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Quality Stores Day Of Reckoning Draws Near – What Should Employers Be Thinking About?

January 16, 2014

By Phil Karter

The Quality Stores employment tax refund case was argued before the Supreme Court on January 14, 2014.  An explanation about the issue at stake can be found in prior Taxblawg.net postings.  Although the outcome of the case remains in doubt, the possibility of a taxpayer victory means that employers should start thinking about the need to satisfy an important prerequisite to qualify their claims for refund.

Employment (FICA) taxes have both an employer and an employee component. A taxpayer victory in Quality Stores will enable both employers and terminated employees to recover their respective shares of FICA taxes withheld from the employees’ severance pay.  The obvious question that is likely to arise from an employer’s standpoint is “what incentive do I have to file on behalf of former employees?”

The answer can be found in Treasury Regulation § 31.6402(a)-2(a)(1)(ii), which stipulates that the employer will not be allowed a refund or credit for the employer’s share of withheld taxes “unless the employer has first repaid or reimbursed its employee or has secured the employee’s consent to the allowance of the claim for refund and includes a claim for the refund of such employee tax.”  In other words, merely notifying ex-employees of their rights to claim refunds themselves is inadequate to perfect the employer’s claim to recover its own share of withheld employment taxes. The employer must take affirmative steps on behalf of the terminated employee.

Thankfully, despite the above language about securing consents, the regulation elaborates that the requirement “does not apply to the extent that the taxes were not withheld from the employee or, after the employer makes reasonable efforts to repay or reimburse the employee or secure the employee’s consent, the employer cannot locate the employee or the employee will not provide consent.  Therefore, it is the attempt to secure consents that counts rather than the actual ability to secure such consents. (This same consent procedure also applies to employment tax refund claims arising from the Supreme Court’s ruling in United States v. Windsor, wherein the court struck down the Defense of Marriage Act (DOMA) as unconstitutional.  Prior to that decision, employers were required to withhold and pay over employment taxes for benefits provided to same-sex spouses of employees.)

Up to this point, a majority of employers that have filed protective refund claims have likely not undertaken the effort to obtain employee consents. There are at least two practical reasons for this.  First, the Sixth Circuit’s 2012 favorable decision in Quality Stores came out only about six months before the expiration of the 2009 statute of limitations (assuming the employer’s return was filed without extension). Thus, for employers eligible for refunds of FICA withholding paid over in that year, there wasn’t a good deal of time to accomplish this task.  Without a full solicitation of consents and tabulation of the refunds owed to employees who had responded affirmatively, there would have been no way to calculate the aggregate employee refund and include it on a refund claim.

Additionally, with the final outcome of Quality Stores, and the consequent entitlement to FICA refunds in doubt, it would have been hard for employers to justify the expense of undertaking the consent process when it wasn’t clear the exercise would be worthwhile when all was said and done.

Assuming the Supreme Court affirms Quality Stores, the simple solution for employers that filed protective claims covering only their share of FICA withholding is to file amended claims to add the aggregate employees’ share for those employees who provide their consents.  The procedure for this is set forth right in the instructions for Form 941-X on which the refund claim is made.  The instructions provide, in pertinent part, as follows:

5b.     . . . In certain situations, you may not have repaid or reimbursed your employees or obtained their consents prior to filing a claim, such as in cases where the period of limitations on credit or refund is about to expire. In those situations, file Form 941-X, but do not check a box on line 5. Tell us on line 25 that you have not repaid or reimbursed employees or obtained consents. However, you must certify that you have repaid or reimbursed your employees or obtained consents before the IRS can grant the claim.

 5c.     Check the box on line 5c to certify that your overreported tax is only for the employer share of social security and Medicare taxes. Affected employees did not give you consent to file a claim for refund for the employee share of social security and Medicare taxes, they could not be found, or would not (or could not) give you a statement described on line 5b.

 5d.     Check the box on line 5d to certify that your overreported amount is only for federal income tax, social security tax, Medicare tax, or Additional Medicare Tax that you did not withhold from your employees.

