One Hake of a Taxpayer Friendly Reasonable Cause Holding

And, could this be heading to SCOTUS?

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

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

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

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

As the court stated, the issue was narrowly defined:

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

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

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

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

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

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

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

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

The District Court noted the Third Circuit stated Boyle:

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

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

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

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

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

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

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

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

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

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

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

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

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

The Timing of Penalty Approval

On November 30, 2016, the Tax Court issued a fully reviewed opinion in the case of Graev v. Commissioner, 147 T.C. No. 16 addressing the issue of the requirement for managerial approval of penalties.  In the Restructuring and Reform Act of 1998 (RRA 98), Congress created IRC 6751 which requires managerial approval of penalties.  We have discussed this issue previously here, here and here, one post each by me, frequent guest blogger Carl Smith and Frank Agostino, respectively.  The Court split pretty sharply in its opinion with nine judges in the majority deciding that the IRC 6751(b) argument premature since the IRS had not yet assessed the liability, three judges concurring because the failure to obtain managerial approval did not prejudice the taxpayers and five judges dissenting because the failure to obtain managerial approval prior to the issuance of the notice of deficiency prevented the IRS from asserting this penalty (or the Court from determining that the taxpayer owed the penalty.)

A number of IRC 6751 cases have been bottled up waiting for this opinion.  Look for a number of cases to now come out on this issue and look also for some of these petitioners to take the issue to the next level.

Because I had an extensive email exchange with Carl Smith about this case, I have placed his comments at the end of the post for those interested in a more in depth review of the issues presented.

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This issue first came to my attention through Frank Agostino and fittingly, Frank represents the petitioners in this case.  As we have mentioned in prior posts, this issue essentially went unnoticed for almost 15 years after the passage of RRA 98.  After a TIGTA report highlighted that the IRS had failed to notice and follow this requirement, Frank picked up on the issue and began asserting that the IRS failed to follow the provision.  In Graev he made the argument but with somewhat unusual facts.  I will briefly discuss the facts before getting to the three different views on the issue expressed by the members of the Court followed by views on the opinions by Carl Smith and me.

Facts

Petitioners claimed a charitable contribution for a façade conservation easement on a home they purchased in a historic preservation district in New York City.  The easement was donated to the National Architectural Trust (NAT).  In a previous opinion, Graev v. Commissioner, 140 T.C. 377 (2013), the Tax Court held that petitioners could not claim a charitable contribution deduction for the donation of the easement because NAT gave them a side letter guaranteeing that it would return the contribution if the IRS disallowed the charitable contribution.

At the time of the contribution, some concern existed about the ability to claim a deduction for a contribution of the façade easement because of a Notice the IRS had issued on a different type of conservation easement but one with enough overlap to suggest that the IRS might not allow a charitable contribution deduction for the type of easement being contributed by the Graevs.  The opinion details the letters sent by NAT before and after the donation regarding pronunciations by the IRS and Congress on the donation of easements.  It also recounts the actions, or inaction, of the Graevs in the face of the correspondence.

The IRS did audit the return filed by Graevs claiming the contribution of the easement.  The agent not only proposed disallowing the contribution but also recommended the imposition of the 40% gross valuation misstatement penalty of section 6662(h).  The agent prepared the penalty approval form – a form the IRS devised specifically to meet the requirements of section 6751 – and his manager signed the form.  Because the agent could not reach an agreement with the taxpayers, he prepared a statutory notice of deficiency, which, due to the issue, required Chief Counsel review.  The reviewing attorney agreed with the notice; however, he recommended that the IRS add to it, as an alternative position, the imposition of the 20% penalty under 6662(a) and (b)(1) for negligence or substantial understatement.  The manager in Chief Counsel’s Office agreed with this recommendation.

The IRS added the alternate penalty to the notice of deficiency but the agent did not go back to his manager for approval of the alternate penalty.  In the first Tax Court case the Court determined that petitioners were not entitled to the charitable contribution deduction because the side letter created a subsequent event that was not “so remote as to be negligible.”  Because of the basis for the decision, the IRS conceded that the 40% penalty did not apply and argued that the 20% penalty did.

In defense to the application of the 20% penalty, the Graevs argued that the IRS did not comply with section 6751 because the agent’s manager did not approve the 20% penalty.

Majority

The majority determines that because the IRS has not yet assessed the liability a determination that it has failed to follow the requirements of section 6751 is premature.  The statute requires “written approval of the ‘initial determination of … assessment’ before a penalty can be assessed.  Notably absent from section 6751(b), however, is any requirement that the written approval of the ‘initial determination of … assessment’ occur at any particular time before the ‘assessment’ is made.”

This is a 106 page opinion.  The majority (and the dissent) goes into many aspects of the statute in reaching its conclusion.  The majority also spends time explaining why the dissent is incorrect.  We may come back with subsequent posts about the opinion but at its core is the view that the language of the statute requires approval before assessment and the Tax Court is a pre-assessment forum.  This facially logical view of the statute leads to trouble in the ability of a taxpayer to challenge the application of section 6751 and raises questions about the Tax Court’s role as a pre-assessment forum.  Of course the drafters of the statute might have thought a little more about that before writing it.

Concurrence

The concurring judges looked to the purpose for the statute which is to prevent the use of penalties as bargain chips.  Here, these judges found that even if the IRS did not strictly comply with the requirements of section 6751(b) the failure to do so did not prejudice petitioners.  These judges would defer the detailed analysis of the statute until presented with a case where the facts did raise the possibility of prejudice.

Dissent

The dissent would require that the IRS obtain managerial approval prior to issuing the notice of deficiency.  Because the IRS issued the notice prior to obtaining approval of the alternative position, it would not sustain the penalty.  The dissent discusses the role of the Tax Court in the assessment process and concludes that to properly fulfill that role it should address the penalty issue as presented in the notice of deficiency.

Conclusion

The majority opinion suggests a taxpayer should never raise IRC 6751 in Tax Court, or anywhere, until liability is assessed and raise it instead in the Collection Due Process (CDP) context after assessment.  This seems contrary to the purpose of Tax Court and puts taxpayers in an awkward position.  By allowing assessment to occur, the panoply of IRS collection options becomes available.  The Tax Court may anticipate that CDP is a process available to everyone for reentry into the Court for a determination but for low income taxpayers and taxpayers with relatively low liabilities, the IRS may collect via offset and fully satisfy the liability without the need to send a CDP notice.  Of course, the taxpayer whose liability is fully satisfied can sue for a refund but if the penalty is $1,200 on a liability of $6000 for wrongfully claiming the EITC, how practical is it to file an expensive suit in district court to contest this issue?

