IRS Launches Initial Compliance Campaign Objectives: Part 2

In For the Record: IRS Launches Initial Compliance Campaign Objectives, the 13 initial income tax compliance campaigns announced by IRS are discussed.

These campaigns represent the current focus of the Large Business & International (LB&I) division’s enforcement efforts:

• Related Party Transactions
• Tax-Free Repatriation of Property into the United States
• S Corporation Losses Claimed in Excess of Basis
• Land Developers Use of Completed Contract Method
• Deferred Variable Annuity Reserves & Life Insurance Reserves
• Energy Credit for Pre-Approved Projects
• Domestic Production Activities Deduction for the Film and Media Industries
• Offshore Voluntary Disclosure Program for Previously Declined or Withdrawn Taxpayers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

The prior article focuses on the first three of these campaigns, each of which has specific importance to middle market companies. This article will focus on the next four. Although these four campaigns concern issues more common in specific industry sectors, the underlying laws and concepts are not limited to those sectors, and potentially impact taxpayers in other industries as well.

Land Developers Use of Completed Contract Method

For tax purposes, income from long-term construction contracts generally must be determined using the percentage of completion method. Under this method, taxpayers must recognize revenue as the taxpayer incurs allocable contract costs. As such, the taxpayer recognizes income in tax years leading up to the contract’s completion.

However, in select instances, taxable income recognition can be deferred until the tax year in which the contract is completed through the use of the completed contract method. This method can be used to defer income recognition if either, (a) the taxpayer anticipates completing the contract within two years and has average annual gross receipts over the last three years of $10 million or less, or (b) the contract is a home construction contract.

As part of the initiative’s focus, IRS is concerned that taxpayers may be incorrectly classifying certain non-qualifying construction activities as home construction contracts and thus, improperly deferring taxable income. Examples of non-qualifying contracts include those that have total contract costs that are not 80% allocable to construction activities, and those that include costs that are not sufficiently attributable to buildings containing four or fewer dwelling units. As such, taxpayers using the completed contract method should confirm they meet the requirements (particularly if their income has increased in recent years). Taxpayers not currently using the completed contract method should likewise determine if they qualify for the deferral.

Deferred Variable Annuity Reserves & Life Insurance Reserves

In determining their taxable income, life insurance companies are permitted to deduct amounts they establish as a tax reserve for future claims. The tax reserve is measured as the greater of, (a) the net surrender value of the contract with regards to any penalty imposed on surrender but without regards to any market value adjustment or, (b) an amount determined by using an IRS prescribed method, which incorporates the applicable tax reserve method, the greater of either the applicable federal or State interest rate and IRS Commissioner’s standard mortality tables. IRS is concerned that these tax reserves are being incorrectly determined and, as a result, companies may be under-reporting taxable income. IRS emphasis in this area reflects a more general focus on their attempts to increase compliance in areas subject to accounting estimates.

Energy Credit for Pre-Approved Projects

A substantial income tax credit is available to taxpayers who make investments in energy property and properly follow the requirements to obtain the credit. One such credit is the Qualifying Advance Energy Project tax credit (Sec. 48C credit). This credit may only be claimed by an approved applicant who invested in a qualifying advanced energy project, received an acceptance letter related to the project in 2013 or earlier and completed the project within three years of the IRS certification letter date.

IRS has asserted that the Sec. 48C credit is sometimes being claimed by taxpayers who either were not pre-approved or have not completed the project within prescribed standards. Common violations of the standards have been noted to include unapproved alterations to the accepted project, the property not being placed in service on time, the property not being located in the United States and the basis of the property not being reduced to reflect the credit.

Domestic Production Activities Deduction for the Film and Media Industries

Broadly speaking, the Domestic Production Activities Deduction (DPAD) was introduced to incentivize domestic investment and production. The DPAD offers taxpayers a deduction equal to 9% times the lesser of, (a) taxable income before accounting for the deduction or, (b) Qualified Production Activity Income (QPAI). QPAI is calculated as Domestic Production Gross Receipts (DPGR) less the sum of costs of goods sold and other expenses, deductions and losses allocable to DPGR. This deduction applies to both traditional industrial companies as well as companies operating in industries such as retail, food and beverage, and film and media. IRS launched this campaign specifically to ensure that multichannel video programing distributors (MVPDs) do not include their distribution revenues as DPGR, thus leading to an overstated DPAD. IRS reasoned in a Chief Counsel Advice Memorandum that even if MVPD properly classify distributed subscription packages as qualified film, a class of qualified production property, the MVPD, are not the producers of such material and, therefore, these distributions are not DPAD-eligible activities. It remains unclear as to whether this campaign will be expanded to specifically identify other DPAD taxpayers.

Conclusion

Taxpayers should be aware that these 13 campaigns are the focal point of the LBI division’s new compliance objectives. Although some of these campaigns appear to be specific to LBI taxpayers in certain industries, the implications from and responses to the campaigns can be much more far-reaching. The six remaining campaigns will be examined in subsequent issues of For the Record.