Rethinking Free File

Today’s post is written by Frank DiPietro, LITC Director at Indiana Legal Services, Inc., and Sarah Taylor, a third-year law student at Indiana University Mauer School of Law. Frank and Sarah review the development of the Free File program and examine possible reasons for its extremely low take-up rate. As Frank and Sarah mention, the National Taxpayer Advocate’s 2018 Annual Report to Congress identifies deficits in the Free File program as the fourth most serious problem facing taxpayers.

One issue of concern to the NTA (and today’s guest bloggers) is the upselling of paid products. While the Memorandum of Understanding governing the Free File program has provisions designed to protect taxpayers from upselling, these protections are limited and they don’t apply to non-Free File preparers. To address this, the 2019 Purple Book includes a recommendation that Congress amend section 6713 so the Treasury Department could write regulations designating the “use of tax return information for certain questionable business practices or the sale of certain products with high abuse potential as civil violations without also making them criminal violations.” Christine

On January 28th, tax filing season officially began. It is estimated by the Internal Revenue Service (IRS) that over 150 million individual tax returns will be filed for tax year 2018. The majority of these tax returns could be prepared and filed electronically for free. According to the Free File, Inc., formally Free File Alliance (Alliance), an organization composed of the largest tax preparation software companies, 70% of taxpayers are eligible to prepare their tax returns and file electronically for free. However, it is estimated that only 3% of those eligible will utilize this service. This post evaluates some of the reasons the Free File program has failed to provide free online preparation and filing for the majority of taxpayers and suggests alternative approaches to addressing the tax preparation needs of the most vulnerable taxpayers.

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The IRS and the Free File Alliance (members include H&R Block, Intuit, Liberty Tax) entered into a memorandum of understanding (MOU) in 2002 to allow financially eligible taxpayers to prepare and electronically file tax returns using Free File Alliance members’ tax preparation software for free. Section 2004 of the IRS Restructuring and Reform Act of 1998 (RRA ’98) mandated that the IRS develop a return-free tax system under which eligible individuals could comply with their filing obligations without preparing a tax return for all returns filed after December 31, 2007. However, in a 2003 report to Congress, the Secretary of the Treasury stressed that such a system would not be feasible without a significant increase in electronic filing and may not actually reduce administrative costs or compliance burdens for low- to middle-income taxpayers. Instead of developing the return-free system Congress envisioned, under the direction and guidance of the Department of the Treasury and the Office of Management and Budget, the IRS entered into the Free File MOU with an intention to increase access to online tax preparation software and free electronic filing options. Yet, over 15 years later, almost all eligible taxpayers still pay tax preparation and electronic filing fees, use of the Free File program is actually declining, and the Secretary of the Treasury has not implemented the return-free mandate for eligible taxpayers or continued to annually update Congress on its development as required by RRA ’98.

The reasons behind the failure of the Free File program are numerous. The National Taxpayer Advocate, Nina Olson, once described it as “a bit like living in the Wild, Wild West.” Each member of the Alliance (currently there are 12) has its own specific eligibility requirements, and eligibility may not be determinable until the return is started or nearly completed. Examples of these varying requirements include active duty military status, differing income and age eligibility requirements, foreign address filing, or required associated tax forms or schedules. Although the IRS website attempts to address this concern with its Free File Software Lookup Tool, the tool is overinclusive in that it only screens for adjusted gross income, age, state of residency, military service, and a self-assessment of whether the taxpayer is eligible for the earned income tax credit. The result is that many Schedule C filers or filers with complicated dependency issues, for instance, may inadvertently think they are eligible for a free version of a specific software when in fact they are not.

Unfortunately, the only way for many filers to discover their ineligibility is to first create an online account with the software company, begin entering their data, and then see if their situation is covered. For instance, H&R Block currently does not support free Schedule C preparation online. However, a taxpayer would not discover this ineligibility until attempting to enter 1099-MISC or other self-employment income data, which could happen well into the process of completing the return. In these situations, the current MOU with the Alliance requires the software company, at this point, to re-direct the taxpayer back to the IRS’s Free File website. Additionally, the company may offer to let the taxpayer continue if he or she agrees to pay to the proposed fee (H&R Block starts at $49.99 for a federal return). Thus, a taxpayer in this situation must determine whether he or she wants to restart the entire process or pay the fee to continue.

Another reason most taxpayers do not use the Free File program is taxpayers may simply not know it exists. Although an Alliance spokesperson stated a lack of an Alliance advertising budget is partly to blame for this awareness issue, a recently filed tax return (available through GuideStar.org) for the nonprofit organization suggests its revenue is steadily increasing. Regardless, according to terms of the MOU, it is ultimately the responsibility of the IRS to advertise and promote the program, and this advertising budget has reportedly been eliminated.

Additionally, unless taxpayers begin their search for the appropriate Free File software from the IRS’s Free File website, which is accessible through the IRS’s homepage, they may never learn of the different software options. A simple “Google” search for “free file” only reveals some advertisements by some of the providers, and the IRS’s website only appears below those advertisements. This can result in taxpayers directly choosing to visit a provider’s page without ever visiting the IRS’s Free File website. If the taxpayer has chosen a provider that he is not eligible for, he may not know there are other options with different eligibility requirements.

Moreover, if the taxpayer has not accessed the provider’s website through the IRS Free File website, he may never land on the “Member Free File Landing Page.” This is a critical step in the functioning of the program because only these “landing pages” are regulated by the MOU. Thus, a software provider may advertise its free filing option in any way it chooses, or not at all, anywhere else on its website, and it is not required to notify taxpayers that they are eligible for a free return if those taxpayers have selected a purchased version of the software.

Finally, the providers are not required to screen Free File eligible taxpayers who enter their websites via any method other than the Member Free File Landing Page. For instance, the TurboTax website offers new users the option of letting the website choose which software is best for them based on taxpayers selecting certain criteria that are applicable to them. But, by choosing the first option “I want to maximize deductions and credits,” the taxpayer is already disqualified for a “Free Edition” version of the software. Even though TurboTax is the leading software provider of taxpayers who use the Free File program, it is not obligated to offer its Free File software anywhere except the Member Free File Landing Page. As another example, Liberty Tax does not advertise its associated Free File software – esmart tax – on its online filing homepage or associated links, nor does it appear on its comparison of its online tax filing products.

It should be apparent by now that the opportunities available and utilized by Free File members to steer otherwise eligible taxpayers into paid versions of their software or other products are numerous. Past practices by these software providers have been well documented and reported, and they include the use of “value add” links promoting products such as audit protection services, refund advance loans, and refund transfer services, charging to file corresponding state returns even if a free filing option is available for that state, and failing to advertise or link to the company’s free file edition from its homepage.

The Internal Revenue Service Advisory Council’s (IRSAC) most recent report addressed some of these concerns, including “the IRS’s deficient oversight and performance standards” for the program which “put vulnerable taxpayers at risk.” The Free File MOU was revised to address some of these concerns, including how members may communicate with previous free file users and how products are advertised on the Member Free File Landing Page and within the Free File version of the member’s software. Additionally, in the most recent Annual Report to Congress, the National Taxpayer Advocate addresses the underutilization and lack of oversight of the Free File program as a “most serious problem” facing taxpayers. The report notes, “With no effective goals, measures, or budget, the IRS’s Free File program in its current format has become an ineffective relic of early efforts to increase e-filing.” It urges the IRS to develop actionable goals and increase its oversight of the program or otherwise discontinue its use.

