IRS Practice and Procedure News Briefs for February 2021

LOAN OR CAPITAL CONTRIBUTION – Hohlet v. Commissioner, T.C. Memo. 2021-5 (2021)

Why this Case is Important: When a business owner advances funds to his or her business, whether the transaction is characterized as a loan or a capital contribution can have significant tax consequences, which consequences business owners should consider before choosing a legal structure.

Facts: Hohlet involved a partnership with four partners. In the years after the company was formed, one of the partners advanced over $650,000 to the company. The company and its owners treated these advances as loans to the company and filed tax returns consistent with this treatment, with a share of the debt repayment obligation being allocated to each owner on the K-1s issued every year. The company stopped operating in 2012 and filed its final tax return. The return still showed the outstanding company debt, but the K-1s issued with that return no longer allocated the obligation among the owners. The return did not report any income from the company being discharged from the debt. The IRS examined the return and determined that, because the company’s debt to the lender/owner had been canceled, the company should have reported income from the discharge of indebtedness equal to the unpaid debt. The IRS adjusted the return accordingly and adjusted each owner’s return, allocating each of them their share of that unreported income. This amounted to unreported income of $178,210 per owner. The IRS issued notices of deficiency to each owner proposing to tax them on this unreported income and the owners filed Tax Court petitions contesting the notices.

Law and Conclusion: Under Section 61(a)(12) of the Internal Revenue Code, taxable income includes income from the discharge of indebtedness. The IRS determined that when the company stopped operating and had no assets, it became certain that the company would not repay its debt to the lender/owner. That being the case, that debt was discharged and the company (through its owners) should have paid tax on the discharged amount. The owners argued that the money advanced to the company was actually a capital contribution, meaning the company had no obligation to repay it and there was no taxable debt cancellation. In determining whether an amount contributed by a partner to a partnership is a loan or capital contribution, the court will consider (1) the presence of a written agreement, (2) the intent of the parties at the time of the transaction, and (3) whether the company could have obtained similar loans from unrelated parties. In this case, while there was no written loan agreement, based on the fact that the parties treated the advances as loans at all times, including by not issuing additional equity to the lender/owner in exchange for his advances, as you would expect with a capital contribution, and because the company likely could not have received similar loans from unrelated parties, the Court determined that the IRS was correct to treat the advances as loans and found in favor of this IRS.

FBAR PENALTIES – United States v. Collins, USDC WD PA, Case No. 2:18-cv-01069, February 8, 2021

Why this Case is Important: Taxpayers with foreign bank accounts and other assets must be aware of their potential obligations to report those assets to the IRS, including by filing “Reports of Foreign Bank and Financial Accounts” (FBARs). As this case demonstrates, failure to file FBARs can result in significant penalties.

Facts: In Collins, the taxpayer had three foreign bank accounts – one in Canada, one in France, and one in Switzerland. Throughout 2007 and 2008, the accounts together held around $850,000. In both years, all three of the accounts separately had balances in excess of $10,000, meaning that the taxpayer was obligated to file FBARs for both 2007 and 2008 disclosing the existence of the accounts to the IRS. While these filings for each year are due by April 15 of the following year, the taxpayer did not file the 2007 or 2008 FBARs until 2013, seemingly after one or more of the foreign banks disclosed the existence of the taxpayer’s accounts to the IRS. In 2015, the IRS sent notices to the taxpayer proposing to assess penalties for his willful failure to timely file the FBARs each year. The total penalty amount was over $300,000, which was half of the maximum penalty the IRS could have assessed. After IRS appeals denied the taxpayer’s appeal of the penalty assessment, he filed a complaint against the IRS in federal district court.

Law and Analysis: Generally, any individual who has a financial interest in, or signature authority over a foreign bank account, the value of which exceeds $10,000 at any point during the year in question, must file an FBAR for that year disclosing the existence of the account to the IRS. For any year in which a taxpayer fails to file an FBAR, the IRS can assess a penalty of up to $10,000 if it determines that the failure was non-willful, or up to the greater of $100,000 or the 50% of the balance of the unreported accounts if the IRS determines that the failure was willful. The taxpayer made several arguments to show that his conduct was not willful but the Court rejected all of them, focusing on the fact that he knew of his obligation to file the FBARs and failed to do so. The taxpayer also argued that, even if his conduct was willful, the penalty amount was excessive, especially in light of the balances of the foreign accounts. The Court rejected this argument as well. It noted that the IRS could have assessed double the penalty amount that it did assess, and held that the amount assessed was reasonable given the penalty calculation framework. Having rejected these arguments, the Court found in favor of the IRS.

If you would like more details about these cases, please contact me at 312-888-4113 or  jnesser@lavellelaw.com.