Tax Court Jurisdiction and the EITC Ban

We welcome William Schmidt who is normally one of our regular designated order blogging. William’s post today results from a request for help from another designated order blogger, Patrick Thomas, who asked for assistance from his colleagues to do an in-depth analysis on a specific designated order from the week of July 23 to 27. During that week the Tax Court issued a heavy load of designated orders that Patrick turned into a three part series without including the case which is the subject of today’s post. William writes about Docket No. 20967-16, Katrina E. Taylor & Avery Taylor, v. C.I.R. (Order here). He focuses on the Taylor case because it brings back a jurisdictional issue for Tax Court regarding the earned income tax credit (EITC) ban that Les has written about before as is cited below. Keith

To begin with some background on the EITC ban, there have been issues through the years regarding fraud on tax returns claiming the EITC. In response, Congress provided the Taxpayer Relief Act of 1997. Its purpose, according to the Joint Committee on Taxation: “The Congress believed that taxpayers who fraudulently claim the EIC or recklessly or intentionally disregard EIC rules or regulations should be penalized for doing so.” The Act provided for an EITC ban under Internal Revenue Code (IRC) section 32(k). The ban disallows a taxpayer to claim the EITC for 10 years when there claim of the credit was due to fraud (or 2 years for reckless or intentional disregard of rules and regulations, though not due to fraud). There have been issues on how fairly the IRS administers the ban. One example is that it was identified as one of the “Most Serious Problems” in the National Taxpayer Advocate’s 2013 Report to Congress.

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The IRS issued a notice of deficiency to the Taylors regarding the 2013 tax year, listing a deficiency of $14, 186 and an IRC section 6662(a) accuracy-related penalty of $2,837.20. The deficiency results from disallowance of car and truck expenses the Taylors claimed on the Schedule C filed with their Form 1040.

The Taylors timely filed their Tax Court petition and the IRS filed their answer. The IRS followed up with an amended answer, raising two affirmative defenses. First, they raise an IRC section 6663 civil fraud penalty of $10,639.50, asserting the petitioners falsely claimed business-related car and truck expenses to reduce their income to make them eligible to claim the EITC. Second, the IRS raises the 10-year EITC ban pursuant to IRC section 32(k)(1)(B)(I) for improperly claiming the EITC.

To complete the procedural history, the Taylors did not participate further in their Tax Court case, which was to their detriment. They did not respond to the amended answer and the IRS followed with a “Motion for Entry of Order that Undenied Allegations be Deemed Admitted Pursuant to Rule 37(c).” The Court issued an order granting that motion, meaning the Taylors are deemed to have admitted all the statements in the amended answer, including the affirmative allegations with respect to the civil fraud penalty and the 10-year ban on claiming the EITC.

Next, the IRS filed a “Motion to Take Judicial Notice,” which requested the Court take judicial notice of the distances between the Taylors’ home and the various addresses Katrina Taylor reported driving during 2013 for her business activities. The motion asserts that the Taylors’ travel logs are unreliable and overstate the travel distances. The IRS provided Google Maps documents that show the distance and driving times for the routes Mrs. Taylor reported for the business destinations. Since the Taylors did not respond, the Court’s order granted the IRS motion, taking judicial notice of that information as facts, the accuracy of which cannot reasonably be questioned.

The IRS prepared a joint stipulation of facts that the Taylors refused to sign. The IRS filed a “Motion for Order to Show Cause Why Proposed Facts and Evidence Should not be Accepted as Established Pursuant to Rule 91(f).” The Court ordered the Taylors to respond to the motion. Since they failed to respond, the Court issued its order making the Order to Show Cause absolute, meaning the facts and evidence set forth in the proposed stipulation of facts was deemed to be established for the purposes of the case.

Turning to the facts established through the orders, the Taylors reported $105,914 in wages on their 2013 Form 1040, with $55,033 earned by Mrs. Taylor as an employee. The attached Schedule C listed financial data on Mrs. Taylor’s business, which reports no business income. It instead reports advertising expenses of $290 and car and truck expenses of $73,740, resulting in a net loss of $74,030. Also included are a Form 4562, Depreciation and Amortization (Including Information on Listed Property), which states the Taylors represent they used two vehicles for business purposes, with a total of 130,513 business miles. Vehicle 1 was driven 65,212 miles and vehicle 2 was driven 65,301 miles. In response to line 24a, “Do you have evidence to support the business/investment use claimed?” their response was to check the box for “no.” Those business expenses reduced their adjusted gross income to $30,690. Since they had three minor children in 2013, they qualified for an earned income credit of $4,417 based on that income.

The IRS audited the Taylors, focusing on their car and truck expenses. The Taylors supplied two versions of a log purporting to show business miles driven for Mrs. Taylor’s business. The logs were not provided contemporaneously with her travel and state she drove the 130,513 miles on business, driving a 2004 Cadillac truck 41,483 miles and a 2006 BMW 89,030 miles. The Court states these logs are demonstrably unreliable because petitioners traded in the 2004 Cadillac truck with Mrs. Taylor signing an odometer disclosure statement reporting the odometer at time of sale as 102,345 miles while according to the provided logs the December 23, 2013 year end odometer reading was 154,990 miles. Similarly, the BMW’s trade-in odometer disclosure statement was 91,333 miles while the purported logs stated the December 17, 2013, reading to be 186,880 miles.

The Court also believed the log mileage to be inflated. The logs stated Mrs. Taylor drove the Cadillac 1,376 miles and the BMW 701 miles (totaling 2,077 miles) on September 22, 2013. The IRS points out the driving distance from Manhattan to Los Angeles is approximately 2,800 miles and “[a]t a constant speed of 70 miles per hour (“MPH”) it would take 29.7 hours to drive 2,077 miles.” The logs also report trips of 1,200 miles to 1,800 miles for other days.

The Court’s discussion within the order itself focuses on how the petitioners have not been responsive. They failed to plead or otherwise proceed within Rule 123(a). Because of the deemed established facts, the Court grants the IRS Motion for Default Judgment and enters a decision against the Taylors.

In the decision, Judge Jacobs ordered and decided that for 2013 there is a deficiency of $14,186 and an IRC section 6663 civil fraud penalty of $10,639.50 (the IRS sought an IRC section 6662 accuracy-related penalty in the alternative so that is denied as moot). Additionally, Judge Jacobs orders and decides “that the 10-year ban for claiming the earned income credit, pursuant to section 32(k)(1)(B)(I), is imposed as sought in respondent’s amended answer.”

There is no analysis regarding the 10-year ban and whether the Court has jurisdiction to impose it. The closest is a prior mention of the affirmative allegations that “petitioners…should be subject to the 10-year ban on claiming the earned income credit.”

