Section 6662: Owe A Little Tax? Pay The Penalty. Owe A Lot More? Maybe Not.

Frequent commenter/guest blogger Bob Kamman brings us a post about the weird way the IRS is choosing to impose the substantial understatement penalty. He brought a couple of Tax Court cases seeking to establish some precedent in the area but the Chief Counsel attorneys handling the cases conceded and prevented him from obtaining court review of the IRS practice in this area. Because the fact pattern he has identified usually involves a relatively small amount of money, taxpayers will struggle to find representation in these cases and may find it easier to concede than to fight.  A case in which the taxpayer contests all or part of the underlying tax may provide the more likely vehicle for a test.  If you see this issue in your client’s case, consider following Bob’s example and seek to set precedent. Even if Chief Counsel’s office continues to concede the issue, maybe someone in that office will speak to the IRS about the bad practice that may be a result of computer programming or maybe just an unusual view of the type of behavior that should be penalized. Keith

I won a couple of Tax Court cases in 2018 that I had expected to lose. My clients are happy that IRS settled. But I’m disappointed, because I hoped a Tax Court opinion would at least highlight the issue. At least along the way I learned a few things. For example, there is the Doctrine of Absurdity.

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But first, some background. Suppose that you are a Member of Congress and on a committee that oversees tax laws and IRS. You think penalties are sometimes needed to encourage tax compliance. You consider two cases:

 

Taxpayer A, in a 15% bracket, wins $32,000 on a slot machine, has no tax withheld when the casino issues Form W-2G, and does not report the income on Form 1040. The IRS computer-matching system eventually discovers the omission and assesses $4,800 tax.

Taxpayer B, in a 25% bracket, withdraws $20,000 from a retirement account, requests federal tax withholding at a 20% rate, and thinking like many others that “I already paid tax on it,” does not report the income on Form 1040. IRS document matching catches this error also, and sends a bill for $1,000 because the withholding is not sufficient to cover the additional tax.

Not as someone with a sense of fairness and logic, but as a Member of Congress you would reach the same result that according to IRS was enacted nearly thirty years ago. Taxpayer A pays $4,800 but no penalty. Taxpayer B pays not only $1,000 but an additional $200 penalty.

That’s how Section 6662, together with Section 6664, operates. These Internal Revenue Code penalty provisions come up frequently, and deserve a closer look. They require findings of an “underpayment” and an “understatement,” which IRS tells us are not the same thing.

Section 6662 assesses a 20% penalty on several varieties of “underpayment.” The two seen most frequently are those due to “negligence or disregard of rules or regulations,” and to “any substantial understatement of income tax.”

IRS computers, lacking human interaction with taxpayers, don’t yet have the intelligence to make accusations of “negligence or disregard.” So the “substantial understatement” clause is invoked when proposed assessments are based only on matching information returns to a Form 1040.

And acknowledging the legal maxim de minimis non curat lex – “the law does not deal with trifles” – Section 6662(d)(1)(A) adds that on individual returns, a “substantial understatement” occurs only if the amount exceeds the greater of—

(i) 10 percent of the tax required to be shown on the return for the taxable year, or

(ii) $5,000.

In most cases, the $5,000 minimum rule applies. So you might ask, why will IRS assess a penalty to our Taxpayer A, who only owed $1,000? The answer is that no credit is given for withholding, when determining if there is an “understatement,” even though the withholding is considered when figuring the “underpayment” amount on which the 20% penalty is calculated.

At least, that is how IRS interprets the Regulations to these two sections. I am not sure the IRS understands the Regulations, nor am I confident the Regulations correctly describe what Congress enacted. Some day perhaps a Tax Court judge will reach the same conclusions.

Here is an example from a Tax Court case in which IRS decided it was not worth arguing with me. My client withdrew money from a retirement account, and had tax withheld. Because she thought the taxes had already been paid, she did not mention it to her tax preparer or report it on her return. The additional tax was $9,158. The withholding was $7,325. The difference was $1,833, which when contacted by IRS she gladly paid with interest. But IRS still wanted $367 “substantial tax understatement penalty.”

(Had the return been filed late, a penalty of $458 would also have been proposed, but under the IRS “one time free pass” policy, it could be abated.)

My client is not a low-income taxpayer but she had a high-respect government career. I did not charge a fee for filing the Tax Court petition, or for several phone conversations with a Chief Counsel paralegal (in Phoenix) who handled settlement of the case in our favor. I did furnish reasons that this case might qualify under the “reasonable cause” exception of Section 6664(c) because my client had acted “in good faith.” These arguments seldom prevail at IRS administrative levels. The settlement process took more than four months, from petition filing to stipulation signing.

