Proposed Regulations Narrow Ability of Private Attorneys to Participate on Behalf of IRS in Exams

A few years ago we discussed litigation involving Microsoft (see, eg., Keith’s Enforcing the Summons Against Microsoft), which implicated Treasury regulations that allowed private lawyers to participate in exams. While the litigation did not strike down that practice, it was heavily criticized, and Treasury now proposes to scale back the practice significantly.

Last week Treasury has proposed to “significantly narrow the scope of the current regulations by excluding non-government attorneys from receiving summoned books, papers, records, or other data or from participating in the interview of a witness summoned by the IRS to provide testimony under oath, with a limited exception.”

The exception relates to lawyers who have expertise in issues other than federal tax law, such as state, local or other countries’ tax laws, or in other substantive areas, like patent law. The exception does not extent to nonsubstantive specialized knowledge (like litigation skills).

Treasury regulations still permit other outside specialists like economists to “receive and review summoned information and fully participate in the summons interview, including questioning witnesses.” The proposed regs also allow for lawyers who are not acting as lawyers but who are performing services associated with outside permitted specialists to participate.

The proposed regs attempt to restrike the balance between the need for outside assistance to help administer the tax laws with the “perceived risk that the IRS may not be able to maintain full control over the actions of a non-government attorney hired by the IRS when such an attorney, with the limited exception described below, questions witnesses.”

Perhaps the rebalancing of these interests will inspire a fresh look at the private debt collection issue, an area that likewise has raised questions about risks associated with non-government employees performing essential IRS functions.

4/3 Update: Title Changed to clarify we are talking about IRS limitations!

Tax Court Determines IRS Actions Do Not Violate Restrictions on Second Examinations

The moral of the story in Planty v. Commissioner, T.C. Memo. 2017-240 is that if you ask the IRS to take another look at your return you cannot successfully claim that this “look” is a second examination of the return subject to the rules and approvals that limit the IRS’s ability to take a second look. In this case, the IRS examined the taxpayers’ return and seemed to have some difficulty coming to the final answer. After some fits and starts, the IRS made a determination and an assessment of $2,755. I could not determine from the description of the case how the IRS obtained permission to make the assessment but it does not seem to be a troublesome aspect of the case for the parties or the court.

After the IRS made the assessment and before paying the additional assessed tax, the taxpayers immediately submitted a Form 1040X claiming a refund of $1,560. The IRS treated the Form 1040X as a request for abatement. After looking at the request, the IRS decided that the taxpayer really owed a corrected tax liability of $64,704. Petitioners concede that the adjustment is correct subject to their argument that the adjustment resulted from an impermissible second examination of the tax year. Additionally, the IRS imposed an accuracy related penalty on this additional tax.

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Second Exam

The Court states that “we may deal summarily with petitioners’ claim that they were subjected to an impermissible second examination of their 2010 return.” The Court cites to IRC 7605(b) which sets out the rules on second exams. The Code does not prohibit second exams but does require that the IRS go through a high level approval process. Most of the time the IRS will not do this because it spotlights that the original examiner and exam manager made a large mistake and provides proof of the mistake to their high level manager. Bureaucrats do not like to highlight their mistakes to high level management since doing so has a tendency to suppress future advancement and current bonuses.

In response to the taxpayers’ argument that the IRS engaged in an impermissible second examination, the IRS responded that IRC 7605 has “no bearing upon the Commissioner’s authority to examine tax returns already in his possession.” The Court points out that it would have been very difficult for the IRS to make a determination regarding their claim for refund without pulling the return and looking at it. Since the IRS was looking at the return to satisfy petitioners’ own request, doing so did not run afoul of IRC 7605.

Petitioners’ actions here point to the problem taxpayers have when they want to file an amended return. They think they are due a refund which they would like to receive ASAP; however, making the request for the refund will cause the IRS to scrutinize their return. Here, the quest for a $1,500 refund results in a $64,000 liability, plus a 20% penalty for good measure. Petitioners should have waited to file their request until the statute of limitations on assessment was about to expire. Had they waited, the IRS would still have denied their refund request but would not have hit them with the large assessment. Their impatience proves very costly.

So, the lesson here is not only should you not argue about an impermissible second exam when you have caused the IRS to look at the return but you should not make the request with gobs of time left on the assessment statute of limitations.

Accuracy Related Penalty

Taxpayers here not only brought unnecessary attention on their return costing themselves over $60,000, but they ramped up the liability to the point where the IRS felt obliged to penalize them adding insult to injury regarding their mistake for filing the Form 1040X too early. The Court finds that taxpayers’ return contains an understatement of the tax. It states that based on the proof provided by the IRS, taxpayers’ only hope of averting the penalty is to mount a credible defense based on substantial authority, adequate disclosure, or reasonable cause.

Taxpayers’ understatement resulted from their erroneous claim of almost $150,000 of real estate losses. The Court quoted from the regulations on the standard for substantial authority which requires that “the weight of authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment.” The Court also pointed out that this is an objective and not subjective standard, and that the existence of a legal opinion does not by itself create substantial authority. Here, the IRS disallowed the loss because of the passive activity loss rules. As authority, taxpayers pointed to an opinion from a tax attorney and the failure of the IRS to notice the issue when it first looked at their return.

Unfortunately, at trial taxpayers did not call the tax attorney to testify. So, the Court says it does not have any evidence to know why she gave the advice and whether her opinion had a basis in tax authorities that would allow the taxpayers to meet the substantial authority test. The Court also finds that the failure of the IRS to notice the issue initially does not constitute substantial authority pointing to provisions in the regulations on precisely this point.

