Closely Held Business Advisor: IRS Campaigns Target Closely Held Business Tax Issues

The IRS Large Business and International (LB&I) division has released its widely anticipated new audit strategy known as “campaigns.”

The LB&I is moving toward issue-based examinations. “This approach makes use of IRS knowledge and deploys the right resources to address those issues,” the IRS stated.

Campaigns Aimed at Closely Held Businesses

Among the 13 specific audit targets, which span a broad range of topics, are these 5 most likely to affect closely held businesses:

1. Micro-Captives. This is an extension of the recent IRS Notice which named micro-captive transactions as “transactions of interest” requiring disclosure on a Form 8886. In these transactions, a taxpayer uses an insurance contract with a related party in a way to reduce the group’s aggregate taxable income. The basic structure of a micro-captive transaction is one where each entity treated as an insured entity claims deductions for insurance premiums paid, and the captive insurance company makes an election to exclude the insurance premiums from income. The transactions targeted by the IRS are those where the insurance contracts administered and applied are not consistent with arm’s length standards and sound business practices. The campaign calls for issue based examinations of such transactions of interest.

2. Related Party Transactions. This campaign focuses on transactions between related parties, specifically those that provide a means to transfer funds from a corporation to related pass-through entities or shareholders. The campaign calls for more issue-based examinations of such related party transactions.

3. Deferred Variable Annuity and Life Insurance Reserves. The IRS has identified Deferred Variable Annuity Reserves and Life Insurance Reserves as two areas where guidance is needed to address uncertainties on issues important to the insurance industry. Those issues include amounts to be taken into account in determining tax reserves for both deferred variable annuities with guaranteed minimum benefits and life insurance contracts. The campaign’s objective is to collaborate with the insurance industry and develop published guidance on the issues.

4. Land Developers Using Completed Contract Method. The IRS is focusing on large land developers that construct residential communities and may be improperly using the Completed Contract Method (CCM). A developer, whose average annual gross receipts exceed $10 million, may only use CCM under a home construction contract. The IRS has become aware that some developers are improperly deferring all gain until the entire development is completed. The campaign calls for the issuance of “soft” letters and issue based examinations.

5. S- Corporation Losses Claimed in Excess of Basis. Shareholders of S corporations report income, losses and other items on a pass-through basis. The tax law limits losses and deductions to the shareholder’s basis in the corporation. The IRS has determined that in many instances, shareholders claim losses and deductions to which they are not entitled because they do not have sufficient basis in stock or debt. Besides conducting issue-based examinations, the IRS will be pursuing other approaches to encourage compliance and “voluntary self-correction” including a new form to assist shareholders in properly computing their tax basis.

Other campaigns not usually associated with closely held businesses may affect many different types of taxpayers:

6. Section 48 C Advanced Energy Credits. This campaign ensures that only those taxpayers who have both obtained approval by the Department of Energy and been allocated a credit by the IRS are claiming credits for advanced energy projects.

7. Domestic Production Activities Deduction (DPAD) for Certain Video Program Distributors and TV Broadcasters. The IRS has become aware that certain Multi-Channel Video Program Distributors and TV Broadcasters are taking a position that they are “producers” of qualified film for purposes of the DPAD where they are only bundling groups of channels or programs that include content from third parties.

8. Basket Transactions. Certain structured financial transactions have been created in which a taxpayer attempts to defer and treat ordinary income and short-term capital gain as long-term capital gain by treating an option or derivative as an open transaction until a “barrier” event occurs.

9. TEFRA Linkage Plan. The IRS has continually revised its approach to auditing income tax returns for partnerships and how to identify, link and assess tax to the terminal investors in partnerships that post the most significant tax compliance risk.

10. Repatriation. The LB&I “is aware of different repatriation structures being used for purposes of tax-free repatriation of funds into the United States in the mid-market population,” the IRS stated. It has also been determined that many taxpayers don’t properly report repatriations as taxable events on their returns.

11. Inbound distributors. U.S. distributors of goods sourced from foreign-related parties have incurred losses or small profits on U.S. returns which aren’t commensurate with the functions performed and the risks assumed. In many cases, U.S. taxpayers would be entitled to higher returns in arm’s-length transactions.

12. Form 1120-F nonfilers. Foreign companies doing business in the United States are often required to file Form 1120-F, “U.S. Income Tax Return of a Foreign Corporation.” The LB&I division has data suggesting that many of these companies aren’t meeting their filing obligations. In this campaign, the IRS will use various external data sources to identify these foreign companies and encourage them to file their required returns.

13. Individual taxpayers who were declined or withdrew from an IRS program. The Offshore Voluntary Disclosure Program (OVDP) allows U.S. taxpayers to voluntarily resolve past noncompliance related to unreported offshore income and failure to file foreign information returns. Under the program, which began in 2009 and has changed over the years, taxpayers may have penalties reduced. This audit campaign addresses OVDP applicants who applied for preclearance into the program but were either denied access or withdrew from the program of their own accord.

Be Prepared

As part of this effort, the IRS stated that “LB&I leaders will continue discussion with the tax community to assist with work on these areas to best meet the needs of the taxpayers as well as tax administration.” These discussions will also help in determining additional areas for future campaigns.

Taxpayers with any of the above issues should be prepared for the possibility of focused audits directed at the issue.