How high-net-worth individuals can plan defensively
The federal government recently has enacted several laws increasing the reporting obligations of both U.S. resident and non-resident taxpayers and imposing additional taxes and penalties on non-compliant taxpayers. But how can the Internal Revenue Service be sure that taxpayers are fulfilling these requirements? The IRS has unveiled a new “holistic audit” program designed to increase compliance among high-net-worth individuals. Let's look at the program, the legal framework underpinning the program and how taxpayers and their advisors can plan defensively for a holistic audit.
Creation of the Program
IRS Commissioner Douglas Shulman announced the creation of the program in a speech before the American Institute of Certified Public Accountants in October 2009.1 The IRS perceived that it was difficult to assess the overall tax compliance of wealthy individuals, due to their sophisticated business and investment arrangements and the attendant complicated, and often opaque, legal structures requiring many different tax returns. The IRS realized that it could no longer audit each tax return in the enterprise as a single and separate entity and that it needed to examine the returns of wealthy individuals as a whole.
In the “holistic” approach, the IRS will take an integrated look at the full range of entities controlled by a taxpayer “to better understand the entire economic picture of the enterprise controlled by the wealthy individual and to assess the tax compliance of that overall enterprise.”2 The IRS is seeking so-called “nodes” of activity where consistent underreporting of income or non-payment of taxes can be detected. In implementing such a program, the United States joins its counterparts in Australia, Canada, Germany, Japan and the United Kingdom, which have formed similar audit groups focusing on the richest taxpayers.
The IRS' holistic audit program will target so-called “high-wealth” taxpayers whose tax returns don't make clear the “economic substance” of their financial arrangements. The IRS hasn't yet promulgated a definition of “high wealth,” but it's expected to cover individuals with $10 million or more in assets or income. Commissioner Shulman stated that “something in the neighborhood of $30 million of assets may be a reasonable dividing line for many countries…. At least initially, though, [the IRS] will be looking at individuals with tens of millions of dollars of assets or income.”3 This guideline could capture thousands of American taxpayers: In 2007, the IRS received 18,394 tax returns reporting adjusted gross income of $10 million or more.4
But income will not be the only criterion identifying a taxpayer as “high wealth.” The IRS also will scrutinize ownership of certain types of assets indicating wealth of $10 million or more, such as real estate investments, privately held businesses, significant investment assets, trusts, private foundations, partnerships and other flow-through entities, royalty and licensing agreements and revenue-based or equity sharing arrangements.5 Other considerations in targeting taxpayers for “holistic” audits include international sourcing of income, tax residency and offshore structures and bank accounts, so a high-wealth taxpayer may be more at risk if he is a dual citizen or a legal resident alien with assets outside the United States, or simply receives a significant amount of income from sources outside the United States.
To centralize the staffing of the holistic audit program, the IRS is creating a Global High-Wealth Industry Group (GHWIG). This group will be part of the IRS' Large and Mid-Sized Business Division (LMSB), whose members have the greatest expertise in understanding complex relationships among various taxable entities. The IRS plans to hire additional agents and other specialists to assist, including flow-through and international specialists, economists, appraisal experts and technical advisors to provide industry or specialized tax expertise.6 The GHWIG is expected to provide coordination among agents and resources in tax areas traditionally covered by the Tax Exempt and Government Entities (TE/GE) Division and Small Business/Self-Employed (SB/SE) Division.7
It appears that the IRS plans to roll out the holistic audit program methodically, starting with just a few targeted examinations. Commissioner Shulman explained that “[w]hat we learn from these initial enterprise examinations will help us define the scope of our future work and build compliance programs going forward.”8 It's unclear what the audit rate will be.
“Economic Substance” Doctrine
The holistic audit program can be viewed as a significant parallel development in the refinement of the economic substance doctrine, a long-standing common law doctrine that was codified by Congress on March 30, 2010.9 It seems that in undertaking holistic audits, the IRS may use the legal theory underlying the economic substance doctrine to identify certain arrangements of high-wealth taxpayers that may literally comply with the Internal Revenue Code but violate the spirit of its provisions. An understanding of how the doctrine is applied in practice will aid taxpayers and their advisors in planning before the audit stage.
The economic substance doctrine has been invoked for decades by the government to deny federal tax benefits to a transaction that doesn't result in a meaningful change to a taxpayer's economic position other than a purported reduction in U.S. federal income tax, even though the transaction may literally comply with the applicable provisions of the IRC.10 Confusingly, though, different jurisdictions have applied different versions of the doctrine, and Congress felt that the varying standards caused the Treasury to lose revenue in taxpayer-friendly jurisdictions.
