Effect of General Power of Attorney On Reasonable Cause Exception to Penalties

Chief Counsel Advice memorandums are great sources of statements on IRS policy and the thought process of the Service on various issues.  They often are not long, which can make them difficult to turn into standalone blog posts.  I found one from September fairly interesting though, which discusses penalty abatement for the delinquency penalties when someone is incapacitated.  The CCA touches on two issues, the first time abatement provisions and the impact of a power of attorney on the reasonable cause exception to the delinquency penalties. The power of attorney aspect is fairly interesting, especially in considering the related issue regarding refund limitations periods being tolled by financial disability.

In CCA 201637012, the Service requested guidance on whether a potentially incapacitated person who suffered from dementia could have delinquency penalties abated for reasonable cause.  I found the CCA interesting because it highlighted the fact that the taxpayer had a valid power of attorney in place, and sought guidance on how that impacted the reasonable cause determination.

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The facts indicating that the taxpayer appointed an agent under a durable power of attorney (one that remains operative after someone is incapacitated) prior to becoming incapacitated.  Under the POA, the agent was authorized to file tax returns and handle other tax aspects for the taxpayer.  The agent knew of the POA.  In a later year,  the taxpayer filed untimely returns, and the Service assessed delinquency penalties under Section 6651(a)(1) (failure to file) and Section 6651(a)(2) (failure to pay).

At some point after the filing of the return, the agent under the POA petitioned the state court for an emergency guardian and conservator for the taxpayer.  Usually, when there is a POA in place, we try not to seek guardianship because an agent should have most of the same powers, so I’m curious as to why this was requested.  It is possible the taxpayer was fighting the agent, or power outside of the POA was needed.   The court did appoint the agent as guardian and used the term “incapacitated” in the order.  This was after the late filing, but the CCA seems to indicate it was close enough in proximity to evidence that the taxpayer was incapacitated when the return was not filed.

The two questions presented to Chief Counsel were:

  1. Whether the Service should abate the penalties because of the alleged incapacity.
  2. Whether the Service should deny the request to abate because the POA failed to fulfill the taxpayer’s obligation to timely file and pay tax on behalf of the taxpayer.

Chief Counsel first noted that Appeals should determine if the taxpayer qualifies for First Time Abatement under IRM 20.1.1.3.6.1.  We have discussed FTA on this blog in the past, which can be found here and here.  All tax practitioners should be very familiar with these provisions, as they provide a simple mechanism for eliminating penalties in many cases.  I have used these procedures in various cases, including some very large dollar cases, and have had no issue obtaining waivers when we fit within the framework.

The remainder of the CCA was the portion that I found more interesting.  The CCA went on to discuss reasonable cause for a person suffering from dementia.  As stated above, the taxpayer had a valid power of attorney in place the year in which she failed to file the tax return.  It is alleged that the taxpayer was incapacitated.  Chief Counsel did indicate that it lacked sufficient facts to determine the taxpayer was incapacitated at the time of filing, but seemed to indicate it was possible, and, for purposes of the analysis, assumed that was the case.

The taxpayer requested abatement of the penalties pursuant to Treas. Reg. Section 301.6651-1(c)(1), which provides for abatement due to reasonable cause.  Serious illness of the taxpayer or a family member can be sufficient to show reasonable cause (but not when your preparer is ill).  See IRM 1.2.12.1.2, Policy Statement 3-2.  The CCA indicated that if it could be shown that the taxpayer was demented during the year in question, and was unable to handle her own financial affairs, it could support a finding of reasonable cause.

What I found slightly more interesting was the discussion about the power of attorney.  In the CCA, Counsel states that the POA does not impact the conclusion.  Counsel essentially stated that if the guardian had been appointed during the year in question, reasonable cause would likely not apply.  This was because the guardian would have a duty to handle the finances, and therefore returns, of the ward.  See Bassett v. Comm’r, 67 F3d 29 (2d Cir. 1995) (taxpayer suffered from incapacity due to being a minor, and legal guardian had duty to file returns).  With a POA, however, there may be authorization to take actions regarding returns, but there is no affirmative legal duty to prepare and file returns on behalf of the taxpayer.  Looking to Boyle, Counsel said the duty to file the tax return is on the taxpayer, and not his agent or employee.

I think this is the correct result, but I found it interesting for two reasons.  First, that statement from Boyle is usually used to preclude reasonable cause defenses when a taxpayer fails to file due to the mistake belief that the taxpayer’s accountant, attorney, or other preparer is properly handling the return.  So, for once, I wasn’t muttering frustration about that case.

Second, this position is different than that applicable to seeking a refund due to financial disability.  In general, a refund must be timely made, and that time frame is normally three years from the date the return is filed or two years from the date the tax was paid, whichever expires later.  This statute can be tolled if the taxpayer is “financially disabled.”   Under Section 6511(h), the statute will not expire if the individual is unable to manage his financial affairs because he has a medically determinable physical or mental impairment that can be expected to result in death or that has lasted or can be expected to last for a continuous period of not less than twelve months.  The general IRS requirements for this are found in Rev. Proc. 99-21.  Most focus on this Rev. Proc. is on the required doctor’s certification.  But, the procedure also requires the person signing the claim to certify that no person was authorized to act on behalf of the taxpayer in financial matters during the period of impairment.