And here is another example from a Tax Court case. My clients unintentionally omitted some W-2 income from their joint return. They and their preparer had rushed to meet the April 15 deadline after receiving a complex, high-dollar Schedule K-1 on April 10. The additional tax was $6,230 and the withholding only $2,012. The difference of $4,218 was not quite as substantial as the $5,000 minimum contemplated by Section 6662(d)(1)(A). Nevertheless, IRS proposed a “substantial understatement” penalty of $844, because the deficiency before withholding exceeded $5,000.

This case was settled by a Chief Counsel attorney (in Dallas) in less than six weeks after the petition was filed. I did not earn a fee on this case either, but as the preparer I avoided reimbursing my clients for an error for which I shared responsibility.

I did not have to ask the Dallas attorney for a copy of the signed managerial approval now required for such assessments. It might not have existed. In Phoenix, the paralegal showed me what the Service Center considers adequate.   I thought it was ambiguous.

In researching these cases, I came across the “Doctrine of Absurdity,” which is discussed in a 2017 Tax Court opinion, Borenstein, in which Keith Fogg of the “Harvard Clinic” filed an amicus brief. (The opinion does not state whether he supported the anti-absurdity argument, which was just one of several.) The opinion explains:

The “anti-absurdity” canon of construction dates back many years. See Rector of Holy Trinity Church v. United States, 143 U.S. 457, 460 (1892) (“If a literal construction of the words of a statute be absurd, the act must be so construed as to avoid the absurdity.”); Scalia & Garner, supra, at 234-239 (“A provision may be either disregarded or judicially corrected as an error * * * if failing to do so would result in a disposition that no reasonable person could approve.”); 2A Sutherland Statutes and Statutory Construction, sec. 46:1 (7th ed.).

The “anti-absurdity” canon, while of ancient pedigree, is invoked by courts nowadays quite rarely. In order for a party to show that a “plain meaning” construction of a statute would render it “absurd,” the party must show that the result would be “so gross as to shock the general moral or common sense.” Crooks v. Harrelson, 282 U.S. 55, 60 (1930); see Tele-Commc’ns, Inc. & Subs. v. Commissioner, 95 T.C. 495, 507 (1990) (citing Harrelson as supplying the relevant standard but upholding the plain language construction of the statute), aff’d, 12 F.3d 1005 (10th Cir. 1993).

Of course the application of the “substantial understatement” penalty to taxpayers who owe small amounts is absurd. But is it more so than many other IRS procedures? Eventually a Tax Court judge may decide that question, if Chief Counsel stops conceding before trial.

Otherwise, it’s unlikely that Congress will revisit the Section 6662 penalty procedures and make sense of a rule where now there is none.

 

The EITC Ban – It’s Worse Than You Realized

We welcome back guest blogger Bob Probasco. Bob tells a disaster story with a happy ending but we must keep in mind that the happy ending only occurred because the low income taxpayer had found her way to a clinic where she received free and highly competent representation. Other stories similar to this one exist in the system without the happy ending provided here.  

As we have written before, the time for contesting the EITC ban in Tax Court is unclear. Another possible avenue for taxpayers in the position of Bob’s client is to seek orders regarding the ban from the Tax Court. I cannot say whether the taxpayer would have obtained relief in the Tax Court but the existence of the prohibited assessments would provide a basis for an injunction which might have gotten the client to the right place. Keith

There is a film genre often referred to, because of the primary plot device, as “disaster movies.” The golden age was the 1970s, with films like Airport, The Poseidon Adventure, and The Towering Inferno. Minor actions or problems interact in ways that create huge challenges. Each time the characters survive one obstacle, losing a few members of the group in the process, a new threat arises. How many, and which, characters will eventually survive?

The tax administration equivalent is the earned income tax credit (EITC) ban.

The EITC ban process is seriously flawed, as has been pointed out frequently. Les discussed it here on Procedural Taxing in blog posts in January 2014 and July 2014. National Taxpayer Advocate Nina Olson has been complaining about it for years, with the most detailed coverage in her 2013 Annual Report to Congress. Patrick Thomas made a presentation on it (outline available on the LITC Toolkit website, if you have access) at the December 2016 LITC Grantee Conference. Les and William Schmidt addressed the specific issue of Tax Court jurisdiction over the ban in 2016 and 2018 respectively. I strongly recommend a thorough review of all of the above – including comments to the blog posts! – to anyone who deals with taxpayers who claim the EITC.