We come back to a jurisdictional issue for the Tax Court. In the Taylor case, the Court had the 2013 tax return at issue. The jurisdictional issue is what authority the Court has with regard to the EITC ban in a case like this. Is the jurisdiction for the year in which the ban arises (2013) or for the years in which the ban will take effect (10 following years, presumably starting with 2014)?

The Tax Court is a court of limited jurisdiction. IRC section 6214(a) states that Tax Court has jurisdiction to redetermine the correct amount of a deficiency at issue. The disallowed refundable credit banned through the EITC ban affects future years that are not before the Tax Court. In fact, IRC section 6214(b) states that the Court “shall have no jurisdiction to determine whether or not the tax for any other year…has been overpaid or underpaid.”

I note that the IRS does have the ability to assert fraud and get facts deemed stipulated in order for the IRS to meet its burden of proof on the issue of fraud. I provide a quote from Console v. Commissioner, T.C. Memo. 2001-32 at *12, aff’d 2003 U.S. App. LEXIS 15535 (3d Cir. 2003): “It is well settled in this Court that the Commissioner may establish fraud by relying upon matters deemed admitted under Rule 90Marshall v. Commissioner, 85 T.C. 267 (1985)Morrison v. Commissioner, 81 T.C. 644, 651 (1983)Doncaster v. Commissioner, 77 T.C. 334, 336 (1981). The Commissioner may also establish fraud by relying on facts deemed to be stipulated under Rule 91(f)Ambroselli v. Commissioner, T.C. Memo 1999-158.” My thanks to Carl Smith for providing this note and citation.

One case to consider is a prior Tax Court case, Ballard v. Commissioner, which included a Tax Court judge’s reluctance to issue an order regarding a 2-year ban on the EITC. Les Book provided prior commentary in Procedurally Taxing here. In that posting, there are links to other posts, including Carl Smith’s discussion of the jurisdictional issue of the EITC ban in the Tax Court. I agree with Les’s view that the Tax Court does not have authority to apply an EITC ban for a year of fraudulent behavior (or reckless/intentional disregard), which could be called a conduct year.

Specifically for the Taylors, I argue that while the petitioners should potentially be subject to the ban, the only year before the Court was 2013. It was within the Court’s authority to find that there was fraud in 2013, but not within their authority to apply an EITC ban for later years.

I am unsure if the Taylors were outmatched in the courtroom. If all of the allegations against them are true, though, I can understand the claims of fraud the IRS made against them. Whether their goal was to inflate business expenses to claim the earned income tax credit or not, the results are unrealistic business miles and mileage logs that do not match. Even if one does not agree with the EITC ban, the ban is an area the IRS has authority to administer. This case does not provide justification that the Tax Court has jurisdiction to administer the EITC ban for later years when 2013 was the conduct year before the Court so went a step too far in ordering the imposition of the EITC ban for the Taylors.

 

Son of Boss Case Shows Limitations of Reliance on Tax Advisors to Avoid Penalty

Son of Boss cases seem to go on forever. In Palm Canyon X Investments, LLC, AH Investment Holdings, LLC, Tax Matters Partner v. Commissioner, No. 16-1334 (D.C. Cir. Feb. 16, 2018), the D.C. Circuit affirmed with a per curiam opinion the decision of the Tax Court to sustain the 40% penalty imposed under IRC 6662 for a 400% misstatement of basis. The case does not break new ground but does serve as a reminder of the limitation of the defense of reliance on counsel.

The taxpayer raised as a defense the existence of reasonable cause citing IRC 6664(c)(1). The basis asserted for the reasonable cause grounded in reasonable reliance on the advice of a “competent and independent professional advisor.” We have written recently, here and here, on the perils of using an expert witness who did not have sufficient independence from the transaction. Today’s case demonstrates the same problem when relying on a professional to avoid an otherwise applicable penalty. In the Palm Canyon case, the taxpayer not only relied on professionals who lacked independence but failed to rely on professionals who did. The existence of the case points to the high dollars at stake in the penalty and the wealth of the taxpayer to push the fight this far.

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The Son of Boss tax shelter came into existence over two decades ago. It involved artificially inflating basis in a partnership interest in order to get a tax write-off for artificial losses created upon dissolution. The D.C. Circuit cited to a 20 year old decision invalidating a transaction based on this scheme. So many people invested in the scheme that the IRS issued Notice 2000-44 specifically warning taxpayers that the use of this scheme could result in the imposition of the type of heavy penalty at issue here. By the time it issued this Notice, several cases already existed sustaining the legal position of the IRS.

The taxpayer here went looking for a tax shelter in 2001. The taxpayer had an accountant and a lawyer. These individuals looked at the Son of Boss tax shelter offered to their client and advised him that the generic tax opinion provided by the shelter promoter was “aggressive.” The D.C. Circuit’s opinion does not say whether they provided the taxpayer with a copy of the IRS Notice or copies of the cases that had already determined this type of shelter would not work. The taxpayer decided to purchase the shelter and paid a $325,000 fee for doing so. He claimed a $5,000,000 loss reducing his tax liability from $1,500,000 to nothing which would have been a great bargain had the IRS not disallowed the loss in full and imposed the 40% penalty.

At the circuit court level, the taxpayer did not dispute the unlawful nature of the transaction but argued only that the reliance on the lawyers and the tax advisors who prepared their advice for those selling the scheme provided a basis for removing the penalty for reasonable cause. The court quickly went through five reasons why the taxpayer could not succeed with a reasonable cause argument.

First, the Notice issued by the IRS expressly warned against doing what he did and did so over a year before he bought into the scheme. The existence of the notice “makes proof of reasonableness in this case an especially steep uphill battle.”

Second, the taxpayer’s reliance on the advice of individuals connected with the promotion of the scheme is “objectively unreasonable.”

Third, the taxpayer could not rely on the advice of his accountant whose role here was to investigate the bona fides of the promoter and not to provide tax advice. Additionally, to the extent that the taxpayer’s accountant did provide tax advice it was that the claimed benefits of the scheme were “too good to be true.”

Fourth, the taxpayer could not rely on the advice of his own lawyer as a shield from the penalty because his lawyer was skeptical of the transaction. Like the accountant, the taxpayer’s lawyer limited his due diligence to the scheme’s players and not to the substance of the transaction.

Fifth, the tax opinions provided by the promoters did not pass muster. The opinions were not based on “all pertinent facts and circumstances” relating to the taxpayer, and the parties giving the opinions were part of the promotion team.