The case is before the Tax Court because the penalty, at least the penalty at issue in this case and in many cases, is a part of the notice of deficiency.  For the reasons stated by the dissent, the Tax Court has jurisdiction to decide the issue. This should not be a post-assessment question.  After all, to borrow from Judge Gustafson, section 6501 also precludes an assessment being made after the SOL has expired, but the Tax Court has a long history of considering compliance with section 6501’s requirements during the deficiency case – i.e. pre-assessment.

If the opinion of the majority stands up on appeal, taxpayers who know or think that the IRS did not obtain the appropriate approval prior to issuing the notice of deficiency should consider making no mention of 6751 during the Tax Court case for fear of alerting the IRS to the defect prior to the making of the assessment and allowing it to cure that defect.  Here, I assume that the IRS will obtain managerial approval before it makes the assessment.  One possible outcome of the case if it comes back to the Tax Court in the CDP context is that the post-decision, pre-assessment managerial approval will satisfy the language of the statute in the eyes of the judges in majority, and perhaps concurring, opinion.

Comments on Opinion by Carl Smith

In  footnote 22 on page 40, the court fairly acknowledges that it is likely just kicking the issue of compliance with section 6751(b) (whatever it means) down the road until a post-assessment Collection Due Process proceeding.  Doubtless, the 6751(b) issues that the court avoids today will have to be addressed in a Tax Court CDP opinion — perhaps even one that the Graevs bring after the penalties are formally assessed and a notice of intention to levy or a notice of federal tax lien (i.e., a ticket to a CDP hearings) is issued.  Query, though, whether challenging an assessed penalty under section 6751(b) in a CDP hearing is prohibited by the language of section 6330(c)(2)(B), which prohibits CDP challenges to underlying liability where a taxpayer has received a notice of deficiency — as the Graevs did?  Or is a section 6751(b) challenge one going to the procedural correctness of the assessment under section 6330(c)(1), not a prohibited underlying liability challenge?

In his concurrence, Judge Nega (joined by two other judges) suggests that a CDP case would be an appropriate case in which to decide the issues avoided by the majority.  On page 68, he writes:  “The failure of the IRS to follow the statute or its administrative practices may be challenged as an abuse of discretion in a collection action. That case is not before us.”

If one can’t challenge non-compliance with section 6751(b) through CDP, then Judge Gustafson points out a statute that might also preclude a later refund lawsuit over the penalty.  See his quote and brief discussion of section 6512(a) on page 78. n. 5.

If neither CDP nor a refund suit is the way to challenge non-compliance with section 6751(b), then taxpayers would be left without a remedy.  The anti-injunction act of section 7421(a) has an exception if no adequate remedy exists; however, probably the exception would not apply, and the act would likely preclude a suit to restrain assessment or collection of the penalty.  And section 7433, which provides a suit for damages from wrongful collection actions would not apply, since the issue being challenged here is an assessment issue, not a collection issue.

This opinion has been a long time in coming.  The case was originally with Judge Gustafson.  And he foreshadowed his dissent in a brief order he issued more than two years ago on July 16, 2014. Clearly, he wrote a proposed opinion along the lines of his dissent, but then at court conference, his opinion did not prevail and Judge Thornton got the assignment to write the majority opinion.  On the day the opinion was issued, an order reassigning the case from Judge Gustafson to Judge Thornton was also entered in the case.

There is an interesting new entry on the Tax Court docket sheet accompanying this opinion that I have never seen before when an opinion is issued.  It reads:  “Internet Sources Cited in Opinion”.  The problem of URL links to court opinions disappearing over time has been a large one for all courts.  Perhaps this is a warning to the Tax Court about what it must think about doing when the government printing office formally prints the opinion in a T.C. volume.  Will the Tax Court later be revising its opinions in the same way that Supreme Court judges currently do?  It is my understanding that the Supreme Court recently has changed its practices of modifying opinions that have already been published.  Now, the court will let the public know of the post-issuance changes to the opinions.  Will the Tax Court do the same?  Perhaps it is worth asking the clerk’s office what the purpose of this new entry on the docket sheet implies.

Finally, Judge Gustafson decides a lot of the questions under section 6751(b) on which the majority postpones ruling.  Judge Gustafson’s opinion is joined by four other judges.  Readers of the opinion should not jump to the conclusion that any of the judges in the majority would disagree with those rulings of Judge Gustafson on the issues on which the majority deferred ruling if the arguments are again presented in a case (presumably a CDP case) where those arguments are ripe.  Thus, this victory for the IRS in allowing a deficiency including penalties to be incorporated into the Tax Court decision may turn into no penalties ever being collected by the IRS if a court, in a future case, decides the deferred issues adversely to the IRS.

My worry about whether compliance with 6751(b) is merely a procedural compliance issue in a CDP case is based in part on the way that the Tax Court has treated compliance with 6501.  The Tax Court has refused to consider 6501 arguments in a CDP case if a taxpayer previously received a notice of deficiency.  But, I am pretty sure the Tax Court judges are going to treat 6571(b) compliance as a CDP procedural issue, since to treat it as an issue barred by 6330(c)(2)(B) would be to deprive a taxpayer of any possibility of judicial review of compliance with 6751(b).

 

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

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

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

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

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

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

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

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

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

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

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

My conclusion the first go around was as follows:

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

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

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

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

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

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

McDonald’s Franchisee Loses Its Payroll Taxes to an Embezzler and Then Loses It Penalty Argument with the IRS

The case of Kimdun, Inc. v. United States provides yet another example of the havoc wrecked by payroll provider companies. Over the last 15 years, a fair number of payroll providers have run off with the money leaving their clients in hot water with the IRS. The IRS standard approach to these cases involved telling the cheated taxpayers that they owed their taxes, penalties, and interest. The cheated taxpayer received little compassion from the IRS as they tried to sort through the financial wreckage caused by the payroll provider.   The traditional IRS view on this issue sees the payroll provider as an agent of the taxpayer and any problems created by the payroll provider as problems the taxpayer must fix.   That approach has a sound legal basis but does not always make good policy because some of the payroll provider cases invoke a lot of sympathy.

I thought the IRS position concerning payroll providers had softened. Several pronunciations seemed to suggest a kinder, gentler approach by the IRS on these cases. I quote from the relatively new IRM on ETA offers at the end of the post and cite there to other relevant IRM provisions that a taxpayer facing this problem should explore.

Kimdun definitely did not meet the kinder side of the IRS. This case does not involve Kimdun’s liability for the stolen taxes themselves but rather picks up at the penalty phase. This case involves delinquency penalties for failure to pay and failure to deposit. Kimdun loses the argument in a preemptory fashion. The five McDonalds franchise locations will need to flip a lot of burgers to pay off the penalty for hiring a company that cheated on it and caused it not to pay its taxes on time.

