District Court Holds That Taxpayer With Rejected E-Filed Return Subject to Late Filing Penalties

Last week, in Spottiswood v US, Docket No. 3:17-cv-00209 [link not yet available], the District Court for the Northern District of California held that a taxpayer who attempted to e-file his return a few days before the filing deadline but who incorrectly entered his child’s Social Security number was responsible for a late filing penalty. The case is the latest in I am certain to be a growing number of cases attempting to apply a 20thcentury approach to tax administration to the realities of 21stcentury tax return filing.

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Here are the facts.

Taxpayer John Spottiswood used Turbo Tax to prepare his federal return and California return. The federal return was submitted to Intuit for the software provider to then submit to IRS for electronic filing. Also using the Turbo Tax software, Spottiswood printed out his state return and mailed the State return via old-fashioned snail mail.

Here comes the problem. On the federal return his child’s Social Security number differed from information IRS had when it crosschecked the numbers with its databases. IRS notified Intuit, which sent an email to Spottiswood telling him IRS failed to accept the return.

Spottiswood failed to notice the email and he had no idea that all was not kosher until months later:

When I was investigating the issue, I discovered the following by logging back into my Turbo Tax 2012 software. [] I discovered that my return, which I thought had been successfully e-filed, had actually been rejected. If I had realized that there was a chance of rejection I would have mailed in my return, but e-filing seemed like an easier option and it was free with the software. Intuit may have informed me in the fine print that I needed to log back in to make sure that my return had not been rejected, but if so I did not read this fine print. Had I logged back in a few days later I would have realized that the return had been rejected. But I did not log back in until 18 months later.

Eventually Spottiswood got around to fixing the error and resubmitting the return.  IRS, however, assessed a late filing penalty of about $89,000.

Spottiswood paid the interest on the penalty and filed a claim for abatement and refund claim, which IRS rejected, leading to a suit (an aside: not clear how this gets around Flora as it does not appear based on the order that Spottiswood paid the penalty). In his motion for summary judgment, he had two main arguments: 1) the rejected return should have been considered a return and therefore no late filing penalty was appropriate and 2) in the alternative he had reasonable cause for the late filing.

The court held for the government and granted its cross-motion for summary judgment.

As to the first issue, the taxpayer’s main argument revolved around how if he had sent the precise information contained in the attempted e-filed return via old fashioned paper return, IRS would have accepted it and the information contained qualified as a return under the Beard standard as to whether a document is a return for federal income tax purposes.

I am sympathetic to this argument, as the IRS’s current approach essentially creates an additional burden for e-filers who, if they had just mailed the return in the old fashioned way, would not have found themselves facing a late filing penalty.

The court sidestepped the argument though because Spottiswood failed to establish that in fact IRS would have treated the information in a paper return differently than the e-filed return:

Plaintiffs argue that the IRS would have accepted a paper-filed return containing the same error, and that the IRS unlawfully applied a more stringent standard to their electronically- submitted return. Pls.’ Mem. at 7-8. Plaintiffs’ only support for this argument is a document entitled “Internal Revenue Manual Part 3. Submission Processing Chapter 11. Returns and Documents Analysis Section 3. Individual Income Tax Returns.” See Pls.’ Opp’n at 1 (“Plaintiffs submit Exhibits 1 through 3”); id., Ex. 2. This document is not authenticated, and Plaintiffs establish no foundation for the document. The document shows a transmittal date of November 17, 2017, and Plaintiffs do not establish any foundation showing the IRS followed the procedures described therein when Plaintiffs attempted to submit their tax return more than four years prior to that date. Plaintiffs also establish no foundation to show their interpretation of the procedures described in the document is correct. Plaintiffs fail to create a triable issue that the same mistake contained in their submission would have been treated differently if it had been presented as a paper filing, and that the IRS’ rejection of their submission because it contained an erroneous Social Security number was not lawful.

The order continued with its critique of the way the taxpayer argued that the information it submitted should have been enough to constitute a return for tax purposes:

Plaintiffs’ assertion that the document “contained sufficient data to calculate the couple’s tax liability” (Pls.’ Mem. at 7) is purely conclusory. Their support for this argument is based entirely on an unauthenticated copy of a document faxed by the IRS to an unidentified recipient on May 23, 2016. Id. (citing Pls.’ Opp’n at 1 (“Plaintiffs submit Exhibits 1 through 3”); id., Ex. 1). Plaintiffs do not set out facts showing the document is a true and correct copy of the data they submitted to the IRS in 2013; indeed, it does not appear to be, given that the document displays information received on January 26, 2015. See, e.g., Pls.’ Opp’n, Ex. 1, passim (“TRDB-DT- RCVD:2015-01-26”). Nor do they set out facts showing the information contained in this document would be sufficient to calculate their tax liability. They thus have not created a triable issue of fact that the document they attempted to submit to the IRS in 2013 qualifies as a tax return under Beard, such that the IRS should have accepted it for filing under their theory of the case. The United States does not actually challenge this point, arguing only that the first Beard factor was not met because the IRS could not calculate Plaintiffs’ tax liability because the return had not been accepted for filing.

