Insuring the accuracy of corporate and partnership US income tax returns
January 2022 | TALKINGPOINT | CORPORATE TAX
Financier Worldwide Magazine
January 2022 Issue
FW discusses insuring US tax returns with David S. De Berry at Concord Specialty Risk.
FW: Could you provide an overview of the latest trends in US corporate and partnership income tax law? How is this income tax being administered and enforced, and what has been the impact on companies and partnerships?
De Berry: The US federal tax law and its administration is guided more by legal and fiscal developments than by trends. However, tax legislation and Internal Revenue Service (IRS) funding are often the end result of political trends and shifting schools of thought concerning economics, fiscal policy and social goals. The current trend seems to be the so-called ‘progressive’ thought that our tax system favours billionaires and corporations and that such favouritism is undemocratic, bad for our economy and dangerous for American society. The thinking seems to be that the vast majority of US corporate stock is owned by the wealthiest 10 percent of Americans and by non-US persons and that such persons should not benefit from lower corporate tax rates. President Biden initially proposed a ‘Build Back Better’ agenda that would increase the US corporate tax rate to 28 percent, impose a 15 percent minimum tax on companies’ global book income and double the minimum tax imposed on earnings by foreign subsidiaries owned by US companies. The House Ways and Means Committee initially proposed a budget that would increase the corporate tax rate to 26.5 percent and would adopt most of Biden’s Build Back Better tax agenda. On 4 November 2021, the Joint Committee on Taxation published its ‘Estimated Budget Effects of the Revenue Provisions of Title XIII – Committee on Ways and Means’ – the Build Back Better Act. The report estimates revenues to fund the expenditures contemplated under the Act by a number of corporate and international tax reforms. These reforms include revisions to the corporate alternative minimum tax, an excise tax on the repurchase of corporate stock, additional limitations on deduction for interest expense, a host of changes for ‘outbound’ international transfers, modifications to the base erosion and anti-abuse tax, and other business tax provisions. We expect further complexity to be added to our tax laws as time proceeds. The draft legislation was modified on 4 November 2021 and on 19 November 2021 was passed by the House of Representatives. At the time of writing, the US Senate has differing legislation pending. Meanwhile, the US economy has seen significant growth in the use of pass-through businesses, such as S corporations and partnerships, that generally incur no entity-level tax. There have been significant developments with respect to partnerships. For tax years beginning after 1 January 2018, however, partnership tax returns can be audited at the partnership level and a tax can be imposed on the partnership, who would then elect to collect the tax – plus interest and penalties – from either its current partners or from the partners that were members during the tax year of the adjusted tax return. The tax assessed against the partnership is calculated at the highest federal income tax rate in effect for the reviewed year. A partnership is eligible to opt out of the revised audit regime if it has 100 or fewer partners and no partner is a partnership, trust or disregarded entity. The Biden administration has thus far championed adding more resources to the IRS. President Biden has proposed increasing the IRS budget by $80bn over the next 10 years. Currently, the large business & international division of the IRS is conducting 53 active campaigns.
FW: How would you gauge the general accuracy of corporate and partnership US income tax returns? What inherent risks do these entities need to consider when completing and filing their returns?
