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.

read more...

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.

read more...

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

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

Majority Opinion

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

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

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

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

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

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

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

Judge Lauber’s Concurrence

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

Judge Holmes’ concurrence and dissent

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

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

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

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

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

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

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

Judge Buch’s concurrence and dissent

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

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

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

Conclusion

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

 

Working Hard to Get Penalized

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

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

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

read more...

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

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

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

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

Getting a Double Penalty Benefit or Getting to the Right Result

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

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

read more...

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

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

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

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

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

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

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

 

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)?

read more...

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.

read more...

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.

read more...

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.

read more...

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.