Perhaps the only surprises in this opinion are that the taxpayer bought the shelter in the first place, given the information about the scheme available at the time of purchase, and that 17 years later he is still fighting about the penalty when the denial of penalty relief here follows consistent patterns of prior opinions on this subject. While it’s easy to be dismissive of the case, this is a sophisticated taxpayer. The case not only provides guidance on when a taxpayer cannot rely on professional advice to avoid a penalty but insight on the power of pull of the tax shelter scheme that it would motivate someone to fight this long after the conclusion of the transaction and in the face of high odds.

 

Where Not to Leave the Joint Return

The case of Plato v. Commissioner, T.C. Memo 2018-7 involves whether petitioner is liable for penalties for filing his return late. The petition says that the IRS determined a deficiency in Mr. Plato’s taxes for the year in issue of $165,133.80. You can see that with a liability of that size filing late could be quite costly. Although the defense was novel, it is not successful or well thought out.

Mr. Plato separated from his wife in December 2007 and they have lived apart since the time of the separation. He prepared a joint return for 2007 and took it to his wife’s separate residence to get her to sign it on April 15, 2008. Perhaps the case would have turned out better had he visited her a little bit earlier. According to Mr. Plato, he left the return and a check for $46,073 (the amount of the liability reported on the return) “under the mat at the front door” of her residence. He left it there for her to sign and mail the return to the IRS; however, there is no evidence that she did so. The opinion does not say whether Mr. Plato expected his wife to be home when he went by with the return or whether he regularly left material for her under the door mat. Since the Court found that no one ever tendered the check, someone may want to look under that mat now.

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The opinion states that Mr. Plato did not request an extension to file but he “asked his wife to request an extension.” It did not say whether this request was made in writing with the package under the mat or was through a separate means of communication. You would think that he might have followed up with her and followed up with his bank account which would not have had $46,073 withdrawn to pay the check, but the opinion is silent on what he did after dropping off the return under her mat.

Eventually, the IRS grew tired of waiting for the former Mrs. Plato to look under her doormat and it prepared a substitute for return for him for 2007. (It is silent about what happened with respect to his wife and that is appropriate though it leaves details about his case unstated.) After the IRS issued its notice of deficiency with respect to the 2007 year, Mr. Plato submitted a return with the filing status of married filing separate and he tendered a check of $43,490. He also filed a Tax Court petition because the notice of deficiency would have contained penalties and perhaps additional taxes. The parties reached agreement on the tax liability with the IRS apparently accepting the late filed return; however, Mr. Plato sought removal of the late filing penalty.

He argued that leaving the signed joint return under the doormat of his estranged’s wife’s residence together with a check for full payment together with his long history of filing compliance should satisfy the reasonable cause exception to the penalty. We have posted before about the IRS administrative rule regarding first time abatement. The opinion does not address this administrative rule since it is a rule that the IRS can apply but one that does not save a taxpayer in a judicial proceeding. If Mr. Plato would have qualified for first time abatement, he should have worked that out with the IRS during the examination phase of his case. The fact that he did not file a return until after the notice of deficiency was issued suggests that he was not working with the IRS during the examination phase.

Mr. Plato found a case on which he relied for his argument that his prior timeliness coupled with his trip to the doormat should excuse him from the penalty; however, the case on which he relied, Willis v. Commissioner, 736 F.2d 134 (4th Cir. 1984), in which the 4th Circuit overturned a decision of the Tax Court, was itself effectively overruled a year later by the case of Boyle v. Commissioner, 469 U.S. 241 (1985). Additionally, the Tax Court pointed to its own non-precedential opinion, Sutherland v. Commissioner, T.C. Memo 1991-619, holding that failing to obtain an estranged spouse’s signature on a joint return does not necessarily constitute an acceptable excuse for failing to timely file. A taxpayer who is separated from their spouse faces a difficult situation with respect to the filing of a joint return. The joint return may significantly reduce the tax liability; however, the other spouse may have many concerns about signing the joint return and signing on to joint and several liability with a person in whom their trust has dissipated. It is understandable to have discussions seeking to persuade an estranged spouse to sign a joint return. Leaving the joint return under the doormat on the last date to timely file does not evoke the kind of sympathy necessary to avoid a penalty. The decision provides no surprises but an interesting fact pattern and a cautionary tale.

Despite losing the failure to file penalty and despite going pro se against three government attorneys, all was not lost for Mr. Plato. The IRS also asserted an estimated tax penalty against him. The Court found that the IRS did not carry its burden of production with respect to his prior year’s liability and the application of exceptions to this penalty in his circumstances. So, it did not sustain the estimated tax penalty. The Court makes no mention of the Graev issue. I cannot tell if the failure to mention Graev results from a failure of Mr. Plato to raise the issue (not all Tax Court judges seem to affirmatively require the IRS to prove the necessary approvals were secured) or a showing of proof that the Court felt unnecessary to discuss.

It’s now been over a decade since Mr. Plato left the check under the doormat. I hope he knows what happened to it. The opinion leaves it as an unsolved mystery.

 

Designated Orders: 4/2 – 4/6/2018

Designated Order guest blogger Patrick Thomas of Notre Dame brings us this week’s post. He examines a pair of bench opinions and expresses frustration with our complex tax system, the poor information provided to taxpayers by our financial system and the impact on compliance of asserting the substantial understatement penalty. In his last paragraph he speculates that the experience will make these two taxpayers more compliant which is logical thinking but there is a study by the National Taxpayer Advocate which reaches the conclusion that imposing penalties can make individuals less compliant. Imposing penalties without thought, which is how the substantial understatement penalty works, needs review as good policy and the NTA keeps suggesting such a review without success as yet. Keith 

This week’s orders bring us two bench opinions from Chief Special Trial Judge Carluzzo analyzing the reasonable cause exception to the substantial understatement penalty under section 6662. These two orders are the only ones discussed at length in this post.

Other orders include a helpful reminder of burden of proof considerations with unreported income, along with highlights of a few interesting procedural mechanisms in the innocent spouse and math error assessment contexts. Judge Carluzzo also issued another order that was light on publicly available facts, but a reminder that the Tax Court may consider what the Service designates as a “decision letter” to actually constitute a Notice of Determination.

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Reasonable Cause – Late/Incorrect 1099 Forms Insufficient for Penalty Avoidance

Docket No. 9285-17S, Zschau v. C.I.R. (Order Here)

Docket No. 6628-17S, Cusack v. C.I.R. (Order Here)

Judge Carluzzo issued bench opinions in two cases, Zschau and Cusack, where the sole issues for decision was whether the petitioners qualified for a reasonable cause exception to the substantial understatement penalty under section 6662. In both cases, the petitioners relied on third parties to properly and timely issue information returns; those third parties (Janus Investments and Chase Bank) failed their statutory obligations. Nevertheless, Judge Carluzzo sustained the penalties in both cases—though in Zschau, only by a hair.

