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.

One Hake of a Taxpayer Friendly Reasonable Cause Holding

And, could this be heading to SCOTUS?

The District Court for the Middle District of Pennsylvania just issued a holding in Hake v. United States regarding the reasonable cause exception for the failure to file penalties for executors who failed to file due to bad advice from their lawyer.  This was a fairly taxpayer friendly opinion, following somewhat closely on the heels of the Thouron case in the Third Circuit, which we covered heavily here.  While Thouron could have been limited, somewhat, to its facts, the Hake opinion applied the case broadly, allowing taxpayer reliance on an advisor to eliminate penalties.  Longtime PT readers will know that I dislike the framework from Boyle regarding reasonable cause for reliance on an expert in this area (but other practitioners disagree, including other PT authors).  Our readers will also likely recall that I was fairly heated in my harsh words against the Eastern District’s decision in Thouron before it was reversed by the Third Circuit.  Although I think allowing reasonable cause is the right thing to do for the Hakes, the case isn’t nearly as strong for reasonable cause as Thouron was, at least in my mind.  So, why do I think the Hakes got lucky (or more specifically their lawyer)?

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Mrs. Hake died in October of 2011 after a period of incapacitation, holding substantial assets including a closely held grocery store chain.  Her five children apparently did not agree on much, and that included the administration of her estate and the value of the assets.  Two of her five children, Ricky and Randy, were named executors, and hired the family lawyer to act as estate and tax counsel.  Normally, the estate tax return, Form 706, would have been due nine months following the date of death, in July of 2012. See Section 6075(a).  Due to the disagreements between the family, it was believed that they would not know the actual values of the estate assets at the filing deadline.

The attorney suggested filing a Form 4768 to obtain an extension of time to file the return and pay the tax due.  In June of 2012, the request for extension was filed.  An associate in the office was tasked with determining the extension, and informed the primary attorney, who in turn informed the client, that the filing deadline and the payment deadline had both been extended by a year.

But, that isn’t really a thing.  The estate had received a six month automatic filing extension, and a one year discretionary extension for payment.  This fact didn’t make it to the executors, who thought they were doing substantial good by prepaying the tax in February of 2013 ( about a month after the return was due) and in July the return was filed.  In August of 2013, the Service notified the estate that about $198k of penalties were due for failure to file a timely return under Section 6651, along with $17k in interest.  The estate took administrative steps to seek abatement, but eventually had to pay the tax due.  It then filed a refund suit in the District Court.

As the court stated, the issue was narrowly defined:

When an executor relies upon inaccurate advice from legal and tax counsel regarding the extended deadline for filing an estate tax return, in a factual context where determination of filing and payment deadlines are governed by a series of mandatory and discretionary rules which may vary depending upon the residence status of the taxpayer, does that reliance upon professional advice constitute reasonable cause to avoid the assessment of late filing penalties and interest?

The Court found that yes, it did constitute reasonable cause, which I applaud, and, as I have said repeatedly in the past, in this particular situation I do not think penalties should be imposed on the estate.  However, this is not in line with most of the case law.  The holding does follow the Third Circuit opinion in Thouron, as discussed below, but this fact pattern pushes the boundaries of the Supreme Court’s holding in Boyle further than Thouron did.

To begin the legal analysis, the court covered the general law, including that a six month extension is allowed under Reg. 20.6075-1 for filing, and that an extension to pay is allowed for up to a year under Reg. 20.6081-1(b).  Pursuant to Section 6081(a), however, the IRS is limited in allowing extensions beyond six months for failure to file (unless the taxpayer is outside of the country).

The Court characterizes this extension in an interesting way, stating:

 thus, with respect to payment and filing deadlines, the legal terrain requires subtle multi-faceted analysis. First, one must determine the initial filing and payment deadlines.  Next one must negotiate a series of deadline extensions rules.  Some of these extensions are automatic; others are discretionary.  Further, one must be alert to the fact that the application of these differing rules can lead to different deadlines for payment and filing.  Finally, one must remain mindful of the fact that the filing rules themselves change depending upon residency status of the executors.

The language is clearly framing this as a difficult issue that lay persons generally would not be capable of figuring out, which is not always how the discussions begin in cases following Boyle.    As our readers know, the failure to file penalty has an exception when such failure was due to reasonable cause and not willful neglect. Section 6651(a)(1).  SCOTUS outlined the general test for executors seeking to show reasonable cause in United States v. Boyle when relying on a tax professional.

