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What’s Abuse for Retroactive TCJA Regs: Clues From Carried Interest

Posted on July 22, 2019
Benjamin M. Willis
Benjamin M. Willis

Benjamin M. Willis (@willisweighsin on Twitter; ben.willis@taxanalysts.org) is a contributing editor for Tax Notes Federal. He formerly worked in the mergers and acquisitions and international tax groups at PwC, and then with the Treasury Office of Tax Policy, the IRS, and the Senate Finance Committee. Before joining Tax Analysts, he was the corporate tax leader in the national office of BDO USA LLP.

In this article, Willis considers statutory abuse under the Tax Cuts and Jobs Act, arguing that regulations issued more than 18 months since the TCJA’s enactment must meet a high threshold to comport with U.S. limits on ex post facto rules.

Treasury had until June 22 to issue retroactive Tax Cuts and Jobs Act regulations. The IRS has threatened to impose regulations that would be retroactive beyond the 18-month period for legislative enactments. To do that, the IRS must show that retroactive regulations would prevent the type of abuse that the TCJA was designed to prevent. It’s a high hurdle, considering the laws and constitutional limitations designed to protect taxpayers from ex post facto laws.

Recent Threats of Retroactive Regulations

Treasury recently issued retroactive regulations for TCJA provisions despite related historic judicial defeats explained below. In fact, the government informally and officially stated that it may use section 7805(b)(3) to retroactively prevent abuse of TCJA provisions through additional regulations. It has already done so in multiple regulation packages and public statements, including the proposed qualified opportunity investment fund regulations (REG-120186-18) and regulations on the 20 percent section 199A passthrough deduction (REG-107892-18).

On June 18, the IRS published final regulations (T.D. 9868) on the TCJA’s expansion of the class of permissible potential current beneficiaries of an electing small business trust (ESBT) to include nonresident aliens. Citing section 7805(b)(3), that regulation package provides: “to prevent abuse of sections 641 and 1361, and the final regulations thereunder, the final regulations apply to all ESBTs after December 31, 2017.” The final and proposed regulations don’t explain any abuses that the new statutory provisions target; rather, the proposed ESBT regulations (REG-117062-18) cite the TCJA Senate amendment, which states that “the Committee believes that allowing a nonresident alien individual to be a potential current beneficiary of an ESBT presents little risk of tax avoidance.” That presumably fails to support retroactive regulations under section 7805(b)(3) and thus why Treasury published the regulation before the June 22 cutoff date.

Less than a month ago, Stephen Tackney, deputy associate chief counsel (employee benefits), said section 7805 allows for retroactive regulations in some instances of abuse but the determination is “a little premature because firm conclusions haven’t been made to know whether we’ll need those in any particular instance.”1 The IRS has lost in retroactive regulation cases under section 7805(b)(3) based on the formidable threshold of proving a congressionally unintended abuse and the protections afforded to Americans against newly created laws penalizing past actions.

Section 7805’s Regulatory Authority, Limitations

Section 7805 is generally known as the code section that authorizes interpretive regulations. It can be contrasted with legislative regulations based on specific statutory grants of regulatory authority “to implement, complete, or make operative particular legislative provisions.”2 After the general grant of authority in subsection (a), section 7805(b) lays out the rules limiting retroactive regulations.

The general rule for retroactive guidance is that no temporary, proposed, or final regulation shall be applicable before the earliest of: the date the regulation is filed in the Federal Register; for final regulations relating to proposed or temporary regulations, the date the proposed or temporary regulation was filed in the Federal Register; or the date on which any notice substantially describing the contents of forthcoming regulations is issued. In short, the general rule prevents retroactive regulations and notices describing them.

While the Revenue Act of 1921 originally enacted3 the predecessor to section 7805, the provision was amended by the Revenue Act of 1934 to expand that application to rulings. Legislative history describing the predecessor to section 7805 explains that retroactive rules applicable “to past transactions which have been closed by taxpayers in reliance upon existing practice, will work such inequitable results that it is believed desirable to lodge in the Treasury Department the power to avoid these results by applying certain regulations, Treasury decisions, and rulings with prospective effect only.”4 Given that declaration, exceptions to the general rule are limited in scope.

Section 7805(b)(2) provides an exception for promptly issued regulations and notices, which are filed or issued within 18 months of the date of the enactment of the statutory provision to which the regulation or notice relates. The importance of this exception is clear based on the flood of guidance published before June 22.

