easement deed restricted use of the property and generally prohibited construction or occupancy of any dwellings. However, DHP retained the right to build single-family dwellings on 11 “building areas,” each no more than two acres with locations subject to NALT approval. Petitioner’s valuation expert described the building areas as being for family use and not for development and sale, but nothing in the easement deed limited the building area residences to those of petitioners or their family members. DHP claimed a deduction for the conservation easement contribution on its 2011 tax return, and petitioners claimed a related deduction on their individual income tax returns based on their shares of DHP. The IRS issued revenue agent reports (RARs) proposing to disallow the charitable contribution deductions and also proposing a gross valuation misstatement penalty under Code § 6662. The petitioners did not administratively appeal, and the IRS then issued notices of deficiency with assessments based on the adjustments set forth in the RARs. Code § 170 generally allows a deduction for a qualified conservation contribution of a qualified real property interest to a charitable organization. Conservation requires a purpose of preserving land for recreational or educational uses by the general public, protection of a relatively natural habitat of fish, wildlife plants or similar ecosystem, preservation of open space for significant public benefit, or preservation of a historically important land area or a certified historic structure. For the contribution to be treated as exclusively for conservation purposes and therefore be deductible, the conservation purpose must be protected in perpetuity. The court noted that prior cases, Belk v. Commissioner, 140 T.C. 1 (2013) (Belk) and Pine Mountain Pres. LLP v. Commissioner, 151 T.C. 274 (2018) (Pine Mountain), impose two distinct perpetuity requirements: (1) use of the property must be restricted in perpetuity, and (2) the conservation purposes must be protected in perpetuity. Based on Belk, Pine Mountain, and other cases, the court found that easements allowing donors to change what property is subject to a conservation easement do not grant a use restriction in perpetuity. Tax Court Decision – Carter The court was not persuaded by petitioner’s arguments that prior cases involved commercial use as distinguished by petitioners’ residential use, finding that Pine Mountain stands for the proposition that building homes is antithetical to preservation of natural habitat and open spaces. The petitioners further argued that exercise of their rights with respect to the limited building areas would not impair the overall conservation purposes in perpetuity. However, the court rejected this argument because it overlooks the “framing issue” imposed by prior opinions: regardless of whether building houses on 11 two-acre lots would impair the conservation purposes in the entire easement, it would impede achievement of the conservation purposes within each building area. The court notes that petitioners’ argument might support perpetual protection, but it does not establish the perpetual restriction requirement as interpreted by the Pine Mountain case. The court determined that the restrictions in the easement that would apply to selected building areas would not prevent development of single-family homes, and that use would not preserve open spaces, natural habitats, or similar ecosystems. The court concluded that this would be antithetical to the easement’s conservation purposes. Based on this analysis and following the Pine Mountain decision, the court held that the easement granted by DHP to NALT did not meet the perpetual restriction requirement of § 170 and was not a qualified real property interest, and that as a result the conveyance was not a qualified conservation contribution. Therefore, the court denied the deduction claimed by the petitioners for the conveyance. As noted, the IRS also assessed gross valuation misstatement penalties in Carter. The court rejected assessment of these penalties because the IRS failed to establish timely supervisory approval prior to imposition of the penalties. Background – Railroad Holdings In Railroad Holdings, the petitioner executed a conservation easement of a 452-acre parcel of property in favor of the Southeast Regional Land Conservancy, Inc. (SERLC). For purposes of the opinion, the court assumed that SERLC was a qualified organization and also assumed that the easement qualified as a charitable contribution deduction, apart from the issue addressed in the case. The easement deed in Railroad Holdings set terms for possible future extinguishment of the easement and sale of the property. In this event, the deed provided that the value of SERLC’s right and interest would be the fair market value as of the date the conservation easement was granted. The deed further provided that upon a future sale, SERLC would be entitled to at least this initial fair market value, which was to remain constant. The petitioner claimed a deduction for the conservation easement contribution on its 2012 tax return. On audit, the IRS determined that the donation was not a qualified conservation contribution under Code § 170 and disallowed the deduction. The petitioner petitioned the Tax Court, and the IRS moved for summary judgment on this conservation easement issue. Tax Court Decision – Railroad Holdings The IRS argued that the allocation of sale proceeds in the event the easement is extinguished and the property is sold failed to protect the conservation purpose in perpetuity, as required under Code § 170. The court noted that Treasury regulations interpreting § 170 acknowledge that an easement may be extinguished, and thus not last in perpetuity. However, the regulations provide that if extinguishment does occur, the donation may be deemed to be in perpetuity if the proceeds are paid to the donee organization and used for conservation purposes. For a deduction to be allowed under these circumstances, the donation must, at the time of the gift, vest the donee organization in an immediate property right with a fair market value that is at least the proportionate value that the perpetual conservation restriction at the time of the gift bears to the value of the property as a whole at that time. This proportionate value of the donee’s property rights is required to remain constant under the regulations. The petitioner in Railroad Holdings argued that its deed used the phrase “at least” so that SERLC would receive a minimum portion of future proceeds but was not capped by the formula, and further argued that a declaration by SERLC and construction of the language supported this position. Thus, the petitioner argued that SERLC would receive proportionate proceeds upon a sale, and the deed simply set a minimum floor below that proportionate amount. The court found no language in the deed to support petitioner’s arguments, and the court determined that a donee must obtain a property right to a proportionate share of proceeds. The court held that where a donee’s only right under a deed is to receive a less-than-proportionate share with only a hope of more proceeds, the deed does not comply with the regulations. The court also relied on another recent case, Coal Property Holdings, LLC v. Commissioner (October 28, 2019) (Coal Property) for the proposition that a future allocation of proceeds in a conservation easement deed could not reduce a donee organization’s proportionate share of the proceeds. In Coal Property, the deed contained a formula that reduced the donee’s share based on value increases after the donation attributable to improvements, and the court held this was not permitted. Similarly, in Railroad Holdings the court found that SERLC’s proportion of potential extinguishment proceeds would shrink over the years if the underlying property appreciated, and concluded that a shrinking contribution cannot be “perpetual” as required by the regulations. Based on these fact findings, the regulations, and prior cases, the court determined that the conservation purpose of the easement in Railroad Holdings granted to SERLC was not protected in perpetuity under Code § 170. As a result, the court held that the IRS properly denied the deduction and granted the IRS motion for summary judgment. Conclusion The Carter and Railroad Holdings cases demonstrate the need to carefully draft conservation easement deed language to protect the donee organization’s interest and conservation purposes in perpetuity, particularly if the deed reserves rights for the donor. These cases, and the other cases referenced by the court, are also a good reminder that conservation easements are an active audit and litigation issue for the IRS. ReplyForward