The Form 941-X instructions also provide a sample consent that can be used as a template by employers:

Employee name ____________________

Employer name  ____________________

I give my consent to have my employer (named above) file a claim on my behalf with the IRS requesting $_________ in overcollected social security and Medicare taxes for 20___. I have not claimed a refund of or credit for the overcollected taxes from the IRS, or if I did, that claim has been rejected; and I will not claim a refund or a credit of the amount.

 Employee signature _____________________

Date _________________

The consents are not sent to the IRS but retained by the employer. However, employers should be mindful not only to retain such consents, but also to adequately document their efforts to obtain consents for all qualifying employees, whether or not they are returned.

On a going-forward basis until Quality Stores is decided, employers can ease the burden of having to track down former employees and send out consent forms to qualify their own refund claims by incorporating a consent form along the lines of the template shown above into the paperwork typically involved in the termination process.  Of course, if Quality Stores is decided favorably, employers from that point forward will no longer be obliged to withhold, obviating the need to continue this practice.

Are Quiet Disclosures of Offshore Accounts Becoming Even Riskier?

October 18, 2013

By Phil Karter

Is the IRS getting closer to ferreting out “quiet disclosures” by taxpayers who chose that route to address the problem of previously unreported offshore accounts rather than by participating in the Service’s offshore voluntary disclosure program (OVDP)?  That’s the conclusion of an increasing number of tax professionals and if taxpayers in this predicament weren’t already worried, they should be.

A quiet disclosure involves the filing of new or amended tax returns that report offshore income, and FBARs (Report of Foreign Bank and Financial Accounts) that provide other account information regarding the taxpayer’s interest in foreign accounts.  It is a discreet disclosure intended to make a taxpayer compliant with his or her tax reporting responsibilities while avoiding penalties imposed under the IRS’s official voluntary disclosure program.

The IRS has made no secret of its distain for those who choose the quite disclosure route over participation in its voluntary disclosure program.  In its frequently asked questions and answers applicable to the most recent iteration of the OVDP, the Service has cautioned taxpayers that those who have already made quiet disclosures should “be aware of the risk of being examined and potentially criminally prosecuted for all applicable years.”  The IRS has encouraged such taxpayers to “take advantage” of the program before discovery.  The FAQs also note that detection of a quit disclosure also eliminates the possibility of reduced penalty exposure offered under the OVDP. (See FAQs 15 & 16.)

To some, the calculus about whether to participate in the OVDP, follow the quiet disclosure path, or do nothing has been viewed as another form of the audit lottery, albeit one with very high stakes in terms of potential monetary penalties and possibly criminal prosecution.  As virtually everyone should know at this point, offshore account holders can no longer rely on bank secrecy to protect them, so the issue of detecting unreported accounts has become more a question of when, not if. Although a quiet disclosure addresses the unreported account problem, either currently or retroactively, that is not necessarily the end of the story . . . or the risk.

Earlier this year, the Government Accounting Office issued a report in which it noted a dramatic increase in the number of taxpayers reporting offshore accounts, concluding that the trend may reflect attempts to minimize or circumvent taxes, penalties and interest that would be owed if not corrected before detection or even upon participation in the OVDP.  Among other things, the GAO recommended that the IRS explore methodologies to detect and pursue quiet disclosures.  Apparently, the IRS has taken the GAO’s recommendation to heart by working on new ways to identify them.  The effort, according to former Acting IRS Commissioner Steven Miller, was to include “analysis of Forms 8938, Statement of Specified Foreign Financial Assets, to identify specific characteristics of the filing population and to assess filing behaviors indicating potential compliance issues.”

