Innocent Spouse Injured by Using the Wrong Form

The difference between innocent and injured spouse can create confusion.  That confusion gets illustrated in the case of Palomares v. Commissioner, T.C. Memo 2014-243 which will soon be argued before the 9th Circuit by a student at the tax clinic at Gonzaga Law School.  The case illustrates something that regularly happens in innocent spouse case – the innocent spouse’s refunds get offset by the IRS to satisfy the liability of the “liable” spouse – and getting them back can prove very difficult for the innocent spouse.

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For anyone unfamiliar with the innocent spouse and injured spouse provisions, I will briefly discuss the distinction between the two types of relief.  Innocent spouse relief allows a spouse who has filed a joint return to obtain relief from the joint and several liability that results from filing a joint return if the spouse requesting relief meets certain criteria set out in IRC 6015(b), (c) or (f).  Injured spouse relief allows a spouse who files a joint return to recover the portion of the refund resulting from that return which relates to the liability of the requesting spouse when the refund would otherwise go to satisfy a tax, or other liability subject to offset, owed solely by the other spouse.  While both forms of relief result from filing a joint return, the goal of each type of relief differs and the difference can create confusion for someone who does not regularly handle these types of cases.

Ms. Palomares got confused.  She needed innocent spouse relief but filed Form 8379 designed for use by injured spouses.  The IRS recognized her confusion and provided her with the correct form, Form 8857.  Upon receipt of the correct form, Ms. Palomares eventually filed it but the delay creates the issue in the case.  The IRS determined she deserved some relief as an innocent spouse; however, the delay in filing the correct form limited that relief.  After incurring the joint liability for which she sought innocent spouse relief, Ms. Palomares found that the IRS took the refunds she claimed in subsequent years in order to satisfy the unpaid liability on the joint return.  In seeking innocent spouse relief, she also wanted a return of the refunds the IRS had offset against the joint liability.  The issue here turns on the timing of her request for refund, which turns on whether the filing of the incorrect form nominally seeking injured spouse relief can meet the requirements of the informal claim doctrine allowing her request for relief to relate to the date of filing the injured spouse relief rather than the date of filing the correct form for innocent spouse relief.

In addition to the general confusion that exists between innocent and injured spouse relief, Ms. Palomares had the additional handicap that English was not her first language, and she spoke very little English.  The years at issue for the refund are 2005 through 2008.  By these years, she had separated from her husband, and she filed returns using the filing status of head of household.  As mentioned above, the IRS took the refunds reflected on these returns as it should using the power of offset granted in IRC 6502.  When she did not receive her refunds for 2006 and 2007, she sought assistance from the Northwest Justice legal clinic which helped her fill out the wrong form on July 1, 2008.  This clinic is not a low income taxpayer clinic but a clinic providing general legal assistance.  On September 24, 2008, the IRS sent her a letter with the correct form.  The Court found that “She did not call or otherwise contact respondent with respect to the September 24 letter.”

Ms. Palomares’s life intervened and kept her from focusing on her taxes for almost two years.  Finally, in August, 2010, she filed the Form 8857 seeking innocent spouse relief with the correct form and seeking a return of the refunds taken from her for four years.  Initially, the IRS took the position that the request came too late because she sent it more than two years after collection activity had begun; however, on May 14, 2012 the IRS reversed its position regarding the two year rule and requests for relief under IRC 6015(f).  The IRS granted her relief as an innocent spouse; however, it limited her refund to amounts paid within two years of the filing of the Form 8857 in 2010.  She appealed arguing that the relief should date from the submission of Form 8379 and that is the issue before the court in this case.

The Tax Court found that the Form 8379 did not meet the requirements for an informal claim.  The requirements for an informal claim do not come from a statute since this is an equitable remedy constructed by the courts to prevent an injustice.  As the Court notes, the sufficiency of an informal claim largely turns on the facts; however, courts generally look for certain markers in deciding whether to treat something other than a formal claim for refund as an adequate informal one.  The underlying principle concerns exhaustion of administrative remedy and whether the IRS had a chance to consider the request.  The more the taxpayer can show that the inappropriate document filed essentially apprised the IRS of what it needed to know in order to grant a refund, the more likely the taxpayer will succeed.

The Court states that a qualifying informal claim must satisfy three requirements.  It quoted from a non-precedential memo opinion to set out the requirements:

It has long been recognized that a writing which does not qualify as a formal refund claim nevertheless may toll the period of limitations applicable to refunds if (1) the writing is delivered to the Service before the expiration of the applicable period of limitations, (2) the writing in conjunction with its surrounding circumstances adequately notifies the Service that the taxpayer is claiming a refund and the basis therefor, and (3) either the Service waives the defect by considering the refund claim on its merits or the taxpayer subsequently perfects the informal refund claim by filing a formal refund claim before the Service rejects the informal refund claim. Jackson v. Commissioner, T.C. Memo 2002-44, slip op. at 10.

