The Freedom of Information Act and the Office of Professional Responsibility

Working for over three decades for Chief Counsel’s office, one of my goals was to avoid disclosure issues both on a personal and professional level. On a personal level, I wanted to know enough to keep out of trouble and on a professional level I wanted to avoid getting labeled as someone who knew disclosure law because that could lead to more assignments regarding disclosure issues which I did not want. At Chief Counsel’s office, FOIA was lumped in with IRC 6103 and the Privacy Act. Practicing at a clinic, I only want to know enough about the Office of Professional Responsibility (OPR) to avoid having contact with it. Just as I did not want to know more about section 6103 than I needed in order to avoid trouble while working at Chief Counsel’s office, I do not want to learn more about OPR. I want to know the ethical rules but not what happens when you break them, because I hope that is knowledge I will never need.

Today’s case takes me into the confluence of two things I try to avoid and yet the case has important lessons worth discussion. In Waterman v. IRS, 121 AFTR2d 2018-__(D.D.C. 1-24-2018), the issue before the court is a request for records from OPR regarding an investigation of an attorney. The attorney, Brad Waterman, practices in D.C. and has for several decades. He graduated from my law school the year before me and we have met on several occasions. He has an excellent practice and the last time we met he was splitting his time between D.C. and Florida, depending on the season. The fact that he is seeking records from OPR concerning an investigation does not mean he engaged in inappropriate behavior. I know nothing about the investigation other than it was quickly closed which, it turns out, is his problem in this case. His case caused OPR to change its procedures despite, or maybe because of, his FOIA difficulties to make it easier for someone in his situation to obtain records from OPR.

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In representing a client in a matter involving a tax exempt bond, Mr. Waterman caused the revenue agent in the IRS Tax Exempt Bond office to feel that Mr. Waterman engaged in misconduct. The revenue agent, through his manager, made a referral to OPR. After investigation, OPR determined that “the allegation against Waterman did not warrant further inquiries or action.” I recently attended the ABA Tax Section meeting, at which I attended the Standards of Practice committee meeting in an effort to keep up on ethical issues. At that meeting, the director of OPR, Steve Whitlock, spoke and he talked about this case. I began writing this post on the plane to San Diego to attend the meeting. So, when the director started talking about this case, I woke up from my normal meeting stupor and started listening carefully. I hope I heard and understood him correctly.

Apparently, OPR decided not to pursue this case without sending out a letter to Mr. Waterman asking him for information. OPR regularly determines that many of the referrals it receives do not warrant further investigation and do not require making the referred individual submit material. When it makes this decision at the internal investigation stage, the case is closed with a letter to the individual informing the individual of the closure of the case without need for input from the individual. This was the normal procedure at the time OPR closed Mr. Waterman’s case. It was also, and still is I believe, the normal procedure for the OPR letter informing the individual of its conclusion to also inform the individual that OPR would retain the file on the matter for 25 years and that it reserved the right to reference the file in any future OPR investigations. Ouch. I suspect that receiving such a letter with the language about retention drove Mr. Waterman to want to know as much about the referral and investigation as possible in the event that it might have future ramifications.

The problem Mr. Waterman faced in trying to obtain information about the referral is that because OPR closed its investigation at the time of the sending of the letter, he could not use the section 6103 procedures, see here and here, that OPR suggests individuals use to obtain information about the referral. Had his case not been closed with an early letter, he would have instead received a far more ominous letter informing him of the investigation and asking him to respond to the allegations. In that situation, OPR would not have a closed investigation but a very open one. During an open investigation, OPR suggests that individuals use the section 6103 process to obtain information about the investigation. Because his investigation was closed by the time Mr. Waterman knew he wanted information, he could not use the section 6103 procedure and instead had to revert to FOIA in order to try to obtain the information.

The OPR director stated at the ABA meeting that because of this case, OPR was changing its procedures. Now, instead of issuing the one letter and closing the case immediately, it is going to issue a preliminary letter giving the target individual 60 days to make a statement to OPR and to obtain information about the investigation through section 6103. See the following paragraph for a link to this letter. Now, a recipient of this “good” OPR letter, if there is such a thing, can use the section 6103 procedures for obtaining information before OPR closes its case 60 days later. If someone receiving this good letter fails to ask for information about the investigation under section 6103 during that 60 day period, then they will face the same FOIA obstacles which Mr. Waterman encountered and which I will discuss below. I hope that neither I nor any reader will need the benefit of this knowledge, but just in case I provide it for any who have the misfortune of a referral.

Attached to the outline created by the director of OPR for his presentation at the ABA meeting were samples of the three letters sent by OPR. The first letter is called the pre-allegation letter. This is the letter alerting the recipient of an OPR investigation that is not being dropped after the initial internal review by OPR. The second letter is called the “soft conduct letter – initial” This is the letter giving the recipient the chance to request information from OPR using IRC 6103 and avoiding the problems faced by Mr. Waterman. This letter would be sent to someone that OPR determines not to investigate further after reviewing the incoming allegations. The third letter is called the “soft conduct letter” which should be sent about 60 days after the initial soft conduct letter and which would inform the recipient that OPR was closing its investigation.

The FOIA case does not discuss the merits of the investigation. From the opinion, it is clear that Mr. Waterman made informal requests for information about the investigation and did not receive everything that he wanted. So, he made a formal FOIA request. In responding to the FOIA request, the IRS withheld certain information asserting primarily FOIA exemption 5, which “allows agencies to withhold information that would not be available by law to a party … in litigation with the agency.”

In the FOIA case, Mr. Waterman agreed that the IRS search for the requested records was adequate. I want to take a brief detour here to mention another recent FOIA case, Ayyad v. IRS, No. 8-16-cv-03032 (D. Md. 2-2-2018). In the Ayyad case, the requester did not agree that the search for the records was adequate and for good reason. An examination of the taxpayer was pending for about a decade when they filed the FOIA request seeking records, which included the administrative file developed by the revenue agent including all written correspondence relating to the examination. With relatively amazing speed for a FOIA case, the IRS identified 2,885 pages of responsive records but did not produce a Vaughn index detailing the redacted and withheld records. After the taxpayers filed their FOIA suit, the IRS informed the Court it found an additional 872 pages. Later, after the taxpayer stated records were still missing, the IRS found another 6,568 pages. Needless to say, the IRS did not cover itself in glory in this case and did not prevail. Its inadequate searches and its failures to submit proper Vaughan indices resulted in an unfavorable FOIA decision. So, it is not unimportant that Mr. Waterman agreed with the IRS search. His case was much less involved and he undoubtedly knew what records were out there, but the Ayyad case provides a note of caution in relying on the first submission of records from the IRS.

