Monthly Journal of Tax Controversy. Contents GOVERNMENT INTERESTS, PUBLIC POLICY, AND OFFERS. Annual LIU Seminar. Upcoming Free Events IN COMPROMISE

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1 July, 2015 Monthly Journal of Tax Controversy Contents GOVERNMENT INTERESTS, PUBLIC POLICY, AND OFFERS Government Interests, Public Policy, and Offers in Compromise 1 The Taxation of PFIC Income Under the New Jersey Gross Income Tax Act 11 A&A Firm News 17 Annual LIU Seminar Civil & Criminal Tax Controversy 2015 August 13 RSVP: See Page 18 Brookville, NY Upcoming Free Events IRS Collections Part I July 21 RSVP: goo.gl/vuu1xr Hackensack, NJ IRS Collections Part II August 4 RSVP: goo.gl/bsovxb Hackensack, NJ The Taxpayer Bill of Rights September 1 RSVP: goo.gl/rzowup Hackensack, NJ Advocacy with the Appeals Office October 10 RSVP: goo.gl/3ik3lh Hackensack, NJ IN COMPROMISE By Frank Agostino, Esq. Brian D. Burton, Esq. 1 Policy Statement P suggests that the Internal Revenue Service will accept an Offer in Compromise (OIC) of an unpaid tax liability when it is unlikely that the tax liability can be collected in full and the amount offered reflects the taxpayer s reasonable collection potential (RCP). 2 This policy is based on the tenet that an OIC is a legitimate alternative to declaring a case currently not collectible (CNC) or entering into a protracted installment agreement. The goal of an OIC is to achieve collection of what is potentially collectible at the earliest possible time and at the least cost to the government. 3 To ensure consistency, the formulas that the Service uses for calculating asset equity, future income, RCP, and compromise amount are almost mechanical. Accordingly, the primary responsibility of an Offer Specialist the IRS employee analyzing a taxpayer s collection offer is to verify the data provided and make the objective determination of whether the amount offered is adequate. However, although the essence of this compromise is the calculation of the taxpayer s RCP, Policy Statement P-5-89 allows the Offer Specialist to reject an OIC that exceeds a taxpayer s (Continued on page 2)

2 (Continued from page 1) RCP upon a subjective determination that acceptance is not in the best interests of the government (NIBIG) or public policy. 4 If an offer is rejected by an Offer Specialist on NIBIG or public policy grounds, the rejection can be appealed by filing a written protest with an IRS Appeals Officer, who, after the AJAC initiative (explored in last month s newsletter), acts as a type of administrative judge. In certain situations, a taxpayer may also have the ability to withdraw an offer prior to recommendation for rejection on subjective grounds. This article explores the Service s discretion to reject a taxpayer s OIC because acceptance would not be in the best interest of the government or public policy, and then focuses on the best practices tax practitioners and taxpayers can use to navigate these issues. I. Offers Not in the Best Interests of the Government Revenue Procedure , Sec. 603 allows for rejection based on the Service s determination that acceptance of the specific offer is NIBIG. At first blush, this authority might seem consistent with the basic tenet of Policy Statement P-5 100, that an offer will only be accepted if it is determined to be in the best interest of both the taxpayer and the Service. 5 However, the IRM makes clear that, in this case, the term best interest is not used to refer to the fairness of the offer amount. 6 Instead, the section provides the example of a taxpayer who has an egregious history of past noncompliance, as evidenced by the taxpayer's failure to voluntarily file correct returns. 7 A. Egregious History of Past Noncompliance Unfortunately, neither the IRM nor other government guidance provide insight as to how to one may properly measure whether a taxpayer s history of noncompliance rises to the level of egregiousness. The only instruction on this point is the second sentence of the above IRM provision s use of the term returns, which suggests that an OIC may not be properly rejected on the basis of a taxpayer s egregious history of past noncompliance when only a single return is involved. However, the second sentence creates much more confusion than clarity, by adding that evidence of an egregious history of past noncompliance includes a taxpayer s failure to voluntarily file correct returns. It may be that the Service s intended position was that an OIC offered by a taxpayer who voluntarily filed incorrect returns in multiple years may be rejected as contrary to the best interests of the government. However, the wording of the example seems to allow the Service, at its discretion, to use the best interests of the government grounds to reject an OIC submitted by a taxpayer who voluntarily failed to file incorrect returns. Most returns are filed voluntarily, so unless coercion is at issue, the group would seem to include all taxpayers who filed amended returns, incorrect returns, or no returns at all (as no return cannot qualify as a correct return ). The Treasury Regulations provide that a history of noncompliance with the filing and (Continued on page 3) 2