The Court found that the Form 8379 meet the first test citing to Kaffenberger v. United States, 314 F.3d 944 (8th Cir. 2003).  The Court found that the Form 8379 did not convey sufficient information to notify the IRS that Ms. Palomares sought relief from the liability created by the joint return with her then husband and sought a refund of amounts applied to the liability created by the joint return.  The Court determined that sending her the form for innocent spouse relief amounted to guess by the IRS that she might have intended to request that relief rather than an awareness that she wanted such relief.  The Form 8379 did not reference 1996, the year for which she wanted innocent spouse relief.  Because it did not reference that year, the IRS lacked sufficient clues to know exactly what she wanted and to make a determination based on her Form 8379 other than that the form she sent did not work for the circumstances of her situation since she had not filed a joint return in the years to which the form related.  So, the Court denied her claim for refund based on the date of filing the Form 8379.

Ms. Palomares presents sympathetic facts.  She clearly did not know the difference between innocent spouse and injured spouse, and neither did the clinic that assisted her with her divorce and that helped her file the wrong form.  The IRS gave her the correct form relatively quickly but she delayed filing that form because of things happening in her personal life.  She appears to deserve the refunds she seeks.    The case deserves watching as it heads into argument in the 9th Circuit because of the effort to expand the informal claim doctrine into an area of some confustion.  If the IRS loses, it will probably do so because it was nice and sent her the innocent spouse form.  The outcome turns on whether the IRS knew what she wanted to a degree that would have allowed it to make an innocent spouse determination at the time it received the injured spouse form or instead made an educated guess based on the unavailability of the relief requested on the form she submitted and the confusion surrounding these two similar but different forms of relief available to spouses.

More Fallout from Chai

The Second Circuit reversed the Tax Court’s decision in Chai v. Commissioner and made clear that the IRS had a duty to show it complied with the managerial approval process required by IRC 6751 prior to issuing a notice of deficiency.  Steve blogged on that decision last week.  We also posted last week on a designated order issued by Judge Cohen requiring compliance with IRC 6751 and citing Chai.  Judge Lauber issued a similar order.

On Friday the IRS took the very unusual step of filing a motion for reconsideration of the Graev v. Commissioner decision.  We reported on Graev here.  The Second Circuit largely adopted the view of the dissent in Chai.  Because the appeal in Graev would go to the Second Circuit, it was clear that the opinion would not stand.  Potentially preempting an appeal, the IRS has asked the Tax Court to reconsider its opinion in Graev.  Here is the relevant language of the motion, which can be found here:

  • Relief is justified here because a recent decision by the United States Court of Appeals for the Second Circuit created “exceptional circumstances” for this case.
  • On March 20, 2017, the United States Court of Appeals for the Second Circuit released an opinion in Chai v. Commissioner, No. 15-1653 (2d Cir. Mar. 20, 2017).
  • The Second Circuit’s opinion in Chai specifically disagreed with the majority opinion in this case. Chai, slip op. at *57, 59.
  • The court in Chai held that compliance with section 6751(b) is an issue in deficiency cases because it is part of Docket No. 30638-08 – 3 – respondent’s burden of production for penalties under section 7491(c). Chai, slip op, at *67.
  • Because an appeal in this case would be heard by the Second Circuit, the majority’s opinion in this case cannot be upheld under the precedent established by Chai.
  • Respondent requests that the Court vacate its decision in this case and order additional briefing on what steps the Court should take in this case in light of the Chai opinion. Respondent has views which it believes will benefit the Court to consider in the changed circumstances of this case.

It will be interesting to learn the views of the IRS on how Chai will impact its operation.  The IRS did not suggest what “views it believes will benefit the Court.”

We will keep you posted.  If you are contesting a case in Tax Court in which the IRS asserted a penalty, expect the IRS to begin a search of its records to determine if the required approval of the penalty occurred.  If the IRS does not come forward with the information proving the correct approval occurred prior to the issuance of the notice of deficiency, you may have a clear path to victory on the penalty.

Tax Court Holds that Points Paid on Interest Only Refinancing Not Deductible

This week in Singh v Commissioner the Tax Court in a summary opinion held that a taxpayer was not entitled to deduct the amounts paid in respect of points on a refinancing of a principal residence. Determining whether interest on a home is deductible is complicated by the reality that for many taxpayers information returns or settlement statements may not completely or accurately indicate the amount that can be deducted.

One such issue relates to when consumers are paying interest on a modified mortgage; as we have discussed before (see. e.g. a guest post by Dave Vendler discussing the issue and related litigation) the Form 1098 that most financial institutions issue does not reflect the amounts that were attributable to the accrued but unpaid interest at the time of the modification. This is an issue that is currently the subject of an IRS guidance project (a copy of the American Bankers Association and Mortgage Bankers Association comments on the proposed guidance can be found here). [As an aside I will moderate a panel discussion on that topic at the ABA Tax Section May meeting in DC as part of the Individual and Family Committee].

Singh does not involve a modified mortgage though does spin off of some of the challenges that many Americans faced following the great recession. In Singh the taxpayer refinanced two mortgages on his principal residence with an interest only loan that was for an indefinite period.

Part of the costs that Singh paid included points on the interest only refinancing. To the extent that the points represent interest taxpayers may deduct the points over the course of the loan (assuming of course that the interest is otherwise deductible). This sweeps in Section 461(g), which requires a cash basis taxpayer to amortize prepaid interest over the life of the loan, just as if the taxpayer were on the accrual method of accounting. Section 461(g)(2) provides an exception to the amortization requirement in 461(g)(1) and allows a taxpayer to deduct the payment of certain points if they were paid “in connection with the purchase or improvement of, and secured by, the principal residence of the taxpayer.”