In Mr. Waterman’s case, the court found that the Vaughn index properly described the withheld documents and the basis for the exemption (also a major issue in the Ayyad case). The documents at issue were pre-deliberative and involved material created by the revenue agent who made the referral, his manager, preliminary findings of the OPR investigator, and an email between OPR and counsel. The court finds all of the documents meet the test under FOIA exemption 5. If I understood Mr. Whitlock correctly, Mr. Waterman would have received the referring documents under a section 6103 request made during an open OPR investigation. I do not believe he would receive the other two documents under section 6103.

I am very sympathetic with Mr. Waterman’s right to know the basis for the investigation. Because OPR is retaining the records for 25 years, he has genuine concerns. I applaud OPR for changing its procedures to allow other similarly situated individuals to obtain records under the more friendly section 6103 procedures. I hope the information in this post is information you and I will never need to know.

 

The Newly Nominated Commissioner

The press reports that President Trump would nominate Chuck Rettig as the new IRS Commissioner were followed with a formal announcement. Assuming he is confirmed, Mr. Rettig will serve as the first tax lawyer in this position in the new millennium. I applaud the return to having someone run the IRS who has a deep understanding of tax law but perhaps this shows my age rather than my management acumen. In addition to applauding the return to the position of commissioner someone who has a career in tax law, I also applaud the selection of Mr. Rettig who will perform ably in this position based on his experience and demeanor.

For those interested in tax procedure and tax controversy, it is especially notable that the President has nominated Mr. Rettig. Even in the bygone era of tax lawyers as commissioners, it was not necessarily the norm to appoint a tax lawyer who specialized in controversy rather than tax planning. This is an important opportunity for the shaping of tax administration by someone very familiar with tax procedure and the issues created when taxpayers have a problem with the IRS. One earlier commissioner with a litigation background (having taken Flora v. United States to the Supreme Court twice) who served with distinction and stood up to President Nixon when he sought to use the IRS to torment his “enemies” was Randolph Thrower. It is a proud tradition to uphold.

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Since the appointment of Charles Rossotti in 1999, Presidents have appointed a series of individuals with management experience but not tax experience. Mark Everson became commissioner in 2003 with a fair amount of government management experience, Douglas Shulman in 2008 with public and private management experience, and John Koskinen in 2013 with significant public and private management experience. Each of the “management” commissioners over the past two decades had the type of experience necessary to run a large organization, but a steep learning curve on the culture of the IRS and the tax laws it administers. With the exception of Commissioner Everson, I met each of the others briefly and formed favorable impressions. Commissioner Koskinen seemed terrific but could not shake the real or apparent hatred of several vocal members of Congress.

From the time I started working at the IRS and for several decades before, the traditional appointee to the position of Commissioner was a tax lawyer. Usually someone from a big firm and someone with decades of tax experience. Even a lawyer at a big firm, however, has no experience managing a large organization like the IRS with many components. As the information technology component of the administration of the IRS became more and more important, the desire for a tax lawyer became less and less. So, for the past two decades we have had a commissioner who was a management specialist rather than a tax specialist who might surround themselves with others with strong management experience. It’s past time to try a tax lawyer again.

So, who are getting? I had the pleasure to serve with Mr. Rettig on the ABA Tax Section governing council first as co-fellows at large and then with Mr. Rettig elevated to the executive leadership of the section in charge of the finances. He took on the leadership position at a time of challenging finances for the section and he immediately took on the hard task of finding places to cut the budget and seeking new sources of revenue. He has done an excellent job in this position. He has management experience as the managing partner of his firm. He has quite a resume of service to the profession and to the government on advisory boards. He has also been one of the creative forces and leaders behind a very successful ABA conference on offshore issues.

Much of Mr. Rettig’s practice in the past several years has centered on representing individuals with assets offshore who needed to reach an agreement with the IRS. In this type of practice he must learn criminal tax law, civil tax procedure, tax litigation, and a lot of client management. My friend John McDougal who spearheaded the IRS efforts in offshore identification and compliance prior to his retirement has nothing but good things to say about Mr. Rettig as a practitioner having worked with him closely on a number of matters. Praise from John is not easy to come by. I have heard praise for Mr. Rettig from those who work closely with him on many occasions.

Mr. Rettig has a great personality and the kind of personality that will allow him to build the kind of rapport with Congress that the IRS desperately needs in order to get back to proper funding levels. I do not mean to suggest that I think he can charm his way to greater budgets, but I think he will figure out how to work with the appropriate people to make it possible to make a winning pitch for the type of support and the amount of funding that the IRS needs to properly do its job.

The non-tax background commissioners of the past two decades have been smart people with lots of relevant experience in running an organization but it will be refreshing to have a leader of the IRS who knows the tax system from the trenches. He is someone who can quickly size up the proposals being made to him from the compliance and taxpayer assistance functions. Having worked with many clients seeking to hide their money offshore and seeking to fix a problem of having an offshore account created by someone else, he will be able to size up the types of strategies that will allow the IRS to put resources into the proper place to promote compliance based not just on reports from various IRS functions but from decades of working with taxpayers seeking to comply (or not) with the tax laws.

The President has made a great choice. I hope Congress will quickly confirm the choice so that the IRS does not go too long without leadership.

Data from ABA Tax Section Meeting

February 8-10 the Tax Section held its mid-year meeting in San Diego. Here are a few items of interest from the meeting concerning the Tax Court, the Department of Justice Tax Division, the revocation of passports and the National Taxpayer Advocate’s annual report.