These cases are eminently frustrating to me. They reflect what I consider to be a wholesale failure of federal tax administration, stemming, it seems, from the taxpayers’ basic lack of understanding of just what the federal income tax is and what their reporting obligations are. I see this among many (though not all) of my clients in the LITC; I’m sure my fellow bloggers have similar experiences.

Indeed, just the other day, I spoke with a new client. Since retiring on a small pension about 10 years ago, she hasn’t filed an income tax return, because—she believed—there’s no requirement to file a tax return or pay taxes after one is retired. I explained the very basic concepts of income taxation and withholding to her. Her eyes lit up. “I had no idea. That makes sense, but no one has ever explained that to me,” she said. Fortunately, after obtaining her information returns, I determined she owed no tax on the unreported income—but had missed out on nearly $10,000 in refunds over the past 10 years.

The issues in Zschau and Cusack are more complex, but I believe, derive from the very same ignorance of how federal income taxation works and what obligations the Code imposes on taxpayers. Most taxpayers that I encounter (and I admittedly self-select those who have run into issues with the Service) understand taxation through unsolicited experience; that is, at some point in their lives, their employer or a payor sends them an information return, which they do not understand. The taxpayer may ignore that form; or they may take it to a trusted friend or relative, who eventually points them to a tax return preparer.

Eventually, the understanding emerges that all taxpayers have an annual filing obligation, and such forms should be provided to a tax return preparer on an annual basis. Taxpayers thus rely on and presume the accuracy and timely delivery of those forms. And perhaps, at some point, taxpayers come to understand the notion that if they receive income—especially in cash—they’re required to pay taxes on that income. But I think (and I’d welcome research on this point) that the provision of an information return with respect to that income would satisfy the taxpayer’s perceived obligation, so long as it was timely delivered to a return preparer; that the absence of such a form, generally speaking, signals to the taxpayer that nothing needs to be provided to a return preparer; and that any error on the form or in delivering the form is the fault of either the third party or the tax return preparer.

In Zschau, the taxpayers didn’t “see” any income from their investment account in cash—and didn’t receive a 1099-B to boot. In Cusack, the taxpayers received a (very) incorrect 1099-R. Both taxpayers had invested with large investment or banking organizations, which presumably have sophisticated tax reporting operations. In both cases, we see errors of the type I describe above.

Zschau’s investment account custodian did not send a 1099-B until long after the petitioners’ return preparer filed the tax return. As such, it wasn’t included on the return. Further, the amounts distributed were reinvested into the account; thus, the Zschau’s didn’t intuit that they had received taxable income, as one might have, had the proceeds been converted to cash in a bank account. They didn’t know about the discrepancy until receiving correspondence from the Service, and then submitted an amended return to include the income (which was unprocessed, due to the outstanding Notice of Deficiency). They also paid the deficiency.

These taxable events that do not result in liquid income often confuse my clients in the Clinic, such that the income is not reported on the return. This is especially true if there’s a delay, like in Zschau, in issuing the 1099-B or other information return, as the tax preparer cannot catch that income either. Cancellation of debt income, pass-through income, reinvested taxable income, and improperly performed retirement account rollovers often lie at the heart of Automated Underreporter (and eventually, Automated Collection Systems) cases in my clinic, and reflect the general ignorance of federal income taxation that I describe above.

The amounts underreported clearly established a substantial understatement under section 6662(d), as the underreported tax exceeded 10 percent of the tax required to be shown on the return (and presumably also exceeded $5,000). Thus, the only legal issue was whether reasonable cause existed for the underreporting.

Before deciding the issue, Judge Carluzzo noted that this was “a very close case”, and that further he was “disappointed that the parties were unable to resolve it between themselves by splitting the penalty.” That short comment struck me and creates a fertile ground for a longer discussion. Notwithstanding the preferences of judges for private settlement, the Tax Court’s institutional interest in efficiency, and litigants’ interests in avoiding the cost and time of trial, surely it’s this very sort of case that the Tax Court exists to decide: a case where equities exist on both sides, are difficult to balance, and where cause the parties to hold seemingly strong views regarding their positions.

Of course, we can only speculate as to what happened before trial. We don’t know whether settlement negotiations occurred, and if so, what took place therein. Perhaps had the Zschaus retained counsel, they would have benefited from a more accurate analysis of litigation hazards. Or perhaps it was respondent who was intransigent.

Putting aside my speculation, Judge Carluzzo ultimately held for the Service. The decision hinged on the Zschaus having received a 2014 year-end summary from Janus before filing the tax return. While the summary didn’t indicate whether any gains were taxable, it did show a large amount of capital gains. Zschau noted that he had only ever provided his return preparer with his Forms 1099-B; Judge Carluzzo found this insufficient (which may surprise a number of tax return preparers). Not helping matters was Zschau’s ownership of an insurance brokerage agency, suggesting he should have known to provide the summary to his return preparer—though I submit that general financial literacy (if that can be imputed to Zschau from ownership of an insurance agency) does not substitute for tax literacy.

Bottom line: a cautionary tale for taxpayers with investment accounts and tax preparers who only require a 1099-B from their clients. To enable accurate reporting and penalty avoidance, taxpayers should provide their year-end summaries to their return preparers, in addition to their tax reporting forms.

The Cusack matter is more straightforward, though still frustrating to me and for the taxpayers. The Cusacks owned an IRA, from which they took distributions amounting to $36,500 due to financial hardship. However, Chase issued the Cusacks a 1099-R reporting only $2,780, which they provided to their return preparer and reported on their return. Chase did not issue a corrected or additional 1099-R for this year.

Judge Carluzzo noted that the taxpayers “were obviously aware that the distributions were made” and that “one or both of them must have known that the amount shown on the return as an IRA distribution was understated.” He concluded that, “we cannot excuse their failure to question the relatively low amount the return preparer included on the return as an IRA distribution.” As such, he upheld the penalty, as the Cusacks did not demonstrate reasonable cause.

We can indeed easily conclude that the Cusacks were aware of the distributions, given they compensated for the taxpayers’ difficult economic circumstances. But I do wonder: were the taxpayers afforded an opportunity to review their return before filing? Could the taxpayers effectively read and understand the items listed on a Form 1040? Did they presume that Chase had accurately reported taxable income from the IRA on Form 1099-R? Did they understand how an IRA works, in the first instance?

I realize that the answers to these questions are not necessarily determinative in the 6662(a) context. Yet the stated purpose of the accuracy penalties is to encourage voluntary compliance. I’d indeed bet that the Zschaus and the Cusacks now have a better understanding of their federal income tax obligations, and are therefore more likely to comply in the future (at least if similar issues arise).

But will these cases have any effect on taxpayers writ large, outside of those already tax-educated few who read this blog? I very much doubt it.