Given calls for increased federal oversight, why do the for-profit Alliance members continue to offer versions of their tax preparation and filing software for free? In short, it keeps the IRS out of the tax preparation business. The current non-compete agreement, which extends the terms of the MOU until October 31, 2021, ensures Alliance members that if individuals wish to self-prepare and electronically file their tax returns for free, they must use Alliance software. During fiscal year 2017, this amounted to approximately 53 million self-prepared and electronically filed tax returns, of which only 2.5 million were filed for free using the Free File program. Given the fact that a significant majority of eligible free file taxpayers still pay, how can the IRS expect these for-profit companies to direct most of their paying customers towards a free version of their software? Also, the current partnership with the IRS and Alliance does nothing to address the return-free mandate of 1998.

The privatization of tax return preparation has created an industry fundamentally at odds with the objectives of the IRS. While the IRS wants citizens to file and pay the correct amount of tax, the software industry wants to generate its own revenue, which does not necessarily entail ensuring legally correct tax returns. For instance, in an evaluation of the various Free File software options, the Taxpayer Advocate Service noted a lack of consistency in the amount of assistance the software versions provide to taxpayers, which can result in filing incorrect returns. Additionally, scholars such as Jay A. Soled and Kathleen DeLaney Thomas have raised concerns with other features of the software, such as displaying the running refund total or balance due throughout the return preparation. Although the Free File program requires members to guarantee their calculations, it does not require any level of assistance to assure taxpayers are claiming legally correct tax positions. This feature of continuously displaying the refund may make taxpayers more susceptible to filing incorrectly in an attempt to game the system.

Realizing the regressive costs of tax return preparation on low- and middle-income individuals, Congress directed the IRS to develop a system that would allow eligible individuals to comply with their filing obligations without the need for preparing a return. One such system implemented in Mexico provides pre-populated tax returns to its citizens – also known as a type of tax agency reconciliation filing system – using cloud-based technology provided by Microsoft’s Azure. The results were that taxpayers were able to complete their returns often in a matter of minutes, and the revenue agency experienced an increase in overall revenue collections by as much as fifteen percent in a single year. This example calls into question whether a complete reliance on industry software and services as the “financial gatekeepers of the income tax system” is the most efficient method for the IRS to administer electronic tax return preparation and filing.

However, in its final annual report to Congress on the matter, the Secretary of the Treasury stressed the need for tax simplification as a pre-requisite to implementation of an American return-free system. The Tax Cuts and Jobs Act of 2017 is expected to significantly reduce the number of individuals who itemize their deductions. Treasury Secretary Mnuchin touted the simplification of the “postcard” sized new IRS Form 1040 for tax year 2018. Could this be the necessary simplification the IRS requires to finally implement the return-free mandate?

Meanwhile, the future of the Free File program is currently undecided. Both houses of Congress have offered vastly different options going forward. The House of Representatives passed the Taxpayer First Act on December 20, 2018 and referred it to the Senate. This bill would have codified the Free File program to guarantee its perpetuity. Alternatively, Senator Elizabeth Warren, along with 11 co-sponsors, presented a drastically different direction for tax return preparation in the Tax Filing Simplification Act of 2017. This act would have prohibited future agreements from barring the IRS from developing its own preparation software and would have provided for optional government preparation of individual tax returns for eligible taxpayers. Neither bill has been voted on in the Senate.

For now, however, the Free File program remains the only option for taxpayers to self-prepare and electronically file a free tax return. Without an advertising budget, it also remains one of the IRS’s best kept secrets. In its current form, an overwhelming majority of taxpayers who are eligible for Free File will never use it.

Getting To Summary Judgment: The Art of Framing the Issue as a Matter of Law. January 28 – February 1 Designated Orders (Part One)

We welcome Professor Caleb Smith from the University of Minnesota writing today about designated orders that might also have been Tax Court opinions.  Each of the three case he discusses has a meaty order deciding the case at the summary judgment stage.  These opinions cause me to wonder what distinguishes a case when it comes to writing an opinion which will get published and one that will not.  Parties researching the issues presented here will need a significant amount of diligence to find the Court’s orders in these case.  Having gone to significant effort to reach the conclusions in these cases, it would be nice for the Court to find a way to make its thinking more transparent.  Keith

There was something of a deluge of designated orders after the shutdown, so in order to give adequate time to each (and to group them somewhat coherently) I decided to break the orders into two posts. Today is post one, which will focus on some of the interesting summary judgement orders.

At the end of January there were three orders involving summary judgment that are worth going into detail on as they bring up both interesting procedural and substantive issues. However, in keeping with the theme (and title) of this blog, focus will mostly be kept on the procedural aspects. Those interested in the underlying substantive law at issue would also do well to give the orders a close read.

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Big Value, BIG Tax? H R B-Delaware, Inc. & Subsidiaries v. C.I.R., Dkt. # 28129-12

We begin with how to get summary judgment in the rarest of places: a valuation question. Judge Holmes begins the order with a note almost of incredulity on the petitioner’s motion for partial summary judgment: “The motion calls for the application of old case law to a half-century old contract, and seeks a ruling that there is no genuine dispute about a material fact — valuation of intangible assets — that is only rarely capable of decision through summary judgment.”

So, how do you get to summary judgment on a valuation issue -which by default tends to be a “material fact” at issue between the parties? Argue that the real material facts are already agreed upon such that a particular value results as a matter of law. How that works in this case is (briefly) as follows:

The “H R B” in petitioner’s caption is referring to the well-known tax preparation service H&R Block -and more specifically, the franchisees of national H&R Block. (Also for your daily dose of tax trivia, H&R Block apparently stands for/is named after Henry and Richard Bloch.) That the petitioners are franchisees of H&R Block is important because the case pretty much entirely deals with the valuation of franchise rights. At its core, the IRS is contending that the franchise rights of petitioner were worth about $28.5 million as of January 1, 2000, and the petitioner is arguing their franchise rights were worth… $0.

The valuation of the franchise rights on January 1, 2000 matters (a lot) because the petitioner converted from a C-Corp to an S-Corp effective of that date. I don’t deal with these conversions in practice (ever), but one of the lessons imprinted upon me from Corporate Tax lectures was that you can’t just jump back-and-forth without tax consequences. In particular, when you convert from subchapter C to subchapter S, you may contend with “unrecognized built-in gain (BIG)” consequences under IRC 1374(d)(1) later down the line. Essentially, you may have “BIG” tax if (1) at the time you convert from C to S you have assets with FMV in excess of your adjusted basis and then (2) you sell those assets within 10 years of conversion. Here, petitioner converted from C to S in 2000, and then sold all its assets back to H&R Block (national) in 2008 (i.e. within 10 years of conversion).

Petitioner reported BIG tax of roughly $4 million on the 2008 return, which apparently included tax on the franchise rights self-report to be worth at about $12 million. But the IRS did the favor of auditing the H&R Block franchisee, which led to a novel realization during litigation: the tax return was wrong in valuing the franchise rights at almost $12 million. It should have been $0.  In other words, petitioner may have vastly over paid their taxes.