For taxpayers who seek to refinance years after the original purchase or who do not use proceeds of a refinancing to substantially improve the residence, the immediate deduction exception in Section 461(g)(2) provides no help. When is a refinancing close enough to the original purchase to be eligible for the 461(g)(2) immediate deduction? There is a well-known 8th Circuit case from 1990, Huntsman v Commissioner, that provides guidance for taxpayers seeking a deduction for points. In Hunstman, the 8th Circuit allowed an immediate deduction, emphasizing that the taxpayer refinanced to extinguish short-term loans from the original purchase, rather than just seeking to get a lower interest rate or accomplish other financial goals. That connection in Hunstman allowed the taxpayer to take advantage of the Section 461(g)(2) exception on the points paid on the refinancing.

This brings us back to Singh. A refinancing arising (and points paid on that refinancing) many years after the original purchase differs from Huntsman. In addition, the Tax Court noted that Singh could not deduct the points even under the general Section 461(g)(1) authority, which treats the points as amortized over the life of the loan, as Singh’s loan was for an interest only loan for an indefinite period.

The upshot for Singh was no deduction, and accuracy-related penalties for good measure. This is a a good reminder that the deductibility of interest on residences is sometimes not just a matter of plugging in information off a form 1098 or settlement document.  I suspect there is a great deal of confusion and error in this area of the tax law.

Almost Immediate Impact of Chai

On March 21, Steve blogged about the important decision of the 2nd Circuit in  Chai v. Commissioner on March 20, holding that the IRS most show, as required by IRC 6721(b), that the immediate manager approved the imposition of a penalty.  In a designated order enter on March 22, 2017, in Henderson v. Commissioner, Docket No. 14187-16L, Judge Cohen cites to the Chai decision in a ruling on the motion for summary judgment filed by the IRS in this Collection Due Process Case.  Like the order in Vigon v. Commissioner issued by Judge Gustafson which we blogged about here, Judge Cohen requires the IRS to address the requirement of IRC 6751(b).  Specifically, she orders “on or before April 10, 2017, respondent may supplement the motion for summary judgment with any additional affidavit or argument concerning compliance with the requirements of law and administrative procedures supporting the notice of determination in this case, specifically with respect to compliance with Internal Revenue Code Section 6751(b)(1)….”

The fact that she added the requirement to show appropriate approval and that she made this order a designated order, signals what may be an important shift on the Court regarding the practice it will now take regarding the IRS obligation to prove the appropriate approval of penalties.  We will continue to monitor this issue because it suggests a potentially huge shift in practice.  Kudos again to Frank Agostino and the attorneys in his office for identifying and pursuing the argument in a statute that lay forgotten for almost 20 years.

For those of you not familiar with designated orders, the Tax Court has a wonderful feature available on the front page of its web site in which it posts the orders entered each day and provides a feature making the orders are searchable.  The searchable feature of the orders makes the Tax Court’s treatment of them vastly superior to PACER.  The feature became available in 2011 limiting the lookback period but that limitation grows less important with each passing day.  As the orders get posted, the judge issuing the order has the opportunity to “designate” the order.  If the judge designates the order, the judge is signaling that the order is somewhat special – at least in the view of that judge.  Keep in mind that orders do not go through the review in the Chief Judge’s office prior to issuance as is required with opinions.  Matters decided by orders also do not have precedential value as we have discussed before.  Yet, a not insignificant percentage of Tax Court cases get resolved through dispositive orders rather than opinions.  Designated orders allow the judge to alert practitioners that something about the order deserves attention; however, the designation of the order does not require, or really provide for, the judge to state explicitly why the judge has labeled it as a designated order.  The reader must surmise from context why the judge has chosen to designate the order.  On any given day the Tax Court may post five orders and maybe one order will be designated.

In the case of the order in the Henderson I surmise that Judge Cohen designated it because of the citation to Chai and the requirement that the IRS put on its proof about the authorization of the penalty.  This blog has regularly mined orders, and especially designated orders, as a source of information about Tax Court procedure that often goes unnoticed.  As mentioned before, Carl Smith has generally served as our eyes and ears on the Court’s orders.  We have decided to begin regularly posting about designated orders from the prior week in order to alert readers to those orders the judges on the Court deem most important.

The Henderson order, citing to Chai in a case which appears appealable to the 9th Circuit and not the 2nd, suggests a new day has dawned for the IRS in meeting its obligation when it asserts a penalty.  We will be watching closely for other orders and opinions.

A Crack in the Glass Ceiling – Victory in a Financial Disability Case

We have reported before here, here, here and here about the IRS’ unbroken string of victories in cases involving a claim of financial disability.  The first two posts listed in this string, a two-part series by Carl Smith, has a particularly important connection to the opinion reported in this post. While taxpayers have obtained relief from the statutory period for filing a refund claim in administrative decisions by the IRS, no one had won a 6511(h) case in court – until now and this victory is one that opens the door of the court but does not grant relief.  In Hoff Stauffer, Administrator of the Estate of Carlton Stauffer v. IRS, a magistrate judge in the District of Massachusetts has recommended that the court has jurisdiction to hear a case involving 6511(h) in the face of a motion to dismiss for lack of jurisdiction.