The Court points out that adequate disclosure has no effect unless the return position has a reasonable basis and the failure of the tax attorney to testify leaves the Court without an ability to determine if there was a reasonable basis. With respect to reasonable cause, the taxpayers admitted that the tax attorney did not prepare their return and they could not show that the return preparer gave them advice with respect to this item that could cloak them with a reason for taking the erroneous position on their return.

Conclusion

The penalty portion of the opinion follows routine patterns but points to the need to obtain the testimony of any tax professional upon whom the taxpayer relies for the position taken on the return. It is not clear that taxpayers would have won if the professional had testified, but without the testimony a loss on the penalty issue was almost a foregone conclusion costing the taxpayers another $10,000 on top of the over $50,000 liability they picked up by filing the amended return.

 

Treasury Intends to End Allowing Outside Counsel To Participate in Exams

Last month Treasury issued Identifying and Reducing Regulatory Burdens in response to Executive Order 13789. In the report Treasury indicated that it plans to substantially revise regulations under Section 7602 that allowed the participation of private contractors to “participate fully” when the IRS interviewed taxpayers or witnesses who were summoned during an examination. In particular, Treasury has stated its intention to remove the power of private domestic attorneys to participate with IRS employees in interviewing witnesses summoned during an examination.

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The report Treasury issued was in response to an executive order that directed the Secretary of the Treasury to identify significant tax regulations that (i) impose an undue financial burden on U.S. taxpayers, (ii) add undue complexity to the Federal tax laws, or (iii) exceed the statutory authority of the IRS. In June, Treasury identified eight regulations, and the report issued last month discusses the plan to mitigate or eliminate the burdens.

One of the regulations discussed was the regulations under Section 7602 that gave IRS power to use outside contractors to assist in interviewing summoned witnesses in an exam. As Keith previously discussed the regulations have been controversial, and while in US v Microsoft district court in Washington found that Treasury had the authority to issue those regulations, the court was troubled by the outside firm participation in the IRS audit of Microsoft, and suggested that Congress may scale the practice back. There has been proposed legislation to do that, though it has not moved much since its introduction.

The Treasury report states that“[u]nder the amendment currently contemplated by Treasury and the IRS, outside attorneys would not be permitted to question witnesses on behalf of the IRS, nor would they be permitted to play a behind-the-scenes role, such as by reviewing summoned records or consulting on IRS legal strategy.” In explaining why, the report embraces the criticism of the practice:

When the IRS enlists outside attorneys to perform the investigative functions ordinarily performed by IRS employees, the government risks losing control of its own investigation. RS investigators wield significant power to question witnesses under oath, to receive and review books and records, and to make discretionary strategic judgments during an audit— with potentially serious consequences for the taxpayer. The current regulation requires the IRS to retain authority over important decisions, but the risk of a private attorney taking practical control may simply be too great. These powers should be exercised solely by government employees committed to serve the public interest, not by outside attorneys. These concerns outweigh any countervailing need for the IRS to contract with outside attorneys. Treasury remains confident that the core functions of questioning witnesses and conducting investigations are well within the expertise and ability of the IRS’s dedicated attorneys and examination agents.

The Executive Order notes however that Treasury intends to retain the power to allow outside experts who are not US lawyers to help with summons proceedings. The report mentions that subject matter experts, including economists, engineers or non US lawyers, may be necessary in a small subset of cases because of a possible “compelling need” to provide expertise that IRS employees may lack.

Conclusion

Treasury candidly discussed why the practice of bringing in outside counsel in summons proceedings was on balance not consistent with some of the key values that underlie sound tax administration. While IRS resources are spread thin, and at times the complexity of cases challenges even the most seasoned IRS employees, IRS does have at its disposal attorneys from the government, including DOJ attorneys who may be able to provide the perspective and expertise that can help ensure that IRS has what it needs to do its job properly in an exam. In addition, Congress should ensure that IRS has the resources it needs so it does not routinely feel that it is outgunned when examining taxpayers who by the nature of the businesses will present complex returns. Relying on the private sector to help with core tax functions in an exam (or collection for that matter, though that is another story) is not the way to sound tax administration, and this report refreshingly tells us why. It carries additional weight when the government itself acknowledges those costs.

 

IRS Campaign Season Begins

Today we welcome first-time guest poster Tom Greenaway. Tom is a principal in KPMG’s Tax Controversy Services practice. He is a former senior attorney in the IRS Office of Chief Counsel’s then-Large and Midsize Business Division. Tom has written on a variety of tax procedure issues and is in the process of updating the chapter on examinations in the 7th edition of Effectively Representing Your Client Before the IRS. We are fortunate to gain his insights as he describes the rollout of IRS changes in its enforcement strategies relating to our nation’s largest taxpayers. Les

For several years, the Large Business & International Division of the IRS (LB&I) has been shifting its approach to its enforcement priorities in light of prolonged budget constraints and reduced staffing. LB&I leadership is trying to better select returns for examination, and to swiftly address noncompliance issues when they find them, all in the name of efficiency and increased productivity.

Productivity in the context of IRS enforcement usually means generating and sustaining meaningful adjustments (though individual revenue agents and managers are not evaluated on this basis). For decades, however, the “no-change” rate for LB&I corporate examinations has been stuck above 20 percent, and the “no-change” rate is more than double that—almost 50%—for LB&I examinations of pass-thru entities and foreign corporations. In IRS jargon, a “no-change” means an audit did not generate any adjustments to the tax return as filed—thus no return on this significant investment of IRS resources. Corporate taxpayers and pass-thrus with more than $10 million in assets on their balance sheets are LB&I taxpayers.

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IRS enforcement serves as a vital backstop to our system of voluntary income tax compliance. But the current trend of fewer examinations owing to budget cuts and increased non-income tax enforcement responsibilities, combined with perennially high no-change rates, is a bad mix. This is a prime reason LB&I is fundamentally changing its process and structure.