The implication is that having a power of attorney in place could preclude the tolling of the statute, because the agent could/should have been acting.  Seeking to recoup improperly paid funds is slightly different that having penalties abated, but the situations are sufficiently similar that it is interesting that the Service has different positions.

Happy (Belated) Thanksgiving!

The Taxatturky was spared again, and can continue providing quality tax advice for another year.IMG_0873

Procedure Grab Bag – Making A Grab for Attorney’s Fees and Civil Damages

Your clients love the idea, and always think the government should pay, but it isn’t that easy.  Below are a summary of a handful of cases highlighting many pitfalls, and a few helpful pointers, in recovering legal fees and civil damages from the government (sorry federal readers) that have come out over the last few months.

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3rd Party Rights

The Ninth Circuit, in US v. Optional Capital, Inc., held that a third party holding a lien on property could not obtain attorney’s fees for an in rem proceeding to determine its rights in real estate that had also been subject to government liens pursuant to the Civil Asset Forfeiture Reform Act, 28 USC 2465(b)(1)(A), or Section 7430.  The Court determined the 3rd party was not the prevailing party “in any civil proceeding to forfeit property,” as required by CAFRA.  The government had lost in a related hearing regarding the lien, but the 3rd party had “not pointed to any work it performed that was ‘useful’ or ‘necessary to secure’ victory against the Government,” so it was not the prevailing party.  It would seem, however, this leaves open the possibility of other 3rd parties prevailing, if meaningful work was done in the underlying case.  This case is a good reminder of another potential option under CAFRA in attempting to claim fees in certain collection matters.

As to Section 7430, the Court found, contrary to the 3rd party’s claims, it had not actually removed the government’s liens from the property, and therefore could not be considered the prevailing party, which is required under Section 7430 to obtain fees.

When You Are Rich Is Important

In Bryan S. Alterman Trust v. Comm’r, the Tax Court held that a trust could not qualify to recover litigation costs under Section 7430 because its net worth was over $2MM.  Section 7430 references 28 USC 2412(d)(2)(B), which states an individual must have under $2MM in net worth in order to recover litigation costs.  That is extended to trusts by Section 7430(c)(4)(D).  The taxpayer argued the eligibility requirement should be as of the time the deficiency notice was issued or the date the petition was filed.  That “reading” of the statute was found incorrect, as Section 7430(c)(4)(D)(i)(II) states the provision applies to a trust, “but shall be determined as of the last day of the taxable year involved in the proceeding.”  At that time, the trust had over $2MM in net worth, saving the IRS from potentially having to shell out capital.  And, that’s why I always keep my trust balances below $2MM…and right around zero dollars.

Key Questions: Are you the Taxpayer?  Did you Exhaust the Administrative Remedies?

The District Court for the Northern District of Illinois dismissed the government’s motion for summary judgment in Garlovsky v. United States on fees under Section 7433, but also gave clear indication that the claim is in danger.  In Garlovsky, the government sought collection on trust fund recovery penalties against an individual for his nursing home employer that allegedly failed to pay employment taxes.  Prior to that collection action, the individual died, and notices were sent to his surviving spouse (who apparently was some type of fiduciary and received his assets).  The taxpayer’s wife paid a portion, and then sued for a refund.  As to damages, the Court found that the taxpayer’s wife failed to make an administrative claim for civil damages before suing in the District Court, which is required under Section 7433.

In addition, although the surviving spouse received the collection notices, none were addressed to her and the Service had not attempted to collect from her.  Section 7433 states, “in connection with any collection of…tax…the [IRS] recklessly or intentionally, or by reason of negligence, disregards any provisions of this title…such taxpayer may bring a civil action…”  The Court found that the spouse was not “such taxpayer”, and likely did not have a claim.  Although I have not researched this matter, I would assume the estate of the decedent could bring this claim (unlike Section 7431, pertaining to claims for wrongful disclosure of tax information, which some courts have held dies with the taxpayer – see Garrity v. United States –a case I think I wrote up, but never actually posted).

Qualifying as a Qualified Offer

The 9th Circuit held that married taxpayers were not entitled to recover attorney’s fees under Section 7430 in Simpson v. Comm’r, where the taxpayer did not substantially prevail on its primary argument, even though they did prevail on an alternative argument.  In Simpson, the wife received a substantial recovery in an employment lawsuit.  The Simpsons only included a small portion as income, arguing it was workers comp proceeds (not much evidence of that).  The Tax Court held 90% was income.  This was upheld.  The 9th Circuit held that the taxpayer was clearly not successful on its primary claim.  They did raise an ancillary claim during litigation, which the IRS initially contested, but then conceded.  The Court held the Service was substantially justified in its position, as the matter was raised later in the process and was agreed to within a reasonable time.  Finally, the Court held that the taxpayer’s settlement offer did not qualify as a “qualified offer”, since the taxpayers indicated they could withdraw it at any time.  Qualified offers must remain open until the earliest of the date it is rejected, the date trial begins, or the 90th day after it is made.  Something to keep in mind when making an offer.