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Kimdun paid the taxes and penalties assessed by the IRS in addition to making payments of the taxes to its payroll provider who ran off with the payments. This case involves a refund suit for return of the money paid for the penalties. Kimdun and the affiliated corporations that made up the franchise group owned by Kim Dobbins have operated in the Los Angeles area for about 30 years. The opinion states that for that entire time or almost that entire time, the companies hired Copac Payroll Service and its clearinghouse bank, Cachet Banz, Inc. to process its payroll, make the necessary deposits, fill out the payroll returns, etc. The payroll company and the bank would electronically sweep the money to pay the payroll and the taxing authorities from the bank accounts of the franchisees. The companies could see (I assume they were looking) that the money was coming out of their bank accounts. They knew their employees received payment because the employees would have quickly sounded an alarm if they had not received payment, and the company assumed that the payroll provider sent the appropriate amounts to the state and federal taxing authorities. Unfortunately the companies apparently did not check up on the timely filing and payment of the taxes.

Some question exists whether the companies had notice of failures before the firing of the payroll company, but eventually the failure became clear. and they fired the payroll provider, The companies also learned that the payroll provider was the subject of a federal grand jury investigation, and the companies received bills from the IRS and California for the unpaid taxes.

Kimdun and the affiliated companies apparently paid over the taxes without a fuss. Having worked on payroll provider cases when I worked in Chief Counsel’s office, I can say that not every taxpayer who gets cheated like this can stroke a check and do that. Many taxpayers who find themselves in this situation face quite a struggle to come up with the taxes for a second time. The ability of Kimdun to pay the IRS the taxes and the penalties attests to the strength of the business and demonstrates that the business stepped up when it learned of the problem and did not shirk from the problem. Hopefully, it also received a theft loss deduction to soften the blow somewhat.

Nonetheless, the IRS stuck to its guns on the penalty. Kimdun argued that the failure to pay the taxes on time and to make the required deposits resulted from reasonable cause and not willful neglect. The court cited United States v. Boyle, 469 U.S. 241 (1985). When a court in this situation cites to Boyle, it is generally a bad sign for the taxpayer and that held true in this case. In Boyle, the Supreme Court set a high bar for taxpayer seeking penalty relief based on the failure of someone on whom the taxpayer relied. The district court here characterized the Supreme Court’s view of the misplaced reliance as providing little relief from penalty where the task involved something the taxpayer could check without expertise such as the timely filing of a return or the timely payment of a debt contrasted with reliance where the expertise of the person on whom the taxpayer relied would reasonably occur such as the taking of a legal position on a return.

The district court here cited to an earlier 9th Circuit case, Conklin Bros. v. United States, 986 F.2d 315 (9th Cir. 1993), involving embezzlement by an in-house bookkeeper rather than a payroll provider. In Conklin, the 9th Circuit, the circuit to which the appeal in this case would lie and the circuit providing controlling precedent to this district court, held that Congress had “charged Conklin with an unambiguous duty to file, pay, and deposit employment taxes and Conklin cannot avoid responsibility by simply relying on its agent to comply with the statutes.”   The district court here applied the same logic in holding Kimdun and its affiliates liable for the delinquency penalties.

This is a tough outcome. If you represent a company whose payroll provider steals its money, look hard at the IRS pronunciations on the relief it may provide to taxpayers in this circumstance. Even if the IRS can win in court decisions that sustain the application of the delinquency, it may not always press for such penalties. It appears there was a little evidence that Kimdun might have had some information to support firing the payroll provider earlier. The case also did not contain information about the IRS failing to follow its own procedures and sometimes you will find that in these cases. Before giving up, seek penalty relief (and in the right circumstances, relief from some of the taxes themselves) but be aware of the precedent and the uphill battle your client will face, because the payroll provider was their agent and ultimately the IRS can place the burden of the loss on the taxpayer.

While Effective Tax Administration offers can prove very hard to obtain, I.R.M. 5.8.11.2.2.1.4 (08-05-2015) entitled “Public Policy or Equity Compelling Factors” has some language that appears to give hope to taxpayers cheated by a payroll provider. The section states:

Compromise may promote ETA and allow for relief if the taxpayer demonstrates that the criminal or fraudulent act of a third party is directly responsible for the tax liability.

In any case involving a fraudulent act of a third party, the taxpayer should be able to provide supporting documentation that the act occurred and was the direct cause of the delinquency. The taxpayer should also be able to show that the nature of the crime was such that despite prudent and responsible business actions the taxpayer was misled to believe the tax obligations were properly addressed. There should be evidence that the funds required for the payment of the taxes were segregated or otherwise identified and were available to pay the taxes in a timely manner. Compromise would promote ETA in such situations only where the failure to comply is directly attributable to intervention by a third party and where the taxpayer has made reasonable efforts to comply and taken reasonable precautions to prevent the criminal or fraudulent acts at issue. If appropriate, the taxpayer’s efforts to mitigate the damages by pursuing collection from the third party should also be considered. Compromise for this reason would only promote ETA where there is a very close nexus between the actions at issue and the failure to comply.

In situations where the actions of a payroll service provider (PSP) contributed to the delinquency, once the offer specialist (OS) has determined sufficient supporting information or documents are available to verify the PSP was the cause of the delinquency and the taxpayer acted in a reasonable manner, the OS may proceed with minimal additional documentation, refer to IRM 5.8.11.5.

Factors which demonstrate the taxpayer was acting reasonably may include, but are not limited to:

– the manner and frequency of monitoring federal tax deposits via EFTPS or other means,

– verifying references prior to entering into the arrangement with the PSP, determining if the PSP was bonded or licensed as required by state laws and regulations and if any corporate filings and licenses required by the state were up to date;

– the fact immediate steps to remedy the problem after learning of the PSP’s misconduct were taken and – whether mitigating factors were involved that may have hampered the ability to identify and correct the problem, e.g. serious illness, natural disaster, etc., as well as a determination as to whether consideration of the taxpayer’s offer under ETA Hardship is a more appropriate resolution

Other IRM provisions worth looking at include IRM 5.1.24.4  (08-15-2012) Types of Third-Party Payer Arrangements; IRM 5.1.24.4.2  (08-15-2012) Payroll Service Provider; IRM 5.1.24.5  (08-15-2012) Collection Actions in Cases Involving Third-Party Payers; IRM 5.1.24.5.1  (11-06-2015)Assignment of Third-Party Payer Client Cases; IRM 5.1.24.5.3  (08-15-2012) Use of Electronic Federal Tax Payment System (EFTPS) for Payment Verification; and 5.1.24.5.8  (08-15-2012)Trust Fund Recovery Penalty (TFRP) Investigations.