Back to the procedural aspects. How do we get to summary judgment on this valuation issue? The IRS argues you can’t because what we are dealing with (valuation) is a contested factual determination. Essentially, this implies that wherever valuation is at issue summary judgment is de facto inappropriate.

Petitioner, on the other hand, argues that the valuation at issue here (of the franchise rights) flows as a matter of law from the undisputed facts as well as some rather old case law. Specifically, petitioner points to Akers v. C.I.R., 6 T.C. 693 (1946) and the slightly more modern Zoringer v. C.I.R., 62 T.C. 435 (1974). Petitioner argues that under these cases (1) where an intangible asset is nontransferable, and (2) terminable under circumstances beyond their control, and (3) the existing business is not being transferred to a third party, the value of the intangible asset is $0 as a matter of law. Because the undisputed facts (namely, the contract in effect at the time of the conversion) show elements one and two, and because this case does not involve the transfer of the business to another party, the value of the franchise rights must be $0.

And Judge Holmes agrees. There can be no genuine dispute about the value of the franchise rights based on the undisputed facts and controlling law. Summary judgment is therefore appropriate. A BIG win for the petitioner in what appeared to be an uphill battle.

There is, frankly, a lot more going on in this case that could be of interest to practitioners that deal with valuation issues, BIG tax, and the like. But, as someone that focuses on procedure, I want to make one parting observation on that point. Although petitioner’s counsel did a wonderful job of researching the applicable tax law, note how the pre-litigation work also plays a large role in this outcome.

As a sophisticated party with a high-dollar and complicated tax issue, there is no doubt in my mind that this case resulted only after lengthy audit (the tax at issue, after all, is from 2008 and the petition was filed at the end of 2012). One of the things that (likely) resulted from the audit was a narrowing of the issues: it wasn’t simply a disagreement about petitioner’s intangible assets broadly, it was a disagreement about the franchise rights specifically. This is critically important to the success of the summary judgment motion.

One argument the IRS raises is that the motion should fail because it isn’t clear which intangible assets are even at issue (the petition just assigns error to the valuation of the intangible assets broadly). But petitioner is able to point to the notice of deficiency and Form 886-A that resulted from the audit, and which clearly states that the dispute is about the value of the “FMV of the Franchise Rights.” In other words, the IRS only put the franchise rights as the intangible asset at issue in the notice of deficiency, so it is necessarily the only intangible asset at issue in the case (barring amended pleadings from the IRS). And, for all the reasons detailed above, the franchise rights have a value that can be determined to be $0 as a matter of law, thus allowing for summary judgment.

Consistency in Law, or Consistency in Fact?: Deluca v. C.I.R., Dkt. # 584-18

In Deluca the Court is faced with another motion for summary judgment by the petitioner, again involving fairly convoluted and fact-intensive law: tax on prohibited transactions under IRC 4975. In the end, however it isn’t IRC 4975 that plays a starring role in the order, but the statute of limitations on assessment and an ill-fated IRS argument about the “duty of consistency.”

The agreed upon facts are fairly straightforward. Petitioners established a regular IRA, and then converted it to a Roth in 2010. The Roth IRA maintained an account with “National Iron Bank” presumably in Braavos (just kidding). The Roth IRA repeatedly made loans to petitioner from 2011 – 2016. Unfortunately, loans between a Roth IRA and a “disqualified person” are a big “no-no.” See IRC 4975(c)(1)(B) and IRC 4975(e)(2). When the creator and beneficiary of an IRA engages in a prohibited transaction the IRA essentially ceases to be. See IRC 408(e)(2)(A). Since petitioner definitely engaged in prohibited transactions in 2014, the IRS issued a notice of deficiency for that tax year finding a deemed distribution from the Roth IRA of almost $200,000.

Those of you paying close attention can probably see where the issue is. The first prohibited transaction took place in 2011. An IRA is not Schroedinger’s Cat: it either is or isn’t. In this case, it ceased to be in 2011, which is when the distribution should have been taxed. Presuming there was no fraud on the part of the petitioners (and that they mailed a return by April 15, 2012), the absolute latest the IRS could hope to issue a Notice of Deficiency for that tax year would be April 15, 2018 (i.e. six years after the return was deemed filed, if it was a substantial omission of income: see IRC 6501(e). We are currently in 2019, so this spells trouble for the IRS.

But perhaps the IRS can avoid catastrophe here, in what appears (to some) to be an unfair result. The petitioners were never taxed on the prohibited transaction that took place in 2011 (they did not report it on their return), and now they are taking the position that the transaction took place then? What about consistency? Maybe the IRA is like Schrodinger’s cat after all: not really dead, but not really alive, but somewhere in-between because no one thought to look into it until 2014?

Fairness and the duty of consistency certainly seem to go hand-in-hand. The Tax Court has described the “duty of consistency” as “based on the theory that the taxpayer owes the Commissioner the duty to be consistent in the tax treatment of items and will not be permitted to benefit from the taxpayer’s own prior error or omission.” Cluck v. C.I.R., 105 T.C. 324 (1995). Generally, the elements of a taxpayer’s duty of consistency are that they (1) made a representation or reported an item for tax purposes in one year, (2) the IRS relied on that representation (or just let it be), and (3) after that statute of limitations on that year has passed, the taxpayer wants to change their earlier representation. Id. In Deluca, the IRS may argue the taxpayer (1) represented that the IRA still existed/that there was no prohibited distribution in 2011 (or any year after), (2) the IRS acquiesced in that position by leaving the earlier returns unaudited, and (3) only now that the ASED has passed does the taxpayer say there was a prohibited transaction. Seems like a reasonable argument to me.

Alas, it is not to be. Under the Golsen rule, because the case is appealable to the 2nd Circuit, that court’s law controls. The Second Circuit has held (way back in 1943, in an opinion by Judge Hand I find somewhat difficult to parse) that in deficiency cases the duty of consistency only applies to inconsistencies of fact, not inconsistent positions on questions of law. Bennet v. Helvering, 137 F.2d 537 (2nd Cir. 1943). Why does that matter? Because summary judgment is all about framing the issue as a matter of law, not fact.

Was Petitioner inconsistent on a matter of fact or a matter of law? On all of the returns (and in repaying the loans to the IRA) petitioner has appeared to have treated the IRA consistently as being in existence. Petitioner, in other words, has consistently behaved as if the “fact” was that the IRA was in existence. Because of the intricacies of IRC 408 and 4975, however, that fact was mistaken (even if treated consistently). As a matter of law the IRA ceased existing in 2011. And (apparently) petitioner is free to presently take the legal position that the IRA ceased existing in 2011 while also implicitly taking the (inconsistent) position that it did exist on that tax return.

If your head is spinning you are not alone.

However, if this appears to be an unfair result and sympathize with the IRS’s position, there is at least some concern to be aware of. Judge Thornton succinctly addresses one issue lurking behind the IRS’s position: “To adopt respondent’s position would essentially mean rewriting the statute [IRC 408(e)(2)] to postpone the consequences of prohibited transactions indefinitely into the future, depending on when the IRS might happen to discover them.” In other words, the cat would be neither alive or dead until and unless the IRS decided to take a look. The duty of consistency would almost write the assessment statute of limitations out of existence under such a reading.