This post discusses the IRS administrative process for applying (and correcting?) the ban. It also points out how the interaction of the EITC ban process with problems elsewhere in the tax administration process can turn a serious issue into an absolute disaster. This is the story of one such disaster.

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Background

Section 32(k)(1), added by the Taxpayer Relief Act of 1997, establishes that the EITC shall not be allowed for

the period of 2 taxable years after the most recent taxable year for which there was a final determination that the taxpayer’s claim of credit under this section was due to reckless or intentional disregard of rules and regulations (but not due to fraud)

If there is a final determination that the taxpayer’s claim of credit was due to fraud, the disallowance period is 10 taxable years instead.

This is an absolute ban but there is also an indefinite potential disallowance, in Section 32(k)(2):

In the case of a taxpayer who is denied credit under this section for any taxable year as a result of the deficiency procedures under subchapter B of chapter 63, no credit shall be allowed under this section for any subsequent taxable year unless the taxpayer provides such information as the Secretary may require to demonstrate eligibility for such credit.

Treas. Reg. section 1.32-3(b) explains that

Denial of the EIC as a result of the deficiency procedures occurs when a tax on account of the EIC is assessed as a deficiency (other than as a mathematical or clerical error under section 6213(b)(1)).

And Treas. Reg. section 1.32-3(c) specifies Form 8862 as the information required to demonstrate eligibility. The instructions make clear that the taxpayer should not file Form 8862 during the years that a ban applies, but it will be required if the EITC is disallowed, even absent a final determination of fraud or reckless or intentional disregard of rules and regulations, to claim the EITC in any other years. If the form is properly completed and the IRS determines the taxpayer is eligible for the EITC, then the taxpayer is re-certified and need not submit Form 8862 again – unless the EITC is denied again.

Under Section 6213(g)(2)(K), the IRS can adjust the tax return by math error correction, rather than the deficiency procedures, if the taxpayer claims the credit during the ban period or without providing the required information for recertification. Nina Olson fought against that idea for years but it was eventually enacted in the Protecting Americans from Tax Hikes Act of 2015.

First obstacle: Location and language

Our LITC client – let’s call her “Maria” – was originally audited with respect to her 2014 return. She did a very good job of responding to the audit before even coming to our clinic. Most often, issues in an EITC audit concern proving relationship to the qualifying child or that the child lives with the taxpayer. Maria resolved those to the satisfaction of Exam/Appeals but one stumbling block remained: filing status. She filed her return as “single,” which of course should have been “Head of Household,” but the IRS insisted that she was married. Section 32(d) specifies that married taxpayers can claim the EITC only if they file joint returns. The IRS reclassified her filing status as “Married Filing Separately.” That was where the resolution bogged down, because Maria was adamant that she was not married.

Unfortunately, Maria lives in Texas, one of only ten states (plus the District of Columbia) that recognize common law marriage. She didn’t know that and she didn’t realize what the IRS was arguing from the correspondence she received. Maria doesn’t speak English and the “common law” part got lost in the translation by her son, who may not be familiar with the concept either. When she came to our clinic, we were able to explain the problem to her. We also determined that she had two arguments for claiming the credit.

First, she arguably did not meet the requirements under Texas law for a common law marriage. She had lived with her putative husband – let’s call him “Jose” – but she did not intend to be married and did not hold herself out to others as being married. We were persuaded as to the absence of intent by her obvious surprise when we explained what the IRS was saying. While corresponding with Exam/Appeals, before she came to the clinic, she submitted proof that she was not married: a certificate from the county clerk’s office that there was no record of a legal marriage between Maria and Jose. That’s not the type of evidence you’re likely to submit if you are aware of the existence of common law marriage. And if you’re not aware, that certainly suggests that you lacked the intent.

The more difficult aspect was the “holding out” requirement, because Maria and Jose had filed joint tax returns for several years prior to 2014. Jose may have held himself out to the IRS as married to Maria but I don’t think she did. She didn’t realize what the tax returns she signed meant. She thought Jose was claiming her as a dependent, not that she was presenting herself as his spouse. But it was always going to be difficult, if not impossible, to prevail on the first argument.