De Berry: According to the ‘IRS Data Book 2020’, corporate tax returns for tax year 2015 – the most recent year that is, unless extended by consent of the taxpayer or by statutory exception, closed to adjustment and for which figures are available – have a broad range of recommended adjustments based upon the amount of assets carried on their balance sheets. Firstly, the number of returns for corporations with assets between $10m-$50m that resulted in an adjustment was 938 out of 1782 closed, or 52.6 percent of examined tax returns. The IRS proposed additional taxes, exclusive of interest and penalties, with respect to those 938 tax returns in an aggregate amount of approximately $127m, $135,394 per tax return. Secondly, on the other end of the spectrum, the number of returns for corporations with assets over $20bn that resulted in an adjustment was 85 out of 122 closed, or 69.7 percent of examined tax returns. The IRS proposed additional taxes, exclusive of interest and penalties, with respect to those 85 tax returns in an aggregate amount of approximately $1.2bn – $14,117,647 per return. This demonstrates that if a corporate tax return for a corporation with more than $10m in assets is examined, an adjustment is more likely than not, and the range of additional taxes, exclusive of interest and penalties, is between $135,000 to $14m. Interest will likely be an additional 25 percent of the tax liability and penalties can be an additional 20 to 40 percent – the latter applicable for gross misstatements of value. These results actually make sense in light of the complexity of our tax system. There are numerous instances in which a tax position is legitimate but uncertain and therefore subject to challenge or when the calculation of gain can only be estimated but tax law requires accuracy. For example, when a US entity buys, sells, provides, receives, borrows or licenses products, services, money or intellectual property (IP) from or to a parent or affiliate that is not subject to US taxes, there is generally an issue of transfer pricing (TP), meaning, was the transfer of goods or services exchanged or paid for pursuant to ‘arms-length’ terms? It is often the case that the transfer between or among affiliates involves components or services or IP that would never be sold to an unrelated party. As a result, there is built-in uncertainty as to whether the terms will be challenged by a taxing authority. Another common example is when a corporation distributes a subsidiary to its shareholders, known as a ‘spin-off’. Whether or not the spin-off is tax-free to the corporation depends, in substantial part, on satisfaction of subjective requirements concerning the corporate purpose for the ‘spin-off’. Yet, a subjective test inherently spawns uncertainty, as there is often some email suggesting a reason or purpose for the spin-off that differs from the purported reason that would satisfy the corporate business purpose required under tax law. Alternatively, if the spin-off is reported as taxable, the gain will be determined, in part, by the value of the spun-off subsidiary. Valuations of businesses are inherently subjective and involve assumptions and estimates.
“The budget deficit and current political climate adds to the sense that taxing authorities are likely to be more aggressive.”
FW: What penalties can the Internal Revenue Service (IRS) impose on entities that fail to follow the code when reporting and paying US income taxes?
De Berry: The most frequently imposed penalty is based on Section 6662 of the IRS Code of 1986, which imposes an accuracy-related penalty equal to 20 percent of any underpayment of federal tax resulting from certain specified taxpayer behaviours, such as negligence, disregard of rules or regulations, substantial understatement of income tax, non-economic substance transactions and certain valuation misstatements. Currently, as set forth in the IRS Manual, IRS procedures direct examining agents to assert the Section 6662 penalty whenever a corporate taxpayer understates its tax liability. There are, however, defences to the penalty. The penalty is increased to 40 percent for either a gross valuation misstatement or a non-disclosed non-economic substance transaction. Code Section 6662 actually imposes an “addition to tax”. This allows the “penalty” to be assessed in the same manner as the assessment of additional taxes. Most importantly, it allows the IRS’s assessment to be subject to the presumption of correctness. In addition, because the Code Section 6662 penalty is an addition to tax, interest accrues on the penalty in the same manner as on the tax itself. Code Section 6662A generally imposes penalties similar to Code Section 6662 but imposes the penalties on understatements attributable to “reportable transactions”. Essentially, a reportable transaction is generally a transaction that the IRS has declared potentially abusive or otherwise meets the criteria of Code Section 6707A(c). Generally, the Code Section 6662A penalty is an additional 20 percent of the unreported tax and, subject to specified exceptions, is in addition to the penalties imposed under Section 6662. The penalty is increased to 30 percent if the disclosure requirement of Code Section 6664(d)(2)(A) is not met.
FW: With the US tax system based on the principle of self-assessment and voluntary reporting, what steps can corporate taxpayers take to safeguard the veracity of their returns?
