Category: Tax

Internal Revenue Service (IRS) Capitalized Legal Fees Incurred by Pharmaceutical Company

 

McDermottLogo_2c_rgbIn a recently released Field Attorney Advice, the Internal Revenue Service (IRS) Office of Chief Counsel concluded that a pharmaceutical company must capitalize legal fees incurred to obtain Food and Drug Administration approval for marketing and selling generic drugs and to prevent the marketing and sale of a competing generic drug.  The IRS Office of Chief Counsel also concluded that it could impose an adjustment on audit to capitalize legal fees that the taxpayer expensed in prior years, including years closed by statute of limitations.

In a recently published Internal Revenue Service (IRS) Field Attorney Advice (FAA 20131001F, March 8, 2013), the IRS Office of Chief Counsel concluded that a pharmaceutical company must capitalize legal fees incurred to obtain U.S. Food and Drug Administration (FDA) approval for marketing and selling new generic drugs and to prevent the marketing and sale of a competing generic drug.  The IRS also concluded that the Commissioner could change the taxpayer’s method of accounting for the legal fees and impose an adjustment on audit to capitalize legal fees that the taxpayer expensed in prior years, including years closed by the statute of limitations.

NDA and ANDA

In order to market or sell a new drug in the United States, a New Drug Application (NDA) must be submitted to and approved by the FDA.  An NDA consists of clinical and nonclinical data on the drug’s safety and effectiveness, as well as a full description of the methods, facilities and quality controls employed during manufacturing and packaging.  An NDA also must disclose all the patents that cover the drug.

To market or sell a generic version of an existing FDA-approved drug, the maker of the generic drug must submit an Abbreviated New Drug Application (ANDA) for FDA approval.  An ANDA generally is not required to include preclinical and clinical trial data to establish safety and effectiveness.  Instead, an ANDA applicant must show that its generic drug is bioequivalent to an existing drug.  In addition, an ANDA applicant is required to provide certification that the ANDA will not infringe on the patent rights of a third party.  Specifically, if an applicant seeks approval prior to the expiration of patents listed by the NDA holder, then a “paragraph IV certification” must be submitted by the applicant to certify that it believes its product or the use of its product does not infringe on the third party’s patents, or that such patents are not valid or enforceable.  The first generic drug applicant that files an ANDA containing a paragraph IV certification is granted, upon approval, 180 days of marketing exclusivity.

For an ANDA with a paragraph IV certification, the applicant must send notices to the NDA holder for the referenced drug and to all patentees of record for the listed patents within 20 days of FDA notification that the ANDA is accepted for filing.  If neither the NDA holder nor the patent holders bring an infringement lawsuit against the ANDA applicant within 45 days, the FDA may approve the ANDA.  If the NDA holder or the patent holders file a patent infringement lawsuit against the ANDA applicant within 45 days, a stay prevents the FDA from approving the ANDA for up to 30 months.  If, however, the patent infringement litigation is still ongoing after the 30 months, the FDA may approve the ANDA.

The Facts

The taxpayer is a pharmaceutical company engaged in developing, manufacturing, marketing, selling and distributing generic and brand name drugs.  In the process of filing ANDAs with a paragraph IV certification, the taxpayer incurred legal fees in lawsuits filed by patent and NDA holders for patent infringement.  In addition, the taxpayer as an NDA holder incurred legal fees in a lawsuit it filed against an ANDA applicant with a paragraph IV certification to protect its right to sell its branded drug until all patents expired.  The taxpayer sought to deduct its legal fees as ordinary and necessary business expenses.

The IRS Analysis

Legal Fees Incurred in the Process of Obtaining FDA Approval of ANDAs

The IRS concluded that the legal fees incurred by the taxpayer as an ANDA applicant to defend actions for patent infringement in the process of filing the ANDA with paragraph IV certification must be capitalized under Treas. Reg. § 1.263(a)-4.  The IRS characterized the fees as incurred to facilitate the taxpayer obtaining the FDA-approved ANDAs with paragraph IV certification, which granted the applicant the right to market and sell a generic drug before the expiration of the patents covering the branded drugs, and by filing early, potentially with a 180-day exclusivity period.  As such, the IRS concluded, the fees are required to be capitalized as amounts paid to create or facilitate the creation of an intangible under Treas. Reg. § 1.263(a)-4(d)(5).  In so concluding, the IRS rejected the taxpayer’s argument that its fees did not facilitate obtaining FDA-approved ANDAs because it could have commercialized its generic drugs after the 30-month stay expired regardless of the outcome of the lawsuits.  The IRS reasoned that the filing of the ANDAs with paragraph IV certification and the defense of the patent infringement lawsuit were a part of a series of steps undertaken in pursuit of a single plan to create an intangible.

The IRS further concluded that the cost recovery of the capitalized legal fees incurred to obtain the FDA-approved ANDAs must be suspended until the FDA approves the ANDAs, and the capitalized fees must be amortized on a straight-line basis over 15 years as section 197 intangibles.

Legal Fees Incurred to Protect Its Right Against Other ANDA Applicants with Paragraph IV Certification

With respect to the legal fees incurred by the taxpayer as an NDA holder in the litigation against another ANDA applicant, the IRS characterized the fees incurred to defend the validity of the patents owned by the taxpayer as amounts paid to defend or perfect title to intangible property that are required to be capitalized under Treas. Reg. § 1.263(a)-4(d)(9).  In contrast, the fees incurred by the taxpayer in the litigation relating to determining whether valid patents have been infringed are not required to be capitalized under Treas. Reg. § 1.263(a)-4(d)(9).

The IRS further concluded that the capitalized fees incurred to protect the patents and the FDA-approved NDA must be added to the basis of the patents to be depreciated under section 167.  The cost recovery begins in the months in which the legal fees were incurred and is allocated over the remaining useful lives of the patents.

