This week we close the books on a long, challenging year and welcome all that 2021 has to offer! While we look forward to many aspects of the New Year, we predict increased enforcement activity by the Internal Revenue Service. The agency’s response to the Covid-19 pandemic, the People First Initiative, put most new enforcement on pause for several months in mid-2020, but new audits steadily ramped back up in the fall. This trend is likely to intensify with the incoming Biden administration, which is expected to increase both civil tax enforcement and criminal tax prosecutions.
In recent months, the IRS has provided some insight into its enforcement strategies and priorities for the future. Leveraging that information—along with our own experience and what we hear from fellow practitioners—we predict what we expect to be the IRS’s top enforcement priorities in the New Year.
The IRS has begun to examine taxpayers’ compliance with provisions of the Tax Cuts and Jobs Act (“TCJA”), and we expect it to begin more tax reform-related audits in 2021. The IRS first signaled its attention on TCJA compliance in late 2019, when its Large Business & International division launched a campaign to examine U.S.-based multinationals’ 2017 and 2018 returns for compliance with the repatriation tax under Section 965of the Internal Revenue Code of 1986.
LB&I next rolled out a broader TCJA-focused compliance campaign in May 2020. This campaign allows the IRS to better understand taxpayers’ behavior under the TCJA and to consider compliance with its provisions on a holistic basis. Expected treatment streams include examinations, soft letter, outreach, new practice units, and the launch of future campaigns. In August 2020, LB&I launched a compliance campaign that targeted individual compliance with Section 965 through examinations and soft letters. Later that month, the IRS announced it would begin enforcing Section 965’s repatriation tax in October 2020 through two methods: letters to taxpayers who it believed needed to comply more fully with Section 965, and audits of taxpayers it believed failed to comply with their transition tax obligations.
Then, in October 2020, the agency revised the Section 965 compliance campaign that it first launched in late 2019 to refocus on identifying and addressing taxpayers with potential material compliance risk. Taxpayers selected for Section 965 examination will also be examined for other material issues, especially those related to TCJA planning.
Examinations of TCJA items are new territory for the IRS. Early experience with Section 965 audits shows that examiners are focusing on earnings and profits (E&P) calculations, foreign tax credits, foreign tax pools, and transactions occurring in 2017–2018, including those that reduced cash and E&P. Indeed, an IRS representative confirmed in a December 2020 webinar sponsored by the District of Columbia Bar Taxation Community that exam teams are using a relatively standardized information document request (IDR). Audits of TCJA-related areas will also include compliance with the base erosion anti-abuse tax (BEAT), global intangible low-tax income (GILTI), and foreign-derived intangible income (FDII) provisions, as well as Code Section 163(j)’s interest deduction limitation.
Against this backdrop of increased enforcement, some taxpayers have already challenged certain TCJA regulations in court. In FedEx Corp. v. United States, the taxpayer has brought a refund claim challenging the foreign tax credit portion of the Section 965 regulation as invalid, in part due to a conflict with the statute. The case is pending in the Western District of Tennessee. Likewise, in Liberty Global, Inc v. United States, the taxpayer has filed a refund claim in the District of Colorado that challenges the regulations promulgated under Code Section 245A. It argues that the rules contradict the statute, suffer from procedural defects, and apply retroactively in an impermissible manner. Taxpayers under audit and the IRS will surely watch these cases closely.
Partnerships’ Tax Compliance
The New Year promises increased partnership audits under the Bipartisan Budget Act’s partnership audit regime that became effective on Jan. 1, 2018. While the number of partnership audits has grown over the past two years, LB&I has signaled in its 2021 Focus Guide that the trend will intensify in 2021. LB&I is also developing a program for partnerships that is similar to its Large Corporate Compliance (LCC) program, which uses data analytics to automatically target large and complex corporate taxpayers having compliance risk for examination. Indeed, the Focus Guide prioritizes expanding the LCC program to partnerships.