Conservation Easements

 As if the onslaught of recent losses in Tax Court was not enough, investors in syndicated conservation easements now have more to worry about. On August 25, 2020, the Senate Finance Committee released a bipartisan report condemning syndicated conservation easements as abusive and encouraging the IRS to take further action to ferret out such abuses.

The Senate report is the culmination of a nearly 18-month investigation.  The findings of that investigation are succinctly stated in the summary to the report:

This report finds syndicated conservation easement transaction to be transactions to provide tax deductions to high-income taxpayers by way of (1) inflated appraisals of undeveloped land through (2) partnership entities that appear to serve no non-tax business purpose for existing other than the provision of tax deductions. 

The Senate report goes on to explain why the appraisals were inflated:  “the report describes appraisals as inflated…because those appraisals value property at multiples of what transaction promoters or their investor paid to acquire ownership interest in that property.”  The Senate report notes the “great lengths” the promoters took to make the transactions appear legitimate on paper, but found that “their emails tell a much different story, that the taxpayer-investors had no interest in a wide variety of land-investment possibility; they just wanted to buy tax deductions.”  Included in the report were some noteworthy statistics:  (i) that the IRS estimates between 2010 and 2017, syndicated conservation easement transactions generated $26.8 billion in deductions, (ii) the combined tax benefit to the investor taxpayers was an estimated $10.6 billion; (iii) that in the years 2015 through 2017, the IRS identified 662 different syndicated partnerships, and (iv) the IRS is auditing or plans to audit 84% of those partnerships.   

The Senate report unambiguously concludes that the IRS has “strong reason for taking enforcement action” and that “Congress, the IRS, and the Department of Treasury should take further action to preserve the integrity of the conservation-easement tax deduction.”   A full copy of the Senate report is linked here (Senate Report).   This report provides further reason for investors to consider participating in an IRS settlement initiative to resolve their dispute with the IRS regarding a syndicated conservation easement.  