One element of LB&I’s new process is to risk assess taxpayers centrally and develop nationwide compliance “campaigns.” According to IRS, a campaign will be developed when LB&I decides, centrally, that an issue requires a response across an identified population of taxpayers in the form of one or multiple “treatment streams.” This centralized risk assessment will include the use of data analytics to identify issues and taxpayers that pose the highest risk to sound tax administration and compliance. LB&I announced this shift in approach more than a year ago, and in response more than 600 campaign ideas were submitted for consideration, mostly from internal IRS sources. Andrew Velarde, Some Complex Issues Won’t Be Part of Initial LB&I Campaigns, Tax Notes Today, (Nov. 15, 2016) available at 2016 TNT 221-3.

On January 31, 2017 IRS released the initial rollout of 13 different LB&I’s campaigns. Each campaign is assigned to an LB&I practice area and executive who will serve as the lead.

Here’s the list of the initial 13 campaigns:

  • Section 48C Energy Credits
  • OVDP Declines-Withdrawals
  • Section 199 Domestic Production Activities Deduction – Multichannel Vide Program Distributors & TV Broadcasters
  • Micro-Captive Insurance
  • Related Party Transactions
  • Deferred Variable Annuity Reserves & Life Insurance Reserves Industry Issue Resolution (IIR)
  • Basket Transactions
  • Land Developers – Completed Contract Method (CCM)
  • TEFRA Linkage Plan Strategy
  • S Corporation Losses in Excess of Basis
  • Repatriation
  • Form 1120-F (Foreign Corporation) Non-Filer Campaign
  • Inbound Distributors

The initial campaigns cover a wide range of topics. They range from technical tax issues affecting multiple industries (e.g., transfer pricing by inbound distributors, cash repatriation strategies), to industry-focused issues (e.g., variable annuity reserves IIR for insurers and completed contract method for land developers), to procedural compliance issues (e.g., OVDI withdrawals, practical workarounds of TEFRA partnership linkage limitations, and foreign corporate non-filers). Some campaigns that have been promised, like Chapter 3 withholding, were not included in this initial rollout.

As promised, the recommended “treatments” for each campaign vary, although all of the campaigns (except the insurance IIR) will involve examinations to some degree or another.

Some of the campaigns already have well-established treatments in place. For instance, IRS has already identified basket transactions as listed transactions and transactions of interest, and recently issued a related Practice Unit. Practice Units on inbound distributors have been available to the public since December 2014. Treatments of other issues, on the other hand, like the Insurance Industry IIR and TEFRA linkages, have been stalled for years.

Large business taxpayers—and their LB&I examination teams—will need to learn how to adapt to IRS campaigns. IRS officials have said that if a return selected for a campaign examination does not fit the targeted facts or concerns, LB&I wants to release the taxpayer and potentially refine the campaign. Amy Elliott, First LB&I Campaign List to Include Inbound and Outbound Issues, Tax Notes Today, (Dec. 19, 2016) available at 2016 TNT 243-3. Practitioners will play an important role in helping examiners understand whether the targeted concern is actually an issue on the returns selected.

On properly selected campaign examinations, the transparency and commitment to collaboration that are hallmarks of the new LB&I generally and the campaign process specifically should lead to faster issue identification, development, and resolution on campaign cases—all of which should be shared goals of both taxpayers and the IRS. Planned ongoing feedback from this process should further help IRS refine or even end a treatment, or a campaign, if the treatments succeed, or do not work.

Another key for practitioners will be to maintain the team’s focus on pre-identified campaign issues. Traditionally, LB&I examination teams enjoyed wide latitude to identify and develop issues for examination. That is all changed now. A shift towards centrally-developed campaigns necessarily comes at the expense of the field teams’ discretion to raise issues. According to at least one official, examination teams working campaign cases may raise other, non-campaign issues “that they feel they cannot walk away from,” but that standard sets a high bar for overloaded examination teams to clear. Andrew Velarde, Some Complex Issues Won’t Be Part of Initial LB&I Campaigns, Tax Notes Today, (Nov. 15, 2016) available at 2016 TNT 221-3.

_______________________________________________________

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author only, and does not necessarily represent the views or professional advice of KPMG LLP.

©2017 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

 

 

IRS Examination Division’s Requirement to Consider Collectibility of Potential Assessment

On September 7, 2016, the Treasury Inspector General for Tax Administration (TIGTA) issued a report, entitled Examination Collectibility Procedures Need to be Clarified and Applied Consistently, looking at the failure of the Examination Division to consider collection in making decisions on who it should examine.  It found that the Examination Division did not follow its own collectibility procedures in 56% of the cases it sampled.  TIGTA pointed out in the report that the failure to follow these procedures led to collection closing 50% of all exam cases that came into the hands of field collection offices and 19% of all exam cases that came into the Automated Collection System (ACS).  At a time when the IRS examination resources have dropped by about 30% over the past six years and collection resources have dropped by almost 40% over that period, does it make sense to go after taxpayers at the examination stage who will turn into uncollectible accounts, or would it make more sense to look on the shelf at cases needing examination where the taxpayer has the ability to pay the liability in the event of an additional assessment.

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IRM 4.20.1.5.1 (February 26, 2013) provides that the Examination function of stovepipe SBSE “must strive for quality assessments and promote and increased emphasis on early collections in the continuing effort to reduce the Collection function’s inventory and currently not collectible (CNC) accounts.”

