Daily Tax Update - April 12, 2011: Section 108 Proposed Regulations On Grantor Trusts And Disregarded Entities Issued

LONG-AWAITED SECTION 108 PROPOSED REGULATIONS ON GRANTOR TRUSTS AND DISREGARDED ENTITIES ISSUED:  Today, the IRS and Treasury issued proposed regulations on the section 108(a) exclusion from gross income of discharge of indebtedness income of a grantor trust or a disregarded entity.  The proposed regulations would apply to discharge of indebtedness income occurring on or after the date final regulations are published.

  • The proposed regulations provide that, for purposes of applying section 108(a)(1)(A) and (B) to discharge of indebtedness income of a grantor trust or a disregarded entity, the term taxpayer (as used in section 108(a)(1) and (d)(1) through (3)), refers to the owner(s) of the grantor trust or disregarded entity (rather than to the trust or disregarded entity itself).
  • The proposed regulations also provide that, for this purpose, grantor trusts and disregarded entities themselves are not considered owners (e.g., if a C corporation wholly owns a disregarded entity and that entity wholly owns another disregarded entity, the "owner" of the second-tier disregarded entity would be the C corporation rather than the first-tier disregarded entity).
  • In the case of a partnership, the proposed regulations provide that the owner rules apply at the partner level to the partners of the partnership to whom the discharge of indebtedness income is allocable.
  • The proposed regulations reject the position that the insolvency exception in section 108(a)(1)(B) is available to the extent a grantor trust or disregarded entity is insolvent, even if its owner is not.  The proposed regulations thus clarify that, subject to the special rule for partnerships in section 108(d)(6), the insolvency exception is available only to the extent the owner is insolvent (as "owner" is determined under the rules in the proposed regulations) (i.e., to the extent insolvency exists when considering the assets and liabilities of the owner and the disregarded entity in aggregate).
  • Similarly, the proposed regulations also provide that, with respect to the bankruptcy exception in section 108(a)(1)(A), it is insufficient for the grantor trust or disregarded entity to be subject to the jurisdiction of a bankruptcy court.  The proposed regulations thus clarify that, subject to the special rule for partnerships in section 108(d)(6), the bankruptcy exception in section 108(a)(1)(A) is available only if the owner of the grantor trust or disregarded entity is subject to the bankruptcy court’s jurisdiction (as "owner" is determined under the rules in the proposed regulations).
  • For additional information, contact Mark J. Silverman at msilverman@steptoe.com, Aaron P. Nocjar at anocjar@steptoe.com, or Lisa M. Zarlenga at lzarlenga@steptoe.com.
  • The regulations can be accessed here.

FINANCE HEARING: BEST PRACTICES IN TAX ADMINISTRATION: A LOOK ACROSS THE GLOBE:  Today, the Senate Finance Committee continued its series of hearings on tax reform. 