With a better foundation, the court would have had to address this issue head on, and I think it is a close case and requires courts and IRS to apply some fresh thinking on the issue.

The court also summarily rejected the taxpayer’s argument that reasonable cause should excuse the penalty, looking to the taxpayer’s failure to check his email account that he provided Intuit and the taxpayer’s failure to look at the “check e-file status” on his software to confirm that everything went well with the e-filing. For good measure, although the court did not emphasize this in the order, IRS also failed to debit the $395,000 that Spottiswood designated as a payment with the  purportedly e-filed return, and he failed to notice this due to as he described the high balance in the account. That failure to confirm that in fact IRS accepted the payment cuts against the argument that he had reasonable cause for failing to file on time.

Additional readings on this and related issues:

For more on this issue, see a prior PT post discussing the Haynes case on appeal in the Fifth Circuit, Boyle in the Age of E-Filing(linking an amicus brief from the ACTC) and a PT post on e-file rejections.

In December of 2017 and January of 2018 ABA Tax Section submitted letters to IRS asking IRS to reconsider its approach to timeliness of e-filed returns after a failed transmission; see here and here. (Note: Keith was the initial drafter of these letters, and he was part of the ABA Tax group that called on Counsel to change its policies on this issue).

A 2012 Journal of Tax Practice and Procedure article by Bryan Skarlatos and Christopher Ferguson making the persuasive case for a new approach to Boyle in the age of e-filing.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Other Temporary Problems Addressed in Rajagopalan

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

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

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

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

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

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

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

 

 

 

Flora and Preparer Penalties: Preparer Two Weeks Late to File Suit in District Court

As we move into tax season, it is worth remembering that IRS has a significant arsenal of civil and criminal penalties to address misbehaving preparers. I recently came across a federal district court case, Bailey v. United States that discussed an exception to the Flora full payment rule for preparers subject to penalties for preparing tax returns or refund claims that have understatements stemming from unreasonable positions or willful/reckless conduct. For preparers, that penalty can be fairly sizeable, as under Section 6694 the amount of the penalty is the greater of $1,000 for each return or refund claim ($5,000 if the understatement is due to willful or reckless conduct) or 50% (75% for willful/reckless conduct) of the income derived by the tax return preparer with respect to the return or claim for refund.

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These penalties are not subject to the deficiency procedures, meaning that if IRS examines a preparer and determines that the preparer’s conduct in preparing the return or refund claim warrants a penalty, the preparer will generally have to pursue a refund suit to guarantee judicial review of the penalty. (I’ll skip the CDP discussion on this, a topic we also have discussed, which turns on whether a preparer has previously had an opportunity to dispute the penalty through its rights to have Appeals consider the matter).

We have often discussed the Flora rule, which requires full payment to ensure jurisdiction for a refund suit. Flora presents a considerable barrier, especially for moderate income persons subject to the penalty but also stemming from the fact that some civil penalties, including the variety of penalties preparers are subject to, can be very significant; Keith has written about that before here, suggesting perhaps it is time to rethink Flora in light of the impact and potential unfairness of requiring full payment to get a court to review the Service’s penalty determination.

Bailey implicates an implicit statutory exception to Flora for the 6694 penalties. IRS asserted $70,000 in penalties due to what IRS felt was his willful or reckless conduct. As per Section 6694(c)(1), if a preparer pays at least 15% of the Section 6694 penalty within 30 days of IRS making notice and demand, the preparer can stay collection and file a refund claim. Section 6694(c)(2) also provides that if a preparer fails to file suit in district court within the earlier of (1) 30 days after the Service denies his claim for refund or 30 days of the expiration of 6 months after the day on which he filed the claim for refund, then paragraph (1) of Section 6694(c) no longer applies. That suggests that a preparer can avoid the full payment rule; to that end see note 1 of the 2016 Bailey opinion, discussing the logical Flora implication of Section 6694(c)(2).