In characterizing the legal fees incurred by the taxpayer in defending the validity of its patents as costs of defending or perfecting title to intangible property, the IRS distinguished the legal fees at issue from the litigation expenses incurred by the taxpayers in defending a claim that their patents were invalid in Urquhart v. Comm’r, 215 F.2d 17 (3rd Cir. 1954).  In Urquhart, the taxpayers were participants in a joint venture that was engaged in the business of inventing and licensing patents.  The taxpayers obtained two patents involving fire-fighting equipment and, after threatening litigation against Pyrene Manufacturing Company, brought an infringement suit against a customer of Pyrene, seeking an injunction and recovery of profits and damages.  The case was dismissed, and Pyrene subsequently commenced an action against the taxpayers seeking a judgment that the taxpayers’ patents were invalid and that its own apparatus and methods did not infringe the patents.  A counterclaim was filed for an injunction against infringement, and an accounting for profits and damages.  Pyrene did not raise any questions as to title to, or ownership of, the patents and was successful in the lawsuit.  The patents held by the taxpayers were found to be invalid.  In holding that the legal fees incurred by the taxpayer were deductible as ordinary and necessary business expenses, the U.S. Court of Appeals for the Third Circuit rejected the IRS’s contention that the litigation was for the defense or protection of title.

Distinguishing the FAA from Urquhart, the IRS focused on the fact that the taxpayers in Urquhart were professional inventors engaged in the business of exploiting and licensing patents, and that Urquhart involved the taxpayers’ claims for recovering lost profits.  By emphasizing that Pyrene did not raise any issue as to title to the patents in Urquhart, the IRS seemed to ignore the fact that, like the taxpayer in the FAA, Pyrene sought a judgment on the validity of the taxpayers’ patents and that the outcome of the litigation in Urquhart also focused on the validity of the patents.

Change of Accounting Method for Legal Fees Incurred by the Taxpayer 

The IRS also concluded that the taxpayer’s treatment of its legal fess associated with each ANDA or patent as either deductible or capitalizable is a method of accounting that the Commissioner can change on an ANDA-by-ANDA or patent-by-patent basis.  The consequence of this conclusion, if valid, is that the IRS can impose on audit an adjustment to capitalize legal fees that the taxpayer deducted in prior years, including years closed by the statute of limitations.  For example, the IRS can include in the taxpayer’s gross income for the earliest year under examination an adjustment equal to the amount of the legal fees the taxpayer previously deducted, less the amount of amortization that the taxpayer properly could have taken had the taxpayer capitalized the legal fees.

A taxpayer that voluntarily changes its method of accounting, however, receives more favorable terms and conditions than a taxpayer that has its method of accounting changed by the IRS on examination.  For example, a taxpayer that changes its method of accounting voluntarily can spread the adjustment resulting from the change over four taxable years, and the first year of the adjustment is the current taxable year as opposed to the earliest open taxable year.

The publication of this FAA likely will bring the attention of examining agents to this issue.  Therefore, if a taxpayer believes it is using an improper method of accounting for legal fees (or any other item), it should carefully consider whether to voluntarily change its method of accounting before the IRS proposes to change the taxpayer’s method of accounting on examination.

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SEC Staff Meets with IRS to Discuss Tax Implications of a Floating Net Asset Value (NAV)

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SEC staff recently met with staff members of the IRS to discuss the tax implications of adopting a floating net asset value (NAV) for money market funds. The discussion centered on the tax treatment of small gains and losses for investors in money market funds, and the IRS reportedly told the SEC there is limited flexibility in interpreting current tax law. A floating NAV could require individual and institutional investors to regard every money market fund transaction as a potentially taxable event.

Investors would have to determine how to match purchases and redemptions for purposes of calculating gains, losses and share cost basis. The SEC reached out to the IRS as it continues to consider measures, including a floating NAV, to enable money market funds to better withstand severe market disruptions.

For additional discussion of money market reform, please see “SEC Debates on Money Market Reforms Continue” in our January 2013 and October 2012 updates.

Sources: John D. Hawke, Jr., Economic Consequences of Proposals to Require Money Market Funds to ‘Float’ Their NAV, SEC Comment Letter File No. 4-619, November 2, 2012; Christopher Condon and Dave Michaels, SEC Said to Discuss Floating NAV for Money Funds with IRS, Bloomberg, March 7, 2013; Joe Morris, SEC Sounding Out IRS on Floating NAV, Ignites, March 7, 2013.

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340B Drug Pricing Program Notices on Group Purchasing Organizations and Medicaid Exclusion File

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Following the recent release of new Program Notices regarding the Group Purchase Organization (GPO) prohibition and Medicaid Exclusion File, 340B participating entities should review their 340B program policies and procedures to ensure compliance with new and clarified guidance regarding GPO purchasing and dispensing of 340B drugs to Medicaid patients.

On February 7, 2013, the Health Resources and Services Administration Office of Pharmacy Affairs (OPA) issued new Program Notices related to the Group Purchasing Organization (GPO) prohibition and the Medicaid Exclusion File (the Program Notice).

GPO Prohibition 

Disproportionate Share Hospitals, children’s hospitals and freestanding cancer hospitals that participate in the 340B program are prohibited from purchasing “covered outpatient drugs” through a GPO or other group purchasing arrangement.  Covered outpatient drugs include most outpatient drugs obtained by written prescription, with the exception of vaccines and certain drugs classified as devices by the U.S. Food and Drug Administration.

Prior to the release of the new Program Notice, OPA had provided little guidance regarding the scope and enforcement of the GPO prohibition.  The Program Notice appears to have resulted from OPA concern that certain hospitals may have been routinely using outpatient GPO accounts when unable to purchase drugs at 340B prices.  With the Program Notice, OPA has now formally established policies regarding the application of the GPO prohibition to drug shortages, outpatient clinics and virtual inventory/replenishment purchasing models.

With the new Program Notice, and accompanying FAQs released subsequent to the publication of the Program Notice, OPA advises that the GPO prohibition applies even when a covered outpatient drug is not available at the 340B price due to a manufacturer shortage.  In such cases, hospitals are instructed to notify OPA of the issue, but may not obtain the drug through a GPO.