The full text of this IRM provision states:

  1. Examination may need to suspend collection activity on a taxpayer’s account. Examiners can suspend collection activity using Transaction Code (TC) 470 with Closing Code (cc) 90 or by using “STAUP” procedures.
  1. The use of TC 470 with cc 90 is restricted to those situations where it is expected that an adjustment will fully pay the tax for the suspended tax year. For example, if the IRS discovers that an obvious error created a balance-due condition in one tax year, and an adjustment will reduce the balance due to zero, the IRS can request the necessary tax adjustment and also request that this collection suspension code be entered for the specific tax year. This will ensure collection action is suspended while the adjustment is made and overpayments for other tax years will not be used to pay the tax in question.
  1. It is imperative that TC 470 with cc 90 is used correctly and only in those instances that meet the criteria outlined above. If TC 470 cc 90 is used incorrectly when adjustments may not be appropriate or when an adjustment does not eliminate the balance due, credits from a taxpayer’s other tax years will be refunded to the taxpayer rather than being used to satisfy the amount still owed for the suspended tax period. See IRM 5.1.15, Abatements, Reconsiderations and Adjustments.
  1. In instances where the TC 470 cc 90 criteria is not met, Collection activity can be suspended for a fixed period of time using Command Code “STAUP.” For example, an examiner encounters the situation where the suspension of collection activities is necessary when one or more of the following is expected to reduce the balance due to zero:
    1. Claims
    2. Net operating loss (NOL) carryback
    3. Credits carried back

In these instances, examiners can request a suspension with Command Code “STAUP.” Command Code STAUP is an IDRS command code used to accelerate, omit, or delay the issuance of an IDRS balance due notice. A STAUP will stop any notice from being issued or destroy a printed notice not yet mailed. See IRM 2.4.28, Command Codes STAUP, STATI, and STATB.

To achieve that goal, IRM 4.20.1.2 (February 26, 2013) provides that Exam employees should consider collectibility during the pre-contact, audit and closing phases of an examination.  In fiscal year 2015 approximately 75% of the accounts receivable owed to the IRS was listed as uncollectible.  The IRM provisions seek to keep the IRS from building more and more inventory in the uncollectible category.

I wrote about this issue previously in the context of the trust fund recovery penalty (TFRP).  Since the collection function handles TFRP investigations it sits in the best place to determine whether to work the case and does not need to refer the matter to anyone in order to make that determination.  Despite language directing the IRS to only pursue TFRP investigations on taxpayers able to pay, the comments received to that post almost uniformly took the view that the collection function did not make a determination on collectibility prior to initiating TFRP investigations.  If collection is not doing this, it is easy to believe that Exam would not follow the requirement to select cases that will result in collection of the resulting assessment.

TIGTA has some good stats in its report.  One is the information that between 2011 and 2015 Collection received an average of 707,789 new delinquent accounts each year as a result of an examination assessment.  TIGTA determined that if the examination division had focused on auditing taxpayers with the ability to pay the IRS “could have assessed approximately $109 million on cases that were more collectible.”  The IRS must balance the use of its enforcement tools such as an examination as a basis for generating revenue against the need to ensure a fair and just tax system.  The idea that taxpayers with a low potential for collection should get a free pass from collection does not sit well.  Yet, neither does the idea that the IRS spends a significant percentage of its examination resources generating assessments that merely sit on the books for 10 years without any resulting collection.

The IRM provisions do not require that the IRS examiners guarantee the collection function will collect on the assessments they generate, but the IRM does suggest that considering the collectibility of an assessment should factor into the decision to pursue an examination.  TIGTA stated that it planned to “review a sample of Examination cases closed as surveyed due to doubt of collectibility; however, the IRS does not systemically track these cases.”  So, TIGTA had no way to determine if the IRS had declined to audit cases, “survey” them in IRS parlance, in circumstances in which the taxpayers had even a less chance of collection than the ones the IRS chose to audit.

TIGTA interviewed examination employees during this course of its study and these employees “told us that they rarely or never survey a return due to collectibility.”  These employees cited the potential adverse impact on voluntary compliance as a reason for not surveying cases due to a lack of collectibility.  TIGTA cited to the language in the IRM which speaks in absolutes about the ability to collect rather than in degrees.  It seems very logical to conclude that the IRS should not exam returns where the chance of collection is absolutely zero.  I have watched it do that on many occasions in the assessment of individuals following a criminal prosecution.  The 2010 changes allowing assessment based on the restitution order removes the need for the IRS to devote examination resources to those cases in most criminal cases, though I do not know whether it walks away from the assessment of additional taxes in all criminal cases in which collection has a near zero chance.

TIGTA recommends that the IRS change the IRM to provide “clear instruction on documenting collectibility determinations, including examples of when cases should be given consideration for being surveyed….”  The IRS agreed with this recommendation and stated that it will update the IRM.  The IRS response also stated that the broader goal of examination in promoting voluntary compliance must enter into the decision and that collectibility should not drive the decision of who to examine.  The IRS response hits the right tone.  Whether the IRS will make changes that meaningfully change the role of collectibility in the choosing of cases to exam is something to watch as the IRS updates this IRM and implements the suggestions made by TIGTA.

The recommendations section of the report contains a discussion of the need for the examination division to coordinate with the collection division in making the collectibility determination.  The response suggests that the examination division has concerns about that proposal.  Based on the comments received in my earlier post about the collection division’s ability to incorporate collectibility into its own TFRP determinations, I cannot fault the examination division for their concerns.  The issue of how to incorporate collectibility into workload decisions requires a deep policy look by the IRS.  The TIGTA report exposes the issue but cannot resolve the policy issues that underlie the correct approach.  The same policy issues presented here also exist as the cases move forward into litigation and the difference in approaches between the litigators in Chief Counsel’s office and the Department of Justice also cry out for a uniform policy that takes into account the need to have a tax oversight system that promotes uniformly fair laws but does not waste limited resources chasing uncollectible accounts.