3 (Continued from page 2) payment requirements of the Internal Revenue Code indicates that acceptance of the offer would tend to undermine compliance with the tax laws. 8 And the IRM provision goes so far as to suggest that a noncompliant taxpayer lacks the credibility to submit an offer, by stating that [i]t is not in the Government s interest to investigate an OIC until the taxpayer demonstrates compliance with filing and payment of the appropriate tax. 9 The leading U.S. Tax Court case on egregious past noncompliance is Oman v. Commissioner. 10 There, the Court remanded an OIC which was rejected on the basis that the taxpayer s history of past noncompliance and an analysis of his current finances indicated compliance with the OIC terms was highly unlikely. In that case, the offer amount was $1,000, while the taxpayer s RCP was $0. The Court found inconsistency between the guidance in Policy Statement P-5-100, which provides that offers that exceed a taxpayer s RCP are in the best interest of the government 11 and Policy Statement P-5-89, which provides egregious history of past noncompliance as a reason to reject an OIC that exceeds a taxpayer s RCP. 12 In light of this conflict, and in order to determine whether IRS Appeals ( Appeals ) abused its discretion, the Court remanded to Appeals for clarification of the reasoning behind the rejection. The issue remains unsettled, as confirmed by the Court in Bennett v. Commissioner, 13 in which the Court stated that its decision in Oman provided no firm conclusions resolving the possible conflict. The Court resolved the Bennett case in favor of the Service and found no abuse of discretion where the Service rejected an OIC on NIBIG grounds and it included an exhaustive narrative to justify the conclusion. In addition to requiring full support by facts outlined in a rejection narrative, the IRM makes clear is that rejections for NIBIG should not be routine. 14 Offers rejected under this section require the review and approval of the second level manager; that is, Territory Manager for the field or Department Manager for Centralized OIC (COIC) sites. A taxpayer is to be advised, although the financial information may show the offer might be acceptable, the offer is being rejected because it is either not in the best interest of the government or contrary to public policy. 15 The provision states that specific issues should be identified to the taxpayer. B. Withdrawal, Settlement, and Appeal Tax professionals must be aware that the IRM requires the Service to advise a taxpayer of the reasons that an offer is being recommended for rejection under NIBIG criteria and the alternatives available to the taxpayer, which include ADR mediation, Appeals, and, ultimately, Tax Court abuse of discretion review (assuming that the actual liability is not at issue). 16 An Offer Specialist should also provide the taxpayer with the opportunity to withdraw an offer prior to an offer rejection recommendation. 17 However, the taxpayer may also use this opportunity to present the Service employee with additional information. Specifically, the Service is instructed to discuss the ba- (Continued on page 4) 3

4 (Continued from page 3) sis for the rejection with the taxpayer. Moreover, in order to allow for the submission of additional information for consideration, the Service is required to compute the taxpayer s ability to pay and provide the taxpayer with its preliminary asset/equity and income/expense tables. 18 A taxpayer might point the Service to the Note in IRM, pt (3) (Mar. 7, 2014) that [f]uture collection potential and the ability to secure a collateral agreement should be considerations prior to recommending an offer for rejection under NIBIG. If the issue is compliance, a taxpayer may point to IRM, pt (8) (Mar. 7, 2014) which states that, if a taxpayer is not in compliance, the offer should be returned, not rejected (presumably, in order to allow for compliance to occur prior to final consideration). Tax professionals and taxpayers should always be prepared to appeal subjective OIC rejections, especially if Tax Court rights are ultimately available. A taxpayer may appeal a rejection of an OIC by an Offer Specialist to Appeals by filing Form Request for Appeal of Offer in Compromise, 19 including the reason for disagreement and any supporting documentation, within 30 days of the rejection. If Appeals rejects an OIC, the taxpayer can file a petition with the Tax Court within 30 days of the rejection. Sections 6320 and 6330 of the Internal Revenue Code also allow a taxpayer to appeal a rejected OIC submitted in connection with a CDP hearing to the Tax Court within 30 days of the rejection. However, because liability for the underlying tax is not at issue, the Court s review is based on an abuse of discretion standard. As a practical matter, one key to avoiding rejection of an OIC on NIBIG grounds is bringing the taxpayer into compliance. It may seem unbelievable, but as few as two years of compliance can transform a taxpayer from problem child to prodigal son in the eyes of the IRS. It also lends credence to the taxpayer s ability to maintain compliance for five years following satisfaction of the OIC payments, which is a condition subsequent to the agreement. In our experience, Appeals would rather reach a mutually agreeable solution with a compliant taxpayer who submits an OIC that satisfies all of objective RCP criteria, rather than have the Tax Court review whether a denial was appropriate. Tax professionals and taxpayers who plan to appeal the rejection of an OIC should consult the Service s Online Self Help Tool 20 while remembering that automated programs compliment, but should not be used in place of, sound alternative to analysis and advocacy. C. Partial Pay Installment Agreement In the case of a taxpayer who lacks the ability to pay the entire tax liability through an installment agreement before the collection statute expiration date (CSED), the IRM provides that an OIC may be rejected on NIBIG grounds in favor of a Partial Pay Installment Agreement (PPIA) where a PPIA approximates the outstanding balance. 21 If such a case, the taxpayer should be provided the opportunity to enter into a PPIA, which is a valid alternative to an OIC, and may be granted (Continued on page 5) 4