Our second argument was better. Under Section 7703(b), Maria could file her return as Head of Household, even though married, if (a) she maintained a household for a child who lived there and (b) she and Jose lived apart for at least the last six months of the year. Under Reg. 1.32-2(b)(2), such a return is not subject to the limitation of Section 32(d).  Jose had moved out in 2013; he was working in the oil fields in South Texas and living in his truck to save money to start a business. When he moved out, she even began paying him rent.

Second obstacle: Exam/Appeals and evidence

Unfortunately, there was no documentary evidence that Jose no longer lived there. He still received mail at the address where Maria lived and continued to use that address on subsequent tax returns he filed. You can’t get mail addressed to a truck and you can’t use the truck as your address on a tax return. There was no rental agreement or utility bill for the truck either, so the IRS could find no records showing a different address for him. So as far as Exam and Appeals were concerned, he still lived with Maria.

The IRS also was not satisfied with the substantiation for the agreement to pay rent. Maria and Jose documented that arrangement with a very formal rental agreement. (How many taxpayers would think to do that?) Unfortunately, Maria’s copy of the agreement was unsigned and it was only for a term of one year, which did not cover all of 2014. Maria continued paying rent after that but they did not think to prepare a new agreement until she was audited. Also, Maria didn’t have records of the payments to Jose, because she paid him in cash.

Maria’s case stumbled over what appears to be a larger problem with correspondence audits. During my limited time at the LITC, Exam and Appeals both appear to rely exclusively on documentary evidence. That may be understandable, given drastic reductions in staffing and the absence of face-to-face meetings in correspondence audits, but I don’t think it’s reasonable – particularly on something like this that had huge potential consequences. We offered to arrange a telephone conference (including translator) with Maria and could have put together an affidavit if they preferred that. But they just rejected the idea of testimony. Luckily, Counsel can and does accept testimonial evidence, so we were still hopeful. Unfortunately, this meant that we had to go to Tax Court, when we encountered another obstacle.

Shortly after we filed the Tax Court petition for the 2014 tax year, the IRS sent an audit notice for 2015. The same process repeated with the same result – Exam and Appeals rejected our explanations due to a lack of documentary evidence and Maria received a notice of deficiency. The IRS had frozen the refund for 2015 during the audit, so further delay did create some financial hardship.

Third obstacle: Error in a ministerial or administrative action

Once Appeals returned the docketed case for 2014 to Counsel, we submitted a declaration by Maria setting forth what her testimony would be. Within a week, the IRS attorney agreed to concede the case in full. The stipulated decision for 2014 was filed a day after we filed the petition for 2015. And in less than three months, we had a full concession from Counsel for 2015 and another stipulated decision. So, great results for Maria, right? Alas, here’s where we ran into an unrelated issue that had a very unfortunate interaction with the EITC ban.

I had never given much thought to the question of how Exam and Appeals proceed after issuing a notice of deficiency. I should have, although I’m not sure I could have avoided this problem. Internal Revenue Manual (IRM) sections 4.8.9.25 and 4.8.9.26 set forth the process when the taxpayer petitions and when the taxpayer defaults, respectively, after a notice of deficiency. It seems to be an elaborate process with many safeguards – a tax litigation counsel automated tracking system, a related docketed information management system, and checking the Tax Court website if not in those systems to confirm that the taxpayer defaulted. There is even a follow-up process for the occasional situation when the responsible employee receives the docket list after tax was assessed.

For both 2014 and 2015, we filed Tax Court petitions timely. As we all know, Section 6213(a) states in unequivocal terms that

no assessment of a deficiency . . . shall be made, begun, or prosecuted until such notice [of deficiency] has been mailed to the taxpayer, nor until the expiration of such 90-day or 150-day period, as the case may be, nor, if a petition has been filed with the Tax Court, until the decision of the Tax Court has become final.

This is a disaster story, though, so you’ve undoubtedly guessed (correctly) that for both years the IRS assessed tax and reversed the EITC, while there was a pending Tax Court case. The IRS imposed the EITC 2-year ban in both cases and issued Notice CP 79A.

Why did this happen? I really don’t know. While I was writing this post, out of curiosity I reviewed the limited number of Tax Court deficiency cases our clinic handled in our two years of existence. For all the non-EITC cases, transaction code 520 “bankruptcy or other legal action filed” was posted to the transcript consistently in less than a month after the date the petition was posted to the Tax Court online docket. But for three of our six EITC cases in Tax Court, including Maria’s cases for 2014 and 2015, transaction code 520 was posted to the transcript significantly later: 64, 212, and 221 days after the respective petition was posted to the Tax Court docket. Every process is only as strong as its weakest link – in this case, human error or delay. Someone somewhere didn’t realize that we had challenged the notice of deficiency and didn’t get the information into the computer, so the assessments – and EITC bans – proceeded for those three cases. (Our other client made it to safety relatively early in the process.)