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Tax Court

The Court had about 22,000 cases pending at the end of October. It continues to close cases faster than it receives them. There are three openings at the moment to fill the empty seats on the 19 judge roster of the court and there are three nominations pending. I got the impression from a separate conversation that perhaps the nominations would move forward in late March based on the current schedule in the Senate. Tax Court nominations go through the Senate Finance Committee rather than through the Judiciary Committee. In addition to the three current openings, Chief Judge Marvel reported that she anticipates the possibility of three additional openings on the Court this year because one judge will turn 70 – the mandatory age for Tax Court judges and the point at which a Tax Court judge turns into a senior judge or retires altogether – and two judges come to the end of their 15-year terms. Chief Judge Marvel observed that it is possible that the makeup of the Court will change by almost 1/3, depending on how the administration deals with the judges whose terms are expiring, and that would be an extraordinary amount of turnover for the Court. (Some administrations have almost automatically reappointed Tax Court judges as their terms expired and some have almost automatically replaced judges as their terms expired. We will soon find out how the current administration approaches the matter.)

Department of Justice

The Tax Division of the Department of Justice was ably led by Dave Hubbert for many months while it was without a political appointee. Dave continues to serve as the deputy in charge of Civil Matters as he did, since 2012, before he was acting as the head of the Tax Division. On December 17, 2017, Richard Zuckerman joined the Tax Division as the Deputy Assistant Attorney General for Criminal Matters and became the Division’s Principal Deputy in charge of the Division. Read more about him here. The Tax Division has three priorities for the coming year: 1) offshore compliance; 2) employment taxes; and 3) return preparers. These priorities are not especially new but continue as areas of emphasis in enforcing the tax laws.

Passports

I attended a panel discussion devoted to the enforcement of the provision which will revoke or deny a passport for individuals with seriously delinquent tax debt. The principal panelist was Drita Tonuzi, the Deputy Chief Counsel for Operations. Drita has held this position for almost one year. So, the panel could hardly have been more authoritative. We have discussed this issue before here and here. The IRS will certify taxpayers to the State Department if the taxpayer owes more than $50,000 and their CDP rights are exhausted, except for taxpayers who fall into certain statutory and administrative exceptions.

The statutory exceptions listed in IRC 7435(b)(2) include debts being paid in an installment agreement (IA) or offer in compromise (OIC) on which the taxpayer is up to date, debts being contested in a Collection Due Process (CDP) hearing and in an innocent spouse request. The manual also notes that the IRS will not refer taxpayers currently serving in a combat zone because of the suspension of action against these individuals in IRC 7508(a). The IRS has created a list of eight administrative exceptions in IRM 5.1.12.27.4 which it published on December 12, 2017. These exceptions are cases in currently not collectible status; cases involving identity theft; cases in which a bankruptcy case is pending; debt of a deceased taxpayer (the IRM specifically limits this exception to the deceased taxpayer himself or herself and makes me wonder how many of these taxpayers have concerns about their passports but I will refrain from making further remarks on this exception); pending OICs and IAs; pending adjustments that will fully pay the liability and taxpayers residing in a disaster zone.

The panel indicated that the letters would be going to the State Department “soon,” which may mean before the end of February.

When the IRS sends a certification to the State Department that a taxpayer is seriously delinquent, it simultaneously will send a letter to the taxpayer. This letter, which will be sent by regular (not certified) mail to the taxpayer’s last known address will give the taxpayer the opportunity to file a petition in Tax Court to contest the decision. The taxpayer has the right to file a petition in Tax Court or in the District Court. The panel stated that the time to go to court is open-ended. It also speculated that most taxpayers will go to District Court because of the desire for speed that would not be afforded under normal Tax Court procedures. The panel stressed that the IRS is just one part of this process and the State Department is the place where the denial or the revocation of the passport occurs. For IRS procedures, look at IRM 5.1.12.27.

National Taxpayer Advocate’s Report

I was extremely glad that the government shutdown that occurred during the Tax Section meeting lasted only a few hours. Had the shutdown continued, I was slated to attempt to fill in for the National Taxpayer Advocate on a couple of panels and that would not have been good for those attending. Since the shutdown ended, the National Taxpayer Advocate was able to deliver the presentation about her report. This will be a glancing blow on the topics covered and I hope to have some individual posts regarding some of the topics needing a longer discussion.

One of her findings this year concerned the reports we have become accustomed to hearing that the IRS audits less than 1% of the returns filed. In her annual report and her discussion, she debunked this myth by pointing out the actual number of returns on which the IRS makes adjustments approaches 7%. She also pointed out that 76% of audits are done by correspondence and that we should be focusing on not just the number of contacts made by the IRS but the nature of the contacts. The contacts are an opportunity for the IRS to educate and to bring taxpayers into long-term compliance but contacts by correspondence have much less of a chance of accomplishing this purpose.

The IRS has decided that it has authority to do retroactive math error adjustments. In 2017, there were a number of filers who used ITINs without updating them as instructed. Chief Counsel has issued an opinion that nothing prohibits retroactive math error adjustments. The IRS intends to send such notices to the individuals who used invalid ITINs in 2017 and then just summarily assess liabilities against the individuals who received refunds.

The 2017 filing season was the first one in which the IRS held up refunds in which the taxpayer sought refundable credits until February 15th. The purpose of the delay in issuing the refunds until that date was to give the IRS time to match third-party data against the returns to cull out bad refund claims. By February 15th, the IRS still did not have the data it needed in order to perform the match with respect to many taxpayers. If the employer or other third party submitted the information returns by paper, the IRS did not have time to transfer that information into its digital file in order to perform the match. The NTA recommends reducing the number of employees, from 50 to 5, an employer can have and still use paper.

The NTA also talked about the new “Purple Book” that was issued as a part of her report. The color was chosen as a blend of red and blue to signify the bi-partisan nature of the legislative suggestions. The book puts together the suggestions from a compilation of suggestions made during the period of the NTA’s service in that position and it provides the suggestions to Congress in a ready to use format. The NTA credits Ken Drexler, who heads up the legislative liaison work in her office, for the idea but noted that its inclusion caused a lot of additional work for the staff. Two of the provisions in the book were passed by Congress during the Tax Section meeting and I will talk about those provisions in a separate post.