5 (Continued from page 4) where a taxpayer has no assets or equity in assets, the equity is insufficient to secure a loan, or liquidation would impose an economic hardship on the taxpayer. 22 A PPIA requires that the taxpayer pay the maximum monthly payment based upon the taxpayer s ability until the CSED. D. Offers Involving Noncompliant Business Entities The IRM also provides for the rejection of an OIC on the basis that acceptance would not be in the best interests of the government where the offer is made by a taxpayer that is: (1) An individual primary responsible party for a related business entity that is noncompliant with it's filing and/or paying requirements (no agreement in place or offer pending); (2) A business compromising employment taxes, where a financial analysis indicates that the business does not have the ability to fund the offer, remain current with future tax obligations, and meet the business's normal operating expenses; or (3) A business that appears to be insolvent, and will remain insolvent, even if the offer is accepted, and it appears that the Government s position would be better protected through a formal insolvency proceeding. 23 II. Offer Acceptance Threatens Public Policy Revenue Procedure provides that the Service may take into account public policy and tax administration concerns in determining whether an offer to compromise is acceptable. However, not all public policies threaten a taxpayer s offer, as Policy Statement P-5-89 establishes that offers may be rejected on the basis of public policy if acceptance might in any way be detrimental to the interests of fair tax administration. 24 Although the term in any way seems a bit overly broad, an offer that is judged to be detrimental to the interests of tax administration may be rejected on public policy grounds even though it is shown conclusively that the amount offered is greater than could be collected by any other means. 25 However, IRM, pt (Mar. 7, 2014) clarifies that decisions to reject offers for this reason should be rare. In fact, the section instructs that a decision to reject an offer for public policy reason(s) should be based on the fact that the public reaction to acceptance of the offer might be so negative as to diminish future voluntary compliance by the general public. Situations which may warrant rejection based on a public policy decision include a taxpayer who: (1) openly encourages others to refuse to comply with the tax laws; (2) engages in criminal activity or conceals the financial benefits of a completed criminal activity; or (3) intentionally dissipates assets. Moreover, an offer is not to be rejected on public policy grounds solely because (1) acceptance would generate (Continued on page 6) 5

6 (Continued from page 5) considerable public interest, some of it critical; or (2) the taxpayer was criminally prosecuted for a tax or non-tax violation. As regards public policy rejections, Offer examiners most frequently misunderstand the IRM provisions regarding dissipated assets. A dissipated asset is an asset that has been sold, transferred, encumbered, or otherwise disposed of and, therefore, is no longer available to pay delinquent federal taxes. 26 IRM, pt (Oct. 15, 2014) provides that, if a determination is made that a taxpayer dissipated an asset(s) and the asset is no longer available to pay the tax liability, a secondary determination must be made as to whether or not to include the value of the dissipated asset as part of RCP. Moreover, IRM (Sep. 30, 2013) provides that inclusion of dissipated assets in the calculation of RCP is no longer applicable, except in situations where it can be shown that, after the tax was assessed or within six months prior to the tax assessment, the taxpayer either: (1) sold, transferred, encumbered or otherwise disposed of assets in an attempt to avoid the payment of the tax liability; or (2) used the assets or proceeds (other than wages, salary, or other income) for other than the payment of items necessary for the production of income or the health and welfare of the taxpayer or their family. For example, if a taxpayer withdrew assets from an IRA or other investment account to pay for items such as a vacation or child s tuition, the value of that asset may be included when determining reasonable collection potential. By contrast, some examples of situations in which the value of a dissipated asset should NOT be included in RCP, include: (1) when through internal research or substantiation provided by the taxpayer establishes that the funds were needed to provide for necessary living expenses; (2) an IRA that is dissolved unemployment or underemployment, where internal sources verify that the taxpayer s income was insufficient to meet necessary living expenses; (3) a substantial amount is withdrawn from a bank account, but the taxpayer provides supporting documentation to establish that the funds were used to pay for medical or other necessary living expenses; and (4) an asset is disposed of and the proceeds are used to purchase another asset that is included in the offer evaluation. A. Withdrawal, Settlement, and Appeal Public policy rejections require a narrative discussing the specific public policy issue implicated by the offer and must be approved by the Small Business/Self-Employed (SB/SE) Collection, Territory Managers (second level) in the field or SB/SE Compliance Services Operations Managers for COIC. And, as in the case of NIBIG rejections, the IRM also instructs the Service to discuss the basis for a public policy rejection with the taxpayer, as well as compute the taxpayer s ability to pay and provide the preliminary tables to the taxpayer in order to allow for the submission of additional information for consideration. 27 However, unlike the NIBIG requirements, the IRM does (Continued on page 7) 6