Making the Granite State Stronger – No Fees For FOIA

Granite seems pretty sturdy, but Citizens for a Strong New Hampshire are hoping for something even sturdier.  The District Court for the District of New Hampshire in Citizens for a Strong New Hampshire v. IRS has denied Strong New Hampshire’s request for attorney’s fees under 5 USC 552(a)(4)(E)(i) for fees incurred in bringing its FOIA case.  That USC section authorizes fees and litigation costs “reasonably incurred in any case under [FOIA] in which the complainant has substantially prevailed.”  The statute defines “substantially prevailing” as obtaining relief through “(I) a judicial order, or an enforceable written agreement or consent decree; or (II) a voluntary…change in position by the agency…”

Strong New Hampshire requested documents through a FOIA request regarding various New Hampshire politicians.  It took the IRS a long time to get back to Strong New Hampshire, and it withheld about half the applicable documents as exempt under FOIA.  Strong New Hampshire continued to move forward with the suit, and the Service moved for summary judgement arguing it complied.  Aspects remained outstanding, but the Court held that the Service had not improperly withheld the various documents.  The IRS did a second search, moved for summary judgement, and Strong New Hampshire did not contest.

The Court held that the voluntary subsequent search by the Service did not raise to the level of substantially prevailing by Strong New Hampshire.  As required by the statute, there was not a court order in favor of Strong New Hampshire, and the actions taken by the Service unilaterally in doing the second search was not sufficient to merit fees.

Specht v. US: When The Preparer is Not Well – Unreasonable Cause In Late Filing

In February of 2015, in a SumOp, I wrote about the terrible case of Specht v. United States out of the Southern District of Ohio, where the Court upheld delinquency penalties against an estate for failure to timely file and pay estate tax.  This case was a dumpster fire on a train wreck in terms of the facts for the executor in Specht, but the Sixth Circuit affirmed the district court upholding the penalties, which is not unexpected (and I’m sure they didn’t love doing it).  The case does not break new ground, but it is a good example of how difficult arguing the reasonable cause exception to the delinquency penalties can be if the delinquency was based on relying on an attorney or accountant to file.

To the unfortunate facts.  Ms. Specht was the cousin of Virginia Escher, who was worth about $12.5MM on her death (interesting side note, she and her husband apparently were frugal, and accumulated the wealth from her husband working at UPS  — in the late 90’s when UPS issued its IPO, there were all kinds of rumors and stories about all the employees becoming millionaires, and many mangers did get millions – Perhaps Virginia’s hubby was one such lucky employee).  A few months prior to her death, Virginia had her lawyer, Mary Backsman, draft a new will naming Ms. Specht her executor.  Attorney Backsman had over fifty years of estate planning experience, and was well regarded.  Ms. Specht had a high school degree but never went to college, was in her 70s, had never served as an executor, had never been in a lawyer’s office, had never dealt with stock, was not business savvy, and did not even own stock.  Not an ideal executor for a large estate comprised of a large holding of UPS stock, but with competent counsel she should have been able to complete the administration…And therein lies the rub.

Attorney Backsman may have been a phenomenal lawyer for decades, but she was quite unfortunately suffering from brain cancer, which she was not disclosing to clients, and her competency was deteriorating.  Not knowing this, Ms. Specht hired her to assist with the administration.  Attorney Backsman informed Ms. Specht that $6MM in tax would be due nine months from the date of death, and UPS stock would need to be liquidated.  Attorney Backsman also suggested her firm could front the $6MM in tax, and be reimbursed after the fact (what?!?!  Was that the cancer, or did her firm really do that? My firm is not currently floating $6MM for clients).  Specht signed the Application for Authority to Administer Estate and a Fiduciary’s Acceptance, but Attorney Backsman did not explain either or her obligations.

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All parties agree that Ms. Specht relied very heavily on Attorney Backsman to handle the administration, which largely resulted in Ms. Specht calling Attorney Backsman to get updates on the statute.  Ms. Specht asked about the returns repeatedly, and was told that an extension had been obtained for filing the return.  This was not true and the return was not filed nor were the taxes paid.  The Sixth Circuit highlighted the fact that Specht had received multiple notices that probate deadlines were missed, and that she relied on Attorney Backsman’s statement that it was being handled and extension were obtained.  The following year, Ms. Specht was contacted by a family friend who also used Backsman, and was told that Attorney Backsman was incompetent.  Ms. Specht went to see Attorney Backsman, and again accepted statements that the administration was moving forward and extensions were obtained.  She also signed “a blank paper”, which the attorney indicated would give her authority to sell the UPS stock on behalf of the estate (the attorney later claimed that paper was sent to UPS, but it never was).  From middle of August 2010 to October of 2010, the wheels really started to fall off.  Ms. Specht received multiple notices from the Ohio taxing authority indicating the return was late.  Various family members called and begged Ms. Specht to fire the lawyer due to incompetence, and Ms. Specht found out that UPS had not been contacted.  At that point, she fired Attorney Backsman.