In predicting the effectiveness of this undertaking, it is worth noting that the IRS has a wealth of experience in implementing computer algorithms on a much larger scale to ferret out trends warranting closer scrutiny.  One need look no further than the Services’ Discriminant Function System (DIF), which is used to flag tax returns for possible audit, among the hundreds of millions filed, to appreciate that improved detection of quiet disclosures is well within the IRS’s capabilities.  Therefore, taxpayers who rely on a limited IRS resources justification to ignore the directional trend regarding quiet disclosures are likely to wish they had examined the issue relative to their own personal circumstances a lot more closely. At the very least, given the prevailing wind on this issue, it would be prudent for those who have made quiet disclosures or are contemplating one to revisit the issue with their tax adviser.

Apple’s Double Irish With A Dutch Sandwich Goes Down Easy with SEC

October 9, 2013

By Phil Karter

Senator Carl Levin (D-Mich.) may have tried to take a bite out of Apple (AAPL) in congressional hearings last May examining the company’s overseas tax structure, calling it “the holy grail of tax avoidance.” However, it appears that more than just Irish eyes are smiling on the company these days, for in the eyes of the SEC, Apple’s efforts to minimize its tax burden are just fine thank you.  See e.g., O’Brian, Chris, “SEC reveals review of Apple’s Irish tax disclosures.” Los Angeles Times, 3 Oct. 2013, LATimes.com, 9 Oct. 2013.

But is that the happy end of the story for Apple and the many other companies such as Google (GOOG), Facebook (FB), Microsoft (MSFT) and Oracle (ORCL) that have replicated the Double Irish structure in one form or another?  Not necessarily given the continuing threat posed by a sweeping application of the economic substance doctrine.  For example, does the creation of foreign subsidiaries for the primary purpose and intent of minimizing tax liabilities meet either or both prongs of the infamous two-prong test examining objective non-tax profitability and subjective non-tax intent?

It very well should if cases like IES v. Comm’r. 253 F. 3d 350 (8th Cir. 2001) and Compaq Computer Corp. v. U.S., 277 F.3d 778 (5th Cir. 2001) continue to represent the state of the economic substance law.  IES’s and Compaq’s transactions were pure tax arbitrage plays whose profitability was derived solely from the monetization of foreign tax credits.  Is anything conceptually different really happening here? Yes, all the fuss over the Double Irish centers around keeping profits abroad beyond the reach of U.S. tax collectors but at bottom, each situation involves ways to reduce ETR and increase after-tax net profits (presumably along with shareholder value) through effective tax structuring.  At this point, the Supreme Court’s pronouncement in Gregory, v. Helvering, 293 U.S. 465 (1935), comes to mind: “The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted.”

The problem is that there remains considerable uncertainty about the potential reach of the economic substance doctrine based on the plethora of less taxpayer-friendly decisions, particularly recent ones.  Moreover, uncertainty about how and when the ESD could apply – along with the new strict liability penalty under § 6662(b)(6) – has only been heightened by the enactment of a statute, § 7701(o), containing far too many undefined terms.  For example, left open under the codified doctrine are such critical questions as when the doctrine is relevant and what the threshold is for non-tax profits to be substantial relative to tax benefits.

Finally, as reflected by taxpayers’ unsuccessful litigation of leveraged lease (LILO and SILO) transactions, the imprimatur by a government agency blessing the transaction is no assurance that it will thereafter be respected by the IRS.

During his illustrious career, the legendary Steve Jobs was renowned for his prescience.  Such talents would have come in handy in foreseeing the end to this story.  For the legion of companies employing these tax strategies, the hope is for a happy ending rather than a  Tofflerian “Future Shock.”

Filing Tax Returns During the Silly Season

October 7, 2013

For my fellow procrastinators whose federal tax returns are on extension, with the October 15th deadline rapidly approaching, perhaps the burning question has crossed your mind, “If I file electronically while the government is shut down, will my return be accepted?”  Yes, I can happily report that a return electronically submitted to the IRS at 3:43 p.m. this day was “accepted for filing” at 4:04 p.m., efficiency approaching a Michael Phelps-like performance. Perhaps the IRS has designed a system that operates better when it is staffed only by computers rather than by people.  Rube Goldberg, eat your heart out.