Retroactivity for Abuse

The Taxpayer Bill of Rights 2, P.L. 104-168, was enacted in 1996 to prevent Treasury and IRS abuses regarding retroactive rulemaking. Section 7805(b)(3) is a limited exception that authorizes regulations as follows: “The Secretary may provide that any regulation may take effect or apply retroactively to prevent abuse.” This provision recognizes that a taxpayer’s expectations can be outweighed by its abusive violations of clear congressional intent expressed through the IRC’s newly enacted provisions.

Congress explained in its House Report that “the bill provides that temporary and proposed regulations must have an effective date no earlier than the date of publication in the Federal Register or the date on which any notice substantially describing the expected contents of such regulation is issued to the public. Any regulations filed or issued within 18 months of the enactment of the statutory provision to which the regulation relates may be issued with retroactive effect. This general prohibition on retroactive regulations may be superseded by a legislative grant authorizing the Treasury to prescribe the effective date with respect to a statutory provision. The Treasury may issue retroactive temporary or proposed regulations to prevent abuse.”5

A Joint Committee on Taxation report6 clarified section 7805(b)(3) by explaining circumstances in which “Treasury would have been permitted to issue retroactive temporary or proposed regulations to prevent abuse of the statute.” In 1996 pre-TBOR testimony before the House Ways and Means Committee, Bennie L. Thayer of the National Association for the Self-Employed explained that the new limitations on retroactive regulations “should prove to be very positive, pro-taxpayer initiatives.”7 The new restrictions on retroactivity support a taxpayer’s right to be informed, to know what they need to do to comply with tax laws without a crystal ball for seeing the future.

More broadly, Black’s Law Dictionary defines abuse as “a departure from legal or reasonable use; misuse.” Merriam-Webster’s dictionary defines abuse as “a corrupt practice or custom.” But most importantly, the courts agree that regulations designed to prevent statutory abuse must target taxpayers clearly departing from a statute as written.

For example, Sala8 involved a form of the son-of-BOSS transaction and addresses section 752 regulations (68 F.R. 37434) issued on June 24, 2003, and the validity of their retroactivity to liabilities assumed after October 18, 1999.

In 2000 Sala decided to invest $9 million in a foreign currency investment program. Between November 20 and 27, 2000, Sala bought 24 foreign currency options, 12 short options, and 12 offsetting long options, for a net cost of $728,297. Sala contributed the long and short options to an S corporation, which contributed the options to GP, a general partnership. The S corporation took a basis in its GP interest equal to the cash contributed plus its basis in the long options but did not adjust its basis in its partnership interest for the assumption of the short options under section 752.

Less than a month later, GP liquidated, distributing cash and two foreign currency contracts to the S corporation. The S corporation took a basis in the distributed property equal to its basis in GP. Because the partner’s basis did not account for the assumption of the short option, its basis in GP far exceeded the value of the property received. In other words, the short option reduced value but not basis. The property received on liquidation was disposed of and resulted in a $60 million tax loss.

The court addressed the validity of the regulation regarding its retroactivity under section 7805(b)(3). The court implicitly adopted the view that the option obligation was not a section 752 liability because the court treated the option obligation as a contingent liability under section 358(h). It held that reg. section 1.752-6T was invalid because there was no evidence that Congress intended to focus on partnership transactions in enacting section 358(h) in the Community Renewal Tax Relief Act of 2000. The court believed that only transfers by corporations to partnerships were intended to be covered.9

The court stated that a “regulation that conflicts with the underlying statute is invalid, even if cast as an antiabuse regulation.” The court went on to hold that: “Accordingly, I hold 26 C.F.R. section 1.752-6 to be unlawful and set it aside. Even if 26 C.F.R. section 1.752-6 was properly issued, that is, even if the regulation was not contrary to the underlying statutes, the Treasury would still lack the authority to make the regulation retroactive under the antiabuse provision of 26 U.S.C. section 7805(b)(3). Without retroactive application, 26 C.F.R. section 1.752-6 being issued many years after Sala entered into the Deerhurst Program has no bearing on this case.”

In Stobie Creek,10 which also addressed the retroactivity of reg. section 1.752-6, the court explained:

“Abuse” is not defined in I.R.C. section 7805. However, it would be an incongruous result to defer to Treasury’s determination that a particular regulation must apply retroactively in order to prevent abuse, when Congress saw fit to decree the end of one named abuse on a retroactive basis (acceleration and duplication of losses), but not all potential abuses related to transfers of partnership assets. Because Treasury Regulation section 1.752-6 exceeds the congressional mandate to address transactions that accelerate and duplicate losses, this broad “abuse prevention” authority cannot serve as an alternate ground for validating retroactive application.