In Bailey, the preparer paid $10,500, or 15 percent of the penalty within 30 days of the IRS notice. He filed a refund claim on March 28, 2014. At the time of the suit, IRS did not deny the claim. Thirty days after the expiration of 6 months (and a day) from the time he filed his claim was October 29, 2014. Bailey filed his refund suit in district court on November 12, 2014. That filing was two weeks late, and he no longer was eligible to take advantage of the exception to Flora.

Because the preparer missed the deadline, the district court granted the government’s motion to dismiss the suit. The failure to comply with the time requirements in Section 6694(c)(2) meant that absent the preparer’s full payment of the penalty, the district court did not have subject matter jurisdiction over the suit. Because the dismissal was without prejudice, the preparer could cure his error by fully paying the balance and refiling his complaint.

Instead of full paying, the preparer filed another action in federal court in 2017; this time, the suit alleged personal misconduct among IRS employees; in light of a motion to dismiss the preparer filed a motion to substitute the US as a party to the suit and restated his allegations that his conduct did not warrant a penalty. In November of last year the court dismissed that suit.

“I Thought I Was Getting a Refund” is An Inadequate Excuse for Late Filing

Parekh v Commissioner  raises what I suspect to be a fairly common situation: a taxpayer believes that he is due a refund, and because of that belief may not file a tax return on time or even request an extension. Because the penalty for failing to file a timely tax return depends on the presence of a tax liability, if the taxpayer believes he is due a refund he may not feel the need to file by the April 15 deadline. (Of course, there still is a need to file a return, which serves both as an original return and as a refund claim, lest you blow the SOL on refunds, but that is another story and perhaps another blog post).

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Sometimes, as in Parekh, the taxpayer is off on the calculations, and in fact does owe taxes. Parekh tees up the issue as to whether a taxpayer can have reasonable cause for not timely filing if the reason for the late (in this case 15-months late) filing is due to the taxpayer believing that it did not really matter because he thought he was getting money back from Uncle Sam.

Here are the facts, somewhat abbreviated. Parekh and his wife filed their 2012 return about 15 months late, and did not request an extension. IRS audited the return, and proposed an approximate $8,000 deficiency due to alternative minimum tax, which the original return did not calculate, as well as a $1,666 late filing penalty under 6651(a)(1). The Parekhs conceded the tax but disputed the penalty. Appeals had found no reasonable cause for the late filing, noting also that the taxpayers had a prior history of late filing and for good measure were late on subsequent returns (important as this likely  took them out of qualifying for the first time abatement, an issue Stephen has discussed before).

The taxpayer’s argument centered on his belief that there were no consequences for late filing a return that reflected a refund:

I figured, reasonably so I thought, that since I’d be getting a refund it was OK to file late * * * . In fact, I had considered the de facto deadline for filing to be three years if one is getting a refund since after that the refund is forfeited. As I take a quick look at some tax advice websites this is pretty much what they say. For example: “if they owe you a refund, the IRS really doesn’t care when you file. In fact, you have three years to file and still get your money.”

In 2012, however, they had an AMT liability due to a job switch and the unusual occurrence of distributions from retirement accounts associated with his former employer.   At trial, and as the opinion notes only after retaining an attorney, the husband also claimed that the late filing was due to frequent travel both to Oklahoma for his new job and on numerous trips to India to care for a sick parent.

This did not amount to reasonable cause. In getting to that conclusion, the opinion notes that at trial the husband agreed that the return was not complicated, and could have been prepared “in a day or two.”

The opinion lists some (not exhaustive) examples where a taxpayer was able to demonstrate that the delinquency was due to reasonable cause and not willful neglect:

  • unavoidable postal delays,
  • the timely filing of a return with the wrong IRS office,
  • the death or serious illness of a taxpayer or a member of his immediate family,
  • a taxpayer’s unavoidable absence from the United States, or
  • reliance on erroneous advice from a competent tax adviser or IRS officer.

The combination of past returns generating a refund and  some unexpected domestic and international travel due to job changes and family illness, especially when the current year was not complex, does not amount to reasonable cause:

Even if we were to credit petitioner husband’s testimony about his heavy travel schedule, it is inconceivable that he could not have found two days in which to fulfill petitioners’ filing obligation, as opposed to filing that return 15 months late. His response at trial–that “he didn’t think his tax return was something he had to do that very minute”–suggests that he did not take petitioners’ timely filing obligation seriously. (emphasis added). If petitioners truly intended to satisfy that obligation but were incommoded by problems suddenly arising in spring 2013 they could have requested an automatic six-month extension of time to file, as they eventually did for their 2014 taxable year. See sec. 6081. Their failure to request such an extension suggests, once again, that the real reason they filed late was their belief that the filing deadline did not matter because they were expecting a refund.