Forthcoming partnership audits will focus on a variety of areas. The IRS is not limiting TCJA compliance audits to corporations, and many aspects of tax reform impact partnerships. LB&I has signaled areas of partnership-related scrutiny in certain compliance campaigns. One campaign focuses on whether distributions to partners are subject to employment tax under the Self-Employment Contributions Act (SECA) tax. Further, the IRS has long shown interest in items impacting private investment funds that typically structure using partnerships, including with respect to carried interest, management fee offsets and waivers, and the treatment of monitoring fees that investment fund affiliates receive from portfolio companies.
The IRS’s focus on partnerships’ compliance extends to their current reporting obligations. The Service has recently required partnerships to report information regarding partners’ capital accounts on Schedule K-1 of Form 1065 (“U.S. Return of Partnership Income”). It is also scrutinizing international aspects of partnership reporting. We anticipate that these areas will become the topics of future audit and enforcement activity.
Stock-Based Compensation Cost-Sharing Arrangements
We expect 2021 will bring continued audits of taxpayers’ stock-based compensation cost-sharing arrangements. The IRS has already started examining taxpayers that didn’t include stock-based compensation costs as intangible development costs under Treasury Regulations §§ 1.482-7A(d)(2) and 1.482-7(d)(3). These examinations are taking place in the wake of the Supreme Court declining to review the Ninth Circuit’s decision in Altera v. Commissioner. In Altera, the Ninth Circuit reversed the Tax Court’s 2015 decision that invalidated the regulations. The audits come as no surprise: The IRS announced in a July 31, 2019 LB&I memorandum that it was lifting its administrative moratorium on examining such cost-sharing arrangements in the wake of the Ninth Circuit’s decision, and encouraged the opening of new examinations of cost-sharing arrangements. Even though Altera only controls in the Ninth Circuit, the IRS indicated that the decision will help its position in all matters before its Independent Office of Appeals and in any future litigation.
Companies that took positions excluding stock-based compensation from cost-sharing arrangements could come under audit given the IRS’s focus. Likewise, any company that filed refund claims in response to the 2015 Tax Court decision invalidating the regulations should expect to see its refund claim denied.
High Net Worth Individuals
It is no secret that the IRS has increased scrutiny of high net worth individuals in recent years, and LB&I’s 2021 Focus Guide suggests the trend will continue in the New Year. LB&I has employed a global high-wealth program, also known as the IRS’s “wealth squad”, for several years. The wealth squad focuses its examinations on obtaining complete financial pictures of high net worth individuals and the entities they control. In July 2019, it announced a high-income non-filer compliance campaign that would target taxpayers who have not filed required tax returns.
The IRS said in February 2020 that it would increase face-to-face visits with high-income individuals who had failed to file returns. While the People First Initiative mostly paused those efforts, when the moratorium on new examinations expired in July 2020, LB&I announced that it would begin a wave of audits of high-income non-filers having interests in partnerships. This increased focus came on the heels of a May 2020 report, “High-Income Non-Filers Owing Billions of Dollars Are Not Being Worked by the Internal Revenue Service,” by the Treasury Inspector General for Tax Administration (TIGTA).
IRS enforcement efforts aimed at high net worth individuals are not limited to non-filers. LB&I also has a compliance campaign focused on individuals who have expatriated and have not met their payment or filing obligations. As previously mentioned, LB&I initiated a campaign focusing on individuals’ compliance with Section 965 in August 2020. And, as we discuss below, the IRS is targeting holders of virtual currency and compliance with FBAR and FATCA filing obligations.
In targeting high wealth individuals for audit, the IRS is likely to use one of the key weapons in its arsenal: data. The data isn’t limited to the mass of information it can glean from filed returns. The agency has vastly enhanced its data analytics capabilities in recent years, and is now able to pool and leverage data from many different sources, including publicly available information from social media, as well as from publicly published leaked data. Other sources include information that it has received through formal discovery (such as the Coinbase summons response), from other U.S. government agencies, and from other countries. The IRS is using newly developed computer tools—including artificial intelligence—to quickly identify interrelationships among taxpayers, third parties, and assets, including virtual assets. We expect it will leverage these tools to identify and work high-net worth individual audits.