  • The witnesses at the hearing were:
    • Mr. Michael Brostek, Director, Tax Policy and Administration, Strategic Issues, Government Accountability Office;
    • Mr. Brian Erard, Ph.D, B.E. & Associates; and
    • Mr. Michael Gaffney, Tax Partner, PricewaterhouseCoopers.
  • In his opening remarks, Committee Chairman Max Baucus said, "Tax compliance is an increasing burden on US businesses, and surveys have found that the US lags far behind other countries in terms of effective tax administration. Our hearing today will examine tax administration practices around the world. We will look at lessons learned and best practices that could work here in the US No single system stands out as an ideal model for the rest of the world, but examples of successful techniques from other countries provide insight into how we can improve."
  • Ranking Member Orrin Hatch said, "So we are here today to hear about how other countries are improving tax administration and tax compliance. Surely one way to improve tax administration and compliance is by reducing complexity – or at least, by not increasing complexity. There are other ways to improve tax administration. One way to improve tax administration is through better computer software and greater interaction via the internet between the revenue authority and taxpayers. However, it is worth considering to what extent greater reliance on technology actually enables greater complexity in the tax code. That is, it is certainly the case that computers can always be improved and programmed to handle ever greater complexity in the tax code. But this may come at the cost of leaving human understanding of the Code behind. And as human beings become ever more mystified as to the workings of the Code, they become less responsive to tax incentives, and less understanding of how their government is funded. Another way to improve tax administration and compliance could be through government-prepared (or "pre-populated") tax returns. While this certainly would reduce the time that many individuals would have to spend on tax return preparation, it also makes them less aware of what the tax law is."  Hatch added, "We see this trade-off between making administration and compliance easier while decreasing the citizenry’s awareness of government financing in another area: Withholding. The system of income tax withholding on wages has been in place since 1943. While it has assured the government a steady stream of revenue, and reduces the chance that some individuals won’t have enough money to pay their taxes come April 15, withholding also makes taxpayers less aware of the substantial amount of money they are paying to the government."
  • Brostek testified on a new GAO report titled, "Preliminary Information on Selected Foreign Practices That May Provide Useful Insights" released in conjunction with today’s hearing.  Brostek said, "I appreciate this opportunity to discuss how some foreign tax administrators have focused on issues similar to those faced by the United States (US). All tax administrators strive to address similar issues regardless of the specific provisions of their laws. Understanding how other tax administrators have used certain practices to address these common issues can provide insights to help inform deliberations about tax reform and about possible administrative changes in our existing system to improve compliance, better serve taxpayers, reduce burden, and increase efficiencies. My statement today will draw from our ongoing work for the committee to describe (1) how foreign tax administrators have approached issues that are similar to those in the US tax system and (2) whether and how the Internal Revenue Service (IRS) identifies and adopts tax administration practices used elsewhere. Our work includes selected practices of New Zealand, Finland, European Union (EU), United Kingdom (UK), Australia, and Hong Kong.1 Our report, to be issued in May 2011, will provide our detailed descriptions of those tax administration practices and their differences from US practices."  Brostek added, "We based our selection of these practices on several factors, including whether the tax administrators had advanced economies and tax systems, tax information was available in English, and the foreign tax administrator’s approach differed from how the US approaches similar issues. We reviewed documents and interviewed officials from 6 foreign tax administrations. We primarily used documentation from each government’s reports that are publicly available. When possible, we confirmed additional information provided to us by officials and held meetings with experts, public interest groups, and trade groups to identify their views about these systems. To describe whether and how the IRS identifies and adopts tax administration practices used elsewhere, we reviewed related documents and interviewed IRS officials. We discussed the information in this statement with officials of IRS and six foreign tax administrators and incorporated their comments as appropriate."
  • Erard said, "I have been asked to focus on tax administration in Canada with a view towards possible lessons for US tax administration." Erard concluded,
  1. "Many of the current electronic self-service options for taxpayers in Canada would be attractive to US taxpayers. 
  2. The Canadian Processing Review Program provides an interesting model for cost-effectively targeting specific credit and deduction items to promote compliance in a systematic way. The National Research Program data would likely be useful for developing selection criteria for selective verification of tax offset items where noncompliance issues have been identified.
  3. While the National Research Program (NRP) provides very good information about compliance with selected taxes, relatively small random audit studies may represent an effective approach for learning about compliance rates and assessing risks for taxes not covered by the NRP.
  4. The use of pilot programs for testing the effectiveness of new services and enforcement strategies before wider implementation is a desirable strategy.
  5. Enhanced partnerships with sub-national jurisdictions and industry trade groups can create opportunities for improving compliance.
  6. Electronic sales suppression is a potentially important issue not only for state sales taxes, but also for federal and state income taxes. Electronic sales suppression may be (or may become) prevalent in industries where cash transactions are frequently undertaken (such as restaurants, grocery stores, convenience stores, hairstylists). The SRM solution in Quebec is one of several possible approaches to address this problem."
  • Gaffney testified, "Taxpayers today expend significant time and resources to comply with an increasingly complex tax code and frequently encounter issues for which there is no clear answer. Similarly, the IRS devotes significant time and resources to administer the tax laws. Given this substantial and shared burden, pursuing initiatives to make the tax administration process more efficient, reduce costs, and minimize tax uncertainty is a goal that all parties have a mutual interest in working together to achieve. Looking back on my experience of what has worked well and what has not, there are some lessons to take away in trying to facilitate the likelihood of the success of programs to increase the efficiency of tax administration."
  • Gaffney stated, "First and foremost, any program should begin with the tax authority and taxpayers working collaboratively to define the goals and the procedures and processes to implement the program. The involvement of senior leadership within the tax authority and the taxpayer is an essential element for success. 
  • Second, the program should be evaluated on how well it achieves the following criteria:
    • Enhance mutual trust between taxpayers and the tax authority;
    • Alleviate tax uncertainty;
    • Provide consistency in application of the law; and
    • Reduce compliance and examination burdens."
  • Testimony can be accessed here.
  • For additional information, contact Philip R. West at pwest@steptoe.com.

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As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.

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