The moral of the story is that while sometimes it may not matter for penalty purposes if a taxpayer files late, the taxpayer should be sure that the return is going to generate a refund. In addition, the late filing of a return that has a liability raises the possibility that the taxes could not be discharged in bankruptcy, an issue Keith has flagged.Doing the math (or more likely plugging in the information on the software) before the fact can save a chunk of change and in some circuits preserve the potential for discharge.

 

 

Recent Tax Court Case Sustains Preparer EITC Due Diligence Penalties

Last week in Mohamed v Commmssioner, the Tax Court sustained $7,000 of EITC due diligence penalties against a preparer. The preparer, who was a CPA, had an active business preparing individual tax returns, including many EITC returns. The opinion provides a rare court review of the imposition of these penalties.

The EITC due diligence penalty has been on the books for a while; the current penalty is $500 for each failure to comply. Requirements include preparing and retaining forms like the Paid Preparer’s Earned Income Credit Checklist, and the Earned Income Credit Worksheet. In addition, the rules require that tax return preparer must not know, or have reason to know, that any information pertaining to the EITC is incorrect.

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This penalty is even more important for preparers, as Congress recently expanded the scope of due diligence penalties to include the child tax credit and the American opportunity tax credit.

There are not many cases involving the penalty, and while Mohamed is a summary opinion, it does provide some insights into the process and limits on Tax Court review of the penalty.

The opinion discusses how IRS examined a number of Mohamed’s clients as part of its EITC due diligence audit program. He was visited by a tax compliance officer, who reviewed 50 of Mohamed’s returns. The audit report proposed a penalty on 20 of the 50 returns; while the penalty is not subject to deficiency procedures, the IRM provides and IRS allowed for Mohamed to challenge the proposed assessment before Appeals.

Mohamed met with an Appeals Officer for 6 hours to discuss the penalty; after the meeting Appeals agreed to remove the penalty from 5 of the returns. Appeals also asked for more information on 4 other returns. Mohamed sent documents to Appeals and also had a follow up phone conversation. The correspondence and phone call led Appeals to remove the penalty from another return, bringing the penalty down to 14 returns, or $7,000.

Appeals sent a closing letter indicating that it was recommending a penalty assessment on 14 of the returns; it also let Mohamed know that he could pay the penalty and file a refund claim and eventually sue in district court or the Court of Federal Claims if he wanted court review of the penalty.

IRS assessed the penalty and issued a notice of intent to levy. Mohamed did not pay and instead filed a CDP request. In the hearing he asked to challenge the underlying assessment. The settlement officer refused that request on the theory that he had a prior opportunity to challenge the penalty in the preassessment Appeals hearing.

PT readers are likely familiar with the legal issue; namely whether a prior opportunity to dispute the amount or existence of the liability includes for these purposes an administrative preassessment Appeals hearing. Taxpayers have lost in Tax Court and circuit courts on this issue (For more see Keith’s discussion Continued Developments in Taxpayer Attempts to Litigate the Merits in CDP Cases.)

Given the Tax Court and appellate courts’ views on this issue, it is not surprising Mohamed had an uphill battle. He gamely attempted to distinguish the adverse authority, arguing that Appeals did not give him a chance to rebut its conclusions and that it terminated the process prematurely.

The Tax Court disagreed, emphasizing that he participated fully in the examination process, had a long in-person meeting with Appeals and follow up conversations and correspondence:

In sum, the record shows that in 2015 petitioner was provided a full and fair opportunity to challenge the imposition of the disputed penalties before the Appeals Office and he meaningfully participated in that proceeding. Although petitioner would have preferred to continue to dispute his liability, we are satisfied hat the Appeals Office conducted a fair and comprehensive review of the matter and acted properly in concluding the matter by issuing its closing letter.

That the Tax Court looked into the process that Appeals provided in the preasessment hearing is a slight opening for other taxpayers who may not have had the same opportunities with Appeals. Yet Mohamed is another in the growing line of cases that show that CDP is not an avenue for challenging the amount or existence of a liability even if there is no prior opportunity for court review.