Within a few months of hiring new counsel, the UPS stock was sold, the federal estate tax return was filed with payment of the tax and interest.  The Service imposed penalties, which the estate subsequently paid.  Somewhat interestingly, the Ohio taxing authority refunded the penalties imposed due to “hardship caused by Backsman’s representation.”   PA hardly ever imposes penalties on death tax returns, and I have rarely seen it on state death tax returns, so I am not that surprised.

Big Brother, however, decided it needed to refill the coffers of the Holding Company, and imposed substantial penalties.  The IRS imposed $1,189,261 of penalties (and interest) for failure to file and failure to pay tax under Sections 6651(a)(1) and (2).  As the Court noted, quoting US v. Boyle, the penalties are mandatory unless the taxpayer had reasonable case; the taxpayer “bears the heavy burden of proving both 1) that the failure did not result from ‘willful neglect’ and 2) that the failure was ‘due to reasonable cause’.”  469 US 241 (1985).  As Keith noted in his recent post on Kimdun, Inc., if the Court is citing Boyle heavily in a reasonable cause case, your client is probably in trouble.

In Specht, the taxpayer was clearly not sophisticated, made reasonable attempts to comply, and made the reasonable decision to hire the attorney who prepared the estate plan, was very well respected, and had decades of experience…but, under Boyle, that is not really applicable to reasonable cause in this instance.

In Boyle, the Supremes dropped what they believed to be a bright line rule, which sometimes causes reasonable people to fall outside of the reasonable cause exception.  In Boyle, the Court stated, “the time has come for a rule with as ‘bright’ a line as can be drawn…[and] Congress has placed the burden of prompt filing on the executor, not on some agent or employee of the executor.”  The Court believed this meant that Congress intended to place the burden on the executor to determine the applicable deadline and ensure filing in a timely fashion.  Further, “[t]hat the attorney…was expected to attend to the matter does not relieve the [executor] of his duty to comply with the statute.”

The Court looked to its prior holding for guidance, in Vaughn v. United States (also covered here previously).  Mo Vaughn, the rotund slugger, had a shady money manager after his retirement who was probably stealing from him and failing to keep his financial affairs and returns in order (if you wanted to argue that Mo was stealing from the Mets the final two years of his career…).  The Sixth Circuit held there that “Vaughn’s statutory duty is non-delegable and is not excused because of the felonious actions of his financial agents.”  The ultimate tax insult to financial injury.  The Court concluded by essentially stating “reasonable causes” are only something beyond the possible control and oversight of the taxpayer, and taxpayers should know the due date and make sure it is followed.

The Court concluded that Specht had agreed to be a fiduciary, which has obligations that are serious.  The Estate could not show that she met the heavy burden of showing reasonable cause in failing to file the returns before the applicable deadline.

My conclusion the first go around was as follows:

I’ve shared my frustration with this line of cases repeatedly in the past, but I do somewhat understand why the rule is crafted in this matter.  I would be interested to know how the malpractice case panned out.  The coverage may have a maximum payout amount, and if there were a bunch of these cases, the various clients could be dividing up a limited pie.  In theory, the executor could be held liable to the beneficiaries for anything not recouped.  Any result where the executor ends up responsible seem completely inequitable to me.

The estate did sue Attorney Backsman, and that case settled, although the amount is unknown.  Some amount may have been recouped, but, as I noted above, Attorney Backsman, probably had a number of claims brought against her, and it is possible that the malpractice policy limited the total payout.

My position on Boyle and reasonable cause remains the same.  I understand why the bright line is in place, as it would be too easy for executors to simply blame counsel for the mistake.  Serving as executor, however, is not a common occurrence, and, with the current estate tax thresholds, having to file a federal estate tax return is fairly uncommon.  For a sophisticated individual, it is possible to determine there is a nine month deadline.  In my view, the IRS is too aggressive in applying this rule to these type of cases.  For instance, the Service extended it to substantive advice as to when taxes had to be paid under complicated Code Sections in Thouron from the Third Circuit.  It is also drastically out of line with how lawyers and clients interact in this arena.  Every single one of my clients relies on me completely to ensure proper and timely filing.  They look to me, often bewildered, as to when the return must be filed, what the extension can be for, when the tax has to be paid and when that can be extended.  And, given how few of these returns are filed each year, it seems unlikely that John Q. Public is going to realize they cannot rely on me as protection from penalties (query if such reliance is a valid defense in a breach of fiduciary liability case).

Boyle modifies a subjective “reasonable cause” standard, and turns it into an objective line in the case where an executor relies on a preparer to timely file.  The statute, which had objective deadlines, included an exception, which is no longer allowed for receiving advice on a deadline in all deadlines.  Interestingly, the Service also recognized how colossally messed up the Code is, and that people are going to miss deadlines.  You get a free pass on the income tax side with the first time abate exception.  Income taxes are filed by essentially everyone, every single year.  Most people will never file an estate tax return.