7 (Continued from page 6) not explicitly require the Service to provide the taxpayer with the opportunity to withdraw the offer prior to rejection on public policy grounds. Aside from the Service s reassurances regarding the rarity of public policy rejections, the Service appears to retain the ability to reject an OIC on public policy grounds if the OIC is submitted by a taxpayer who has committed multiple acts of noncompliance. Would this include participants in the Service s Offshore Voluntary Disclosure Program, who admit to willful noncompliance, so that a participant be denied an OIC under the public policy or NIBIG provisions? 28 To date, the Tax Court has not has the occasion to consider these issues. So far, Tax Court guidance concerning public policy rejections is mostly limited to the decision in Tucker v. Commissioner, 29 in which the Court held that Appeals did not abuse its discretion in denying a taxpayer s OIC on the basis that day trading losses constitute dissipation of assets. 30 The Service s rejection of the OIC on NIBIG grounds was upheld, although the dissipation of assets, interestingly, appears as a public policy (not NIBIG) example in the IRM. 31 As to the abuse of discretion standard of review, the Court explained that it would not disturb an OIC rejection without a finding that the Service s decision was arbitrary, capricious, or without sound basis in fact or law. Best practices dictate that any appeal involving a public policy rejection should focus on the same factors that the IRS uses when considering an offer based on special circumstance, including the (1) taxpayer s age and employment status; (2) number, age, and health of the taxpayer s dependents; (3) cost of living in the area the taxpayer resides; and (4) any extraordinary circumstances affecting the taxpayer, such as special education expenses, a medical catastrophe, or natural disaster. 32 The lesson is to tell a story that helps form a positive impression of the taxpayer for the Appeals Officer. As basic as it seems, an Appeals Officer that likes a taxpayer is far more likely to reach a subjective determination that the Service s hazards of litigation, and public policy statements about the desire to afford taxpayers a fresh start, are best served by working past the rejected offer and settling the taxpayer s case. III. Alternative Dispute Resolution/Mediation for Collection Cases 33 Appeals has developed offers two alternative dispute resolution (ADR) mediation programs for collection cases: (1) Fast Track Mediation; and (2) Post-Appeals Mediation. 34 Fast Track Mediation (FTM) 35 is a pre-rejection device that allows taxpayers to resolve disputes at the earliest possible stage in the collection process. 36 In order to invoke FTM, the taxpayer must first try to resolve all issues with the IRS, which means working cooperatively with the Revenue Officer, followed by a conference with the officer s manager, before seeking the services of an (Continued on page 8) 7

8 (Continued from page 7) Appeals mediator. A taxpayer may apply for the FTM program, by sending the Revenue Officer or Offer Examiner handling the case a completed Form 13369, Agreement to Mediate, and a written statement detailing the taxpayer s position on the disputed issue(s). FTM is a viable option for a taxpayer who has withdrawn his or her OIC after being advised by the Service that it would be rejected on NIBIG grounds. With FTM, the taxpayer (or taxpayer representative) presents the arguments to a trained mediator from Appeals, who is assigned to help the taxpayer and IRS Collection reach a mutually agreeable resolution regarding the disputed issue(s). 37 Other important features of FTM are that the mediator lacks authority to impose a decision on either the taxpayer or the IRS, the taxpayer may withdraw at any time, and the taxpayer still retains all otherwise applicable appeal rights if no resolution is reached through FTM. Also, like its name suggests, FTM is intended to be fast, with the goal to resolve a case within 40 days from receipt of the FTM application. Post Appeals Mediation (PAM) 38 is appropriate only after Appeals settlement negotiations are unsuccessful. PAM uses the service of a mediator from Appeals as a neutral party to help Appeals and the taxpayer reach a negotiated settlement on the disputed issue for which mediation is requested. For a taxpayer s matter to be eligible for PAM, the taxpayer is required to first work cooperatively and try to resolve all issues with the Appeals Officer or Settlement Officer prior to seeking the services of an Appeals mediator. Once an OIC is rejected, a taxpayer may submit a specific request for PAM along with a written statement detailing the taxpayer s positions regarding the disputed issue(s) to the Appeals Officer or Settlement Officer handling the taxpayer s case. As with FTM, the PAM mediator lacks authority to impose a decision on either the taxpayer or the IRS, and the taxpayer may withdraw at any time retaining all otherwise applicable appeal rights should no resolution be reached. Once a PAM application is accepted, the goal is resolution within days. IV. Conclusion Tax professionals whose clients face OIC rejection on NIBIG or public policy ground should be well aware of the restrictions contained in the Service s guidelines, including: (1) the requirement to discuss the reasons for possible rejection with the taxpayer; (2) the taxpayer s ability in a NIGIB matter to withdraw an offer prior to rejection; (3) the availability of a PPIA; and (4) the taxpayer s Appeals, ADR, and Tax Court rights. The tax professional must also have a complete understanding of the taxpayer s RCP and the Service s asset/equity and income/expense tables. However, because the Offer Specialist s subjective judgment can result in rejection, a request cannot stand solely on numbers and calculations. In fact, the key to a successful OIC application is often the effective tax advocacy. Tax professions have the best results when they are able to convey a taxpayer s story as advancing the Service s fresh start mission. In addition to strategy, tax profes- (Continued on page 9) 8

9 (Continued from page 8) sionals must also employ persistence, as the case may need to wind its way through Appeals to ADR and ultimately to the Tax Court. These hurdles may be unsurprising; if securing an OIC for less than full tax liability were simple, it would erode taxpayer motivation to pay the full amount due on time. The art of securing an OIC is what makes advocacy a valuable component in the process. Tax practitioners who present a taxpayer s story in a compelling manner will have far more success in securing OIC acceptance, as well as appealing subjective OIC rejections that are based on grounds such as NIBIG and public policy. 1. Frank Agostino, Esq., is principal of, and Brian Burton, Esq., is an associate at Agostino & Associates, P.C. 2. See IRM, pt (Feb. 26, 2013). 3. See, e.g., Policy Statement P-5-100, as quoted in IRM, pt (1) (Jan. 30, 1992). 4. IRM, pts (4) (Jan. 30, 1992), (Jul. 26, 1960). 5. IRM, pt (1) (Jan. 30, 1992). 6. IRM, pt (Mar. 7, 2014). 7. Id. (emphasis added) C.F.R (c)(3)(ii)(A). 9. IRM, pt (Mar. 7, 2014). 10. T.C. Memo See IRM, pt (Mar. 7, 2014). 12. See IRM, pt (Jul. 26, 1960). 13. T.C. Memo IRM, pt (1) (Mar. 7, 2014). 15. IRM, pt (Mar. 7, 2014). 16. IRM, pt (Mar. 7, 2014). 17. Id. 18. Id. 19. Available at Available at Self-Help-Tool-(START). 21. IRM, pt (3) (Mar. 7, 2014) C.F.R defines the term economic hardship as an inability to meet reasonable basic living expenses. 23. IRM, pt (3) (Mar. 7, 2014); see also IRM, pt (Sept. 27, 2011), Consideration of a Potential Bankruptcy Filing on the Calculation of RCP in an OIC Investigation, regarding insolvent businesses and OICs. 24. IRM, pt (Jul. 26, 1960). 25. Id. 26. IRM, pt (Sep. 30, 2013). 27. IRM, pt (2) (Mar. 7, 2014). (Continued on page 10) 9