In short, the abuse targeted by section 7805(b)(3) must be clear from the statute, and any regulation that isn’t consistent with the statute will likely be invalidated.11

Congress and the states are prohibited from passing retroactive laws under the Constitution’s ex post facto clause. While generally viewed as applicable in the criminal setting, it could also apply to civil violations.

In describing the limitation on retroactive laws, Thomas Jefferson explained, “The sentiment that ex post facto laws are against natural right is so strong in the United States, that few, if any, of the State constitutions have failed to proscribe them. The federal constitution indeed interdicts them in criminal cases only; but they are equally unjust in civil as in criminal cases, and the omission of a caution which would have been right, does not justify the doing what is wrong.”12

Carried Interest Abuse?

For purposes of the TCJA’s new carried interest holding period, section 1061(c)(4) provides that the term “applicable partnership interest” excludes any interest in a partnership directly or indirectly held by a corporation. Under Notice 2018-18, 2018-12 IRB 443, released March 1, 2018, the coming IRS regulations, effective for tax years beginning after December 31, 2017, will provide that the term “corporation” doesn’t include an S corporation. Many believe this notice violates the plain wording of the statute and will result in another IRS loss if litigated.13

Notice 2018-18 states that “section 1061(c)(4)(A) provides that the term ‘applicable partnership interest’ shall not include any interest in a partnership directly or indirectly held by a corporation. . . . The regulations will provide that the term corporation in section 1061(c)(4)(A) does not include an S corporation. . . . The Treasury Department and the IRS intend to provide that regulations implementing section 3 of this notice will be effective for taxable years beginning after December 31, 2017.”

Given section 7805(b)(1)(C)’s broad language for notices substantially describing the expected contents, the IRS did indeed substantially describe coming regulations that could be retroactive to the date the notice was issued. Notice 2018-18 described regulations treating an applicable partnership interest held by an S corporation as one not held by a corporation for purposes of section 1061(c)(4)(A). But does the IRS have the authority to alter the plain language of the statute? The definition of a corporation in the code is clear and includes an S corporation. The default rules for both C and S corporations, per section 1371(a), are found in subchapter C.14

The clock is ticking for retroactivity back to March 1, 2018, absent a finding of abuse based on a taxpayer’s reliance on the word corporation. Notice 2018-18 provides that regulations implementing the notice will be effective for tax years beginning after December 31, 2017. There is no authority cited for that retroactivity, and the IRS has already missed the cutoff for regulations that are effective upon enactment of the TCJA.

Further, Treasury itself has recently described its policy against notices not followed by timely issued regulations. Treasury’s March 5 policy statement on the tax regulatory process limits the use of notices forecasting regulations to 18 months to eliminate taxpayer confusion.15 While there is some uncertainty regarding the weight accorded to the policy statement, a similar issue was addressed by the Seventh Circuit when an informal IRS publication assured taxpayers of effective date limitations.

In Gehl,16 the court examined an informal IRS handbook publication on domestic international sales corporation rules. The handbook provided that “modifications which may be adverse to taxpayers will apply prospectively only,” and the court concluded in “view of this promise, we agree with the Second Circuit that the Commissioner abused his discretion in giving retroactive effect to Treasury Regulation section 1.993-2(d)(2).” The court explained that the “special statement on retroactivity contained in the handbook differentiates it from the standard Treasury publication. This is more than an interpretation of existing law; it is an express promise that the Commissioner will not in the future exercise his discretion to apply adverse changes retroactively.”

It appears that the IRS may have missed its window of opportunity for section 7805(b)(2) retroactive regulations that would relate back to the enactment of the TCJA. Because the statute is clear, an argument for abuse is unlikely to have merit. Therefore, the only avenue that may remain for retroactivity may be via the date of the issuance of the notice based on section 7805(b)(1), which focuses on the date the notice forecasting regulations was issued. Courts have concluded that applying guidance before a proper notice is an abuse of discretion under section 7805.17

Based on the recent references to section 7805(b)(3), it appears Treasury and the IRS have clearly contemplated retroactive regulations permitted for preventing statutory abuses. It’s unclear, however, that they appreciate the TBOR and other policies against ex post facto laws. Even if a legitimate abuse violating the statute was included in future retroactive regulations, the government cannot simply include the rules described in Notice 2018-18 in otherwise valid regulations. Doing so would indicate to courts that Treasury and the IRS aren’t respecting the statute or exercising sound judgment with respect to congressionally imposed limitations on retroactive revenue rules. Adding to taxpayer confusion based on overly broad interpretations of abuse in order to support retroactive regulations also goes against Treasury’s promises to taxpayers in its policy statement and violates the president’s executive orders prohibiting unduly burdensome and costly regulations. If Treasury believes the TCJA has failed in some respect, as indicated by not withdrawing the section 385 regulations yet, it should think twice before attempting to rewrite the law in defiance of the legislative and judicial branches of government.