If you have any questions about syndicated conservation easements, the 2020 IRS settlement initiative, or ways to mitigate IRS risks associated with such transactions, please do not hesitate to contact me

 

Captive and Conservation

The IRS said Thursday it will be sending settlement offers with terms that are stricter than ones it offered last year under an earlier micro-captive initiative. The IRS has been focusing on cracking down on certain types of tax avoidance schemes, such as syndicated conservation easements and micro-captive insurance, while also stepping up tax enforcement efforts against holders of digital currencies such as Bitcoin and Ethereum, despite a decreasing number of IRS audits overall in recent years. The crackdown isn’t entirely new. In 2016, the Treasury Department and the IRS issued Notice 2016-66, which identified certain micro-captive transactions as having the potential for tax avoidance and evasion.

Captive and Conservation

If a taxpayer participated in a reportable transaction and filed an incomplete disclosure statement, or didn’t file a disclosure statement with its return, and/or didn’t file a complete disclosure statement with OTSA (if required), the IRS may assess a penalty under Internal Revenue Code (IRC) § 6707A. Where the taxpayer participated in a listed transaction, the period of assessment with respect to that transaction will remain open until the taxpayer or a material advisor properly discloses the participation in that transaction. See IRC § 6501(c)(10) for more information. In addition, where a reportable transaction is not properly disclosed, any IRC 6662A reportable transaction understatement penalty will apply at the 30% rate rather than the 20% rate for reportable transactions that are properly disclosed.

Captive Audits

 The Internal Revenue Service announced today the mailing of a time-limited settlement offer for certain taxpayers under audit who participated in abusive micro-captive insurance transactions.

Taxpayers eligible for this offer will be notified by letter with the applicable terms. Taxpayers who do not receive such a letter are not eligible for this resolution.

Abusive micro-captives have been a concern to the IRS for several years. The transactions have appeared on the IRS "Dirty Dozen" list of tax scams since 2014. In 2016, the Department of Treasury and IRS issued a notice which identified certain micro-captive transactions as having the potential for tax avoidance and evasion.

Following wins in three recent U.S. Tax Court cases, the IRS has decided to offer settlements to taxpayers currently under exam. In recent days, the IRS started sending notices to up to 200 taxpayers.

Tax law generally allows businesses to create "captive" insurance companies to protect against certain risks. Under section 831(b) of the Internal Revenue Code, certain small insurance companies can choose to pay tax only on their investment income. In abusive "micro-captive" structures, promoters, accountants or wealth planners persuade owners of closely held entities to participate in schemes that lack many of the attributes of genuine insurance.

The IRS has consistently disallowed the tax benefits claimed by taxpayers in abusive micro-captive structures. Although some taxpayers have challenged the IRS position in court, none have been successful.  To the contrary, the Tax Court has now sustained the IRS' disallowance of the claimed tax benefits in three different cases.

The IRS will continue to disallow the tax benefits claimed in these abusive transactions and will continue to defend its position in court. The IRS has decided, however, to offer to resolve certain of these cases on the terms outlined below.

"The IRS is taking this step in the interests of sound tax administration," IRS Commissioner Chuck Rettig said. "We encourage taxpayers under exam and their advisors to take a realistic look at their matter and carefully review the settlement offer, which we believe is the best option for them given recent court cases.  We will continue to vigorously pursue these and other similar abusive transactions going forward."

The settlement brings finality to taxpayers with respect to the micro-captive insurance issues. The settlement requires substantial concession of the income tax benefits claimed by the taxpayer together with appropriate penalties (unless the taxpayer can demonstrate good faith, reasonable reliance). Taxpayers eligible for the settlement will be notified of the terms by letter from IRS. The initiative is currently limited to taxpayers with at least one open year under exam. Taxpayers who also have unresolved years under the jurisdiction of the IRS Appeals may also be eligible, but those with pending docketed years under Counsel's jurisdiction are not eligible. The IRS is continuing to assess whether the settlement offer should be expanded to others.

Taxpayers who receive letters under this settlement offer, but who opt not to participate, will continue to be audited by the IRS under its normal procedures. Potential outcomes may include full disallowance of captive insurance deductions, inclusion of income by the captive, and imposition of all applicable penalties.

Although taxpayers who decline to participate will have full Appeals rights, the IRS Independent Office of Appeals is aware of this resolution initiative. Given the current state of the law, it is the view of the IRS Independent Office of Appeals that these terms generally reflect the hazards of litigation faced by taxpayers, and taxpayers should not expect to receive better terms in Appeals than those offered under this initiative.