10 (Continued from page 9) 28. For an interesting discussion of whether an OIC from an OVDP participant might be rejected by the Service on public policy grounds, see Keith Fogg, Anderson v. Commissioner Public Policy Determination as Defense to Collection Due Process Challenge, PROCEDURALLY TAXING, Nov. 20, 2013, T.C. Memo Citing NIBIG grounds, although dissipation of assets appears in the IRM, pt (Mar. 7, 2014) as a reason for OIC rejection on public policy grounds. 31. IRM, pt (3) (Mar. 7, 2014). 32. IRM, pt (5) (Sept. 23, 2008) 33. The ADR topic will be more fully explored in next month s A&A Newsletter. 34. IRM, pt (Mar. 16, 2015). See also Rev. Proc For Fast Track Mediation Procedures for Collection Cases, see IRM, pt (Dec. 05, 2014). 36. See IRS Pub. 3605, Fast Track Mediation: A Process for Prompt Resolution of Tax Issues. See also IRS Appeals Mediation Programs Self-Help Tool, available at Mediation-Self-Help-Tool. 37. The taxpayer has the option to request in the ADR application that a second non-irs mediator should be included at the taxpayer s expense. 38. For Post-Appeals Mediation Procedures for Collection Cases, see IRM, pt (Mar. 06, 2015). 10

11 NOT ALL INCOME IS CREATED EQUAL: THE TAXATION OF PFIC INCOME UNDER THE NEW JERSEY GROSS INCOME TAX ACT By Frank Agostino, Esq. Jairo G. Cano, Esq. 1 The enactment of the Foreign Account Tax Compliance Act ( FATCA ), together with the establishment of the Internal Revenue Service s Offshore Voluntary Disclosure Program ( IRS OVDP ), created an opportunity for New Jersey taxpayers with previously unreported foreign income, bank accounts and assets to become compliant with U.S. tax reporting requirements. The New Jersey Division of Taxation ( Division ) offers a complementary program designed to bring New Jersey taxpayers who participate in the IRS OVDP into compliance with their state tax obligations as well (sometimes, New Jersey OVDP ). Participation in the New Jersey OVDP requires the taxpayer to submit a copy of his Closing Agreement with the IRS which identifies the items of unreported income that the IRS determined were taxable. 2 However, as this article explains, participation in the New Jersey OVDP requires more than a submission of the IRS s determinations to the Division. This is because there are fundamental differences between the definition of gross income under the Internal Revenue Code and the New Jersey Gross Income Tax Act. These differences create a unique paradigm where an item of income for federal income tax purposes may not be gross income under the New Jersey Gross Income Tax Act. 3 Income from passive foreign investment companies ( PFICs ) is one area that showcases the incongruity between the Internal Revenue Code and the New Jersey Gross Income Act, which has caused considerable practical difficulties for taxpayers who participate in the New Jersey OVDP. This article analyzes how the federal and New Jersey tax systems differ in their treatment of PFIC income. It also offers advice for how PFIC income is to be treated for purposes of the New Jersey Gross Income Act in connection with a taxpayer s participation in the New Jersey OVDP. The United States Anti-Deferral Legislation The United States generally does not tax the appreciation of investments (e.g., stock) until the underlying investment is sold or otherwise disposed. However, to prevent taxpayers from permanently deferring income recognition, Congress has adopted a number of anti-deferral rules that impose a tax on certain categories of income regardless of whether the taxpayer receives a distribution from the investment. The main anti-deferral regimes are the controlled foreign corporation rules, i.e., subpart f rules and the PFIC rules. This article focuses on the latter anti-deferral regime applicable to PFICs. (Continued on page 12) 11