The Program Notice also provides that the GPO prohibition does not extend to certain off‑site outpatient clinics.  A hospital may use a GPO to purchase covered outpatient drugs for an off-site outpatient clinic if all of the following requirements are met:

Further, OPA establishes that a hospital may not use a GPO to purchase covered outpatient drugs for dispensing to patients through a contract pharmacy.  This guidance does not prohibit a contract pharmacy that is not owned by a hospital (which is the entity that would be subject to the GPO prohibition) from accessing GPO pricing through its own account, so long as the hospital is not involved in the pharmacy-GPO arrangement and does not benefit from the pharmacy’s GPO pricing.

  • The off-site outpatient clinic is located at a different physical address than the hospital
  • The off-site outpatient clinic is not registered in the OPA 340B database as participating in the 340B program
  • Covered outpatient drugs for the off-site outpatient clinic are purchased through a separate pharmacy wholesaler account than the hospital
  • The hospital maintains records demonstrating that drugs purchased through a GPO for the off-site outpatient clinic are not utilized by or transferred to the hospital or any off-site outpatient location registered in the OPA 340B database

Hospitals, including their outpatient sites, subject to the GPO prohibition must discontinue GPO purchasing of covered outpatient drugs before the first day of their respective 340B program eligibility, although each may continue to dispense previously purchased GPO inventory.  Those hospitals that maintain pharmacy inventory through a virtual inventory/replenishment model, in which 340B drugs are purchased based on prior dispensing to 340B-eligible patients, are also prohibited from using a GPO to purchase covered outpatient drugs.  OPA has advised that hospitals utilizing a replenishment model in “mixed use” (inpatient and outpatient) pharmacies must now account for (“accumulate”) dispensed drugs for inventory replenishment as either inpatient, 340B-eligible or outpatient non-340B.  Drugs accumulated for outpatient non-340B replenishment may only be purchased through a non-340B, non-GPO account.  In addition, a hospital may not purchase drugs on a 340B account until the 340B-eligible accumulator reaches a full package size and/or minimum order quantity.  The result is that such drugs typically must be purchased at wholesale acquisition cost (WAC) or prices individually negotiated between the hospital and manufacturer.

The new Program Notice advises that hospitals subject to the GPO prohibition that are found in violation of the prohibition may be immediately removed from the 340B program and subject to repayment to manufacturers for the period of non-compliance.  However, in a separate FAQ on the OPA website, OPA advises that it will not enforce the GPO prohibition until after April 7, 2013.  Those hospitals that are unable to meet the compliance deadline are advised to either notify OPA of non-compliance and submit a corrective action plan (such submissions will be handled on a case-by-case basis) or disenroll either the entire hospital or, if applicable, non-compliant off-campus locations, from the 340B program.

Medicaid Exclusion File

Drug manufacturers are not required to provide a 340B discount and Medicaid rebate on the same drug.  In order to prevent these “duplicate discounts,” OPA maintains the Medicaid Exclusion File.  This database lists all 340B participating entities (covered entities) and indicates whether the covered entity has elected to dispense 340B drugs to Medicaid patients (carve-in) or obtain drugs for Medicaid patients at non-340B pricing (carve-out).  Covered entities that have elected to carve-in are listed in the Medicaid Exclusion File by Medicaid billing number.

State Medicaid programs are instructed to access the Medicaid Exclusion File to ensure they do not seek manufacturer rebates from those covered entities that are listed in the database.  In the Program Notice, OPA reminds states to use the Medicaid Exclusion File to prevent duplicate discounts and to report any discrepancies between provider billing practices and the information in the database to OPA.

The Program Notice advises covered entities of a change in OPA policy regarding the timing of changes to a covered entity’s decision to carve-in or carve-out.  While changes previously could be made at any time, OPA will now only permit changes on a quarterly basis.  OPA also clarifies that a covered entity may choose to carve-in or carve-out for a subset of 340B enrolled locations, but if it does so, must obtain a separate Medicaid provider number for any eligible locations that carve-in.  Covered entities are also reminded that they must ensure their information is accurately reflected in the Medicaid Exclusion File and that they may be subject to manufacturer repayment if the database reflects that the covered entity opted to carve-out, but the covered entity has been dispensing 340B drugs to Medicaid patients.

Next Steps

340B participating hospitals subject to the GPO exclusion should review their current operations and policies and procedures to evaluate compliance with the guidance released in the new Program Notice and FAQs, with particular attention to use of GPO purchasing to obtain covered outpatient drugs that are not available at 340B pricing and for replenishment inventory.  As necessary, hospitals should cease purchasing covered outpatient drugs through a GPO and begin revising purchasing procedures to ensure compliance by April 8, 2013.

Hospitals should also evaluate current policies regarding use of GPOs at off-site outpatient clinics not registered in the OPA 340B database to determine whether such locations may be eligible to purchase covered outpatient drugs through a GPO.  Previously, many such off-site outpatient clinics were restricted to only purchasing at WAC pricing due to the GPO exclusion.  The new Program Notice makes clear that, so long as purchasing is conducted through a separate pharmacy wholesaler account (not the hospital’s), hospitals subject to the GPO exclusion can use a GPO to purchase drugs for off-campus outpatient clinics that are not registered in the OPA 340B database.  Therefore, outpatient sites now have the flexibility to purchase drugs through a GPO for those clinics that are not yet eligible for 340B enrollment (e.g., they have not yet appeared on a filed Medicare cost report) and to opt-out of enrolling off-site outpatient clinic sites if certain locations would see greater benefit from GPO purchasing than from 340B participation.  Further, hospitals may wish to explore opportunities for selective enrollment of off-site outpatient locations to ensure patient access to certain drugs, such as intravenous immunoglobulin, that have historically been difficult to obtain at 340B pricing and cost-prohibitive to obtain at WAC.