 

Happy Holidays Thanks to Graev III

As discussed in our previous post, the Tax Court in Graev III has reversed the position it adopted in November, 2016 and agreed with the Second Circuit’s decision in Chai v. Commissioner, 851 F.3d 190 (2nd Cir. 2017). That reversal had immediate consequences for four cases that Judge Holmes was holding in his inventory. On December 20, 2017, the same day the Court issued Chai, Judge Holmes issued designated orders in four cases in his inventory that had pending issues regarding penalties. In each of the four cases, he turned back an IRS request to reopen the record to allow it to put in evidence of compliance with IRC 6751(b). This amounted to a loss by the IRS on its attempt to impose a penalty on each of the taxpayers in question. These cases will go to circuits other than the Second Circuit giving the IRS the opportunity to try to overturn Chai and create a conflict among the circuits.

The four case are Estate of Michael Jackson (a relatively well known singer); Warren Sapp (a NFL Hall of Famer) and his ex-wife Jamiko together with consolidate case petitioners, Kumar Rajagopalan & Susamma Kumar, et al ; Kevin Sells and Oakbrook Land Holdings. The cases present similar but not completely identical fact patterns. The cases have quite old docket numbers and the parties had already had extensive opportunity to present matters to the Court.

Judge Holmes was not the only judge holding cases; he was just the quickest to release the cases he held due to the pending decision in Graev III. On December 21, Judge Buch issued four designated orders and Judge Paris issued a non-designated order. There could be more to come as it is clear the IRS has been moving to reopen the record to put in information required by IRC 6751(b) and judges have held up cases waiting for the publication of Graev III. Other judges may have similar motions in their inventory of undecided cases and the orders from these three judges may just signal more orders to come perhaps as holiday season ends.

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The Estate of Michael Jackson case was tried in February, 2017. Judge Holmes mentions that:

“… no one tried to introduce evidence about whether the Commissioner met his burden of production under I.R.C. § 6751(b)(1) to show that “the initial determination of such assessment [i.e., of the penalties] [wa]s personally approved (in writing) by the immediate supervisor of the individual making such determination.”

In July of 2017 the IRS saw problems with 6751(b) coming on the horizon. It had filed the motion for reconsideration in Graev that led to Graev III. It filed a motion in the Jackson Estate case, appealable to the 9th Circuit, seeking to reopen the record so that it could place into the record the evidence of compliance with the penalty approval process required by 6751(b). It had not attempted to do so during the trial. That motion sat because, no doubt, Judge Holmes knew that the Court was in the process of reconsidering Graev, and he did not want to rule until he knew where the Tax Court was headed.

Judge Holmes denied the motion filed by the IRS to reopen the record and allow it to place into evidence information regarding the approval of the penalty it asserted against the estate for either the gross valuation misstatement or accuracy related penalty – a 40 or 20% add on to any deficiency the Court might determine. A nice holiday gift for the estate.

He quoted from his concurring opinion in Graev III where he adopted language from a Justice Scalia concurrence as he warned of the consequences of the decision:

In our concurring opinion in Graev III, this division of the Court warned that ‘”[l]ike some ghoul in a late-night horror movie that repeatedly sits up in its grave and shuffles abroad,’ [this construction of I.R.C. § 6751] will serve only to frighten little children and IRS lawyers.”

The Jackson Estate made clear after the Graev case brought to light a new way to challenge the assertion of penalties that it intended to put 6751(b) at issue but the IRS waited before filing its motion until after the trial and during the trial it did not put on the evidence of compliance with the statute. The trial itself occurred before the Second Circuit’s decision in Chai. The IRS position in Chai was that it did not have to present this type of evidence. Now, at least at the Tax Court level, it pays a price for not hedging its bets.

The outcomes in the other three designated orders issued by Judge Holmes follow a similar path. Those three cases all were tried in Birmingham Alabama and have an appellate path that leads to the 11th Circuit. The parties in those cases claimed conservation easements, the same claim made by the Graevs. Judge Holmes recounts the facts in each of the cases and the knowledge and opportunity for the IRS to put into the record the evidence of compliance during the trial concluding again by denying the request of the IRS to reopen the record after trial to put into the record the evidence of compliance with IRC 6751.

Judges Buch and Paris did not go as far as Judge Holmes in the orders that they issued. The four orders issued by Judge Buch include Hendrickson, Sherman, Triumph Mixed Use Investments, and Dynamo Holdings Ltd Partnership. Judge Buch gives a nice history of the 6751(b) litigation and how it relates to each of the cases. The quote below is taken from the Dynamo case. In the order he then invites the parties to respond to the latest developments rather than issuing a dispositive order at this time. Some attorneys at Chief Counsel with use or lose leave may be working at a time they expected to be on leave:

The question before us is how Graev III might affect this case. In this regard, a timeline may be helpful.

-Section 6751 enacted (July 22, 1998)

-Section 6751 effective (notices issued after December 31, 2000)

-Chai v. Commissioner, T.C. Memo. 2015-42 (March 11, 2015)

-Legg v. Commissioner, 145 T.C. 344 (December 7, 2015)

-Graev v. Commissioner, 146 T. C. No. 16 (November 30, 2016)

-Dynamo v. Commissioner, Dkt. No. 2685-11, Trial Held (January 23, 2017, to February 3, 2017)

-Chai v. Commissioner, 851 F.3d 190 (2nd Cir. March 20, 2017)

-Dynamo v. Commissioner, Dkt. No. 2685-11, Briefing Completed (July 3, 2017)

-Graev v. Commissioner, 149 T.C. No. 23 (December 20, 2017)….

To assist the Court in addressing this issue, it is

ORDERED that respondent shall file a response to this Order by January 5, 2018 addressing the effect of section 6751(b) on this case and directing the Court to any evidence of section 6751(b) supervisory approval that is in the record of this case.

It is further

ORDERED that petitioners may file a response to this Order by January 12, 2018 addressing the effect of section 6751(b) on this case.

It is further

ORDERED that any motion addressing the application of section 6751(b) on this case shall be filed by January 19, 2018. The parties are reminded that any such “motion shall show that prior notice thereof has been given to each other party or counsel for each other party and shall state whether there is any objection to the motion.”

Judge Paris follows the lead of Judge Buch, including the helpful timeline, and does not issue a dispositive order. In Blossom Day Care Centers, a case tried about 18 months ago, she issues the following order:

To assist the Court in addressing this issue, it is

ORDERED that, on or before January 12, 2018, petitioners shall file a Sur- Reply to respondent’s Reply to Response to Motion to Reopen the Record.