The District Court discussed Boyle, but largely through the context of Thouron v. United States, the 2014 Third Circuit failure to pay case, which found the executor had reasonable cause for failing to timely pay estate tax because of his reliance on a tax professional regarding the extended deadline.

At the outset, it is important to note that most courts, practitioners, and commentators believe the failure to pay case law and the failure to file case law is largely interchangeable in this area, which I agree with.

The District Court noted the Third Circuit stated Boyle:

identified three distinct categories of late-filing cases. In the first category consists of cases that involve taxpayers who delegate the task of filing a return to an agent, only to have the agent file the return late or not at all…[SCOTUS] held…such…reliance…was not reasonable cause…The second category…is where a taxpayer, in reliance on the advice of an accountant or attorney, files a return after the actual due date, but within the time that the…lawyer or accountant advised the taxpayer was available.  Finally, in the third category are those cases where “an accountant or attorney advises a taxpayer on a matter of tax law.”

The District Court believed that Thouron had instructed it to construe Boyle narrowly, only clearly applying to the first set of failure above.  As to the second set, it believed Boyle did not hold on the issue leaving the lower courts to make their own determinations, and that under the third set of cases, Boyle would not apply.

The government’s contention is that the requirement for timely filing is non-delegable, and reasonable cause based on misunderstanding the deadline is never sufficient.  Such a failure is, in its mind (I am assuming), a malpractice claim between the taxpayer and its advisor.  The Service would never allow reasonable cause in the second set of cases, and would likely argue against it in most of the third set of cases.

The District Court in Hake, in the remainder of the opinion, somewhat appeared to begrudgingly agree with the Third Circuit’s analysis that reasonable cause could, and perhaps should, apply in all second and third category cases.  Towards the end, the Court stated the following not-so-ringing endorsement of its holding:

In reaching this conclusion, however, we wish to emphasize the very narrow scope of our ruling. We do not purport to stake out new or novel legal theories in this decision.  Rather, we attempt to simply and faithfully apply the law of this circuit to the facts of this case.  Moreover, our decision regarding the reasonableness of the executor’s reliance upon legal advice is strictly limited to, and bound up in the facts of this case.

The Court did then note, as a positive, the fact that the executors had overpaid the amount of tax due before the deadline for doing so (making the imposition of the penalty seem a little boorish on the part of the Service).  Finally, in foot note 6, the Court invited the government to consider taking this case up through various appeals to clarify the disparity in case law on this matter that is found in the other Circuits compared to the Third.

I have no specific knowledge of the case, but the opinion seemed to indicate that the district court judge in Hake 1)  doesn’t agree with Thouron completely, 2)  appreciated the fact that taxes were timely (over) paid, and 3)  didn’t want to be overruled on the opinion.

Thouron, however, in my mind left the door potentially open for the judge in Hake  to hold the other way, had it wanted to.  Hake doesn’t clearly state whether it falls within the second or third group of Boyle cases indicated above.  The language of the case would indicate the judge in Hake was analyzing the case under the second group, where the taxpayer files within the time frame erroneously indicated by a practitioner, not where there was clear reliance on legal advice (although the discussion of the complexity of the filing dates does drift into what I would view as a discussion more related to reliance on legal advice).

Thouron, likewise, didn’t specify whether it was a second or third group case.  It stated that Boyle only held on clerical oversight in an agent failing to file by the deadline.  “It did not rule on when taxpayers rely on the advice of an expert, whether that advice relates to a substantive question of tax law or identifying the correct deadline”.

Thouron certainly indicates a willingness of the Third Circuit to allow a reliance case in either a second (advice regarding deadline) or third (reliance on expert for tax law advice), but it does not flesh out the issue any further.

One key distinction between Thouron and Hake, in my opinion, is that Thouron seems more like reliance on an expert regarding tax advice, which happened to impact the filing deadline.  In Thouron, the estate failed to timely pay tax because the estate erroneously believed it qualified for deferral of payment under Section 6166.  That Section allows deferrals on certain closely held business interests, and is incredibly complicated, including substantial regulations, rulings, etc.  Section 6166 itself, which only deals with the extension to pay, is about 4,000 words long.  Determining whether or not an estate qualifies is clearly an expert’s job, and to attempt to penalize an estate for such reliance when the expert is wrong in the analysis is antithetical to the statutes and regulations regarding the reasonable cause exception.  Hake, instead, was just a normal extension request.

