IRS Exam Activity Resumes After July 15, 2020—Are You Ready?

The IRS has issued a new guidance memorandum that normal enforcement procedures will resume after July 15, 2020.  The new guidance effectively ends the temporary suspension of certain exam activity due to COVID-19 that began with the IRS’ People First Initiative announced in March of 2020 and two subsequent interim guidance memoranda.  To prepare for the restart, it’s helpful to consider some of the likely areas of IRS focus. 

Tax Cuts and Jobs Act Implementation Campaign

The IRS’s Large Business and International Division recently initiated a Tax Cuts and Jobs Act (TCJA) campaign to closely monitor TCJA issues and share information learned across the different IRS operating divisions.  The goal of the campaign is to identify transactions, restructuring and technical issues and better understand taxpayer behavior under the new law.  The IRS also plans to use the campaign to identify and develop future issue-based campaigns. Depending upon the issue, the IRS may also consider the impact of the CARES Act. 

TCJA added a substantial number of new provisions to the Internal Revenue Code, effective for the 2017 and/or 2018 tax years.  Based on TCJA Training Materials released by the IRS, it is likely that the qualified business income deduction under IRC Sec. 199A and the interest expense limitation rules under IRC Sec. 163(j) will be two areas of increased IRS focus.   

IRC Sec. 199A Readiness -- IRC Sec. 199A provides owners of sole proprietorships, partnerships, S corporations and some trusts and estates with a deduction of up to 20% of income from a qualified trade or business (QBI deduction). Calculation of the QBI deduction requires an analysis of a complex set of rules. In addition, taxpayers that overstate their QBI deduction are more likely to get hit with a 20% accuracy-related penalty. This is because TCJA imposes a special rule for taxpayers that claim an IRC Sec. 199A deduction, applying a reduced threshold of 5% (instead of 10%) of the tax required to be shown on the original return or $5,000, whichever is greater, in determining whether a substantial understatement of income exists. Therefore, it is critical that taxpayers have appropriate documentation in place to support both their eligibility for the QBI deduction and the amounts claimed on their return.

IRC Sec. 163(j) Readiness -- TCJA added new IRC Sec. 163(j) to limit the amount of interest deduction a business could claim.  Subsequently, the CARES Act revised IRC Sec. 163(j) to temporarily ease the interest expense deduction limitations in light of expectations that taxpayers would require additional debt or initiate modifications to existing debt arrangements due to COVID-19. IRC Sec. 163(j) provides distinct rules for different types of entities.  Final and proposed regulations under IRC Sec. 163(j) are expected to be released in the near future.

Examinations focused on intercompany debt (whether bona fide debt or equity) are not new.  We expect this focus may continue with the enactment of new IRC Sec. 163(j) and the IRS’ ability to limit interest expense deductions.  Taxpayers with significant related party debt should ensure appropriate documentation is in place to report transactions for both tax and financial statement purposes and to minimize the risk that a large interest expense deduction will be disallowed.

Mandatory Repatriation under IRC Sec. 965

The IRS is also focused on IRC Sec. 965 and how it interacts with other international provisions enacted by TCJA.  Under IRC Sec. 965, a U.S. shareholder (as defined) is required to pay a transition tax on any untaxed foreign earnings of certain specified foreign corporations (an “SFC” within the meaning of IRC Sec. 965(e)) as if those earnings had been repatriated to the U.S.  If a domestic pass-through entity is considered a U.S. shareholder of an SFC, the domestic pass-through owners will also be subject to IRC Sec. 965. The goal of the IRS’ campaign is to promote compliance with IRC Sec. 965 and will focus on identifying and addressing taxpayers with potential material compliance risk.  The focus on IRC Sec. 965 is especially noteworthy due to the lengthier six-year statute of limitations on assessments that applies to IRC Sec. 965 liabilities.

IRC Sec. 965 Readiness: IRC Sec. 965 calculations required a plethora of historical tax data which made determinations challenging for many taxpayers. To support compliance with IRC Sec. 965, calculations should be adequately documented and taxpayers should be prepared for the IRS to focus on each of the following: (1) identifying whether a taxpayer is a U.S. shareholder subject to IRC Sec. 965 and whether a foreign corporation is a SFC; (3) verifying correct E&P and tax pool calculations for SFCs; (4) reviewing IRC Sec. 965(c) deduction calculations; (5) reviewing the proper treatment of intercompany transactions treated as disregarded; (6) reviewing IRC Sec. 965 elections; (7) determining whether anti-abuse rules apply; and (8) identifying various  foreign tax credit issues.

Refund Claims and the CARES Act

The IRS expects to see lots of refund claims as a result of the CARES Act which modifies IRC Sec. 172 and allows taxpayers to carry back net operating losses generated in 2018, 2019 or 2020 up to five tax years to fully offset income in those years.  Previously, under TCJA, net operating losses (NOLs) could only be carried forward and were limited to 80% of taxable income. 

A taxpayer claims the benefits of the NOL carryback by filing a tentative refund claim on Form 1139 or Form 1045 or an amended return on Form 1120X or Form 1040X.  The advantage of filing a tentative refund claim is that it is subject to limited IRS review before issuance and refunds are generally issued within 90 days of filing the claim.

NOL Refund Claim Readiness: Because Form 1139 and Form 1045 refund claims are tentative, the IRS may exam and adjust the loss year return at a later date to determine the proper amount of NOL available for carryback. Therefore, taxpayers could have to repay some or all of the refund, with interest. Corporate refunds that are greater than $5 million ($2 million for individuals and other taxpayers) are subject to procedural, computational, and technical accuracy review by the Joint Committee of Taxation. Therefore, it is also important to consider and document proper application of the complex NOL ordering rules under IRC Sec. 172, the distinct rules that apply if you carry back to an IRC Sec. 965 transition tax year, and any special statute of limitation provisions that may apply to credits freed up as a result of the NOL carryback. 

Taxpayers are still waiting for guidance from Treasury and the IRS on various TCJA and CARES Act provisions. Therefore, it is essential to evaluate the documentation in place to support positions reported on tax returns. Contemporaneous documentation that provides a well-reasoned analysis of the tax return position taken will help to ensure a smoother IRS review and may provide penalty protection if the IRS and the taxpayer disagree. Please reach out to your tax advisor to better understand the intricacies and interdependencies of the TCJA and CARES Act provisions and to ensure you are ready to effectively manage a review by the IRS.