All covered entities should review their information in the Medicaid Exclusion File to ensure the database reflects current Medicaid billing practices and be aware that any changes will only be effective as of the next quarter beginning January 1, April 1, July 1 or October 1.  Covered entities should also use this opportunity to review state Medicaid program requirements regarding carve-in or carve-out restrictions and billing rules related to 340B drugs.

© 2013 McDermott Will & Emery

DOL, IRS, and HHS Put the Brakes on Stand-Alone Health Reimbursement Arrangements Used to Access Health Insurance Coverage in the Individual Market

The National Law Review recently featured an article regarding Health Reimbursement Arrangements written by Alden J. Bianchi and Gary E. Bacher of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.:

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In a set of Frequently Asked Questions1 (FAQs) posted to the Department of Labor’s website on January 24, the Departments of Health and Human Services, Labor, and Treasury (the “Departments”) put a stop to an approach to health plan design under which employers furnish employees with a pre-determined dollar amount (a “defined contribution”) that employees can apply toward the purchase of health insurance coverage in the individual health insurance market.

An arrangement under which an employer provides an amount of money to employees to pay for unreimbursed medical expenses or for individual market premiums is itself a “group health plan.” Such an arrangement is referred to and regulated under the Internal Revenue Code as a “health reimbursement arrangement” or “HRA.”2 The HRA approach described above is referred to as a “stand-alone HRA” to distinguish it from arrangements in which the HRA is paired with an employer’s group health plan. This latter HRA design is referred to as an “integrated HRA.”

The rules governing HRAs stand in contrast to cafeteria plans and medical flexible spending arrangements, which pave the way for employee contributions to be paid with pre-tax dollars. Where employee contributions are limited to premiums, the cafeteria plan is referred to colloquially as a “premium-only” plan. Where employees can set aside their own money to pay for certain medical expenses including co-pays and co-insurance with pre-tax dollars, the arrangement is referred to as a “medical flexible spending arrangement” or “medical FSA.” Medical FSAs can include employer money (typically in the form of “flex credits”), but they cannot be used to pay health insurance premiums.

While some vendors have begun to market stand-alone HRAs, it was never clear that HRAs used to access individual market coverage could pass muster under the Patient Protection and Affordable Care Act (the “Act”) or other applicable laws. The regulatory hurdles, both before and after 2014, include the following:

  1. Before 2014, carriers issuing coverage in the individual market are free to impose all manner of underwriting conditions, which raise the specter of discrimination based on health status in violation of Title I of the Health Insurance Portability and Accountability Act (HIPAA). These concerns disappear commencing in 2014 as a consequence of the Act’s comprehensive overhaul of health insurance underwriting practices.
  2. The Act generally prohibits group health plans and health insurance carriers from imposing lifetime or annual limits on the dollar value of essential health benefits. In prior guidance, the regulators gave a “pass” to integrated HRAs, but not to stand-alone HRAs.
  3. Because individual market products are age rated, the same coverage will cost more in the hands of an older employee than in the hands of a similarly-situated younger employee. Before 2014, the variations in premium costs are a matter of state law; from and after 2014, the Act establishes a federal floor under “modified community rating” rules that permit a disparity of no more than 3:1. Under either regulatory regime, a flat dollar amount is thought to raise questions under the Age Discrimination in Employment Act (ADEA). Under the ADEA, variations in premiums are permitted only where the added cost charged to an older employee is justified by the actuarially-adjusted cost of providing the benefits to the older employee.

The FAQs cite the Act’s ban on lifetime and annual limits as the basis for their objection to stand-alone HRAs used to access individual market coverage. Specifically, the FAQs note that—

“[A]n HRA is not considered integrated with primary health coverage offered by the employer unless, under the terms of the HRA, the HRA is available only to employees who are covered by primary group health plan coverage provided by the employer. …”

The Departments state their objections unequivocally: an HRA used to purchase coverage in the individual market cannot be considered integrated with that individual market coverage. Therefore, such an arrangement does not satisfy the requirements Act prohibiting group health plans and health insurance carriers from imposing lifetime or annual limits on essential health benefits. The Departments also made clear that an employer-sponsored HRA may be treated as integrated with other coverage only if the employee receiving the HRA is actually enrolled in that coverage. Thus, if an HRA credits additional amounts to an individual only when he or she does not enroll in the employer’s group health plan, the HRA will not comply with the Act.

Recognizing the potential hardship to existing stand-alone HRAs, the FAQs include a special rule for amounts credited or made available under HRAs in effect prior to January 1, 2014. Whether or not an HRA is integrated with other group health plan coverage, unused amounts credited before January 1, 2014 may be used after December 31, 2013 to reimburse medical expenses without running afoul of the Act. If the HRA did not prescribe a set amount or amounts to be credited during 2013, then the amounts credited cannot exceed the amount credited for 2012.

©1994-2013 Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.

District Court Holds IRS Lacks Authority to Issue and Enforce Tax Return Preparer Regulations

The National Law Review recently featured an article, District Court Holds IRS Lacks Authority to Issue and Enforce Tax Return Preparer Regulations, written by Gale E. Chan and Robin L. Greenhouse with McDermott Will & Emery:

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On January 18, 2013, the District Court for the District of Columbia (District Court) issued a surprising decision in Loving v. Internal Revenue Service, No. 12-385 (JEB), holding that the Internal Revenue Service (IRS) lacked the authority to issue and enforce the final Circular 230 tax return preparer regulations that were issued in 2011 (Regulations).  The District Court also permanently enjoined the IRS from enforcing the Regulations.

Background

As part of the IRS’s initiative to increase oversight of the tax return preparer industry by creating uniform and high ethical standards of conduct, the IRS created a new category of preparers, “registered tax return preparer,” to be subject to the rules of Circular 230.  Attorneys, certified public accountants, enrolled agents and enrolled actuaries were already subject to IRS regulation under Circular 230, and thus, were not affected by the issuance of the Regulations.