Because this is the recommendation of a magistrate judge, the district court must accept it before it becomes final; however, the decision here coupled with the order entered by Judge Gustafson in another Boston case, Kurko v. Commissioner, suggests that perhaps a new day is dawning for those seeking relief for financial disability.  Because the IRS has only issued guidance in the form of an onerous revenue procedure and has never allowed public comment on the now 20-year old provision of the law and because most of the cases have been brought pro se, it has taken a long time to crack the ceiling and take steps toward meaningful administration of this provision.

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Carlton Stauffer passed away in 2012 at the age of 90.  His son, Hoff, discovered that the father had not filed a return since 2006 and proceeded to prepare the outstanding returns as was his fiduciary duty.  In 2013, Hoff Stauffer filed several back returns for his father’s estate and requested refund of an overpayment exceeding $100,000 for 2006.  The IRS disallowed the claim as untimely and declined to hold open the statute using 6511(h).  As a part of the process of appealing the denial of the claim, Hoff submitted a written explanation from a licensed psychologist who had treated his father from 2001 until his death.  The psychologist explained in his report that the father had a variety of mental and physical conditions which prevented him from properly managing his affairs from at least 2006 until his death.  The IRS rejected the explanation, citing to Rev. Proc. 99-21 which requires a statement from a physician and not a psychologist.

Tom Crice, a local Boston attorney whom I had met because of his pro bono work on behalf of low income taxpayers, brought suit for the estate after the denial of the claim.  Tom practiced as a criminal prosecutor and an actuary before settling into tax controversy work.  His background may have helped in the attack he took on Rev. Proc. 99-21.  The IRS filed a motion to dismiss for lack of jurisdiction because the claim for refund was untimely.  This caused the Court to examine 6511(h) which suspends the time frame if the claimant was financially disabled.  Examining the statute led to an examination of Rev. Proc. 99-21 which “sets forth in detail the form and manner in which proof of financial disability must be provided.”  The Rev. Proc. states that the claimant must submit “a written statement by a physician (as defined in section 1861(r)(1) of the Social Security Act, 42 U.S.C. 1395x(r), qualified to make such determination…”  The court noted that the Rev. Proc. does not define “physician” but borrows the definition from the Social Security statute.  The reference to section 1861(r)(1) creates confusion because that section does not have subsections.  Instead it has one large paragraph defining physician that includes five categories: (1) “a doctor of medicine or osteopathy,” (2) a doctor of dental surgery or of dental medicine,” (3) “a doctor of podiatric medicine,” (4) “a doctor of optometry,” and (5) “a chiropractor.”

The Court states that it assumes the IRS intends to refer to the first category but notes that the Rev. Proc. introduces further confusion by linking section 1861(r)(1) to 42 U.S.C. 1395x(r) because the latter provision “essentially tracks verbatim the wording and format of section 1861(r), but does not contain a corresponding reference to a subsection one.  Indeed, section 1395x(r), like section 1861(r), does not formally contain any subsections.”  This raises questions of whether the reference to 1861(r)(1) is a scrivener’s error or intended to narrow the scope of physician.

The court notes that the Rev. Proc. does not receive Chevron deference because it expresses the view of one employee and not the view of the agency.  The Rev. Proc. receives deference “only to the extent that those interpretations have the power to persuade.”  The court then explains how the Rev. Proc. fails to persuade:

section 6511(h) allows a disability to be based on a showing of a  ‘mental impairment’ and Revenue Procedure 99-21 directly undermines that goal where it demands a note from a physician but then defines that term to exclude a whole class of professionals generally considered competent to opine on the existence of a mental impairment.  On the record before the Court, there is no evidence that the IRS has considered the implications of its interpretation of the word ‘physician’ as used in the revenue procedure.  On the contrary, and as noted, Revenue Procedure 99-21 was drafted principally by a single IRS employee who without elaboration or explanation selected a definition of ‘physician’ as used by the SSA.  In the absence of additional information, there is just no basis to assess the soundness of the IRS’s interpretation of the work ‘physician’ in Revenue Procedure 99-21.

The court goes on to say that if the IRS sought to find someone competent to render an opinion on a physical or mental impairment it could have looked elsewhere in the rules governing Social Security cases.  Social Security regulation 20 CFR 404.1527(a)(2) provides “medical opinions are statements from physicians and psychologists or other acceptable medical sources that reflect judgments about the nature and severity of your impairment(s)….”  The court also cites to case law accepting the opinion of the treating psychologist while noting that the SSA and IRS definitions of disability are virtually identical.  So, the limitation argued by the IRS in its Rev. Proc. does not make sense and is inconsistent with the SSA rules it apparently sought to mimic.

The court states that the IRS may have reasons for limiting the opinions in financial disability cases to physicians but it does not explain those reasons in the Rev. Proc.  Without a reasoned explanation and in light of the fact that the opinion of psychologist in these types cases is viewed as acceptable in other contexts, the Rev. Proc. does not provide persuasive authority.  The court states “I conclude that the defendant’s interpretation of the term ‘physician’ in Revenue Procedure 99-21 is not entitled to deference here.  I conclude further that to the extent the psychologist’s statement the plaintiff submitted supports a financial disability based on a mental impairment, the IRS was not required to reject it on the ground that it did not constitute a ‘physician’s statement.  Consequently, I find no basis on this record to deem the plaintiff’s claim for refund untimely under section 6511(h), and thus do not agree that the Court lacks jurisdiction to hear the plaintiff’s suit.”