I reported the issue of premature assessments from these cases in the Systemic Advocacy Management System (SAMS) last year, and I suspect other people have done so as well. It’s always a problem, but the consequences can be worse when the EITC ban is put into play.

Fourth obstacle: The difficulty of reversing an illegitimate assessment and EITC ban

Section 6213(a) provides a remedy if the IRS assesses or takes collection actions while a Tax Court case is pending:

Notwithstanding the provisions of section 7421(a), the making of such assessment or the beginning of such proceeding or levy during the time such prohibition is in force may be enjoined by a proceeding in the proper court, including the Tax Court, and a refund may be ordered by such court of any amount collected within the period during which the Secretary is prohibited from collecting by levy or through a proceeding in court under the provisions of this subsection.

It doesn’t provide for enjoining the imposition of the EITC ban, though. In addition, IRM 4.13.3.17 provides that errors concerning an EITC assessment can be resolved through the audit reconsideration process, although presumably this is intended to apply when the taxpayer provides additional documentation after a legitimate assessment.

Perhaps foolishly, we tried to resolve the problem for 2014 informally. I gave the IRS attorney assigned to the case a copy of the notices issued by the IRS and asked if she could have it corrected. Because she had already referred the docketed case to Appeals, she passed that documentation along to the Appeals Officer. I followed up with the Appeals Officer twice, with no response. But the problem was eventually resolved; the assessment was reversed, and the IRS mailed Notice CP 74, recertifying Maria for EITC. Problem solved, and since the Tax Court case was still pending, no harm, no foul.

For 2015, I responded directly to the assessment and Notice CP 79A. That notice presents the ban as a fait accompli; there was no reference to what the taxpayer should do if she disagreed with the IRS action. As noted above, the recertification process applies only after the ban period. The accompanying Notice CP 22E for the assessment suggested the taxpayer call if she disagreed with the changes. Instead, I wrote a letter – remarkably polite under the circumstances – pointing out that the assessment and imposition of the ban were illegal because of the pending Tax Court case and requesting the IRS “take all necessary corrective actions immediately.” Exactly one month later (which qualifies as “immediately” in any large bureaucracy), the assessment was reversed. We had filed the stipulated decision in the meantime and finally, almost six months after our letter and five months after the stipulated decision, the IRS issued a refund. This was a long time for a low-income taxpayer to wait for a refund, but better late than never.

Let’s summarize the timeline, because this is getting confusing.

2014 tax year

  • Notice of deficiency – 11/30/2016
  • Tax Court petition filed (timely) – 2/24/2017
  • Assessment/ban – 4/17/2017
  • “Bankruptcy or other legal action” posted per transcript – 5/3/2017
  • Clinic contacts Counsel and Appeals regarding the premature assessment – 6/5/2017, 6/21/2017, 7/24/2017
  • Assessment reversed – 11/13/2017
  • Tax Court stipulated decision – 1/23/2018

2015 tax year

  • Notice of deficiency – 10/16/2017
  • Tax Court petition filed (timely) – 1/16/2018
  • Assessment/ban – 2/26/2018
  • Clinic letter to IRS – 3/2/2018
  • Assessment reversed – 4/2/2018
  • Tax Court stipulated decision – 4/5/2018
  • Refund issued – 8/3/2018
  • “Bankruptcy or other legal action” posted per transcript – 8/29/2018

Fifth obstacle: Enter the math error adjustment

Just when we thought Maria’s problems were over, on 7/2/2018 she received Notice CP 12, a math error adjustment denying EITC, for her 2016 tax return. We either didn’t notice or didn’t realize the significance at the time, but when the IRS reversed the premature assessment for her 2015 tax year, it did not issue Notice CP 74 recertifying her for EITC.

There had been an assessment of tax, on account of the EITC, as a deficiency for 2015, so it met the requirements of Treas. Reg. section 1.32-3(b) and Section 32(k)(2). Of course, that assessment for 2015 was illegal and had been reversed. The stipulated decision in the Tax Court case meant there never was and never would be a legitimate final assessment or determination of reckless or intentional disregard of rules or regulations for 2015. Because there is no process to confirm the validity of the EITC ban first, the failure to recertify automatically resulted in issuance of the math error adjustment.