Uncharted Waters of International Law: Emilio Express, Inc. Et. Al, v. C.I.R., Dkt. 14949-10

Two wins on two taxpayer motions for summary judgment: might the government go 0 for 3? As a matter of substantive law, Emilio Express, Inc. is probably the most compelling order of the three. It is also the only one where the IRS makes a cross-motion for summary judgment -and wins.

The substantive law at issue is well-beyond my expertise (I’m not in the “international-tax cloister” that Judge Holmes refers to while helpfully describing what “competent authority” means). I highly recommend that those who so cloistered, and particularly those that regularly work with Mexican tax issues, give this order a closer look. It appears to be an issue of first impression.

But, again in keeping with the procedural focus of this blog, we will focus on the cross motions for summary judgment. Again, we will look at the framing of the motions, and the facts established to understand why the petitioner’s motion for summary judgment was doomed, and the IRS’s was ultimately successful.

The consolidated cases in this order involve a C-Corporation (later converted to S-Corp.) “Emilio Express” as well as individual tax return of the sole shareholder, Emilo Torres Luque. Mr. Torres was a Mexican national and permanent resident of the United States. Mr. Torres did essentially all of his business moving cargo between Tijuana and southern California -the latter being where he appeared to live.

The gist of the issue is that the petitioner is arguing he owes no US Tax because he was (1) a resident of Mexico under the terms of the relevant US-Mexico treaty, (2) Mexico accepted his tax returns as filed for the years at issue, and (3) on their understanding of the treaty, their income should only be taxed by Mexico (in whatever amount Mexico determines) and not “double-taxed” by the US. Apart from needing to be correct on their understanding of the substantive law, for petitioner to prevail this motion for summary judgment they would have to show that there was no genuine issue of material fact.

The factual questions surrounding Petitioner’s residency matters because it is critical to how they frame the legal argument: as their argument goes if their residency is in Mexico, then the fact that Mexico accepted their tax returns means they are not subject to US income tax. The immediate problem is that determining their residency is a highly factual inquiry, with a lot of contested aspects. Everyone is in agreement that under the terms of the treaty petitioner is a “resident” of both the US and Mexico. There are additional rules under the treaty for determining “residency” where the taxpayer is, essentially, a dual-resident. Here, the petitioner needed to show that he had a “permanent home” in Mexico. Unfortunately, there was a legitimate question about exactly that matter raised by the IRS. And since that was a material fact that would need further development, petitioner’s summary judgment motion can be disposed of without even getting to whether the law would be favorable.

So how does the IRS prevail on a summary judgment motion if, as just stated above, there was a genuine issue on material fact? Because the IRS’s (winning) argument makes that fact (residency) immaterial.

As the IRS frames the issue, the residency of the petitioner (Mexico or US) is irrelevant: the law at issue really just concerns whether the individual is subject to double-taxation. In this case, the petitioner had no Mexican tax liability (the accepted returns had a $0 liability) so regardless of residency under the treaty, petitioner could be subject to US tax. The thrust of the treaty is all about double-taxation, which is the key issue here and can be resolved (based on the other agreed-upon facts) without delving into whether or not the petitioner owned a home in Tijuana. He didn’t owe Mexican tax under Mexican law. He does owe US tax under US law. Case closed.

All very interesting stuff. Again, if you work with international tax (and particularly Mexican-American tax) I recommend giving the order a closer look for the substantive issues at play.

Is It Time To Reconsider When IRS Guidance Is Subject to Court Review?

I have been working on an essay that looks at the possible way that Congress could breathe more life into the 2015 codification of the taxpayer bill of rights. My essay Giving Taxpayer Rights a Seat at the Table, which is in draft form and up on SSRN, makes a relatively simple claim: before IRS issues guidance it should be statutorily required to consider whether in its view the guidance is consistent with the taxpayer rights that the IRS adopted in 2014 and that Congress codified in 2015. In making my claim, I acknowledge the limits of the current statutory taxpayer rights framework, which arguably provides no direct way to hold the IRS accountable for actions that violate taxpayer rights unless the right relates to a separate specific cause of action for its violation.*

In researching my article on taxpayer rights, I came back to a stubborn problem with the IRS guidance process and for taxpayers and third parties who believe that the IRS guidance violates a procedural requirement under the Administrative Procedure Act:  there are at times insurmountable obstacles to challenging IRS guidance for procedural adequacy. That problem has led me to think about some interesting and important articles that have addressed this issue in the past few years.

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In the tax world, unlike other areas of federal law, statutes like the Anti-Injunction Act and the Declaratory Judgment Act, have proven formidable barriers to test the adequacy of IRS fidelity to for example the notice and comment requirements under the APA until well after the rule has been in place. In other words, a taxpayer or third party often has to wait for a refund or deficiency case (i.e., an enforcement proceeding) to argue that there was a procedural infirmity that would result in the court’s possibly invalidating the regulation or possibly subregulatory guidance.

This has contributed to some calling for a careful look at the Anti-Injunction Act, with Professor Kristin Hickman and her co-author Gerald Kerska arguing in Restoring the Lost Anti-Injunction Act in the Virginia Law Review (reviewed here by Sonya Watson) that history supports a reading of the AIA that would generally allow pre-enforcement challenges to IRS guidance. The article takes as a starting point that IRS has not always been faithful to APA requirements and not every possible challenge neatly fits into an enforcement proceeding. On top of that, as Professor Hickman has highlighted in prior work as well, it is questionable that there would be an adequate remedy in certain instances even if a court were to find a procedural infirmity in the context of a challenge that arises in a deficiency or refund case.

Despite my sympathy with a reading of current law that would allow for greater pre-enforcement challenges, there are strong legal and policy arguments against courts on their own extending the circumstances when there will be challenges to the procedural adequacy of IRS guidance. For example, expanding the opportunity for procedural challenges will naturally soak precious agency resources.  As Professor Daniel Hemel, in The Living Anti-Injunction Act in the Virginia Law Review online edition argues in an essay responding to Hickman and Kerska’s article, it would be best institutionally for Congress rather than the courts to open the door to pre-enforcement challenges.

Professor Stephanie Hunter McMahon in a 2017 Washington Law Review article Pre-Enforcement Litigation Needed for Taxing Procedures also takes up the subject of challenging IRS guidance. In her article, she sizes up the current landscape:

While Congress only permits procedural challenges late in the tax collection process, this offers little to most taxpayers. The delay in litigating procedural complaints reduces what is challenged and affects taxpayer behavior throughout the period from its promulgation until someone, eventually, challenges the procedures. In the process, delayed litigation requires that taxpayers plan their affairs under the spectre of guidance that might not survive a procedural challenge. Moreover, in deciding whether to follow the tax guidance, taxpayers must not only assess its substance but also the procedures used to create it under procedural requirements that are not consistently interpreted by the courts.