While I agree the automatic extension provisions and the discretionary extension for payment can be confusing, and arguably could be expert advice, I think the case is less clear that it would fall within group three.   Again, the holding in Thouron lumps groups two and three together, but it does not state whether Thouron was in one or both groups.  It also does not state that all cases involving an accountant or lawyer advice regarding a deadline would qualify under group two (for instance, it would be interesting to see a court have that type of holding with the same automatic extension to pay income taxes and an extension to pay income tax).  I suspect the Third Circuit would affirm Hake, and probably would have reversed it had the holding been for the government.  Its statements in Thouron were somewhat clear in stating it would find reasonable cause for reliance on determining an extension or on legal advice.

I do not believe Hake has been appealed to the Third Circuit yet, and may not be.  If it or other similar cases should continue to be affirmed by the Third Circuit, it would result in a sufficient split to allow SCOTUS to weigh in on how Boyle should be applied, or more accurately, how the underlying law should be applied in groups two and three.  I think cases in group three have to remain reasonable cause, but it would be really interesting to see what happens with group two.

Preparer “Doctors” the Return Adding Phantom Income: Court Sustains Preparer Penalties

Tax return preparers have heightened requirements when preparing returns claiming many refundable credits. While the IRS lost the battle over regulating unlicensed preparers, it does have tools to examine and sanction preparers who violate those rules. There have been very few opinions considering whether a preparer’s conduct justifies the imposition of civil penalties. Last week in Foxx v US the Court of Federal Claims held that a preparer was subject to a civil penalty under Section 6694(b) for his willful or reckless conduct relating to his failure to make reasonable inquiries into income from taxpayer’s purported auto-detailing business. The IRS claimed that the taxpayer did not in fact earn the income in question. The Foxx case presents the what frequent guest poster Carl Smith has referred in a guest post to as the topsy-turvy world of earned income tax credit (EITC) cases because the creation of the phantom income fueled a refundable EITC that exceeded the taxpayer’s income and self-employment tax liability.

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George Foxx came to the attention of the IRS after it audited the tax return of Shakeena Bryant. Bryant had claimed an EITC; almost all of the earned income on the return was from an auto-detailing business she reported on Schedule C. Foxx referred to himself as the tax doctor and claimed to have 37 years of tax return prep experience. Bryant went to the tax doctor with a friend of hers, Herman James. On audit of Bryant’s return, the IRS disallowed the credit. During the audit, she agreed that she did not have the income necessary to justify her claiming the credit. In correspondence, Bryant claimed that she was instructed by Foxx to report the income to justify the refund.

IRS then examined Dr. Foxx and assessed a $5,000 penalty under Section 6694 for his willful or reckless conduct in preparing the return (note there is a separate $500 penalty under Section 6695(g) for violating the due diligence rules; that penalty was not at issue in the case). After an administrative appeal of his penalty IRS reduced it to $2500. Foxx paid and sued for refund.

The government deposed Bryant’s friend (James) who accompanied her to Dr. Foxx when the Tax Doctor prepared her return.

The case on the surface turned on whether the preparer George Foxx 1) facilitated the improper claiming of the credit by instructing the taxpayer how to goose the credit and make it look legitimate by applying for a business license even in the absence of the actual business or 2) prepared the return based on what Bryant told him about her business.

A bad fact for the Tax Doctor in this case was that James on deposition supported Bryant’s version of the facts. Both Bryant and James stated that she obtained a business license the same day the return was prepared pursuant to Dr. Foxx’s instruction. James also stated that Dr. Foxx “explained that such a license would allow him to obtain more money for Ms. Bryant, and Dr. Foxx, not Ms. Bryant, created the false business income that appeared on Ms. Bryant’s tax return.”

According to the opinion, Foxx clamed that in preparing the return he relied upon Bryant’s business license and two pages of his notes that outlined expenses associated with the business.

What was potentially a he said/they said case evolved into the court concluding that it did not matter which version was true. Even if Bryant did tell the preparer about her income the court concluded that Foxx had an affirmative obligation under the specific EITC due diligence regulations to dig deeper:

Dr. Foxx argued before the IRS that his reliance on Ms. Bryant’s alleged statements regarding her business was reasonable because Ms. Bryant otherwise would have only earned approximately $15 in 2007 based on the W-2 she provided to Dr. Foxx. Such an argument is misplaced; Ms. Bryant’s financial situation did not relieve Dr. Foxx of his obligation to make reasonable inquiries into any auto detailing business purportedly conducted by Ms. Bryant after she did not provide adequate documentation. His failure to do so was an intentional or reckless disregard of relevant Treasury Regulations [referring to the due diligence regulations under Section 6695]

Schedule C and Compliance Generally

As the Foxx case illustrates, the EITC creates the odd incentive for the creation of phantom income that could fuel a tax refund. That phantom income could also create a record of social security benefits that could generate Social Security benefits.

