Podcast: Disputing Tax: 2021 IRS Enforcement Priorities
In this episode of Ropes & Gray’s podcast series Disputing Tax, Isabelle Farrar, an associate in the tax controversy group, is joined by Kat Gregor, a tax partner and tax controversy group co-founder, and Elizabeth Smith, counsel in the tax controversy group, to examine some potential areas of focus for IRS enforcement efforts in 2021.
Isabelle Farrar: Hello, and thanks for joining us today on Disputing Tax, a Ropes & Gray podcast series focused on tax controversy-related matters and developments. I’m Isabelle Farrar, an associate in the tax controversy group. Joining me today are Kat Gregor, a tax partner and tax controversy group co-founder, and Elizabeth Smith, counsel in the tax controversy group. We will be discussing several areas that promise to be focal points of IRS enforcement efforts in 2021. Kat, we are recording this podcast with a new administration in the White House. How do you expect the new administration to approach enforcement policies?
Kat Gregor: Hi, Isabelle—thank you for having me. For much of the last year actually, the IRS was preoccupied, of course, with the fallout of the COVID-19 pandemic. Nearly all new enforcement activity was paused from March through July under the People First Act, enacted as a result of the pandemic. But we did see enforcement activity pick back up in fall 2020, and we expect the Biden administration to accelerate that trend. When announcing the American Jobs Plan and the Made in America Tax Plan in March 2021, the President promised to increase tax enforcement against corporations and high-income Americans. The American Families Plan, announced in April 2021, would be funded in part through revitalized tax enforcement against high-net-worth individuals, large corporations, businesses, and estates. It also would require financial institutions to file information reports on account flows to ensure that earnings from investments and businesses are subject to reporting similar to how wages already are reported to the IRS. The President has also asked for the IRS’s 2022 budget to be increased by 10.4%, and Treasury Secretary Yellen released a statement that the budget increase would make it harder for taxpayers to break the law. We have even heard that efforts to collect unpaid tax, or closing the tax gap, is likely to make its way into the scoring for eventual legislation based on the President’s proposals.
Isabelle Farrar: As an initial matter, Elizabeth, does it make sense to talk briefly about how the IRS identifies taxpayers for enforcement actions?
Elizabeth Smith: Sure. As you can imagine, the IRS has a lot of tools it can use to guide its enforcement activity. On the civil side, the Large Business and International Division (or LB&I) has a campaign-based approach to identifying the areas of taxpayer non-compliance on which LB&I wants to focus. Certain campaigns target types of taxpayers (like high-income non-filers). Other campaigns target subject matter areas (like the SECA Tax and Syndicated Conservation Easement Transactions). LB&I campaigns are announced periodically and give us decent insight into the IRS’s enforcement priorities. To target taxpayers with the greatest risk of non-compliance for examinations, LB&I and the IRS’s Criminal Investigative division use data analytics to comb the massive amount of information that the IRS has available from filed returns, formal discovery, information sharing with other government agencies—and other governments—and even public sources like social media.
Isabelle Farrar: Thanks for that context, Elizabeth. Kat, has the Service indicated which particular areas they plan to focus on in this coming year?
Kat Gregor: They have. One area of current focus is the Tax Cuts and Jobs Act (also known as the TCJA) and particularly Section 965, which deals with repatriated income back in 2017. At a high-level, Section 965 required U.S. shareholders in certain foreign corporations to pay a transition tax on untaxed foreign earnings as if those earnings had been repatriated back to the U.S.
Isabelle Farrar: And Kat, this isn’t the first time the IRS signaled its interest in Section 965 compliance, correct?
Kat Gregor: That’s right. The IRS first announced these efforts in late 2019, with a campaign focusing on compliance with Section 965’s requirements. In May 2020, the IRS began a broader campaign designed to better understand taxpayers’ behavior under the TCJA. Then, in October 2020, the agency began to audit and send soft letters to taxpayers about their compliance with Section 965. Our early experience with these Section 965 audits shows that the IRS seems to be particularly interested in earnings and profits calculations, foreign tax credits, and foreign tax pools.
Elizabeth Smith: And Kat, apologies for interrupting, but we don’t expect these audits will be limited to Section 965, either. The IRS has signaled that examinations of 2017 and 2018 returns will consider implementation of other TCJA-related areas that include compliance with base erosion anti-abuse tax (or BEAT), global intangible low-tax income (or GILTI), Section 163(j)’s interest deduction limitation, and foreign-derived intangible income (or FDII).
Isabelle Farrar: Good point, Elizabeth. Kat, have we started seeing taxpayers react to these audits?