The courts generally have applied three different standards. First, there's a “conjunctive two-prong test,” which has a subjective, or “business purpose” component (that is, what was the subjective intent of the taxpayer entering into the transaction?) and an objective, or “economic substance” component (that is, did the transaction have some non-tax effect?) Under this test, if the taxpayer had a business purpose in entering into the transaction and it resulted in a meaningful and appreciable enhancement in the net economic position of the taxpayer (other than to reduce tax), it's considered to have economic substance. Second, there's a “disjunctive two-prong test,” which uses the same components as the conjunctive two-prong test, but only one factor must be present for the taxpayer to prove that economic substance existed. Finally, some courts have applied a “practical economic consequence test,” which views business purpose and economic substance as factors to determine whether the transaction had any practical economic effects other than income tax effects.
To determine the taxpayer's subjective intent (that is, whether the taxpayer primarily planned the transaction for tax purposes), the IRS has looked for evidence of the following:
- whether the transaction was sold to the taxpayer as a tax shelter with limited consideration of the underlying components of the transaction;
- whether the taxpayer, or the taxpayer's advisors, investigated market risk prior to entering into the transaction;
- whether the independent parts making up the transaction were entered into at arm's length; and
- whether a prudent investor would have or could have accomplished similar objectives using much simpler or more direct methods.11
It generally is unclear how much “non-tax effect” is enough to meet the objective requirement, but factors such as the following are informative: the profitability of the transaction, whether other similarly situated businesses undertook comparable transactions and whether the transaction meaningfully altered the economic relationships or positions of the parties to the transaction.12
The IRS also has drawn a distinction between “direct” and “indirect” evidence of both components. Direct evidence includes correspondence or other communication by the taxpayer identifying his tax goals. Indirect evidence includes correlations between the tax benefits received and the taxpayer's economic income; for example, whether the taxpayer was able to shelter an unusual windfall from taxation. The IRS also has attempted to demonstrate similarities between particular transactions entered into by other clients of the same promoter.13
New IRC Section 7701(o) codifies the two-prong conjunctive approach described above and provides that a transaction (or series of transactions) will not have “economic substance” for purposes of the economic substance doctrine unless: (1) the transaction changes in a “meaningful way” (apart from U.S. federal income tax effects) the taxpayer's economic position (the objective component); and (2) the taxpayer has a “substantial purpose” (apart from U.S. federal income tax effects) for entering into such transaction (the subjective component).14 The term “transaction” includes a series of transactions.15 The new section imposes a penalty of 20 percent for disclosed transactions and 40 percent for undisclosed transactions, on underpayment of tax that results from any disallowance of claimed tax benefits from transactions claimed to lack economic substance, with no exceptions.16 These provisions apply to transactions entered into after March 30, 2010 and to underpayments, understatements, refunds and credits attributable to transactions entered into after March 30, 2010.17
Under the new provisions, neither a profit potential nor a minimum return is required for a transaction to have economic substance, and the taxpayer may rely on profit potential to demonstrate the transaction has “economic substance.”18 But if relied upon, the pre-tax profit must be substantial in relation to the present value of the expected net tax benefits.19 Achieving a financial accounting benefit is a valid “substantial purpose” for entering into a transaction, if the origin of the financial accounting benefit is not the reduction of U.S. federal income tax.20
The codification of the economic substance doctrine still leaves much to the IRS' imagination. Regulations will have to be promulgated to clarify, for example, when a taxpayer's economic position has changed in a “meaningful way” and when a purpose is “substantial.” The new provisions also don't specify when the economic substance doctrine will be applied; they merely state that the determination whether the economic substance doctrine is relevant to a particular transaction will be made in the same manner as if the new statutory economic substance provision had not been enacted.21 The legislative history notes that the codification wasn't intended to replace or supplant existing precedent.22
The codification of the economic substance doctrine provides a tempting tool for IRS audit teams and the IRS' enforcement and litigation activities, and the IRS may apply the components of the economic substance doctrine at the audit stage to transactions entered into by high-wealth individuals. Codification of the doctrine also provides clarity where case law was muddled or inconsistent. The codification of the economic substance doctrine isn't projected to be a significant revenue-generator for the IRS initially, although it's estimated to raise about $7 billion in revenue over 10 years.23 It's unclear whether this estimate contemplates the impact of the holistic audit program.
Taxpayers and their advisors can use information gleaned from the IRS' announcements and the codification of the economic substance doctrine to plan transactions and prepare for a holistic audit. The holistic audit program will influence the practice of transfer-tax planning in several ways.