In June 2011, the IRS and the U.S. Department of the Treasury (Treasury) issued the Regulations relating to registered tax return preparers and practice before the IRS.  T.D. 9527 (June 3, 2011).  Under these rules, registered tax return preparers have a limited right to practice before the IRS.  A registered tax return preparer can prepare and sign tax returns, claims for refunds and other documents for submission to the IRS.  A registered tax return preparer who signs the return may represent taxpayers before revenue agents and IRS customer service representatives (or similar officers or employees of the IRS) during an examination, but the registered tax return preparer cannot represent the taxpayer before IRS appeals officers, revenue officers, counsel or similar officers or employees of the IRS.  In addition, a registered tax return preparer can only advise a taxpayer as necessary to prepare a tax return, claim for refund or other document intended to be submitted to the IRS.

The Regulations also impose additional examination and continuing education requirements on registered tax return preparers in addition to obtaining a preparer tax identification number (PTIN).  Under the rules, to become a “registered tax return preparer,” an individual must be 18 years old, possess a current and valid PTIN, pass a one-time competency examination, and pass a federal tax compliance check and a background check.  The Regulations require a registered tax return preparer to renew his or her PTIN annually and to pay the requisite user fee.  To renew a PTIN, a registered tax return preparer must also complete a minimum of 15 hours of continuing education credit each year that includes two hours of ethics or professional conduct, three hours of federal tax law updates and 10 hours of federal tax law topics.

Loving v. Internal Revenue Service

In Loving, three individual paid tax return preparers (Plaintiffs) filed suit against the IRS, the Commissioner of Internal Revenue and the United States (collectively, Government) seeking declaratory relief, arguing that tax return preparers whose only “appearance” before the IRS is the preparation of tax returns cannot be regulated by the IRS, and injunctive relief, requesting the court to permanently enjoin the IRS from enforcing the Regulations.  In filed declarations, two of the Plaintiffs indicated that they would likely close their tax businesses if they were forced to comply with the Regulations, and the third Plaintiff, who serves low-income clients, indicated that she would have to increase her prices if forced to comply with the Regulations, likely resulting in a loss of customers.  The Plaintiffs and the Government each filed separate motions for summary judgment.

At issue in the case was the IRS’s claim that it can regulate individuals who practice before it, including tax return preparers.  The IRS relied on an 1884 statute, 31 U.S.C. § 330, which provides the Treasury with the authority to regulate the people who practice before it.  The statute currently provides that the Treasury may “regulate the practice of representatives of persons before the Department of the Treasury.”  31 U.S.C. § 330(a)(1) (emphasis added).  The statute further requires that a representative demonstrate certain characteristics prior to being admitted as a representative to practice, including “competency to advise and assist persons in presenting their cases.”  31 U.S.C. § 330(a)(2)(D) (emphasis added).  The statute also gives the Treasury authority to suspend or disbar a representative from practice before the Treasury in certain circumstances, as well as to impose a monetary penalty.  31 U.S.C. § 330(b).

The District Court’s Application of Chevron

The District Court applied the framework of Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984), and concluded that the text and context of 31 U.S.C. § 330 unambiguously foreclosed the IRS’s interpretation of the statute.  Chevron applies a two-step inquiry to determine whether a statute is ambiguous.  The first step asks whether the intent of Congress is clear in the statute—i.e., has Congress “directly spoken to the precise question at issue.”  Chevron, 467 U.S. at 842.  If a court determines that the intent of Congress is clear, under the Chevron framework, that is the end and the court “must give effect to the unambiguously expressed intent of Congress.”  Id. at 842–43.  However, if the court determines that the statute is silent or ambiguous, the court must proceed to step two of Chevron and ask whether the agency’s interpretation “is based on a permissible construction of the statute.”  Id. at 843.  An agency’s construction under step two is permissible “unless it is arbitrary or capricious in substance, or manifestly contrary to the statute.”  Mayo Found. for Med. Educ. & Research v. United States, 131 S. Ct. 704, 711 (2011) (citation omitted).

In Loving, the District Court concluded that 31 U.S.C. § 330 was unambiguous as to whether tax return preparers are “representatives” who “practice” before the IRS for three reasons.  First, the District Court stated that 31 U.S.C. § 330(a)(2)(D) defines the phrase “practice of representatives” in a way that does not cover tax return preparers.  As noted above, 31 U.S.C. § 330(a)(2)(D) requires a representative to demonstrate that he or she is competent to advise and assist taxpayers in presenting their “cases.”  The District Court stated that the statute thus equates “practice” with advising and assisting with the presentation of a case, which the filing of a tax return is not.  Thus, the District Court concluded that the definition in 31 U.S.C. § 330(a)(2)(D) “makes sense only in connection with those who assist taxpayers in the examination and appeals stages of the process.”

Second, the District Court stated that the IRS’s interpretation of 31 U.S.C. § 330 would undercut various statutory penalties in the Internal Revenue Code (Code) specifically applicable to tax return preparers.  The District Court noted that if 31 U.S.C. § 330(b) is interpreted as authorizing the IRS to penalize tax return preparers under the statute, the statutory penalty provisions in the Code specific to tax return preparers would be displaced, thereby allowing the IRS to penalize tax return preparers more broadly than is permissible under the Code.  Thus, the District Court stated that the specific penalty provisions applicable to tax return preparers in the Code should not be “relegated to oblivion” and trumped by the general penalty provision of 31 U.S.C. § 330(b).

The District Court also stated that 31 U.S.C. § 330(b) does not authorize penalties on tax return preparers because Section 6103(k)(5) of the Code, which provides that the IRS may disclose certain penalties to state and local agencies that license, register or regulate tax return preparers, does not identify 31 U.S.C. § 330(b) as one of the reportable statutory penalty provisions.