Professor Hunter McMahon drills deeper on the disincentives associated with challenging tax guidance in enforcement proceedings:

Disincentives are increased because, unlike in other areas of law that permit pre-enforcement litigation, people are not suing in post- enforcement tax litigation simply to perfect the agency’s procedures. Instead, they are suing over their own tax obligations. The personal nature of the result and that the costs are already imposed likely changes the way people perceive the litigation. With pre-enforcement litigation, a judge remanding a case to the agency to correct the procedures would be a victory. In a tax refund or deficiency case, remand is insufficient to accomplish the goal of reducing the taxes owed. If courts are likely to remand procedural matters without vacating the rule, the taxpayer has little incentive to challenge the rules because the personal outcome remains the same.

These issues are even more pernicious when the rules in question relate to lower income or marginalized taxpayers, who are less likely to be able to get to court and as Professor Hunter McMahon aptly points out may not have the means or resources to influence the guidance process in the first instance. (That latter point is indirectly highlighted by the draft article “Beyond Notice-and-Comment: The Making of the § 199A Regulations” by Shu-Yi Oei and Leigh Osofsky that Keith discussed recently).

Professor Hunter McMahon proposes a legislative fix. That fix would be to allow an amendment to the Anti-Injunction and Declaratory Judgment Act to allow for a limited time period challenges to the procedural adequacy of the guidance:

[T]his proposal would permit pre- enforcement litigation of procedural requirements and a judicial evaluation of whether the process used, including the clarity of the statement and the comment period, suffices for APA purposes.

As Professor Hunter McMahon notes, the benefit of allowing a limited time to challenge to procedural adequacy is that it could focus attention on procedural issues early in the life of the guidance, which would allow for consistency in application of the substantive rules. A second part of Professor Hunter McMahon’s legislative fix is for Congress to delineate more specifically which forms of guidance are required to go through notice and comment—she focuses on guidance that is intended to change taxpayer behavior rather than define prior action as the candidate for a default requirement to go through the notice and comment process.

Conclusion

I believe that Professor Hunter McMahon’s approach merits serious consideration. I am reflecting further on my proposal about ways to give the taxpayer rights provisions more teeth -my proposal relies heavily on the Taxpayer Advocate Service and enhancing its institutional role in the guidance process, including giving the National Taxpayer Advocate specific authority to comment on regulations (something that the NTA herself as recommended in both Purple Books that accompanied the last two annual reports). As Congress signals a further willingness to take on IRS reform issues, I believe that it should directly address the current reach of the Anti-Injunction Act and the issue of when and to what extent taxpayers and third parties should be able to test the adequacy of IRS guidance conforming to APA requirements.

As part of this approach I am intrigued by the possibility of tying in the IRS’s fidelity to taxpayer rights principles in the rulemaking process. I would be grateful for comments on my draft article or reactions to any of the issues raised in this post.

*An example of how a taxpayer right relates to a specific cause of action is taxpayer right number 7, the right to privacy, and Section 7213, which authorizes a suit for unauthorized disclosure of a taxpayer’s any tax return or return information. An example of a taxpayer right that does not so relate to a cause of action is right number 5, the right to appeal an IRS decision in an independent forum, which as we discussed last year in connection with the Facebook case does not seem to carry with it a direct way to challenge IRS action that arguably conflicts with that right.

 

 

IRS Still Ignores Allocation of Underpayment Mandated by 2011 Pullins Opinion in Computing Section 6015(f) Relief

I came back out of retirement to become the acting director of the Harvard Federal Tax Clinic for the first six months of this year, while Keith is on sabbatical.  One of the depressing things I just discovered is that the IRS is still ignoring the method for computing innocent spouse relief in underpayment cases under section 6015(f) that the Tax Court adopted (at least for some cases) in Pullins v. Commissioner, 136 T.C. 432 (2011).  In a nutshell, the IRS computers take the joint tax return liability as reported and allocate it between the spouses based on each’s relative proportion of total reported taxable income.  But, in Pullins, the court said that, at least in that case, relief should be to eliminate all tax except that which would be paid by the requesting spouse had she filed a married filing separately return.

I dealt with this issue when I was the director of a tax clinic at Cardozo School of Law some years ago, and every time I saw the allocation the IRS had done of the spouse’s taxes for purposes of underpayments cases, I had to ask the IRS to recompute the relief consistently with Pullins.  The IRS always did so at my request, increasing the amount of relief.  But, I shouldn’t have had to ask.  And I wondered about all the thousands of pro se requesting spouses out there who were seeking (f) relief in underpayment cases.  They would never have known to challenge the IRS computations of their relief the way I knew to make the challenge.

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Last week, I consulted with a taxpayer who had reached a resolution of a Tax Court section 6015(f) underpayment case and who asked me to look at the IRS settlement computations.  Once again, the computations ignored Pullins.  The amount by which the taxpayer was being cheated was $300.  However, after I pointed this out to her, she decided not to make a fuss about this – not wanting to possibly jeopardize the settlement that she had already achieved on the major issue of getting relief at all.

But, I want to alert everyone to what is going on, and I hope the National Taxpayer Advocate will look into this matter.  After all, it is now almost 8 years since Pullins rejected the way the IRS computers are programmed to calculate section 6015(f) relief in underpayment cases.

The goal of the innocent spouse provisions (at least where there has been no abuse) is to relieve a requesting spouse only of the tax on the nonrequesting spouse’s income, not the tax on the requesting spouse’s income.  But, implementing this goal can be tricky.

If the tax as to which innocent spouse relief is sought is a “deficiency” – i.e., attributable to an audit adjustment increasing reported tax (a situation involving an “understatement”) – then relief may be available to the taxpayer under section 6015(b), (c), or (f).  Congress provided rules for calculating relief under section 6015(c) that provide, as a general rule, that “[t]he portion of any deficiency on a joint return allocated to an individual shall be the amount which bears the same ratio to such deficiency as the net amount of items taken into account in computing the deficiency and allocable to the individual under paragraph (3) bears to the net amount of all items taken into account in computing the deficiency.”  Section 6015(d)(1).  In a simple example, if the deficiency were $30,000, and the underlying adjustments to income were $80,000 of unreported income of the husband and $20,000 of unreported income of the wife, and the wife requested section 6015(c) relief, she could be relieved, at most, of 80% of the $30,000 deficiency – or $24,000.

The IRS uses this allocation system for subsection (c) relief also when computing relief from deficiencies under subsections (b) and (f).  And I take no issue with the IRS doing so.

However, there is no provision of section 6015 that tells the IRS how to compute relief under subsection (f) in an underpayment case – i.e., where the IRS has no issue with the tax reported on the return except that, when the return was filed, not all of the tax shown thereon was paid.  The IRS has filled this gap only in Manual section 25.15.3.9.2.1(7) (7/29/14), which states, in part:

If liability is attributable to both the RS [requesting spouse] and NRS [nonrequesting spouse], equitable relief will only be considered for the portion attributable to the NRS.

Note:

. . . .  Underpayments of tax are allocated based on each spouse’s pro rata share of the joint taxable income.

Note:

For purposes of determining how much of an underpayment is attributable to each spouse, the EITC and ACTC is allocated to each spouse in proportion to the spouse’s share of the adjusted gross income.

