The Treasury Inspector General for Tax Administration (TIGTA) has completed an analysis of the IRS Direct File pilot program. The report indicated there were several recommendations given to the IRS to improve the Direct File program.

Direct File is a free Federal tax preparation tool. It was offered by the IRS as a pilot program during the 2024 Filing Season. The program was offered initially to IRS employees and staff. After approximately 1,850 IRS employees tested the program, Direct File was offered to taxpayers in 12 states. Over 140,000 taxpayers used the basic Direct File program.

The TIGTA report reviewed three Direct File recommendations and the IRS response.

1. Health Insurance Checker — The report suggested that the initial program did not have sufficient information for taxpayers to understand whether they were qualified to use the health insurance coverage section. The Direct File program had an eligibility checker to clarify whether taxpayers who purchased insurance through the “Marketplace” offering were qualified. The IRS agreed that this eligibility checker needed to be improved and updated the program on March 27, 2024.

2. Spanish Translation — The report notified the IRS that the Spanish translation for the Direct File eligibility checker had missing entries. The IRS created a program to allow individuals to determine whether they were eligible to use Direct File. Because Direct File was limited to very basic tax return information with limited deductions and credits, many individuals were not qualified. The IRS agreed the Spanish language version of Direct File was not complete and updated the pilot version on March 12, 2024.

3. Direct File Milestones — The report indicated TIGTA notified the IRS there needed to be metrics or milestones that would allow the IRS leadership to decide when to expand the program. The IRS generally agreed with the creation of various milestones. The IRS noted it had been reviewing a wide range of comments from users and these responses would enable the IRS leaders to decide when to expand the program.

The IRS is also reviewing the Customer Support Chat information to determine when and how it should expand the program. The IRS had 297 Live Chats with 600 questions that were designed to show the operation of the Direct File pilot program.

Editor's Note: The Direct File program covered W-2 wage income, Social Security income, unemployment compensation and interest income of up to $1,500. Eligible credits were limited to the Earned Income Tax Credit, the Child Tax Credit and the Credit for Other Dependents. Taxpayers could claim a standard deduction as well as a deduction for student loan interest and educator expenses. The IRS stated, "The Direct File pilot was intentionally built with limited scope." The primary goals were to assess the viability for middle-income taxpayers in 12 states. The IRS now plans to expand Direct File program for next year.

Mandatory Repatriation Tax Upheld by U.S. Supreme Court

In Charles G. Moore et al. v. United States; No. 22-800, the Supreme Court upheld a tax on accumulations of foreign corporations.

The Tax Cuts and Jobs Act imposed a one-time passthrough tax on American shareholders of American-controlled foreign corporations. These foreign corporations had accumulated trillions of dollars in undistributed income. The Mandatory Repatriation Tax (MRT) levied a rate of 8% to 15.5% on the prorata accumulations of these shareholders.

Americans Charles and Kathleen Moore invested in controlled foreign corporation KisanKraft. Between 2006 and 2017, KisanKraft accumulated income that was not distributed and therefore not taxed to the Moores. The MRT resulted in a tax bill of $14,729 based on the Moore's pro rata share of the KisanKraft accumulated income. The Moores paid the tax and sued for a refund. They claimed the MRT violated the Direct Tax Clause of the U.S. Constitution. The U.S. Supreme Court determined the MRT was constitutional.

Under Article 1 of the Constitution, direct taxes must be apportioned among the states per each State’s population. An exception to the direct tax rule is the Sixteenth Amendment to the Constitution which permits the federal government to tax income.

The Government claimed that MRT is a tax on income, while the Moores contended it is an impermissible direct tax on property.

The government noted that passthrough taxation on partnerships, Subchapter S corporations and other entities has been permitted, and a decision that invalidated passthrough taxes could result in a loss of trillions of dollars of federal tax revenue. The Moores claimed that partnerships are different from the MRT because this was a tax on accumulated income over a decade and, therefore, a direct tax on property. The Moores also claimed that there was a "doctrine of constructive realization" that required a reasonable level of control before there would be taxation.

The Supreme Court issued an opinion delivered by Justice Kavanaugh. The opinion reviewed the general provisions of the passthrough rules. It noted there are multiple provisions in the tax code related to the passthrough provisions. The Court was careful to create a limited rule that stated the MRT was constitutional because it was a tax on undistributed income. The Court decision relied heavily on other decisions that referred to various "attribution" rules for passthrough income. It did not discuss the question of what exactly a “direct tax” is and how the "realization" provisions apply to a direct tax.