12 (Continued from page 11) Passive Foreign Investment Company Income A PFIC is a foreign corporation that earns 75% or more of its gross income from passive sources or that owns at least 50% of passive income generating assets. 4 In the context of the IRS OVDP, most foreign mutual funds fall into this category of investment. During the 1980s, Congress ended the benefits associated with the deferred taxation of PFIC income with the enactment of a regime that imposes an interest charge on distributions or gains from the sale of PFIC investments. 5 In lieu of the interest charge, certain taxpayers can elect mark-to-market reporting of their PFIC investments. With the mark-to-market election, the taxpayer is required to report annual increases in the fair market value of his investment as income. 6 In years where the fair market value decreases, the taxpayer is allowed to claim a loss for the reduction in value but the amount of the loss is limited to an amount that cannot exceed previously reported PFIC gain. 7 When a taxpayer who holds PFIC investments enters into the IRS OVDP, the IRS applies special rules. First, the taxpayer and the IRS agree on the adjustment basis for the PFIC investments at the beginning of the first disclosure year. 8 Thereafter, the taxpayer reports the annual appreciation in fair market value of the PFIC investments as income in each year. 9 For the earliest disclosure year, the taxpayer is also required to pay an interest charge for the taxes attributable to the PFIC investments. 10 For the years in which the investment decreases in value, the taxpayer is allowed to report the decrease as a loss. 11 However, the amount of the loss is limited to the amount of previously included PFIC gains. 12 Finally, both the income and losses are characterized as ordinary rather than as capital gains or losses. 13 The ability to report PFIC gains and losses as ordinary rather than capital ensures that taxpayers will pay tax on no more than their net economic gain from the disposition of their PFIC investments. Gross Income Under New Jersey Gross Income Tax Act Section 61 of the Internal Revenue Code defines gross income as income from whatever source derived and enumerates several examples of income that meet that definition. The broad statutory language is designed to include all conceivable forms of income, not just those enumerated by statute. By contrast, the New Jersey Gross Income Tax Act definition of gross income is more narrowly tailored. That is to say that an item is not gross income for New Jersey Gross Income Tax purposes unless it fits into one of the enumerated categories of income identified in N.J.S.A. 54A:5-1. It is this fundamental difference between federal and New Jersey law that makes it imperative for taxpayers and their advisors to carefully analyze an item of federal income to determine whether it is also gross income under the New Jersey Gross Income Tax Act. (Continued on page 13) 12

13 (Continued from page 12) Under the New Jersey Gross Income Tax Act, net gain from the sale of an investment is taxable income that must be reported in accordance with the accounting method allowed for federal income tax purposes. 14 Two points are noteworthy. First, the plain language of N.J.S.A. 54A:5-1c expresses a legislative intent to tax a taxpayer s economic gain from the sale of property. 15 In other words, there must be a disposition transaction that creates an accession to wealth in order for there to be taxable income. 16 Second, New Jersey taxpayers must report their income using the method of accounting that was used to report income under the Internal Revenue Code. PFIC Income as a Method of Accounting The statutory definition of net gain from the disposition of property suggests that a taxpayer does not need to report PFIC income until there is a disposition of the PFIC investment. It is important to note that the Division does not agree with this interpretation. According to the Division, New Jersey taxpayers are required to report PFIC income to the Division in the same manner that it was reported to the IRS. The Division s position is supported by the statutory language in N.J.S.A. 54A:5-1c, which requires taxpayers to report net gains from the disposition of property using the same accounting method that was used for federal purposes. In essence, the Division argues that the inclusion of PFIC fair market value increases in income at the Federal level constitutes a method of accounting that must be applied to report PFIC income in New Jersey. The Division s interpretation appears to give meaning to the method of accounting language, but that interpretation is at odds with the other provisions of N.J.S.A. 54A:5-1c and the structure of the New Jersey Gross Income Tax Act. As explained in detail below, the Division s interpretation does not address the transaction requirement contained in the statute and fails to address the need for a taxpayer to claim offsetting losses. In other words, the taxation of PFIC income in a manner similar to the manner used for federal purposes is not possible given the structure of the New Jersey Gross Income Tax Act. The New Jersey Legislature enacted N.J.S.A. 54A:5-1c to empower the Division with the ability to tax a taxpayer s economic gain. 17 New Jersey courts have repeatedly determined that the taxation of more than a taxpayer s economic gain is prohibited. For example, in Koch v. Dir., Div. of Taxation, 18 the New Jersey Supreme Court concluded that a tax that requires a taxpayer to report more than his economic gain as income is therefore prohibited. 19 The Koch case involved the sale of partnership interests at a time when the New Jersey Gross Income Tax Act did not allow the flow-through reporting of income that was allowed at the federal level. When the taxpayer sold his partnership interests, he calculated his adjusted basis without a reduction to account for the partnership losses that were allocated to him at the federal level. The Division argued that the method of accounting provision of N.J.S.A. 54A:5-1c required the taxpayer to use the same ad- (Continued on page 14) 13