In 2021, the IRS will continue its long effort to bring virtual currency holders into compliance, leveraging recent filings, international cooperation, and robust data analytics. The agency has explicitly prioritized enforcement of virtual holdings since July 2018 when LB&I launched a campaign targeting cryptocurrency. Since then, it has increasingly ramped up its activities.
The New Year will allow the IRS to leverage recent virtual currency filings-both responses to targeted letters and routine filings-in its enforcement efforts. In July 2019, the IRS sent three types of letters to taxpayers regarding potential non-reporting of virtual currency transactions (Letters 6173, 6174, and 6174A). It reported that these letters resulted in the filing of certain amended returns. Routine tax forms that all individual taxpayers are required to file now include questions related to virtual currency. For filings made in 2020 related to the 2019 tax year, these questions were located on the 2019 Form 1040’s Schedule 1 that many filers don’t use. There, filers were forced to answer whether, “[a]t any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” Going forward, all filers will be forced to answer that question, because for filings made in 2021 related to the 2020 tax year, the question is now located on the 2020 Form 1040, not only on the Schedule 1. These routine filings will mean the IRS has multiple years of information regarding virtual currency to leverage, making it easier to establish the intent necessary for elevated penalties and for criminal prosecution.
Virtual currency enforcement in 2021 will likewise leverage expertise developed in the recent past. A global effort to target virtual currency holders was publicized in the November 2019 Crypto Challenge of the Joint Chiefs of Global Tax Enforcement, or J5, which groups the revenue authorities of Australia, Canada, the Netherlands, U.K., and U.S. The Crypto Challenge provided a publicly visible example of collaboration between these tax authorities and data scientists to identify non-compliance.
There are many processes in place for such information-sharing between countries, including through the U.S.’s Foreign Account Tax Compliance Act (FATCA) reporting, as well as international processes such as Automatic Exchange of Information (AEOI), Exchange of Information on Request (EOIR), common reporting standards (CRS), and country-by-country (CBC) reporting.
Indeed, the Crypto Challenge was quickly followed by the J5’s Day of Action in January 2020, with coordinated international enforcement actions against tax evaders. In a November 2020 message, James Lee, the new head of IRS Criminal Investigations, publicly reiterated his support for the J5 collaboration, and noted that the agency’s “investment in cybercrimes and data analytics has positioned [the IRS] to be at the forefront of cases involving cryptocurrency.”
More recently, a high-profile arrest and indictment by the U.S. Department of Justice and the IRS shows that the IRS is making good on its promises to make virtual currency holders pay their fair share to the federal government. In that case, the DOJ and IRS announced on Dec. 9, 2020 the arrest and indictment of Amir Bruno Elmaani, better known as “Bruno Block,” for tax evasion. Block is the founder of the virtual currency Oyster Pearl and was indicted for failing to report income to the IRS. The U.S. Securities and Exchange Commission simultaneously charged him with conducting an illegal securities offering.
FATCA and FBAR Compliance
The IRS has focused on international compliance with respect to foreign financial accounts in recent years, and we expect the trend to continue in the New Year. Foreign Bank Account Reports (FBARs) and FATCA impose overlapping disclosure requirement for holders of foreign bank accounts, and the banks themselves. FBARs are required filings for holders of foreign bank accounts. FATCA requires international financial institutions to report data to IRS. LB&I announced in October 2018 a campaign targeting FATCA filing accuracy. IRS announced in a July 2020 memorandum the resumption of FBAR examinations, and announced in a November 2020 memorandum that FBAR enforcement activity would be continuing. The IRS also continued to initiate new FATCA exams, even during the COVID-19 crisis. It has seen increased cooperation from some foreign governments, with Canada and Switzerland announcing that their financial institutions would cooperate with FATCA requirements.