Filing Your Tax Return

–Phil Karter

Supreme Court Accepts Certiorari In Quality Stores

October 1, 2013

By Phil Karter

The U.S. Supreme Court today accepted the government’s petition for certiorari in  United States v. Quality Stores (Civil No. 10-1563, 6th Cir. 2012), a case in which the Sixth Circuit affirmed a lower court’s decision that supplemental unemployment compensation benefit (SUB) payments are not taxable as wages and are consequently exempt from FICA taxes.  In accepting the case for consideration, the Supreme Court is expected to resolve a conflict between the Sixth Circuit and the Federal Circuit, which decided a prior case,  CSX Corp. v. United States, 518 F.3d 1328 (Fed. Cir. 2008), in favor of the government.

The case is of considerable interest to thousands of taxpayers, at least 2,400 of whom have filed administrative refund claims according to government estimates.  More than a billion dollars in potential tax refunds is riding on the ultimate outcome of this issue.   Quality Stores will be decided by eight justices, as Justice Elena Kagan is taking no part in the case.

For past coverage on this issue, please click here.

Cleaning Up After The Elephants – A Practical Reminder On Document Preservation Policies and Litigation Holds In Tax Disputes

September 2, 2013

By Phil Karter

Any corporate tax executive who has ever been involved in contesting an audit adjustment knows all too well how unfavorable documents relating to the subject of the adjustment – particularly improvident comments reflected in email correspondences – can be an ongoing impediment to resolving a tax dispute from the audit phase right up to and through litigation with the IRS or Department of Justice.  When such documents exist, even where taken out of context, the government will zealously sink its teeth into them like a junkyard dog, making the prospects of reaching a reasonable settlement or gaining an IRS concession all the more difficult.  One can’t fault the government for taking a hardline position.  Precedent reflects that this is a good strategy, particularly in economic substance cases, as demonstrated by the numerous times these unfavorable documents work their way into the text of court opinions as the factual underpinning for an adverse finding against the taxpayer.  Like a Dickensian character, they will come back to haunt you again and again.

The solution, of course (conveniently ignoring the practical realities of many understaffed and overburdened tax departments), is for the tax function to do a better job of policing both document production and retention policies, particularly outside of its own direct jurisdiction and normal supervision.  Non-tax business justifications pervade so many tax disputes that it is incumbent on the tax executives to ensure that these justifications are not only well-documented, but consistently followed in practice after the transaction is put into place.  The tax folks are, after all, the ones ultimately on the front lines defending the non-tax business justification.  As they say, it’s like cleaning up after the elephants in the circus parade – unpleasant but necessary.

In the course of this process, it is important to remain mindful that once documents are created, particularly in connection with a transaction where future litigation may reasonably be anticipated, a duty to preserve via a litigation hold may override a company’s normal document destruction policies.  See e.g., Silvestri v. General Motors Corp., 271 F.3d 583, 591 (4th Cir.2001)  (duty to preserve evidence “arises not only during litigation but also extends to the period before the litigation when a party reasonably should know that the evidence may be relevant to anticipated litigation.”)  Indeed, the failure to put a litigation hold in place can have deleterious consequences, from waiver of attorney work product protection (see e.g., Samsung Electronics Co., Ltd.. v. Rambus, Inc., 439 F. Supp. 2d 525 (ED Va. 2006) (rev’d on other grounds, 523 F.3d. 1374 (Fed. Cir. 2008)), to IRS challenges regarding the completeness of a taxpayer’s Schedule UTP disclosures (which does not require reserves to be recorded for positions “expected to be litigated”), a topic I have written about before.  Simply put, it is difficult to persuasively argue that an issue was reasonably anticipated to be litigated (e.g., for work product protection or UTP purposes), where there is a failure to implement a litigation hold predicated on that very anticipation.