There is one other aspect of the case worth noting. Mohamed also challenged the penalty under Section 6751(b) which requires that no IRC penalty “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 or such higher level official as the Secretary may designate…”

The court considered this issue on the merits and found that the compliance officer had prepared a Form 8484, which is used to refer preparers for possible discipline to the Return Preparer Office. That form was where the compliance officer proposed the penalties, and the supervisor signed that form and approved referral.   Interestingly the record did not include a Form 8278, which is what IRS typically uses to propose preparer penalties. The lack of that form did not trouble the Tax Court:

On its face, Form 8484 is a report that IRS personnel are encouraged to use to convey information to the OPR about questionable practitioner conduct. Although the form does not function to authorize the assessment of a penalty, in this case the TCO’s acting immediate supervisor placed her digital signature on the Form 8484 indicating that she agreed with the referral of the matter to the OPR and that she approved the audit report (attached to the Form 8484) which recommended that 20 section 6695(g) penalties be assessed against petitioner. The audit report included a detailed explanation in support of each of the 20 penalties. Under the circumstances of this case, we conclude that the TCO’s initial determination to assess the penalties in dispute was personally approved in writing by her immediate supervisor within the meaning of section 6751(b).

As this is a summary opinion not subject to further review, there is no chance to in this case see if the IRS’s failure to seek penalty approval in the proper manner amounted to compliance with Section 6751(b). As we have discussed (most recently in Samantha Galvin’s Designated Order post from a few weeks ago), the 6751(b) issue is one that the Tax Court and other courts are increasingly facing.

Designated Orders: 7/31/2017-8/4/2017

Professor Samantha Galvin of University of Denver Sturm College of Law brings us this week’s edition of Designated Orders. This week’s post looks at an order involving Section 6751 and an order involving the Court’s power to impose sanctions. Les

The Tax Court designated four orders last week and two are discussed below. The designated orders that are not discussed are an order that a petitioner respond regarding his objection to respondent’s motion for summary judgment (here) and an order denying a petitioner’s motion for reconsideration to vacate the Court’s decision and dismissal where petitioner repeatedly failed to file a disclosure statement as required by Rule 20(c) (here).

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Section 6751(b) Compliance is Designated Again

Docket # 13535-16SL, Adrian Antionette McGee v. C.I.R. (Order Here)

Here is yet another section 6751 designated order. After the Graev decision opened the door for these arguments, PT has posted frequently on the topic including, most recently, in a very informative designated order post dedicated to section 6751 a few weeks ago (here).

In this designated order, Judge Leyden is raising the issue of whether the IRS has complied with section 6751 when imposing an accuracy-related penalty. Judge Leyden also raised this issue in another (non-designated) order last week (here) which dealt with a failure to deposit penalty.

McGee is a pro se petitioner from Florida. Undoubtedly, she did not raise section 6751(b) non-compliance during her CDP hearing. As mentioned in our previous designated orders post, this issue is being treated slightly differently depending on the Judge. Judge Leyden appears to be one of the judges that does not think a taxpayer waives the section 6751(b) issue by not raising it.

In the present case, respondent filed a motion for summary judgment. Respondent’s motion was premature but petitioner didn’t object on that basis, so interestingly, the Court exercised its discretion and allowed the motion to proceed.

In case you haven’t been following the other posts, section 6751(b)(1) provides that, “a penalty cannot be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination or such higher level official as the Secretary may designate.” To demonstrate compliance with this section, respondent must show: 1) the identity of the individual who made the “initial determination”, 2) an approval “in writing”, and 3) the identity of the person giving approval and his or her status as the “immediate supervisor.” The settlement officer’s declaration stated that the requirements of applicable law or administrative procedure were met, but did not specifically verify that section 6751 requirements were met nor did it include any documents to substantiate that the requirements under the section were met.

The Court gives respondent three options: 1) prove that the requirements of section 6751(b)(1) were met, 2) prove that the “automatically calculated through electronic means” exception under section 6751(b)(2) applies and compliance need not be shown, or 3) concede the penalty.

The IRS must supplement its motion by August 15, and the petitioner may respond by August 30 – so we will wait in anxious anticipation to see where this one goes.

Section 6673 Penalty Imposed on Egregious Tax Protestor

Docket # 27787-16, Gary A. Bell, Sr. v. C.I.R. (Order Here)

The Tax Court sees a lot of tax protestors, in part because taxpayers do not have a lot to lose when petitioning the Tax Court. They can represent themselves, the tax liability is not required to be paid beforehand, and the court filing fee is not cost prohibitive and can be waived if the taxpayer can demonstrate economic hardship. The section 6673(a)(1) penalty is one of the Tax Court’s defenses against egregious tax protestors, and others who may meet the section’s criteria.