14 (Continued from page 13) justed basis that was reported at the federal level to report his gain under the New Jersey Gross Income Tax Act. The Supreme Court of New Jersey determined that the Division s interpretation led to the taxation of more than the taxpayer s economic gain. 20 Accordingly, the taxpayer was not required to use the same adjusted basis that was used at the federal level. The requirement that a taxpayer report PFIC income in the same manner that it is reported at the federal level can lead to the unfair results that the New Jersey Supreme Court disallowed in Koch. Suppose, for example, that a taxpayer purchased an interest in a PFIC in 2005 for $100,000 and sold it in 2010 for $95,000. The taxpayer sustained an economic loss of $5,000 from that transaction. The body of case law that analyzes N.J.S.A. 54A:5-1c makes clear that the statute cannot be implemented in a manner that taxes more than the taxpayer s economic gain from the disposition of the stock. If the taxpayer is required to report the interim increases in fair market value as income, he is paying tax on more than his economic gain. Equally important, at the federal level, PFIC income and loss are characterized as ordinary income or loss. This means that a taxpayer can use PFIC losses to offset ordinary income in the year that the PFIC loss is sustained. When the taxpayer disposes of his PFIC investments, the net result is that the taxpayer pays tax on his economic gain from the transaction. In other words, the taxpayer receives the tax benefit from the PFIC losses that is required to reduce his overall taxable income to his economic gain from the sales transaction. The structure of the New Jersey Gross Income Tax Act precludes the taxpayer s ability to realize a tax benefit from the interim PFIC losses. Without an ability to claim those losses, the New Jersey Gross Income Tax Act does not provide a mechanism to ensure that the taxpayer pays tax on no more than his economic gain. As previously discussed, the New Jersey Gross Income Tax Act defines income in the context of specific categories of income. Each category of income is reported separately and the taxpayer cannot offset income from one category of income with a loss sustained in another category of income. Furthermore, the taxpayer cannot carry unused losses into other tax years. 21 Therefore, the taxpayer will pay tax on more than his economic gain from the disposition of a PFIC investment if he does not have sufficient net gain from the disposition of property income in the years that PFIC losses are recognized. Finally, it is important to note that even if the taxpayer was permitted to claim an offsetting loss, the case law does not support the use of offsetting deductions to correct the harm created from the taxation of more than a taxpayer s economic gain. 22 (Continued on page 15) 14

15 (Continued from page 14) Compliance with the Division s New Jersey OVDP Submission Requirements A taxpayer who participates in the New Jersey OVDP must comply with the Division s rules and regulations. This includes the submission of amended state income tax returns together with copies of the amended tax returns that were submitted to the IRS. In addition, the taxpayer must submit a copy of his closing agreement with the IRS and Form 4549 which set forth the items that the IRS adjusted. To the extent that the adjustments include items that are taxable at the Federal level but not at the state level, the taxpayer must disclose those items and explain why those items are not gross income under the New Jersey Gross Income Tax Act. If the agent assigned to the case disagrees with the position taken by the taxpayer, the taxpayer will have an opportunity to dispute the proposed inclusion of the item in gross income by either filing a protest for a hearing with the Division s Conference & Appeals Division or by filing a complaint to commence a suit in New Jersey Tax Court. Conclusion The different definitions of gross income under federal and state law require that taxpayers and practitioners carefully review those laws and determine what items must be included in gross income. A failure to take this approach can result in the reporting of items that are not gross income at the state level. 1. Frank Agostino, Esq., is principal of, and Jairo Cano, Esq., is an associate at Agostino & Associates, P.C. 2. IRS Form 906 Closing Agreement on Final Determination Covering Specific Matters is an agreement between the IRS and the taxpayer with respect to the specific items identified in the Form For example, section 61(a)(12) of the Internal Revenue Code provides that income from discharge of indebtedness is taxable income. By contrast, in New Jersey, the statutory definition of gross income contained in N.J.S.A. 51A:5-1 does not support a conclusion that income from the discharge of indebtedness is taxable income under the New Jersey Gross Income Tax Act. See Weintraub v. Dir. Div. of Taxation, 19 N.J. Tax 65, 75 (2000). 4. I.R.C. 1297(a). 5. See H.R. Rep at 641(1986)(Conf. Rep.); I.R.C See H.R. Rep at 625 (1997)(Conf. Rep.). 7. I.R.C IRS Offshore Voluntary Disclosure Program Frequently Asked Questions and Answers available at (last visited July 14, 2015). 9. Id. (Continued on page 16) 15

16 (Continued from page 15) 10. Id. 11. Id. 12. Id. 13. Id. 14. N.J.S.A. 54A:5-1c. 15. Walsh v. State, 10 N.J. Tax 447, (1989). 16. Id. 17. See Id. at N.J. 1, 8-14 (1999). 19. See id. at 9; see also Miller v. Dir., Div. of Taxation, 352 N.J. Super. 98, 105 (App. Div. 2002); Moroney v. Dir., Div. of Taxation, 21 N.J. Tax 210, 229 (2004). 20. The taxpayer was required to reduce his adjusted basis at the federal level for partnership loss allocations because those allocations provided a tax benefit, i.e., he reduced his taxable income in those years. Because the taxpayer did not receive a tax benefit for those losses under the New Jersey Gross Income Tax Act, a reduction of the taxpayer s adjusted basis to account for those losses would result in the taxation of the return of capital. 21. See N.J.S.A. 54A:5-2; see also Estate of Guzzardi v. Dir. Div. of Taxation, 15 N.J. Tax 395, (1995). 22. Miller, 352 N.J. Super. at