The IRS made a couple more arguments that the court rejected.  First, it argued that the psychologist’s statement failed because the estate did not submit the statement at the same time as the claim for refund but only submitted it with the initial appeal.  The court noted other cases that had rejected this technical argument by the IRS stating that “the practice is to accept the missing information at a later stage so it and the taxpayer’s claim may be considered.”

Second, the IRS argued in a footnote that the psychologist was unqualified to opine on the disability because he appeared to base the opinion in part on the taxpayer’s physical ailments and this is outside of the psychologist expertise.  The court rejects this argument because the sufficiency of the statement was not before the court and because the mental impairments alone may have been sufficient to support the financial disability determination.

Under Federal Rule of Civil Procedure 72(b), the IRS was to file an objection to this recommendation within 14 days of the receipt of the report.    On February 27, 2017, the IRS filed its objection to the magistrate judge’s report.  It took issue with just about every aspect of the report but most strongly objected to the failure of the court to bow down to Rev. Proc. 99-21 as controlling:

The United States has numerous objections to the Report. First, the United States objects to Magistrate Judge Cabell’s interpretation of Congress’ delegation to the Secretary. The Report misapprehends the plain language of § 6511(h) and the Secretary’s authority under that statute. The Secretary did what Congress told it to do and, as discussed in greater detail below, there is no reason to expand § 6511(h) beyond what is prescribed in Rev. Rule. 99-21, which is something that the Report attempts to do. Neither the language of § 6511(h) nor Rev. Proc. 99- 21 support Magistrate Judge Cabell’s view that a psychologist is permitted to medically determine a mental impairment. The Report’s discussion regarding the proper level of deference afforded to Rev. Proc. 99-21 is simply irrelevant pursuant to § 6511(h). In short, a psychologist’s statement is invalid pursuant to § 6511(h). Accordingly, the plaintiff’s failure to comply with Proc. 99–21 is fatal to its refund claim because federal courts have no jurisdiction over a tax refund suit until a claim for refund or credit has been “duly filed” with the Secretary. Second, the United States objects to Magistrate Judge Cabell’s conclusion that the Eighth Circuits decision in Abston v. Commissioner, 691 F.3d 992 (8th Cir. 2012), is distinguishable from the case at bar. Contrary to the Report, the Eighth Circuit, as well as numerous other federal courts, have found that taxpayers cannot establish a medical disability under § 6511(h) without submitting a “doctor’s note” as required by Rev. Proc. 99-21. The plaintiff did not provide a doctor’s note as it was required to do. Third, the United States objects to Magistrate Judge Cabell’s rejection of the United States’ alternative argument. Even if the psychologist’s statement at issue could be considered a “doctor’s note,” it continues to be deficient pursuant to Rev. Rule 99-21.

Plaintiff’s response to the IRS motion is also attached.

While Judge Gustafson cracked the glass in the 6511(h) ceiling with his order in the Kurko case, Magistrate Judge Cabell punches his fist through the glass.  This may allow others to follow and finally break the choke hold in this area.  Perhaps the IRS will consider, after two decades, the idea of getting comments on what a reasonable rule would look like and talk to the representatives who assist individuals with financial disability.  Taxpayers claiming this exception, by definition, face difficulties.  Rev. Proc. 99-21 adds to those difficulties and does not provide a reasonable basis for working through this issue.  The facts here follow fairly closely the facts in the case Brockamp v. United States, 519 U.S. 347 (1997), in which another 90 year old gentleman failed to timely file a refund claim and the failure was discovered by his executor after the ordinary statute of limitations had expired.  The facts of that case so moved Congress that it created the statutory exception in 6511(h).  Let’s work together to find a reasonable way to allow those with valid claims for refund and legitimate reasons for filing late to get their money without imposing undue barriers.

 

 

Second Circuit Tosses Penalties Because of IRS Failure To Obtain Supervisor Approval

–Or, Tax Court Burnt by Second Circuit’s Hot Chai

Yesterday the Second Circuit decided a very important decision in favor of the taxpayer pertaining to the Section 6571 requirement that a direct supervisor approve a penalty before it is assessed.  In Chai v. Commissioner, the Second Circuit reversed the Tax Court, holding the Service’s failure to show penalties were approved by the immediate supervisor prior to issuing a notice of deficiency caused the penalty to fail.  In doing so, the Second Circuit explicitly rejected the recent Tax Court holdings on this matter, including Graev v. Commissioner, determining the matter was ripe for decision and that the Service’s failure prevented the imposition of the penalty.  Chai also has interesting issues involving TEFRA and penalty imposition that will not be covered (at least not today), and is important for the Second Circuit’s rejection of the IRS position that the taxpayer was required to raise the Section 6571 issue.   It is lengthy, but worth a read for practitioners focusing on tax controversy work.