Taxpayers who are offered this private resolution and decline to participate will not be eligible for any potential future settlement initiatives. The IRS also plans to continue to open additional exams in this area as part of ongoing work to combat these abusive transactions.

Conservation Easements

 The Internal Revenue Service announced today the mailing of a time-limited settlement offer for certain taxpayers under audit who participated in abusive micro-captive insurance transactions.

Taxpayers eligible for this offer will be notified by letter with the applicable terms. Taxpayers who do not receive such a letter are not eligible for this resolution.

Abusive micro-captives have been a concern to the IRS for several years. The transactions have appeared on the IRS "Dirty Dozen" list of tax scams since 2014. In 2016, the Department of Treasury and IRS issued a notice which identified certain micro-captive transactions as having the potential for tax avoidance and evasion.

Following wins in three recent U.S. Tax Court cases, the IRS has decided to offer settlements to taxpayers currently under exam. In recent days, the IRS started sending notices to up to 200 taxpayers.

Tax law generally allows businesses to create "captive" insurance companies to protect against certain risks. Under section 831(b) of the Internal Revenue Code, certain small insurance companies can choose to pay tax only on their investment income. In abusive "micro-captive" structures, promoters, accountants or wealth planners persuade owners of closely held entities to participate in schemes that lack many of the attributes of genuine insurance.

The IRS has consistently disallowed the tax benefits claimed by taxpayers in abusive micro-captive structures. Although some taxpayers have challenged the IRS position in court, none have been successful.  To the contrary, the Tax Court has now sustained the IRS' disallowance of the claimed tax benefits in three different cases.

The IRS will continue to disallow the tax benefits claimed in these abusive transactions and will continue to defend its position in court. The IRS has decided, however, to offer to resolve certain of these cases on the terms outlined below.

"The IRS is taking this step in the interests of sound tax administration," IRS Commissioner Chuck Rettig said. "We encourage taxpayers under exam and their advisors to take a realistic look at their matter and carefully review the settlement offer, which we believe is the best option for them given recent court cases.  We will continue to vigorously pursue these and other similar abusive transactions going forward."

The settlement brings finality to taxpayers with respect to the micro-captive insurance issues. The settlement requires substantial concession of the income tax benefits claimed by the taxpayer together with appropriate penalties (unless the taxpayer can demonstrate good faith, reasonable reliance). Taxpayers eligible for the settlement will be notified of the terms by letter from IRS. The initiative is currently limited to taxpayers with at least one open year under exam. Taxpayers who also have unresolved years under the jurisdiction of the IRS Appeals may also be eligible, but those with pending docketed years under Counsel's jurisdiction are not eligible. The IRS is continuing to assess whether the settlement offer should be expanded to others.

Taxpayers who receive letters under this settlement offer, but who opt not to participate, will continue to be audited by the IRS under its normal procedures. Potential outcomes may include full disallowance of captive insurance deductions, inclusion of income by the captive, and imposition of all applicable penalties.

Although taxpayers who decline to participate will have full Appeals rights, the IRS Independent Office of Appeals is aware of this resolution initiative. Given the current state of the law, it is the view of the IRS Independent Office of Appeals that these terms generally reflect the hazards of litigation faced by taxpayers, and taxpayers should not expect to receive better terms in Appeals than those offered under this initiative.

Taxpayers who are offered this private resolution and decline to participate will not be eligible for any potential future settlement initiatives. The IRS also plans to continue to open additional exams in this area as part of ongoing work to combat these abusive transactions.

Did You Participate in a 419 Plan, 412i Plan, Or Abusive Tax Shelter? You Could Be Fined, Or Sued!

Did You Participate in a 419 Plan, 412i Plan, Or Abusive Tax Shelter? You Could Be Fined, Or Sued!

Cryptocurrency

 The IRS released long-anticipated cryptocurrency transaction characterization and reporting guidance in the form of Rev. Rul. 2019-24 (the revenue ruling) and a Q&A-style guide on October 9, 2019.

The guidance arrives concurrent with many crypto investors receiving letters from the IRS requesting information related to their crypto transactions. The IRS guidance may prove useful for taxpayers seeking confirmation about the validity of prior reporting positions and guidance about documenting anticipated crypto transactions, however, many unanswered questions still remain.