17 AGOSTINO & ASSOCIATES IS HIRING! Agostino & Associates is looking for a recent graduate with a demonstrated interest in tax and tax controversy. The candidate would work on offshore voluntary disclosures, assist with the preparation of documents for tax controversies before the IRS examination and collection divisions as well as the IRS office of appeals. The candidate would also assist with A&A events, including the A&A USTCP seminar series. A knowledge of QuickBooks, tax preparation software, Excel and Microsoft Publisher is preferred. The applicant is expected to pass the EA exam within one year of hiring. Applicants should send their resume and a writing sample to Caren Zahn at CZahn@AgostinoLaw.com UPCOMING UNITED STATES TAX COURT CALENDAR CALLS All Calendar Calls are Held at: Jacob K. Javits Federal Building 26 Federal Plaza Rooms 206, 208 New York, NY September 21, Newark, NJ September 28, New York City October 5, Newark, NJ October 26, Westbury, NY November 2, New York City AGOSTINO & ASSOCIATES, P.C. CONTACT INFORMATION Frank Agostino, Esq. Ext. 107 Fagostino@agostinolaw.com Lawrence Brody. Esq. Ext. 132 Lbrody@agostinolaw.com Brian Burton. Esq. Ext. 105 Bburton@agostinolaw.com Jairo Cano, Esq. Ext. 144 Jcano@agostinolaw.com Jeffrey Dirmann, Esq. Ext. 119 Jdirmann@agostinolaw.com Christopher Grau, EA Ext. 143 Cgrau@agostinolaw.com Eugene Kirman, Esq. Ext. 142 Ekirman@agostinolaw.com Jeremy Klausner, Esq. Ext. 130 Jklausner@agostinolaw.com Dolores Knuckles, Esq. Ext. 109 Dknuckles@agostinolaw.com Tara Krieger, Esq. Ext. 118 Tkrieger@agostinolaw.com Lawrence Sannicandro, Esq. Ext. 128 Lsannicandro@agostinolaw.com Erica Son, Esq. Ext. 131 Eson@agostinolaw.com Matthew Turtoro, Esq. Ext. 112 Mturtoro@agostinolaw.com Caren Zahn, EA Ext. 103 Czahn@agostinolaw.com 17

18 School of Professional Accountancy Tax and Accounting Institute Civil and Criminal Tax Controversy Updates for 2015 WHEN: Thursday, August 13, 2015, 9:00 AM 5:00 PM Sign-in and breakfast at 8:15 AM 8.2 NY CLE *, NY & NJ CPE CREDITS FOR $150 4 ENROLLED AGENT CE CREDITS (Free Tuition for Government Employees) SPEAKERS: Frank Agostino, Esq., Agostino & Associates, P.C. Robert Beranger, CPA, Special Agent, IRS CI Thomas Bishop, Assistant Special Agent in Charge, IRS CI Yvonne Cort, Esq., Tenenbaum Law, P.C. Noelle Geiger, JD, Grassi & Co. Barry Ginsberg, Esq., Acting Deputy Commissioner, NYSDTF Criminal Investigations Division Bernard Mark, Esq., Kestenbaum & Mark TOPICS: New York State Sales Tax Audits & Collections New York State Criminal Tax Enforcement Updates Taxpayer Bill of Rights New York State Residency Audits WHERE: Long Island University C.W. Post Campus 720 Northern Blvd. Tilles Center, Patron s Room Brookville, NY Margaret Neri, Esq., Taxpayer Advocate, NYSDTF Argi O Leary, Esq., Deputy Commissioner, NYSDTF Civil Enforcement Division Bradley Polizzano, Esq., Tenenbaum Law, P.C. Bryan Skarlatos, Esq., Kostelanetz & Fink, LLP Karen Tenenbaum, Esq., CPA, LL.M., Tenenbaum Law, P.C. Shannon Woolard, Special Agent, U.S. Department of Labor New York State Civil Tax Enforcement Updates New York State Taxpayer Advocate Constituent Services International Criminal Tax Updates Register with LIU using the attached registration form * NY CLE - This course or program has been approved in accordance with the requirements of the New York State Continuing Legal Education Board for a maximum of 8.2 credit hours. Of these, 0 credits qualifies for ethics. NJ CLE - This program has been approved by the Board on Continuing Legal Education of the Supreme Court of New Jersey for 8.2 hours of total CLE credit. Of these, 0 qualify as hours of credit for ethics/professionalism, and 0 qualify as hours of credit toward certification in civil trial law, criminal trial law, workers compensation law and/or matrimonial law. NY & NJ CPE, EA CPE - Based upon our interpretation of the regulations by the New York and New Jersey State Boards of Accountancy, this event will qualify for 8.2 CPE credits. Of these 1 credits will qualify for ethics. Our New Jersey CPE Sponsorship number is 20CE The LIU Institute of the School of Professional Accountancy New York CPE Sponsorship number is Our Office of Professional Responsibility Sponsor Number is 68UVJ.

19 Registration Instructions/Form Complete this form: Make your check payable to: Return form & check to: LIU Post Please register me for the following seminars: Thursday, August 13, 2015 LIU Post, Tax & Accounting Institute, School of Professional Accountancy, 720 Northern Blvd. Brookville, NY Civil and Criminal Tax Controversy Updates for 2015 Credits: 8 CPE/Tax. 5 CE Enrolled Agent Credits Registration for this program $150 enclosed Program Start Time: 9:00am - 5:00 pm (Morning Refreshments & Luncheon Buffet) Location: Patron s Lounge, Tilles Center; Total Amount Enclosed or Charged to my credit card: $ Name: Phone: Address: City: State: Zip: Address: VISA DISCOVER (security code needed) MASTERCARD AMEX Card Number Expires (month & year) Signature on Card: In order to keep our records up-to-date, please complete all the information requested. Thank you.