Imagine a case where the total tax shown on the joint return was $6,400 and the return only showed two items of income:  $80,000 of wages of the husband and $20,000 of wages of the wife.  After standard deductions for a married filing jointly return and two personal exemptions, assume that the taxable income is $58,000.  Imagine that the balance unpaid on that return is currently $4,000.  How much the requesting spouse should be relieved of under (f) is determined, in part, by how much of the total $6,400 of tax the requesting spouse already paid – either through income tax withholding, estimated tax payments, and payments made after the IRS commenced collection.  Under the Manual provision, though, the IRS would also say that the $6,400 of total tax should be allocated to the spouses 80% to the husband and 20% to the wife because that is their relative shares of the taxable income reported.  So, the wife would be allocated $1,280 of the reported joint tax liability of $6,400.

Pullins presented a similar fact pattern – i.e., the wife sought relief, and the wife’s income was relatively small compared to the total reported joint taxable income. Judge Gustafson, though, rejected the method the IRS used to determine section 6015(f) relief in that underpayment case.  Instead, he noticed that, had the wife filed a return as married filing separately, she would have had less tax.  That is because, by adding her income to her husband’s to file a joint return, both spouses got taxed at a high bracket.  But, her income alone would have been taxed at a low bracket if she had filed married filing separately.  In my example in the previous paragraph, the wife could have filed a married filing separately return showing only $20,000 of gross income.  Taking a combined standard deduction and personal exemption of, say, $11,000, the wife’s taxable income would have been only $9,000.  All of that $9,000 would be subjected only to the 10% tax bracket, so the tax she would have paid would have been about $900 – $380 less than her proportionate share of the joint liability.

In Pullins (at page 432), the judge wrote:

As we stated above, for purposes of determining the extent of her liability for or overpayment of tax on her own income, we use Ms. Pullins’s computation on the basis of married-filing-separately status, rather than the IRS’s computation that made a pro rata allocation of the reported liability (based on married-filing jointly status). To reckon the amount of tax liability that Ms. Pullins should have to pay because it is fairly attributable to her, we think that on the facts of this case it is reasonable to figure Ms. Pullins’s tax liability separately. The IRS’s method assumes a joint liability and then attributes to her a pro rata share of the joint liability, but the purpose of section 6015 is to grant relief from joint liability.  Under the IRS’s method, if we found Ms. Pullins to be otherwise entitled to section 6015 relief, we would nonetheless leave her liable for a portion of the joint liability.  Our aim here, however, is to figure Ms. Pullins’s own liability apart from joint liability and then ensure that we do not excuse her from paying her own liability.  To accomplish that aim, a determination of her separate liability, rather than an allocation of the joint liability, is most reasonable here. [footnotes omitted]

In footnote 8 on that page, the judge noted that the allocation that he was making was similar to one that would be made if it was determined that there was no joint return at all because the return had been signed under duress.  The footnote reads:

As an analogy, see 26 C.F.R. sec. 1.6013–4(d) (to allocate liability where a supposedly joint return was signed under duress, ‘‘The return is adjusted to reflect only the tax liability of the individual who voluntarily signed the return, and the liability is determined at the applicable rates in section 1(d) for married individuals filing separate returns’’ (emphasis added)). [emphasis in the Pullins original]

I think that Judge Gustafson declined to set down a general rule for all underpayment cases under section 6015(f) because he might want to adopt the IRS system of allocating the reported joint tax in proportion to relative taxable income when the requesting spouse was a person with much higher gross income than the nonrequesting spouse.  Also, there is the problem of the earned income tax credit.  If that credit applies for a married couple, it is only available if they file married filing jointly.  The nonrequesting spouse could not get any earned income tax credit with married filing separately status.  Section 32(d).

The case on which I was recently consulted was one like Pullins, where the requesting spouse had relatively small income compared to her husband’s and her income would have been taxed at a much lower rate had she filed a married filing separately return.  The return also involved no earned income tax credit.  Over the years, I have probably seen a half-dozen of this kind of case.  All presented this fact pattern.  My suspicion is that this is the typical innocent spouse case because, in my experience, the requesting spouse is usually the low earner in the family.

After almost 8 years since the issuance of Pullins, I think it high time that the IRS modify its Manual provision to reflect the Pullins system for calculating section 6015(f) relief in underpayment cases.  The IRS can adopt exceptions to deal with (1) the unusual situation of tax on a married filing separately return basis exceeding the allocation of the joint return tax in proportion to relative taxable income and (2) earned income tax credit returns.  I like the idea of allocating that credit between the spouses, though I would modify the allocation to be based on relative shares of the total earned income, not adjusted gross income.  After all, the tables for the earned income tax credit are computed with respect to combined earned income.

NTA Issues 2018 Annual Report to Congress

Yesterday, National Taxpayer Advocate Nina Olson released the 2018 Annual Report to Congress. In an accompanying news release and in the report’s preface, she highlights the impact of the government shutdown on taxpayer rights, and also emphasizes the crucial need for IT modernization to replace antiquated systems at the IRS.

We will be highlighting issues of interest to readers in forthcoming posts. I look forward to reading the report.

Will the IRS Take My Home?

LITC practitioners hear recurring worries from taxpayers with IRS problems: will I go to jail? will the IRS take my home? For the vast majority of people who owe taxes, the answer to both questions is no. Someone who simply owes a tax debt usually does not need to worry about going to jail or having their home taken by the IRS. However, this is not to say it never happens. There are perhaps one or two cases per month reported on daily tax news services, and the National Taxpayer Advocate’s 2017 Annual Report to Congress identified 60 opinions in that fiscal year involving section 7403Recent cases illustrate the steps the government must take and the factors courts consider when evaluating a request to foreclose. 

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The government has two separate legal mechanisms to seize a taxpayer’s home in order to collect a tax debt. The National Taxpayer Advocate explains in her 2017 ARC Purple Book: 

The IRS has two options, which cannot be used concurrently, to collect against the principal residence of a taxpayer or a residence that is owned by the taxpayer but occupied by the taxpayer’s spouse, former spouse, or minor child. One option is to obtain a court order allowing administrative seizure of a principal residence under IRC § 6334(e)(1). … The other option is a suit to foreclose the federal tax lien against a principal residence under IRC § 7403.

The IRS makes use of both options, by way of making a recommendation and referral to the Department of Justice Tax Division, which represents the IRS in Federal District Court. The IRM explains that  

[s]uits should still be brought to foreclose the federal tax lien and reduce the tax liability to judgment in lieu of bringing a section 6334(e)(1) proceeding whenever it is determined that such suits would be optimal. A lien foreclosure suit may be preferable to a section 6334(e)(1) proceeding when there are questions regarding title or lien priority that create an unfavorable market for administrative sale. See 35.6.3.2 for discussion of lien foreclosure suits. A lien foreclosure suit may also be a specific option when the collection statute of limitations is about to run.  

34.6.2.5.1 (06-12-2012), Procedures for Instituting a 6334(e)(1) Proceeding.  So, taxpayer representatives should be familiar with the requirements for both actions.

Administrative seizure with judicial approval 

In August of 2018, Keith blogged about an Eighth Circuit decision under section 6334United States v. Brabant-Scribner, No. 17-2825 (8th Cir. Aug. 17, 2018). Keith explains: 

The 1998 Restructuring and Reform Act added IRC 6334(e)(1)(A) to require that prior to seizing a taxpayer’s principal residence the IRS must obtain the approval of a federal district court judge or magistrate in writing. Before the passage of this provision, the IRS could seize a taxpayer’s home with the same amount of prior approval needed to seize any other asset owned by the taxpayer. No approval was necessary to seize any asset of the taxpayer.