 

ABA Tax Section Submits Comments on Rev. Proc. 99-21

We welcome guest blogger Caleb Smith who runs the tax clinic at University of Minnesota and who regularly blogs with us on designated orders. Recently, Caleb headed up a comment project for the ABA Tax Section on Rev. Proc. 99-21. In the almost 20 years after the passage of section 6511(h), the IRS has not issued regulations concerning that subparagraph and to my knowledge had not previously called for comments. The opportunity to comment on this provision is a very positive development and the group headed by the Caleb did an excellent job in their comments on this provision and how the IRS could change some of the rules it applies in administering the provision to follow more closely the purpose of the statute and to make it easier for taxpayers to comply without making it more difficult for the IRS to administer. The IRS is rightfully concerned that it does not want to open a floodgate of requests for relief that it would have to manage and concerned that it would not receive appropriate information to allow it to make the proper decision concerning relief to allow someone to claim a refund after, and sometimes long after, the statute of limitations had expired.  

Because I was aware that the ABA Tax Section was making these comments and because I wanted to highlight the specific issue of who can appropriately provide information to the IRS regarding someone’s disability, I also sent in comments on this issue on the narrow issue of who the IRS should listen to in making this decision. I am hopeful that a fresh look at this issue after 20 years of administration and litigation will allow the IRS the opportunity to improve upon the original procedures making it easier for it and taxpayers to appropriately determine and obtain relief. Keith

With all the focus on Graev, it can sometimes be easy to lose sight of the other, important issues that Procedurally Taxing has consistently blogged about. One such issue that, absent PT’s coverage, may not have been at the forefront of practitioner’s consciousness are the problems with Rev. Proc. 99-21 in determining “financial disability.” Much like supervisory approval in Graev, financial disability is a product of the 1998 IRS Restructuring and Reform Act that may not have been given quite its due in the decades after its enactment. Since the ABA Tax Section recently submitted comments to the IRS about concerns it has with the Rev. Proc. now seems a good time to get reacquainted with the issue.

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The Crux of Rev. Proc. 99-21: Showing “Financial Disability”

The phrase “Financial Disability” probably doesn’t mean a lot to most tax practitioners (or doctors, or anyone else, for that matter). But for tax purposes, the concept is somewhat simple: under IRC 6511(h), financial disability of a taxpayer tolls the statute of limitations for claiming a refund. Thus, financial disability allows for refunds that would otherwise be time-barred. There aren’t a lot of exceptions to the mechanical (and mind-boggling) statutory provisions governing refund claims, so this provision may come as both a surprise and relief to many. The problem is largely in proving that one is financially disabled. And this, in turn, is problematic at least in part because of the IRS procedures for showing financial disability in Rev. Proc. 99-21.

Along with Christina Thompson of Michigan State and Eliezer Mishory of the IRS, I presented on this topic at the most recent Low-Income Taxpayer Clinic conference in Washington, D.C. On giving the presentation, I encountered two general reactions: (1) many practitioners expressed that they previously had no idea what “financial disability” was (some expected our presentation to be about collection issues, probably “financial hardship”) and (2) practitioners that did know what financial disability was shared very similar frustrations with how to prove it. Those frustrations almost all dealt with Rev. Proc. 99-21.

Procedurally Taxing has covered this issue numerous times. Early posts note the near-futility of taxpayers challenging the IRS in court on financial disability grounds. The trend, however, has shifted in taxpayer’s favor (posts here and here). Courts progressed from questioning Rev. Proc. 99-21 in Kurko v. Commissioner to outright holding for the taxpayer when the IRS failed to provide rationale for rules within Rev. Proc. 99-21 in Stauffer v. IRS.

IRS Request for Comments and the ABA Tax Section Submission

My hope is that, in the aftermath of Kurko and Stauffer, the IRS will be more receptive to changes to Rev. Proc. 99-21 because there is little reason to stick with a sinking ship. The general criticisms in the ABA comments could be summarized as:

(1) Rev. Proc. 99-21 is not faithful to the intent of the enabling statute, stemming largely from the Congressional override of the Supreme Court in Brockamp;

(2) Changes are needed to ensure that vulnerable taxpayers are protected and any such change should, at the minimum, make it likely that the taxpayer in Brockamp would be found “financially disabled”; and

(3) Rev. Proc. 99-21’s disallowance of psychologists as a professional that can attest to a mental impairment is poorly reasoned, poorly drafted, and vulnerable to challenge in Court.

The suggestions provided to remedy these issues were sensitive to IRS worries that changes to Rev. Proc. 99-21 may open floodgates for late refund claims that cannot be quickly resolved, or that may allow the simply negligent to cash-in. The four recommendations are meant to balance legitimate IRS concerns while also protecting taxpayer rights and getting to the correct outcome. Some of the recommendations work towards administrative ease (publishing a list of prima facie section 6511(h) applicable medical conditions), while others focus on the realities that “financially disabled” (often low-income) taxpayers face (like poor medical records and greater involvement with psychologists and social workers than medical doctors).

I encourage readers to take a look at the submitted comments and to keep financial disability on their radar in the future. It can mean quite a lot to the more vulnerable individuals in society.

 

 

Scamming Taxpayers: 2018 Version

IRS has released information this week about the latest twist on identify theft related tax scams. This scam involves thieves who access personal client information from preparers, and then submit fraudulent tax returns claiming a refund. The funds arrive via direct deposit in a legitimate bank account. The thieves then pounce on the unsuspecting refund recipient, leaving messages detailing how the IRS has issued an erroneous refund and in order to correct the situation the individual must send the cash to a collection agency. Some versions of the scam threaten criminal prosecution; others threaten a so-called blacklisting of the individual’s social security number.

IRS notes that new versions of the scam are appearing; it all stems, however, from thieves compromising personal information from a preparer’s client files. Earlier this month, IRS reminded preparers on ways to secure data.

All of this reminds me about the generational shift in  tax preparation and filing and how technology has changed the dynamics, mostly for the better but in its wake creating 21st century problems and legal issues. We have discussed the effects of this shift, including recently in Delinquency Penalties: Boyle in the Age of E-Filing, where we looked at an amicus brief the ACTC filed in Haynes v US. That case tees up if a taxpayer who uses an authorized e-filer expecting that the return be timely filed can avoid a delinquency penalty if in fact there was an error in the processing of the e-filed return but the IRS or the preparer did not notify the taxpayer of the error in time to fix the glitch.