Taxpayers had previously relied on five-year-old Notice 2014-21 for basic characterization guidance for cryptocurrency transactions; the notice asserted the IRS’s position that cryptocurrency was considered to be property in the hands of the taxpayer and would be treated as a capital asset for US tax purposes.  Accordingly, as a capital asset, crypto wouldn’t be treated as a form of fiat currency or money. The notice, while fairly basic, was the sole US-tax authority guidance available for taxpayers and tax advisors for the five years prior to the release of the revenue ruling and the Q&A.

The revenue ruling builds on the basic concepts provided in the notice by providing guidance on hard forks, air drops, and additional technical matters such as valuation and tax basis.

Hard Forks

Rev. Rul. 2019-24 addresses several issues pertaining to so-called hard forks. The revenue ruling defines a hard fork as a split in cryptocurrency existing in the distributed ledger as a result of a protocol change. In other words, a hard fork is a change in the blockchain due to the creation of a new, distinct, and separate cryptocurrency.

Often a hard fork is accompanied by what the IRS refers to as an airdrop. Essentially, an airdrop is the creation of new units of the new cryptocurrency created by the hard fork, and the distribution of these units to taxpayers who also hold the original cryptocurrency, usually in a pro-rata fashion.

However, not every hard fork is accompanied by an air drop.

In determining whether and when a holder of cryptocurrency should recognize taxable income as a result of a hard fork, an airdrop, or both, the revenue ruling focuses on whether the taxpayer has “dominion and control” over the new units of cryptocurrency.

To illustrate these principles of dominion and control, the government provides two fact patterns resulting in two different conclusions.

1. In the first example, a hard fork occurs, but the subject taxpayer doesn’t receive any of the new cryptocurrency—in other words, there’s no airdrop—and the revenue ruling concludes that the taxpayer doesn’t realize taxable income under section 61 because there is no “accession to wealth.”
2. In the second example, a taxpayer does receive new and assessable crypto assets as a result of a hard fork. In the second instance, the taxpayer has realized income under section 61 because there’s an accession to wealth—the taxpayer has received a valuable asset that presumably has a saleable value.

As the second conclusion explains, the ability of the taxpayer to dispose or transfer the new asset resulting from an airdrop provides the taxpayer with dominion and control over the new cryptocurrency, and the taxpayer should recognize ordinary income in that year. The basis of the airdropped coin is the fair market value of the airdropped coin the moment it is recorded on the distributed ledger.

The issue of valuing a crypto asset that may not have a developed market at the time of the air drop isn’t addressed in the revenue ruling, although some guidance may be found in the Q&A.  This could potentially become a problematic issue as it’s common for the tradable value of crypto assets to fluctuate widely over relatively short periods of time. 

The question of dominion and control is therefore determinative as to whether the taxpayer derives income from an airdrop. The revenue ruling provides a taxpayer won’t have dominion and control over cryptocurrency where the exchange holding the taxpayer’s wallet doesn’t support the new cryptocurrency resulting from the airdrop. A potential implication of this conclusion is that if airdropped currency became supported by the taxpayer’s wallet, the taxpayer would have income at the moment the exchange begins to support the new cryptocurrency.

Further, the revenue ruling provides while a taxpayer may not have dominion and control over airdropped cryptocurrency not supported by their exchange, a taxpayer has constructive receipt over cryptocurrency that is received prior to the airdrop being recorded on the distributed ledger—the receipt occurring when the taxpayer has the ability to move, transfer, or dispose of the new coins. However, the revenue ruling doesn’t discuss how value is to be determined by the constructive receipt of an airdropped crypto asset that isn’t recorded on any ledger; presumably it’s not tradable.

Technical Matters

The IRS also released guidance in the form of a Q&A to describe certain technical tax matters of cryptocurrency transactions, such as:

• Determining tax basis
• Computing gain and loss
• Determining fair market value

Notice 2014-21 defined convertible virtual currency as property for US tax purposes. For this reason, the Q&A generally refers taxpayers to existing IRS publications regarding the taxation of property-related transactions as addressed in Q2.

Consistent with the notice, the Q&A confirms that trading cryptocurrency for another cryptocurrency or fiat currency, or disposal of the currency by using it to pay a service provider, will result in a taxable event for US federal tax purposes. Additionally, where a taxpayer receives cryptocurrency in exchange for services, the taxpayer should recognize ordinary income equal to the fair market value of the cryptocurrency in USD at the moment of receipt.