While noncompliance with the EITC generates significant attention, the absence of information reporting that ties much income to self-employed taxpayers contributes to those taxpayers in general comprising the largest source of the individual tax gap. EITC noncompliance among self-employed taxpayers is a small but significant part of the tax gap that is associated with self-employed taxpayers. Despite the EITC comprising a small portion of the tax compliance problem among the self-employed, there are special due diligence obligations imposed on preparers who prepare EITC returns with Schedule C’s that do not apply to other Schedule C returns.

On the IRS’s EITC web page for professionals it has a special training section discussing Schedule C. The training states that preparers “generally can rely on the taxpayers’ representations, but EITC due diligence requires the paid preparer to take additional steps to determine that the net self-employment income used to calculate the amount of or eligibility for EITC is correct and complete.”

IRS has on its EITC due diligence web site a series of scenarios discussing what it believes are examples of when preparers need to take additional steps. One of the scenarios involves a self-employed housecleaner who comes to a preparer claiming exactly $12,000 in earnings with no records and no expenses. A similar example is in the regulations. For the house-cleaner with the rounded off income figures and no expenses the IRS advice states that a preparer should “probably not” prepare the return in the absence of at least a written record of expenses and earnings, though opens the door a bit if the taxpayer “can reasonably reconstruct” the earnings and expenses. To that end the advice suggests that the preparer should ask how much she charges per house, as well questions relating to how many houses she cleaned on average per week and probe as to the reason for the lack of expenses (e.g., the homeowners provided all supplies).

Back to Foxx

One does not need to have a suggestion that a preparer has encouraged the fabrication of phantom income to generate preparer penalties. A cautious reading of the Foxx opinion is when preparing a return with an EITC based on self-employment income the preparer should  require documentary evidence supporting the amount claimed to have been earned and any expenses that are incurred. In the absence of records (a sure bet for many) the preparer should document and retain an explanation as to how he came to the net earnings, tying conclusions to specific information that the client has provided. For a taxpayer with little in the way of documents, it would be a good idea to have the taxpayer in writing affirm the manner that the preparer computed a business’ net earnings and state that the facts that the preparer is relying on are accurate to the best of the taxpayer’s recollection. Absent that the preparer opens himself up to a charge that he has failed to make “reasonable inquiries” in the presence of incomplete information (one of the requirements under the due diligence regulations).

Procedure Round Up(date):   Regulations, Mount Up! & State Law SOL Issue When Suing Promoters.

This will be a short post that touches on some temporary and final regulations that were issued in the last quarter of last year that impact tax procedure, specifically information reporting and the preparer due diligence rules, which we have previously covered.  The second portion of the post will deal with a state law statute of limitations issue from a tax shelter participant suing the promoter.

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Regulation Update

What is Keno?

Back in March of 2015, I wrote about the temporary regulations dealing with reporting of winnings from bingo, keno, and slot machines.  The Service has finalized those regulations, which can be found here.  I believe the final regulations are similar to the temporary regulations (although aspects regarding electronic slot machines were not included in the final regs). These rules peg the required reported winnings at $1,200 for bingo and slot machines (but $1,500 for keno).  Anyone have any idea why those amounts are different (or what keno is, I don’t go to casinos much)?  The information on the information reporting must include the name, address, and EIN of the payee, along with a description of the two types of ID used to verify the payee’s address.

Discharge Reporting- Buy Now, Three Years, No Payments!

I thought I had written up the proposed regulations from 2014 relating to the rules on discharge of indebtedness reporting when a borrower had not paid for more than three years, but I cannot find the post (very possible I just read about it and found it interesting).  Under Section 6050P, prior regulations treated nonpayment of debt for 36 months as an “identifiable event”, which indicated formal discharge of indebtedness and required the issuance of a Form 1099-C.  This caused many borrowers to believe the debt had been discharged, but it was simply an IRS reporting requirement.  Tax professionals, lenders and borrowers did not like the rule.  The final regulations can be found here.  The regulations eliminate the passage of that time frame as a reportable event, which is a good result.  This change may have come from discussions started in the ABA Tax Section, Low Income Taxpayer Committee.