The narrow ruling emphasized that shareholders of an entity may be taxed on undistributed income if it is attributed to the shareholders and the entity itself has not paid tax.

Editor's Note: The decision included two concurring decisions and a dissent by Justice Thomas (joined by Justice Gorsuch). The dissent noted the Court needed to face up to two important questions — to define what constitutes a direct tax and what is or is not “realization.” The dissent noted that, historically, there has been a differentiation between the "fruit and the tree." Income is treated as fruit and the tree is treated as the property that produced the fruit. The Sixteenth Amendment permits only taxation of the fruit. Both the majority and dissenting opinions were careful to emphasize that the opinion did not approve a wealth tax.

Exempt Status Denied For Church Using Controlled Drug

In Iowaska Church of Healing v. Daniel I. Werfel et al.; No. 23-5122, the U.S. District Court for the District of Columbia denied exempt status to the Iowaska Church of Healing. Denial of exempt status was due to a religious practice to consume Ayahuasca tea with controlled substance dimethyltryptamine (DMT). Because Iowaska did not have the required approval to use the illegal drug, it lacked standing under the Religious Freedom Restoration Act of 1993 (RFRA).

The IRS regulations for Section 501(c)(3) entities require passage of both the organizational and operational tests. An organizational test requires that the entity be "engaged primarily in activities which accomplish one or more exempt purposes." If more than an insubstantial part of the activities is not in furtherance of an exempt purpose, it will not qualify.

With respect to a church, the IRS does not "attempt to evaluate the content of whatever doctrine a particular organization claims are religious, provided the particular beliefs of the organization are truly and sincerely held." In addition, the organization’s practices cannot be illegal or contrary to public policy.

The IRS has taken the position that a nonprofit organization may not advocate the use of a controlled substance, such as DMT. However, a nonprofit may obtain an exemption to permit use of a controlled substance either from the Drug Enforcement Agency (DEA) or a federal court. Under RFRA, a federal court may issue an exemption to prevent the government from substantially burdening a person's exercise of religion, even if the burden results from a rule of general applicability. The government may not burden religious exercise in violation of a statute. Thus, a plaintiff filing a RFRA claim must prove that free exercise has been substantially burdened.

The Iowaska church contended that the consumption of Ayahuasca tea, with the accompanying DMT, is a sincerely-held religious belief. It applied for exempt status under Section 501(c)(3) and also applied separately for a DMT exemption with the DEA. The DEA has not acted on the Iowaska request for an exemption. The IRS determined that Iowaska failed the organizational test, in part, because it was created for an illegal purpose of distributing DMT, a controlled substance.

The District Court agreed that the use of controlled substance DMT was not permissible and Iowaska had not obtained an exemption. Therefore, it did not have standing under RFRA to claim an exemption. Standing is required under Article III of the Constitution for an injury that is concrete and particularized.

The Iowaska church claimed it would suffer from programmatic concerns and loss of "charitable contributions and membership income." This potential loss, however, is not traceable or determinable. Because the church does not have a determinable loss and cannot quantify its reputational interest injury, it does not have standing to assert an RFRA defense.

Iowaska church also claimed the proposed Ayahuasca tea use is "presumptively legal" and RFRA effectively amends the law to permit the use of Ayahuasca tea as a sincere religious exercise. The court confirmed that a DEA exception or federal court order were required to qualify for standing. Because the Iowaska church did not meet either requirement, its RFRA claim is blocked by use of a controlled substance and there is no standing. Thus, exempt status was properly denied.

Applicable Federal Rate of 5.4% for July: Rev. Rul. 2024-13; 2024-28 IRB 1 (17 June 2024)

The IRS has announced the Applicable Federal Rate (AFR) for July of 2024. The AFR under Sec. 7520 for the month of July is 5.4%. The rates for June of 5.6% or May of 5.4% also may be used. The highest AFR is beneficial for charitable deductions of remainder interests. The lowest AFR is best for lead trusts and life estate reserved agreements. With a gift annuity, if the annuitant desires greater tax-free payments the lowest AFR is preferable. During 2024, pooled income funds in existence less than three tax years must use a 3.8% deemed rate of return. Charitable gift receipts should state, “No goods or services were provided in exchange for this gift and the nonprofit has exclusive legal control over the gift property.”