Victims of payroll tax providers should take a hard look at the ETA offer provisions because they do provide a way out of the problem caused by paying over the taxes twice. Of course, the IRS does not want to serve as a taxpayer’s insurer; however, this relatively new section of the IRM suggests that in the right circumstances, the IRS will take the hit for the taxpayer because that provides the most effective manner to administer the tax laws.

Venue on Appeals from Tax Court Attorney Sanctions

Frequent guest blogger Carl Smith writes about appellate venue in a yet unsettled corner of tax litigation.  Congress cleaned up some ambiguities last year but did not address the issue of appellate venue where the Tax Court sanctions the taxpayer’s counsel for frivolous actions in the Tax Court.  Keith

Hopefully, readers of PT will never have to consider this issue, but what is the proper venue on appeal from sanctions imposed by the Tax Court on attorneys under IRC sec. 6673(a)(2)?  The answer is not clear.  But recent appeals of the rulings in Best v. Commissioner, T.C. Memo. 2014-72 and T.C. Memo. 2016-32, and May v. Commissioner, T.C. Memo. 2014-194 and T.C. Memo. 2016-43, will try to dodge the issue, since both the taxpayers and the same counsel in each case (all of whom were sanctioned) have protectively appealed to the Ninth Circuit (Docket Nos. 16-71777(Best) and 16-71795(May)) and the D.C. Circuit (Docket Nos. 16-1188(Best) and [not yet assigned](May)).

Compounding the venue confusion is that both the Best and May cases are Collection Due Process (CDP) cases filed in the Tax Court prior to December 2015, when section 7482(b)(1) was amended to prospectively overrule the holding of Byers v. Commissioner, 740 F.3d 668 (D.C. Cir. 2014), for petitions filed thereafter.  In Byers, the D.C. Circuit held that, absent stipulation otherwise, only the D.C. Circuit was the proper venue on appeal from Tax Court CDP cases that did not include challenges to the underlying liability.  For Les’ post on Byers when it came out, see here.  For Les’ post on the overruling of Byers by the PATH Act, see here.  To quote Les from the latter post:

“The upshot of the PATH legislation with respect to CDP appeals is to push CDP and innocent spouse appeals into the same general rule as deficiency cases, that is the venue on appeal is tied to an individual’s residence (or principal place of business for other taxpayers) of the petitioner at the time of petition filing unless the parties stipulate otherwise.”

But, that legislation, sadly, did not resolve the issue of the proper venue on appeal from Tax Court attorney sanctions under section 6673(a)(2).

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The taxpayers in Best and May all lived in the Ninth Circuit when they filed their Tax Court petitions in 2010 and 2012, respectively.  In neither case were the taxpayers contesting the amount of underlying liability.  In both cases, the taxpayers were represented by a Phoenix attorney named Donald MacPherson.  In the Tax Court, MacPherson’s arguments were only [21]  that (1) the Appeals Settlement Officer abused her discretion in relying only on computer transcripts to verify that the taxpayers’ unpaid tax had been properly assessed and (2) collection could not proceed because the IRS had failed to furnish the taxpayers with Form 23C or RACS 006 (including the name and signature of the assessment officer and the date of the assessment), rather than the Form 4340 transcripts that the IRS had furnished the taxpayers.

The judges in the Best and May cases (Halpern and Lauber, respectively) rejected these arguments as so frivolous at this point that the judges considered the cases to have been filed by the taxpayers primarily for delay.  Section 6673(a)(1) allows the court to sanction taxpayers who bring or maintain suits primarily for delay or who maintain frivolous or groundless positions in their cases.  In their initial opinions in the cases, the judges both held that collection could proceed and the taxpayers were subject to penalties under section 6673(a)(1) of $5,000 and $500, respectively.

In follow-up opinions in both cases issued earlier this year, the judges decided to impose penalties on MacPherson under section 6673(a)(2) of $19,837.50 and $7,188, respectively.  That section provides that “[w]henever it appears to the Tax Court that any attorney . . . has multiplied the proceedings in any case unreasonably and vexatiously,” the court may require that the attorney “pay personally the excess costs, expenses, and attorneys’ fees reasonably incurred because of such conduct.” The judges computed the excess costs using a well-settled “lodestar” amount for the work of IRS attorneys and law clerks.

In the second Best opinion, the court applied a rule of the Ninth Circuit and most appeals courts that bad faith is needed to impose sanctions, even though not all courts of appeal require this. In part, the Tax Court did this to make the split irrelevant by holding that the IRS passed the higher test (bad faith), writing:

Moreover, appellate venue regarding section 6673(a)(2) is uncertain.  Venue for appeal of Tax Court decisions is governed by section 7482(b). The venue for appeal is likely either the Court of Appeals for the Ninth Circuit (because of the legal residence of petitioners), see sec. 7482(b)(1)(A), or the Court of Appeals for the District of Columbia Circuit, see sec. 7482(b)(1) (flush language). . . .  Because we are unsure of appellate venue, and because we find that Mr. MacPherson’s conduct would constitute bad faith under the Court of Appeals for the Ninth Circuit’s test for bad faith, we will for purposes of this case (and without deciding the standard in this Court), adopt that standard.

T.C. Memo. 2016-32, slip op. at *11- *12.

In the second May opinion, the Court stated that it was following the reasoning of the second Best opinion and cited opinions on sanction standards both from the Ninth Circuit and D.C. Circuit, as follows:

We find that Mr. MacPherson knowingly or recklessly advanced arguments that he knew were frivolous and lacking in any legal basis. Because his actions thus manifested subjective bad faith, they are deserving of sanction under section 6673(a)(2). See Moore v. Keegan Mgmt. Co. (In re Keegan Mgmt. Co., Sec. Litig.), 78 F.3d 431, 436 (9th Cir. 1996); Reliance Ins. Co. v. Sweeney Corp., 792 F.2d 1137, 1138 (D.C. Cir. 1986); Takaba v. Commissioner, 119 T.C. 285, 296-297 (2002).

T.C. Memo. 2016-43, slip op. at *15 (footnote omitted).

In early June, notices of appeal were filed in both cases in the Ninth and D.C. Circuits. All four of the notices attach the rulings of the Tax Court in the opinions that sanctioned MacPherson, but not the earlier opinions concerning the taxpayers. All notices of appeal nominally are in the names of the taxpayers, but are signed only by MacPherson. While the notices of appeal are a bit confusing (and may not be jurisdictionally-sufficient for all of the parties desiring to appeal), it appears that the appeals are intended to be both on behalf of the taxpayers and MacPherson, even though MacPherson has not put his name in the captions of the appeals as an appellant.