The government has adopted Treasury Regulation 301.6334-1(d) incorporating additional procedures and standards. Keith summarizes: 

To convince the court to allow the sale of a personal residence, the IRS must show compliance with all legal and procedural requirements, show the debt remains unpaid and show that “no reasonable alternative” for collection of the debt exists. 

… the taxpayer has a right to object after the IRS makes its initial showing and “will be granted a hearing to rebut the Government’s prima facie case if the taxpayer … rais[es] a genuine issue of material fact demonstrating … other assets from which the liability can be satisfied.”  

Also, the regulation provides for written notice to family members and occupants of the property.  

Unfortunately for taxpayers, judicial approval may not be difficult for the IRS to obtain despite the above standards and procedures. In Brabant-Scribner, the court reasoned that an alternative “for collection” must provide for payment of the debt; therefore, it held that the IRS was not required to consider the taxpayer’s offer in compromise. Similar reasoning has been followed by other courts. E.g. United States v. Gower, No. 3:16-cv-01247 (M.D. FlaJul. 10, 2018). Nevertheless, the administrative collection statutes and regulations provide some procedural protections for the taxpayer and certain family members living in a home owned by the taxpayer. IRM procedures also provide significant safeguards, which the National Taxpayer Advocate has recommended that Congress codify in section 7403

Suit to foreclose judgment lien 

The government’s second option, if it seeks to seize a taxpayer’s home, is to foreclose the federal tax lien by filing suit pursuant to section 7403Les has discussed section 7403 previously, and I will borrow his summary:

Under Section 7403, a federal district court can “determine the merits of all claims to and liens upon the property, and, in all cases where a claim or interest of the United States therein is established, may decree a sale of such property,…, and a distribution of the proceeds of such sale according to the findings of the court. 

Yet that power to force a sale and distribution of the proceeds is limited. In the 1983 case US v Rodgers the Supreme Court said that while the government has broad discretion to force a sale, “Section 7403 does not require a district court to authorize a forced sale under absolutely all circumstances, and that some limited room is left in the statute for the exercise of reasoned discretion.” Keith has discussed the application of Rodgers in prior posts here and here. 

To assist courts in exercising that discretion, Rodgers identifies factors: 

1) “the extent to which the Government’s financial interests would be prejudiced if it were relegated to a forced sale of the partial interest actually liable for the delinquent taxes[;]” 

(2) “whether the third party with a nonliable separate interest in the property would, in the normal course of events (leaving aside § 7403 and eminent domain proceedings, of course), have a legally recognized expectation that that separate property would not be subject to forced sale by the delinquent taxpayer or his or her creditors[;]” 

(3) “the likely prejudice to the third party, both in personal dislocation costs and … practical undercompensation [;]” and 

(4) “the relative character and value of the nonliable and liable interests held in the property ….”

Once the government has decided to sue for foreclosure, the taxpayer and others hoping to prevent that outcome face an uphill battle. The government prevailed in 58 of the 60 cases identified by TAS in the 2017 Annual Report to Congress, and one case resulted in a split decision. The taxpayer prevailed in only one case. These lopsided statistics are consistent with prior years’ reports.  

At times courts’ analysis of the Rodgers factors is cursory or nonexistent, but sometimes the factors do make a difference and judicial discretion is exercised. In United States v. Kwitney, No. 6:18-cv-1366-Orl-37TBS (M.D. Fla. Feb. 8, 2019), the district court rejected a magistrate’s recommendation in favor of foreclosure, because the interests of a third party had not yet been adjudicated.  

A less happy outcome for the interested third party occurred on January 30 in United States v. Jackson, No. 3:16-cv-05096 (W.D. Mo. Jan. 30, 2019). Mr. Jackson’s wife jointly owned properties with him, but she was not liable for the tax debt. Unfortunately for her, Mrs. Jackson came to the court with unclean hands, having previously collaborated with Mr. Jackson in what the court found were fraudulent transfers of the property. The court nevertheless examined the Rodgers factors: 

With respect to the first factor, the Court finds Plaintiff’s financial interests would be prejudiced if it were relegated to the forced sale of only Phil Jackson’s interest in the Properties. As a practical matter, if Plaintiff foreclosed on Phil Jackson’s interests only, Sharon Jackson retains her interests in the Properties. Thus, the sale of Phil Jackson’s interests would not decrease the judgment amount Phil Jackson owes to Plaintiff. 

Translation: it will be hard, perhaps impossible, to find a buyer for Mr. Jackson’s half-interest in the property. The government is likely to collect nothing under this alternative.  

With respect to the second factor, Sharon Jackson lacks an expectation that the Properties would not be subject to sale. Sharon Jackson, as owner with Phil Jackson, participated in the fraudulent transfers (since disclaimed) of the Properties. In the Court’s view, this conduct “tilts the balance of legal expectation against” her under this factor. United States v. Bierbrauer, 936 F.2d 373, 376 (8th Cir. 1991). 

With respect to the third factor, Sharon Jackson will receive full compensation for her interests in the Properties. … 

Finally, with respect to the fourth factor, because Phil Jackson’s and Sharon Jackson’s interests in the Properties are equal, forced sale could net Plaintiff as much as half the value of each of the properties to apply to the tax judgment against Phil Jackson. Under these circumstances, the Plaintiff is likely to recover more than “a fraction of the value of the property.” Bierbrauer, 936 F.2d at 375. 

Mrs. Jackson also argued that if the properties were sold, she should receive half of the sale price before any of the sale expenses were deducted and before certain property tax liens were paid. The Court held against her on both counts. As co-owner Mrs. Jackson was equally liable for the property taxes, and the court reasoned that her legal interest in the property is subject to those liens. Regarding the administrative costs of sale,  

[The Jacksons] cite no legal authority for the premise that the sale costs for the Properties should be borne by Plaintiff. Thus, the Court relies on “the Government’s paramount interest in prompt and certain collection of delinquent taxes” to conclude that Plaintiff net proceeds from the sale of the Properties should be distributed to PALS first. Rodgers, 461 U.S. at 712. 

The government’s “paramount interest” certainly makes these cases very difficult for taxpayers and their family members to win.

The bottom line 

The case numbers are low: the government probably won’t try to seize your home for back taxes. However, it’s in taxpayers’ interests to resolve their collection disputes rather than ignore the IRS. And certainly, don’t try any funny business with fraudulent transfers.

Update on Haynes v US: Fifth Circuit Remands and Punts on Whether Boyle Applies in E-Filing Cases

One of the foundational principles in tax procedure is that reliance on an accountant or lawyer to file a tax return cannot in and of itself constitute reasonable cause to avoid a late-filing penalty. The Supreme Court said as much in the 1985 case United States v Boyle. Over the last few years taxpayers and practitioners have started to challenge Boyle in the e-filing context. The basic question is whether courts should reconsider the bright line Boyle rule when a taxpayer provides her tax information to her preparer and the preparer purports to e-file the return, but for some reason the IRS rejects the return and the taxpayer arguably has little reason to suspect that the return was not actually filed.