Earlier this month, U.S. District Judge Shira Scheindlin (S.D.N.Y.), author of the landmark Zubulake opinion on electronic discovery, raised the stakes further when she ruled, in Sekisui American Corp. v. Hart, 2013 WL 4116322 (S.D.N.Y. Aug. 15, 2013), that a party who failed to preserve electronically stored information (ESI) by not implementing an adequate litigation hold was subject to an adverse inference about the content of such evidence.  The ruling was notable because it bucked the trend of courts to overlook a party’s destruction of ESI in the normal course of its business practices, notwithstanding the obligation the party may have had to implement a litigation hold to preserve such documents.  (See Fed. R. Civ. P. 37(e), requiring “exceptional circumstances” to impose sanctions.)  In Sekisui, Judge Scheindlin imposed the adverse inference sanction (in addition to monetary damages) even without finding any malevolent intent or substantial prejudice to the opposing party.  The court simply ruled that the failure to implement a litigation hold was enough to constitute a willful intent to destroy documents.

It doesn’t take a great deal of imagination to appreciate that a ruling invoking an adverse influence as a result of the failure to preserve documents can be fatal, an even more likely outcome in a bench trial where the judge making the ruling is also the trier of fact.  At the very least, being slapped with such a sanction will preclude any benefit of the doubt that documents interpreted negatively by the IRS may be accorded a more favorable interpretation by the trier of fact.

I have heard – certainly more than once – government counsel advocate to a court words to the effect that “memories fade but documents never lie.”  It is true that the odds of prevailing in a tax dispute are not helped by poor recordkeeping practices, by which I include both shoddy documentation as well as carelessly policed documentation containing ill-conceived content readily subject to misinterpretation and misuse.

If nothing else, the ruling of an influential jurist like Judge Scheindlin should heighten tax departments’ sensitivities about monitoring company recordkeeping practices from the outset of a transaction.  These efforts should be quantitative in terms of fully apprehending the documents to be generated and maintained, and qualitative to reduce the risk that problematic documents are generated carelessly and maintained thoughtlessly.  No less thought should be put into the timely implementation of litigation holds to ensure that company records – hopefully those that will help it carry the day in a tax dispute – are adequately preserved, particularly when the ramifications of their destruction can exponentially increase the likelihood of an unfavorable outcome.

Sixth Circuit Moves The Ball Forward For Companies Seeking FICA Tax Refunds On Supplemental Unemployment Compensation Benefit Payments

January 8, 2013

By Phil Karter and John Hackney

For companies that have implemented employee layoffs in the past several years and made severance payments to terminated employees, the prospect of eligibility for federal tax refunds for any FICA taxes withheld from such payments took another step forward with the Sixth Circuit’s January 4th denial of the government’s petition for rehearing en banc in United States v. Quality Stores (Civil No. 10-1563, 6th Cir. 2012).

The rehearing petition was filed after a government loss in September of last year in which the appellate court affirmed a lower court’s decision that supplemental unemployment compensation benefit (SUB) payments are not taxable as wages and are consequently exempt from FICA taxes. Under section 3402(o)(2) of the Internal Revenue Code, SUB payments are defined as “amounts which are paid to an employee, pursuant to a plan to which the employer is a party, because of an employee’s involuntary separation from employment (whether or not such separation is temporary), resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions.”

The Sixth Circuit’s decision in Quality Stores directly conflicts with the Federal Circuit’s prior decision in CSX Corp. v. United States, 518 F.3d 1328 (Fed. Cir. 2008), which held that such payments were subject to FICA.  With the denial of the petition for rehearing in Quality Stores, the stage is now set for the government to seek Supreme Court review.  Because the eventual outcome of this conflict has enormous financial implications, a petition for certiorari is reasonably foreseeable.  Such a petition would be due by April 4, 2013.

Although the final word on the issue may not yet be written, for companies located within the Sixth Circuit’s purview (Kentucky, Michigan, Ohio and Tennessee), the taxpayer-friendly Quality Stores decision is currently binding authority which, unless reversed by the Supreme Court, will entitle those who have filed timely refund claims to the refund of FICA taxes paid over on SUB payments. In the rest of the country, Quality Stores is not binding on the IRS.  Nonetheless, the case at least raises the prospect of a taxpayer victory on the issue when the dust finally settles.