In the notices of appeal to the D.C. Circuit, MacPherson explains (without citing Byers) that venue on appeal of CDP cases such as Best and May is unclear, and so the filings in the D.C. Circuit are essentially protective. He states that the appellants prefer that the appeals be heard by the Ninth Circuit and that he has asked counsel for the government to stipulate to the Ninth Circuit as the proper venue.

I expect that the government will agree to the requested stipulation – both for the taxpayers and MacPherson’s penalty appeals.

First, in Notice CC-2015-006 (issued before Byers was legislatively repealed), and on which I blogged here, Chief Counsel expressed its disagreement with the D.C. Circuit’s venue holding in Byers that, absent a stipulation otherwise, CDP cases not involving underlying liability issues are appealable only to the D.C. Circuit, writing:

When evaluating appellate venue after a taxpayer files a notice of appeal, if the taxpayer appeals a non-liability case to the D.C. Circuit, and the case is not enumerated in section 7482(b), Chief Counsel attorneys should not recommend objecting to venue since Byers is controlling in the D.C. Circuit. If a taxpayer appeals a non-liability case to the proper regional circuit, Chief Counsel attorneys should likewise not object to venue as the taxpayer’s choice of venue is consistent with our position.

(Emphasis added.)  It is thus the IRS preference to litigate CDP cases in the regional Circuits of the taxpayers’ residence.

Second, I don’t expect the IRS to object to venue of MacPherson’s penalty appeals in the Ninth Circuit, either, since judicial economy (and government briefing expenses) would be served by hearing the taxpayers’ and their lawyer’s appeals together.

But, I do want to discuss the open question as to the proper venue for an attorney who is appealing penalties imposed by the Tax Court under section 6673(a)(2).

Recall that section 7482(b)(1)’s flush language provides a general rule that appeals from the Tax Court go to the D.C. Circuit, unless one of a series of lettered subparagraphs applies.  Subparagraph (A) directs appeals by individuals from rulings involving petitions seeking redetermination of tax liability to the Circuit of the individual’s residence.  Just as in Byers, where the D.C. Circuit held CDP petitions not to fall within subparagraph (A), in Dornbusch v. Commissioner, 860 F.2d 611 (5th Cir. 1988), the Fifth Circuit held that an appeal from a Tax Court criminal contempt order against a third-party witness could not be heard by the Circuit of the petitioner’s residence but had to be heard by the D.C. Circuit under the flush language of section 7482(b)(1).  In that case, the Fifth Circuit transferred the criminal contempt appeal to the D.C. Circuit.

More recently and to the point, the Tax Court has speculated that appeals of its section 6673(a)(2) penalties on attorneys also probably don’t fall within subparagraph (A) of section 7482(b)(1) or any other subparagraph, so, absent stipulation otherwise,  should go only to the D.C. Circuit. Takaba v. Commissioner, 119 T.C. 285, 297 (2002); Edwards v. Commissioner, T.C. Memo. 2003-149, aff’d, 119 Fed. Appx. 293 (D.C. Cir. 2005) (D.C. Cir. opinion lacks any discussion of venue); Davis v. Commissioner, T.C. Memo. 2007-201, taxpayer’s appeal only aff’d, 301 Fed. Appx. 389 (6th Cir. 2008) (attorney’s appeal dismissed because notice of appeal did not make clear that attorney was appealing).

The issue of venue for appeals of section 6673(a)(2) penalties once came up in a D.C. Circuit opinion.  The taxpayer had appealed his case, Powell v. Commissioner, T.C. Memo. 2009-174, to the Sixth Circuit, where the appeal was pending when the taxpayer’s attorney appealed his section 6673(a)(2) sanctions in the case to the D.C. Circuit.  The DOJ apparently moved to transfer the attorney’s appeal to the Sixth Circuit, but the D.C. Circuit directed briefing on the entire case (including the transfer issue), and when the D.C. Circuit issued its opinion in Barringer v. U.S. Tax Court, 408 Fed. Appx. 381 (D.C Cir. 2010)[free copy unavailable], it affirmed the Tax Court without transferring the case, writing:  “Because the appeal has been fully briefed and argued, the judicial economy rationale of the Tax Court’s suggestion this appeal be transferred to the Sixth Circuit where the taxpayer’s appeal is pending, no longer exists.” Thus, the Barringer opinion also does not decide the normally-correct venue on appeal for a section 6673(a)(2) penalty case.

In hunting around for other venue rulings on section 6673(a)(2) penalties, I found one opinion from a regional Circuit, Johnson v. Commissioner, 289 F.3d 452 (7th Cir. 2002). In the Tax Court case related thereto, the taxpayer, Johnson, lived in Indiana (within the Seventh Circuit). Johnson v. Commissioner, 116 T.C. 111, 112 (2001). After ruling against the taxpayer, the Tax Court also sanctioned her attorney, Joe Izen, under section 6673(a)(2). Izen was from Texas. Apparently, only Izen appealed the case to the Seventh Circuit to contest his penalties. The Seventh Circuit held that the penalties were warranted, but did not discuss the venue on appeal – leading me to assume the DOJ did not raise the issue of possible improper venue.

In sum, there are no appellate court opinions – precedential or otherwise – on the correct venue on appeal from attorney penalties imposed by the Tax Court under section 6673(a)(2), just Tax Court speculation that proper appellate venue, absent stipulation otherwise, probably is only the D.C. Circuit.

May readers never have to be involved in a case where this issue has to be resolved.

 

Tax Procedure Grab Bag – Preparer Problems

Two quick items here.  First, the IRS in late April 2016 has issued final regs under Section 6708 regarding the penalty for material advisors for failure to make available lists with respect to reportable transactions.  General write up can be found on the TaxAdvisor webpage here.  Some changes have been viewed positively, as easing slightly the penalties on advisors.

More interesting to me, but somewhat substantive, is an update to the Cosentino case we covered in SumOp back in 2014, which can be found here.  In Cosentino, the Tax Court held that malpractice proceeds received by a taxpayer against his accountant were not taxable income.  The accountant had advised the taxpayers to enter into a transaction that was later determined to be a tax shelter.  The shelter was used to artificially inflate the basis in real estate, which didn’t work (very oversimplified, and you can find more on the specifics from Roberts and Holland here).  The taxpayers claimed they would not have entered into the transaction had they known it was bunk, and, as such, should be entitled to the tax back from the accountant.  They ended up getting $375,000.