PT regulars know that we have covered this topic on the blog in the past, including the recent taxpayer loss in the very divided Tax Court decision in Graev v. Commissioner.  Keith’s post on Graev from December can be found here.  For readers interested in a full review of that case and the history of this matter, Keith’s blog is a great starting point, and has links to prior posts written by him, Carlton Smith, and Frank Agostino (whose firm handled Graev and also the Chai case). Graev was actually only recently entered, and is appealable to the Second Circuit, so I wouldn’t be surprised if the taxpayer in that case files a motion to vacate based on the Second Circuit’s rejection of the Tax Court’s approach in Greav.

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Before discussing the  Second Circuit holding, I will crib some content from Keith, to indicate the status of the law before yesterday.  Here is Keith’s summary of the holding in Graev:

The Court split pretty sharply in its opinion with nine judges in the majority deciding that the IRC 6751(b) argument premature since the IRS had not yet assessed the liability, three judges concurring because the failure to obtain managerial approval did not prejudice the taxpayers and five judges dissenting because the failure to obtain managerial approval prior to the issuance of the notice of deficiency prevented the IRS from asserting this penalty (or the Court from determining that the taxpayer owed the penalty.)

That paragraph from Keith’s post regarding the holding doesn’t cover the lengthy and nuanced discussion, but his full post does for those who are interested.  The Second Circuit essentially rejected every position taken by the majority and concurrence in Graev, and almost completely agreed with the dissenting Tax Court judges (with a  few minor differences in rationale).

For its Section 6751(b) review, the Second Circuit began by reviewing the language of the statute.  It highlighted the fact that the Tax Court did the same, and found the language of the statute unambiguous, a conclusion with which the Second Circuit disagreed.

Section 6751(b)(1) states, in pertinent part:

No penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination…[emph. added]

The Tax Court found the lack of specification as to when the approval of the immediate supervisor was required allowed the immediate supervisor to approve the determination at any point, even after the statutory notice of deficiency was issued or the Tax Court reviewed the matter.

The Second Circuit, however, found the language ambiguous, and the lack of specification as to when the approval was required problematic.  The Second Circuit stated “[u]understanding § 6751 and appreciating its ambiguity requires proficiency with the deficiency process,” and then went through a primer on the issue.  To paraphrase the Second Circuit, the assessment occurs when the liability is recorded by the Secretary, which is “essentially a bookkeeping notation.”  It is the last step before the IRS can collect a deficiency.  The Second Circuit stated the deficiency is announced to the taxpayer in a SNOD, along with its intention to assess.  The taxpayer then has 90 days to petition the Tax Court for review.  If there is a petition to the Court, it then becomes the Court’s job to determine the amount outstanding.  As it is the Court’s job to determine the amount of the assessment, the immediate supervisor no longer has the ability to approve or not approve the penalty.  The Second Circuit agreed with the Graev dissent that “[i]n light of the historical meaning of ‘assessment,’” the phrase “initial determination of such assessment” did not make sense.  A deficiency can be determined, as can the decision to make an assessment, but you cannot determine an assessment.

The Second Circuit then looked to the legislative history, and found the requirement was meant to force the supervisor to approve the penalty before it was issued to the taxpayer, not simply before the bookkeeping function was finalized.  The Court further stated, as I noted above, if the supervisor is to give approval, it must be done at a time when the supervisor actually has authority.  As the Court noted, [t]hat discretion is lost once the Tax Court decision becomes final: at that point, § 6215(a) provides that ‘the entire amount redetermined as the deficiency…shall be assessed.”  The supervisor (and the IRS generally) can no longer approve or deny the imposition of the penalty.  The Court further noted, the authority to approve really vanishes upon a taxpayer filing with the Tax Court, as the statute provides approval of “the initial determination of such assessment,” and once the Court is involved it would no longer be the initial determination.  Continuing this line of thought, the Second Circuit stated that the taxpayer can file with the Tax Court immediately after the issuance of the notice of deficiency, so it is really the issuance of the notice of deficiency that is the last time where an initial determination could be approved.

This aspect of the holding is important for two reasons.  First, the Second Circuit is requiring the approval at the time of the NOD, and not allowing it to be done at some later point.  Second, this takes care of the ripeness issue.  If the time is set for approval, and it has passed, then the Court must consider the issue.

Of potentially equal importance in the holding is the fact that the Second Circuit stated unequivocally that the Service had the burden of production on this matter under Section 7491(c) and was responsible for showing the approval. It is fairly clear law that the Service has the burden of production and proof on penalties once a taxpayer challenges the penalties, with taxpayers bearing the burden on affirmative defenses.   The case law on whether the burden of production exists when a taxpayer doesn’t directly contest the penalties is a little more murky (thanks to Carlton Smith for my education on this matter).  The Second Circuit made clear its holding that the burden of production was solely on the Service, and the taxpayer had no obligation to raise the matter nor the burden of proof to show the approval was not given.  The Service had argued the taxpayer waived this issue by not bringing it up earlier in the proceeding, which the Second Circuit found non-persuasive.

As to the substance of the matter, the Second Circuit held the government never once indicated there was any evidence of compliance with Section 6751.  Since the Commissioner failed to meet is burden of production and proof, the penalty could not be assessed and the taxpayer was not responsible for paying it.  A very good holding for taxpayers, and we would expect a handful of other case to come through soon.  Given the division within the Tax Court, and the various rationales, it would not be surprising to see other Circuits hold differently.