I certainly don’t have a better solution at this point, which diminishes the usefulness of this post, but  I always feel bad for the executors.  I understand, however, why the cases are decided as they are under Boyle by the lower court judges.  If possible when bringing one of these cases, I would try to show the missed deadline was tied to substantive advice regarding the due date.  A showing that there was a general understanding, issues were raised, and incorrect advice was given.

There is one other aspect of the case that is worth noting, which was the failed argument regarding Mrs. Specht’s ability or capacity to do the job of executor.  The Sixth Circuit noted that Boyle left open the possibility that an executor’s ability level would potentially impact the reasonableness of the late filing of the return.  The Court specifically highlighted the concurrence by Justice Brennan as stating mental health or diminished capacity as reasons that could get around the bright line rule.  The Court, however, also cited to the rule that a great majority of people can determine the deadline and ensure compliance, which it found true of Mrs. Specht.  Mrs. Specht, although unfamiliar with the rules, did not suffer from a disability that would have caused her to miss the deadline.  This could be an avenue in future cases, with the right fact pattern, to claim reasonable cause when someone has relied on a preparer to ensure timely filing.

Grab Bag: Mitigation Rules (Trusts and Determinations)

Mitigation doesn’t get covered too often on PT, mostly because it doesn’t come up too often in published cases or guidance.  I wrote about it with regard to a failed attempt by taxpayers to use the provisions to assist with refunds in cases of tax paid on the sale of shares in life insurance companies after the companies had demutualized.   Over the last few months, another case and some IRS guidance was published.  The case is not extraordinary, but highlights one area where mitigation is available.  The second item is more interesting, which is Chief Counsel advice, and indicates a stipulated settlement is not a “determination” for purposes of the mitigation rules.

Before getting to the specifics, I have recreated a paragraph out of the second part of the post on demutualization and mitigation, which summarizes the concept behind mitigation.

As our readers know, Section 6511(a) imposes a three year statute of limitations.  It is a somewhat arbitrary cutoff, notions of fairness be damned, but useful for the administration of the tax system.  There are some statutory provisions in the Code that address unfair results of double taxation, or double non-taxation, in very specific stated circumstances outside of the limitations period.  The income tax mitigation provisions, found in Sections 1311 to 1314, have not been heavily covered in PT before.  Aspects of these provisions can be complicated (and the new edition of SaltzBook will have an updated Chapter 5 covering the material in depth),  but the general idea is that neither a taxpayer nor the government should be able to take opposite positions before and after the statute of limitations closes to their benefit.  Inconsistency is the key, and that allows the aggrieved party to potentially open a closed year.

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Costello v. Comm’r: Trust, Beneficiary? Someone Must Pay

Costello v. Comm’r fits fairly neatly within the framework of the mitigation provisions.  The facts boil down to an IRA was payable to a trust.  The trust made distribution of that income to each beneficiary, and took a distribution deduction for the amount distributed thereby eliminating income at the trust level.  Each beneficiary received a K-1 and reported the income on his or her Form 1040 and paid the tax.  On audit of the 1041 (that doesn’t happen often), the IRS determined tax was due at the trust level, and the SOL was extended and the trustee consented to the assessment.  Shortly thereafter, the IRS determined the beneficiaries did not have to pay the tax, and refunded the same.  After the trust paid the tax due, the SOL passed on the beneficiaries’ returns.  The trust then requested a refund by filing an amended 1041X, which the IRS granted.  This was not subsequently challenged, so presumably the IRS determined the amended return (which was probably similar to the original) was correct.  The IRS then attempted to collect the tax due from the beneficiaries, but was blocked by the SOL.

The mitigation provisions allow for opening the SOL in limited circumstances.  There are very specific statutory requirements, all of which will not be discussed here.  There first must be a determination that the situation fits within the statute.  Double exclusion of income between related parties is one area that qualifies under Section 1312(3).  Related party is defined under Section 1313, and includes  a trust and beneficiary .  Here, the taxpayers argued that the beneficiaries never took an inconsistent position, as required under Section 1311, because it was the actions and mistakes of the Service that caused the issue. Essentially, the beneficiaries were passive in all prior years until requesting the refund, so they were not inconsistent in positions.  The Tax Court disagreed and found the position was inconsistent and the IRS was entitled to recoup the refunded amount to the beneficiaries.  It is worth noting, the application of “inconsistent position” is not consistent in all cases and before all courts.  It is not inconceivable that there is case law contrary to his holding.

Stipulated Settlement Not a “Determination” For Mitigation

The Service has released CCA 201622032, which provides the Service’s position on whether or not a stipulated settlement agreement entered onto the record by the Tax Court is a “determination” for an open year.  In the advice, a taxpayer submitted Form 1041s, which were untimely unless mitigation applied.  The value of assets had been reported on a Form 706, which was challenged and litigated by the Service.  That value was used as the basis for reporting gains on the Form 1041.  The litigation resulted in a stipulated settlement agreement, which changed the values and would have resulted in a refund on the Form 1041.