Many companies have already filed protective tax refund claims to preserve their rights to receive potentially significant refunds of FICA tax.  For those that haven’t, filing such claims for each open taxable year in which FICA was withheld on SUB payments is an absolute prerequisite to obtain any refunds. There is little cost associated with filing a protective refund claim but the potential benefit could be quite large.  Accordingly, any eligible employers who have not already done so are advised to file their claims as soon as possible for all open years to avoid being barred by the applicable statute of limitations, which typically remains open for the later of three years after the return due date or two years after the date of payment.

A final point about which employers filing refund claims should take note is that under Treas. Reg. § 31.6402(a)-2, a refund claim seeking the refund or credit of an employee’s share of FICA taxes requires the employer to certify either that it has repaid or reimbursed the tax to its employee or that it has secured the employee’s written consent to the filing of the refund claim (except to the extent the taxes were not withheld from the employee).  In Quality Stores, for example, roughly 1,800 of 3,000 former employees consented to the company filing FICA tax refund claims on their behalf.  Consequently, the employer’s refund claim for its own share of FICA taxes exceeded the refund sought for its former employees’ share.

Squib Note: Clarifying the 2013 Capital Gains Rates

January 2, 2013

It has been universally reported that under the newly passed American Taxpayer Relief Act of 2012, net capital gain tax rates have risen to 20% for taxpayers with taxable income greater than $400,000 for single filers and $450,000 for joint filers.  To clarify this broad statement, under section 102 of the new law, the higher capital gains rate applies only to the gain that, when added to other taxable income, exceeds the threshold amounts.  Taxpayers below the 39.6% taxable income threshold before capital gains are taken into account will have their capital gains taxed at 15% up to the taxable income threshold and 20% on the excess.  The following two examples illustrate how the net capital gain tax rate is calculated:

In Example 1, joint taxpayers earn $400,000 of ordinary income and another $200,000 in net capital gains.  Under the new law, the first $50,000 of net capital gains is taxed at the lower rate, with the remaining $150,000 taxed at the higher rate.  The effective rate of 18.75% reflects the blending of the 15% and 20% rates.

2013 Capital Gain Rate Example 1

In Example 2, joint taxpayers now earn $200,000 of ordinary income and another $400,000 in net capital gains.  Because a greater portion of the taxpayers’ taxable income has shifted from ordinary income to net capital gain, the effective net capital gain rate is lower than the previous example because a greater portion of the taxpayer’s below-the-threshold income is taxed at the 15% rate, leaving a smaller remainder subject to the 20% tax.

2013 Capital Gain Rate Example 2

The above examples do not take into account the new 3.8 % medicare surtax on capital gains (and other net investment income) imposed by section 1411 of the Internal Revenue Code. Because the income threshold under that section is lower than the 39.6% tax rate threshold ($200,000 for single filers and $250,000 for joint filers), the surtax would apply to the entire net capital gain amounts in both examples, resulting in an effective rate of 22.55% and 20.68% respectively.

Could The New Economic Substance Statute Apply To End-Of-Year Stock Sales And Repurchases?

December 28, 2012

By Phil Karter

With the looming increase in tax rates on investment income and capital gains in particular, a large number of stock market investors have been selling long-term positions to lock in the 2012 rate, which currently tops out at 15%.  Come January 1,2013, gain on the same sale could be taxed at a rate as high as 23.8%, consisting of a long-term capital gains tax rate of 20% plus a Medicare surtax of 3.8% imposed on joint filers with AGI greater than $250,000 and single filers with AGI greater than $200,000.  (See Internal Revenue Code § 1411).