Kat Gregor: Yes, for sure. Taxpayers are building defenses to IRS determinations, and some have already filed suits challenging the validity of some of the TCJA regulations themselves. We’ve seen issues around TCJA make their way into courts faster than we normally might, because the taxpayers being audited have often taken positions that are not entirely consistent with the IRS’s regulations on a particular statutory provision. Often, taxpayers had developed positions themselves based on the plain language of the statute, and the IRS ultimately released regulations that were more government-favorable. Taxpayers have questioned the validity of many provisions in the regulations for several reasons, including based on retroactivity and conflicts between the regulations and statutory language that taxpayers claim is plain, therefore leaving no room for regulatory interpretation. Perhaps not surprisingly, the IRS has repeatedly stated that they plan to stick by their regulations, both at the IRS examination and through the administrative appeals level, and they do not plan on settling issues with taxpayers based on questions of valid regulations. This means that taxpayers are left with a single option to advance their positions: go to court.
Isabelle Farrar: Taxpayers and the IRS will definitely keep a close eye on how those early cases are resolved. Elizabeth, another area involving disputes over the validity of regulations, but where the IRS has recently seen favorable decisions from the courts, has to do with stock-based compensation. Can you please give us some background?
Elizabeth Smith: Absolutely. A key case is Altera v. Commissioner. Back in 2015, the Tax Court invalidated regulations relating to stock-based compensation cost-sharing arrangements, which led the IRS to declare a moratorium on enforcing these regulations. In 2019, the Ninth Circuit reversed the Tax Court’s decision. Shortly afterwards, the IRS declared an end to the moratorium on auditing and enforcing the disputed regulations. In June 2020, the Supreme Court declined to hear Altera. Afterwards, the IRS confirmed that examinations were underway of taxpayers that didn’t include stock-based compensation costs as intangible development costs. We expect refunds claimed based on the Tax Court’s 2015 decision to be denied, and audits enforcing these regulations really to pick up this year.
Isabelle Farrar: Very interesting. Another area that has been picking up in recent years is audits of partnerships, right, Elizabeth?
Elizabeth Smith: Correct. In 2018, the new centralized partnership audit regime under the Bipartisan Budget Act (or BBA) took effect, allowing the IRS to assess and to collect liabilities from the partnership, rather than having to chase down every partner. In this way, the BBA regime makes it much easier for the IRS to collect partnership liabilities. We’ve seen increased partnership audits since 2018—although at a relatively slow pace of growth—but the IRS has indicated that more are coming. In fact, the 2021 LB&I Focus Guide noted that audits of large partnerships would be a major focus this year, and an IRS spokesman said to expect an uptick on audits of large partnerships in late summer 2021. The Service has also announced that it’s developing a program for partnerships that is similar to its Large Corporate Compliance (or LCC) program. This program uses data analytics to target large and complex taxpayers with complicated compliance risks for exam.
Kat Gregor: That’s right, Elizabeth. We know that the IRS is interested in several aspects of partnerships’ tax compliance, but has long been hamstrung in auditing partnerships under the old regime that required collection of tax from the individual taxpaying partners (who often own interests through several tiers of large partnerships). We know that the IRS is interested in many areas impacting private investment funds that are unique to partnerships, including carried interest, management fee offsets and waivers, and the treatment of monitoring fees received from funds’ portfolio companies. But we also know that they will be auditing the tax reporting positions of partnerships in the same manner as they would a large corporation—for example, we anticipate that a partnership’s compliance with the TCJA provisions will be a key focus for partnerships in the same manner as for corporate taxpayers currently.
Isabelle Farrar: The 2021 LB&I Focus Guide also promised more scrutiny of high-net-worth and high-income individuals. Kat, can you tell us a bit about how the IRS plans to approach these taxpayers?
Kat Gregor: Of course. This seems to be a recurring theme in IRS enforcement policies, and was highlighted by the President in his March 31 announcement of the American Jobs Plan and the Made in America Tax Plan. For several years, the IRS has had a global high-wealth program commonly referred to as the “wealth squad” that focuses on high-net-worth and high-income individuals. In May 2020, the Treasury Inspector General for Tax Administration published a report finding that the IRS was failing to pursue these individuals. We are seeing, and expect to continue to see, an emphasis on audits of high-net-worth and high-income individuals in many areas this year. In fact, in January 2021 the deputy commissioner of the Small Business/Self-Employed Division (or SB/SE) specifically said that the IRS was “work[ing] all high-income nonfiler cases,” reaching back to the 2016 year.
Isabelle Farrar: Cryptocurrency is one of those audit areas, right?