A further technical matter covered by the Q&A is how one determines the fair market value of cryptocurrency. Q25 provides that, generally, the fair market value of cryptocurrency will be the amount recorded by the taxpayer’s cryptocurrency exchange in USD. Where a transaction isn’t actually recorded on the distributed ledger, the fair market value is the USD amount the cryptocurrency was trading for on the exchange at the exact date and time the transaction would otherwise have been recorded on the blockchain--as addressed in Q26.

Interestingly, when an exchange isn’t facilitating the transaction, the IRS will accept support of the fair market value as determined by a cryptocurrency explorer, which analyzes worldwide cryptocurrency trends and pricing and provides value of the coin at the moment of the transaction. Further, where a taxpayer cannot ascertain an explorer value, general valuation principles apply.

Information Reporting & Withholding

The new guidance in the revenue ruling and Q&A may usher in or confirm additional compliance burdens given the government’s clear interest in, and emphasis on, information reporting.

On October 8, 2019, the IRS released guidance under section 6045 of its priority guidance plan as it related to information reporting of virtual currency. Section 6045 relates to broker-dealers and defines a broker as a dealer, barter exchange, or any other person acting as a middleman in a property or services transaction.

Forthcoming guidance will presumably provide information on how cryptocurrency exchanges and other institutions would be included or excluded from the current definition.

Crypto transactions on foreign exchanges haven’t previously required reporting on Financial Crimes Enforcement Network’s (FinCEN) Form 114, Report of Foreign Bank and Financial Accounts. Additionally, cryptocurrency transactions didn’t create Foreign Account Tax Compliance Act (FATCA) reporting requirements. However, due to an apparent concern that investors may be motivated to take their cryptocurrency trading offshore by opening accounts with non-US exchanges, the IRS and FinCEN are reportedly considering whether such accounts should be required to report on Foreign Bank Account Reports (FBARs) and be subject to other FATCA reporting.

Unfortunately, neither the revenue ruling nor the notice provide guidance on whether or how cryptocurrency exchanges should report tax information to the IRS. This would seem to be an important issue, given the requirement under the revenue ruling for taxpayers to report income from trading and from airdrops. These items are expected to be covered in the near future according to the 2019-2020 Priority Guidance Plan. 

Despite the relative lack of guidance around information reporting, the IRS recently released a draft version of the 2019 Form 1040, which includes a direct question of whether the taxpayer received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency during the 2019 tax year.

International Compliance – Value-Added Tax

Many jurisdictions other than the US federal government have been wrestling with questions regarding the taxation of cryptocurrency. The UK Commercial Court recently decided a case that may have implications as to whether cryptocurrency transactions are subject to value-added tax (VAT).

In Robertson v. Persons Unknown, the claimant asked for and received an Asset Preservation Order (APO) over more than £1 million worth of Bitcoin that had been stolen through a cyber-attack. An APO is generally made with respect to property, but English common law only recognizes two types of personal property:

• Physical things over which rights can be exercised
• Intangible rights against another person

Under this definition, neither type appears to apply to cryptocurrency. In Robertson, the claimant argued, and the Court effectively agreed, that cryptocurrency is a type of intangible asset, despite Bitcoin not clearly meeting the definition of intangible property. Accordingly, Robertson illuminated the stark legal uncertainty that affects cryptocurrency in jurisdictions worldwide and how its inconsistent treatment from jurisdiction to jurisdiction.

For VAT purposes, a fundamental question is whether the supply constitutes goods or services, and being unable to answer this question may create further VAT questions. The only clear guidance related to VAT and cryptocurrency from UK taxing authority, Her Majesty’s Revenue and Customs (HMRC), is in the form of Revenue & Customs Brief 9/2014, stating where Bitcoin is exchanged for sterling or other foreign currencies, no VAT will be due on the value of the Bitcoins themselves. In this respect, HMRC is treating Bitcoin as fiat currency, which appears to be contrary to the holding in Robertson that the cryptocurrency were effectively goods.

At this point, cryptocurrency remains outside the VAT net, but further guidance is expected from HMRC and other global taxing authorities, including the Organisation for Economic Co-operation and Development (OECD).

Moving Forward – Enforcement

On October 28, 2019, IRS Commissioner Charles Rettig stated that, given the new guidance, there is “no excuse for delinquency.” The Commissioner further stated the IRS has the technology to trace cryptocurrency transactions and had recently done so in a child exploitation case, leading to an arrest. Rettig stated the arrest should be considered a “message to the community” concerning the IRS’s technology and knowledge to determine cryptocurrency ownership on the blockchain, and, by inference, perhaps cooperation of the exchanges to provide information.