IRS Launches Initial Compliance Campaign Objectives

IRS’ issue-based approach to tax examinations could present new challenges to taxpayers.

The New State of Internal Revenue Service Tax Examinations

In 2016, the Large Business & International Division of IRS announced new compliance campaigns to comply with the Service’s Future State initiative. The campaigns involve identifying income tax areas wherein IRS perceives significant levels of non-compliance among taxpayers, communicating such areas of non-compliance to the general public and targeting for audit specific groups of taxpayers that appear most likely to be non-compliant as to one or more of those specific areas. Through informational campaigns and the tax examination process, IRS looks to bring taxpayers into compliance as to the areas identified.

The following thirteen initial compliance campaigns represent the first step of the initiative:

• Related Party Transactions
• Tax-Free Repatriation of Property into the United States
• S Corporation Losses Claimed in Excess of Basis
• Energy Credit for Pre-Approved Projects
• Domestic Production Activities Deduction for the Film and Media Industries
• Deferred Variable Annuity Reserves & Life Insurance Reserves
• Land Developers Use of Completed Contract Method
• Offshore Voluntary Disclosure Program for Previously Declined or Withdrawn Taxpayers
• Form 1120-F Non-Filers
• Inbound Distributors and Transfer Pricing
• Micro-captive Insurance Contracts to Reduce Taxable Income
• TEFRA Linkage Plan Strategy
• Basket Transactions which Defer or Reclassify Income

More campaigns will be announced at an undisclosed time in the future. These campaigns will serve to fundamentally shift the tax examination approach of IRS from comprehensive, enterprise-wide examinations to issue-based examinations. In addition to the more narrowly-focused exams, compliance as to specific tax issues will also be encouraged through the use of soft letters encouraging voluntary correction of taxpayer oversights, the publishing of additional IRS guidance on the issues and the creation of new forms to assist taxpayers with calculations.

The remainder of this article will discuss the first three campaigns listed above. Articles in subsequent issues of For the Record will address the remaining campaigns.

Related Party Transactions

IRS is concerned that transactions between commonly controlled entities operating in the mid-market space have been used to shift corporate income from C corporations directly to stockholders or pass through entities, resulting in the avoidance of double taxation. Transactions that may receive scrutiny include compensation, rent, and other payments made to stockholders, partners, and family members; as well as sales and loan transactions among stockholders, partners, their families and controlled entities under terms that are inconsistent with those involving unrelated taxpayers. To mitigate potential tax exposures in this area, taxpayers should plan and document related party transactions on the same arms-length basis that would be employed in transactions with unrelated parties.

Tax-free Repatriation of Property into the United States

U.S. corporate taxpayers receive cash from their foreign affiliates through many avenues, including dividends, royalty payments, payments for services rendered, repayments of loans as to which the taxpayers are creditors, or borrowings under loans as to which the taxpayers are debtors. IRS is aware that some taxpayers are not reporting taxable repatriation events, so this campaign seeks to increase compliance in an increasingly complex reporting environment. The effects of this campaign may be altered or enhanced if legislative changes are enacted, such as a territorial-style system with a mandatory deemed repatriation tax.

S Corporation Losses Claimed in Excess of Basis

The income or losses of S corporations are reported to the shareholders, who then report that activity directly on their individual income tax returns. Losses reported to an S corporation shareholder may often offset taxable income that the shareholder receives from other sources, such as wages or portfolio income. However, a shareholder may not deduct S corporation losses that exceed the taxpayer’s basis in the S corporation, and IRS is concerned that many S corporation shareholders do just that.

An S corporation shareholder has basis in his or her stock of the corporation, and also may have basis in loans that he or she makes to the corporation. Stock basis is generally calculated as (1) the shareholder’s stock purchase price, plus (2) the shareholder’s cumulative share of income items, minus (3) the shareholder’s cumulative share of losses, and minus (4) distributions. Loan basis is generally calculated as (1) the face amount of the loan, minus (2) the shareholders net losses allocated against that loan after the shareholder’s stock basis has been reduced to zero. Note that the forgoing sets forth the general provisions as to the determination of an S corporation shareholder’s stock and loan basis; each calculation requires a strong understanding of both the specific shareholder fact pattern and the provisions of the tax law.

Taxpayers that have claimed S corporation losses in their tax returns should make certain they have adequate tax basis to do so. Taxpayers that have not claimed S corporation losses should nonetheless understand their tax basis in the event that losses may be claimed in the future. In addition, taxpayers also need to understand their tax basis to properly report distributions and loan repayments from the S corporation, or to properly report gain upon the sale of the S corporation stock. Partners in partnerships and members in Limited Liability Corporations should also be alerted that a similar campaign to target excess losses claimed by partners or LLC members would be a logical extension of the S corporation campaign.

Conclusion

The IRS shift from ongoing, comprehensive tax examinations to issue-based compliance campaigns will inevitably lead to uncertainty in the short term as IRS agents develop experience with the new process and the underlying tax issues. Taxpayers should take advantage of the public announcement of this focus area and confirm that they have not only appropriately addressed these areas in their tax return filings, but also maintain the required documentation. To the extent that corrections as to prior tax filings are in order, taxpayers should consider filing amended tax returns in advance of a potential IRS examination.