Two court decisions released in late 2020 have made it even easier for the IRS to prosecute FBAR-related violations: the Fourth Circuit’s October 2020 decision in Horowitz v. United States, and the Eastern District of Pennsylvania’s December 2020 decision in Bedrosian v. United States. In both cases, the taxpayers—holders of Swiss bank accounts—were challenging penalties asserted by the IRS. In Horowitz, the Fourth Circuit held that the taxpayers had recklessly disregarded FBAR filing requirements and could therefore be assessed a penalty for a willful violation.
In Bedrosian, the district court—on remand from the Third Circuit—similarly supported the imposition of a penalty for a willful violation. Importantly, the Bedrosian court expanded the concept of willfulness by assessing the taxpayer’s intent objectively, not subjectively: “This court’s prior analysis was focused almost entirely on Bedrosian’s subjective intent and did not adequately consider whether the evidence warranted a conclusion, from an objective point of view, whether Bedrosian acted either ‘knowingly or recklessly.’ ” These two decisions will likely clear the way for the IRS to assert elevated penalties against taxpayers. This may prove to be a significant source of income for the IRS, as willful penalties for FBAR violations can be up the greater of $100,000 or 50% of the amount in the account.
CARES Act and Other Pandemic-Related Matters
The IRS has already begun to examine compliance with requirements related to the various COVID-related assistance measures provided to taxpayers by the federal government, including through provisions of the Coronavirus Aid, Relief, and Economic Security, or CARES, Act. Related IRS enforcement activities in 2020 have initially focused on possible criminal activity: for example, charging individuals for fraudulently obtaining Paycheck Protection Program (“PPP”) loans, economic impact payments (“EIPs”), and unemployment assistance. We expect this trend to continue into 2021.
The CARES Act also created opportunities for taxpayers to receive refunds arising from net operating losses (NOL). Agency statements in 2020 show that officials are expecting a wave of CARES Act-related refund requests, and are preparing their staff to audit the claims. The IRS is also working closely with the Joint Committee on Taxation (JCT), which will have to approve many of the requests. The JCT must approve tax refunds in excess of $2 million, or $5 million for C Corporations. We expect that large CARES Act-related refunds will receive close scrutiny, especially in light of legislators’ (rejected) proposals to reverse the CARES Act NOL carrybacks. We also anticipate that a material portion of refund claims will be disputed by the IRS, particularly in light of these comments.
Requests for refunds based on NOL carrybacks can affect existing audits—and also trigger new audits. If the taxpayer is already under examination, the exam team will often review the carryback, even if it is outside of the years under review. This often adds time and complexity to an audit. Taxpayers not under audit who file refund claims attributable to NOLs often come under exam for the year (or years) giving rise to the NOL, as well as the years to which the NOL is carried back, even if the statute of limitations has expired. When examining closed years, inspectors can look for unrelated issues to reduce any tentative refund that was already paid, and they may also adjust closed-year items to reduce the amount of the carryback available for other years. Audits of large losses are common and often fast-paced, as the IRS anticipates that taxpayers claiming substantial losses may pose collection risks.
The New Year promises to be a busy one for IRS enforcement. In addition to the areas of focus detailed in this article, we expect the IRS to continue scrutinizing syndicated conservation easements and microcaptive insurance arrangements to identify potential taxpayer abuse. The Service has likewise devoted significant resources to stepping up its fight against civil and criminal fraud, including by creating and staffing a new Fraud Enforcement Office housed in its Small Business/Self Employed Division in 2020. A key part of its mission is to coordinate fraud investigations between the IRS’s civil divisions and its Criminal Investigative division. We anticipate that the Fraud Enforcement Office will be very active in 2021, both in connection with initiatives detailed in this article and beyond.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Kat Gregor is a tax partner and co-founder of the tax controversy practice, Elizabeth Smith is counsel, and Isabelle Farrar is an associate at Ropes & Gray LLP.