For more on the changes in tax administration relating to the shift, I recommend a review of the Electronic Tax Administration Advisory Committee (ETAAC) annual reports; recently that group has shifted its focus to more directly include security issues generally and identity theft tax refund fraud in particular. The 2017 report discusses what IRS, working with private sector and other government partners, has done and its progress in recent years. As this week’s IRS news release indicates, IRS efforts to secure the tax system from creative and motivated thieves is a little bit like whack a mole; one scam disappears and a new one pops up in its place.

 

 

Bankruptcy Cases Involving Evasion of Payment and Classification of the Failure to File Penalty

A pair of recent bankruptcy cases deserve some mention. Conard v. IRS and In re Colony Beach & Tennis Club take a look at IRS claims from two perspectives and provide some insight on whether a bankruptcy petition will prove beneficial in certain circumstances. In the Conard case, the husband gets no relief but his wife will get the opportunity to fully litigate the issue of discharge. In Colony Beach, a defunct partnership’s liability gets classified in a way that will help other creditors of the debtor if not the debtor itself; however, in fashioning the equitable remedy that subordinates the IRS claim, the bankruptcy court loses sight of the true party to blame for the problem and creates an inequitable result at odds with earlier precedent and good sense.

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Evasion of Payment

Conard involves the application of facts to BC 523(a)(1)(C). This bankruptcy code section excepts from discharge tax debts incurred through evasion of a tax debt either in the filing or a return or the payment of the tax. The Conrads’ case involves evasion of a tax debt though efforts taken not to pay the tax. The amount of the liability was not in dispute and the IRS did not argue that the Conards did anything to keep the IRS from knowing the correct amount of the liability. Instead, the IRS seeks to deny the Conards a discharge because they have attempted to evade payment of the debt prior to filing their bankruptcy petition. The IRS must prove by a preponderance of the evidence that the Conards did not pay their taxes in an improper effort to avoid doing so. Guest blogger Lavar Taylor discussed this issue previously here and here. I wrote about it here, in a case involving evasion of the creation of the liability and not evasion of payment but the post has links to a couple of earlier discussions of the issue.

Mr. Conard operated a life insurance agency in Northern Virginia. The case caused me to notice that in the district where I practiced bankruptcy law while representing the IRS a new bankruptcy judge had been appointed, Judge Keith Phillips, who I knew and liked as a practitioner. Judge Phillips describes Mr. Conard as someone who “chose to put his federal tax obligations ‘on the back burner’ in favor of paying business expenses ‘to keep the business … afloat’ and expanding his business to generate more income.” Mr. Conard placed his federal taxes so far on the back burner that by the time he arrives in bankruptcy court he owed the IRS almost $700,000 for the years 2004-2009.

Of course, as is common in these types of cases, he made purchases that make it very difficult to have sympathy for him. He bought an $86,000 Mercedes Benz, a $47,000 BMW, a $50,000 Buick Lacrosse, and a $4,000 Harley motorcycle. In addition, he spent $48,000 on his son’s tuition as well as a litany of other goods and services that did not reflect the lifestyle of someone scuffling to get by. Judge Phillips found Mr. Conard’s case so straightforward that he ruled for the IRS on a motion for summary judgment. He finds, citing cases from the 3rd, 5th, 6th and 10th Circuits, that the IRS need to meet the criminal standard of beyond a reasonable doubt for evasion of payment.  The IRS needs to prove that Mr. Conrad attempted to evade the payment of his taxes – essentially the same, if not the same, proof as in a 7201 evasion of payment case; however, the proof does not need to be beyond a reasonable doubt or even clear and convincing in order to have the taxes determined to be excepted from discharge under BC 523(a)(1)(C).  The IRS can have the taxes excepted from discharge if they can prove the attempt to evade payment by a preponderance of the evidence.

However, the Court determined that the IRS had not shown that Mrs. Conard was sufficiently willful in not paying her taxes. It refused to rule on summary judgment with her and will hold a trial to determine her role in the non-payment. I do not know enough about the case against her to have an opinion. With respect to Mr. Conard, he presents the classic case of someone excepted for discharge for seeking to avoid the payment of taxes. If you are not going to pay your taxes, try not to purchase expensive cars and other big ticket items during the period of non-payment.

Reasonable Cause and Equitable Subordination

The Colony Beach case involves a situation in which the IRS seeks to have a penalty claim elevated to administrative claim status. If the claim achieves that status, it will get paid before all other unsecured claims. The debtor, a limited partnership, filed its chapter 11 bankruptcy petition in October, 2009, but by August of 2010 it followed the path of many businesses that start in chapter 11 and converted to a chapter 7 liquidation. It was a fiscal year taxpayer whose year ended on April 30. The return for the year ending in 2011 was initially due July 15 and the extended due date, had it requested an extension, would have been due on January 15, 2012. The trustee filed the return on January 7, 2012 apparently operating under the mistaken impression that his accountant had requested an extension. Because neither the trustee nor his accountants requested an extension, even though they could have done so, and because this penalty applies at the partnership level, the IRS filed a proof of claim for a penalty of $356,695.46.

The trustee, the same person who filed the return late, objected to the claim arguing that reasonable cause existed for late filing. Additionally, the trustee argued that it would be inequitable to allow the IRS to have a priority claim for the penalty and get paid ahead of all other unsecured creditors of the bankruptcy estate. (I do not know exactly how much money was in the estate but it is possible that the penalty claim made the estate “administratively insolvent” which would have meant the trustee would not receive his full fees.)

The first sentence of the reasonable cause portion of the opinion contained a citation to Boyle, which I have noted before is almost always a signal that things will not go well for the party arguing reasonable cause. My use of Boyle as a predictor on this point proved accurate again. The trustee argued that he was involved in “complex litigation which required his full attention.” He also argued that the business was in disarray impeding his ability to reconcile accounts. These all seem like reasons for requesting an extension of time to file which would only have taken a few moments and would have bought the trustee the time he needed to put things together. The court pointed out that the trustee did not file an application to employ accountants to prepare and file the 2011 return until five days before the extended deadline for filing the return. He testified that he thought the debtor’s former accountants would take care of requesting an extension though he never checked on whether they had done so. Consequently, the court had little trouble turning back his reasonable cause claim.