Finally, the District Court stated that if the IRS’s interpretation of 31 U.S.C. § 330 is accepted, Section 7407 of the Code would be duplicative.  Section 7407 of the Code provides the IRS with the right to seek an injunction against a tax return preparer to enjoin the preparer from further preparing returns if the preparer engages in specified unlawful conduct.  This right is similar to the authority under 31 U.S.C. § 330(b) to penalize if the IRS’s interpretation of 31 U.S.C. § 330 is accepted.  Under the IRS’s interpretation of 31 U.S.C. § 330, the IRS could disbar a representative from practice before the IRS if a tax return preparer engages in the conduct described in 31 U.S.C. § 330(b) (incompetence, being disreputable, violating regulations and fraud).  Thus, the District Court noted that disbarment under 31 U.S.C. § 330(b) is wholly within the IRS’s control and would be an easier path to penalize a tax return preparer than offered by Section 7407 of the Code.  The District Court stated that under the IRS’s interpretation, the IRS likely would never utilize the remedies available under Section 7407 of the Code, thereby rendering the statute pointless.

Conclusion

The District Court granted the Plaintiffs’ motion for summary judgment, holding that the IRS lacked statutory authority to issue and enforce the Regulations against “registered tax return preparers,” and permanently enjoined the IRS from enforcing the Regulations.  The Government will likely appeal the District Court’s decision.  Nevertheless, the District Court’s decision will have a great impact on the hundreds of thousands of tax return preparers ensnared by the Regulations and the clients they serve.

© 2013 McDermott Will & Emery

Employers Can Obtain Refund for Excess FICA Tax Paid as Result of Increased Excludable Limit for Transit Benefits

The National Law Review recently published an article, Employers Can Obtain Refund for Excess FICA Tax Paid as Result of Increased Excludable Limit for Transit Benefits, written by Maureen O’Brien and Ruth Wimer, Esq., CPA with McDermott Will & Emery:

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On January 11, 2013, the Internal Revenue Service published Notice 2013-8 providing a special administrative procedure for employers with respect to 2012 transit pass benefits.  The American Taxpayer Relief Act retroactively increased the monthly transit benefit exclusion under Section 132(f)(2)(A) of the Internal Revenue Code for commuter highway vehicles or transit passes from $125 per participating employee to $240 per participating employee for the 2012 calendar year (the monthly transit benefit exclusion for parking remains at $240).  The notice addresses employers’ questions regarding the retroactive application of the increased exclusion, which can result in both decreased FICA and federal income tax liability.  Employers acting promptly, in many cases by January 31, may have less administrative burden in obtaining a benefit for themselves and their employees with respect to the retroactive increase for employer-provided transit benefits.

Background

Section 132(a)(5) of the Internal Revenue Code provides that any fringe benefit that is a qualified transportation fringe is excluded from gross income for federal income tax purposes, and the FICA rules allow for the same exclusion.  The term “qualified transportation fringe” includes (when provided by an employer to an employee) transportation in a commuter highway vehicle between home and work and any transit pass (Transit Benefits), or qualified parking.  Prior to the enactment of the American Taxpayer Relief Act (ATRA), the 2012 monthly limit for qualified parking was $240, and the monthly limit for other Transit Benefits was $125.  ATRA amended Section 132(f)(2) to increase the maximum monthly excludable amount for Transit Benefits to an amount equal to the maximum monthly excludable amount for qualified parking (i.e., $240), effective retroactively beginning on January 1, 2012.

As a result of ATRA, employers that provided Transit Benefits in excess of the pre-ATRA maximum monthly excludable amount may be able to obtain a refund of FICA amounts paid on such benefits.  Generally, corrections of overpayments of FICA tax are made when an error has been ascertained using either the adjustment process or using the refund claim process, and requires a Form 941-X to be filed for each quarter in which excess FICA taxes were reported.  (Correction of over-withheld federal income tax can not be made until after the year-end in which the over-withholding occurred.)

IRS Notice 2013-8 provides a special administrative process to obtain a refund for excess FICA tax paid as a result of the retroactive amendment on the monthly excludable limit for Transit Benefits.  To benefit from the retroactive increase in the excludable limits for Transit Benefits, the employer must have actually paid amounts for Transit Benefits in excess of the limit either from its own resources or from employee salary deferrals.

Employers that have not yet filed their fourth quarter Form 941 for 2012 must repay or reimburse their employees the over-collected FICA tax on the excess transit benefits for all four quarters of 2012 on or before filing the fourth quarter Form 941.  The employer, in reporting amounts on its fourth quarter Form 941, may then reduce the fourth quarter wages, tips and compensation reported on line 2, the taxable social security wages reported on line 5a and Medicare wages and the tips reported on line 5c by the excess transit benefits for all four quarters of 2012.  By taking advantage of this special administrative procedure, employers will avoid having to file Forms 941-X, and will also avoid having to file Forms W-2c.

Employers that have already filed the fourth quarter Form 941 must use Form 941-X to make an adjustment or claim a refund for any quarter in 2012 with regard to the overpayment of tax on the excess transit benefits after repaying or reimbursing the employees or, for refund claims, securing consents from its employees.  Similarly, employers that, on or before filing the fourth quarter Form 941, have not repaid or reimbursed some or all employees who received excess transit benefits in 2012 must use Form 941-X to make an adjustment or claim for refund with respect to the excess transit benefits provided to those employees, and must follow the normal procedures.

Employers that have not furnished 2012 Forms W-2 to their employees should take into account the increased exclusion for transit benefits in calculating the amount of wages reported in box 1, Wages, tips, other compensation; box 3, Social security wages; and box 5, Medicare wages and tips.  Employers that have repaid or reimbursed their employees for the over-collected FICA taxes prior to furnishing Form W-2 should reduce the amounts of withheld tax reported in box 4, Social security tax withheld, and box 6, Medicare tax withheld, by the amounts of the repayments or reimbursements.