Tax Expenditures and Complexity

I returned last week from a conference that focused on the challenges that tax agencies across the world face in administering tax systems. One part of our tax system stood out in comparison with other systems. While most systems rely in some part on tax agencies to administer tax laws that promote social goals in addition to raising revenue, IRS seems to be the champ in terms of administering social programs embedded in the tax laws.

The other day the Congressional Budget Office released a blog post summarizing tax expenditures. Whether a particular item in the Code is classified as an expenditure is subject to some debate, but the CBO defines the terms as an “array of exclusions, deductions, preferential rates, and credits that reduce revenues for any given level of tax rates in the individual, payroll, and corporate income tax systems.”

Like direct spending, tax expenditures promote certain activities (like home ownership) or benefit some classes of taxpayers or entities. CBO estimates that tax expenditures will reach around $1.5 trillion in 2017, or around half of all federal revenues.

As the CBO blog post notes, the top expenditures in terms of total revenues foregone are the following:

  1. The exclusion from workers’ taxable income of employers’ contributions for health care, health insurance premiums, and premiums for long-term care insurance;
  2. The exclusion of contributions to and the earnings of pension funds (minus pension benefits that are included in taxable income);
  3. Preferential tax rates on dividends and long-term capital gains;
  4. The deferral for profits earned abroad, which certain corporations may exclude from their taxable income until those profits are returned to the United States; and
  5. The deductions for state and local taxes (on nonbusiness income, sales, real estate, and personal property).

The CBO post and its link to recent Congressional testimony and an annual Joint Committee report discussing tax expenditures have more detail on these and others (like refundable credits, deductions for charitable contributions and home mortgage interest deductions).

The National Taxpayer Advocate, in her 2016 annual report has noted the complexity and burden that follows from many expenditures. Congress’ desire to target benefits to certain taxpayers or reward certain activities often is accompanied by complexity in terms of eligibility criteria. Not surprisingly, lobbyists can influence legislation in ways that are meant to hide the impact of provisions that favor certain industries or even specific taxpayers.

As Congress perhaps turns its attention to tax reform (though there seems to be many legislative balls in the air so reform is no sure thing), it would be wise for Congress to consider administrability and complexity in determining whether the IRS is the appropriate agency to be in charge of specific programs or benefits.

In this year’s annual report the NTA proposes that Congress take a “zero-based budgeting” approach that specificically calls on Congress to weigh burdens on taxpayers and the IRS:

The starting point for discussion would be a tax code without any exclusions or reductions in income or tax. A tax break or IRS-administered social program would be added back only if lawmakers decide, on balance, that the public policy benefits of running the provision or program through the tax code outweigh the tax complexity burden the provision creates for taxpayers and the IRS.  At the end of the exercise, tax rates can be set at whatever level is required to raise the amount of revenue that Congress determines is appropriate.

There are many specific targets for consideration if Congress is not up for the task of taking on wholesale reform. When one considers the array of education benefits and the hodgepodge of family status benefits embedded in the tax code it seems like a Congress intent on simplifying the lives of taxpayers and IRS would have plenty of places to start.

 

 

What is a Taxpayer Assistance Order?

A recent Program Manager Technical Assistance (PMTA) opinion (CC:NTA-POSTN-132247-16) issued by the attorney to the National Taxpayer Advocate provides insight on taxpayer assistance orders (TAOs).  Only select employees of the Taxpayer Advocate Service (TAS) can issue TAOs.  Taxpayer representatives benefit from understanding TAOs because having the authorized TAS employee issue a TAO on behalf of your client can go a long way toward resolving a case in which the IRS has taken an incorrect or unreasonable position that you cannot otherwise convince it to reverse.  The PMTA does not describe how to obtain a TAO but instead describes the process within TAS and the operating division after the issuance of a TAO.  This post will discuss the process of obtaining a TAO and then the path that the TAO might follow.

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Around the country there are Local Taxpayer Advocates (LTAs) in every state.  Larger states have more than one and every service center has one.  There are a total of 84 LTAs.  If you do not know the LTA for your area, you might want to get to know them because this person will assist you when your client has a serious hardship.  Better to know your LTA and develop a relationship of trust before you face the pressure of seeking their assistance with a time sensitive hardship matter.  The LTAs constantly have outreach efforts so that representatives in the area of their geographical coverage do know who they are and what they can accomplish.

If your taxpayer experiences significant hardship because of IRS action, and this does not just include collection action, although that is traditionally a source of hardship, and if your client’s case meets TAS case criteria for acceptance, then the LTA can initiate a TAO ordering the appropriate IRS operating unit to take action or to stop action in order to alleviate the hardship.  The power of the LTA to do this derives from IRC 7811 and delegation from the National Taxpayer Advocate.  The delegation does not go below the LTA so case advocates working the case with the taxpayer or the representative do not have the authority to issue a TAO but must convince the head of their office, the LTA, to do so.

The LTA will only issue the TAO if convinced that the operating division has acted incorrectly based on the Code or, more likely, the Internal Revenue Manual.  The more research you provide to the TAS caseworker and the LTA showing that the IRS has acted inappropriately, the more likely the LTA will consider a TAO.  The LTA does not want to issue a TAO and have the operating division point out the basis for the TAO is incorrect since the LTA will lose credibility.    Some LTAs issue TAOs regularly and some almost never.  In addition to getting to know your LTA, you want to get a sense of whether your LTA has demonstrated a willingness to issue TAOs and under what circumstances.