The taxpayer’s argued that this was a replacement of capital, and, to the extent the replacement of capital didn’t exceed  basis, was not taxable.  The Service disagreed, stating the correct amount of tax on the sale of the property was sold (which it believed removed the case from a set of precedent that held if more than the proper amount of tax was paid, the recovery of the excess was not taxable).  The Court held that the taxpayers would have sold the property, but used Section 1031 to defer the tax, had they known the accountant was providing shady shelter advice, and then got a step up in basis at death—a bit speculative.  The Court holding essentially gave them the step up during lifetime, without possibly passing through the estate tax system.  An interesting result, but this is a difficult situation to put the parties back into their prior positions.

The Service did not appeal the case.  Apparently it didn’t view this as the winning case to take on appeal, didn’t like the venue, or wasn’t ready to keep arguing this point.  In April, however, the Service let us all know that it intends to continue litigating this issue in other cases.  See AOD 2016-001.  We do not see many IRS actions on decisions anymore these days, so this is pretty exciting.

There has been lots of other great coverage on this case.  We haven’t linked Ed Zollar’s writing enough here on SumOp, but we check his blog pretty frequently.  He wrote about the AOD here.   The always entertaining Tony Nitti also wrote about the case back in 2014 for Forbes.  You can find more background in that article, which is found here.

Discharging the Failure to File Penalty in Bankruptcy

The recent case of United States v. Wilson highlights one more reason for timely filing your tax return.  Mr. Wilson requested an extension of time to file his 2008 tax return until October 15, 2009; however, he did not actually file until 2011.  On July 24, 2012, he filed a chapter 7 petition.  His was the rare chapter 7 case that actually had assets available to distribute to creditors.  His 2008 liability got paid by the chapter 7 trustee; however, the estate did not have enough funds to pay the failure to file or failure to pay penalties.  In a chapter 7 case penalties get paid at the very end of the line.  So, having these liabilities go unpaid in the bankruptcy case provides no surprises.

After the bankruptcy ended, the IRS did not write off the penalties. Instead, it sought to collect them by offsetting Mr. Wilson’s subsequent California state refund and by levying on his social security benefits.  Mr. Wilson thought that the bankruptcy discharged the penalties and brought an action in bankruptcy court to enjoin the IRS from collecting on these penalties and to obtain the return of his money.  In response, the IRS conceded that the failure to pay penalty was discharged but argued, successfully, that the failure to file penalty was not.  The district court overturned the bankruptcy court in holding for the IRS on a narrow interpretation of Bankruptcy Code section 523(a)(7) and the rules regarding the discharge of penalties.

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The discharge rules for taxes reside in 523(a)(1). Generally, if a tax liability meets the priority criteria of section 507(a)(8) then bankruptcy will not discharge the tax.  For income taxes to meet the priority criteria generally the taxes must have been due to be filed within three years of the date of bankruptcy filing with the due date including extensions to file.  Taxes assessed within 240 days of the bankruptcy petition and taxes not yet assessed but still assessable can also have priority status subject to certain exceptions.  The 2008 taxes of Mr. Wilson had priority status because he filed bankruptcy less than three years after the extended due date for the filing of the 2008 return – October 15, 2009.

The rule for discharging penalties, however, resides in a different subsection of 523. Penalties can never achieve priority status (not counting the trust fund recovery “penalty”) and have their own separate subparagraph (7) for determining dischargeability.  Section 523(a)(7) provides that ‘[a] penalty imposed on unpaid taxes accruing more than three years before the filing of the bankruptcy petition” is discharged.  The question facing the court in Wilson concerns the meaning of “accruing more than three years before.”  One possible interpretation is that penalties like the failure to file and the failure to pay accrue each month with each continuing month’s failure.  If this were the test for accruing, the lookback would go from the date of the bankruptcy petition, to the penalty imposed for a month occurring within the three year period.  The debtor would discharge some of the accruing penalties for the months more than three years prior to the filing of the bankruptcy petition but would still owe the penalty for the months that ran within the three year period.  Courts have rejected this approach.

Another approach would be to look at the due date for filing the return to which the penalties relate in order to determine if the due date occurred more than three years before the filing of the bankruptcy petition. If the due date occurred more than three years before the filing of the petition, the penalty receives the discharge.  Here the due date for paying the taxes occurred on April 15, 2009.  That date was more than three years before the filing of the bankruptcy petition.  The IRS conceded that it should have discharged the failure to pay penalty because this penalty ran from the due date of the return.  It argued that its failure to discharge and write off the failure to pay penalty did not impact the case because the amount of the failure to file penalty exceeded the amount that it had collected post-bankruptcy.  The court did not engage in a discussion of sanctions against the IRS for violating the discharge injunction and, so, tacitly seemed to agree with the position of the IRS.

Now, the tricky part of the case because the language of 523(a)(7) does not talk about due dates or extended due dates. Here the bankruptcy case was filed more than three years after the original due date of the tax return but less than three years after the due date for filing the tax return as extended.  The taxpayer argued that the extended due date mattered for calculating the priority of the tax itself because the language of 507(a)(8)(A)(i) concerning the impact of the extension was very explicit in that section establishing the priority of tax claims.  In contrast, the language of 523(a)(7) provides no mention of extended due date.  So, the taxpayer argued that the original due date of the return should mark the time for the running of the three year period in 523(a)(7) in the absence of explicit language in the statute regarding extensions and the failure to file penalty for 2008 should have been discharged.  At least one court prior to the bankruptcy court in this case had reached that conclusion.

The IRS argued that the extended due date marked the due date for the 2008 return for purposes of determining the discharge of the failure to file penalty. Since the extended due date fell within the three year period before the filing of the bankruptcy petition, the taxpayer cannot discharge the failure to file penalty.  The district court, reversing the bankruptcy court, agreed with the IRS.  It stated that Section 523(a)(7)(B) “makes dischargeable any tax penalty imposed with respect to a transaction or event that occurred before three years before the date of the filing of the petition.”  The transaction or event giving rise to this penalty was Mr. Wilson’s failure to file by the extended due date since he had permission not to file by the original due date.  The district court acknowledged that the issue was close.  This fact pattern will not come up with great frequency but is something to consider when deciding the timing of a bankruptcy filing.  Generally, the taxpayer in Mr. Wilson’s case who timely files a return by the extended due date will want to wait for three years past the extended due date in order to discharge the taxes.  Since he did not timely file his return by the extended due date, the date for discharging the taxes themselves ran (subject to the McCoy line of cases discussed in earlier posts) two years from the late filing of the 2008 return.  So, he was not focused on the extended due date in thinking about discharge timing.  If the holding in Wilson is followed by other courts, others in this position must think about the impact of the extended due date for filing the return on the ability to discharge the failure to file penalty which makes the calculation of when to file a bankruptcy petition to maximize the tax benefits just a bit more complicated.

