TIGTA Report Suggests Improvement in IRS Handling of Fraudulent Returns

A newly released report that presents the results of the Treasury Inspector General for Tax Administration's (TIGTA) review of the IRS's Criminal Investigation (CI) Division's Questionable Refund Program (QRP) reveals that over $1 billion in fraudulent refunds was issued during the 2006 and 2007 processing years (PYs). The review was intended to determine the effectiveness of the IRS's processes to identify and stop questionable refunds.

According to the report, the CI has relied on the fraud detection system to identify fraudulent returns. Because the system was not in operation during PY 2006, approximately $864 million in fraudulent refunds was issued. During PY 2007, Fraud Detection Centers (FDCs) stopped over $1.2 billion in fraudulent refunds, an increase over the $412 million stopped during PY 2005, when the fraud detection system was last operational. However, TIGTA notes that the CI became more efficient in stopping fraudulent claims because it put dollar thresholds in place, limiting the selection of returns to those with the highest potential for fraud, thus excluding thousands of returns from the screening process. Had those returns been included in the screening process, TIGTA estimates that an additional $742 million in fraudulent refunds would have been identified.

TIGTA believes that the IRS may continue to issue a greater number of fraudulent refunds, resulting in a significant annual revenue loss to the federal government, if this trend continues. While acknowledging that the IRS has limited resources and additional priorities besides the QRP, the report recommends, among other things, that the IRS work with the Treasury Office of Tax Policy to "develop a more urgent approach to achieving legislative change that will exempt the IRS from having to issue statutory notices of deficiency on fraudulent returns" and that the Service develop a long-term, strategic approach to balancing available resources with the growth in refund fraud and other compliance priorities.

The IRS agreed with some of the report's recommendations, acknowledging that refund fraud is an increasing concern and that a strategic approach to managing the QRP is necessary.

TIGTA Report: An Estimated $1.6 Billion in Fraudulent Refunds Was Issued During the 2006 and 2007 Filing Seasons (Ref. No. 2008-10-172).

Proposed Regulations Address Discharge of Partnership Debt in Exchange for Partnership Interest (NPRM REG-164370-05)

Proposed regulations addressing the change to the cancellation of indebtedness (COD) income rules for partnerships under Code Sec. 108(e)(8) made by the American Jobs Creation Act of 2004 (P.L. 108-357) have been released. As amended, Code Sec. 108(e)(8) states: (1) when determining COD income, a debtor partnership that transfers a capital or profits interest to a creditor in satisfaction of its recourse or nonrecourse indebtedness is treated as satisfying the indebtedness with money equal to the fair market value of the interest transferred; and (2), that any COD income recognized is included in the distributive shares of the partners of the debtor partnership immediately before the debt for equity exchange. The proposed regulations provide two primary rules. First, if certain conditions are met, the fair market value of the transferred debt-for-equity interest is the liquidation value of that interest. Second, the non-recognition rules of Code Sec. 721 apply to a creditor's contribution of debt to a debtor partnership in exchange for a partnership capital or profits interest.

In order for the fair market value of the transferred debt-for-equity interest to equal the liquidation value of that interest, four conditions (listed below) must be met. For this purpose, liquidation value equals the money the creditor would receive with respect to its newly obtained interest if immediately after the debt for equity transfer the partnership sold all of its assets (including goodwill, going concern value, and any other intangibles associated with the partnership's operations) for cash equal to the fair market value of those assets, and then liquidated. If a partnership maintains capital accounts in accordance with the standard capital account rules, then Reg. §1.704-1(b)(2)(iv)(b) and (d) will cause the creditor's capital account to increase by the fair market value of the indebtedness. If the four conditions are not met, a facts and circumstances test is used to determine the fair market value of the interest. The four conditions are:

(1) The debtor partnership determines and maintains its partners' capital accounts according to the rules of Reg. §1.704 1(b)(2)(iv);

(2) The creditor, debtor partnership, and its partners treat the fair market value of the indebtedness as equal to the liquidation value of the debt-for-equity interest when determining the tax consequences of the debt discharge;

(3) The debt-for-equity exchange is an arm's length transaction; and

(4) Following the debt discharge, neither the partnership redeems nor any person related to the partnership purchases the debt-for-equity interest as part of a plan at the time of the debt-for-equity exchange which has as a principal purpose the avoidance of COD income by the partnership.

In addition, the proposed regulations generally apply the non-recognition rules of Code Sec. 721 to the creditor's exchange of debt for a partnership interest. The preamble to the proposed regulations state that non-recognition is appropriate because the transaction results in the creditor joining the partnership enterprise. However, Code Sec. 721 will not apply to a debt for equity exchange where the debt is unpaid rent, royalties or interest on indebtedness, including accrued original issue discount. The proposed regulations do not supersede the rules under Code Sec. 453B relating to dispositions of installment obligations, nor do they apply to a partnership interest transferred in connection with the performance of services. Because the proposed regulations apply Code Sec. 721 to the debt for equity exchange, the creditor's basis in the partnership interest is generally, under Code Sec. 722, a carry-over basis.