The PMTA describes the process of what happens after TAS issues the TAO.  Before issuing the TAO, the LTA will call the impacted operating division.  Let’s say that your small business client was the victim of a fraudulent payroll services provider similar to the unfortunate McDonald’s franchisee I blogged about last year.  Your client now owes $40,000 in payroll taxes to the IRS it paid to the payroll services provider but which was stolen.  Your client’s business has more than $40,000 in equity and income resources so that it does not qualify for an offer in compromise on doubt as to collectability; however, if it pays over another $40,000 the payment will severely cripple the company.  The company makes an effective tax administration offer in compromise of $5,000 which the special OIC unit for ETA offers rejects.  You bring the case to the LTA and point out the IRM provisions that suggest the IRS will consider an ETA under these circumstances.

The LTA can issue a TAO to the OIC unit that considers ETA offers asking that it reconsider the OIC taking into account the IRM provisions.  First, the LTA will call.  After being rebuffed, the LTA will write up the TAO citing to the IRM provisions and detailing the hardship created by the embezzlement.  If the manager of the OIC unit refuses to reconsider the OIC, the normal path is for the LTA to forward the TAO to his or her manager, the Deputy Executive Director Case Advocacy (DEDCA).  The refusal process may involve phone discussions between the LTA and the OIC manager after receipt of the TAO or it may simply involve a written response denying (appealing) the requested action in the TAO.  The LTA cannot accept the OIC but can only use the TAO process to direct and persuade the appropriate function within the IRS to take the action that the LTA thinks would appropriately follow the rules and regulations governing the IRS.  When the LTA receives the appeal of the TAO from the operating unit, the LTA can modify or rescind the TAO, or sustain the appeal.  If the LTA disagrees with the response, the LTA forwards the appealed TAO to the DEDCA for review.  The PMTA describes the process in detail.

If the TAO moves from the LTA to the DEDCA, the DEDCA reviews the TAO to determine its correctness.  This process might involve a fair amount of back and forth between the LTA and the DEDCA.  Just as the LTA must be persuaded that issuing the TAO will not create an embarrassment, so must the LTA now persuade the DEDCA.  The more persuasive the LTA can present the facts and the law (or the IRM) the more likely that the LTA will convince the DEDCA that the TAO should be sustained.  If the DEDCA agrees with the TAO, the DEDCA will raise it to the level of the territory manager.  The manager of the offer unit knows that this is a possibility from the start and knows that if the OIC unit has followed the wrong process or made a boneheaded decision, this process will shine a light on that fact.  Conversely, if the head of the OIC unit feels strongly that they have correctly interpreted the applicable rules and evaluated the circumstances surrounding the OIC, the manager will deny the TAO and stand ready to face the scrutiny from the territory manager.  The elevation of the TAO will cause one or more conversations between the territory manager and the OIC manager about the case which may result in acceptance of the TAO or rejection and the rejection may, or may not, include new facts not previously mentioned.

If the territory manager rejects the TAO, then the DEDCA must decide whether to send it to the NTA.  If the TAO goes forward to the NTA, she raises it to the Commissioner or Deputy Commissioner.  The process provides an interesting dance of competing bureaucratic emotions.  The operating divisions hate being told what to do and that they have done something wrong.  Many can be quite smug about the correctness with which they handle the matters coming through their office but at the same time they also hate shining the light on their practices to their boss and their boss’ boss.  The practice can have good effect of fixing bad practices, it can expose TAS as too overbearing if it pushes a TAO not properly grounded and it can create animosity between TAS and the operating division rather than a spirit of cooperation to reach the right result.  Sometimes, TAS becomes more the “enemy” than the taxpayer.

The PMTA focuses on what to do when new facts come to light during the process of the TAO.  Because the TAO causes the operating division to carefully look at what it did and to justify its actions, the possibility exists that the action it took was correct for a reason it did not mention to the taxpayer or even to the LTA when the TAO was first issued.  The PMTA opines that when the operating division raises new facts in response to a TAO or the appeal of a TAO, the appropriate person within TAS has the ability to go back to same level of employee within the operating division with a supplemental memo “to the same official addressing the concerns raised in the response and ordering that the official reconsider the matter again in light of the new information before modifying or sustain the TAO to the next level IRS official for further consideration.”

The current IRM does not address the situation of sending the case back from the same level for reconsideration.  The IRM contemplates a back and forth but does not mention this formal move seeking reconsideration.  The guidance here is not radical and simply formalizes what probably was happening in a less formal way.  It does provide a formal opportunity for clarification and resolution of the issue at lower levels.  Such a resolution is good for the taxpayer and the IRS.  Because the TAS is a voice for taxpayers behind the curtain of the IRS, we do not get to see what goes on between the two sides in the TAO disputes.  The PMTA gives a good description of the process.  For taxpayers being “represented” by TAS in this process and for taxpayers or representatives considering the use of TAS to resolve a problem, understanding the process and the possibilities makes use of the process more possible.  If done correctly, it has the ability to greatly assist taxpayers, to fix systemic problems within the IRS and to avoid litigation or feelings of utter frustration.