Kahanyshyn v. Comm’r: Tax Court Rules It Lacks Deficiency Jurisdiction Over Sec. 6676 Excessive Refund Claim Penalty

We welcome back frequent guest blogger Carl Smith who writes about a case caught in the fall out of Rand in which the IRS sought to assert a penalty under 6676 after losing in Rand the effort to assert penalties on overpayments of refundable credits under 6662.  We are not normally this close to the news but the Court’s order was issued yesterday.  On Tuesday, the Tax Court issued another interesting order in the Rand lineage in the case of Galloway v. Commissioner.  Judge Halpern suggests that the PATH legislative fix to the Rand problem may not have quite done the trick.  These are interesting cases to follow while we wait for the IRS to abate the hundreds of thousands of wrongful assessments still on its books for Rand type cases assessed during 2009-2011.  Keith

Readers of PT probably never heard of the 20% excessive refund claim penalty of section 6676 before the Tax Court issued its opinion in Rand v. Commissioner in November 2013.  Keith’s post from January 6, 2016 contains links to five prior posts on Rand.  This is still another post on the fallout from Rand.

Post-Rand, in PMTA 2014-15 (Aug. 6, 2014), the IRS held that where it determined a section 6676 penalty on the disallowance of a refundable tax credit, the section 6676 penalty should be included in the notice of deficiency disallowing the credit, since the penalty was related to the disallowed credit.  The PMTA acknowledged that where the section 6676 penalty was not imposed on a tax amount subject to the deficiency procedures, the penalty should be asserted directly by assessment without a deficiency notice.  Section 6671(a).  But, the PMTA noted that the Tax Court often has jurisdiction over penalties that are computed based on a deficiency.  In a post I did on February 19, 2015, I criticized the IRS’ reasoning that the 6676 penalty could ever be subject to the deficiency procedures and predicted that the Tax Court would reject any attempt to assert that it ever had deficiency jurisdiction over a section 6676 penalty. In a post on November 3, 2015, Professor Del Wright agreed with me that the IRS’ reasoning was the result of bad logic and noted that Saltzman and Book similarly rejects the idea that section 6676 penalties can be assessed under the deficiency procedures.

Apparently, one attorney in the IRS did not get the memo.  In a motion filed on July 10, 2015, in the Tax Court in Kahanyshyn v. Commissioner, Docket No. 29697-14, the attorney argued, contrary to PMTA 2014-15, that the court lacked jurisdiction to consider a section 6676 penalty relating to a disallowed refundable First Time Homebuyer Credit (FTHBC) involved in the deficiency jurisdiction case.  In an order in the case issued on September 4, 2015, Special Trial Judge Armen granted the IRS’s motion and dismissed for lack of jurisdiction the taxpayer’s attempt to litigate the section 6676 penalty.  In an order issued on February 10, 2016, Judge Gustafson gave more factual background on the case and the penalty before disallowing the FTHBC and granting the IRS summary judgment, since there were no other contested issues in the case.

Although the jurisdictional ruling was only in an unpublished order, I have no reason to think that the Tax Court will ever rule any differently in any future case attempting to assert that it has jurisdiction under its deficiency procedures to consider the validity of a section 6676 penalty.

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Prior to Rand, the IRS did not assert the 20% section 6676 excessive refund claim penalty when it disallowed a refundable tax credit, but rather, based on the appropriate conduct, the IRS included in the notice of deficiency disallowing the refundable credit a 20% section 6662 (accuracy-related) or 75% 6663 (fraud) penalty. The section 6676 penalty cannot be imposed when the same disallowance is subject to a penalty under section 6662 or 6663. Section 6676(d).

Rand disabused the IRS of the idea that it could collect section 6662 or section 6663 penalties on the entire amounts of refundable tax credit disallowances.  Rand held that, while entire disallowed refundable tax credits can form part of the “deficiency”, as defined in section 6211, disallowed refundable tax credits can only be subject to those penalties to the extent that the credits were used to reduce the tax down to $0, but not below $0.  That is because there is a provision at section 6211(b)(4) that adds the amount of disallowed refundable tax credits that exceed the tax shown on the return into the deficiency computation as a negative amount of tax.  At the time Rand was decided, though, there was no provision similar to section 6211(b)(4) in the definition of “underpayment” in section 6664(a) on which the sections 6662 and 6663 penalties are imposed.  But Rand also pointed out to the IRS that (except in the case of EITCs), the IRS still could get 20% section 6676 penalties on the portions of the disallowed credits that were not included in the “underpayment” calculation.  So, except as to EITC disallowances, the IRS was not really any worse off as regards penalties with respect to non-fraudulent, but incorrect, claims of refundable credits.

Kahanyshyn Facts

Apparently, the IRS auditor of Mr. Kahanyshyn’s 2010 return and the auditor’s boss read Rand and took it to heart.

Mr. Kahanyshyn filed a 2010 income tax return reporting a lot of gross income, but also taking a large schedule C loss and various itemized deductions, such that he reported taxable income of $0 and income tax of $0.  In the payments section of his return, he listed a withholding tax credit of $10,013, and a FTHBC of $8,000.  He sought a refund of $18,013.

From the orders, I can tell that the return was filed 5 or more months late, though I do not know the exact date it was filed.  On January 9, 2012, the IRS processed the return and issued a refund check in the amount only of the income tax withheld, not the FTHBC.  It appears that the IRS either froze the refund of the FTHBC or, more likely, performed some math error adjustment.  The orders don’t mention a notice of deficiency ever being issued seeking to adjust the $8,000 FTHBC.

On April 2014, an IRS auditor sent an IDR to the taxpayer informing him that the IRS was examining his return to determine the applicability of the section 6676 penalty. The IDR sought information regarding Mr. Kahanyshyn’s qualification for the FTHBC, including that the home he purchased was his principal residence and that he had a reasonable basis for claiming the FTHBC.

In an undated letter, Mr. Kahanyshyn responded to the IDR and provided a narrative of why he was entitled to the FTHC and a copy of the residential sale and purchase contract for the property.

On May 21, 2014, the IRS mailed Mr. Kahanyshyn a Letter 950 and an examination report showing a proposed section 6676 penalty and notified him that he could request a conference with the IRS Office of Appeals if he disagreed with the proposed changes.

On May 30, 2014, Mr. Kahanyshyn responded to the examination report and stated that he did not agree with the findings, was submitting a written protest, and requested a telephone conference.