If the four-prong test described above is not met and the transferred interest has a liquidation value less than the fair market value of the contributed debt, the IRS and Treasury believe the creditor/contributor's basis in the partnership should still be increased by the adjusted basis of the contributed debt and that the creditor should not recognize any loss. Finally, because the creditor obtains a carry-over basis for the debt-for-equity interest, the creditor can tack the holding period in the indebtedness onto the holding period for the debt for equity interest under Code Sec. 1223(1).

The IRS and Treasury recognize that the following issues have not been addressed and request comments on these and any other issues relevant to the proposed regulations: (1) whether any special allocation rules of COD income should apply where partnership indebtedness owed to a preexisting partner is satisfied with the transfer of a partnership interest; (2) whether COD income arising from a debt-for-equity exchange should be treated as a first-tier item under Reg. §1.704 2(f)(6) for purposes of the minimum gain chargeback rules; and (3) how the rules in the noncompensatory partnership options regulations relating to convertible debt interact with the rules in the proposed regulations under Code Sec. 108(e)(8). A public hearing to discuss issues related to these proposals has been scheduled for February 19, 2009. Written or electronic comments must be received by January 29, 2009. Outlines of topics to be discussed at the public hearing scheduled for February 19, 2009, must be received by January 27, 2009.

Proposed Regulations, NPRM REG-164370-05, 2008FED ¶49,837

Other References:

Code Sec. 108

CCH Reference - 2008FED ¶7010.61

Code Sec. 721

CCH Reference - 2008FED ¶25,243.14

Tax Research Consultant

CCH Reference - TRC SALES: 3,254

TRC PART: 9,000

TRC PART: 18,250

TRC PART: 21,252

Facade Conservation Contribution Overvalued; Appraiser's Report Admissible; Penalty Imposed (White House Hotel Limited Partnership, TC)

The proper value of a partnership's qualified conservation contribution was calculated by the Tax Court, based on appraisals from the partnership and the IRS. The court first rejected the partnership's claim that the contribution, which obligated the partnership to maintain the historic facade on one building, diminished the highest and best use value of the partnership's entire parcel, including a contiguous building. Under state (Louisiana) law, the conservation easement did not convey any rights with respect to the contiguous building. The court also rejected two elements of the partnership's valuation of the facade easement, because the reconstruction cost method was inappropriate for a historic building that was unlikely to be reconstructed if it was destroyed, and the income method was too speculative. Instead, the court relied on the comparable sales method to determine the value of the conservation contribution, based on the value of the affected building before and after the conservation restriction was imposed.

An IRS appraiser's testimony as to the value of the qualified conservation contribution was admissible. His knowledge, experience and education qualified him as an expert real estate appraiser in general, regardless of his experience in valuing donations of historical facades in particular. In addition, his report was sufficiently reliable to be admitted as evidence, even if it did not satisfy the standards for qualified appraisals submitted by taxpayers. The partnership's claims that his appraisal did not consider the value of a contiguous building or satisfy the Uniform Standards of Professional Appraisal Practice (USPAP) might affect the persuasiveness of his report, but they did not render it inadmissible.

Finally, the partnership was liable for the gross valuation misstatement penalty because it overstated the value of the conservation contribution by more than 400 percent. The partnership failed to show that its good faith investigation into the value of the property qualified it for the reasonable-cause exception to the penalty. The general partner failed to provide any basis for his testimony regarding the partnership's investigation, and one of the partnership's two appraisals valued only the building itself, not the conservation contribution.

Whitehouse Hotel Limited Partnership, 131 TC No. 10, Dec. 57,572

Other References:

Code Sec. 170

CCH Reference - 2008FED ¶11,660.60

CCH Reference - 2008FED ¶11,710.15

Code Sec. 6662

CCH Reference - 2008FED ¶39,654.48

Tax Research Consultant

CCH Reference - TRC INDIV: 51,364.45

CCH Reference - TRC INDIV: 51,458

CCH Reference - TRC PENALTY: 3,110.20

Deductions Disallowed, Amount of Deficiency Limited to IRS Pleadings (Baker, TCM)

An individual was not entitled to deductions claimed on his tax return because they were not properly substantiated. The taxpayer could not rely on old tax returns and information returns without other records or credible testimony to substantiate the deductions. The returns were only statements of his claims, not proof of them. Moreover, the IRS was not estopped from challenging these deductions even if it had not done so in previous years.

However, even though the taxpayer filed a return that showed a much higher amount of income than the IRS had used to create a substitute return, and although that additional income was not offset by the greater deductions that the individual also claimed in this late return, only the deficiency originally claimed by the IRS was at issue. The Tax Court considered only the proposed deficiency amount because the IRS had not pled a claim for an increased deficiency by amending its answer. Estate of Petschek, CA-2, 84-2 USTC ¶9598, followed. Finally, the taxpayer was liable for an addition to tax under Code Sec. 6651(a)(1) for a failure to timely file his tax return. The individual conceded that he had filed the return late and did not offer any explanation for the delay.

K.M. Baker, TC Memo. 2008-247, Dec. 57,575(M)

Other References:

Code Sec. 6001

CCH Reference - 2008FED ¶35,111.35

Code Sec. 6214

CCH Reference - 2008FED ¶37,554.109

Code Sec. 6651

CCH Reference - 2008FED ¶39,475.28

Tax Research Consultant

CCH Reference - TRC LITIG: 6,122