“Nevertheless, it is appropriate in this case to deny the United States’ claim as an administrative expense under 503(b) and to equitably subordinate it.” So, losing the reasonable cause argument in this case does not have any apparent negative impact on the trustee or most of the creditors of the estate. The court notes that penalties can achieve administrative claim status; however, to do so they must relate to a tax incurred by the estate. Here, the taxes related to the late file return are the responsibility of the partners and not the partnership in bankruptcy. So, the claim does not qualify for administrative claim status under section 503((b)(1)(C).

The IRS wants this money so it argued even if the penalty claim does not qualify under (b)(1)(C) it should qualify as a “generic” administrative expense, citing In re 800Ideas.com, Inc., 527 B.R. 701, 702 (Bankr. S.D. Cal. 2015). That case involved a late filed S Corporation return which had the same tax passthroughs as the partnership return and the same late filing penalty application at the corporate level. The bankruptcy court here, acknowledging the appropriateness of the citation, declines to accept the reasoning of that case concluding that “it is appropriate to give meaning to the exclusion of penalties that are unrelated to taxes owed by the bankruptcy estate.” The court also points out the real elephant in the room which is the impact of allowing the penalty claim as an administrative claim on the unsecured creditors who had no hand in the late filing of the return.

Here is where I disagree with the court. It states that in the 800ideas.com case “the impact of the penalty fell on the trustee because the claim, as an administrative expense, reduced the trustee’s compensation.” The court further states that in this case “the trustee will be paid in full, regardless of the United States’ claim receiving administrative status or not….” That makes no sense. The court could have the IRS claim for the late penalty paid in lieu of the trustee’s payment and subordinate the trustee’s payment, to the extent of the penalty claim to general unsecured status. The trustee in this case need not be paid in full while the IRS gets stiffed on its penalty claim that arose because of the trustee’s failure. I totally agree with the court that this penalty should not be borne by the other unsecured claimants but allowing the trustee to take ahead of the IRS cannot be reconciled with equity.

Conclusion

The bankruptcy court in 800ideas.com understood how to fashion an equitable remedy in this situation. I hope the IRS appeals the case to a district judge who has a similar understanding of equity. If the trustee in a situation like this receives his full fee, he learns that filing late has no consequence. That should not be the lesson learned from filing late. This court loses sight of how to fashion an equitable remedy no matter how sorry one feels for a busy trustee.

 

 

Avoiding the Federal Tax Lien Securing Penalties in a Bankruptcy Case

The case of Hutchinson v. United States [No. 17-01076] (E.D. Cal. 2017) involves an effort by taxpayers in bankruptcy to avoid a federal tax lien securing the payment of penalties. The bankruptcy court denies the effort by the taxpayers to avoid the lien while acknowledging that the bankruptcy trustee could have avoided the lien had the trustee sought to do so. As discussed below, the reason that the bankruptcy court allows one party, the trustee, to avoid a federal tax lien securing penalties but not another party, the debtor, results from the benefit Congress sought to confer in allowing avoidance of the federal tax lien securing penalties in a chapter 7 case.

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The taxpayers owed $162,690 in penalties at the time they filed their bankruptcy petition. Prior to the filing of the petition, the IRS had filed a notice of federal tax lien in the city or county in which their residence was located. In their bankruptcy schedules, taxpayers indicated that the value of their home was $185,000 and that it was encumbered by a first deed of trust in the amount of $87,000. They claimed a personal exemption of $100,000. Because they lived in California, which has a generous exemption provision for personal residences, this was possible. Not all states have such a large exemption for personal residences.

Taxpayers’ problem with the exemption was that it removed the property from the bankruptcy estate allowing them to keep the property and the home equity; however, the federal tax lien continued to attach to the property after bankruptcy putting them in the position of going through the bankruptcy only to find that on the other side they had not obtained the relief they needed. Because the federal tax lien still attached to the home, the IRS had/has the ability to sell the home either administratively or through a foreclosure proceeding. The taxpayers presumably sought to avoid the lien in their case in a post bankruptcy discharge action in order to keep the IRS from taking their home and using the equity in excess of their first mortgage to satisfy the tax debt.

Before discussing the Hutchinsons’ case further I stop to note that the IRS is generally very reluctant to take taxpayers’ homes. Before 1998 it did not take taxpayers’ home frequently, but after the Restructuring and Reform Act of 1998 the IRS very rarely takes taxpayers’ homes or other tangible property. The situation gets a little stickier for the IRS in the post bankruptcy situations. Absent bankruptcy, the IRS can simply take no collection action operating under the fiction that the statute of limitations on collection is still open and it might collect from the taxpayers through some mechanism other than seizure and sale of property. No one at the IRS is forced to make a decision concerning collection and the general practice of only seizing tangible assets in rare circumstances usually results in a decision to do nothing which is different than an affirmative decision to walk away from the only property that could satisfy the liability.

When a taxpayer obtains a bankruptcy discharge and before the filing of the bankruptcy petition the IRS  a filed federal tax lien for the discharged taxes discharged, someone at the IRS must make an affirmative determination whether to pursue collection from any assets the taxpayer brought into the bankruptcy estate to which the federal tax lien attached. The equity available in a debtor’s property such as the home equity available in the Hutchinsons’ case is the only thing from which the IRS can collect to satisfy the discharged liability because the bankruptcy discharge turned what was an in personam liability into an in rem liability.  The rem, or the thing securing the debt, in the Hutchinsons’ case, their house, is the only asset the IRS has from which it can satisfy the liability. Someone at the IRS must make an affirmative determination to release the lien.  In this situation the IRS employee assigned to the case cannot rely on the fiction that the IRS might later collect the liability from future earnings or a voluntary payment. The IRS employee knows that if they release the lien they are walking away from $100,000 in equity and that the only way to collect the $100,000 is to enforce the lien on the property. Here, it becomes more likely that the IRS will take action against the property to obtain the equity to which its lien attaches than if the taxpayer had not sought bankruptcy relief.