On July 7, 2014, the IRS issued to Mr. Kahanyshyn a Notice of Penalty Charge under Section 6676, for $1,600 (i.e., 20 percent of the $8,000 claimed refund) and attached to it a Form 886-A, “Explanation of Items”. The Form 886-A explained that the facts indicated that he did not use the property and occupy it as his principal residence and that a related income tax examination showed that his adjusted gross income, as corrected by disallowances of the Schedule C loss and all itemized deductions and inclusion of unreported income, now exceeded the level at which the FTHBC could be claimed.

Apparently, at this time, the IRS assessed the section 6676 penalty and somehow permanently disallowed the FTHBC without sending a notice of deficiency. Math error authority?

This is the first case I have ever seen where the IRS actually assessed a section 6676 penalty on a disallowed refundable tax credit disallowance, following the guidance of the Tax Court on this subject in Rand.  In pre-Rand cases, the IRS simply included 20% section 6662 penalties on disallowed refundable credits in the notices of deficiency disallowing such credits and did not assert section 6676 penalties. See, e.g., Rand (EITC and ACTC) and Morales v. Commissioner, T.C. Memo. 2012-341, affd. 2015 U.S. App. LEXIS 21713 (9th Cir. 2015) (FTHBC).

On October 7, 2014, the IRS issued a notice of deficiency to the taxpayer for 2009 and 2010 income taxes.  With respect to 2010, the notice sought a deficiency of $39,600.  That deficiency was all attributable to unreported income, the disallowed Schedule C loss, and the disallowance of itemized deductions.  The deficiency amount was calculated without the $8,000 of disallowed FTHBC, since apparently the FTHBC disallowance had been previously assessed.  The notice sought a fraud penalty under section 6663 equal to 75% of the proposed deficiency and a late-filing penalty under section 6651(a)(1) equal to 25% of the excess of the deficiency over the amount of taxes that had been withheld.

Tax Court Proceedings

The taxpayer attached the notice of deficiency to a timely pro se Tax Court petition.  However, the only issue that the taxpayer sought to litigate was his entitlement to the FTHBC in 2010 and the section 6676 penalty imposed thereon.

In a motion filed on July 10, 2015, the IRS attorney argued, contrary to PMTA 2014-15, that the court lacked jurisdiction to consider the section 6676 penalty, though, under section 6211, the court could consider the FTHBC itself in computing the total amount of deficiency in the case.  I assume that, if the court agreed with the taxpayer that he was entitled to the FTHBC, it would reduce the proposed deficiency by $8,000 – thereby undoing the FTHBC’ previous disallowance.

In an order dated September 4, 2015, Judge Armen granted the motion to dismiss the section 6676 penalty issue from the case.  The Judge wrote, simply:

Section 6676, which is entitled “Erroneous Claim for Refund or Credit”, provides a penalty if a claim for refund or credit with respect to income tax is made for an excessive amount. The section 6676 penalty is an assessable penalty under subchapter B of chapter 68 that is not subject to the deficiency procedures. Sec. 6671(a); see Smith v.  Commissioner, 133 T.C. 424 (2009). Therefore, we are obliged to dismiss so much of this case that purports to relate to that penalty.

In Smith v. Commissioner, the Tax Court had held that, other than in the course of a Collection Due Process case in the Tax Court, the court had no jurisdiction to consider section 6707A penalties for failing to report engaging in listed transactions.

In Judge Armen’s order, he does not even discuss the IRS’ argument in PMTA 2014-15 that the Tax Court’s deficiency jurisdiction over disallowed refundable tax credits should give the court associated deficiency jurisdiction over related section 6676 penalties.

In my view, the IRS argument in the PMTA makes no sense, since it is only section 6665 that allows certain penalties to be assessed under deficiency procedures.  While section 6665 covers penalties under sections 6662, 6663, and 6651, as well as assessable penalties at section 6672 et. seq., section 6665 applies only “[e]xcept as otherwise provided in this title”.  Section 6671(a) provides for the assessment of assessable penalties (including section 6676 penalties) simply on notice and demand, without any deficiency procedures.  Thus, section 6671(a) obviously overrides section 6665’s allowing certain penalties to be assessed though deficiency procedures.

Since the Tax Court’s website does not allow me to review the IRS motion, I can’t even tell whether the IRS attorney in the case discussed section 6665, section 6671, or PMTA 2014-15.

In his order yesterday granting the IRS summary judgment in the case, Judge Gustafson ruled that, since the taxpayer is not contesting the income adjustments in the case that increased adjusted gross income to above the FTHBC phase-out amount, the taxpayer is not entitled to the FTHBC.  Thus, the judge upheld the notice of deficiency in full.

Observations

As you know from Keith’s post of January 6, 2016, section 209 of the PATH Act recently repealed Rand by amending section 6664(a)’s definition of “underpayment” to include rules similar to the refundable credit rules for computing a deficiency at section 6211(b)(4).  That repeal is retroactive to cases open in the Tax Court on the date of the PATH Act’s enactment on December 18, 2015 – which would include the Kahanyshyn case.  As Keith pointed out, Chief Counsel has instructed IRS attorneys to apply the amendment retroactively in pending cases.  In the Kahanyshyn case, after December 18, 2015, the IRS attorney could have sought to amend the answer to include a section 6663 fraud penalty on the disallowed FTHBC, and the Court would have had to rule that (as always) it had jurisdiction over fraud penalties and that fraud penalties now extend to disallowed refundable tax credits that (as in this case) were not used to reduce tax down to $0.  In that instance, the taxpayer could have raised the previously-assessed section 6676 penalty as mitigating the amount of the fraud penalty – by equitable recoupment of any amount he had previously paid toward the section 6676 penalty.  The section 6676 penalty literally now should not also apply to the taxpayer, since the IRS could assert a section 6662 or 6663 penalty on the same disallowance.  However, the IRS attorney did not at this late date assert the fraud penalty – perhaps not wanting to shoulder the burden of proving fraud with respect to the FTHBC penalty at the forthcoming trial.  (The case was still pre-trial, so there was not much reason to think the court wouldn’t allow belatedly raising the fraud penalty and simply converting the motion to one for only partial summary judgment.)

We are also now never likely to see the IRS include section 6676 penalties in notices of deficiency.  Now that Rand has been overruled, the IRS will instead assert either the section 6662 or 6663 penalty in notices of deficiency disallowing refundable tax credits.  The IRS will now never have to propose section 6676 penalties in that instance at all.  So, I don’t expect this jurisdictional issue regarding section 6676 penalties ever again to be litigated in Tax Court deficiency cases.  Indeed, I think section 6676 is now a dead letter in the Code, since it only applies to erroneous claims for income tax refunds that are not subject to section 6662 or 6663 penalties, and I can’t think of any instances where an income tax disallowance couldn’t now be subject to section 6662 or 6663 penalties.