The petitioner in this case is particularly egregious. In the present case, he petitioned the Tax Court on CP71A notices for four different tax years. The CP71A notices are annual reminder notices informing the taxpayer of a balance due and do not provide a taxpayer with the right to petition the Court.

Petitioner had previously petitioned the Tax Court eight years ago for three out of the four years listed in his petition and the Court had rendered a decision for those years. As for the fourth year, neither a notice of deficiency (nor a notice of determination) had been issued. This meant the Court lacked jurisdiction for every year listed in petitioner’s petition.

As a result, in the present case, respondent filed a motion for summary judgment for lack of jurisdiction and requested that a section 6673(a)(1) penalty be imposed. Petitioner filed a Notice of Objection.

According to the Tax Court, “the purpose of section 6673 is to compel taxpayers to think and to conform to settled tax principles; it was designed to deter frivolity and waste of judicial resources.” In total, the petitioner had previously petitioned the Tax Court six separate times on various tax years using tax protestor arguments and had been warned about the imposition of the section 6673 penalty, to some degree, in all cases. Under section 6673, a penalty of up to $25,000 can be imposed whenever it appears to the Tax Court that proceedings before it have been instituted or maintained by the taxpayer primarily for delay; the taxpayer’s position in such proceeding is frivolous or groundless; or the taxpayer unreasonably failed to pursue available administrative remedies.

Due to the petitioner’s repetitively egregious behavior, the Court was convinced that petitioner instituted and maintained the proceeding for the purpose of delay and imposed a section 6673 penalty of $5,000.

Take-away points:

  • The Court likely designated this order as a warning to other tax protestors who wish, or continue, to drain the Court’s resources in a similar way.
  • The penalty is a necessary option for the Court since a taxpayer can take advantage of the Court’s time and resources, even when he or she has no basis on which to be there.

 

Wells Fargo and The Negligence Penalty for A Transaction Lacking Reasonable Basis

Over the last few weeks, Stephen, Keith and I (with some help from others like Jack Townsend who is the lead author on the criminal penalties chapter) are all writing up the next update for IRS Practice and Procedure, and are sorting through and writing about 125 developments from March through early July for addition to the book.

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A few of the developments are major ones we did not address in Procedurally Taxing. One is the Wells Fargo case from earlier this spring. You may recall Wells Fargo v US where Stu Bassin in a post on PT discussed the government’s loss in its efforts to use the economic substance doctrine to disallow interest expense deductions for a transaction that lacked a non tax business purpose. The case also has an interesting and important penalty component involving the government’s assertion of a negligence penalty in connection with Wells Fargo’s claiming of disallowed foreign tax credits.

The issue was teed up for the district court in a somewhat odd manner, with Wells Fargo stipulating that if the foreign credit generating transaction was a sham, it should not be subject to the penalty because “there was an objectively reasonable basis for Wells Fargo’s return position under the authorities referenced in § 1.6662–3(b)(3).”

The court held that the foreign credit generating transaction was a sham. Wells Fargo agreed to the stipulation to limit discovery, but the effect of the stipulation prevented it from arguing that it exercised ordinary and reasonable care in the preparation of its tax return. In other words, Wells Fargo felt that the authority for the position was sufficient to shield it from penalties without regard to any independent effort it made to assess the merits of the transaction prior to taking its position on its tax return. Wells Fargo did so because the regulations insulate from negligence a return position that has a reasonable basis; i.e., the position is reasonable based on one or more authorities (as further defined in the regulations).

In the opinion considering the penalties, the district framed the issue as follows:

Is it enough for Wells Fargo to show that its return position had a reasonable basis under the authorities referenced in § 1.6662–3(b)(3)? Or must Wells Fargo prove that it actually consulted those authorities in preparing its tax return?

The district court held that Wells Fargo was subject to the penalty because it had to prove that it in fact consulted with the authorities before adopting its position on the return. This was the view the government urged under the regulations; the taxpayer argued that the statute and regulatory focus is on an objective analysis, with the taxpayer’s efforts beside the point.

The Court found the regulations to be ambiguous, specifically that Treasury Regulation §1.6662-3(b)(3) states a reasonable basis is satisfied if “a return position is reasonably based on one or more” authorities. That was important, because under administrative law principles (so-called Auer deference) an agency is entitled to deference regarding an interpretation of an ambiguous question relating to the meaning of its own regulations.