Preparer Due Diligence Regs Updated.

The Government has issued temporary/proposed regulations regarding the preparer due diligence rules, which can be found here.  We’ve talked about preparer due diligence repeatedly on the blog, including one of our first posts (and most popular), where Les extensively discussed peeing in pools.  That was re-posted earlier this year, and can be found here.  In both 2014 and 2015, Section 6695 dealing with preparer due diligence was amended.  The penalty was indexed for inflation, and the due diligence requirements were expanded to include the Child Tax Credit, the Additional Child Tax Credit, and the American Opportunity Tax Credit.  The proposed regulations update the provisions to take into account these changes.

Information(less) Returns

In late December 2016, the Service issued guidance (Notice 2017-9) regarding the new de minimis safe harbor provisions enacted under the PATH act.  In general, failure to include all required information on an information return or payee statement will result in a penalty being imposed on the issuer.  The penalty is dependent on various factors, including the amount incorrectly reported, when it was not reported, how quickly it is rectified, and potentially other factors.

The penalty under Section 6721 can be reduced or eliminated in certain circumstances.  There is a de minimis exception to Section 6721, which allows the penalties to be waived if the error is corrected on or before August 1st in the year it is filed.  This is limited to the greater of ten returns or .5 percent of the information returns filed.  For returns required to be filed after December 31, 2016, there is a safe harbor that applies, where, if the information return has an error of $100 or less, or involves less than $25 of withholding, then the safe harbor applies, and no corrected return is required.  The notice is clear that this does not apply for intentional acts or intentional disregard.  It also indicates that regulations will be forthcoming regarding the safe harbor.

The de minimis safe harbor will not apply, however, if the payee elects out of the safe harbor.  Under Section 6721(c)(3)(B) and Section 6722(c)(3)(B), the payee can make an election and the payor has thirty days to furnish a corrected payee statement to the payee and the IRS.  If it is not done within thirty days the penalties will apply (it is possible for additional time in limited circumstances).

The payor must provide the manner for making such an election, which can be any reasonable manner including by writing, electronically or by telephone.  The payee must be told in writing the fashion in which the election can be made.  The notice goes on to indicate the timing of when the election must be made, and indicates the election must: 1) clearly state the election is being made; 2) the payee’s name, address, and TIN; 3) the type of statements and account numbers; and 4) the years in which the election should apply.

So, if you are super angry that Gigantor Bank and Lack of Trust Company misstated your 1099 by $4.37, you now have your avenue for redress.

Shelter Participant SOL Against Promotor Runs From Final Tax Court Ruling, Not Notice of Tax Deficiency

I initially saw this suit, and thought some aspect pertained to federal law claims against the tax shelter promoter, but the claims were state law based.  It is, however, still an interesting statute of limitations issue, that could impact future rulings based on state law.

In Kipnis v. Bayerische Hypo-Und Vereinsbank, AG, the Eleventh Circuit, following direction from the Florida Supreme Court, has reversed the district court in holding the statute of limitation on state based claims against a tax shelter promoter by a participant were not time barred.

The particular holding is for a relatively straightforward issue.  After the defendant admitted fault, the IRS issued a notice of deficiency to the plaintiff for his involvement in the shelter.  This occurred in October of 2007.  On November 1, 2012, there was a final tax court order disposing of the case (90 days thereafter appeal rights expired).  On November 4, 2013, plaintiff filed suit against the defendant alleging various state law claims including fraud from the promoting and selling of the transaction.

The defendants moved to have the case thrown out as being outside of Florida’s four and five year statute of limitations for the claims made.  The issue was appealed to the Eleventh Circuit, which sought guidance from the Florida Supreme Court on the issue, specifically:

Under Florida law and the facts in this case, do the claims of the plaintiff taxpayers relating to the CARDS tax shelter accrue at the time the IRS issues a notice of deficiency or when the taxpayer’s underlying dispute with the IRS is concluded or final.

The Florida Supreme Court, which the Eleventh Circuit followed, determined that the claims accrued at the time the tax court order became final, which was ninety days after the order was issued when the appeals period had passed. See Kipnis v. Bayerische Hypo-Und Vereinsbank, AG 202 So. 3d 859 (Fla. 2016).  I think this is inline generally with what the federal law would be in most analogous situations, but would invite others to comment on this aspect if they have thoughts.

Additional Courts Hold Promoter Penalties Not Divisible For Refund Claim

So Flora is not an option.