In all cases, however, employers must report in box 2, Federal income tax withheld, the amount of income tax actually withheld during 2012.  The additional income tax withholding will be applied against the taxes shown on the employee’s individual income tax return (Form 1040, U.S. Individual Income Tax Return).  The same procedures are available to filers of other employment tax returns reporting FICA taxes (e.g., the related Spanish-language return or return for U.S. possessions) and to filers of employment tax returns reporting taxes under the Railroad Retirement Tax Act.

© 2013 McDermott Will & Emery

Operational and Technical Changes for FACTA Compliance – January 30 – February 1, 2013

The National Law Review is pleased to bring you information about the upcoming Global Financial Markets – Operational and Technical Changes for FACTA Compliance:

key topics

  • Assess the full implications of the finalized FATCA regulation
  • Coordinate an optimal approach to operational, infrastructural and technical changes under FATCA
  • Identify strategies to effectively manage client accounts
  • Integrate existing internal procedures with FATCA compliance
  • Understand what is expected by the IRS

key features

  • Pre-Conference Workshop on January 30, 2013 for an Additional Cost:
  • Pre-Conference Workshop: The Intergovernmental Agreements: Changing the Face of International Tax lead by JP&MF Consulting and Mopsick Tax Law LLP

event focus

FATCA is amongst the biggest topics of debate in financial institutions across the globe. The effect that it will have on these institutions cannot be underestimated and its operational impact on the existing systems is set to be both time consuming and costly. The ability to successfully align all key stakeholders, including operations, technology, risk, legal and tax, will determine the ultimate cost of FATCA compliance. Moving on from mere interpretive matters, this GFMI conference will not only address key FATCA requirements but also discuss the practical impacts of IGAs and strategies for achieving operational and infrastructural efficiency.

The Operational and Technical Changes for FATCA Compliance Conference will be a two and half day, industry focused event, specific to Senior Executives working in Banks, Insurance and Asset Management Companies. Attendees will address key FATCA requirements, while discussing the practical implications of IGAs and strategies for achieving operational and infrastructural efficiency.

Key Themes of the Operational and Technical Changes for FATCA Compliance Conference Include:

1. Challenges of FATCA regulations and prospects for the final regulation

2. Achieving operational and infrastructural efficiency

3. Coordinating existing AML/KYC procedures with FATCA compliance

4. FATCA from the FFI’s perspective 5. Beyond banking: the challenges of FATCA implementation

6. Coping with the withholding obligation under FATCA

This is not a trade show; our conference series is targeted at a focused group of senior level executives to maintain an intimate atmosphere for the delegates and speakers. Since we are not a vendor driven conference, the higher level focus allows delegates to network with their industry peers.

Operational and Technical Changes for FACTA Compliance – January 30 – February 1, 2013

The National Law Review is pleased to bring you information about the upcoming Global Financial Markets – Operational and Technical Changes for FACTA Compliance:

key topics

  • Assess the full implications of the finalized FATCA regulation
  • Coordinate an optimal approach to operational, infrastructural and technical changes under FATCA
  • Identify strategies to effectively manage client accounts
  • Integrate existing internal procedures with FATCA compliance
  • Understand what is expected by the IRS

key features

  • Pre-Conference Workshop on January 30, 2013 for an Additional Cost:
  • Pre-Conference Workshop: The Intergovernmental Agreements: Changing the Face of International Tax lead by JP&MF Consulting and Mopsick Tax Law LLP

event focus

FATCA is amongst the biggest topics of debate in financial institutions across the globe. The effect that it will have on these institutions cannot be underestimated and its operational impact on the existing systems is set to be both time consuming and costly. The ability to successfully align all key stakeholders, including operations, technology, risk, legal and tax, will determine the ultimate cost of FATCA compliance. Moving on from mere interpretive matters, this GFMI conference will not only address key FATCA requirements but also discuss the practical impacts of IGAs and strategies for achieving operational and infrastructural efficiency.

The Operational and Technical Changes for FATCA Compliance Conference will be a two and half day, industry focused event, specific to Senior Executives working in Banks, Insurance and Asset Management Companies. Attendees will address key FATCA requirements, while discussing the practical implications of IGAs and strategies for achieving operational and infrastructural efficiency.

Key Themes of the Operational and Technical Changes for FATCA Compliance Conference Include:

1. Challenges of FATCA regulations and prospects for the final regulation

2. Achieving operational and infrastructural efficiency

3. Coordinating existing AML/KYC procedures with FATCA compliance

4. FATCA from the FFI’s perspective 5. Beyond banking: the challenges of FATCA implementation

6. Coping with the withholding obligation under FATCA

This is not a trade show; our conference series is targeted at a focused group of senior level executives to maintain an intimate atmosphere for the delegates and speakers. Since we are not a vendor driven conference, the higher level focus allows delegates to network with their industry peers.

A Brief Explanation of the American Taxpayer Relief Act of 2012

The National Law Review recently published an article by Joseph W. Zitzka Jr. and Amanda Wilson of Lowndes, Drosdick, Doster, Kantor & Reed, P.A. regarding The American Taxpayer Relief Act of 2012:

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In the past few weeks, attention has focused on Washington and how the politicians would deal with the tax component of the so-called fiscal cliff (the tax increases that would automatically go into effect on January 1).  On January 1, 2013 Congress passed the American Taxpayer Relief Act of 2012 (the “Act”), and President Obama signed the Act into law on January 2.  Politicians have stated that the Act was designed to keep America from going over the fiscal cliff.  But what does that mean?  As explained below, the Act did reduce the number of tax increases that would go into effect, but unfortunately, many other tax increases still went into effect.

What Did the Act Address?

The main component of the looming tax increases was the expiration of the tax cuts introduced under President Bush.  The rates for all federal ordinary income tax brackets were set to return to 2003 rates, which would increase the tax rates across all brackets (generally, by 3 to 5%).  The Act changed this result, keeping the Bush era tax rates in place for all taxpayers except for those over a certain high-income threshold.  This threshold (the “Act Threshold”) is $450,000 for joint filers, $400,000 for single filers, and $225,000 for married taxpayers filing separately.  Taxpayers with income over the Act Threshold will be subject to tax at a maximum rate of 39.6%.