It is further

ORDERED that the Simultaneous Answering Briefs are extended to January 3, 2018

Conclusion

The Court and the parties will be busy dealing with the aftermath of the most recent decision in Graev and this may keep the Tax Court and the circuit courts busy for some years to come. Interesting how a little noticed, poorly drafted provision can create so much havoc almost two decades after enactment. Les wonders whether dealing with the poor draftsmanship in 6751 may give the Tax Court practice in addressing issues raised by the hastily drafted legislation that passed earlier this week.

Carl Smith points out another open question as the 6751(b) issue moves forward, viz., does the petitioner need to affirmatively raise penalties in their petitions now or are penalties always at issue:

Will some judges still say that since lack of 6751(b) compliance was not mentioned by the taxpayer (and it never will be by a pro se taxpayer), the court won’t consider the issue.  My hunch is that is no longer good law.  But, also remember that there is still on the books Tax Court opinions holding that where the taxpayer fails to state a claim with respect to a penalty or addition to tax in the pleadings, the Commissioner incurs no obligation to produce evidence in support of the individual’s liability pursuant to section 7491(c), see Funk v. Commissioner, 123 T.C. 213, 216-218 (2004); Swain v. Commissioner, 118 T.C. 358, 364-365 (2002).

Carl points out other issues in a comment he made to the prior post on Graev III for those seeking additional insight.  In the season of giving, Graev III will be giving us additional opinions, and possibly nightmares, for the foreseeable future.

 

 

 

Tax Court Reverses Itself a Year After a Fully Reviewed Opinion Acknowledging a “Graev” Mistake

Christmas came a little early to at least four Tax Court petitioners, including the estate of Michael Jackson. It also comes early for bloggers who like to write awful titles to our posts. I will discuss the Christmas presents to these petitioners in a companion post but today I focus on the underlying cause which is the reversal by the Tax Court of its decision in Graev v. Commissioner, 147 T.C. No 16 (2016)(sometimes known as Graev II). In that case the Tax Court decided that it did not have the authority in deficiency cases to look at whether the IRS obtained the proper penalty approvals under IRC 6751(b) though the Court split significantly in a fully reviewed decision. We have blogged about this issue more times than deserve links; however, a few links are here and here for those needing background on the issue. I suspect there will be more posts to come before this issue reaches a stable position.

The latest decision in Graev v. Commissioner, 149 T.C. No. 23 (2017)(Graev III) reverses the decision made just last year, adopts the intervening opinion of the Second Circuit in Chai v. Commissioner, 851 F.3d 190 (2nd Cir. 2017) and holds that in deficiency cases the Tax Court does have the ability to review whether the IRS obtained the appropriate signatures prior to the imposition of the penalty. Although, with the exception of Judge Holmes who agreed with the decision solely based on the Golsen rule since Graev’s appeal will go to the Second Circuit, the Court again split rather substantially. This time the split is primarily on the application of IRC 6751(b) and not whether it should apply, though Judge Holmes writes extensively on why he believes the Tax Court should have stuck to its position in Graev II. Mostly because of Judge Holmes’ concurrence (in result only), the opinion is long. This post is no more than a very cursory overview. For those interested in tax procedure, the opinion deserves a careful read.

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Well, it would have been interesting to be in the Tax Court’s conference room on the day(s) it discussed this case. The statute provided lots of room for debate as the Court struggled to fit its language into existing tax procedure norms. Maybe before the case reaches its final resting place, the conference room will be renamed the Graev room for many meetings the case has, and may still, cause. As we have referenced before, kudos go to Frank Agostino for paying attention to a provision in the 1998 act that everyone else seemed to overlook. Frank’s client comes away from the latest opinion in this case a bit empty handed but the split on the Court may provide ample room for Frank to obtain some relief at the next level.

I will discuss the case by looking at each of the four parts: 1) the majority opinion written by Judge Thornton; and then the concurring opinions by 2) Judge Lauber; 3) Judge Holmes, partially dissenting and 4) Judge Buch, partially dissenting.

Majority Opinion

The Court reverses its prior opinion and adopts the Second Circuit’s view of IRC 6751(b) as expressed in Chai. It does this with relatively little fanfare:

Having considered the opinion of the Court of Appeals for the Second Circuit in Chai, and in the interest of repose and uniformity on an issue that touches many cases before us, we reverse those portions of Graev II which held that it was premature to consider section 6751(b) issues in this deficiency proceeding.

The Court then went on to talk about what that means:

In the light of our holding that compliance with section 6751(b) is properly at issue in this deficiency case, we also hold that such compliance is properly a part of respondent’s burden of production under section 7491(c).

Once it decided that it could consider the 6751(b) issue and that the IRS had the burden of production with respect to the issue, the majority then looked at each penalty imposed in order to determine whether the IRS met its burden. Based on its analysis, with which Judge Buch disagrees, the Court sustained the imposition of the penalty.

The majority found that the Chief Counsel docket attorney who reviewed the notice of deficiency initiated part of the penalty and that his supervisor approved his recommendation/determination of the applicability of the penalty. The determination came in the form of a review of the proposed statutory notice of deficiency. When the IRS received his recommendation regarding the penalty to be imposed on the Graevs, it adopted the recommendation in the notice of deficiency sent to the petitioners.

In addition, the Chief Counsel docket attorney assigned to try the case added an additional penalty after the filing of the Tax Court petition. Her supervisor approved this additional penalty. The majority found that the penalties generated by the Chief Counsel attorneys met the requirements of 6751(b). The majority found that the taxpayers’ conduct regarding the unpaid taxes and the claiming of the gift warranted the imposition of the penalty. Since the Chief Counsel attorneys and supervisor’s actions satisfied the approval requirement and since the penalties were otherwise appropriate, the Court determined that the petitioners owed the penalties.

Judge Lauber’s Concurrence

Joined by four other of the eight judges in the majority, Judge Lauber wrote to take issue with the separate opinion written by Judge Buch. He discusses in detail why the approval by Chief Counsel lawyers meet the statutory test as initial recommenders of the penalty. He looks at both delegation orders and the intent of the statute.

Judge Holmes’ concurrence and dissent

Judge Holmes writes at length about the problems and uncertainty that the decision will cause. He has many concerns about the Second Circuit’s opinion and the problems it will cause. His opinion is not a full on dissenting opinion because he agrees that the Tax Court must follow the Second Circuit here pursuant to the Golsen rule; however, he wants to preserve the Tax Court’s approach in Graev II for another day and for a case appealable to a different circuit.

He does not like the Second Circuit’s approach to the case and argues forcefully that compliance with the statute is not ripe for court review in a deficiency case. He notes initially that 6751(b) has existed for almost 20 years. Adopting the Second Circuit’s approach means that many cases during that period have resulted in penalty imposition without appropriate proof by the IRS. He states:

Adopting this reading as our own, and rolling it out nationwide, amounts to saying that we have been imposing penalties unlawfully on the tens of thousands — perhaps hundreds of thousands — of taxpayers who have appeared before us in that time.