Sometimes the preparer may fail to receive a rejection notice from the IRS; sometimes the preparer gets the reject notice and fails to tell the client. In either situation, the client then gets a surprise letter from the IRS months or maybe years later, leading to late filing penalties.

In the case of the Hayneses, the taxpayers heard from their accountant/preparer that on the last day for filing their 2010 tax return he had in fact e-filed the return. But for some reason the Social Security Number erroneously appeared on the line designated for an employment-identification number, and the IRS rejected the return. The preparer did not get a reject notice and neither he nor his clients took any steps to confirm that the IRS processed the supposedly e-filed return. After eventually receiving IRS correspondence the taxpayers filed their return and paid a late filing penalty. They sought a refund for the penalty, first with the IRS and then after the IRS denied the claim in federal district court. The district court granted the government summary judgment, concluding that as a matter of law under Boyle the taxpayers could not rely on their accountant to satisfy a return filing obligation even if the return filing process in the 21st century differs in kind from what was done back in the Reagan years.

In last month’s brief opinion, the Fifth Circuit took a different approach to the dispute. While noting that the application of Boyle in the 21stcentury world of e-filing is an “interesting” issue, it remanded the case back to the district court. It did so because it believed that there was a factual dispute that the lower court needed to resolve before it could even get to the legal issue:

Whether it was reasonable for Dunbar [the accountant] to assume, based on the IRS’s silence, that it had accepted the Hayneses’ return or whether ordinary business care and prudence would demand that he personally contact the IRS to ensure acceptance is a genuine question of material fact for the jury to decide. Because Dunbar is the Hayneses’ agent, if a jury determines that his actions meet the reasonable-cause standard, it must find the same to be true for the Hayneses—barring any determination of independent negligence by them.   After all, principals are not only bound by their agents’ failures, as in Boyle, but also by their diligence.

If, as a matter of fact, it was reasonable for the accountant to assume that the IRS accepted the return without seeking confirmation, then the penalty does not stand. If, however, the jury finds it was not reasonable, then the 21st century Boyle issue is teed up:

It is this question of material fact that makes it unnecessary for us to decide whether a broad e-filing exception to Boyle exists. That complex question need only be answered if Dunbar, in fact, acted negligently in filing the Hayneses’ tax return. Only then would the Hayneses be relegated to relying solely on their reliance on Dunbar to meet the reasonable-cause standard, thereby teeing up the Boyle question.

Conclusion

We will closely follow this case, as well as the handful of other cases that are percolating in the courts that raise the issue.

For prior PT coverage on this issue, see our post on the lower court opinion in the Haynes case and our post discussing a similar issue in the Spottiswood case. Those posts generated thoughtful comments and also link to some other useful sources.

 

 

Restitution Order, IRA Account, Community Property = Unfortunate Result for Non-Liable Spouse

It’s never a good thing for your spouse to be the subject of a $2,165,126 restitution order. You know when that comes out in the first few sentences of an opinion that things do not look good for the non-liable spouse. That proves true in United States v. Berry, No. 4:17-cr-00385 (S.D. Tex. 2018).

From the perspective of the IRS, this case presents the not always available situation of a wayward party who still has assets after a criminal prosecution. Here, the asset takes the form of an IRA. An IRA generally does not provide the best place to hold assets if you seek to protect them from creditors. Here, the court mentions the general rule that ERISA does not govern IRAs as a shorthand way to state that the substantial protections from creditors afforded to individuals holding assets in an account covered by ERISA do not apply when the retirement account instead exists in an IRA. The court does not make mention of the fact that ERISA’s protections do not insulate a taxpayer from the collection tools available to the IRS. Because of the way this case arises, I am unsure if the IRS tools are available here. So, the fact the account existed in an IRA could make a crucial difference not always present in federal tax collection cases.

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The Berrys live in Texas although I am unsure where Mrs. Berry is serving her 51 month sentence for wire fraud, mail fraud and filing a false tax return in violation of IRC 7206. In this case the government seeks to obtain 100% of Mrs. Berry’s retirement account and 50% of Mr. Berry’s account. The Berrys make four legal arguments and one equitable argument in an effort to protect their accounts. I will go through the arguments in the order presented by the court. Spoiler alert – none of the arguments work for the Berrys.

Federal Pre-emption

They argue that retirement funds are not community property. The retirement accounts are IRAs. The court finds that because the funds are held in IRAs and not ERISA protected retirement accounts, no pre-emption of state community property laws exists.

State Law

They argue that the retirement accounts are governed by Pennsylvania law because the custodial agreement says that the funds are governed by the law of that state which happens to be the state where Vanguard is located. Mrs. Berry argues that Pennsylvania law (and Texas law if PA law does not apply) waives her rights in the accounts and removes them from community property. She did not sign a specific waiver of her community interest in the property. Because she did not waive her interest in community property, the court finds that the retirement accounts are community property allowing the restitution liens to attach. The court cites United States v. Elashi, 789 F.3d 537, 551 (5th Cir. 2015) in support of its position. Since Mrs. Berry had a ½ interest in Mr. Berry’s solely managed community property, the government can seek to obtain her half interest in that account.

Consumer Credit Protection Act

The Berrys argue that even if the government can reach half of Mr. Berry’s retirement account despite the previous two arguments, its ability to reach Mrs. Berry’s community property interest in Mr. Berry’s property is limited to no more than 25% pursuant to section 30 of the Consumer Credit Protection Act. This Act limits the maximum garnishment to 25% of the earnings for that week. The court finds that the weekly limitation imposed by this act depends on whether Mr. Berry is limited to receiving periodic payments or has the ability to cash out. Because he has the ability to take out the entire amount at any time, the government is not limited in the amount of Mrs. Berry’s interest that it can obtain.

Facially Invalid

The Berrys argue that the writ of garnishment issued in this case overstates the amount due because it includes a future debt to the IRS not currently due. The court finds that the amount listed does not invalidate the writ of garnishment.

Equity for Mr. Berry

The Berrys argue that even if their legal arguments do not prevail it would be a significant strain on Mr. Berry to allow the government to take half of his retirement account. The case does not make clear how his finances would be impacted by the taking of half of this account. Certainly taking half of funds in his IRA limits his future ability to take distributions but what that does to his finances is unclear. Perhaps the court does not go into this type of detail because the court finds this type of equitable argument to be unavailing where the government has the legal right to take the property. It seems that the Berrys were essentially asking for the court to create something akin to the Rodgers factors and apply them to this situation.

I think that something could be made of the Rodgers factors in a case like this if the facts support Mr. Berry’s need for the funds in order to avoid seeking benefits from the state. The equitable portion of the opinion is too short to provide an adequate description of the arguments made by the Berrys or the thought process of the court.

Conclusion

Similar to the result in bankruptcy, holding funds in an IRA provides little more protection from creditors than holding funds in an ordinary bank account. Because the government is collecting pursuant to a restitution order rather than a tax assessment, its ability to use the powerful collection tools of the IRC may be limited but that does not matter here. The court does not discuss whether the restitution order would allow the IRS to assess all of part of the amount in the order. If some or all of the restitution order covered taxes, then it could have gone about collection by first assessing the taxes and then pursuing normal federal tax collection alternatives as discussed here.