Because I represent low income individuals, a high percentage of the cases in which I represent individuals in Tax Court involve assessments the IRS will probably never collect.  I tell my clients that the fight in Tax Court represents a skirmish.  Even if we lose that skirmish, we can win the overall battle by obtaining an offer in compromise.  We do not send our clients away after the Tax Court phase, and post-trial work on those cases is often more important than the pre-trial or trial work because we settle the matter for a very low payment.  Knowing that the case will get resolved for a nominal payment makes me sad at all of the resources that Exam, Counsel, and the Tax Court put into the case so that my client will pay $50 and keep current on their filing obligations for the next five years.  I do not have the answer but it lies in a policy that avoids spending significant resources on uncollectible cases.

 

Using the IRM to Help Taxpayers During Audits Exploring a Taxpayer’s Unreported Income

Today we welcome first time guest poster David Breen, the Acting Director of Villanova’s Federal Tax Clinic, former Senior Counsel with the IRS Office of Chief Counsel in Philadelphia and longtime adjunct faculty member in Villanova’s Graduate Tax Program. In addition to his Counsel experience, Dave began his career with Exam. He has taught courses in Villanova’s graduate tax program for years, including Tax Procedure and our innovative trial litigation simulation course. While Keith has been visiting at Harvard, Dave has ably directed our tax clinic. In today’s guest post, he discusses some of the IRS’s own rules relating to examinations that focus on unreported income as well as some of the powers practitioners can but rarely do exercise in the context of those examinations. Les

The country is approaching the half way point of the NFL season and during the Eagles games I’ve watched so far, I can’t help but again notice the tendency of coaches to cover their mouths while talking to one another. This practice, which dates back to at least 2000, prevents opposing teams from employing lip readers to intercept the play the opposition is calling. Stealing plays in a game? By professional lip readers? Really? A bit of overkill, don’t you think? But football is not alone in this type of larceny. Less than one month into this year’s baseball season, the Padres were accused of positioning a spy inside the scoreboard with binoculars to telegraph pitches to San Diego batters.

This got me to thinking about the lengths that professional athletes will go to increase ever so slightly an edge over their opponents. And with that in mind, it made me look to my own profession as a tax attorney for whatever edge, legally, of course, that I could exploit as well. I didn’t have to look far.

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When I was an IRS Revenue Agent back in the 1970s, the Internal Revenue Manual was IRS’s playbook, containing well-guarded tips, resources, recommendations, and directions on how to audit taxpayers. As a Senior Counsel in IRS’s Office of Chief Counsel from 1987 to my retirement in 2014, Part 35 of the IRM, also called the CCDM, provided the same practical guidance and advice for IRS attorneys. Today the IRM continues to guide IRS employees in the performance of their duties and thanks to the Freedom of Information Act (FOIA) it can be an invaluable resource for practitioners as well. In my experience, however, I find that many practitioners fail to avail themselves of this resource. In other words, they don’t take advantage of the ability to read IRS’s lips from across the gridiron to see what IRS’s next step will be.

When it comes to an IRS audit, particularly in the SBSE division which includes self-employed Schedule C filers, unreported income is the name of the game. From 2008 – 2010 the average annual tax gap was $458 billion, up from $450 billion in 2006. IRS revenue agents are given discretion in deciding which deductions to scrutinize on a return. Proof for deductions that are LUQ (large, unusual, or questionable) is sure to be requested. Examiners do not, however, have discretion in examining gross income. Unlike deductions, gross income must be examined in all audits. It is one of the relatively few mandatory items examiners must investigate.

This article discusses how a practitioner can utilize the IRM to represent clients more competently during an audit of gross income. I am limiting my comments to IRM Part 4 – Examining Process, but the advantages of being well-versed in IRS’s own procedures applies well beyond this area.

The law is clear on gross income: all income from any source is taxable unless specifically excluded somewhere in the Code. Taxpayers are required to maintain books and records to support items on their returns. If a taxpayer refuses to provide books and records, IRS may issue a summons to the taxpayer and third parties to compel production of documents and to give testimony under oath. Finally, before an examiner may use financial status or economic reality examination techniques to determine the existence of unreported income there must be an indication that there is a likelihood of unreported income.

While the above paragraph would score well on a law school tax final, it provides little insight into how the law is put into action. Let’s put some flesh on the bones by looking at how examiners are taught to audit returns.

To insure that returns are examined within the 3 year statute of limitations, IRM 4.10.2.2.2-1 requires that the examination and disposition of individual income tax returns be completed within 26 months after the due date of the return or the date filed, whichever is later. For example, if an examiner is assigned a timely filed 2015 return, the audit should not be started if it cannot be completed by June 2018 (26 months from April 15, 2016). This includes, however, the time to process the return, select it for examination, ship it to the examination group closest to the taxpayer’s location, assign it to an examiner, and schedule an appointment. To add additional incentive to IRS to examine returns promptly, interest is suspended if the Service fails to notify the taxpayer of a liability within 36 months of the later of the date the return is filed, or the due date for the return without regard to extensions. Like soggy hors d’oeuvres once the main course is served, returns falling short of this timeframe are forgotten about, “surveyed” as excess inventory and replaced by fresher, more current work. The lesson here is that despite the three year statute of limitations on assessment of tax, the likelihood of a return being audited is actually much less than three years after its filing under the 26 month cycle rule.

For those returns that are audited, however, examiners are given specific guidelines for verifying gross income. How does an IRS examiner decide how detailed the gross income investigation must be? To answer, we have to consider one more Code section, IRC § 7602(e), enacted as part of the IRS Structuring and Reform Act of 1998:

(e)Limitation on examination on unreported income

The Secretary shall not use financial status or economic reality examination techniques to determine the existence of unreported income of any taxpayer unless the Secretary has a reasonable indication that there is a likelihood of such unreported income.