Although a Tax Court decision would be a “determination”, the Service position was that “simply because the taxpayers have met the requirements in form regarding what constitutes a determination does not mean that they have met the substantive requirements.”  As an example, the Service highlights that a Tax Court decision for the same year may not be a determination that could open mitigation because perhaps it applies to a different topic or isn’t something mitigation is available for (seems like that would fail in logic).  The Service highlights Fruit of the Loom, 72 F3d 1338 (7th Cir. 1996) for the proposition that administrative settlements are not determinations under Section 1313, which is again not directly on point.

I bet you could formulate a quality argument against the Service on this.  I also wonder if practitioners should negotiate in terms into the stipulated settlement agreement stating that the some aspects are determinations for the mitigation provisions.

Sixth Circuit Follows Second on Overpayment Interest for Not-for-Profit Corps

In late April of this year, I wrote a post on the Second Circuit case, Maimondies, where the Court determined if a not-for-profit corporation that was exempt from income tax under Section 501(c)(3) was a “corporation” for overpayment and underpayment interest rates.  The same issue was decided by the Sixth Circuit in August in United States v. Detroit Medical Center.

The issue in Detroit Medical is that “corporations” under Section 6621(a)(1) receive interest at a lower rate  that non-corporations on overpayments of tax.  The not-for-profit corporation had an overpayment of employment taxes paid on medical residents (exact same issue as Maimondies) and believed it should receive interest at the non-corporate rate.  Detroit Medical’s argument is based on a blend of policy arguments and statutory construction.   The IRS disagreed, arguing a corporation is a corporation, profit or not.  Here is the issue as stated by the Court:

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Consider our task today. The question at hand sounds simple enough: Should a nonprofit corporation be treated like a for-profit corporation when it comes to the interest it receives on overpaid taxes? Now consider the question in the context of the Internal Revenue Code:

(a) General rule:

(1) Overpayment rate. The overpayment rate established under this section shall be the sum of—

(A) the Federal short-term rate determined under subsection (b), plus

(B) 3 percentage points (2 percentage points in the case of a corporation).

To the extent that an overpayment of tax by a corporation for any taxable period (as defined in subsection (c)(3), applied by substituting “overpayment” for “underpayment”) exceeds $10,000, subparagraph (B) shall be applied by substituting “0.5 percentage point” for “2 percentage points.”

(2) Underpayment rate. The underpayment rate established under this section shall be the sum of—

(A) the Federal short-term rate determined under subsection (b), plus

(B) 3 percentage points.

. . .

(c) Increase in underpayment rate for large corporate underpayments

(1) In general. For purposes of determining the amount of interest payable under section 6601 on any large corporate underpayment for periods after the applicable date, paragraph (2) of subsection (a) shall be applied by substituting “5 percentage points” for “3 percentage points”.

. . .

(3) Large corporate underpayment. For purposes of this subsection—

(A) In general The term “large corporate underpayment” means any underpayment of a tax by a C corporation for any taxable period if the amount of such underpayment for such period exceeds $100,000.

(B) Taxable period. For purposes of subparagraph (A), the term “taxable period” means— (i) in the case of any tax imposed by subtitle A, the taxable year, or (ii) in the case of any other tax, the period to which the underpayment relates.

What starts as a basic question gets less basic the more one reads. Yes, this is a tax case. Some complexities—different rules for overpayments and underpayments, different interest rates for different taxpayers, some exceptions to some rules—come with the territory. But the first sign that the author of this provision was not thinking of his readers appears in the parenthetical of the flush paragraph: “To the extent that an overpayment of tax by a corporation for any taxable period (as defined in subsection (c)(3), applied by substituting ‘overpayment’ for ‘underpayment’) exceeds $10,000, subparagraph (B) shall be applied by substituting ‘0.5 percentage point’ for ‘2 percentage points.’” The meaning of this exception turns on a cross reference to another subsection that applies to the opposite form of payment mentioned in the first subsection but only for “C corporation[s],” not “corporations” in general.

The Sixth takes a strict statutory construction look at the statute, first determining if the entity is a “corporation”, finding if the statute does not specifically define a term fully then Congress intends to adopt its customary meaning.  The Court found “corporation” generally includes not-for-profit corporations, looking to Chief Justice Marshall 1819 holding in Trustees of Dartmouth College v. Woodward.  The Second Circuit had cited to this case, and, not to be outdone, the Sixth Circuit decided to look even further back through legal history, citing to the 1612 holding in The Case of Sutton’s Hospital where the nonprofit was treated as a corporation.  And, to the writings of William Blackstone in 1753, who listed three general types of corporations, including charitable or “eleemosynary” as he termed them.  The Court then looks to various places in the Code where charitable entities are referred to as corporations, and various other everyday uses of the term.