Kat Gregor: Yes, it is. The IRS is very interested in taxpayers’ cryptocurrency holdings, and we have seen a lot of recent IRS activity in this space involving both individuals and entities. All individual taxpayers are asked to disclose their cryptocurrency activity on their 2020 Form 1040, but the majority of enforcement efforts are focused on deep pockets. To that end, the IRS has teamed up with other U.S. enforcement agencies, like the SEC, to identify and prosecute noncompliance in the cryptocurrency area. On December 9, 2020, we saw some of the fruits of these efforts when “Bruno Block,” the founder of virtual currency Oyster Pearl, was arrested and indicted for tax evasion. In early March 2021, the IRS announced Operation Hidden Treasure, which is tracing cryptocurrency transactions and identifying taxpayers who have omitted income from returns. And, in late March 2021, the IRS asked two U.S. federal courts for permission to serve John Doe summonses on cryptocurrency exchanges Kraken and Circle. In those summonses, the IRS is seeking information regarding the exchanges’ account owners and their transaction activity to ensure that users are complying with their tax obligations. Which brings us back to the box on the Form 1040—if a taxpayer is identified through these efforts and they failed to disclose their positions on their tax return, they will have an even harder time resolving the matter before the IRS without steep penalties.
Elizabeth Smith: Just to add to that, Kat, the IRS’s collaboration with other agencies extends across international borders. The Service has teamed up with revenue authorities in Australia, Canada, the Netherlands and the UK to form the Joint Chiefs of Global Tax Enforcement, known as the J5. In January 2020, the J5 collaborated on what they dubbed a “Day of Action,” where the group launched coordinated international enforcement actions against tax evaders. Past J5 efforts have focused on cryptocurrency. The J5 partnership remains ongoing, and this year’s J5 exercise in March 2021 focused on the FinTech industry. The IRS’s press release about the J5 exercise explains that the novel nature of certain FinTech companies may allow their users to engage in tax avoidance and money laundering. This suggests that the ultimate targets of the J5 investigations may be end users, and not the FinTech companies themselves. The recent exercise resulted in each country identifying specific companies that will be investigated. The IRS summonses to Kraken and Circle may or may not be two of the U.S. targets coming out of the March 2021 J5 collaboration.
Isabell Farrar: It’s fascinating to see international revenue authorities work together to tackle international problems. Are we seeing this kind of international cooperation in other areas as well, Kat?
Kat Gregor: We are. Both FATCA and FBAR are two reporting regimes that allow the IRS to identify U.S. citizens with foreign bank accounts to ensure they are complying with the tax laws. FBARs (or Foreign Bank Account Reports) require individuals to disclose their foreign assets. The FATCA regime requires foreign financial institutions to report certain data to the IRS. The IRS resumed FBAR examinations in July 2020, and it continued with FATCA enforcement through the pandemic. We’ve seen foreign governments announce they’ll be helping the IRS with enforcing these reporting provisions.
Isabelle Farrar: The IRS also recorded some legal victories with respect to FBARs, right?
Kat Gregor: That’s right. And in fact, two in particular recently—Horowitz, out of the Fourth Circuit, and Bedrosian, out of the Eastern District of Pennsylvania. Both cases involved Swiss bank account holders that were challenging the willfulness penalties imposed for FBAR-related violations. The upshot of these cases is that the definition of “willfulness” has been broadened, which will allow the IRS to assess significant penalties against more taxpayers.
Isabelle Farrar: Before we close today’s discussion, I wanted to circle back to where we began. The COVID-19 pandemic has interrupted every facet of our lives and its impacts are certainly being felt in 2021 as well. In March 2020, Congress passed the CARES Act, which provided taxpayers with many benefits, including loans, economic impact payments, and unemployment assistance. Elizabeth, can you tell us a bit about what enforcement challenges the CARES Act and other COVID-related relief have created for 2021?
Elizabeth Smith: Sure. There are a couple of general categories when it comes to COVID-19-related enforcement. The first relates to fraudulent claims by taxpayers for COVID-19-related benefits to which they were not entitled. We’ve already seen crackdowns on taxpayers that fraudulently obtained Paycheck Protection Program (or PPP) loans and economic impact payments. We expect that this enforcement will continue in the coming year. A second area relates to net operating losses (or NOLs) and their carrybacks that were authorized by the CARES Act. The IRS is expecting that a lot of taxpayers experience large losses in 2020. Those taxpayers can carry losses back to earlier tax years, and then apply for refunds of taxes previously paid in those earlier years. The IRS has already announced those refund claims will be closely scrutinized. NOL carrybacks also allow auditors to conduct a holistic analysis of any year in which the taxpayer seeks to apply the losses in order to reduce any refund claimed and to reduce the amount of carryback available for other years. Not only will NOL carrybacks trigger new audits, they may extend the length of time of existing audits.
Isabelle Farrar: It'll be interesting to see where this all goes. That’s all the time we have for today. Elizabeth and Kat, I want to thank you for sharing these insights. Please visit the Tax Controversy Newsletter webpage at www.disputingtax.com, or, of course, www.ropesgray.com for additional news and commentary about other important tax developments as they arise. If we can help you to navigate this complex and rapidly developing area of the law, please do not hesitate to contact us. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.