Luckily, although a math error adjustment can be assessed without judicial review, taxpayers can simply request that the adjustment be reversed within 60 days, although – if appropriate – it can be re-asserted through the deficiency process. Section 6213(b)(1) and (2). That’s exactly what we requested for the 2016 tax year, by letter on 7/24/2018.

And, of course, since this is a disaster story, you know that Maria also received Notice CP 12 for her 2017 tax return.

Sixth obstacle: Further delay for an audit?

The IRS mis-handled our protest of the math error adjustment for 2016. Of course. Notice CP 12 states:

If you contact us in writing within 60 days of the date of this notice, we will reverse the change we made to your account. However, if you are unable to provide us additional information that justifies the reversal and we believe the reversal and we believe the reversal is in error, we will forward your case for audit. This step gives you formal appeal rights, including the right to appeal our decision in the United States [Tax] Court before you have to pay additional tax. After we forward your case, the audit staff will contact you within 5 to 6 weeks to fully explain the audit process and your rights. If you do not contact us within the 60-day period, you will lose your right to appeal our decision before payment of tax.

That’s consistent with Section 6213(b) as well as IRM 21.5.4.5.3 to 21.5.4.5.5 (general math error procedures) and IRM 21.6.3.4.2.7.13 (EITC math errors specifically). A substantiated protest can result in just reversing the math error adjustment; an unsubstantiated protest will result in referral to Exam.

The IRS treated our protest of the math error adjustment for 2016 as an unsubstantiated protest and referred it to Exam. Perhaps they misclassified our protest because they expect a substantiated EITC protest to provide documentation regarding relationship or residence or SSNs. Our protest was based on a premature assessment and assertion of the ban, and the failure to reverse the ban imposed as a result of the audit of 2015. We certainly had substantiated our basis for that. But when you provide a type of substantiation that they’re not anticipating . . .

So we received an audit letter dated November 9th. Further delay before Maria will receive her refund. To add insult to injury, the notification of what was happening was inadequate and would have been confusing to an unrepresented taxpayer. There was no response to the protest, telling us that they were referring the case to Exam for review. That might have provided an opportunity to clarify the nature of our protest before initiation of the audit. The audit letter did not explain the connection with the math error adjustment. For that matter, the IRS did not – as specified in the IRM – abate the disputed adjustment.

I have a sneaking suspicion that the same thing would have happened when we protested the math error adjustment for 2017 as well. Luckily . . .

The rescue party arrives! Maria makes it to safety!

Our efforts hadn’t met with much success, so we contacted our Local Taxpayer Advocate office in mid October. The case advocate spent a lot of time and effort, chasing from one office to another on Maria’s behalf. He pointed out the premature bans, the decisions by the Tax Court, and the IRS policy against auditing an issue that were examined in either of the two preceding years with no change or a nominal adjustment. Even after he elevated the discussion to managers in the operating units, there was still a lot of resistance. I’m not sure he would have succeeded without the gentle reminder of the possibility of a Taxpayer Assistance Order. Just as I was finishing this post, he called us with the good news. The 2-year ban is being lifted, the two math error adjustments are being reversed, and the examination of 2016 is being closed. Soon Maria will be getting the remainder of the refunds she requested on her 2016 and 2017 tax returns.

Final thoughts

I’m getting used to the unfortunate difficulty of convincing Exam/Appeals that our clients are entitled to the EITC. I didn’t worry that much about the EITC ban because most of the time either we prevail or our clients aren’t entitled to the EITC and won’t claim it in the future anyway. I certainly didn’t anticipate how much trouble the EITC ban can cause even when we win the battle over the EITC itself.

TAS Systemic Advocacy also continues to look at these issues. They approached me after hearing about the case, before I even got around to reporting it in SAMS. Nina Olson has been fighting the problems with the EITC ban for years but still meets with resistance. Maybe this example of how much can go wrong will help in that fight. We can only hope.

The positive part of any ordeal like this is that, amid all the mindless adherence to byzantine and flawed processes, you can still encounter the IRS working the way it should: getting the right result, protecting the government fisc while also protecting taxpayer rights. In Maria’s case, those bright spots were Counsel, the case advocate at LTA, and the folks at TAS Systemic Advocacy. Without people like them, these tax issues can be devastating, not just for Maria but also for a lot of other taxpayers in similar situations.

 

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.