Finding the entity was clearly a “corporation”, the Court then looked to the hanging language and the reference to (c)(3).  There the Court held that the parenthetical modified only the taxable period, and not the remainder of the paragraph, so the c-corporation language did not modify (a)(1) to only apply to c-corporations.  The Sixth Circuit provides a lengthy discussion about why this is the correct statutory interpretation, which is similar to that in the Second Circuit holding.

The Court does note that this is a strange statutory design, to have the nonprofit receiving less interest than Warren Buffett, musing that perhaps Congress had not thought it through because nonprofits don’t pay income tax.

In the final paragraph, the Court does note that it is in agreement with the Second Circuit (the first reference to the case).  This is probably on appeal in other circuits at this point, as it appears there were a lot of nonprofit hospitals in the same position following Mayo.  As the Tax Court has previously held that the S-corporations were not subject to the lower rate based on the same provisions, there is at least some potential for another circuit to hold differently regarding not-for-profits, providing a split.  We shall see.

Professor Book Presents at Loyola (LA) on Taxpayer Rights, Social Psychology, and the EITC

Les is out on the West Coast today presenting at Loyola Law School’s Tax Policy Colloquium.  Les is the first presenter this year, and the other speakers cover a broad range of topics.  Les’ talk is based on research and a paper he is currently working on, some of which is based on his prior writing and a number of Procedurally Taxing posts where he discusses the EITC, compliance, and criticism of the IRS in relying on sanctions like the Section 32(k) ban.   He also weaves in his interest in viewing these issues through the social science and behavioral economics lenses.

Some of Les’ recent PT posts that he pulls from for the talk and paper are:

Legislative Language Directs IRS to Make Self-Prepared EITC Claims More Burdensome

Warren Buffet Calls For Expanding EITC: Tax Administration Impact Highlights There is No Free Lunch

IRS Issues New Report on EITC Overclaims (Title A)

H&R Block CEO Asks IRS To Make it Harder to Self-Prepare Tax Returns and Why That is Good for the Tax System

The paper will likely not be finalized until later this fall, but the abstract for the paper and talk is as follows:

Thinking About Taxpayer Rights and Social Psychology to Improve Administration of the EITC

 Abstract

The IRS is a reluctant but key player in delivering social benefits to the nation’s working poor.  The earned income tax credit (EITC) is generally praised for its role in reducing poverty and incentivizing low-wage work. While the EITC has generally received bipartisan support, the IRS faces strong criticism over EITC compliance issues. Opponents focus on headline-generating reports of improper payments and a characterization of errors as likely due to fraud. Advocates look to the intersection of legal complexity and the characteristics of recipients as the main driver of error and the relatively low share of the tax gap that is attributable to refundable credits in general and the EITC in particular.

The current compliance challenge presents an opportunity to think about the compliance problem differently than before. In prior research, building off the work of sociologists Kidder and McEwen, I applied a typology of noncompliance to EITC claimants. That typology suggests that the problem of EITC overclaims is not a single problem but best thought of as many different compliance problems, some of which reflect intentional taxpayer misconduct and others which reflect problems that are more directly connected to the characteristics of the claimants (such as transiency or literacy challenges), perceived unfairness of eligibility rules, or actions attributable to third parties, such as return preparers who play an important role in the delivery of the EITC. In this article, I build on that typology by integrating recent compliance studies, current research on the increased complexity of American family life and two approaches that may present an opportunity for the IRS to improve the likelihood that claimants will voluntarily comply. One approach is based on research that suggests tax agencies can enhance voluntary compliance by an appropriate mix of power and measures that will enhance greater trust in the IRS. The other is based on social psychology research that has shown that by increasing psychological costs and the perceived likelihood of detection through changes in forms, disclosure statements and a more personalized communication approach people may be more inclined to be truthful in the first instance.

By explicitly tying in how possible administrative and legislative solutions relate to the complex structure of today’s American family life, trust in the tax administration, and social psychology research, this article takes the small but I believe important step of recognizing that IRS and Congress cannot principally rely on detecting and deterring noncompliance through audits, penalties and expanded summary tax return adjustment powers. While there is no silver bullet that Congress and IRS can turn to, and audits and penalties are and should remain an important part of a tax agency’s approach, the article provides insights from tax compliance researchers and offers specific administrative and legislative proposals that may improve administration of the EITC.

 

Grab Bag – OICs: Dissipation and, not of, Weed

Or

OICs – 1) The IRS Takes the High-ish Road and 2) Tax Court Explains What IRS OIC Calculations Should Be and Highlights Important 2013 IRM Changes.

This post will cover two interesting developments regarding offers in compromise from over the last few months.  The first is an internal memo from SBSE (SBSE-05-0416-0016) relating to collection potential of a company in the medical marijuana industry, and specifically if the public policy position in the IRM should cause it to reject an OIC outright.  The second is the Alphson v. Comm’r case, where the Tax Court did an exhaustive review of the calculations that should go into a review of an OIC on doubt as to collectability, and noted a 2013 charge to the IRM regarding dissipation of assets.

