And don’t be fooled by the term “business,” as LB&I, through its campaigns, also targets individuals.
In a previous Alert, we wrote about increasing IRS audit activity and those taxpayers being targeted. Despite the IRS processing delays as a result of the pandemic and the extension to file 2020 federal individual income tax returns to May 17, audits targeting high-net-worth individuals has remained a high priority.
Several years ago, the IRS announced a new audit strategy for its Large Business and International Division (LB&I) known as "compliance campaigns." And don’t be fooled by the term “business,” as LB&I, through its campaigns, also targets individuals. With these new initiatives, LB&I essentially shifted to examinations based on compliance issues that LB&I determined presented greater levels of compliance risk, thereby improving return selection and, ultimately, audit results.
Recently, LB&I added two new tax compliance campaigns (aka audits) to its list of focused and targeted audit initiatives, bringing the current total active campaigns to nearly 60.
The first of these new campaigns focuses on the Puerto Rico Act 22, aka the Individual Investors Act. The intent of this act is to attract new residents to Puerto Rico through the provision of a comprehensive income tax exemption on all passive income realized or unrealized after legal residency in Puerto Rico is established, in an attempt to stimulate the island’s struggling economy.
Here’s how it works: A person, in accordance with Section 936 of the Internal Revenue Code, is a legal and bona fide resident of a U.S. territory if (1) they are present in the territory for at least 183 days during the tax year, and (2) they do not maintain a tax home outside of the territory or have a closer connection to the U.S. or a foreign country than to the territory. Typically, any income from sources within the U.S. or effectively connected with the conduct of a trade or business within the U.S. is not treated as income, nor deemed effectively connected from sources within any U.S. territory. As such, the IRS is concerned with potential abuses in this area, namely, taxpayers who claim benefits under the act without meeting the requirements of Code Sections 936 or 937 by excluding income or erroneously reporting U.S. source income as Puerto Rico source income to engage in a tax avoidance scheme. This campaign will address noncompliance in this area through examinations, outreach and "soft letters."
The second new campaign focuses on taxable asset transactions by matching buying and selling parties who enter such transactions under certain provisions of the IRS code, and where the parties did not properly report these transactions on asset allocation statements as required.
The required reporting, via Forms 8594 and 8883, is completed by both parties (purchaser and seller) of business assets that are recorded on the trade or business’ books and includes (1) goodwill or going concern value that attaches, or could attach to such assets, and (2) the purchaser's basis in the assets, which is determined only by the purchaser’s cost basis in the assets. A particular focus of the campaign will be inconsistent reporting―where the buyer and seller reported the transaction differently or did not report the transaction at all.
TAG’s Perspective
If you are a high-net-worth taxpayer and have offshore investment activity, you have always been high on the IRS radar. With these two new campaigns, the IRS intends to focus specifically on offshore activity designed to evade U.S. taxation, as well as asset sale reporting. Therefore, if your portfolio contains any of this activity or you have or plan to become a resident of Puerto Rico, your chances of audit increase exponentially. In the event you are contacted by the IRS and informed that your return or a component of your return is being audited or adjusted, it is imprudent to ignore it. But we urge caution―do not respond directly. We recommend, for those with exposure, engaging truly independent tax lawyers and CPAs who fall under attorney-client privilege, such as those in our National Tax Controversy Group, to represent your interest. Or, in advance of any IRS examination, to conduct a simulated audit to assess exposure and mitigate risk.
For More Information
If you would like more information about this topic or your own unique situation, please contact Michael A. Gillen, Steven M. Packer or any of the practitioners in the Tax Accounting Group. For information about other pertinent tax topics, please visit our publications page.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.