De Berry: More than a decade ago, Douglas Shulman, the then IRS commissioner, answered this question in the wake of a new and unprecedented tax form – Schedule UTP – which would require corporations to self-disclose their uncertain tax positions to the IRS. In 2009, Mr Shulman addressed the National Association of Corporate Directors Conference. He emphasised the importance of involving boards of directors in overseeing corporate tax risks and strategies and recommended that corporations do the following. First, establish a threshold confidence level required for a tax position and review major tax positions. Second, engage an independent tax firm that will directly dialogue with the board of directors. Third, specifically address transfer pricing and the relative profit allocated to low-tax jurisdictions, and make sure they reflect real economic contributions made in those jurisdictions. Fourth, inquire of the corporate tax director and external auditors about their process for identifying uncertain tax positions, quantifying their exposure, and calibrating the risk. Finally, ensure that boards know how their management has chosen to control the tax expense and be able to assess the degree of aggressiveness in their tax positions. It is a part of their financial stewardship, but beyond the monetary loss from a large tax assessment is potential reputational harm.
FW: What role can tax return insurance play in helping corporates and partnerships to manage the risks arising from the complexities of US tax law, and improving tax compliance? How does it function?
De Berry: Tax return insurance for businesses provides three significant advantages. First, during the underwriting of the submission, tax positions are clarified, re-evaluated and supported by the gathering of evidence and by the implementation of loss-mitigation techniques, designed to further demonstrate adherence to the Code. Second, in the event of an IRS audit, the tax insurer may serve as additional tax counsel to support the team of professionals and internal management of the insured taxpayer. Finally, in the event that the IRS succeeds in adjusting the insured tax return, the insurance, depending on the policy terms, may pay cash to the full amount of insured loss – thus potentially preventing derivative suits, securities class actions suits and, just as importantly, allowing the insured taxpayer to mitigate reputational harm by claiming that its tax position, although successfully challenged, was not an attempt to evade taxes and was thoroughly vetted and even insured.
FW: What advice would you offer to corporates and partnerships that may be considering tax return insurance? How should they go about evaluating policies, coverage, terms and pricing, for example?
De Berry: The appropriate advice is largely going to depend on the particular facts and circumstances of each insured and their risk. Generally speaking, it is beneficial for the tax return insurance policy to reflect a complete understanding of the taxpayer’s financial accounting methods and processes and how its tax accounting methods differ from its financial accounting methods. Premiums must be both fair and adequate. It can be beneficial for the policy period to be co-extensive with the risk of audit and for retentions to be reasonable.
FW: Looking ahead, do you expect to see an uptick in appetite for tax return insurance? In your opinion, is tax return insurance good for the US economy?
De Berry: We expect an uptick in submissions for tax return insurance by businesses. The coronavirus (COVID-19) pandemic has demonstrated that risk and uncertainty are real dangers. The budget deficit and current political climate adds to the sense that taxing authorities are likely to be more aggressive. Legitimate positions need to be defended and resolved fairly. Tax insurance cultivates a culture of compliance. The IRS cannot issue private letter rulings on every uncertain tax position and tax insurance serves as a badge of approval because, in stark contrast to a promoter, or even the issuer of a tax opinion, the insurer ‘puts its money where its mouth is’. If the insurers are too often wrong, they will be out of business. If the insurers are right, then they are an ally if not an adjunct to the fair and efficient administration of our tax regime. The Department of the Treasury has now amended its regulation and issued guidance, such as Rev. Proc. 2014-12, which suggests the purchase of tax insurance. Most corporations and partnerships could stand to benefit by tax return insurance by transferring tax risks and thus potentially obtaining easier and cheaper access to capital and better terms for directors and officers insurance.
David S. De Berry is chief executive officer for Concord Specialty Risk, a series of RSG Underwriting Managers, which is a subsidiary of Ryan Specialty Group. Concord Specialty Risk provides underwriting and loss mitigation-evaluation services regarding representations & warranties insurance, tax insurance, litigation insurance, and other contingent liability insurance. Mr De Berry is an attorney, admitted in both New York and New Jersey. He also has a masters in tax law (LLM, from New York University). He can be contacted on +1 (212) 784 5678 or by email: david.deberry@concordspecialtyrisk.com.
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