One year ago, the Internal Revenue Service announced that it would be reviewing hundreds of high-income individuals’ tax returns in the last half of 2020.
We discussed this announcement in our article Athletes, Artists, and Audits—IRS Renews Focus on Global High-Wealth Individuals. In this article, we provide an update on audit and enforcement activity involving high-net-worth individuals, with a particular focus on sports professionals.
The IRS Is Down But Not Out
As feasible in light of budget constraints (see more on this below), the IRS is not pulling any punches on pursuing high-net-worth individuals in audit and litigation. In one high-profile example, the IRS asserted that the estate of Michael Jackson had grossly undervalued itself at an estimated $7.2 million and that its true value was closer to $1.125 billion. Per the IRS, this undervaluation resulted in an estimated $505 million tax underpayment and nearly $200 million in penalties. The valuation differences centered in large part on Jackson’s image and likeness—assets that are often subject to substantial valuation debate. Since the case commenced in 2013, the IRS has been vigorously pursuing the Jackson estate and defending its positions.
The Tax Court, in its decision issued on May 3, 2021, unambiguously rejected the IRS’s positions, particularly with respect to valuations of the estate’s assets. The court said that the IRS’s valuations were “fantasy” and involved valuing the “wrong asset,” included “unforeseen events” at the time of Jackson’s death in the valuation, and “miscalculated the assets’ value.”
Although the Tax Court rejected the government’s position in the Jackson case, the dispute highlights what some see as a hyper-aggressive approach by the IRS to pursue perceived tax abuses by high-net-worth individuals. Whether the IRS refines its approach to such disputes in cases going forward is to be seen, but it is a safe bet that the IRS will not be taking the pressure off high-net-worth taxpayers any time soon. For athletes, in particular, these sorts of valuation battles are a continuation of the types of disputes involving personal intercompany transactions or estate tax matters involving an athlete’s likeness or image.
The Administration Is Chomping at the Bit
On April 28, the Biden administration introduced the American Families Plan (AFP), a $1.8 trillion legislative framework including provisions to “grow the middle class, expand the benefits of economic growth to all Americans, and leave the United States more competitive.” The AFP would expand access to education, reduce the cost of childcare, create a national comprehensive paid family and medical leave program, and extend or make permanent certain tax credits for families with children and low- and middle-income households. To fund and offset the cost of these proposals, the AFP would increase taxes on high-income and wealthy taxpayers. The AFP is meant to work in tandem with the American Jobs Plan, an infrastructure reform plan proposed by President Joe Biden in late March 2021 that is funded by various corporate and international tax reforms.
The AFP proposes increasing the long-term capital gains and qualified dividend rate from 20% to 39.6% for taxpayers earning $1 million or more. Combined with the existing 3.8% surcharge tax on net investment income, the top capital gains rate may reach 43.4% (not including any state or local taxes). According to the Biden administration, this proposal would affect only 0.3% of households, where investment income is concentrated. While globally the increase affects a limited number of taxpayers, it is likely to (disproportionately) capture professional athletes who are engaged in investment activities.
Additional changes in the AFP would also affect many professional athletes. For example, under current law, taxpayers are assessed a 3.8% Medicare tax on net investment income above $200,000 for single filers and $250,000 for joint filers. Stating that the “application is inconsistent across taxpayers due to holes in the law,” the AFP proposes applying the tax consistently to those making more than $400,000 per year. In another example, the highest marginal federal income tax rate is currently set at 37% and applies to taxable income above $523,600 for single filers and $628,300 for married filers.
The AFP proposes increasing the top marginal rate to 39.6%, which would restore the top marginal rate to what it was before the 2017 Tax Cuts and Jobs Act (Public Law 115-97). According to the Biden administration, this increase would affect only the “wealthiest 1% of taxpayers”—but, again, that will include many professional athletes. In a major change in law that would affect estate planning considerations, the AFP aims to revamp the basis step-up at death. Currently, taxpayers are not subject to capital gains taxes upon death and their heirs receive a basis step-up to fair market value. With some exceptions, the AFP would repeal the basis step-up for gains in excess of $1 million per person (or in excess of $2.5 million per couple when combined with real estate exemptions), assuming the property is not donated to charity. The AFP provides scant technical explanation as to how these objectives would be accomplished.
Other material tax proposals are included in the AFP that may affect some high-net-worth individuals, potentially including some athletes, such as the elimination of the so-called “carried interest loophole,” permanently extending the limitation on some excess business losses and eliminating like-kind exchange treatment for certain real estate gains greater than $500,000.
The Enforcement Gloves Are Off
The above proposals, assuming any or all become law, will only be effective to help close the tax gap (meaning the difference between what taxpayers owe under the law and what they pay) if they are enforced by the U.S. Department of the Treasury and the IRS. The IRS is thus in a delicate position: Should the IRS focus its attention on athletes and other high-net-worth individuals too aggressively without offering balanced interpretations of law, the courts may not only reject the IRS positions but discredit them as “pure fantasy.” This is one of the lessons of the Jackson case.
On the other hand, the IRS will be expected to enforce the laws as proactively as it can to collect the revenue that the Biden administration needs to pay for its infrastructure plan (let alone to dig out of the pandemic-fueled budget deficits). The IRS needs greater resources to accomplish these at-times conflicting goals, and Commissioner Charles Rettig has made numerous pleas for them. According to the most recent IRS Data Book, for the last decade the IRS has seen an increase in the number of returns filed along with a decrease in resources available for examinations. (For example, in 2010 the IRS received 230.4 million returns and employed 13,879 revenue agents, compared to 253.0 million returns and 8,526 revenue agents in 2019 (See IRS Data Book, page 32).)
This drop in staffing means the IRS simply cannot audit the vast majority of individual tax returns that it receives. For all returns filed for tax years 2010 through 2018, the IRS examined 0.60% of individual returns filed, and the IRS examined the returns of 9.26% of taxpayers filing individual returns reporting total positive income greater than $10 million for tax years 2010 through 2018. Moreover, the Treasury has stated that the average investigation of a high-wealth individual takes two years to complete. The IRS cannot effectively audit high-net-worth individuals, who are very often represented by highly skilled tax professionals, without the necessary resources to do so.
To address these budget concerns, the AFP would increase investment in IRS budget over the next decade by a reported $80 billion—a hefty sum. Such an increased budget would of course provide the IRS with the resources it needs to exercise its enforcement power in its audits of high-net-worth taxpayers. The Biden administration estimates that such an investment in the IRS would increase revenue by $700 billion over 10 years.
These enforcement measures, if they come to fruition, mean that more high-net-worth professional athletes will be audited and, presumably, the audits will result in increased collections–and disputes.
The Ball’s in Your Court
One of the keys to effective enforcement in a self-reporting system like U.S. taxation is publicity. By taking on high-profile cases and individuals, such as the Michael Jackson estate, the IRS, when it is successful, sends a message to taxpayers that it will fulfill its mission to enforce the tax laws fairly regardless of wealth or status. When it is unsuccessful, the IRS seeks to learn from its experience and improve its enforcement approaches.
As the administration’s current proposals show, the IRS may be getting a massive budget infusion to step up its improving approach to auditing high-net-worth individuals. Now more than ever, professional athletes–some of the most wealthy and high-profile among us—need to be on their game when it comes to meeting their tax obligations and, potentially, preparing to defend themselves should they find themselves “in the ring” with the IRS.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Morgan, Lewis & Bockius LLP partners Sarah-Jane Morin and Tom Linguanti represent clients in both complex tax controversies and litigation, and the tax aspects in a variety of transactions.
Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.