FOOTNOTES

1 See Stephanie Cummings, “Will Executives’ TCJA Tax Baggage Lead to Early Ousters?Tax Notes Federal, June 24, 2019, p. 2040.

2 See APA June 1945 House hearings discussed in Donald L. Korb et al., “Is Treasury’s Policy Statement on the Regulatory Process Pro-Taxpayer?Tax Notes, Apr. 22, 2019, p. 565.

3 Section 1314 of the Revenue Act of 1921 provided:

That in case a regulation or Treasury decision relating to the internal-revenue laws made by the Commissioner or the Secretary, or by the Commissioner with the approval of the Secretary, is reversed by a subsequent regulation or Treasury decision, and such reversal is not immediately occasioned or required by a decision of a court of competent jurisdiction, such subsequent regulation or Treasury decision may, in the discretion of the Commissioner, with the approval of the Secretary, be applied without retroactive effect.

4 H.R. Rep. No. 73-704, pt. 2, at 554 (1934).

5 H.R. Rep. No. 104-506 (1996).

6 Joint Committee on Taxation, “Background and Information Relating to the Taxpayer Bill of Rights,” JCX-15-95 (Mar. 21, 1995).

7 1996 WL 205524.

8 Sala v. United States, 552 F. Supp. 2d 1167 (D. Colo. 2008), rev’d, 613 F.3d 1249 (10th Cir. 2010).

9 See also Murfam Farms LLC v. United States, 88 Fed. Cl. 516, 527 (2009) (“the basis rule in section 358(h) only applies to liabilities that are assumed in exchanges between a corporation and its shareholders, and the 2000 Tax Act did not direct a corresponding change to the basis rules in the partnership context as found in section 752”).

10 Stobie Creek Investments LLC v. United States, 82 Fed. Cl. 636, 671 (2008), aff’d, 608 F.3d 1366 (Fed. Cir. 2010).

11 See, e.g., Klamath Strategic Investment Fund LLC ex rel St. Croix Ventures LLC v. United States, 440 F. Supp. 2d 608, 623 (E.D. Tex. 2006) (concluding that “‘the Internal Revenue Service does not have carte blanche’ authority to issue retroactive regulations”).

12 Thomas Jefferson, Letter to Isaac McPherson Monticello, Aug. 13, 1813.

13 Emily L. Foster, “Treasury Assumes Authority to End Carried Interest Debate,” Tax Notes, Mar. 12, 2018, p. 1425.

14 See also Trugman v. Commissioner, 138 T.C. 390 (2012), in which the Tax Court held that an S corporation that owned a residence occupied by its two shareholders was not entitled to claim the first-time homebuyer credit under section 36 because it is a corporation. The relevant statute defines a first-time homebuyer as “any individual if such individual . . . had no present ownership interest in a principal residence during the 3-year period ending on the date of the purchase of the principal residence.” In support of its conclusion the court explained: “We hold that S corporations are not individuals for purposes of section 36. A corporation, at its core, is a business entity organized under State or Federal law, whether an association, a company, or another recognized form. See sec. 301.7701-2(b), Proced. & Admin. Regs. A corporation that satisfies certain criteria may elect small business status for Federal income tax purposes. Sec. 1361. An S election does not alter the corporation’s corporate status; it merely alters the corporation’s Federal tax implications.”

15 Treasury’s policy statement provides that “failure to promulgate regulations previewed in notices on a timely basis can cause confusion or uncertainty for taxpayers. To limit the uncertainty that these situations may create, the Treasury Department and the IRS will include a statement in each future notice of intent to issue proposed regulations stating that if no proposed regulations or other guidance is released within 18 months after the date the notice is published, taxpayers may continue to rely on the notice but, until additional guidance is issued, the Treasury Department and the IRS will not assert a position adverse to the taxpayer based in whole or in part on the notice.”

16 Gehl Co. v. Commissioner, 795 F.2d 1324 (7th Cir. 1986).

17 See, e.g., Klamath, 440 F. Supp. 2d at 625 (“All of the conduct complained of in this litigation occurred before Notice 2000-44 was published or issued. Taxpayers, including the Plaintiffs, were entitled to rely on the well-established position of the Service for the past 25 years in the 752 Cases. See Snap-Drape, 98 F.3d at 202; Anderson, Clayton & Co., 562 F.2d at 981. The decision to retroactively apply a regulatory change that is in conflict with this long line of cases without any prior notice is therefore an abuse of discretion.”).

END FOOTNOTES

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