This is just the beginning of his concerns about the case. To the extent he is concerned, he might feel better knowing that the IRS does not care when it has hundreds of thousands of improper penalty assessments on its books as it demonstrated following the Rand case. Unlike the Rand case in which most taxpayers could still oppose the penalty if they knew that they had a basis for doing so, the penalty decisions over the past two decades made without the now adopted standards involve a Tax Court decision and cannot, by and large, be undone.

He next engages in a close reading of the Chai opinion and what it says. In doing so he points out the differences in the language of the statute and how taxes work:

And here is where a closer reading of the text and a broader understanding of tax litigation ought to make a difference. As the majority and Chai implicitly acknowledge, liability for penalties — indeed, liability for tax of any kind — is fixed by the Code sections imposing penalties and tax. See Chai, 851 F.3d at 217 (explaining that penalty “aris[es] under [section] 6662(a)”). “Assessment” is just a recording of the liability. See Hibbs v. Winn, 542 U.S. 88, 100 (2004); United States v. Galletti, 541 U.S. 114, 122 (2004) (assessment is “little more than the calculation or recording of a tax liability”). Liability “arises and persists whether vel non that tax is assessed.” Principal Life Ins. Co. v. United States, 95 Fed. Cl. 786, 790-91 (2010); see also Kelley, 539 F.2d at 1203 (“liability is imposed by statute independent of any administrative assessment”).

He points out that Chai conflates liability and assessment and that in doing so it will play havoc with the burden of proof rules. The Second Circuit looked to the purpose of a statute that did not make good sense rather than pay close attention to the technical language. He thinks that it is possible to achieve a correct result based on a technical reading of the statute and that the correct technical reading takes the Tax Court out of 6751 since the statute refers to assessment. He produces numerous examples to show how difficult it will be to make the statute work. His portion of the opinion cogently explains many aspects of tax procedure but he is left alone among the judges deciding this case because of his desire to adhere to the result in Graev II.

Judge Buch’s concurrence and dissent

Judge Buch, joined by five other judges, three of whom who like him had worked at Chief Counsel’s office prior to joining the Court and the other two having worked in the Tax Division of the Department of Justice, agreed that the Tax Court should apply Section 6751(b) in a deficiency proceeding but disagreed with the application of the new rule to penalty determinations by Chief Counsel lawyers. His opinion focuses on the role that Chief Counsel attorneys play in the process. He characterized this role as one of advisor rather than the person making the determination.

I agree that the Chief Counsel attorney’s role in reviewing the notice of deficiency is that of advisor. The IRS does not have to agree with the Chief Counsel attorney in this situation. If the Chief Counsel attorney’s advice is something different than a determination then it provides another example of something that does not fit the language of the statute. This segment of the opinion does a good job of showing the problems with the statute raised by Judge Holmes in the preceding section.

Two Chief Counsel attorneys made penalty recommendations/determinations in this case. The attorney who reviewed the notice of deficiency prior to it issuance made one which fits the description in the prior paragraph and then another attorney was assigned to the case once the petitioners filed in Tax Court. The second attorney made another penalty determination. Once the case is petitioned, Chief Counsel’s office can make a decision on adding or removing penalties without getting the opinion of the IRS. The opinion here does not distinguish between the two situations in which the penalty determinations were made by the Chief Counsel attorneys and their managers but it would be possible to split hairs here continuing to demonstrate the potential problems with the statute.

Conclusion

For the reasons detailed by Judge Holmes in the many examples he provided, the Tax Court has not seen the last of the many variations of how 6751(b) can cause mischief. Anyone defending a penalty will want to read Judge Holmes’ concurrence carefully in order to gather ideas on how to challenge the approval process chosen by the IRS. The IRS also needs to read that section carefully in order to create procedures that will withstand attack. Of course, the Second Circuit may still have more to say on how to interpret 6751 as it applies to the Graevs.

 

Working Hard to Get Penalized

The case of Whitaker v. Commissioner, T.C. Memo. 2017-192 provides another example of a taxpayer who works hard to make sure that the IRS penalizes him. In the process, he drains resources at the IRS and the Tax Court. I have no great sympathy for the behavior, but it is a generally sad process to watch. In this case, it is especially sad because it appears that if the Whitakers had filed a proper return claiming the retirement distribution, they would have received back all of the withholding. They do not appear to have enough income to be taxed since their standard deduction and personal exemptions exceeded the amount of the pension. Unless there was other taxable income not reflected in the report of the case, they traded a $3,600 refund for a $10,000 penalty.

The opinion involves the imposition of the frivolous tax return penalty of IRC 6702(a). This is one of over 50 assessable penalties found in Chapter 68, Subchapter B of the Internal Revenue Code. Section 6702 entered the Code in 1982. Taxpayers making frivolous tax returns or frivolous submissions get hit with a $5,000 penalty. I have written about this penalty before here, here, here and here. What interests me about this case, and what has interested me before because it is hard to tell, is why Mr. Whitaker was permitted to litigate the merits of his 6702 penalty in a Collection Due Process (CDP) case. I believe taxpayers should have the right to litigate the merits of assessable penalties in CDP cases because they do not have the right to a prepayment forum; however, the IRS generally objects and the Tax Court sustains the objection based on the IRS regulations. I will discuss the issue further below, but I cannot tell why the IRS did not object to the litigation in this case. As an outside observer without all of the information driving the decision not to object, it is unclear to me why the IRS objects in some cases and not in others.

Additionally, the IRS can reject frivolous arguments in CDP cases; however, it can only reject cases based on frivolous submissions and not frivolous returns. Because Mr. Whitaker’s case involves a frivolous return described in 6702(a) rather than a frivolous submission described in 6702(b), the bar to making an argument in a CDP case does not preclude him from making his type of frivolous argument in this CDP case.

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The Court lays out the three bases for the 6702 penalty: 1) “the taxpayer must have filed a document that ‘purports to be a return of a tax imposed by’ title 26;” 2) “the purported return must be a document that either ‘does not contain information on which the substantial correctness of the self-assessment may be judged’ or ‘contains information that on its face indicates that the self-assessment is substantially incorrect:’” and 3) “the taxpayer’s conduct must either be ‘based on a position which the Secretary has identified as frivolous’ or must ‘reflect a desire to delay or impede the administration of Federal tax laws.’”