In the below post, we will discuss the somewhat recent holdings in Diversified Group v. United States and Larson v. United States, two cases dealing with whether or not promoter penalties under Section 6707 are divisible for refund claim purposes.  An interesting issue, and one that may require a tweak to the law from Congress.

In September of 2015, Keith wrote about Diversified Group Inc. v United States, where the Court of Federal Claims held that shelter promoter penalties imposed under Section 6707 were not divisible, and therefore the promoter could not pay the penalty imposed on just one investor (this case was decided based on prior versions of Section 6111 and 6707, but the underlying concepts are still valid).  In November, the Court of Appeals for the Federal Circuit affirmed the Court of Federal Claims; the opinion can be found here.

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As explained by Keith and in the opinion, in general, a taxpayer can only sue for a refund in a district court after the amount of tax has been paid in full.  SCOTUS created an important exception to this rule in Flora v. US, where it indicated an excise tax may be divisible based on each taxable transaction or event, allowing full payment to occur with a small amount of tax.  Under Section 6707, certain promoters who fail to file required returns, or do so with a false or incomplete return, regarding reportable transactions are subject to penalties.  The penalty then imposed was 1% of the aggregate investment amount (now the penalty is $50,000 for each transaction, or, if relating to a listed transaction, it is the greater of $200k or 50% of the gross income derived by the advisor (increased to 75% if the failure is intentional)).  The promoter paid a portion related to one transaction and sued for refund, and the IRS objected.  The lower court determined the penalty was not divisible, and was related to the singular act of failing to report the promoting of the tax shelter (and not the imposition of the amount on the 192 clients separate transactions).

The appellate court affirmed that the singular act of failing to report the shelter was what occurred to impose the penalty.  Further, it reviewed the applicable language, finding the Code viewed the shelters in the aggregate (not individually) for determining if the penalty was applied,  and Section 6111 required disclosure the day on which the shelter was initially offered, and did not relate to each investor  buying in.  Providing more evidence it was the initial failure and not each purchase of the shelter.

I quote briefly from Keith’s post regarding the direct impact of this case:

While feeling sorry for someone who promotes an egregious tax shelter scheme requires a great deal of effort, I think parties should have the opportunity to litigate the imposition of a tax or penalty without full payment.  The Court of Federal Claims decision rests on firm ground, yet barring someone against whom the IRS assesses a penalty, any penalty, from disputing that penalty in court without paying over $24 million seems inappropriate.  Maybe tax shelter promoters have access to that kind of money but most parties do not.

Keith’s post also discusses the potential for CDP as an avenue for a merit review by the courts, which is not without issues.  If readers have not previously reviewed that aspect of Keith’s prior post, I would encourage them to do so.

The Diversified holding was followed by Larson v. United States, which was decided by the District Court for the Southern District of New York on December 28th.  Larson is continued fallout from the KPMG tax shelter case from the mid-2000s.  Mr. Larson paid a fraction of the $63.4MM Section 6707 penalty related to one transaction (the overall penalty was initially a $160.2MM penalty, but others paid portions of it).  He argued that the partial payment was valid under Flora.  The Southern District came to the same conclusion as the Federal Circuit.

Jack Townsend wrote up the case on his Federal Tax Crimes Blog here, where he summarizes the holding and quotes the salient aspects of the case.  At the end of the post, Jack highlights his takeaways from the case, which include similar contents to Keith’s thoughts on Diversified.  Jack thinks, given the huge dollar amounts that can be involved, that there needs to be some prepayment or partial payment review, otherwise taxpayers could be inappropriately precluded from litigating the merits.  Mr. Larson attempted to make similar arguments in his case, based on the APA and the Constitution, which the Southern District did not agree with.  These are discussed below.

Jack also highlights an APA challenge raised by Mr. Larson.  Larson argued for judicial review under the APA claiming the denial of his refund claim was arbitrary, capricious, and an abuse of the IRS discretion.  The Court found this argument lacking, stating “an existing review procedure will…bar a duplicative APA claim so long as it provides adequate redress. Clark City Bancorp. v. US Dept. of Treasury, 2014 WL 5140004 (DDC Sept. 19, 2014)”.   The “existing review procedure” here was the full payment of  the claimed amount due, and the request for review of a refund denial in the district court.  Jack’s post highlights other language summarizing this holding.