Prior to the enactment of IRC § 7602(e) examiners could (and often did) investigate gross income by engaging in intrusive inquiries into a taxpayer’s private life and finances. Interviews of business associates, co-workers, lenders, and even neighbors were conducted, sometimes without the taxpayer’s knowledge. Time consuming, intensive, expensive requests for voluminous records were the norm rather than the exception.

IRC § 7602(e) put the brakes on IRS examiners. Before an examiner may conduct an in-depth, intrusive examination – what the statute refers to as financial status or economic reality techniques – the examiner must first have some reason to suspect that a taxpayer has not reported all gross income. So called “indirect methods” are economic reality techniques. How does an IRS agent determine if there is a likelihood of unreported income to gain entrée into a detailed investigation? The answer is in the IRM.

IRM 4.10.4 sets forth a number of mandatory “minimum income probes” examiners must perform. If the minimum income probes indicate a likelihood of unreported income, the examiner must consult with a group manager. They jointly determine whether to conduct a more in-depth examination of income and document their findings in the workpapers. This more in-depth examination may include, but is not limited to a bank deposits and cash expenditures analysis, a source and application of funds analysis, or a net worth analysis – what IRS calls a formal indirect method of proof. ( Note, however, that IRC § 446(b) allows IRS to use any reasonable method. The high water mark of reasonable may have been IRS’s Atlantic City Tip Income Project back in the 1980s when IRS reconstructed cocktail waitress tip income by placing undercover special agents in casinos to watch how much tip income waitresses typically received during a shift and applying those findings to compute tip income for a “normal waitress.”).

All practitioners want to dissuade examiners from conducting time-consuming, costly, detailed indirect methods. Volumes have been written on defending a client when IRS determines under one of these methods that a taxpayer hasn’t reported all income. But remember, the minimum income probes are the gateway to the use of a formal indirect method of proof. For that reason, they should be the first line of defense in representing clients.

What are these “MIPs”? It depends on the type of taxpayer. The minimum income probes for individual business returns, i.e. Schedule C taxpayers, include: preparing a financial status analysis; conducting an interview with the taxpayer or representative; touring the business; evaluating internal controls; reconciling the income per return to the taxpayer’s books and records; testing gross receipts by tying original source documents to the books; preparing an analysis of the taxpayer’s personal and business bank and financial accounts; preparing an analysis of business ratios; and determining if there is Internet use and e-commerce income activity.

I present two ways for the minimum income probes to be used proactively by representatives.

  1. Lay the groundwork during return preparation. Most return preparers send some form of tax organizer to clients which clients complete (or at least are supposed to complete) as part of having their returns filed. I encourage preparers to include questions concerning the minimum income probes in their client surveys. Gathering information on internal controls, bank accounts, business ratios, and e-commerce activity will serve as reminders to clients on what they records they should be keeping and also identify potential weak areas in the client’s operations. Weaknesses that can be corrected or anticipated in the event of an audit.
  2. Challenge the examiner’s conclusions regarding the use of an indirect method. If early in the audit, say after the initial meeting and taxpayer interview, an examiner issues a detailed, voluminous information document request (IDR) clearly focused on income or personal living expenses, that is a clear indication that the examiner is “ramping up” the examination of gross income. Representatives should not simply shrug and hope for the best. I encourage representatives to ask the examiner in writing, if the examination has extended into IRC § 7602(e) territory. If the examiner answers affirmatively, or doesn’t answer at all, the representative should take the offensive and request a meeting with the group manager, request the examiner’s workpapers detailing the minimum income probe analysis and the discussion with the group manager green-lighting the indirect method, file a FOIA request for the workpapers, or all of the above. A taxpayer should be given an opportunity to respond to an examiner’s determination that the minimum income probes reflect unreported income. If the agent’s analysis is flawed, it is better for IRS and your client to not waste time on needless issues. To date, however, I have yet to find a representative who has taken any of these pre-emptive steps. My suspicions were confirmed when my opinion search of 7602(e) on the Tax Court’s website produced a single case which dealt only with the effective date of the statute.

In summary, as a representative you should adhere to the old adage, “Forewarned is forearmed” and study the IRM as if it were the Cowboys playbook and you were the coach of the New York Giants.

Summary Opinions through 12/18/15

Sorry for the technical difficulties over the last few days.   We are glad to be back up and running, and hopefully won’t have any other hosting issues in the near future.

December had a lot of really interesting tax procedure items, many of which we covered during the month, including the PATH bill.  Below is the first part of a two part Summary Opinions for December.  Included below are a recent case dealing with Section 6751(b)(1) written approval of penalties, a PLR dealing with increasing carryforward credits from closed years , an update on estate tax closing letters, reasonable cause with foundation taxes, an update on the required record doctrine, and various other interesting tax items.

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  • In December, PLR 201548006 was issued regarding whether an understated business credit for a closed year could be carried forward with the correct increased amounts for an open year.  The taxpayer was a partner in a partnership and shareholder in an s-corp.  The conclusion was that the corrected credit could be carried forward based on Mennuto v. Comm’r, 56 TC 910, which had allowed the Service to recalculate credits for a closed year to ascertain the correct tax in the open year.
  • IRS has issued web guidance regarding closing letters for estate tax returns, which can be found here.  This follows the IRS indicating that closing letters will only be issued upon taxpayer request (and then every taxpayer requesting a closing letter).  My understanding from other practitioners is that the transcript request in this situation has not worked well.  And, some states will not accept this as proof the Service is done with its audit.  Many also feel it is not sufficient to direct an executor to make distributions.  Seems as those most are planning on just requesting the letters.
  • Models and moms behaving badly (allegedly).  Bar Refaeli and her mother have been arrested for tax fraud in Israel.  The Israeli taxing authority claims that Bar told her accountant that she resided outside of Israel, while she was living in homes within the country under the names of relatives.  Not model behavior.
  • The best JT (sorry Mr. Timberlake and Jason T.), Jack Townsend, has a post on his Federal Tax Procedure Blog on the recent Brinkley v. Comm’r case out of the Fifth Circuit, which discusses the shift of the burden of proof under Section 7491.
  • PMTA 2015-019 was released providing the government’s position on two identity theft situations relating to validity of returns, and then sharing the return information to the victims.  The issues were:

1. Whether the Service can treat a filed Business Masterfile return as a nullity when the return is filed using a stolen EIN without the knowledge of the EIN’s owner.