So, the Hutchinsons would like to eliminate the IRS lien in order to eliminate the possibility that the IRS would take their home. Because the lien at issue here is a lien in which the underlying liability is a penalty and not a tax and because the taxpayers filed a chapter 7 petition, the trustee could have avoided the lien using the powers available in Bankruptcy Code sections 724(a) and 726(a)(4). The Hutchinsons brought this action to avoid the penalty under Bankruptcy Code section 522(h). Section 522 is the section that addresses exempt property. The IRS responded to the action by arguing that 522(c)(2)(B) specifically allows it to assert its lien against exempt property and that only the trustee has standing to assert the lien avoidance provisions of 724(a).

The court acknowledged that the trustee could have avoided the tax lien and then found that if the trustee does not do so debtors can avoid liens under section 522(h) but not tax liens. Citing the earlier Ninth Circuit case of In re DeMarah, 62 F.3d 1248,1250 (9th Cir. 1995) the court holds that “where the lien sought to be avoided secures back taxes, 522(c)(2)(B) eviscerates the debtors’ 522(h) powers.” The court noted that the fact that the debtor could exempt property from the estate does not mean that the debtor can remove the lien “or that portion of it which secures the penalty.” The purpose for allowing the trustee to avoid the tax lien securing penalties in a chapter 7 case is to allow the trustee to obtain a greater recovery for the benefit of the other creditors of the bankruptcy estate. The purpose of the provision allowing avoidance was not to allow the debtor to gain relief.

This case does not break new ground but presents a bankruptcy issue we had not previously discussed on the blog. The penalty avoidance powers in chapter 7 are strong and represent an effort by Congress to clear up some equity for other creditors who should not be penalized themselves by the debtors’ bad tax behavior. The provision allows the removal of the lien on penalties as an impediment to the payment of a creditor with no lien interest or an inferior lien interest and avoids having limited estate funds go to satisfy a debt based on bad behavior towards the IRS.  Those avoidance powers were not intended to allow the debtor to use bankruptcy to escape from their bad tax behavior. In the absence of a filed federal tax lien and if the penalty is not for fraudulent behavior, bankruptcy serves as an excellent mechanism for discharging penalties more than three years old but the existence of the filed federal tax lien changes the game and gives the IRS the opportunity to pursue available equity in a debtor’s property to collect penalty claims if it has the desire to do so.

 

 

Designated Orders, January 29 – February 2: Holmes Continues Plumbing the Depths of Graev

Regular contributor Professor Caleb Smith continues on our theme of discussing the long reach of Graev and related issues.  Les

There were five designated orders last week, but only one worth going into much detail on. Of course, it involved Judge Holmes once more considering some implications of Graev. The other orders involved a taxpayer erroneously claiming the EITC with income earned as an inmate (here); and three orders by Judge Gustafson working with pro se taxpayers: two of which are in the nature of assisting the taxpayer (how file a motion to be recognized as next friend here, and clarifying how to enter evidence here) and one granting summary judgment to the IRS (here). Note parenthetically that in the latter order Judge Gustafson goes out of his way to mention that the IRS approved a 6662(a) penalty in compliance with IRC 6751 [erroneously cited as 7651]. IRC 6751, of course, is the issue du jour, and the focus of today’s post.

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Rajagopalan & Kumar, et al. v. C.I.R., Dkt. # 21394-11, 21575-11 [here]

Supervisory Approval: Is it Needed for Every “Reason” Behind the Penalty?

For those that need to catch up, the Procedurally Taxing team has provided a wealth of analysis and insight on the Graev/Chai case developments. For “Graev III” fallout readers are encouraged to visit this, this and this post (to name a few). Judge Holmes in particular has been at the forefront of raising (if not quite resolving) unanswered questions that lurk in the aftermath of Graev III. In Judge Holmes’s most recent order, we see two questions bubble to the surface. One of those issues should only provide a temporary headache to the IRS: the procedural hurdle for the IRS to introduce into evidence that they complied with IRC 6751 if the record has been closed. The other issue, however, could well create a lasting migraine for the IRS: whether the IRS form showing supervisor approval also sufficiently shows approval for the rationale of the penalty. That problem isn’t directly answered in the order, but I think it is the most interesting (and most likely to remain a lasting problem) so we will begin our analysis with it.

Imagine the IRS asserts that a taxpayer understated their tax due by $5500 (with that amount being more than 10% of the total tax due). The IRS issues a Notice of Deficiency that throws the book at the taxpayer with an IRC 6662(a) penalty because of this substantial understatement of income tax and because the taxpayer was negligent. In so doing, the IRS is relying on two separate subsections of IRC 6662 as their legal basis for the penalty’s application: subsections (b)(1) and (b)(2).

Imagine further that the IRS did the right thing and had a supervisor sign-off on the penalty prior to issuing the Notice of Deficiency. Does the supervisor need to approve of both rationales (i.e. (b)(1) and (b)(2))? Or is the fact that the penalty, to some degree, got supervisory approval enough on its own? What if the Tax Court finds that this same taxpayer only understated $4500 in tax on their return? Now only negligence could get the IRS to a 6662(a) penalty: do we need to have proof that the supervisor approved of that ground for raising the penalty?

These are questions that Judge Holmes has raised before, in his concurrence of Graev III. Judge Holmes lays out a parade of horribles beginning on page 45 of the opinion, one of which deals with approval of one, but not two, grounds for an IRC 6662(a) penalty (on page 46, point 4). This made me wonder exactly what the supervisory approval form looks like, and if it sets these points apart. With the sincerely appreciated assistance of frequent PT blogger Carl Smith and lead Graev III attorney (also PT contributor) Frank Agostino, I was able to gaze upon this fabled supervisory approval form, which can be found here. And, sure enough, the form does break down 6662 penalties (to a degree). It breaks down IRC 6662 into four categories: (1) Negligence, (2) Substantial Understatement, (3) all other 6662(b) infractions, and (4) 6662(h). The neatly delineated checkboxes certainly make it seem like a supervisor is only “approving” whichever specific penalty rationale they check yes next to.