At or around the time of the opinion, Jim Malone of Post & Schell wrote a terrific blog post critiquing the district court opinion, suggesting that perhaps Wells Fargo deserved to be penalized but that the court’s approach to the issue was “troubling”. There was also a piece in Bloomberg that quoted Jim and former PT guest poster Andy Grewal, with Andy saying that “it would be more sensible to apply Section 1.6662-3(b)(1) in accordance with its plain meaning and examining all relevant authorities supporting the treatment of a position, whether or not the taxpayer was aware of them.”

The Wells Fargo outcome is a departure from the norm in these cases because it has generally been thought that reasonable basis is an objective inquiry; i.e., if the position is more or less plausible based on an authority, then the taxpayer is free from the penalty. As Jim discusses, there are some cases along the lines suggesting that if a taxpayer had some separate reason to do a bit of digging then more than just objective analysis is warranted, yet the Wells Fargo opinion suggests a differing starting point than what many believed to be the case under the regulations.

I am not sure that other courts will follow this approach but it is something that advisers should be aware of when considering the effect of a stipulation as well as what may be necessary to put in the record if one is looking to rely on this defense to penalties.

 

 

Chai not Gaining Traction with Tax Court or IRS

Back in March, Steve blogged about the 2nd Circuit’s decision in Chai v. Commissioner reversing the Tax Court and finding that the IRS had a duty to prove that the immediate supervisor of the employee imposing a penalty met the requirements of the previously long forgotten IRC 6751.  The Chai decision came shortly after a fully reviewed Tax Court opinion in which the Court, in Graev v. Commissioner, held that the IRS did not have a duty to prove that the immediate supervisor had signed.  See my blog post here.  The 2nd Circuit essentially adopted the views of the dissent in Graev.  Because appellate venue for Graev lies in the 2nd Circuit, the decision in that case will unlikely stand; however, the opinion can still provide precedent for Tax Court cases appealable to other circuits as the Tax Court applies its Golsen rule.  This post will focus on what is happening post-Chai and how that might impact your clients who are unable to move to New York City or other fine locations in the 2nd Circuit.

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The first matter to discuss is Graev.  The IRS has chosen not to roll over and accept Chai as applying in a way that resolves the Graev case.  The IRS filed a motion with the Tax Court asking it to reconsider its opinion in Graev in light of the Chai decision.  The critical paragraph of the motion states:

“Respondent requests that the Court vacate its decision in this case and order additional briefing on what steps the Court should take in this case in light of the Chai opinion. Respondent has views which it believes will benefit the Court to consider in the changed circumstances of this case.”

The Tax Court granted this motion and issued an order vacating the decision and requiring the parties to file simultaneous briefs by June 1, 2017.  The petitioner and respondent timely filed these briefs.  The Court ordered the parties to file responsive briefs by June 20; however, petitioner filed a motion requesting until June 30 to file responsive briefs and permission to file a response to the responsive briefs by July 31.  The Court granted petitioner’s request so it will be at least a month before this case becomes fully at issue again.

The vacation of the decision raises an interesting question with respect to the Golsen rule.  Does the Graev opinion control future decisions of the Tax Court if the decision in the case is vacated at the request of the government?  The answer to that question appears to be yes as discussed further below.

While you might have expected that the IRS requested the vacation of the decision in Graev so that it could concede the IRC 6751 issue, the IRS has taken the fight to a new level, and in fact, in the first post-Chai brief filed in the Graev case, the IRS did not even cite to Golsen.  The brief filed by Frank Agostino’s firm cited Golsen four times and devoted the first of six sections of the brief to this issue.  In the statement of the case, petitioner’s brief states:

The issue is whether the rule in Golsen v. Commissioner, 54 T.C. 742 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971), and the United States Court of Appeals for the Second Circuit’s opinion in Chai v. Commissioner, 851 F.3d 190 (2d Cir. 2017), aff’a in part and rev’a in part, T.C. Memo. 2015-42, 109 T.C.M. (CCH) 1206 (2015), require this Court to vacate its decision determining the Graevs liable for 20% accuracy-related penalties under section 6662(a) and instead enter a decision for the Graevs adjudging them not liable for the penalties because the Commissioner failed to comply with the written-approval requirements of section 6751(b)(1).

So, the next opinion by the Tax Court in this case will have the opportunity to decide a number of issues concerning the application of the 2nd Circuit’s decision on the these types of cases.  Petitioner frames the issues in this manner:

The Second Circuit’s opinion in Chai requires this Court to vacate the March 7th Decision for five reasons. First, Chai is controlling in this case pursuant to the rule in Golsen v. Commissioner, 54 T.C. 742, 757 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971), because this case is appealable to the Second Circuit, because the holdings in Chai are squarely on point and the facts are indistinguishable, and because the failure to follow Chai would result in inevitable reversal upon appeal.