Additionally, the Bush tax cuts generally lowered the tax rate on capital gains to 15% and provided that qualified dividends would be taxed at a preferential 15% rate (instead of at ordinary income rates).  On January 1, capital gains rates were set to increase to 20% and dividends were set to be taxed at ordinary income rates.  The Act stopped these increases for taxpayers below the Act Threshold.  For taxpayers with income over the Act Threshold, capital gains and dividends will generally be taxed at an increased rate of 20% (which, for dividends, is better than the anticipated increase to ordinary income rates).

The Act has also increased tax liability for higher income taxpayers by reimplementing exemption and deduction phaseouts.  The threshold amount for these phaseouts (“Phaseout Threshold”) is $300,000 for joint filers, $250,000 for single filers, and $150,000 for married taxpayers filing separately.  Taxpayers with adjusted gross income above the Phaseout Threshold will be limited in the personal exemptions that they can claim, as their personal exemption amount will be reduced by 2% for each $2,500 by which the taxpayer’s adjusted gross income exceeds the applicable Phaseout Threshold.  In addition, these same taxpayers will be limited in the amount of itemized deductions that they can claim.  The amount of itemized deductions that can be deducted will be reduced by 3% of the amount by which the taxpayer’s adjusted gross income exceeds the Phaseout Threshold (subject to a limitation that the reduction shall not exceed 80% of the allowable itemized deductions).

The Act also addressed the looming threat that the alternative minimum tax (AMT) will impact more taxpayers.  The Act retroactively increased AMT exemption amounts to reduce the number of taxpayers that will be subject to AMT.

The Act extended the availability of 50% first-year bonus depreciation, and increased the expensing limitation for depreciable property for 2012 and 2013.  In 2012, the expensing limitation was $139,000 (with a phaseout threshold of $560,000), and this amount was set to be reduced dramatically in 2013.  The Act increased the expensing amount for 2012 (retroactively) and 2013 to $500,000 (with a phaseout threshold of $2 million).

Finally, the Act addressed the impending tax increase in the estate, gift, and generation-skipping transfer area.  Absent legislation, the maximum tax rate was set to increase from 35% to 55%, with the exemption amount decreasing from $5 million (actually, $5.12 million as the exemption is adjusted for inflation) to $1 million.  The Act makes the $5 million exemption (adjusted for inflation) permanent and provides for a maximum tax rate of 40%.

What Did the Act Not Address?

Several upcoming tax increases were not addressed by the Act.  The expiring tax holiday for payroll taxes was not address, meaning that the reduced 4.2% tax rate for the employees’ portion of the Social Security payroll tax has expired and the rate has returned to 6.2%. This will be a 2% tax rate increase that employees will immediately see on their paychecks.

In addition, the new 3.8% tax (referred to as the Unearned Income Medicare Contribution) on investment income will apply to most joint filers with adjusted gross income above $250,000 and single filers with adjusted gross income above $200,000.  The tax is essentially a flat tax at a 3.8% rate on investment income above the $250,000/$200,000 threshold.  The tax applies to the following:  dividends; rents; royalties; interest, except municipal-bond interest; short and long-term capital gains; the taxable portion of annuity payments; income from the sale of a principal home above the $250,000/$500,000 exclusion; a net gain from the sale of a second home; and passive income from real estate and investments in which a taxpayer does not materially participate.  Although the tax applies only to investment income above the threshold, other income (including wages or Social Security) can increase a taxpayer’s adjusted gross income above the threshold, exposing the taxpayer to this tax.

Finally, the Medicare tax rate will increase by .9 percent (from 1.45 percent to 2.35 percent) on wages for certain employees (i.e., those with wages over $200,000 for single filers, wages over $250,000 for joint filers, and wages over $125,000 for persons who are married but filing separately).

In short, the Act did prevent many tax increases from going into effect, but it was only a partial fix.  Many other provisions were allowed to go into effect, with the result that many taxpayers will face greater tax liability.

“Notice Under U.S. Treasury Department Circular 230:  To the extent that this e-mail communication and the attachment(s) hereto, if any, may contain written advice concerning or relating to a Federal (U.S.) tax issue, United States Treasury Department Regulations (Circular 230) require that we (and we do hereby) advise and disclose to you that, unless we expressly state otherwise in writing, such tax advice is not written or intended to be used, and cannot be used by you (the addressee), or other person(s), for purposes of (1) avoiding penalties imposed under the United States Internal Revenue Code or (2) promoting, marketing or recommending to any other person(s) the (or any of the) transaction(s) or matter(s) addressed, discussed or referenced herein.  Each taxpayer should seek advice from an independent tax advisor with respect to any Federal tax issue(s), transaction(s) or matter(s) addressed, discussed or referenced herein based upon his, her or its particular circumstances.”

© Lowndes, Drosdick, Doster, Kantor & Reed, PA

The Fiscal Cliff Legislation: An Executive Summary of What You Need to Know

The National Law Review recently published an article, The Fiscal Cliff Legislation: An Executive Summary of What You Need to Know, written by Michael L. Pate and Elizabeth L. McGinley of Bracewell & Giuliani LLP:

Bracewell & Giuliani Logo

 

As everyone knows, the American Taxpayer Relief Act of 2012 (aka, the “Fiscal Cliff Deal”) was passed by the U.S. House of Representatives late in the evening on January 1, 2013. The legislation includes provisions related to tax relief, business tax extenders, energy tax extenders, and the federal budget, among other issues.

To help you navigate this legislation, we have prepared documents featuring concise information on these provisions:

  1. A Summary of the Provisions in the American Taxpayer Relief Act of 2012
  2. The Fiscal Cliff Deal: What’s Included, What Isn’t, and What’s Next
  3. Estimated Revenue Effects of the American Taxpayer Relief Act of 2012

© 2012 Bracewell & Giuliani LLP