2. Whether the Service can treat a filed BMF return as a nullity when the EIN used on the return was obtained by identifying the party with a stolen name and SSN…

4. Whether the Service may disclose information about a potentially fraudulent business or filing to the business that purportedly made the filing or to the individual who signed the return or is identified as the “responsible party” when the Service suspects the “responsible party” or business has no knowledge of the filing.

And the conclusions were:

1. The Service may treat a filed BMF return as a nullity when a return is filed using a stolen EIN without the permission or knowledge of the EIN’s owner because the return is not a valid return.

2. The Service may treat a filed BMF return as a nullity when the EJN used on the return was obtained by using a stolen name for Social Security Number for the business’s responsible person. The return is not a valid return.

  • Back in 2014, SCOTUS decided Clark v. Rameker, which held that inherited IRAs were not retirement accounts under the bankruptcy code, and therefore not exempt from creditors.  In Clark, the petitioners made the claim for exemption under Section 522(b)(3)(C) of the Bankruptcy Code for the inherited retirement account, and not the state statute (WI, where petitioner resided, allowed the debtor to select either the federal exemptions or the state exemptions).  End of story for those using federal exemptions, but some states allow selection like WI between state or federal exemptions, while others have completely opted out of the federal exemptions, such as Montana.  A recent Montana case somewhat follows Clark, but based on the different Montana statute.  In In Re: Golz, the Bankruptcy Court determined that a chapter 7 debtor’s inherited IRA was not exempt from creditors.  The Montana law states:

individual retirement accounts, as defined in 26 U.S.C. 408(a), to the extent of deductible contributions made before the suit resulting in judgment was filed and the earnings on those contributions, and Roth individual retirement accounts, as defined in 26 U.S.C. 408A, to the extent of qualified contributions made before the suit resulting in judgment was filed and the earnings on those contributions.

The BR Court, relying on a November decision of the MT Supreme Court, held that an inherited IRA did not qualify based on the definition under the referenced Code section of retirement account.  I believe opt-out states cannot restrict exemption of retirement accounts beyond what is found under Section 522, but it might be possible to expand the exemption (speculation on my part).   Here, the MT statute did not broaden the definition to include inherited IRAs.

  • In August, we covered US v. Chabot, where the 3rd Circuit agreed with all other circuits in holding the required records doctrine compels bank records to be provided over Fifth Amendment challenges.  SCOTUS has declined to review the Circuit Court decision.
  • PLR 201547007 is uncool (technical legal term).   The PLR includes a TAM, which concludes reasonable cause holdings for abatement of penalties are not precedent (and perhaps not persuasive) for abating the taxable expenditure tax on private foundations under Section 4945(a)(1).  The foundation in question had assistance from lawyers and accountants in all filing and administrative requirements, and those professionals knew all relevant facts and circumstances.  The foundation apparently failed to enter into a required written agreement with a donee, and may not have “exercised expenditures responsibly” with respect to the donee.  This caused a 5% tax to be imposed, which was paid, and a request for abatement due to reasonable cause was filed.  Arguments pointing to abatement of penalties (such as Section 6651 and 6656) for reasonable cause were made.  The Service did not find this persuasive, and makes a statutory argument against allowing reasonable cause which I did not find compelling.  The TAM indicates that the penalty sections state the penalty is imposed “unless it is shown that such failure is due to reasonable cause and not due to willful neglect.”  That language is also found regarding Section 4945(a)(2), but not (1), the first tier tax on the foundation.  That same language is found, however, under Section 4962(a), which allows for abatement if the event was due to reasonable cause and not to willful neglect, and such event was corrected within a reasonable period.  Service felt that Congress did not intend abatement to apply to (a)(1), or intended a different standard to apply, because reasonable cause language was included only in (a)(2).  I would note, however, that Section 4962 applies broadly to all first tier taxes, but does specify certain taxes that it does not apply to.  Congress clearly selected certain taxes for the section not to apply, and very easily could have included (a)(1) had it intended to do so.

I’m probably devoting too much time to this PLR/TAM, but it piqued my interest. The Service also stated that the trust cannot rely on the lack of advice to perform certain acts as advice that such acts are not necessary.  I am not sure how the taxpayer would know he or she was not receiving advice if it asked the professionals to ensure all distributions were proper and all filings handled.  I can hear the responses (perhaps from Keith) that this is a difficult question, and perhaps the lawyer or accountant should be responsible.  I understand, but have a hard time getting behind the notion that a taxpayer must sue someone over missed paperwork when the system is so convoluted.  Whew, I was blowing so hard, I almost fell off my soapbox.

  • This is more B.S. than the tax shelters Jack T. is always writing about.  TaxGirl has created her list of 100 top tax twitter accounts you must follow, which can be found here. Lots of great accounts that we follow from writers we love, but PT was not listed (hence the B.S.).  It stings twice as much, as we all live within 20 miles of TaxGirl, and we sometimes contribute to Forbes, where she is now a full time writer/editor.  Thankfully, Prof. Andy Gerwal appears to be starting a twitter war against TaxGirl (or against CPAs because Kelly included so many CPAs and so few tax professors).  We have to throw our considerable backing and resources behind Andy, in what we assume will be a brutal, rude, explicit, scorched earth march to twitter supremacy.  We are excited about our first twitter feud, even if @TaxGirl doesn’t realize we are in one.
  • This doesn’t directly relate to tax procedure or policy, but it could be viewed as impacting it, and we reserved the right to write about whatever we want.  Here is a blog post on the NYT Upshot blog on how we perceive the economy, how we delude ourselves to reinforce our political allegiances (sort of like confirmation bias), and how money can change that all.