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Public Policy – IRS has mellowed on pot shops, but only on OICs

There is a cottage industry popping up around offering “advice” on Section 280E, which the IRS continues to enforce against state legal marijuana related businesses (for those of you unfamiliar with Section 280E, it is fairly nuanced, but generally states various normal business deductions are disallowed for any enterprise dealing with schedule I narcotics, which includes the Mary Jane).  A lot of this advice seems doobious, at best, but the Service has been issuing more guidance this year.  In any event, various people in and out of that industry feel the imposition on state legal businesses is incorrect (including the largest dispensary in the US, Harborside Health in California), and feel the IRS is being overly aggressive.  In at least one way, the Service is taking a somewhat rational view of the industry, which is that it will not automatically reject an OIC from a state legal pot shop based on the IRS’ public policy provisions in the IRM (the Service will, however, calculate that collection potential in a fashion certain to bring you down).

In an internal SBSE memorandum regarding collections, the Service has instructed its employees not to reject OICs simply on public policy grounds where their actions are legal under state law.  The IRM, under IRM 5.8.7.7.2, Public Policy Rejection (Mar. 7, 2014), provides internal guidance on when to reject on OIC based on public policy.  The IRS policy is a rejection can occur on public policy grounds, even if it is clear that the funds could not be collected.  One example of why this might be appropriate under the IRM is “indicators exist showing that the financial benefits of a criminal activity are concealed or the criminal activity is continuing.”  As this is federally illegal, it is understandable why an IRS employee might have questions.

The guidance indicates there will be no blanket rejection based on the fact that the enterprise is continuing and illegal under federal law, and such offers should be considered.  This is great news, as the tax burden on these state legal businesses can be huge, but… The guidance further goes on to direct how collection potential should be calculated, which has the potential to effectively block any offer.  The guidance states the Service will only allow deductions against future income in calculating collection potential based on what is deductible under Section 280E (not that much).  This will drastically artificially inflate the collection potential to levels that likely will not provide much benefit to the taxpayer.  My guess is the IRS has the discretion to allow the deductions in calculating collection potential, which I would encourage from a revenue generation standpoint and the general reasons behind OICs, but this is, like so many other IRS problems, something Congress needs to deal with.

Alphson –OICs, Dissipating Assets, and  the IRM

The second OIC matter is Alphson v. Commissioner, TC Memo 2016-84, from May.  The case does not break any new ground, but does have a good discussion of how the Service did and should calculate collection potential, the latitude the Service has in rejecting OICs and the guidance under the IRM, and the dissipation of assets.  In Alphson, the Tax Court upheld the Service’s rejection of an offer as reasonable, even though there were minor errors in the calculation by the Service (no abuse of discretion).  Alphson apparently ran up a $200k tax bill from ’08 to ‘10.  Over the same time period, he settled some litigation and was awarded $1.2MM.  The OIC for doubt as to collectability offered $2,400, and the Service rejected the offer based on the fact that the Service felt Mr. Alphson wasted over $1MM.  Alphson claimed he was unemployed, couldn’t find work over the last three years, was broke, and had thousands of monthly expenses.

The Court noted, “we’re certainly aware of the longstanding rule that the IRM doesn’t have the force of law, but because Section 7122 gives such wide discretion to the Commissioner to establish guidelines for evaluating OICs, we’ve generally upheld a settlement officer’s determination rejecting an OIC as reasonable when he follows the IRM.”  The Court also then cited case law standing for the proposition that the Court will hold up determinations that are less than correct stating, “close enough for government work” (or folk music—just kidding, that was the Court holding, but it didn’t say “close enough for government work”).

The Court then worked through both the net equity aspect of the calculation and the future income.  Both are extensive and worth a read, but I want to highlight the net equity, specifically the dissipation discussion.  The IRS position was that Alphson had about $1.5MM in net equity, while Alphson submitted that he had $501 in net equity.  Some of the difference was due to accounts Alphson failed to list (not a strong starting point), but the largest aspect was about $1.2MM from the settlement that was not included.  The Service believed the assets were dissipated for frivolous reasons, while Alphson contended they were for necessary living expenses and should be included.

Alphson argued that language added in September 2013 to the IRM was applicable, stating dissipated assets were only those that the taxpayer had frittered away while attempting to avoid the tax.  See IRM 5.8.5.18(1) (Sept. 30, 2013).  The Court agreed the Service had not shown Alphson was attempting to avoid tax, but the provision was added after the review by the Service in June of 2013.  Under the old version, dissipated assets were simply reviewed to see if they were used on nonpriority items.  The Court found the Service properly applied this standard to the review of Alphson’s claim of necessary living expenses, including substantial credit card bills (without explanation of the charges), country club costs, and rent of $9,700 a month (nice digs).

Couple parting thoughts.  The 2013 change to the IRM, which is still there, is taxpayer friendly (I think it also changed the look back from five to three years).  The Alphson argument would have been stronger had his OIC been reviewed later in the year.  I would have also been nervous taking that case through the tax court; such a low offer and with some fairly bad facts.  Sometimes there is no other choice though.