There are various other interesting arguments made in this case.  For instance, Mr. Larson argued the fines under Section 6707 violate the 8th Amendment of the Constitution (excessive fine, not cruel and unusual punishment, although if I told my wife I owed a fine of that amount I am certain it would result in cruel and unusual punishment).  The Court questioned whether it had jurisdiction to review the matter, but eventually determined that didn’t matter, as Larson failed to state a claim.

Sticking with long shot Constitutional challenges, Mr. Larson also argued that his due process rights under the Fifth Amendment would be violated by the penalty under Section 6707 if it was not divisible because the imposition of the full payment rule would preclude him from being able to pay and therefore from being able to have a review.  The Court rejected this argument, stating courts have consistently held that the inability to pay penalties has never been determined to be a due process violation (citing to various cases, including the recent case of his one-time co-defendant, Robert Pfaff, 117 AFTR2d 2016-981 (D. Colo. 2016)).  I understand if this was not the rule, everyone would claim inability to pay, and it is possible that much lower fine amounts would clog the courts.  Here, however, the fine was $63MM!  I think less than .1% of the population would ever be able to pay that.

I have no further insight beyond what Jack and Keith stated.  For the most part, the people arguing these cases have violated the tax law, and done so knowing full well that the areas they were flirting with had substantial penalties.  They did this for significant financial gain.  But, the penalties can easily be many times more than the assets of the individual, making it impossible for full payment, and there should be some way for the merits to be litigated.  This will likely require a legislative change, although I am uncertain who is going to advocate for the tax shelter promoters.

Some Updates to Prior Posts and Tax Procedure Conferences of Note

In today’s post I will update readers on some past cases we have discussed and highlight a couple of conferences that relate to tax procedure and administration.

First, to the updates.

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Senyszen v Commissioner: Tax Court Holding Insufficient to Free Convicted Former IRS Employee

Readers may remember the Tax Court case of Senyszen v Commissioner. Keith discussed it twice, first in Collateral Estoppel in Civil Tax Case Following Conviction of Tax Evasion and also Motion for Reconsideration. In that case, Mr. Senyszen, a former CPA who was working for the IRS, pled guilty to 1) filing false returns; (2) tax evasion; (3) structuring financial transactions; and (4) bank fraud. The Tax Court considered the impact of his tax evasion conviction on the amount of his civil liability. The evasion charge included allegations in the information that he embezzled about $250,000 from a former business associate.

At Tax Court IRS argued that Senyszen was subject to collateral estoppel on the issue of his civil tax liability stemming from the embezzled $250,000. The Tax Court, however, found that Senyzsen had actually returned the embezzled funds and held that the IRS cannot use collateral estoppel to impose a liability where it otherwise does not exist. The IRS did not like that outcome and filed a motion for reconsideration. On reconsideration the Tax Court refined its reasoning but stuck to its guns and held that without an actual tax liability the prior tax evasion conviction was not enough to justify his civil tax liability.

As a result of the Tax Court victory, Mr. Senyszen filed a motion with a federal district court in New Jersey for relief from his criminal conviction. The court considered the pro se motion as a writ of error coram nobis, which gives the court the power to overturn a prior conviction if he could establish, in light of all the evidence, it was more likely than not that no reasonable juror would have convicted him.

Senyszen essentially argued that the district court should reconsider his conviction in light of the Tax Court finding that he had no taxable income from the embezzlement (an issue he had raised previously with the district court and Third Circuit when he tried unsuccessfully to withdraw his tax evasion plea). The district court opinion took note of the significance of the Tax Court outcome on the evasion charge:

The Tax Court’s finding certainly contradicts a portion of the second count of the Information, which alleged tax evasion as a product of “embezzled taxable income from the sale of real estate.”…To that extent, the Court acknowledges that the Tax Court’s decision conclusively establishes that Petitioner is not guilty of evading taxes through the embezzlement of taxable income in 2003.

The district court did not go as far as Senyszen wanted:

[H]owever, that is not all that the Information alleges. Notably, the first paragraph under the second count reads: “The allegations contained in paragraphs 1 through 10 of Count One of this Superseding Information are repeated, realleged and incorporated by reference as though fully set forth herein.” In other words, Petitioner’s conduct under the first count was also sufficient to establish his guilt under the second count. The Tax Court confirmed: “[Petitioner’s] preparation of a fraudulent return on behalf of [the corporation] were themselves sufficient grounds to justify his conviction for tax evasion.”

The upshot is that for now Senyszen’s 36 month sentence stands. The court’s power to overturn a conviction is narrow; the Tax Court holding only went so far and did note that the Senyszen’s preparation of a false return on behalf of the corporation was sufficient to justify the evasion conviction.