First, advisors should review the provisions of Section 7701(o) before recommending a transaction that could attract scrutiny from the IRS. It's unclear to what extent, if at all, Section 7701(o) can be applied in the estate, gift and generation skipping transfer tax arena. It seems that most common estate-planning transactions shouldn't fall under Section 7701(o) because they usually do result in a transfer of wealth from generation to generation and because individuals usually have significant non-tax reasons for wishing to transfer wealth to heirs (such as maintaining control of a family business, providing for disabled or special needs children, keeping a vacation home within the family, etc.). Confidentiality also is a very real concern to many high-net-worth clients, especially those with connections to foreign countries, who may face significant political risk or threats to their personal security in their country of origin. The cautious estate planner will review these factors with a client in advance and, perhaps, even maintain written explanations of the client's objectives and purposes in the advisor's files. As with other recent changes in the law, the holistic audit program will increase the cost of compliance and make it more critical than ever for clients to seek sophisticated legal and accounting advice.
Second, taxpayers and their advisors can reduce the cost of complying with the IRS' document requests by keeping thorough and well-organized files. Due to the nature of the holistic audit process, which is designed to evaluate the taxpayer's entire “enterprise,” the IRS is likely to ask for multiple returns across various tax disciplines (for example, estate tax, gift tax, partnership tax, fiduciary income tax, etc.). Taxpayers should be prepared for the fact that if they are selected for audit, the initial requests from the IRS are likely to be both intrusive and costly. The holistic audit program also may require advisors to adjust their new client intake procedures. Whereas previously copies of basic documents might have sufficed, it will now be important for advisors to understand the full scope of a new client's business and investment affairs and to request copies of all related documents, not just those related to estate planning.
Third, in responding to a holistic audit, advisors should help the IRS narrow its focus to the particular area or return that is of greatest concern. While the manner in which the advisor conducts an audit will depend on individual facts and circumstances, the client probably will be best served by an approach that can quickly resolve any minor or ancillary issues and move right to the “heart” of the audit. The client and advisor also will need to educate the agents conducting the audit about the client's financial affairs. Advisors should consider providing affirmative explanations as to why certain transactions were undertaken, given the taxpayer's personal circumstances or the nature of the investment.
Finally, advisors will need to have candid conversations with clients to explain that even if they haven't done anything “wrong,” they are potential audit targets merely because of their wealth. Unfortunately, the holistic audit program probably will “discriminate” against taxpayers whose wealth is derived from certain lines of business (such as commercial real estate, literary or artistic productions or the licensing of intellectual property), entrepreneurs who still control their companies and individuals with connections to foreign countries. Two clients both with a net worth of $50 million will look very different to the IRS, depending on their sources of income. Advisors should identify which of their clients could be most at risk and notify them of the possibility that they will be selected for audit. When it comes to a holistic audit, a good offense may be the best defense.
- Remarks of Douglas H. Shulman, Commissioner, Internal Revenue Service, at the American Institute of Certified Public Accounts National Conference on Federal Taxation, Oct. 26, 2009, www.irs.gov/irs/article/0,,id=215606,00.html (Shulman Remarks).
- Statistics of Income — 2007, Individual Income Tax Returns, Table 1, IRS, Washington.
- Shulman Remarks.
- See, e.g., Frank Lyon Co. v. United States, 435 U.S. 561 (1978), Knetsch v. U.S., 364 U.S. 361 (1960), Gregory v. Helvering, 293 U.S. 465 (1935); Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966).
- Donald L. Korb, Remarks at the 2005 University of Southern California Tax Institute, Jan. 25, 2005, www.irs.gov/pub/irs-utl/economic_substance_(1_25_05).pdf.
- Internal Revenue Code Section 7701(o).
- IRC Section 7701(o)(5)(E); see also Treasury Regulations Section 1.6011-4(b)(1) (“transaction includes all of the factual elements relevant to the expected tax treatment of any investment, entity, plan, or arrangement, and includes any series of steps carried out as part of a plan”).
- H.R. 4872, the Health Care and Education Reconciliation Act of 2010, Section 1409 (b)-(d).
- Ibid, Section 1409(e).
- IRC Section 7701(o)(2).
- IRC Section 7701(o)(5)(D).
- The Joint Committee on Taxation, JCX-18-10, March 21, 2010, www.jct.gov/publications.html?func=startdown&id=3673 at p. 156.
- The Joint Committee on Taxation, JCX-28-09, June 11, 2009, www.jct.gov/publications.html?func=startdown&id=3558.
- H.R. 4872.
Stephanie E. Heilborn, far left, and Kathryn Keneally, center, are partners and Lindsay H. Brown is an associate at Fulbright & Jaworski LLP in New York City