The Court explains why Mr. Whitaker’s, and the actions of his deceased wife, meet the criteria of the statute. Basically, they kept submitting documents purporting to be returns that showed zero income and zero tax, but withholding which they wanted to use as a basis for obtaining a refund (a refund it looks like they were entitled to, had they properly listed their income.) The IRS conceded the penalty for one of the returns during the Tax Court case which may have influenced the Tax Court not to impose the 6673 penalty, which it had done in a prior case involving frivolous submission penalty, but the imposition of the penalty itself breaks no new ground. The Tax Court may have been influenced not to impose a 6673 penalty because of the apparent lack of a tax liability on the return had it been correctly filed and the sadness of the case.

We have written extensively on the efforts to litigate the merits of a tax liability before the Tax Court of individuals faced with large assessable penalties who have no easy, and sometimes no realistic, way to pay the penalty and bring a refund suit. The Whitaker case contains no explanation of why the taxpayer did or did not have an opportunity to bring the merits of the assessed penalty to Appeals at the time of the assessment and why that opportunity did not foreclose the opportunity to raise the merits of the penalty at the CDP stage of the case. Did the IRS fail to offer an Appeals hearing at the time it imposed this penalty? Did the IRS simply fail to object to raising the merits during the CDP process and allow a tax protestor to go forward with the merits litigation in Tax Court, tying up the resources of the Court and three Chief Counsel attorneys on what seems like a fairly wasteful case (though the concession of one of the three penalties suggests the existence of a partially meritorious suit)? Does the fact that the IRS allowed Mr. Whitaker to bring a merits case on his assessable penalty mean that other taxpayers should at least try to bring merits litigation in the CDP context hoping that they will be allowed to do so? I would like to know why the merits litigation was allowed here, and in other cases I occasionally see where I would have expected the taxpayer to have the opportunity to go to Appeals at the time of the imposition of an assessable penalty, when most taxpayers get turned away. The answer may lie in a simple failure to offer a conference with Appeals at the time of assessment, but it is unclear.

As mentioned above, another interesting feature of this case is that the IRS could have turned this case away from CDP consideration under the provision of IRC 6330((c)(4)(B) if his frivolous position were a “submission” rather than a “return.” This section precludes the taxpayer from raising an issue at a CDP hearing if the issue meets the requirement of clause (i) or (ii) of section 6702(b)(2)(A). The bar to raising frivolous positions in CDP cases is intended to keep persons from using the CDP process to promote such positions. This case shows how the CDP process can still be used to promote a frivolous position as long as the taxpayer takes the position on a tax return, as Mr. Whitaker did, rather than on another type of document such as a CDP request. The case also points out the terrible result that can happen when tax protestor arguments are pursued.

Getting a Double Penalty Benefit or Getting to the Right Result

It’s easy to feel sorry for the people who invested in Son of Boss tax shelters. They really wanted to pay the right amount of taxes but were hoodwinked into investing into tax shelters that did not turn out like they hoped causing them to have significant problems with the IRS that they never intended.

If that’s your take on Son of Boss investors, you will love a case that came out earlier this summer. If that’s not your take, you might still find the situation amusing. I think the IRS found the situation just slightly less amusing than paying out attorney’s fees to tax shelter promoter BASR. In Ervin v. United States, the district court found that investors in a Son of Boss shelter were entitled to a refund of penalties paid to the IRS even though they recovered the penalties from their tax advisors who brought them into the tax shelter in the first place. How did we get there?

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The investors brought a suit against the IRS to obtain a refund of the valuation misstatement penalty and penalty interest payments. They convinced a jury of their peers that they had reasonable cause for the tax positions they took. Now, they want the IRS to give them a refund of the penalties they paid.

In the meantime, the investors sued some of their tax advisors – BDO Seidman and Curtis Mallet – to recover the penalties asserted against them for investing in the Son of Boss shelter and they won that suit also. It came out in the tax refund suit that they had won the suit against their advisors and recovered a substantial amount of money. The IRS argued that it should not have to refund the penalties and interest to them because the recovery that the investors received from their advisors was intended to pay for the penalty. If the investors got to keep the recovery and did not have to pay the penalty, the investors would receive a windfall. The IRS argued that it should keep the money the investors paid to it because they were already made whole and the payments by the advisors represented the true payments of the penalties. The investors argued that they should receive the entire refund despite the private settlement. They also argued that the IRS does not have a claim of right with respect to the penalty payments.

The Court rejected the argument made by the IRS and rejected it without giving the IRS any further discovery. It finds that the investors did not fail to disclose a matter “bearing on the nature and extent of injuries suffered.” The suit was about their liability for penalties and the private suit against their advisors really had nothing to do with it. The Court said that it could not find a single instance in which a court has excused the IRS from its obligation to repay the improperly assessed and collected tax in a refund suit and ordered the IRS to pay here.

This case brings up an issue that Steve and I have debated before and he has written about. When a taxpayer argues reasonable cause based on the advice of tax advisor, the case is in many ways the malpractice case involving the advisor. If the taxpayer succeeds in fending off the penalty, maybe the taxpayer does not pursue the advisor. So, a victory for the taxpayer may be an economic victory for the party who caused the problem just as much for the taxpayer.

If taxpayers are going to defend against the IRS and sue their advisor in situations in which they can win both cases because they were reasonable in relying on the advisor and the advisor did give bad advice, maybe this feels bad to the IRS but it puts the economic loss in the right place, or maybe it misallocates the placement of the economic loss which is why the IRS was complaining.

The advisor who gives the bad advice should be liable and pay for the damages caused by the bad advice. The bad advice has really harmed both the IRS and the taxpayer. If the taxpayer pays the right amount of tax after the audit, the IRS is whole from the perspective of collecting the correct amount of tax but has still had to expend effort to collect that tax instead of having the self-reporting system work as it should. If the taxpayer pays the correct amount of tax in the end, should the taxpayer be freed from paying the advisor who caused the taxpayer to incur the problem in the first place? The taxpayer may have had to pay more money to fight with the IRS about the correct amount of tax and certainly did not get the value bargained for.

In cases where the taxpayer avoids an otherwise appropriate penalty because the taxpayer reasonably relied upon the advisor, should the system penalize the advisor so that the IRS recovers something akin to the appropriate penalty and so that the advisor feels the pain of causing the problem while also allowing the taxpayer to recover from the advisor at least the cost of the original bad advice plus perhaps the cost of the advice to fix the problem created? The IRS is right to complain here, in the sense that some penalty payment seems appropriate. It also seems right to allow the taxpayer to avoid paying the penalty to the IRS where the taxpayer reasonably relied on the advice of a professional and to allow the taxpayer to recover the cost the taxpayer paid for the bad advice. Maybe we should look at recasting the penalty scheme to bring all of the players to the table. Where I am particularly bothered, the advisor is continuing to represent the taxpayer in the reasonable cause litigation and I felt that the advisor was using the taxpayer’s more sympathetic case as a shield for the advisors’ less sympathetic one.