Looking to the statute at issue provides little guidance on what “amount” of supervisory approval is needed, only that the “initial determination” is personally approved before making the determination. Taking the above accuracy penalty as an example, one could argue that the penalty needing approval is only IRC 6662(a), so that is all that need be approved broadly. The supervisor has agreed that the penalty should apply and the worry of it being used as a bargaining chip is lessoned. The statute isn’t intended to provide a through legal review of all penalty theories, but only to be sure that they aren’t being applied recklessly as “bargaining chips.”

However, one could just as reasonably argue that the nature of the penalty’s application requires some degree of specificity: the penalty is only applied to the amount of the underpayment attributable to that rationale. If our hypothetical taxpayer understated by $5500, but only $1,000 of it is due to negligence, then you would have two potential penalty values: $1,110 (20% of substantial understatement) or $200 (20% for the portion attributable to negligence). Yes, the penalties arise under the same code section (broadly: 6662(a)), but their calculation depend on the rationale (narrowly: 6662(b)(1) or (2)). Since that leads to two different potential penalty amounts, it would seem (in a sense) to be two different penalties. Certainly, one would think two separate approvals were needed if the penalties were IRC 6662(a) or IRC 6662(h), as they apply two different penalty percentages. Why should it be different if they potentially apply against two different amounts of understatement?

Questions I’m sure Judge Holmes looks forward to in future briefs. Though the intent of IRC 6751 is laudable, the language certainly leaves much to be desired.

In the interest of taxpayer rights, however, I think it is important to note that the IRS has created at least some of these problems on their own. From my perhaps biased perspective, accuracy penalties under IRC 6662(a) are most troublesome when applied “automatically” or with little thought against low-income taxpayers that may simply have had difficulty navigating complicated qualifying child rules. In my practice I deal less with the “bargaining chip” and more with the “punitive” aspect of penalties. We have already seen how reflexively the IRS will slap EITC bans without proper approval or documentation here. There may be reason to believe the IRS is just as reflexive with these IRC 6662(a) penalties. Consideration of the relevant IRM is illustrative:

IRM section 20.1.5.1.4 details “Managerial Approval of Penalties.” It lays out the general requirement of IRC 6751 that supervisory approval is required for assessment of a penalty, and then details two important exceptions (one of which I’ll focus on): there is no need for supervisory approval on penalties that are “automatically calculated through electronic means.”

This, by the IRS interpretation, includes IRC 6662(a) penalties for both negligence and substantial understatement if so determined by AUR… so long as no human employee is actually involved in that AUR determination. In other words, we are to trust that no safeguard is needed when the (badly outdated) computers of the IRS determine that there was negligence on the part of the taxpayer. I would note that it appears that this also applies for campus correspondence exams though that is not immediately clear. IRM 20.1.5.1.4(2)(b) implies as much by referring to IRM 20.1.5.1.4(4) (the exception to human approval provision), but that latter provision only mentions the AUR function.

But wait, there’s more. Per that same IRM, if the taxpayer responds to the letter (or notice of deficiency) proposing the penalty then the IRS needs supervisory approval because now it is out of the realm of machines and into the realm of humans. This would seem to imply that taxpayers only have the protection of IRC 6751 if they are noisy. If they aren’t noisy, the IRS hasn’t violated a right of the taxpayer they failed to assert: the right never existed by virtue of failing to assert it. (Apologies for getting metaphysical on that one.)

Bringing it back to the realm of legal/statutory analysis, this still doesn’t seem quite right. Wasn’t the “initial” determination of the penalty already done prior to the taxpayer responding? Or is that irrelevant because at the computer stage it was not an “initial determination of such assessment” (whatever that means)? Judge Holmes, again, has signaled what he believes to be a coming storm on the “initial determination” question. I have no doubt that, given the sloppiness of the statute and the rather poor procedures in place for the IRS, that question is likely to be litigated.

Other Temporary Problems Addressed in Rajagopalan

Though I have devoted the bulk of this post to the issue of “types” of supervisory approval, most of the designated order actually dealt with a different issue. Luckily it is an issue that should be less of a problem moving forward: the IRS scrambling to get evidence of supervisory approval into the court record when the record’s already closed.

As the docket numbers indicate, these consolidated trials have been going on for quite some time: a child born when the Rajagopalan petition was filed would probably be learning their multiplication tables right now. The supervisory approval requirement of IRC 6751 was in effect well before the Rajagopalan trial and record was closed… so how could the IRS possibly have an excuse to reopen the record at this later date?

Obviously, because of the brave new post-Graev III world we now live in. Judge Holmes notes that the IRS had some reason to anticipate the IRC 6751 issue, but doesn’t seem to fault the IRS too much for that failure. Instead, Judge Holmes lays out the requirements to reopen the record: the late evidence must be (1) not merely cumulative or impeaching, (2) material to the issues involved, and (3) likely to change the outcome of the case. In other words, it must be very important towards proving what is at stake (not simply disproving other evidence). But even if it is all of these things, if the diligence of the party trying to reopen the record has to be weighed against the prejudice reopening the record will do to the other party. This final weighing test demonstrates the high importance we place on parties being able to question and examine evidence in a usual proceeding.

So, the IRS has the “golden ticket” (i.e. a document that shows actual supervisory approval) but the record is closed. Is that golden ticket enough to reopen or is the petitioner so prejudiced by this inability to confront the evidence that it should remain closed?

Clearly the supervisory approval form is very important to the case, meeting tests (1), (2) and (3) above. Further, the supervisory approval form is admissible as a hearsay exception through the business records rule (FRE 803(6)). However, the IRS supervisor declaration authenticating the supervisory approval form does, potentially, run afoul of the rules of evidence since it is offered after trial without reasonable written notice to the adverse party. See FRE 902(11).

In the end, the petitioners concern with being unable to challenge the supervisory approval forms is given little weight. Cross-exam would likely have done nothing. The issue is supervisory approval, which is shown by a particular form that the IRS is now offering: either the forms “answer those questions or they don’t.”

This seems like a practical way to frame an increasingly thorny issue.