For more detail on the opinion check out Jack Townsend, who in his Federal Tax Crimes blog has discussed the Tax Court case, and he also reports on the case’s latest chapter. Jack notes that the oft-litigating Senyszen has filed a motion for reconsideration and suggests that another appeal is likely.

More on the Secret Subpoena in Tax Court

The law firm of McDermott Will & Emery has an excellent tax controversy practice and that group publishes a blog called Tax Controversy 360. Last week Andy Roberson, a PT guest poster, partner in the firm’s tax controversy group, petitioner’s counsel in the important penalty decision in Rand which Keith discussed in Government Drops Appeal in Rand Case, and prior winner of the ABA Tax Section Janet Spragens Award for his commitment to pro bono, discussed the Tangel case. In his post he noted the differing approach Judges Chiechi and Holmes have on whether parties have a notice requirement before service of non-party subpoenas for the production of documents, information or tangible things, a topic I also discussed last week. Andy offers some practical tips for overcoming the surprise that is the harm from allowing a party to issue a subpoena without notifying the other side:

Until the Tax Court adopts a uniform rule against “secret subpoenas,” taxpayers should routinely and regularly issue discovery requests on the IRS seeking: (1) a list of all third-party contacts, including the documents sent and received; (2) copies of all subpoenas, including a copy of all documents sent and received; and (3) a list of the dates on which the third-party contacts occurred, including phone calls and meetings. These requests should be made at the beginning of every case, and it should be stated that the requests are continuing in nature.

Conferences on Tax Administration and Procedure of Note

There are some interesting tax procedure conferences that Keith and I are involved in, one very near term and another in March of next year.

 Low Income Taxpayer Workshop

This afternoon in Washington at the offices of McDermott Will & Emery the ABA Tax Section is cohosting a low income taxpayer representation workshop that will cover important developments, property tax issues, criminal tax matters and health insurance marketplace issues. The session includes Keith and Andy Roberson talking about their so far unsuccessful actions seeking to get the IRS to abate the penalties made against taxpayers that the IRS agrees were wrongfully made based on the Tax Court decision in Rand (for more on Counsel guidance after the 2015 PATH legislation see Keith’s January 2016 post here), Tax Court Special Trial Judge Judge Diana Leyden, Harvard Tax Clinic fellow Caleb Smith and Vermont Legal Aid’s Christine Speidel, Treasury’s Rochelle Hodes, and many others.

Second International Taxpayer Rights Conference

This March in Vienna the Institute for Austrian and International Tax Law at Vienna University of Economics and Business is hosting the second international taxpayer rights conference. It is sponsored by Tax Analysts and is convened by the US’s National Taxpayer Advocate. The first international taxpayer rights conference in 2015 brought together many administrators, practitioners and academics. It was a terrific conference, with panelists discussing issues like transparency, privacy, rights to administrative and judicial appeal, the relationship of trust to ensuring tax compliance and the role of ombuds offices. The above link takes you to the 2015 proceedings. Keith and I were speakers at that conference. If you would like to read our conference papers, Keith wrote about tax collection and taxpayer rights which you can see here; I discussed how IRS can learn from nontax scholars who have looked at the ways that administrative agencies interact with low-income individuals; that paper is here.

The second conference is accepting registrations at the conference website; the agenda includes the following topics:

  • Taxpayer Rights in Multi-Jurisdictional Disputes
  • Privacy and Transparency in Tax Administration
  • Access to Taxpayer Rights: The Right to Quality Service in Today’s Environment
  • Transforming Cultures of Agencies and Taxpayers
  • Impact of Penalty Administration on Taxpayer Trust

I will be speaking about taxpayer rights with a focus on refundable credits and am in the process of writing a paper on that important topic.

I was reminded of the importance of taxpayer rights as last week I watched parts of Senator Harry Reid’s farewell speech to the Senate. It was a personal and deeply moving speech, touching on topics like the suicide of Senator Reid’s father and the stigma of growing up poor in Searchlight, Nevada. As part of his talk Senator Reid discussed some of his legislative highlights. The first item he mentioned was his role, along with Senators Pryor, Grassley and others, in getting the first Taxpayer Bill of Rights enacted. Taxpayer rights have come a long way since that legislation but there is considerable room for improvement. Conferences like the International Taxpayer Rights Conference help situate some of the issues and identify common global challenges and best practices.

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.

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.