A question attracting attention as the year draws to a close and the pace of this activity has accelerated has been whether a stock sale undertaken solely to take advantage of the lower 2012 capital gains tax rates might fall within the scope of Code § 7701(o), the relatively new economic substance statute codified as part of the landmark Health Care and Education Reconciliation Act of 2010 (Pub. L. 111-152, 124 Stat. 1029).  Concerns about coming within the scope of this statute are that it might subject the investor to a 20% penalty enacted as part of the new law.  See Code § 6662(b)(6).  The penalty, if applicable, is a “strict liability” one, which means that taxpayers cannot avoid it on grounds of reasonable cause, such as reliance on a tax advisor. (The penalty for a transaction determined to lack economic substance is also increased to a whopping 40% if the transaction is undisclosed.  See Code § 6662(i).  However, as long as a taxpayer reports the transaction on his or her tax return, the 40% penalty should not apply.)

Thankfully, the eleventh hour concerns expressed about this issue should be put to rest for stock investment gain-recognition transactions in 2012.  Even assuming the economic substance statute is conceptually broad enough to ensnare stock sale transactions undertaken to lock in lower capital gains tax rates, the penalty is only applicable to “underpayments.”  Because a long-term capital gain recognized in 2012 does not reduce a taxpayer’s taxable income but rather increases it (unless the gain is offset by otherwise unused capital losses), there is no underpayment against which to apply a penalty.

Now let’s vary the circumstances by introducing a simultaneous buyback of the stock at the time of sale to reestablish the same position.  Does that change anything vis a vis a potential penalty risk?  We still have a gain recognition transaction in 2012, so there is no tax underpayment against which a penalty could apply for this year.  As for the repurchased stock, its cost basis is at the repurchase price, which means that a subsequent sale in a future year will either produce a smaller taxable gain or larger taxable loss than would have occurred had the original share lots with their lower cost basis simply been maintained.  Some have speculated that this could produce a tax underpayment against which the strict liability economic substance penalty might apply in the year of sale.  After all, in defining a transaction that has economic substance, § 7701(o) requires (1) that the transaction change in a “meaningful way” the taxpayer’s economic position apart from federal tax benefits, and (2) that the taxpayer have a non-tax purpose for entering into the transaction.

In theory, a sale and instantaneous repurchase might fail to satisfy both of these tests.  On the other hand, a repurchase transaction that occurs sometime after the sale introduces an element of market risk from stock price fluctuation that should mitigate any penalty risk.  Similarly, a repurchase in a different type of account (e.g., in a tax-deferred account where the original sale was in a taxable account or vice versa) should also put the taxpayer on firmer ground.

So what are the real risks that the IRS might choose some unfortunate taxpayers to assert a strict liability penalty?  It has, after all, been less than forthcoming in providing guidance on what types of plain vanilla transactions, if any, may be viewed as falling within the scope of the new economic substance statute.  Perhaps the best indicator one can draw upon is the title of § 7701(o), “Clarification of Economic Substance Doctrine.”  The codified doctrine has been portrayed as merely a clarification of the economic substance law in effect for transactions entered into before March 30, 2010. Under the pre-codification doctrine, which is derived solely from the common law, there do not appear to be any reported economic substance cases involving a taxpayer’s sale and repurchase transaction that results in accelerated gain recognition. Couple this with the fact that no court has been asked to interpret the breadth of the new economic substance statute since it was passed in 2010, and it is reasonable to believe that the IRS would prefer to choose a different, and presumably more compelling battleground to make its first stand defending the application of Section 7701(o) and the strict liability penalty.

Finally, in the case of a 2012 gain-recognition stock sale and simultaneous repurchase, it cannot be entirely certain that the transaction will even produce a tax savings when all is said and done.  This is because of the difference between the tax rates for long and short term capital gains (which are taxed at ordinary income rates).  Because a new holding period is established for the repurchased stock, it remains possible that the stock, when sold, will produce a short-term capital gain subject to a larger tax burden than might have occurred if if the original long-term position was held into 2013 or beyond.  In the end, the lack of certainty about the ultimate tax effect until the second sale occurs may be taxpayers’ best argument that the sale and repurchase transaction had economic substance after all.


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