Deciding Whether to Pursue a Liability – The Differing Standard between Trust Fund Recovery Penalty Cases and Examination Cases

 

As we have mentioned before, Les, Steve and I are engaged in updating IRS Practice and Procedure by Saltzman and Book.  Last year I wrote a number of posts on Collection Due Process as I prepared to update that part of the book.  I have now created an entire chapter on CDP cases which will come out with the 3rd Edition of the book.  Now, I am beginning to update Chapter 17 which covers both transferee liability and the trust fund recovery penalty (TFRP).  So, look for more posts on those topics.  In this post I will examine a unique facet of the TFRP with respect to the when the IRS makes a decision to assess that liability.

In TFRP cases the IRS has decided that it has the ability to look at a taxpayer’s collection potential in deciding whether to set up a tax liability in the first place.  This post will examine the policy behind the decision that the IRS can use collection as a basis for not pursing a liability in TFRP cases yet it pays no attention to collection in ordinary examination cases particularly the cases involving low income taxpayers with little or no collection potential.

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The determination to purse TFRP is made under IRM 5.7.4.1, which is made as soon as possible after the initial contact (IRM 5.1.10.3) with the taxpayer and within 120 days of being assigned to a revenue officer.  IRM 5.7.4.1.1 lists the factors to consider when determining the amount of the TFRP.  After the initial contact, collectability will be determined.  IRM 5.7.5.3.1 gives the IRS the option of non-assertion based on collectability.  To assert non collectability the IRS will look to the factors listed in IRM 5.7.5.1(1).  Those factors include:

  • Current financial condition
  • Involvement in a bankruptcy proceeding
  • Income history and future income potential
  • Asset potential (likelihood of increase in equity in assets and taxpayer’s potential to acquire assets in the future

More guidelines on the impact of collectability in making the TFRP assessment follow in IRM 5.7.5.1(2) and (3), which includes:

If responsible person financial analysis shows. . . Then. . .
Any present or future ability to pay Assess the penalty and take the appropriate collection action based on an analysis of the taxpayer’s financial condition.
No present, but future ability to pay Assess the TFRP based on future income potential and possible refund offset. Prepare a pre-assessed Form 53 and file lien if appropriate.
The responsible person cannot be located or contacted but internal research identifies assets or income sources Assess the TFRP since there is a good possibility of some collection from the assets/income sources that were located.
No present or future income potential exists over the collection statute period Do not assess the TFRP since the financial analysis shows there is little prospect that the taxpayer will receive any increase in income or acquire assets that will enable the Service to collect any of the penalty.

 

The TFRP will normally not be assessed when:

  • There is no present or future collection potential.
  • Neither the responsible person nor their assets/income sources can be located

IRM 5.7.4.8 discusses whether to pursue the TFRP in Installment Agreement or Bankruptcy Situations, while IRM 5.7.4.9 analyzes TFRP in offer in compromise situations.

The focus on collectability before making the assessment in the TFRP situation stands in stark contrast the approach of the IRS in making an assessment in other situations.  The use of collection in the TFRP situation creates difficulties in reconciling the policy here regarding assessment with the Congressional policy on this type of liability expressed in the bankruptcy code.  The TFRP stands as the only tax liability incapable of getting discharged no matter how old the period for which the taxpayer owes the tax or how long ago the assessment took place.  Bad actions such as filing a fraudulent return, late return or no return can also result in a liability excepted from discharge but in those situations it is the action of the taxpayer with respect to the tax rather than the tax itself.

Given that the taxpayer cannot discharge the TFRP and the IRS has a guaranteed 10 years to collect the liability if it wants to have that period, why would the IRS choose this debt among all others to exercise a collectability determination as part of deciding whether to assess.  Why would it not save this type of determination for low income taxpayers and dependency exemption cases like the taxpayer Les wrote about on Mother’s Day?

I think that the IRS makes a distinction for TFRP taxes because this is the one tax that gets assessed by the collection division.  Employees of the collection division approach assessment with a pragmatism employees of the examination division do not.  While the IRS does not evaluate employees based on metrics (see Restructuring and Reform Act of 1998 Sec. 1204) such as how many dollars they have assessed or collected, exam employees generally measure their worth by the number and amount of assessment with little care for whether the assessment will ever be collected.  Collection officers, however, hate the thought of going through the assessment process for nothing.  As a consequence, they built into the portion of the assessment process they control a look at collection.  Nothing stops the IRS from applying this same logic to all assessments it makes.  If it did, probably a decent percentage of the assessments against low income taxpayers would go unmade.  That might be good for a system in which the IRS has limited resources.

It seems especially unsatisfactory that the one tax Congress chose to single out for the worst treatment in bankruptcy, the one tax based on the taxpayer’s breaching the trust to hold public funds for payment to the IRS, the one tax where the taxpayer responsible for non-payment nevertheless receives full credit for the unpaid withheld taxes on their individual income tax return and on the calculation of their social security benefits would be the tax that the IRS gives a break to deciding to make an assessment by looking first to its ability to collect the tax after assessment.  To limit this pragmatic approach to individuals engaged in behavior we otherwise view as reprehensible seems not to make sense.  Perhaps, the IRS should take another look at why it adopted the policy and why it only applies this beneficial approach to responsible officers who owe the TFRP.