Next, in rejecting the majority’s holding and reasoning in Graev II that the 6751(b)(1) issue was not ripe in a deficiency proceeding (i.e., it was premature), the Second Circuit in Chai held that the issue of the Commissioner’s compliance with the requirements of section 6751(b)(1) is ripe for review in a deficiency proceeding.

Third, by rejecting the concurrence’s holding and reasoning in Graev II that the Commissioner’s failure to comply with the written-approval requirements of section 6751(b)(1) is excusable as harmless error, the Chai Court held that the written-approval requirement in section 6751(b)(1) is a “mandatory, statutory element of a penalty claim” that is not subject to harmless error analysis.

Fourth, the facts of this case, as found in Graev I and Graev II, require a holding that the Commissioner did not comply with the requirements of section 6751(b)(1) in determining the 20% accuracy-related penalties at issue.

Fifth, the Chai Court rejected the Commissioner’s contention that an amended answer filed by his attorneys can cure his failure to comply with the written-approval requirement of section 6751(b)(1) because compliance at the time of the initial determination is a “mandatory, statutory element.” Thus, the Court must vacate the March 7th Decision and its determination that the 20% accuracy related penalties may be assessed.

In contrast, the IRS frames the issues as follows:

Because this case is appealable to the Second Circuit, this Court’s holding in Graev v. Commissioner, 147 T.C. No. 16 (2016), regarding the timing of the supervisory approval of the initial determination of a penalty assessment cannot stand on appeal. Therefore, this Court must face additional issues regarding whether there was adequate supervisory approval of the initial determination of a penalty assessment in this case.

Those issues are: (1) whether the timely supervisory approval of a 40 percent accuracy-related penalty was, in effect, approval of the alternative position of the 20 percent penalty; (2) whether an attorney’s recommendation to include the 20 percent penalty in the statutory notice of deficiency, which recommendation was approved and adopted, can constitute the initial determination of the penalty assessment in this case; and (3) if a penalty assessment arises from an assertion raised in the amendment to answer in this case, whether the initial determination of that penalty assessment was made by the attorney who asserted the penalty in the amendment to answer. To avoid the potential for piecemeal litigation of these issues, respondent requests a ruling on each one even if the Court decides more than one issue in respondent’s favor.

So, the next phase of Graev could focus on the ability of the Chief Counsel attorney and the supervisor of that attorney to initiate and provide the appropriate supervisory approval.  If the IRS wins this argument, it will win the case and it will avoid the problem that occurs in cases in which Chief Counsel attorneys in the answer or subsequent pleadings change the penalty from the penalty imposed by the Commissioner in the notice of deficiency.  We will closely watch the case and keep you informed.

Meanwhile, there are many other cases in which petitioners have suddenly decided to raise the failure of the IRS to obtain the proper supervisory approval for a penalty.  We blogged about such a case decided almost immediately after Chai.  A more recent case shows another side.  On June 12, 2017, Judge Lauber issued an order in the case of Zolghadr v. Commissioner in which he rejected their Chai argument for two reasons.  First, petitioners did not raise the argument in time in a deficiency case.  Remember that both Chai and Graev were also deficiency cases where  the timing of raising the argument was also a concern.  Second, and more important for this discussion, he addressed the merits and the current viability of Graev stating:

“Alternatively, even if petitioners’ argument were timely, their reliance on Chai is misplaced because this case is appealable to the U.S. Court of Appeals for the fourth Circuit, not to the U.S. Court of Appeals for the second circuit, which decided the chai case.  For cases in which the appellate venue is a court of appeals other than the second Circuit, the applicable Tax Court rule is that enunciated in Graev v. Commissioner, 147 T.C. (slip. Op. at 42 n.25).  Under that case respondent has no burden of production to demonstrate compliance with section 6751(b).”

While we are waiting for the “final answer” in Graev, you should not wait to raise the IRC 6751 argument in your case.  In addition, you now know that at least one judge on the Tax Court views Graev as controlling which means you may have to move your case into the applicable circuit court if your client lives outside the Second Circuit.  I think Judge Lauber’s view of the current applicability of the Golsen rule as it applies to Graev is a view shared by other judges on the Tax Court.  Do not expect to roll into Tax Court citing Chai and automatically winning.